MarketAxess Holdings Inc (MKTX) — Q2 2018 Earnings Call Transcript

Good morning. And welcome to the MarketAxess Second Quarter 2018 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 beliefs regarding future events that, by their nature, are uncertain. The company's actual results and financial conditions 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, 2017. I would also direct you to read the forward-looking statements 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 2018 results. This morning we reported strong second quarter results, driven by increased trading volumes, year-over-year market share gains across all four of our core products, and record open trading activity. Overall trading volume of $421 billion was up 16% year-over-year. Our estimated U.S. high-grade market share of 17.4% was up from 17% last year. Second quarter revenue of $107 million was up 11%, compared to Q2 2017. Operating income for the quarter was $52 million, up 6% from a year ago, and diluted EPS was up 7% to $1.07. Open Trading adoption continues to accelerate and reached record volume of $89 billion, up 57%. Additionally, emerging market and Eurobond volume both saw rapid growth during the quarter. Overall secondary trading conditions were less favorable in the second quarter versus Q1. Credit spread volatility and interest rate volatility both declined, and high-grade new issue volume was up. That combination in the short term creates a more difficult environment for market share gains. The flattening of the yield curve tends to reduce average years to maturity of bonds traded on the platform. This negatively impacts our high-grade fee capture. Strong results during the quarter in other products helped to offset slower than normal growth in high-grade. Open Trading represented 21% of our volume in Q2, up from 16% last year. Over 256,000 Open Trading transactions were completed in the second quarter, up from 155,000 in Q2 2017. Liquidity providers were price makers on the platform and drove 802,000 price responses, representing a 45% increase in activity in the second quarter. Liquidity takers saved an estimated $38 million in transaction costs through Open Trading on the system, up 71% from the second quarter last year. Importantly, Open Trading volume is growing rapidly across all four core products as dealer and investor clients embrace this new source of liquidity. Our international business experienced another quarter of rapid growth. MiFID II continues to have a positive impact on client trading behavior, leading to a 27% increase in volume with European clients. Eurobond volumes from European clients were up 34% year-over-year. Emerging market volume was up 27%, with strong growth in both external debt markets and the 24 local EM markets where we currently operate. We now have over 600 international client firms active on the platform, representing a 17% increase in the number of institutions year-over-year. Our growing footprint in international credit significantly expands the long-term growth opportunity for our shareholders. Now let me turn the call over to Tony to discuss the financial results in greater detail.

Thank you, Rick. Please turn to Slide 8 for a summary of our trading volume across product categories. U.S. high-grade volumes were $231 billion for the quarter, up 13% year-over-year, primarily due to an 11% increase in U.S. high-grade TRACE market volume. We completed approximately 5,200 block trades during the second quarter. However, the tailwinds from major short data paper selling programs experienced in the first quarter did not repeat in the second quarter, and new issuance was fairly robust in Q2. Volumes in the other credit category were up 23% year-over-year, while estimated aggregate market volumes for emerging markets high yield and Eurobonds was down 7%. Market share gains were the main driver behind the 32% growth in Eurobond volume and 27% growth in emerging markets volume. Healthy growth in client engagement is evidenced across each of our core products. We now have over 1,450 client firms active on the platform, an increase of over 300 in just the past two years, and we have almost 850 clients trading in three or more products. Overall revenue was up 11% year-over-year. The 16% increase in trading volume drove commissions 10% higher. The effective tax rate was 23.9% in the second quarter and 22.6% year-to-date. Our diluted EPS was $1.07 on a fairly stable diluted share count of 37.9 million shares. On Slide 10, we have laid out our commission revenue, trading volumes and fees per million. Total variable transaction fees were up 2% year-over-year as the 16% increase in trading volume was offset by the impact of our new high-yield fee plan implemented in the third quarter and revisions to the Eurobond fee plan together with the mix shift within certain products. Segment expenses were up 16% year-over-year, leading to a 6% increase in operating income. Looking forward, our full year 2018 expenses are projected to fall in the lower half of the guidance range of $220 million to $232 million, inclusive of approximately $8 million in duplicate rent expense.

Thank you, Tony. We were pleased with the overall growth in trading activity during the quarter. Most importantly, we are seeing good progress on long-term growth priorities, including Open Trading and international expansion. The increased investment in trading automation by both dealer and investor clients is a clear sign that the future of electronic trading in credit is bright. Now I'd be happy to open the line for your questions.

Hi, good morning. Excuse me. So first question, I guess, is on probably like you noted some of the micro-lot, fixed assets, you said you're having there, I think it’s mostly on the institutional side, obviously, but there are some retail assets you looked that last year, they didn't end up winning. But at that time, it sounded like there was analysis done regarding this build versus buy mentality for the retail space. And it sounded like you may be kind of looking at developing some point to quick the trade functionality for – to introduce this year. Just wondering has that been an investment priority this year? And then is there something you anticipate rolling out more directly in the retail space, I guess, over the near to medium term?

Yes, that’s a good question, Kyle. Thank you for that. I think we're very comfortable that our liquidity pool is among the most competitive for micro-lot trade sizes. We have not prioritized the investment in the retail segment in the first half of the year, but we continue to look closely at that opportunity that would involve some modest tweaks to the technology platform to suit the retail client segment and some improved focus on sales and marketing towards that community. We are engaged with market makers and increasingly talking to participants in the retail segment, which we think is a long-term opportunity for the company to look at how we could enter that space organically.

Okay, fair enough. The second question will just be on Open Trading, just given the record percentage of your volume in the quarter at 21%. Can you just talk about, I guess, longer-term, what internally, like what targets do you have? Or where do you think that can go as a percentage of your total market – of your total volume? And then I guess, what kind of timeframe do you think it will take you to get there?

I don't know whether we have a specific target on where Open Trading percentages will go. Our focus has always been on broadening and deepening our liquidity pool to better serve our clients. The best part of Open Trading is that it's the most important thing we've done to add new liquidity, broaden the liquidity pool, and improve execution quality. Judging by the rapid growth in the last few years, we would expect Open Trading to be a significantly higher percentage of our volume. That said, dealers continue to be a very important part of the liquidity pool, and we expect that to be the case, especially in larger trades and less liquid bonds. So there will always be a balance between traditional clients and dealer activity on the platform and Open Trading activity.

Okay. And then last one from me. Just to follow-up on Open Trading. You gave a breakdown of Open Trading penetration between your different products. It looks like the Eurobond and EM uptake of Open Trading continues to grow quite rapidly from a lower base than some of the other products. Can you just talk about what's changed there in each of those buckets in EM and Eurobonds in the past year, whether it would be regulatory changes driving increased adoption, or protocol changing? I think you introduced may be local EM site. But yes, could you kind of highlight what's changed and what the outlook is there? Thank you.

Yes, thank you for that. I think we mentioned in last quarter's call that we made some technology changes in Open Trading for Eurobonds. That has made it easier for market makers to respond to Open Trading orders, and we've seen the benefit of that through greater Open Trading activity in Eurobonds. On the EM side, I think it's just organic adoption as the quarters roll on. Dealers and investors are seeing more trading opportunities available in EM in the open order book. The behavior is changing, and we're seeing better price responses coming back. Most of it is in external debt. It is very difficult to solve the riddle around trade settlement in many of the EM local markets, but we are working through that one market at a time.

Yes, good morning, Rick. Good morning, Tony.

Good morning, Rich.

Good morning, Rich.

So not to beat this anymore, but tremendous success with the Open Trading. And I guess, what surprises me, and this is reflected in the other numbers as well, but as the previous call said the penetration, but your volume in Open Trading was up quarter-to-quarter off the robust first quarter levels. So I guess, my question is how much – what's driving – from the first quarter to now, there had to be some changes to get this penetration, like what's the incremental change that actually saw your penetration go up so much, your volume go up in Open Trading when overall volume was down, I think, 9%, 9.5%?

I think it's a sign of growing acceptance of all-to-all trading in credit. It's really all cylinders contributing to the sequential growth that we announced this morning, Rich. The dealer community is using Open Trading more actively for their own source of liquidity. It's an increasingly valuable tool for them to turn their balance sheets over more rapidly and move bonds off their balance sheet that may have become aged. Investors are responding to more trade inquiries as they see opportunities rolling through. The third piece is really the increased use of algos, whether it's a disclosed inquiry or anonymous inquiry. All three pieces are combining to create a much more valuable marketplace and source of liquidity for both our dealer and investor clients.

And again, not to get too deep into this, Rick, but, but the volume being up, but if you look quarter-to-quarter, again, the price responses were down. The 802,000 price responses down from 820,000 so we may be getting too far in the weeds in this. But just a last follow-up on this is block trading as a lower percentage – was it also the size of trades block trading being a lower percentage 2Q versus 1Q that helped Open Trading?

Yes, that could be a piece of it too. I think that's a reasonable observation. As I mentioned, I think, a very modest decrease in price responses had much more to do with market conditions than anything else. The second quarter was significantly quieter than the first. And we were the beneficiary of better interest rate and credit spread volatility in Q1, creating the best block quarter that we had ever had. That was not the case in Q2. You saw much lower levels of volatility in both credit spreads and interest rates. So it was just a different quarter, and I think that was the primary driver of slightly reduced trading activity levels across the platform and slightly fewer price responses.

Got it, and just one last regulatory, I guess, sort of follow-up or question. During the quarter, the SEC Commissioner Jackson, who I know you know, talked in – I think he was quoted saying that the fixed income markets were – had conflicts of interest hidden costs and were – just did not provide a level playing field. You're on the fixed income advisory committee. And I guess, the question is, how much action – or what could we expect in the second half of the year in regards to regulation or, let's just say, the next 18 months in the fixed income markets since you are so close to it? And how would that – do see that benefiting market access and the electronic platforms?

Sure, well, thanks for that. The subcommittee that I chair on e-trading and trading and technology made the recommendation to the SEC to revisit and consider modernizing the regulatory framework for fixed-income e-trading, which is currently fragmented. The institutional market favors RFQ protocols which do not fit with the current ATS framework whatsoever. We are primarily regulated as broker-dealers, and there is an important need for the SEC to focus on fixed-income e-trading to ensure that the regulatory framework is consistently applied across all platforms. I expect that this topic will be focused on in the second half of this year, which we view as a good thing for the e-trading markets in fixed income.

Hey, good morning guys. First I was hoping, if you could speak to some of the puts and takes in your information services and post-trade services revenues in the second quarter? And what your expectations are going to be like for the remainder of the year?

Sure, Patrick. Probably sticks out more on the post-trade services side. In the prepared remarks, I was commenting year-over-year on what drove that change, which is really due to MiFID II related services and new customers associated with that. When you look at sequentially, post-trade services was down around $1 million sequentially due to a combination of factors. Looking forward, we do expect over the next several quarters, the quarterly run rate will improve beyond what you saw in Q2.

Great, thank you for that detail. I guess, you guys touched on block trading a little bit, but I don't know if I caught what your market share of block trading was in the second quarter?

Yes, so Patrick, we didn't state what the block trade number was, but you recall in the first quarter we were a little bit shy of 11% in the first quarter. And in the second quarter, we were just a little bit north of 9%. Really the main driver there, in the first quarter around the interest rate movement, principally right in the middle of the first quarter, there were a number of short dated selling programs in the marketplace. We did not see a repeat of that in the second quarter.

Okay, great. And I guess, maybe a final question, a bigger picture question. So we've seen a lot of growth. It would seem like in some of the retail-oriented trading platforms, the ones that had the streaming executable trading quotes. And I think there is some data that suggest that the quotes are actually reasonably small, although maybe there is not a whole lot of depth of book at the inside quote. Do you think we're at a point where the market structure is ready for streaming quotes to move up market and for institutions to be able to be willing to trade off of that type of protocol? Or do you think that request for quote is going to remain the dominant trading protocol for some period of time?

Yes, it’s a good question, Patrick. It's – I think you're seeing increased automation and trading at all levels of the client spectrum. Our understanding is that the retail and ATS system, the average trade sizes tend to be around $30,000 or $40,000, so it’s a very different business than what the institutional platforms operate today. Most of what is streaming are offers on those platforms. The bid type tends to be more RFQ. To date, the evidence shows that for the institutional market, they see more competitive pricing through RFQ protocols. We do have that micro-lot liquidity base, and if market makers and clients believe that they're ready for a full live environment, that is something that we have to be prepared to provide.

Good morning guys.

Good morning Chris.

Thanks for the color on July in terms of the market share. I was wondering if you could give us maybe a little bit more flavor in terms of how the environment's shaping up relative to 2Q. It looks like volumes according to BondTicker for high-grade and high yield are down decent amount, but obviously, the July 4th week there. So any color just in terms of the July environment and maybe how the month has been progressing whether it's starting to pick back up again in the back half of the month or it's just consistent with the course of the month?

Sure, Chris. So it's been pretty typical July from a market volume standpoint. The tepid trading around July 4, every year, we have that same anomaly. Right now, we're looking at U.S. credit; looking at high-grade and high-yield market volumes compared to last year at the same point in time, they are running about 5% lower right now. But I would caution that we still have five trading days left here in the month. Not that I would guarantee anything, but we could expect that more than a quarter of the volume is still ahead of us. The new issue calendar really in that first week was shut down, but we've seen from the last two weeks a much healthier new issuance.

Just to expand on that a little bit, Chris, over the medium term, we're watching the great unwind of quantitative easing around the world. The Fed has stopped their quantitative easing program, and it will be interesting on the treasury side because the Fed is no longer buying treasury bonds, and the treasury is about to start issuing a lot more bonds. I think that the likelihood is that the market environment will improve as we see this gradual unwind of quantitative easing.

Thanks. One thing that caught my eye recently was recent reports just a news article about liquidity, particularly over in Europe, and corporate bond markets being a bit challenged, could be using more derivatives there in the credit markets. Wondering how your – like whether you've seen similar action and how you guys are thinking about the impact of that theoretically on you guys?

Yes. In some of the European government markets, the futures contracts have more liquidity than the underlying cash market. It hasn't really been the case on the credit side. We did see slightly lower volumes during Q2 due to lower volatility, but we don't really see the same impact on the credit side.

If you look at EM year-to-date, there has been more caution in the EM markets over the course of this year. Our best estimate is that EM volumes year-to-date are down 7% or 8% from where they were in the first half of last year.

Got it. And just a quick numbers question. Compensation declined sequentially from the first quarter. I'm assuming lower variable comp and obviously some seasonality. But I'm guessing hiring kind of continues, how do we think about the trajectory of that line moving forward?

Yes Chris, when you look at sequentially, you're right. It was lower variable compensation directly tied to operating income. We are tracking about 30 new hires expected to start in the third quarter, and you would expect some uptick there.

Great, thanks guys.

Hey guys, good morning.

Good morning Chris.

In the second quarter, I guess, I would have thought that with the volume on some of the big high-yield ETFs growing pretty nicely in the quarter that market share in high yield would have been up a little bit more. I know there's always a lot of puts and takes, but maybe just put that in perspective for me?

Chris, on the high-yield side, what we saw on our platform was a little bit less of a bid wanted market. We do better when the order flow leans toward bid wanted. We did see volatility drop in the high-yield market. The ETF community is an important element of our high-yield business, and the percentage of their volumes overall did decline in the second quarter.

Okay, that helps, Tony. Just one bigger picture question. Rick, I want to get your thoughts on some of these fixed income data aggregation platforms, so ALFA probably being the best known one. Obviously, really early days, but how do you look at the kind of the long-term competitive risk from those? And in other words, is it, in your view, really important to own the trading desktop?

Yes, there is quite a bit of movement on data aggregation across the industry. We're tracking about 12 or 13 different data aggregators in the EM that's faced currently, and that numbers seems to grow every quarter. There are more solutions out there. I think it's another sign that clients have more data available to them ever before and they need technology tools to aggregate and filter the data to make sense of it for their trading operation. We think it's a natural evolution of the market. The important piece for us in all this is the differentiated liquidity pool. We've done a very good job of that historically, and that has been for lack of competition.

Rick, I apologize, If you mentioned this. But I'm getting a bunch of emails to ask you what your actual volume in July to date is?

You got a curious client base, Rich. It was an unusual week with the holiday falling right in the middle. If you look at the numbers since then, it's pretty close to normal. The only thing I would reiterate is that month-to-date high-grade share is running a bit below Q1 average and high-yield share is running significantly above the Q2 average.

Thank you for joining us this morning. Enjoy the rest of summer, and we'll talk to you next quarter.