MarketAxess Holdings Inc (MKTX) — Q2 2016 Earnings Call Transcript

Good morning and welcome to the MarketAxess Second Quarter 2016 Conference Call. For the call, Rick McVey, Chairman and 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 second quarter results. This morning we reported strong second quarter results, driven by record trading volumes. Second quarter revenues were a record at $97 million, up 28% compared to the second quarter 2015. Record pre-tax income for the quarter was $51 million, up 36% from a year ago, and diluted EPS was a record $0.88, also up 38%. Record trading volume of $338 billion, up 38% from a year ago, was driven by a powerful combination of market share gains across all four of our core products and the near-record level of overall U.S. high-grade and high-yield TRACE market trading volumes. Our estimated U.S. high-grade market share was 16.1% in the second quarter, up from 14.8% a year ago, and estimated high-yield market share was 7.1%, up from 5.4%. Open Trading adoption continues to accelerate and reached record volume and client participation in the second quarter. Volumes continue to benefit from transaction cost savings, and the number of market participants providing liquidity through open trading protocols continues to grow. Overall, second quarter market volumes remain elevated at near-record levels, with high-grade TRACE volumes of 17% and high-yield volumes of 12%, from a year ago. We believe the increase in trading activity in these markets reflects an active new issue calendar, higher credit spread volatility, and inflow into U.S. credit from global investors searching for yield. This ongoing transformation is encouraging, as it could signal a return to higher levels of secondary turnover for credit products, with a growing base of outstanding debt that now totals approximately $8.5 trillion for U.S. high-grade and high-yield products alone.

Thank you, Rick. Please turn to Slide 7 for a summary of our trading volume across product categories. U.S. high-grade volumes were $1.89 billion for the quarter, representing a 27% increase from the second quarter of 2015, on a combination of the increase in estimated market share and higher TRACE volumes. Volumes in the Other Credit category were up 68%, as trading in Eurobond more than doubled year-over-year, and both emerging markets and U.S. high-yield volumes were up more than 45%. The second quarter marked our launch of trading in municipal bonds. And while it is early days, we are encouraged by the level of client participation. We have documented over 250 investor clients in almost 100 dealers, and over 160 firms have executed a TRACE since the launch. With two trading days left in July, we expect overall average daily trading volume will be slightly below second quarter levels, while the year-over-year volume growth rates versus July 2015 look similar to the second quarter. We expect U.S. high-grade market share to be below the second quarter levels and U.S. high-yield market share to be above the second quarter level.

Thank you, Tony. Our second quarter results reflect accelerating adoption rates for e-trading and credit products, combined with strong market volumes. This momentum continues in Europe, and we believe we are on the right track for more meaningful earnings contribution from the region. Open Trading is leading the charge for alternative sources of liquidity in credit markets. Operating leverage is readily apparent in our business model, as top line revenue growth drives attractive earnings momentum. Now, I would be happy to open the line for your questions.

Hey, guys, good morning.

Hi, Chris. I look forward to your questions.

Thanks. So, first, on the high-yield market share gains. I mean, they’ve been really strong now for a few quarters in a row, Open Trading really seems to be shining there. So I know it’s a market that’s even more liquidity-constrained than high-grade, there are few dealers. So maybe just walk us through what you think has been going on in high-yield over the last few quarters? And to what extent, do you think the pickup in share is attributable to ETF market makers and what’s going on ETF market?

Sure, happy to take that, Chris. I think it’s a combination of factors. First, as you pointed out, high-yield is a less liquid product area, and arguably an area where Open Trading can add even more value. And you see that coming through in the transaction cost savings numbers that I mentioned in the prepared remarks today, which are quite meaningful to our clients. In fact, there are many open trades that we complete, where the initial increase does not result in any dealer responses. We’re seeing that the less liquid product area happens to be where clients see more value in Open Trading. We think there’s no doubt that’s part of what’s driving the high-yield market share increases. As we’ve also said in prior calls and as you point out, growth in ETF is aligned with our business model because the vast majority of ETF market participants transact most of their volume electronically. So, as we continue to see the shift toward ETF assets under management, it does improve the market share results in high-yield and other products. Finally, I think the third factor is just growing participation. We talk extensively about the cross-selling efforts that we have to ensure clients who have historically seen good results and benefits from high-grade trading, are now doing the same in emerging markets, high-yield, and now Eurobond. So, the third factor is simply that we have many more clients trading high-yield today than we did a year ago.

Okay, make sense, thanks. And then, Rick, I’m just stepping back, I mean, how is MarketAxess working to address the pre-trade transparency issue, which I know is a top concerns for a lot of people? It seems to me that even in Open Trading, the dealers are a very integral part of that ecosystem on the buy-side for the most part isn’t ready to start making prices without receiving quotes from the dealers. You just mentioned maybe not at all times, particularly in high-yield, but can you give me your thoughts on how you are going to address that issue?

Sure, two things I would point out. First, we were the first trading platform to fully integrate TRACE data into our high-grade platform, dating back to 2002 when TRACE started. We’ve now obviously done that for high-yield as well. So all available TRACE prints are fully visible pre-trade to all dealers and clients on the platform. Secondly, we've worked very hard over the last 12 to 18 months to enhance the European system with Trax data. This was one of the primary benefits of acquiring Trax over three years ago—the ability to deliver price discovery tools to our dealer and investor clients directly on the trading platform. All available regulatory trade reports are now integrated with the trade system in the U.S. through TRACE and in Europe through Trax. We're aggregating all data sources that we have to create a composite price across more and more credit securities that is also available pre-trade. With the growing base of data from the increased market share on the trading platform, combined with TRACE, Trax data, and quotes, we create a composite price to help investors and dealers have a starting point for the mid-market in a variety of credit securities.

Gotcha. And then last one, if you breakdown your market share gains into subcategories, so I don’t know how you do it, less than a million, somewhere between $1.5 and then over the block trades. How would we see those market share gains trending by different buckets? Any color on where the growth is coming from would help?

Chris, this is Tony. On the market share gains whether you’re looking year-over-year or sequentially, regardless of how you look at it, we are taking up market share across all size buckets. What was more noticeable sequentially was in TRACE sizes of $1 million or trades and block trades. That’s where it was more noticeable, but we’re taking up market share across all categories. We have that ability with high-grade, and to a lesser extent with high-yield to get more granular, but it is across all trade sizes.

Hey, good morning, guys.

Good morning, Patrick.

Good morning, Patrick.

So taking up on your comments to the last question and talking about block trading, as we look at the competitors that are out there trying to make a push into the space. It seems like most of them are focused on the block trade experience. Can you just talk about some more solutions that you are putting out there for block trading, and maybe how they’re differentiated versus some of these competitors?

I’m happy to. It’s been a large area of investment for us over the last six to nine months to enhance our Open Trading protocols with solutions designed to limit information leakage for dealers and investors for block trades. We are seeing growing usage of both client access and private access. Client access allows dealers or investors to post access to the community they would like to on the platform. The good news in the second quarter, as we saw growing usage of client access from the dealer community as an efficient way to get trade access and indications out to their clients. Private access, something we rolled out during the second quarter, allows investors or dealers to share their orders broadly within the system in a completely private way, so that no one sees those orders, allowing us to identify and match them. We continue to believe that we have the broadest menu of Open Trading protocols in the business and importantly the largest network of clients, around 110 active investor and dealer clients on the platform, and it’s that level of participation that creates the content and increases our chances of identifying matches compared to our competitors.

Got it, that’s helpful. And then follow-up for me, we saw really a nice sequential increase in your information post-trade services revenues. And it sounds like you’re getting some traction with your market data revenues over in Europe. What are your expectations for that going forward? Do you think that this is still in the early stages of kind of growth as a revenue line item?

Patrick, it’s a good question. Information in post-trade is about two-thirds data related. So both U.S. and UK data products constitute about a third of that line item, which is tied to fixed income and equity market volume. We saw growth in the data side driven by Trax, particularly in Europe. New contract volumes in the first half of the year were greater than all of 2015. So we do see some traction there. We’ve had some Trax volume, pricing, composite pricing, and access to reference data—all contributing to the uplift. I would caution that it’s a combination of subscription revenue and one-time revenue, so projecting revenue quarter-to-quarter can be challenging. However, we’re more optimistic about our data business and post-trade business than we’ve been in the past.

Yes, and Patrick, as you know, we think about the benefits of quality data in two ways. One is the discrete data revenue opportunity that Tony outlined. The other is simply making our trading platform much more valuable for our clients. Just in the last three weeks, we released a new market summary page with real-time data from our Trax reporting and matching business that is now the homepage for our European trading platform. This is drawing significant interest from clients and dealers because it’s the best real-time price discovery tool available for European fixed income and we expect that to contribute to more clients trading on the platform and growing trading volumes. So we’re extracting value from our investment in data in both revenue and as a contribution to trading volumes.

Good morning. Thanks for taking my question.

Good morning, Kyle.

So Eurobond activity, which I say in Europe is up substantially, and it seems that a large portion of the growth here is just simply market share gains. Just wondering if you could give us some more color on where you believe those market share gains are coming from? Is it primarily from taking the share from competitor electronic platforms or is there also growth in electronic penetration in those markets in general?

It’s hard to determine, Kyle, because we don’t have access to discrete trading data from most of our competitors. Anecdotally, we think it’s probably from taking market share from clients. That said, we’re optimistic that there’s plenty of room for Eurobond and European fixed income e-trading to grow. We think that e-trading share is likely growing in Europe, especially through emerging markets, where client adoption in both external and local markets is increasing.

Okay. Thank you. I did want to turn to expenses real quick. It looks like your guidance implies a quarterly run rate for the remainder of the year at a level lower than the second quarter expense level? Tony, is it fair to say there’s a bit of a true-up in bonus comp in the second quarter?

No, Kyle.

We did increase the expense guidance here. You can see where the variances were in the first half of the year in comp and benefits, professional and consulting fees, and third-party clearing costs. When you look at the midpoint of the new guidance range, it’s up around $8 million from the midpoint of our prior guidance range. A lot of it is comp and benefits. There’s no true-up in the second quarter, but we’ve been hiring at a faster rate. The attrition rate has been lower than originally budgeted. The incentive accrual is running higher than last year and higher than what we budgeted, all due to improved revenue performance. We have significant infrastructure projects underway, which are driving year-over-year growth in professional and consulting fees, and the increase in third-party clearing costs due to the growth in Open Trading accounts. Even with these developments, we have updated our full-year 2016 expense guidance, and now believe expense will range from $178 million to $183 million.

Okay. I actually had a follow-up on just the expenses you mentioned, the clearing arrangement I think you have with brokers for the Open Trading trades for MarketAxess as the counterparty? I believe that that’s all variable, in terms of the cost you paid a broker based on your Open Trading revenue? Can you give us an update on whether or not you’re evaluating alternative options that may be better for MarketAxess and from a cost perspective versus the current arrangement?

Yes, Kyle, you’re correct. Currently, we clear through a third-party clearing broker, and we’re transparent about costs and the Open Trading revenues. Third-party clearing costs are running around 20% to 21% of our Open Trading revenues. We’re looking at different clearing alternatives and ways to be more efficient. Long term, we believe that costs won't scale the way they have or what you see in our results. We think we can drive down the per-ticket fee and also decrease clearing costs as a percentage of trading revenue. It’s an ongoing process, and we’re exploring clearing arrangements, including things like direct clearing, which may take longer. But we’re confident that we can eventually reduce those expenses.

Good morning, gentlemen, how are you doing?

Good morning, Mike.

So the question on pricing. I think earlier this month you guys introduced some pricing changes around Open Trading. It’s been quite a while since you’ve modified pricing in any way. I’m curious if you could walk us through why you’re making the changes now, especially given the rapid growth in Open Trading? And have you seen any changes in customer activity in early days?

Yes, Mike. We’re assessing the value that we deliver to clients in Open Trading, competitor levels, and different levels of participation from clients. As this is in the early stages, we will continue to tweak pricing, aiming for a long-term scalable revenue model. The modest changes we made recently align with that goal. They are not material in terms of total fee capture for Open Trading or the system, but it’s about refining and finding the right pricing models for Open Trading.

Got it. And a couple of housekeeping items here. Tony, when discussing the data revenue earlier, you mentioned that sometimes one-time revenue items can move. Were any of those realized in 2Q?

Mike, some were in Q2. The majority of the revenue growth is more sustainable, but a portion of Q2 revenue growth came from one-time items. We typically have some of that every quarter. The majority of the increase should be more sustainable.

What I’m encouraged by is that early subscribers of our enhanced data products in Europe are the largest, most sophisticated players in the credit markets. Their interest gives me confidence that this will be a growing area for our data revenue in the future.

Got it. Are you exclusively charging for the majority of the data revenue now? I know some of it helps to grow your transaction business. What’s the mix today?

In some cases, we provide access to data while clients trade on the platform. However, we are primarily reporting hard dollar revenues. Providing data promotes more velocity on the platform, which is the path we intend to take as trading revenue is a more valuable stream for us.

One last question for you, Tony, as we think about expenses this year and whether we come in at the high-end or low-end of the range. A big factor is going to be the incentive comp. Would you provide that number for 2015, and where accruals are in the first half of 2016, just to help us frame it?

Mike, I could, but I’m not going to. We’re beyond transparent. You can pull open our proxy statement, which spells out how the expense accruals work. It’s straightforward; it’s a percentage of pre-tax pre-bonus income that translates into the incentive bonus accrual. There’s no mystery to how that accrual builds throughout the year.

Our tremendous business growth is benefitting all our constituents. We’re hiring more to support growth in existing and new products, expanding margins for our shareholders, and investing more actively than ever before for our clients. We’re pleased to invest as actively as we are because of the tremendous results the business has consistently achieved.

Good morning, all. This is Marcus Carney, standing in for Ashley.

Hi, Marcus.

Hi, Marcus.

I just had a couple of questions. One, could you comment on the cross-currents in Europe kind of between the ECB's repurchase program and your efforts to increase liquidity on the European platform?

Sure. The ECB has been active over the last two to three months in their Corporate bond purchase program, as part of QE. Our estimates are consistent with what you’ve seen in other market reports. We think it’s been averaging around 6% to 7% of Eurobond volume. While it’s not currently a large part of the market, we’re seeing a significant transition in how European investors think about e-trading. We’re pleased that we’re ahead of this curve. Post-Brexit, significant European dealers have altered their business models, carrying less inventory for market-making, with fewer people doing it. The solutions we've been delivering to European clients to give investors choices on how broadly they want to send their order flow are gaining momentum, and we’re excited about that transition.

Excellent. Thank you. With respect to the new initiatives, the munis and the loans. What early client feedback have you received on these products and where do you see pools of liquidity building?

Client feedback is positive, but as Tony mentioned, it’s very early days. Signing up a client is just the beginning; technology integration and trader training need to occur. In municipal bonds, we have about 250 investors and nearly 100 muni dealers engaged. We remain optimistic that technology solutions that work for taxable credit products will also work for munis. Regarding leveraged loans, we expect a pilot version available in Q3, accommodating single dealer loan orders initially, with a multi-dealer product in Q4.

Hi, good morning.

Good morning, Hugh.

Good morning, Hugh.

I appreciate you taking my questions. I just wanted to touch upon, I really appreciate some insights you gave about adoption of Open Trading among top clients. As we think about the third of your top clients that aren’t adopting at this point, what’s the feedback that you hear regarding the challenges for them to start using Open Trading? Are there capabilities you can create that would help, or is it more a function of just internal issues they need to resolve?

I believe it’s purely the latter. There’s no feedback suggesting a lack of solutions or protocols for Open Trading. It’s a material change for investment managers. Two key requirements for investors to participate in Open Trading are the evolving interaction between portfolio management and trade execution. Early adopters facilitate better communication between portfolio managers and traders, allowing for a more fluid relationship. The second is compliance and control; many firms have strict processes around order execution, and there are technology projects needed to ensure compliance. Each firm is working on this, and we are optimistic about a broader base of participants in Open Trading a year from now.

Great, that’s very helpful. I appreciate that. One other question, as we think about entering the muni space, have you seen any change in the competitive landscape with competitors adjusting their offerings?

We haven’t seen much change. We do see messaging services that help find potential trading partners using manual execution and post-trade methods. There are also retail platforms in munis, but in much smaller trade sizes with wider bid offers. We haven’t observed significant changes in competitive dynamics since we announced our intention to enter the muni market.

Thank you for joining us this morning, and we look forward to updating you again next quarter.