MarketAxess Holdings Inc (MKTX) — Q2 2015 Earnings Call Transcript

Good morning. And welcome to the MarketAxess Second Quarter 2015 Conference Call. For the call, Rick McVey, Chairman and Chief Executive Officer, will review the highlights for the quarter and provide an update on trends in our businesses, and then Tony DeLise, Chief Financial Officer, will review the financial results. Before I turn the call over to Rick, let me remind you that today's call may include forward-looking statements. These statements represent the company's belief regarding future events that by their nature are uncertain. The company's actual results and financial condition may differ materially from what is indicated in those forward-looking statements. For a discussion of some of the risks and factors that could affect the company's future results, please see the description of Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2014. I would also direct you to read the forward-looking disclaimer in our quarterly earnings release, which was issued earlier this morning and is now available on our website. Now, let me turn the call over to Rick.

Good morning. And thank you for joining us to discuss our second quarter 2015 results. This morning we reported strong results for the second quarter on the back of record volumes across our core products: U.S. high-grade, high-yield, and emerging market volumes. Total trading volumes were a record $245 billion, up 32% compared to the second quarter of last year. Continued strong momentum in market share gains drove our record volumes, with estimated adjusted U.S. high-grade market share up 3 percentage points year-over-year. This was the third consecutive quarter that we achieved year-over-year estimated share gains in U.S. high-grade of more than 2 percentage points. This increase in volumes and share growth contributed to our robust year-over-year revenue growth of 16% to $76 million. Pre-tax income was $37 million, up 28% compared to last year, and EPS was $0.64, up from $0.48. Volumes from European clients were up 44%. The number of active European clients continues to grow and was up 26% from a year ago. We continue to develop unique data products and post-trade solutions in the region to help our dealers and investor clients prepare for their new and extensive regulatory obligations under MiFID II. Open trading adoption rates continued at a healthy pace during the quarter, with record open trading participation and trading volumes. Slide four provides an update on market conditions. Credit spreads and credit spread volatility remain above year-ago levels. Combined U.S. high-grade and high-yield market volumes were up 6% year-over-year, down slightly from Q1. New issuance remained close to record levels with $328 billion in U.S. high-grade issuance during the quarter. U.S. high-grade and high-yield debt outstanding is now close to $8 trillion. The boom in corporate bonds over the last five years has led to a significant increase in the number of corporate bond issuers and a number of corporate bonds outstanding. This has caused the market to become more fragmented, with more issues trading each month and less concentration of volume in the actively traded 1,000 corporate bonds. The increased fragmentation in the market combined with the increased bank regulations places further stress on secondary market liquidity. U.S. high-grade and high-yield market volume in July are off to a weaker start compared to the second quarter of 2015 but are in line with July 2014 levels. Slide five provides an update on open trading. We are very pleased with the continued growth in open trading participation this quarter. Completed open trading transactions more than doubled year-over-year to 38,000, and open trading volume was $21 billion, up 153% compared to the second quarter of 2014. 375 different firms provided open trading liquidity during the quarter, up from 260 a year ago, with liquidity being provided by a diverse group of firms. 41% of market-list trades were won by traditional long-only asset managers, 35% by dealers, and 24% by alternative liquidity providers such as market makers and hedge funds. Among our most active buy-side clients, approximately 30% are regularly acting as price makers on the platform, with many more working on adapting their internal trading processes to enable more engagement with open trading. According to a recent investor survey by Woodbine Associates, 60% of respondents planned to increase their use of MarketAxess open trading, and 60% plan to break up large trades into multiple smaller transactions. Over 500 firms benefited from this new liquidity by completing an open trading transaction, representing over half of our active system participants during the quarter. In the second quarter, open trading represented approximately 10% of our U.S. trading activity, up from 5% during the second quarter of 2014. The increased efficiency and access to our extensive all-to-all trading network continue to generate significant cost savings for participants, averaging 3 basis points in yield or about $1,800 per million traded in U.S. high-grade. We continue to invest heavily to enhance our open trading protocols to provide our clients with a broad range of trading options for all trade sizes, and we believe that there is significant runway ahead for open trading adoption. Slide six provides insights into our U.S. high-grade market-share gains. We saw increased momentum in our market-share gains during the quarter. Our analysis shows a positive correlation over time between credit spread volatility and our market-share. Greater volatility in the market was one of the drivers of our record share. Share growth has been consistent across all trade sizes, and we are especially encouraged by our growing share of block trading. During the second quarter, 72% of volume traded on MarketAxess was in trade sizes of over $1 million, and 20% of volume on the platform was over $5 million in size. Our block trades account increased 35% from the second quarter of last year. Increased regulatory obligations including compliance requirements under the Volcker rule that came into effect this week are putting further pressure on secondary market liquidity, particularly for larger trade sizes. According to FINRA, in 2009 trades greater than $25 million in size made up 23% of trade volumes, and so far in 2015, trades of this size make up only 14% of trade volumes. This suggests that investors are increasingly breaking up large blocks into smaller trades. Client inquiry count on the platform was up 34% year-over-year, demonstrating growing engagement as investors seek to utilize our all-to-all marketplace to access new sources of global liquidity. Now, I would like to turn the call over to Tony for additional detail on our volumes and financial results.

Thank you, Rick. Please turn to Slide 7 for a summary of our trading volume across product categories. Our overall global trading volumes were up 32% year-over-year to $245 billion. U.S. high-grade volumes were a record $149 billion for the quarter, up 28% from the second quarter of 2014. The majority of the high-grade volume gain was attributable to an increase in estimated market share. Volumes in the other credit category were up 42% compared to the second quarter of 2014, driven by an over 50% increase in order flow. We registered record trading volumes for high-yield in emerging market bonds and continued substantial growth in euro bond trading volume. Trax and TRACE data indicate that overall emerging markets and euro bond market volumes declined by 15% or more, where high-yield market volume was up approximately 6% year-over-year. This means that market share gains more than offset the overall market volume challenges. Slide 8 displays our quarterly earnings performance. Revenues of $75.5 million were up 16% from a year ago, driven by the estimated market share gains and resulting growth in commission revenue. For the second consecutive quarter, the stronger dollar dampened revenue growth by approximately $900,000. Excluding the impact of foreign currency changes, information in post-trade service revenue, the majority of which is derived from our Trax business, was up 3%. The drop in technology products and services revenue reflects the winding down of a professional services engagement. Prospectively, we expect this revenue line item to taper modestly from the second quarter level. Total expenses were $38.4 million, up 7% from the second quarter of 2014. Absent the impact of the stronger dollar, the expense increase was approximately 10% year-over-year. Operating margin expanded more than 400 basis points year-over-year to 49%. The effective tax rate was 34.6% for the second quarter and 35.4% on a year-to-date basis. The year-to-date effective tax rate is running approximately 150 basis points below the 2014 level and reflects an income shift to lower tax rate jurisdictions and a reduction in certain statutory foreign and state tax rates. We are updating our full year 2015 guidance range and now expect the effective tax rate will be between 35% and 36.5%. Our diluted EPS was $0.64 on a diluted share count of 37.6 million shares. The year-over-year decline in our diluted share count was principally due to share repurchases. On Slide 9, we've laid out our commission revenue, trading volumes and fees per million. Total variable transaction fees were up 32% year-over-year, consistent with the growth in trading volume. Our U.S. high-grade fee tax was influenced by a number of factors, including the duration of bonds traded on the platform. On a sequential basis, lower duration on slightly higher yield and slightly lower average years to maturity accounted for the declines in the US high-grade fees per million. The sequential uptake in the other credit category fees per million was primarily due to a mix shift within this category with the heavier weighting in the current period to high-yield bonds and lower weighting to euro bonds. Distribution fees were consistent with first quarter levels. Slide 10 provides you with the expense detail. Total second quarter expenses were consistent with first quarter levels. On a more granular level, the decline in compensation and benefits was largely attributable to seasonally higher first quarter employment taxes and benefits of $800,000, offset by an increase in wages on some headcount expansion. The sequential market expense increase reflects greater spending on advertising campaigns, customer events, and sales activities. On a year-over-year basis, the 12% growth in compensation and benefits was due to a combination of higher variable bonus accruals, which are tied directly to operating performance, and higher equity-based compensation. The year-over-year change in non-compensation costs was consistent with variations over the past several quarters. Depreciation and amortization increased as a result of the significant investment in product enhancement and technology over the past several years. Professional consulting fees declined on lower IP consulting costs, and G&A expenses increased mainly due to higher clearing costs. We still expect full year 2015 expenses will be within our expense guidance range. On Slide 11, we provide balance sheet information. Cash and securities available for sale as of June 30 were $237 million, and trailing 12 months free cash flow reached $100 million. During the second quarter, we paid our quarterly cash dividend of $7.5 million and repurchased 63,000 shares at a cost of $5.5 million under our share buyback program. At June 30, approximately $48 million was available for future repurchases under the program. Our board approved the $0.20 regular quarterly dividend payable on August 20 to record holders on August 6. There was no change in our capital structure during the second quarter; we have no bank debt outstanding and didn't borrow against our revolving credit facility. Now, let me turn the call back to Rick for some closing comments.

Thanks, Tony. We are encouraged by the trends evident in our business during the second quarter. Investors and dealers are using market access for a growing proportion of their secondary trading needs. New open trading solutions are providing a much-needed expansion of the secondary liquidity pool. We see many opportunities ahead in this new regulatory environment to serve our clients with innovative technology solutions for pre-trade data, trade execution, and post-trade reporting and matching. Now I would be happy to open the line for your questions.

Hi, thank you for taking my questions. I guess touching on the non-commission revenue on the technology line, sorry I heard you say that you expect revenue to taper from here, by this exactly what was the decrease caused by and then just on the information in post-trade revenue, I know you said its some effects headwinds in the release, so I just wonder if you happen to have the organic growth rate on a constant currency basis?

Two questions there on tech service and then information on post-trade. The first one on tech service if that revenue line item, it was a combination of professional services where we were project managing for companies in our space, and there were some software licensing and maintenance in support of all of the net tech services line item. It's not a big piece of our revenue plan and today really not a core emphasis for us. We did have one, we’ve mentioned in our prepared remarks one engagement in the second quarter, we were using contractors to deliver much of that engagement. That's one of the reasons you see a decline in professional and consulting fees. And prospectively I mentioned that we are expecting that line item will be somewhere around $500,000 per quarter in the near-term. Quite frankly, we're probably going to vary that line item in other income building, as it is just not of the year event. And one more thing to note on that, this is not a high margin product or business for us. Even with the decline we did not have a material impact on earnings. You can see where our focus is; we are focused today on our core opportunity in credit. Right now, that handles the tech services piece. You did have the information in post-trading. If you're thinking about the year-over-year, the year-over-year gains, it was excluding foreign currency about 3% year-over-year. But when you take a deeper dive on that one, we had two areas within information for post-trade about 40% of our revenue is post-trade reporting and matching that is very much tied to market volume about 60% today is in data products. And when you look at year-over-year, adjusting for foreign currency, data revenue is up about 17% year-over-year, much of that was from our new data products and market liquidity products, where we saw the decline in information post-trade was in post-trade services tied to market volumes. When you look at overall Eurobond equity market volumes in that region, it was down year-over-year. So it maps a little bit -- the improvement in data revenues maps a little bit by the decline in post-trade volume.

Okay. Thanks, Tony, it's really helpful. Next on the follow-up on the post-trade line. I guess on the Axess All product in Europe, last quarter you mentioned that you would potentially reevaluate the pricing of this product in the coming months. So I was just wondering if there were any updates there with respect to either charging for the product or having plans to do so?

No real change. We are seeing growing adaptation of the Axess All real-time trade tape by both dealers and investors, and have some plans in the coming quarters to deliver that through API which will make it even more efficient for our clients. We do see consistent and growing demand for all of our volume products, which makes sense that dealers are trying to determine on a more quantitative basis, the likely demands for bonds that they may be making markets in, and clients are trying to better measure liquidity in their portfolios. So we are seeing very good growth around the volume products within the Trax data.

Okay. Thanks. And then just last one from me and I will get back in line. Just on capital, you currently have $237 million in cash in the balance sheet and built in the back half of the year. I know you previously said that you want to keep excess cash in the balance sheet just to facilitate open trading. But I guess the first question is low level; do you feel that you have enough cash to adequately support open trading if you're not there already? And then if you did have enough additional cash above that level at year-end, what would be the preferred means to return that cash to shareholders? Thanks.

On capital management and on cash; the first part of your question regarding support of open trading; we do feel that we have adequate capital today to support what we are doing in open trading. And just as a reminder, what we are doing in open trading does not affect regulatory capital, but we are cautiously holding excess capital in our regulated businesses to support the open trading initiative. We are comfortable with the cash position today, given the level of activity. We do think having healthy capital -- clients or counterparties is comfortable with taking credit. So in terms of the amount of cash we do believe we have enough to support our business. Right now, our capital management includes dividends and buybacks where we are active on that front. We have an active dividend program in place; we have been consistently paying out about a third of our free cash flow in earnings, and we are increasing that dividend as free cash flow and earnings increase. We discuss it with the board every quarter on the level of that dividend, and right now, yes we have more flexibility with that cash position growing, but we are staying the course on the dividend side. On the other side, it's the same story where we have a repurchase plan in place. It's serving the purpose of offsetting dilution from employee equity grants. We are staying on course right now with that dividend program we already have more flexibility.

Hey, good morning. Thanks for taking my questions. I guess I had a question or two on the high yield topic. It looks like from the data you presented us with that you guys saw a nice increase in high yield volumes quarter over quarter up, maybe 4 or 5%. I was wondering if you could give us a sense of how that trended throughout the quarter as we look at some of the industry data. It looks like industry data started to soften a bit during the quarter. If you could give us some clarity there.

Yes, on the high yield side, it did taper off as you pointed out throughout the quarter. We look at some volatility specifics. It looks like volatility has dipped down during the quarter. In fact, we're seeing in July that high yield trade volume is down from the second quarter level. It's not down appreciably, and it is up compared to July 2014. If we look at volatility, there is an impact there but not an appreciable year-over-year change. At least that’s what we are seeing so far in July.

Okay, and as we take a look at the kind of U.S. high-grade fee capture, I know that you mentioned that the duration was down during the quarter, and I guess it's a period where we saw the yield curve steepen. Were you guys kind of surprised at how things traded, just given that typically you would anticipate the steep yield curve would probably cause investors to go a bit longer and you to benefit there? And, you know, is there anything you're seeing right now with the duration that's solid in July?

You know, really nothing to speak of. There may have been a slight steepening of the yield curve. That doesn't always have to affect immediately and directly client trading behavior. The change sequentially lately, the $8 per million change, mentioned that it was a slight increase in yield and a slight decline in years to maturity. Those years to maturity are still within the post-crisis range of bonds traded on our platform; it was still close to 8 years, and not a big change there.

Ok. And then, on the Euro bond activity, obviously you've seen a meaningful increase year over year in part because of some of the share gains you guys have enjoyed. Do you look like, you know, that it was down on a quarter-over-quarter basis where we were seeing a softening in activity for year gone for the industry? But, I was wondering, can you talk about what you're seeing at other competitors as you guys have made changes to the platform? Are you seeing reactions from your competitors, and are you seeing any differences in trading activity as a result of some of their changes?

Not really. We're pleased with the results that we had in the second quarter; there was a modest shift in the product mix traded by the European clients on the MarketAxess system. But the 44% volume gained year-over-year feels like very good progress to us, and the number of clients that are engaged in using the system each month and each quarter continues to grow. So, it really feels like we are on the right track. With respect to competition, we haven't seen anything terribly new from the incumbents; they are forming new platforms in Europe, as you are aware, just like we see in the US but we are not really aware of whether those new platforms are gaining any significant traction.

Good morning. Rick, I just want to get a sense if there is a noticeable difference in the geographic adoption of open trading. I mean looking at your European and US clients, what does the pipeline of new liquidity providers look like?

Sure, it's hard to tell really because we are in the early stages of open trading in Europe. We are seeing growing adoption from European clients; they trade U.S. high-grade as well as emerging markets products, which is consistent with the pattern that we’ve seen in the US. With respect to Eurobond, it's very early because we just really launched open trading about three months ago, and more clients are documenting with MarketAxess each week in order to be able to utilize those tools. The anecdotal feedback we’re getting is very positive because you could probably say in the past that it's been even more challenging in Europe than in the US, but it's still difficult to make a comparison directly given the early stages that we are in Europe.

Okay. Then on this stress test, what do you think that they could potentially do to accelerate market structure changes? What are you hearing from both clients directly this year?

We’re hearing consistently from the large investors that they’re meeting more regularly with regulators to talk about liquidity stress testing within their portfolios. Basically, what the regulators are trying to better understand is whether investment managers have sufficient liquidity in their portfolios to meet various redemption scenarios. Our sense is this is still in very early stages, but it’s a great sign that the regulators are spending so much time with industry participants to better understand those trends. We see investor managers taking a variety of steps to prepare for any redemption scenarios, from adding liquidity to their portfolios to using electronic trading to a greater extent, which is closely reflected in our market share gains. There are signs that they are using ETFs more actively as additional liquidity in their portfolios setting up backstop lines, so there are various steps that we know investor managers are taking to ensure that they have sufficient liquidity in their portfolios to meet potential redemptions.

Okay. And then on the increase in block trading, it's picked up nicely over the past few quarters. Just wanted to get some cover on what's driving the uptake and whether you’re seeing any client-to-client blocks being transacted here means actively or it's still mainly dealers driving the bus?

It's a little bit of both. We are seeing block trades crossing from client to client but capturing in open trading with non-traditional liquidity providers, and we’re seeing more electronic increases from investors on the block trading side that they are using with the dealers. Quite also, we consistently see that the price responses are even better in block trading and what we’ve seen in round sizes. So, if we have block trades, the liquid advantage and that reduction in transaction costs is equally relevant for clients trading on blocks, as it is for smaller trade sizes.

Good morning, guys. Congrats on the strong Q2. Following up on the block question, what is the market share that you have right now of block size trades? And what is that trend look like if you could give a map force?

Yeah, Mike. Right now on the block trading, and this is where we define it as over $5 million in trade size, it's right around 8%. So, I think, I cost normally because we have just continued reporting around that if you listen to the way which condition remains, around 8%. That’s is, it is growing consistent with the growth in market share across our other sizes, but it’s quick mention in the prepared remarks and buckets. If you look back over the past four years, block trading market share has more than doubled over the past four years. There's been consistent growth in block trading, we're doing better there. We think we have protocols to address trading in larger trade sizes, you know, the bigger piece of what we're doing today. I mentioned in my prepared remarks Mike that block trade year-over-year, trade count was up about 35%, so we're gaining share at a slightly faster pace in blocks than what you see overall in high-grade.

And then last one for me, just want to talk about some of the liquidity concerns in the market. There were some reports that back in June, FINRA had hosted a meeting with credit traders to discuss delays to TRACE trade reporting for block size trades. So I mean if you have any insight, do you mind commenting on the meeting and maybe the likelihood of such a delay being implemented? And then second, what would this mean for MarketAxess? Because I know you guys have talked about TRACE helping grow your business.

Sure. I think that the consistent theme, whether you're talking to large dealers or large investors, is that they believe that some delay in the reporting of the largest blocks would be helpful in secondary liquidity for large block trades. I have voiced support for that. If you look at trade sizes over $10 million in high-grade corporate bonds, the transactions are only about 300 trades per day or about 1% of TRACE trades. If it would help the market with secondary liquidity, it has some delay to allow market participants to manage their risk on those very large trades. I think that would be a positive step for the industry. It doesn’t sacrifice the positive steps that have been made in transparency in the U.S. markets by FINRA through TRACE because 99% of the trades would still presumably be reported in real-time. Quite honestly, the theme was consistent as I mentioned between dealers and investors, but as you would expect, the regulators have plenty of questions about how that would impact market knowledge of what's taking place through the day, volume and various securities, pricing in securities, end of day closing prices, etc. So I don’t think that there will be any quick changes on this, but it is one of the topics being discussed in terms of how the regulators may be able to contribute to better secondary market liquidity.

So this morning I saw a news article that said that Bondcube, one of the startup competitors in the space, just shut down; basically, they weren’t getting any traction and they weren’t getting enough funding to keep going. So that's just, and I think it's consistent with your commentary that a lot of these new startups are really struggling to get traction, but just be curious to take -- when you're having dialogues with your customers, what is their tone in terms of all these new competitors kind of knocking on their doors and trying to get in there and try out their platforms?

I think the institutional market is struggling with bandwidth. There are so many new entrants trying to get client adoption, and in the early stages of even signing up clients, that I think both investors and dealers are struggling with the bandwidth to embrace many of the new platforms. As I mentioned in the past, it's not an easy decision. I think people have to assess the liquidity benefits of any platform, but then they have to work through legal agreements, they have to think about the clearing on the platform, they have to go through technology due diligence, and they have to ultimately get either their trade capture system or their OMS connected to the platform. This is not a quick decision, and as a result, those platforms that have no trading activity and limited connectivity today, I think are having the hardest time with that adoption given the number of new entrants in the market.

Next on Europe, so you guys have kind of been disruptive to the status quo in Europe and opened up the platform to more than just three or four dealers, and you obviously had success there. How easy is it for your big competitors, and by that I mean trades like Bloomberg, how easily can they replicate what you have done in terms of market structure? Because obviously they’ve seen your success and that's probably the way the market is heading.

I think it's difficult for us to comment on what their strategy might be. From a technology standpoint, it's relatively straightforward should they choose to increase the number of dealers that investors can access on any electronic inquiry. The far more difficult piece in my opinion is moving towards open trading and all-to-all, which is something that we’ve been investing in for many years and continue to invest in heavily every quarter. So simply changing around the number of dealers is fairly straightforward, but the next step is undoubtedly a bigger one.

So I guess recently there has been a pretty high-profile debate about the impact of bond ETFs on market liquidity and what happens in a rising rate environment. I think that you made some really public statements about that last week. Do you kind of have a take on that subject? Do you think that the growth of ETFs and fixed income has contributed to some liquidity issues that people are worried about?

I actually think the growth in ETFs has been positive for market liquidity. It's a standardized form of being able to trade a basket or index of bonds that can be traded either in shares or by the APs and the dealers of the trading, the underlying assets. So we see it as a positive contributor. The ETF business continues to take inflows at a very healthy clip, so the assets are growing. I think the only way that changes is if there is a material increase in interest rates or default rates that are far in excess of what we’ve observed over the last three or four years, neither of which seems all that likely in the near term. We see open trading as a piece of the very positive evolution of ETF's secondary market liquidity. You see the APs active in our open order book every day. So they have more volumes and more trade opportunities to manage. There are businesses and provide liquidity that's critical to the functioning of the ETF market, and they have never had more before. We see this as a real positive and it certainly is becoming a more significant part of what we see on the trading system and also in open trading.

And then lastly from me, so you talk about how the sequential increase in other credit fee capture per million was a function of mix shift, but within the individual lines high-yield emerging markets and probably euro bonds, how has the pricing from those products trended over the last year or so?

The only, so that other credit category is dependent on the mix shift within those three products. And you are right; there is some dynamic even among the products. And so the only one that has been noticeable has been in emerging markets, where our volume is a combination of emerging markets sovereign bonds and emerging market corporate bonds, and what we’ve seen over the past year has been a shift towards sovereign bonds. That has caused you waiting for sovereign bonds for us. That means that the fee capture is lower on sovereign bonds versus corporate bonds. So we have seen a decline in that particular part; we have seen a decline of somewhere around 10% in the fee capture on that particular product. Again that's also to do with the mix within it, not the retained pricing plan.

Now that open trading has grown nicely, do you have any revenue number to attach to all your open trading volume?

We don't break it out specifically for open trading, but we’ve said in the past that the fee capture for open trading is similar to the fee capture for traditional clients as dealer trading. As I said this morning, it represents roughly 10% of our activity in the U.S. products currently.

Okay. And for open trading, how much trading would you say that is now occurring on open trading that is truly incremental to the platform versus if that change in execution did on your platform?

I think it represents almost entirely incremental liquidity on the platform, which is one of the factors that I am convinced is driving our order flow and our market share up at a faster pace. These are non-traditional counterparties that are meeting in the open trading order book, and when two parties can find a natural match in the open order book, it is driving really important transaction cost savings to both parties. So this is incremental liquidity, it's new counterparties, it's adding to the secondary market ecosystem. And the best news, in my opinion, is that we are still in very early innings. As I mentioned, the participation rates are growing, but we still see about 30% of our traditional asset management clients actively participating in open trading, but most of the rest are telling us that they are doing the work so that in future quarters they too can take advantage of the trading opportunities within the open order book.

Thank you for joining us this morning, and we look forward to catching up with you next quarter.