MarketAxess Holdings Inc. Q1 2008 Earnings Call Transcript

| About: MarketAxess Holdings, (MKTX)

MarketAxess Holdings Inc. (NASDAQ:MKTX)

Q1 2008 Earnings Call

May 07, 2008 8.30 am ET


Stephen Davidson - IR

Rick McVey - CEO and Chairman

Kelley Millet - President

Jim Rucker - CFO


Daniel Harris - Goldman Sachs

Joe Heary - Banc of America Securities


Welcome to the MarketAxess first quarter 2008 Earnings Call. (Operator Instructions)

I would now like to turn the call over to Mr. Stephen Davidson, Head of Investor Relations at MarketAxess. Please go ahead, sir.

Stephen Davidson

Good morning. Welcome to the MarketAxess first quarter 2008 conference call. For the call this morning, Rick McVey will review the highlights for the quarter. Kelley Millet will provide an update on the North American businesses. And then Jim Rucker 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, possibly 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 31st, 2007. I would also direct you to read the forward-looking disclaimers in our quarterly earnings release that was issued earlier this morning and is available on our website. I would now like to turn the call over to Rick.

Rick McVey

Thank you, and good morning. In the first quarter, we delivered solid financial results in spite of the ongoing credit market dislocation. Earnings were $0.05 per share for the quarter on revenue generation that was down only 3% from the prior year first quarter.

The foundation of our franchise continues to get stronger, with a record number of investor clients electing to connect their order management systems to MarketAxess, increasing the points of connectivity with our clients and creating even higher barriers to entry for our competition. We are embedded in the workflow for investor clients.

Due to the increased integration with investors, the level of client inquiry count was up 4% above the prior-year quarter in a period when US high-grade credit trading declined overall. We continue to see higher transaction fees per million in our US high-grade product, due to a significant increase in the average maturity of bonds traded on the system. Our new products in the other category recorded a 16% increase in inquiry count with particular strength in EM, high yield, and CDS.

While we are disappointed with our European trading volumes, we do know that bank and finance paper, and floating rate notes, make up a larger percentage of the overall market in Europe. And those two areas have been most affected by the current credit crisis. In addition, the new issue calendar was largely dormant in Europe during the first quarter.

With the addition of Greenline, we have gained a significant beachhead in a large growing market for fixed-related services. This high-potential revenue stream will serve to complement our core secondary trading related revenues in future quarters. Also with Greenline, we've expanded our client base, enhanced our technology products and services, and extended our product reach into other asset classes.

Dealer liquidity is the missing piece in the secondary credit markets again for the first quarter. Dealers are facing balance sheet and credit risk constraints, reducing their ability to serve clients in a market-making capacity. On MarketAxess, that has resulted in fewer dealer responses per inquiry and a wide disparity in dealer prices.

In the overall OTC credit market, the reduction in dealer liquidity is causing a disruption in the normal functioning of the market and a decline in credit trading activity. This will gradually improve through dealer balance sheet repair and an improvement in the dealer and bank funding markets.

Ultimately, we are big believers in open, transparent markets to promote growth and liquidity for all market participants. We will continue to take steps to expand our client base, increase our sources of liquidity, and further enhance our technology in order to drive network benefits for our dealer and investor clients.

On slide four, we provide an update on factors that are driving trading activity in our core market. In the upper left hand corner, liquid high-grade index spreads have widened a full 114 basis points form the end of June 2007. In the upper right hand corner, rolling 3-month volatility spiked to 8% in April, highlighting the fact that unfavorable credit market conditions persisted throughout the first quarter. Both the yield curve and the TED spread, while showing some retracement from the highs, still reflect risk aversion among investors and challenging funding markets for banks.

The steepening of the yield curve in the lower left hand corner continues to have a beneficial impact on US high-grade revenues, due to an increase in average maturities traded on our system, leading to an increase in average variable fees per million.

The reduction in dealer risk appetite and liquidity resulting from dealer balance sheet constraints has had a dampening effect on trading activity in corporate bonds with US high-grade trace volumes down 18% year over year. We are seeing some recent evidence that investor risk appetite is growing and dealer liquidity has improved. Should that continue, we believe that overall credit trading activity will grow.

With that, let me turn it over to Kelley to discuss the North American Results.

Kelley Millet

Thank you, Rick, and good morning. On slide five, we present three core elements of our franchise that are critical to our growth strategy. First, our core trading businesses continue to show underlying strength despite the drop-off in dealer liquidity. When markets stabilize, we expect that the favorable mix of business, combined with an increase in investor demand for our trading solutions and increased industry volumes will positively impact our financial results.

Second, our connectivity with clients has never been stronger as we continue to imbed ourselves deeper into our clients' daily workflow. 151 investor clients are now connected. For the full year 2007, 37 new clients were connected. And in the first quarter of this year alone, we connected 13 new clients with another 32 in testing. 30% of trade counts and 29% of executed trading volumes has now generated by client OMS system, compared to 18% for both in the first quarter of last year.

Finally, with our acquisition of Greenline, TWS, and the build-out of our organic technology services, our overall product offering has been greatly expanded. And we have diversified our client base to include more hedge funds, global exchanges, and other electronic trading platforms.

On slide six, we show the long-term trend in FINRA TRACE, our respective share, and provide more detail on the mix of fixed and floater rate bond trading for both TRACE and MarketAxess. Overall buying and share measures are only one factor in establishing the value of the MarketAxess franchise. A deeper dive is required to fully understand our performance.

Lack of balance sheet, unattractive risk-reward characteristics, and concentration in bank and finance credits have impaired the trading liquidity in FRNs. As a result, estimated industry FRN volumes went from 79 billion in the first quarter of last year to 48 billion in the first quarter of 2008, a decline of 39%. MarketAxess volumes fell further as investors saw scarce liquidity over the phone and dealers worked to orders on an agency basis.

Excluding FRNs, our fixed-rate, high-grade share would be essentially unchanged with an estimated 7% in first quarter 2008 versus 7.1% in the first quarter of last year. Thus, this quality business with much higher fees per million has remained on this system.

Now let me comment briefly on the TRACE data for April. TRACE average daily volume has increased in April to 9.4 billion per day, up from 8.2 billion in average daily volume in March.

On slide seven, we show the continued strength of inquiry count driven by our investor clients. In North America, our core RQ client franchise showed continued strength across high-grade, as well as high yield and EM, despite difficult market conditions, where both dealer responses and hit rates declined.

The quality of the business that was executed over our platform continues to improve with high-grade average weighted years to maturity of 55%, European years to maturity up 12%, high yield up 10%, and finally EM up 3%.

An increase in the average weighted years to maturity is one of the key drivers in increasing average fees per million and reflects the continued positive trend for the platform. This signals to us that we are facing broad macroeconomic issues. And we are confident that investors remain actively engaged on the system.

One final comment regarding our new product areas, including DealerAxess and CDS, in this type of market with dealers focused on risk management amidst extreme market volatility, it has been more difficult to get dealers to embrace new e-trading activity and accelerate the growth of these two products.

Slide eight is an update on our technology products and services. We have assembled the key components of our tech services offering. And the integration and performance of Greenline is on schedule. Greenline reported approximately $6 million in revenue in 2007, which was 40% above 2006. And based on our early experience with the business, we see solid growth rates continuing. Current projections are for Greenline to be earnings neutral in 2008, including the impact of the amortization of intangibles and the opportunity cost to funding. We expect the acquisition to be cash flow positive this year in 2008. And we expect Greenline to be accretive to EPS in 2009.

Our focus is on creating and achieving revenue synergies, as we capitalize on our relationships with more than 30 dealers and over 1,000 institutional clients. As Rick mentioned, it appears that the fixed product is less affected by the current market conditions. New exchanges are emerging globally. And high-velocity fixed messaging is at the forefront of customer technology spend. We do believe this business will provide good growth that is not correlated to market trading volumes and is one part of our drive to build further scale and revenue diversification.

Now I'd like to turn the call over to Jim for a review of the financial results.

Jim Rucker

Thank you, Kelley. Please turn to slide nine for our earnings performance. Revenue for the quarter of $22.9 million was $560,000 or 3% above the fourth quarter of 2007, but 3% below the first quarter of 2007. Earnings per share of $0.05 were $0.02 below the prior-year period.

The effective tax rate was 46% this quarter due to several unfavorable items, including the absence of the research and development tax credit, a decrease in tax-exempt investment income, and an increase in non-deductible expenses, relative to the decline in pretax income. We anticipate that the effective tax rate for the full year will be between 42% and 45%.

Now let me turn to some of the details regarding our first quarter results. On slide 10, we've laid out trading volumes and fees per million. Total trading volume for the quarter of 64 billion was down 38%, compared to the first quarter of 2007.

Turning to US high-grade, we're now breaking out our fixed-rate and floating-rate high-grade business, so that we provide a higher level of transparency with regard to the mix of business traded over the platform. Total US high-grade trading volume declined 36% versus the prior-year first quarter. High-grade transaction fees were $119 per million, up from $80 in the first quarter of 2007 and $112 in the fourth quarter of 2007.

This is primarily the result of two factors. First, total FRN trading volumes were down 82%, while the higher-margin, higher-quality fixed-rate trading volume showed a much smaller decline of 17%.

Secondly, we've seen an increase in the duration of bonds traded over the platform. And we earn higher fees on trades of longer-maturity bonds. The average weighted year to maturity of bonds traded over the platform increased to 8.2 years from 5.5 years in the first quarter of 2007.

European high-grade trading volumes were down 72%, reflecting the more difficult credit market environment there. I'll talk more about the European fees when we turn to the next slide.

Other volume increased 15%, primarily due to increases in CDS volume on our inter-dealer platform DealerAxess. As CDS transactions incur lower fees per million than some of the other products in this category. The average fee per million declined from $148 to $131.

Slide 11 provides you with the revenue detail. US high-grade commissions, including monthly distribution fees and transaction fees were down $1.3 million, or 9%, from the first quarter of 2007. The first quarter of 2007 included $1.5 million in DealerAxess monthly minimums. The absence of the DealerAxess minimums in this quarter and the 3% decline in commission revenue were partially offset by an increase of $400,000 in the monthly distribution fees.

Total European high-grade commissions were down by only $165,000, or 3%, compared to the first quarter of 2007, as a result of the new European fee plan, which was introduced in June of last year. In accordance with the new fee plan, we now receive monthly dealer distribution fees that were $3.7 million for the quarter, as well as transaction fees that were $106 per million and totaled $900,000 for the quarter.

Given the recent consolidations in the dealer community, including the acquisition of Bear Stearns by JPMorgan and ABN Amro by Royal Bank of Scotland, we are expecting these two dealers to come off the system in the third quarter of 2008, which will reduce our US and European high-grade monthly distribution fees by approximately $750,000 per quarter.

All other revenues were 19% above the first quarter of 2007, primarily driven by an increase in our technology products and services revenue, which totaled $770,000, the majority of which came from Greenline. This was partially offset by a decline in our investment income.

Slide 12 provides you with the expense detail. Total expenses were just 4% above the first quarter of 2007. Excluding the impact of the Greenline and TWS acquisitions, our expenses would have shown a small decline compared to the first quarter of 2007.

Employee compensation and benefits expense was 4% below the prior-year quarter as a result of lower incentive compensation that varied according to operating income. Employee compensation and benefits, as a percent of revenue, was 48%, in line with the first quarter of 2007, and included $400,000 in severance.

Employee headcount, as of March 31st, was 202, compared to 171 in the first quarter of 2007. The 202 headcount number includes an additional 30 staff from the Greenline and TWS acquisitions.

On slide 13, we've updated the expense guidance for full-year 2008. We expect total expenses to be in the range of $81 million to $84 million. This guidance reflects additional Greenline related expenses and lower variable incentive compensation. I expect non-cash expenses to be approximately $15.5 million, including an estimated $1.4 million in amortization of intangible assets related to the Greenline acquisition.

We expect our free cash flow generation for the full year to be approximately two times our reported net income, in line with the multiple for 2007. We continue to expect CapEx for the year to be in the range of $5 million to $7 million.

On slide 15, we have summary balance sheet data. Our cash, cash equivalents, and securities balances, as of March 31st, were $89 million, down from $124 million at year end, as a result of the $35 million in cash used for the purchase of Greenline. Cash and securities on the balance sheet represent $2.65 per share. And the deferred tax asset represents another $1.17 per share.

Our Board continues to regularly evaluate all uses of our cash balances to maximize shareholder value. Total stockholders' equity as of March 31st, 2008, was $180 million, representing book value on a diluted basis of $5.39.

Now, let me pass the call back to Rick for concluding remarks.

Rick McVey

In conclusion, we remain confident in the growth prospects for our business for the following reasons; investor demand for our electronic trading solutions remained strong, despite short-term declines in market liquidity and trading volumes. We are broadening our relationships into both new electronic trading markets and broader technology solutions with positive signs of growth.

Our competitive position remained strong with the dominant share of the institutional client-to-dealer electronic credit market and growing barriers to entry. We are confident that market liquidity will normalize, and investor interest in the credit space will grow, due to improved valuations in this sector with wider credit spreads.

Now, I would be happy to open the line for your questions.

Question-and-Answer Session


(Operator Instructions). Your first question comes from the line of Daniel Harris from Goldman Sachs. You may proceed.

Daniel Harris - Goldman Sachs

Morning, guys.

Rick McVey

Good morning, Daniel.

Jim Rucker

Morning, Daniel.

Daniel Harris - Goldman Sachs

If we go on the assumptions that credit has sort of bottomed here, and I think we actually got some comments on that over the last few days from some people in some pretty high places. And I think I get the sense here at Goldman that we think that we might've seen the worst. What do you think it's going to take for the brokers or the dealers to open up their balance sheets to provide more liquidity to this system? Is it just a high level of risk taking? Or they just feel that they're going to be able move product at a faster rate?

Kelley Millet

Daniel, its Kelley. I think I'd look at the market in a couple different segments. In the very short-end of the marketplace, I do believe that both short-term fixed and FRNs will remain somewhat problematic for '08. And as you know, as we've broken down those differences, it's more of a volume issue for us and much less of a profitability issue. I just think people have learned from a dealer perspective that the risk-reward characteristics are not especially strong there.

When I look at the fixed-rate business, as we talked about, the average year to maturity has extended. I think at these spread levels, that will continue to extend. I think that would be a good sign. And what I also like is the fact that our share of that fixed-rate business has actually been stable, despite the fact that we've had probably the worst credit market certainly in my 25 years on the street. So, I would look at the market and probably segment it in two ways, the short-end probably still being a challenge, but the longer-term fixed-rate business coming back.

The final point would be, obviously, the new issue business has been very, very robust. We had a $9 billion offering yesterday. Probably, I think it is the largest offering in six years. After those deals free to trade and are more liquid in the secondary market that tends to be a boost in trading in our system, but on a like basis. So I think it will be a little bit of a mixed bag. But quite frankly, I view it as if we are in fact coming out of a bottom a constructive view for the second half.

Daniel Harris - Goldman Sachs

So maybe try to put it a different way and I appreciate those comments. If you're seeing increased demand or increased client interactions on a hit rate side, but just putting those requests in, but dealers are still not responding and Kelley and Rick, you guys worked at some large investment banks in the past. What do you think it's going to take for management to say let's start responding more to these things on the electronic platform, because I hear I think that there's a lot of positive things relative to where we've been going out on the market. But it still feels to me like the penetration from the brokers is still somewhat, not the penetration, but their responses are still somewhat lower than I would've otherwise thought.

Rick McVey

I think, Daniel, this is not an electronic issue. This is an overall market issue. We consistently hear from large investors that they're having similar results in getting dealers to respond and utilize their balance sheet for market making, whether they go by phone or electronically.

And just to add to Kelley's response in terms of what it will take to change that dynamic, one is seeing a gradual increase in tier I capital ratios. We have seen some improvement there over the last three or four weeks. Banks and dealers have been successful both raising new capital and selling some credit risk intensive assets. So as that improves, then I think the balance sheet will start to free up for market making for clients.

The other positive sign we've seen in the very recent past is that bank funding cost pressures seem to be abating. And if they're able to fund assets at better levels, that, too, will help in making them more willing to warehouse credit assets for their clients in a market-making capacity.

So I think that the other sign we see is that, clearly, the clients are using the system more for their inquiries, not less. So that means on a relative basis that the clients are having at least as good of an experience electronically as they are by phone, with the only exception really being the FRN market, where it has been so difficult for the banks to fund FRN positions at attractive levels that they have been unwilling to take them onto their balance sheet. And as a result, most of the business that's getting done in FRNs in our opinion is being done on an order or agency basis, not the traditional market making.

Kelley Millet

And two other things that I watch very carefully, Daniel, in terms of the health of the dealers just broadly, but also on the platform; one, what's their capacity to bid for their own paper, and broadly speaking, bank and finance paper in general, which is such an enormous part of the corporate cash market. At the depth of the crisis, in fact, we saw dealers not even willing to use their own balance sheet to bid on their own paper. So the health of the bank and finance paper market is really key to better understanding where the health of the dealers are and where risk taking is in general. We're beginning to see much better signs.

Secondly, as you're at these wide spread levels, as Rick talked about, if you're concerned about liquidity, you're going to be very careful about shorting bonds you don't have in inventory. Over the last two months, we had people only willing to, in a sense sell bonds, offer bonds that was actually in their inventory even for partial size. We are seeing, we are hearing, both on the platform, away, the willingness of people to short bonds, because they feel they have enough liquidity to get it back. And at these spread levels, they're probably more concerned of bonds moving tighter than they are moving wider.

Daniel Harris - Goldman Sachs

That actually was really helpful, guys. Thanks. Just a couple of more. With the disruptions that we've seen in the credit market, putting the peak leading up to the Bear Stearns meltdown, have you guys got any more feedback from clients that those clients would look to the MKTX platform as a potential, increasing your penetration of the CDS market. That they're looking for you to take a leading role in that? It does look like your other income was much better than some of your other areas. So it certainly seems that way to us.

Kelley Millet

Well, Daniel, again, it's Kelley. We have seen, and I'm going to underscore modest progress in the CDS franchise. What we're seeing is that the emerging markets asset class appears to be the area where we can get most traction. I think it's because it's a more electronic market, a more global market, and a more concentrated market. That has clearly been the best volume and most consistent activity in our inter-dealer or DealerAxess platform. And we're very pleased that we're beginning to see client-to-dealer activity in EM, both in index, the index role, as well as single names in both corporate and sovereigns.

From what we understand, we are the only true client-to-dealer electronic solution and producing results. But let me underscore that these are baby steps with a modest number of dealers and a modest number of buy side clients. But Rick knows better than I do that's the way in which these new markets develop. So we are seeing some encouraging signs. But again, dealers are somewhat leery of embracing new e-trading activity, especially in the light of intense market disruption.

Daniel Harris - Goldman Sachs

Okay. Thanks very much. And then, Jim, I just want to make sure I understand what you were saying on your comments surrounding the monthly minimums. So you're expecting to lose two clients as of the third quarter. And that's across Europe and the US about $750,000 in total per quarter.

Jim Rucker

Yes, Daniel, that's right. That was the number for the third quarter. We expect that they will come of at the end of the second quarter. And the number I gave of $750,000 includes the impact both for the US and the European monthly distribution fees.

Daniel Harris - Goldman Sachs

Okay. Thanks, guys.

Rick McVey

Thanks, Daniel.

Kelley Millet

Thank you, Daniel.


(Operator Instructions). Your next question comes from the line of Chris Allen from Banc of America Securities. You may proceed.

Joe Heary - Banc of America Securities

Hey, guys. This is actually [Joe Heary].

Rick McVey

Hi, Joe.

Jim Rucker

Hi, Joe.

Joe Heary - Banc of America Securities

How you doing?

Rick McVey

Good. Thank you.

Joe Heary - Banc of America Securities

On the tax rate, how should we think about the increased tax rate in terms of the interplay with the NOLs and their ability to continue shielding income going forward? Is there any impact on that?

Jim Rucker

Yes, the only impact really on the NOLs, Joe, obviously, is that we use the NOLs at the rate of the tax provision. But, given the modest change in the tax rate, I don't think it should have any significant impact on the way that you look at the deferred tax asset on the NOLs.

Joe Heary - Banc of America Securities

Okay. Great, and then in terms of the severance cost that you mentioned, what was that specifically related to? Is that from the deals that you did? And should we expect to see more as we go forward? Or is that pretty much something that you did and that’s behind us right now?

Rick McVey

It was partly due to the fact that we did have some new opportunities through the acquisitions and partly due to some very modest downsizing that we did in order to make some existing operations more efficient.

Joe Heary - Banc of America Securities

Okay. Just one quick question on the share count, it came down a bit more than I would've expected, given the Greenline deal, and the end to the share buyback program. I was wondering what drove that during the quarter.

Jim Rucker

Yes, I would just say two things on that, Joe. One is, remember that the Greenline acquisition only took place in March. And so, on a weighted average basis, you might have seen the full impact from the 725,000 shares that we issued as part of the Greenline acquisition. The second thing at play here is the impact of the stock options and restricted stock under the treasury method, given the fact that the stock price has been low through the quarter. And the impact of the options and restricted stock is less than it was both the year ago and in the fourth quarter.

Joe Heary - Banc of America Securities

Okay. And then in terms of just your bias at this point on capital management deals versus potentially restarting the share buyback program, any thoughts on that?

Rick McVey

None that we're prepared to really comment on today, Joe. I think we are always interested in new technology assets with great growth characteristics that will further round out the set of services that we provide to the institutional credit markets. So fair to say that we're very pleased with what we've done with TWS and Greenline. And we continue to look for more opportunities along that path, but nothing beyond that to comment on today.

Joe Heary - Banc of America Securities

Okay. And just lastly, with respect to the variable fees, we've obviously seen the US fees moving up. Given the mix shift that's gone on already in your volumes, and where the yield curve is at, are we reaching a high water mark in terms of where those fees per million can go in the US?

Rick McVey

I think that what we would expect, Joe, is that, as dealer balance sheet constraints hopefully dissipate and market making returns to normal that we will see a return of floating-rate note business traded electronically on the MarketAxess system. And all else equal, as that business comes back, we should see a positive return to overall trading volumes and market share. But it will also cause a lower blended fee per million in our total high-grade fees. So, that is one factor, I think, to look out for with respect to the future periods and the average fee per million.

The other really relates to the shape of the curve. If it stays as steep as it has been over the recent past, I think these numbers are a reasonable estimate of what to expect in the future. However, if the curve starts to flatten out, then we would probably see some decline in the average maturity of bonds traded on the system.

Joe Heary - Banc of America Securities

Okay. Great. Thanks, guys.


This concludes the question and answer portion of the call. I would now like to turn the call over to Mr. Rick McVey for closing remarks.

Rick McVey

Thank you for joining us. And we look forward to talking to you next quarter.


Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. And have a wonderful day.

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