MarketAxess Holdings Inc (MKTX) — Q1 2016 Earnings Call Transcript

Good morning and welcome to the MarketAxess First Quarter 2016 Conference Call. For the call, Rick McVey, Chairman, Chief Executive Officer will review the highlights for the quarter and will 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, 2015. I would also direct you to read the forward-looking statement 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 first quarter 2016 results. This morning we reported record first quarter results, driven by record trading volumes and an acceleration of market share gains across each of our four core products of U.S. high-grade, U.S. high-yield, emerging markets and Eurobonds. First quarter revenues were a record $89 million, up 15% compared to Q1 2015. Record pre-tax income for the quarter was $44 million, up 15% from a year ago. And diluted EPS was up 18% to $0.77. Our estimated U.S. high-grade market share was 14.9% in Q1, up from 13.7% a year ago. And estimated high-yield market share was 6.4%, up from 4.8%. We believe that share gains in Eurobonds and emerging market bonds were similar to the high-yield pace. Open Trading adoption accelerated and reached record volume and participation in the first quarter. Transaction cost savings continue to grow as Open Trading solutions identified more trade matching opportunities for our clients. Slide 4 highlights our trading volume across product categories. Our overall global trading volumes were $310 billion, up from $244 billion one year ago. We surpassed $5 billion in average daily trading volume in the first quarter, one quarter after reaching $4 billion in average daily trading volume for the first time. U.S. high-grade volumes were a record $178 million for the quarter, up 22% from the first quarter of 2015, on a combination of a 1.2 percentage point increase in estimated market share and a 12% year-over-year improvement in estimated high-grade TRACE volume. Volume in the Other Credit category increased 43% year-over-year as trading in Eurobonds, high-yield, and emerging market bonds each achieved record quarterly levels. We are excited about our recent launch of municipal bond trading and the opportunity to deliver broader access to liquidity and greater efficiency to this highly fragmented market. Today, we have approximately 65 dealers and 200 investor clients onboarded to trade municipal bonds and we expect this number to expand in the coming months. Based on MSRB data, we estimate that secondary trading in municipal bonds averages around $6 billion per day. We have implemented a tiered fee schedule based on maturity and trading value, and currently expect the fees per million traded will be between $350 and $400. With three trading days remaining in April, estimated high-grade market share is running above the first-quarter level. Total average daily trading volume for April is similar to the first quarter 2016 level, while market volumes are slightly lower. Slide 5 provides an update on market conditions. Overall market volumes reported by trades hit record levels in the first quarter with high-grade volumes up 12% and high-yields volumes up 9% from a year ago. The expansion of trading volume reflects the growing size of debt outstanding in the credit markets and the global demand for yield. Fixed income mutual fund flows stabilized, while dealer inventories remained well below historical levels. Many dealers have scaled back their credit market-making activities, while others have exited entirely. Our solutions are increasingly valuable in a market where the traditional providers of liquidity are adjusting to the constraints of new regulations and higher capital costs. Slide 6 provides an update on Open Trading. Open Trading volumes more than doubled year-over-year, reaching a record $37 million in the first quarter. Over 82,000 all-to-all trades were completed during the quarter compared to 35,000 in Q1 2015. Open Trading average saving volume was up 36% sequentially versus the fourth quarter. We were especially encouraged by the increasing number of unique liquidity providers or price markers on the platform, which grew to 527 firms, up from 346 in Q1 a year ago. This expanding pool of participants helped drive a 259% year-over-year increase in Open Trading price responses. In the first quarter of 2016, transaction cost savings for U.S. high-grade open trades averaged 5 basis points in yield and high-yield trades at average savings of $0.5 or $5,000 per million traded. We continue to invest in new and innovative trading protocols to expand the set of open trading solutions for our clients. Our most recent technology release includes private trade, order blotter matching to limit information leakage for larger trades as well as open trading functionality for the municipal bond market. We are encouraged by the growing success of open trading as an alternative pool of liquidity for large and growing global credit markets. Slide 7 provides an update on Europe. Our European business continues to grow with a 46% year-over-year increase in trading volumes from European clients during Q1. European client volume growth was driven by Eurobond, emerging markets and U.S. credit products trading. Data revenue was up 17% year-over-year. We are also encouraged by the rapid adoption of Open Trading in Europe with 65% of Eurobond inquiries now being submitted to MarketAxess. The ECB has recently announced plans to have investment-grade corporate bonds denominated in Euros to the asset-purchase program beginning in June. The current expectation is that most of these bonds will be purchased in a primary or new issue market. Depending on the size of the corporate bond purchases, this could crowd out private sector purchases of corporate bonds and result in a margin reduction, affecting overall secondary turnover with some bonds. MiFID II is expected to be implemented in 2018, expanding opportunities in electronic trading, data, and regulatory reporting. The regulations will require increased regulatory transaction reporting for both investor and dealer firms and will bring greater transparency to European markets. We are enthused about our growing involvement in European markets. Now, let me turn the call over to Tony for more detail on our financial results.

Thank you, Rick. Please turn to Slide 8 for a summary of our quarterly earnings performance. Revenue reached a record $89 million, up 15% from a year ago. The record trading volumes led to an 18% year-over-year improvement in quarterly commission revenue. As to the impact of the strength in the dollar, information, and post-trade revenue was up 6%, mainly driven by a 12% increase in data revenue. Total expenses were $44 million, up 15% year-over-year and reflect our continuing investment in people and systems to support our growth initiatives. Compared to the first quarter of 2015, our headcount increased by 54, with the vast majority related to newly created positions in technology and customer-facing roles. The effective tax rate was 34.7% for the first quarter. The year-over-year reduction in the effective tax rate reflects a higher percentage of income attributable to lower tax rate jurisdictions. Our diluted EPS was $0.77 on a stable diluted share count of 37.7 million shares. On Slide 9, we have laid out our commission revenue, trading volumes, and fees per million. Variable transaction fees were up 23% year-over-year, as the increase in trading volume was offset by a slight decline in overall transaction fees per million. Our U.S. high-grade fee capture is influenced by a number of factors including the duration of bonds traded on the platform, trade size, and dealer fee plan mix. The $6 per million sequential increase in high-grade fee capture was due primarily to slightly higher years to maturity and a small shift in trade size. In line with the comments made on the year-end earnings call, distribution fees were sequentially lower, reflecting the movement of several dealers to the all-variable fee plans during the fourth quarter. Now, the other credit category fee capture is influenced by the product mix between Eurobonds, emerging markets, and high-yields, and mix with enterprise. The $21 per million sequential decline in fee capture was due to several factors. We experienced higher growth in trading volumes from Eurobonds, a greater percentage of high-yield bonds traded on our spreads protocol, and the emerging market trading volume skewed towards sovereign bonds versus corporate bonds. Each of the mix changes results in the heavier weighting of lower fee capture products. Slide 10 provides you with the expense details. The majority of the $4.5 million sequential increase in expenses was due to higher compensation and benefits costs. The variable bonus accrual, which is tied directly to operating performance, was $1.7 million higher. Employment taxes and benefits were $1.1 million higher and reflect the typical first-quarter seasonality where items like employer taxes are front-end loaded. Salaries were also $700,000 higher and reflect the headcount increase and wage adjustments effective at the beginning of the year. An increase in third-party clearing costs associated with the growth in Open Trading and larger reference data spending to support new product launches accounted for the remainder of the variance. We continue to target a roughly 10% increase in employee headcount over the course of this year when compared to the year-end 2015 balance. The timing of the expected headcount increase, level of performance-based variable incentive compensation, and foreign currency movements between the dollar and pound sterling, among other items, could cause variations in the expense outcome. On Slide 11, we provide balance sheet information. Cash and investments as of March 31 were $285 million and consistent with the year-end 2015 level. During the first quarter, we paid out our year-end employee cash bonuses and related taxes of roughly $27 million, the quarterly tax dividend of $10 million, and capital expenditures of $6 million. We have no bank debt outstanding and didn’t borrow against our revolving credit facility. We initiated repurchases under our new share buyback program on March 1 to offset dilution from equity grants. During the first quarter, we repurchased 10,000 shares at a cost of $1.2 million. As of March 31, approximately $24 million was available for future repurchases under the program. Based on the first quarter results, our board has approved a $0.26 regular quarterly dividend. Now let’s turn the call back to Rick for some closing comments.

Thank you, Tony. Our first quarter results reflect a broad-base increase in demand for electronic trading solutions in global credit markets. We are encouraged by the breadth of volume and market share gains across products, regions, and client segments. The market need for open trading solutions to more easily connect buyers and sellers of bonds is becoming more apparent each quarter. Our launch of municipal bond trading is another step toward expanding our footprint to provide our clients with best-in-class technology solutions in new areas of the credit markets. Now, I will be happy to open the line for your questions.

Good morning, gentlemen. Congrats, you did it again, another record quarter here.

Hey, Mike.

So, first question, on Europe, a big uptick in the Eurobond volume in the first quarter. I think it was up like 70% sequentially, give or take. So could you dissect this growth a bit, between seasonal factors, new customer adds, share gains, anything else worth mentioning? And then, what do you attribute these gains to, because you’ve been investing in Europe for a while, so what was the tipping point for customers?

Mike, it’s really a continuation of what was started last year. You’ll recall, we did make some protocol changes at the start of last year, where we opened up the trading protocols to give clients the choice of the dealers they go out to on inquiries. We launched Open Trading a year ago. That made the difference. We have more clients engaged in Eurobonds today than we ever had in the past. We had an increase, this is just year-over-year. We had an increase of about 30% in the number of clients that are actively trading Eurobonds. So we’re delivering more value with more content on the platform. It’s driving more order flow to the platform. Some of that is driven around protocols and the data that’s exposed on the platform, but it’s a combination of all that.

Got it. And then, somewhat similar question on some of the statistics you’re providing on Open Trading. The big spike in the response count this quarter, what do you attribute that to and what percentage of your customers at this point are actually price makers?

So the 525-or-so that we’re responding on the system during the first quarter would represent approximately 50% of the active clients on the system, which we think is a very encouraging sign. And as you heard in the prepared remarks, as participation grows in the price responders, the transaction cost savings are also growing. So this is a virtuous cycle, where the more people that are in the pool, the better transaction cost savings we can deliver. What I reflect, Mike, is that the behavioral change taking place is a combination of traditional market participants that now have a new way to provide enforced liquidity in the credit markets as well as our platform enabling new participants to be more involved in credit market making than they have in the past. It was a very encouraging quarter for us in Open Trading and we’re seeing positive results across most of our product areas.

Got it. And last one for me, but muni bond trading, it’s been up for - I think up in right now for all of two weeks, so it’s a bit premature to go here. But I’d like to anyway. What’s been the initial response from customers, the good and the bad? And what kind of volume has been executed on the platform today?

Yes, it’s very early. In fact, it’s not even two weeks, Mike. It’s about six days of trading, so very difficult to draw any immediate conclusions from the activity level. The client and dealer response has been very positive. We think the first release of the municipal bond technology has been very well received. Like with all products we have plenty of ideas for upcoming releases, and the technology will continue to improve. But there are many aspects I like. It’s very simple when we look at past successes; you really need three key components. You need a comprehensive technology solution that suits the practices in that market. We are highly confident that we have that, with single security solutions, firm-offer solutions, and open trading all live for municipal bond trading. You need broad-based dealer pricing and liquidity. We already have about 65 dealers onboarded for municipal bond trading. We expect that number to grow to something like 90 to 100 over the coming months. So we have broad-based dealer interest in the product. Within that, I am very encouraged because the other thing we are seeing with munis, is that nearly half of the muni dealers that come on MarketAxess are brand new broker dealers for the company. Third, you need broad-based investor demand, and that is showing up as well with the 200 clients that have onboarded for munis with more coming again in the coming months, and early experiences with them have been positive. We don’t have specific volume information reported, but we’re trading munis every day and more clients are in testing the software and having good results. We expect that the balance of this quarter will be about laying the foundations in terms of dealer approvals for clients and the ongoing training for all the municipal participants on the buy-side and sell-side. We think we’re in really good shape; the third quarter will probably provide a better reflection of adoption rates.

Got it. Great color, Rick. I’ll get back in the queue. Thanks.

Hey, good morning, gentlemen.

Hello, Kyle.

Good morning, Kyle.

Good morning. So just first question would be on Open Trading, just a follow-up, so the market with trade count by client segment, looks like the percentage of long-only investor managers winning these trades is growing pretty substantially, so I think it was at 48% in the first quarter, up from 33% in the fourth quarter. Can you just elaborate on what’s driving that growing proportion of long-onlys winning the trades? Is it just more long-onlys getting comfortable with putting up those prices, or is there any color you can provide there?

I think it’s 48% of the volume with Open Trading that is being completed with price responders from the long-only community. Their average ticket sizes are higher than some participants on the platform, but it also reflects a behavioral change for many of them. The number of opportunities that we’re providing each day is creating a greater focus for traditional investment managers, who are discovering new ways to buy and sell bonds in the secondary market. We also see a trend where more and more traditional investment managers are hiring trading skills from the street, where people are very comfortable being opportunistic price makers and that is becoming a reality on the platform as well. There is still a lot of work to do. This is a big change for investment managers that have typically had a fairly rigid trading process and structure and historically have gone to dealers for pricing. I would not underestimate the amount of change that’s still in front of us. But sequentially, we are very encouraged by the results that we see and the investment management community continuing to move in that direction.

Hey, Kyle, hi, just one clarifying point, just to be clear on that slide; that slide is showing the volume distribution by segment, by client segment. If you look back in prior quarters with the trade count distribution, everything Rick provided in terms of color and more engagement from the buy-side is absolutely spot-on. It’s just the view was a little different quarter-to-quarter.

Okay. All right. So just another question, I guess on expenses. If you analyze the first quarter expenses you get above the high-end of your guided range. So am I right to think about this as a step function in the first quarter and that there might be some tapering off of expenses throughout the year, or should we expect the expense base to continue to grow?

Kyle, on the expenses, in the earnings press release, we did reconfirm our expense guidance. The expense guidance was $168 million to $176 million. You can’t simply take the first quarter and use that as a jumping-off point. This is a bit of an anomaly; every first quarter where you have employer taxes, 401 K matching, and other items which hit primarily in that first quarter. It’s not one where you’re going to take that number and jump off. It’s a little early to say where we’re going to fall within that guidance range. I mentioned in the prepared remarks some swing factors with employee headcount and variable incentive pay, and foreign exchange; those are all items that could swing the outcome. But I leave you with one message: we’re continuing to invest, we think the time is right with all the market structure changes going on. We’re expanding the addressable market, increasing geographic reach, and launching new products, and we’re going to continue on that path.

Okay, understood. And then just one last follow-up. Sorry, Rick, I missed this. Can you repeat what you said in terms of high-grade market share for April so far? I think you said roughly the same as Q1, but I just want to confirm that.

We actually said that the April month-to-date high-grade shares are running above the first quarter level, and total average daily volume on the system is consistent with the first quarter level.

Hi, thanks for taking my questions. Good morning.

Good morning. Hugh, how are you?

Great. So definitely appreciate some of the color you guys provided with the granularity on the municipal bond trading, pricing, fee capture, that type. I was wondering, can you just remind us again as you think about the longer-term addressable market for that product for electronic trading, where do you kind of see that? And as we think about trading maybe a year from now, is there a particular market share goal that you guys have set?

Yes, we think that a significant portion of the municipal bond market is addressable for electronic trading. It has similar characteristics to the corporate bond market in terms of very high percentages of small tickets. As you know we continue to add trading enhancements that are designed to address concerns about information leakage for larger trades. We think a significant portion of the market will be addressable by electronic trading venues. We haven’t set a specific market share target. We have internal estimates, but it’s really difficult to predict. These markets historically always take time to get clients to change their trade behavior and move toward their business electronically. I would repeat, though anecdotally as we launched this product, the feedback we’re getting from both investors and dealers is, in my opinion, the most positive we’ve ever seen. So, we’re cautiously optimistic that the adoption rate for this product could happen faster than we’ve seen in the past but we don’t have any specific market share targets to share with you today.

Sure, sure. That’s definitely helpful. And I understand it’s completely early days. But given that roughly half of the dealers that you are bringing onto the platform for munis are newer to MarketAxess, what are some of the anticipated challenges from getting people comfortable with the system and responding, and those types of things? Are there lessons that you’ve learned from other rollouts that you guys expect to aid in that? And what are the challenges you anticipate just from getting used to and leveraging the platform for these dealers?

I think two things. One part of the headcount increase that Tony talked about earlier was specific to the muni product. We’ve been bringing in experienced muni bond professionals that are working with dealers as well as dedicated investor outreach and salespeople to cover investors more broadly and understand the nuances and specifics of the muni bond market. But the other point is I would say two things: we get very high marks for the ease of use of our technology platform. All accounts, it’s very intuitive. The logic is comfortable for dealers and investors because we do try replicate the practices in each individual market. So we are confident that we will have a successful launch in terms of client and dealer usage and ease on the platform. Finally, the key driver of all this is investor order flow. We are working very hard on the investor side to get them to understand the benefits of the platform and utilize it as soon as possible.

Great, that’s helpful. Thank you. And then, just shifting a little bit towards the other category, fee capture in the quarter, you mentioned kind of within the high-yield product about the shift towards the high-yield spreads protocol. Can you just remind us what the differential is in fee capture within high-yield amongst those categories?

Sure, Hugh. There were several factors during the quarter driving the other credit fee capture down. I’ll tell you first that it was a great quarter. All the products in that group grew, so it wasn’t that we changed pricing. It was a pretty spectacular outcome. On your specific question, we have some high-yield bonds that trade on price and some high-yield bonds, mainly cross-overs, that trade on our spread protocol. Just to put it in context, the spread protocol means that the fee capture would look similar to the high-grade fee capture. Then, you have high-yield bonds that trade on price, which may capture around 3x the high-grade fee capture. So when you do have a shift, which does happen occasionally, you will see variations in fee capture depending on whether there is a larger or smaller share of price-based or spread-based transactions. The bigger change during the quarter was Eurobond; if you’re looking at the fourth quarter fee capture, and jumping off a point for estimating other credit fee capture, the influence during the fourth quarter, which had a lighter growth ratio for high-yield and emerging-market compared to Eurobond.

Yes, I definitely appreciate the color. In backing into the numbers for the others, the points were self-evident. We’ve talked about in the past the mix shift with Eurobond growing, and also with EM sovereign, and the corporate. I was just asking specifically about the high-yield category because those details should help in the analysis. I noticed that you likely saw a little bit of a downturn in the high-yield bucket and just wanted to get some color around the dynamics for that particular product category. So it’s definitely helpful to me. Thank you very much.

Hey, good morning, guys.

Good morning, Patrick.

I was hoping you could give an update on your leveraged loan initiative in terms of expected rollout or trading there. And I guess your expectations in terms of customer adoption of leveraged loan trading relative to customer adoption of muni trading?

Yes, the leveraged loan product area we said in the past, the average daily volume estimates that we have, we do just somewhere around $2 billion or $2.5 billion a day. So it’s roughly a third of the size of the muni market in terms of average daily volume. The release date has moved towards the end of this quarter or early Q3. It will have the normal onboarding issues to tackle upfront. I would guess that we are looking at Q3 for the leveraged loan product in terms of getting the foundation in place. The focus in the second quarter is going to be mostly on the municipal bond launch.

Got it. Thank you. Quick question on your distribution fees, Tony, I apologize if I missed it. But I don’t think you gave any guidance for second-quarter distribution fees. Should we probably expect those to be roughly flat quarter-over-quarter?

I think that’s a pretty good assumption. Right now, we are not tracking anything of substance. But, again, I’ll also remind you that we do provide choices to the dealers in fee plans. They are responding to the economics of the plan and changes in what they’re committing to capital and changes in the size of their debts. There is always a possibility of fluctuations. But right now, we aren’t tracking anything significant.

Good morning, gentlemen. This is Marcus Carney in for Ashley Serrao.

Good morning.

I just had a question. A competitor startup recently announced plans to offer maker-taker rebates on their electronic bond trading platform. I was wondering if you could just give us your thoughts on the competitive landscape in general and whether or not something like that would work well for electronic corporate bonds.

I’ll be happy to start with the competitive landscape in general and then your specific question on maker-taker. When you look at our sequential growth, Q4 to Q1, we added roughly $60 billion in trading volume sequentially. So we feel really good about the acceleration of share gains on the MarketAxess platform. We have seen a few volume reports in the media from some of the startups in the credit space. Anecdotally, we pick up information most weeks as well and we’re highly confident that that volume and market share growth for MarketAxess in Q1 represents a strengthening of our competitive position relative to others in the space. We feel very good about that. Regarding the new platform, we haven’t heard a lot about it. The critical aspects of reducing transaction costs for credit market participants rely on the size of the network and the technology to identify matches. Those cost savings opportunities are notable, as we discussed in our prepared comments, considering that credit differs from commoditized product areas, which is not just centered around transaction fees. It’s fundamentally about the technology, the breadth of the network, and the ability to identify matches that ultimately deliver significant transaction cost savings for our clients. What we’re seeing is that the benefit we have is due to the enormous investment in trading protocols tailored to the credit markets, which we have made over the last 16 years and continue to do at a larger level than anybody else in the space, combined with over 1,000 institutional firms that are actively trading on the platform. And that’s what ultimately delivers value to our clients.

Excellent. Thank you. And then, just a follow-up on the new initiatives. I believe last quarter you said that you expected business promotion expenses to be about $2 million to $3 million. With the successful launch of munis and slight pushback in the loans, is that kind of still the range you expect?

Yes, Marc, I think it is. We did sort of run in low some of the muni expenses. So we’re sitting here now with about 10 dedicated personnel; most of those in sales and technology and even in the support area. There are reference data and some other costs associated with that, but fully loaded, it’s probably $3 million plus. Over the course of this year, because the other will be staged, then it’s still that $2 million to $3 million number.

Hey, guys. A question on pricing. I know one area where you have utilized some pricing incentives is with open trading. So I’m curious if the success that you’ve been seeing has had any impact overall in pricing, and if you could try to quantify that for us? Just trying to understand what the continued growth could mean for pricing a couple of years from now.

Mike, this is Tony. On the pricing side, we do provide some incentives in open trading. It’s one of those things that we’re continuing to look at the pricing models and different ways of incentivizing behavior. I can’t say there is anything - if anything is imminent right now. We’ll continue to look at it and evaluate the fee plans. But nothing imminent at this stage right now.

Okay. But Open Trading to date hasn’t really moved your revenue per million in any of the various buckets yet?

Mike, on an overall basis, it really does not influence the U.S. high-grade fees per million, nor does it influence the overall fees per million. If I can, I’ll tell you that the overall fees per million, Open Trading influences may be $1 or $2 per million impact in the overall fees per million, but really it’s not influencing it right now.

Got it, great. And, Tony, I’ll squeeze one last one here. I know you guys have provided some color on April. But just given some of the underlying mix shifts in the other credit bucket, could you comment on the mix of other credit in April? Have you seen any changes or should we expect that to be relatively stable?

Mike, getting that granular right now will be a little too detailed. Also, if you’re trying to get at where fee capture is going, it’s a little early to start talking about that. From a fee capture standpoint, what we’re seeing in April is no significant difference from what we saw in the first quarter. I’m talking about total fees per million and variable transaction fees per million; not completely different. Some of that has to do with market volumes, and these products growing at different rates right now. It would just be a little bit premature to dive deep into that analysis.

Got it. That’s good color. Thanks, Tony.

Thank you for joining us this morning. We look forward to catching up with you again next quarter.