Chicago Board of Options: A Buy on Takeover Speculation?

The Chicago Board of Options (CBOE) is a major options exchange in the US. It is also smack in the middle of swirling rumors surrounding how other exchanges will respond to the Deutsche Bourse/NYSE (NYX) tie up. While expensive on a P/E ratio, CBOE has strong prospects going forward, both in CBOE's exclusive rights to list certain index options and in its new C2 all electronic exchange. Throw in some takeover speculation and CBOE shares are an interesting option.

The biggest thing CBOE has going for it is the exclusive rights it has to index options on the S&P 500, S&P100, and DJIA, as well as its Volatility Index, or VIX. These index options are much, much more lucrative to CBOE then regular single equity options, due to CBOE having exclusive listing rights. In the 4th quarter of 2010, the rate per contract, or RPC, of index options was $0.59, compared to $0.177 for equity options. More importantly, volume in Index options was up 21.2% in 2010 over 2009, compared to a 9.7% decrease in equity option volume, leading to expanding margins at CBOE.

Compounding that gain was a more than tripling in average daily volume (ADV) in its Futures division, which is the exclusive place to trade VIX Futures, going from an ADV of 5,000 in 2009 to 17,000 in 2010. Futures RPC for 2010 was $1.723, so the Futures segment is rapidly becoming a huge driver. CBOE expects ADV in Vix Options to increase 59% in 2011 vs, 2010, and Vix Futures volume to more than double. Strong volume gains in exclusive, high RPC contracts like the index options and Vix Options and Futures make CBOE an attractive potential acquisition, and the lack of competition in these products should command a premium valuation.

CBOE's new all electronic exchange, C2, was rolled out in October of 2010. ADV so far in 2011 is 153,000 contracts a day, which, while impressive since the exchange is merely a few months old, is a very meager number at less than 1% of the US options market. However, CBOE is planning on launching S&P 500 index products on C2 in 2011, and that should cause an explosion in volume. As C2 continues to ramp up volume and list all of CBOE's products, expect volume to climb substantially from where it is now. Electronic exchanges are highly profitable and grow rapidly, so there is huge potential for gains as CBOE expands C2 in 2011.

Neither of the two points listed above are new, and have failed to cause shares of CBOE to rally. The shares have rallied as consolidation has re-emerged in the industry, sparked by the LSE bid for TSX and the DB/NYSE tie up. CBOE, with a market cap of $2.6 billion, is seen as a target, not buyer. Fuel was added to the fire with reports the board was open to the idea of "strategic transactions," viewed as code for a buyout. The Nasdaq (NDAQ) is seen as the exchange most desperate to react to the DB/NYSE bid, and each day there is a different report about of how Nasdaq, the CME Group (CME), or the Intercontinental Exchange (ICE) will react. A common theme in media reports is CBOE being a target, and all that chatter is the reason for the run of about $5 in CBOE shares since industry reconsolidation began earlier in the month.

Expect rumors to continue to swirl, adding a bid under CBOE shares until all the drama plays out. I would not expect CBOE's board or shareholders to accept a bid less than its IPO price of $29 done in June last year. Based on earnings of $1.03 per share in 2010, shares are currently trading at a lofty 29 times earnings. Bulls would be quick to point out that CME paid close to 40 times earnings when it purchased CBOT, and closer to 35 when it purchased Nymex. Bears would argue that both those deals were done prior to the financial crisis, and that those premiums were given in an era of cheap liquidity and a buyout boom.

That being said, CBOE shares are trading as if the days of independence are numbered. CME, ICE, and Nasdaq will all be forced to make a move if the DB/NYSE deal goes through, and CBOE is low hanging fruit. Price will be an issue, but a desperate Nasdaq may be willing to overpay now to secure its independence. The space is once again consolidating, and with CBOE as a small company with high margin products, expect it to be swallowed up. Look for shares to get back towards the 52-week highs of $34 as all the drama plays out, and to fall back towards $24 if CBOE is passed over.

Disclosure: I am long CBOE.