Cboe Global Markets, Inc. (CBOE) Earnings Call Transcript & Summary

Welcome, Ed Tilly, Chairman, President and CEO of Cboe; as well as Brian Schell, the company's CFO. While recent market volatility environment has obviously been somewhat challenging, Cboe continues to focus on numerous organic and inorganic initiatives that leverage the firm's technology and product expertise to drive growth. We look forward to getting an update from Ed and Brian on how Cboe is positioned for 2021 as well as their general thoughts around the evolution of the exchange landscape broadly. Gentlemen, thank you both for being with us this afternoon.

Great being here, Alex. Thank you.

Thanks, Alex.

Great. So I'm going to kick it off with a bunch of questions. And as always, for our listeners on the webcast, there's a box right in the -- underneath the screen there for you. You ask question, and then I'll try to incorporate them into our conversations would go along or towards the end. Now the first one, Ed, this one is really for you. Just thinking about the strategy and maybe getting an update there. So over the last year, you've done a number of smaller-sized acquisitions, but you've done a handful of them, right? You had EuroCCP, which actually I think was announced at our conference last year, at present, it's been a year. MATCHNow and most recently BIDS as well as a handful of others. Now while each of these is slightly different. I was hoping you could start us off by thinking about like Cboe's strategic vision over the next 2 to 3 years of how all these various assets ultimately come together to enhance the firm's organic growth profile.

Alex, I think it's a great place to start. And let's put the M&A of this year and include EuroCCP in 2 different categories, right? There is the Information Solutions group, that's the FT, Hanweck and Trade Alert acquisitions that we are currently integrating. And that is really with the goal of providing a seamless workflow for the asset, you asked a more sophisticated derivatives exposed traders. That is the beauty of having a pre, at and post-trade offering and integrating those companies, those businesses into one, really, that allows for a seamless flow. That M&A and looking for missing pieces, it's pretty good spot right now. I really like what we put together, and it's just a matter of integrating. Take that Hanweck Analytics Solution and overlay that with FT, a view or a Silexx access point. Those are going to work together nicely and don't expect us to go out and continue the smaller M&A on that front. Like what we're doing, it's integration time to bringing these companies together, bring the benefits of a seamless solution to our customers. If you put the M&A -- the other M&A in a different bucket. That's our more traditional matching buyers and sellers. It's either geographic expansion. It's a continuation into a different asset class. And that makes sense for us if we look at the Cboe advantage of having a technology stack that allows us the success we've had in the most competitive geographies, in the most competitive asset class equities, the ability to branch out beyond a very competitive U.S. and European market. MATCHNow is into Canada and an easy and logical extension for us. A nice market just for the North, many of our same customers, a market structure that's recognizable from the U.S. perspective, common customers, and we'll be migrating off of that MATCHNow technology for the next year. And then if we look at the latest transaction, BIDS from a traditional exchange operator, we have not been in the off-exchange business at all. So this is our first entrance into off-exchange trade, and in this case, the largest block trading platform in the U.S., our current partner in large and scale trading in Europe. So we know BIDS well. We know the team well. We know the capacity and their capabilities really well. And already, we said we'd like to move that block trading mechanism into the Canadian market. So BIDS will have its own growth and expansion as well. So won't just rely on where Cboe is today. But with the platform, the infrastructure and the scale that is Cboe in a more important way. And then you mentioned it, we announced EuroCCP and that allows us to go to the more sophisticated trade in Europe, and that is going from European equities platform to allowing for the trade and matching the buyers and sellers in derivatives. And therefore, the clearing of those derivatives EuroCCP. And so all coming along for a midyear launch of derivatives in Europe. So I guess, you're right, lot's been happening. So it's time to integrate. It's time to launch, and we're on track and have not really lost a beat in the most unusual, as you know, and crazy times. We're happy to be able to report that we are right on schedule. Brian, what I missed?

I think you got it all. There's a lot going on, and I think you -- at each of the asset classes.

Great. So despite the fact that there's a lot going on, you guys continue to have very strong balance. And that's always been sort of a cornerstone of the franchise, and you continue to have a lot of capacity, arguably on the balance sheet from a debt perspective relative to a lot of your peers in the space. I guess, how should we think about inorganic growth opportunities for Cboe from here? I don't want to put words in your mouth, but does it sound like you guys are -- the focus really integrate what you've got because you guys have done a lot in the last 12 to 18 months or so and then look out again? Or there are still pockets of opportunities where inorganic growth could make a lot of sense?

I think there's always pockets where inorganic growth makes a lot of sense. It's why we keep the balance sheet flexible. We are not just going to buy to buy. We know Alex, you follow this space so closely. We were not involved in some of the exchanges that have traded over the last year. They're wonderful business as they fixed -- fit the vision for Cboe. That doesn't mean though that there might not be other opportunities that we're on the lookout for and the balance sheet that's able to act, we'll act. We have a Board that appreciates our ability to integrate, and we've proven that. And as I say, being successful in the most competitive asset class, in the most competitive geographies allows us to be a little bit more broadly and inclusive business to where we look. Is there something we have to stop doing today and pivot away from the core business? No. It does allow us flexibility to continue to look around in choosing buyers and continue our expansion of asset class and geography in a measured Cboe way.

Got it. Got it. Well, speaking of the core franchise. Let's spend a couple of minutes on the VIX first. Look, obviously, a very challenging environment this year. The term structure being flat is far from perfect for your customer base and for obviously Cboe's volumes in both VIX options, VIX futures. And we've seen maybe a little bit of stabilization in volumes recently, especially around November and the election. But overall, this is not an ideal environment. So what I was hoping to go with this is really understand what's happening with institutional pools of capital that are trafficking in these products over the course of 2020. And really try to understand what would it ultimately take for these products to start coming back to some extent. Because it is simply a cyclical dynamic where, look, VIX term structure needs to steepen, and therefore, a lot of those strategy will kind of come back in favor? Or are you guys seeing other issues?

I think you recognize that there has been a change in the VIX options, as a matter of fact, the uptick in VIX options happened after the election. So there is a reengagement, and I think a lot of that is the uncertainty around Jan 5 in Georgia. So if you're an institutional trader, and you did not get the certainty that you were hopefully looking for in the election and the clarity of what the next 4 years the administration would look like, whether the Biden administration is unchecked or if it's a balanced government and things may be a little bit more not one directional in the change or it's create a change, it might be without a balanced government. So if you're an institution, really don't have the clarity that we all thought we may have had in and around November. So if we put that in that bucket of uncertainty, gosh, Jan 5 is right around the corner, we kind of like that. And the VIX term structure just doesn't steepen on its own. It's because of your expectation of the future, it's conviction to change the term structure, right, as a chicken and egg, this is implied volatility, the implied cost of insuring a portfolio of the S&P 500, pick your moment of time by looking out of the term structure. So that uncertainty around Jan 5 is still there. Not surprised. We think that it's relatively flat, and there is no conviction beyond Jan 5. So we would expect that with some certainty, the expectations and engagement of institutions will then affect Europe, one's assumption of what risk looks like going forward. And that in itself would be the cause of the change in the term structure. Do we ever get back down to those low teens? In this environment, probably not. There's too much uncertainty around the vaccine rollout today. I mean if you look at the market today, right? We started down 15. So we're up 10. That kind of uncertainty, information changing within the day, it doesn't surprise me that vaccine will keep us a little bit elevated. But the fact that we're talking about it means that we're look -- starting to look past this uncertainty that we had in March and April. So I think all good things, eliminating the headwind would be a huge change for us in the proprietary mix looking to 2021.

Right. And I guess similar line of questions for SPX option volumes, generally better than the VIX, for sure, this year, if you just kind of look at the relative volumes. But if I look at some of the comparable asset classes, and I know it's probably not a perfect comparison. But if you look at, let's say, SPY options, it seems like the volumes there have been holding up much better than this VIX options complex. And that's probably partially related to the mix sort of institutional versus retail. So maybe we can kind of say double-play coming from the institutional end of the market and dissect also kind of how much of this is simply a cyclical dynamic? And what would it take to sort of reinvigorate the growth in the SPX option complex?

I think you've nailed it. I love the comparison with SPY. SPY is not an institutional, has not historically been institutional trading. Shouldn't be an institutional trade, trade 10x among the SPY contracts. The same notional coverage as one SPX, just doesn't make sense for an institution, managing physical settlement. Now is it easy for a institution, cash settlement is easy, got an embedded position in the ETF, managing settlements in and around in America is now exercised, very, very difficult. It's cumbersome, it's extra steps, it doesn't make sense. I think what we haven't talked about, I think, is the opportunity, not only in SPY, but then we've seen the multilist options in general. SPY is no different. SPY is the easiest way to express a broad view of the U.S. market with the country's benchmark, the S&P 500. So I think from engagement that you're seeing, it's just the uplift you've seen in the all multilist. In multi-list options in general, and that is the retail effect. And if we look at what retail is trading, new retail and old retail, I'm old retail, I use one of the legacy platforms. I love it. And it's super simple for me to operate. But new retail wants to see things different, wants to engage differently, and they trade differently. The duration of the holding period that we're seeing in SPY or pick your favorite stay at home that's engaged retail. It's very short dated, very short premium and directional place by using the leverage available in. What we haven't talked is the opportunity not just to decide to in general, is to teach more sophisticated use of derivatives, how to protect positions, how to answer long equity positions by using derivatives. And quite honestly, from an investors perspective, how to derisk pure Delta One exposure. That's an opportunity going forward, but it's not unique to spot. So I like the build-up of SPY. It allows us to tell a story to retail, hey, if you like SPY, I got a product for you, it's a Mini-SPX product. It's the exact same notional at SPY. It's cash settled. It's a European exercise. And there's -- in the U.S., you're a retail investor, there's a 60-40 blend between long- and short-term capital gains, instantly, like $100 in SPY pay all short-term capital gains, like $100 in excess fee, you trade at blended rate long and short tax rate. So the conversion is there. New retail platforms pick on the big two, neither one of them allow access to see those proprietary products yet. One of them is moving in the first quarter. And hopefully, the other large new retail platform is moving shortly after and hopefully, the first half of the year. So for us, I see all opportunity from new retail into our proprietary product set, whether it's full-size SPX or it's mini-size SPX. So really good stuff coming for us. We've got to embrace in retail. We haven't done it, but that's top of list for 2020.

Great. Well, speaking of retail, it really kind of dovetails on my next question. You've introduced many VIX contracts as well for retail users. So I was wondering if give us an update on how that's been going. Obviously, we can see the volumes, but more curious about the response in the market so far. And what's working, what's not working, sort of what's the near-term strategy and incentives maybe that you guys put into place to accelerate growth from those products?

I think, Brian, is talking about the incentive plan. But I think if things aren't working, there's a flat volatile structure for big VIX, there's a short volatile structure for Mini VIX. The difference is that these are bite-sized contracts and know that new retail, who has a fraction of what more traditional retail has in their trading account like bite-sized contracts. So Mini VIX is just an easy extension for us to make pure vol trade, pure exposure to volatility, whether it's speculating or hedging in a bite-size form, and we've seen a slow adoption from different platforms, including a ramp-up in the mix, not all professional, but including now involvement from really big retail and the Mini VIX. But again, big VIX has a flat term structure and not -- if bolt-on doesn't work there, it's not going to work on Mini VIX. But we will continue to add incentives for the liquidity for others to be there, when, in fact, the trend structure goes steepen. Brian, anything on incentives?

Yes. I think the other thing is that, again, always remember, as we think about incentives and whether it's this new contract, which is a little different than, say, than something mature like equities, which we probably want to talk about later as far as is that payment, is that investment really incenting the actual behavior that you're looking for, if not do you tweak and figure out what's going on. It looks different for a new product than it doesn't mature. And I'd say the only thing I'd add to that, Ed, is not only liquidity is also quality. Is one of the things we're also focusing on is the quality of those markets so that overall, those trading participants are coming out of that with what they're thinking or I call it, a quality trade as far as that activity and then that activity continues to build on positive, positive activity.

Got it. Okay. Makes sense. Look, one of the larger initiatives that I wanted to touch on among some of the newer things is EuroCCP. And you touched on that a little bit in the beginning of your prepared remarks. But feels like 2021 is going to be a big build-out for that strategy for that initiative for you guys. So can -- I guess, a, you update us on the efforts there so far? What has been the key sort of customer response to what you're trying to build there? What are some of the largest hurdles you think exist in this build out? And maybe update us on any sort of financial implications for Cboe in '21 on the back of that build-out?

Yes. I'll let Brian talk about the financial implications. The hurdles, I think we've identified, it's just really the build in enabling a -- as you mentioned to trade European derivatives that is technology. Of course, we're borrowing off the stack from the U.S. and customizing that for the audience and pools. So that is really aligned with what I think we do really well. And I think it is a Cboe advantage when we expand from Delta One into derivatives. I think that market is good as anyone in the globe. So that's moving along nicely and on track for what we laid out roughly a year ago. As far as EuroCCP, the need to be able to clear those derivatives and what was super important to us was being able to not only represent a take on exposure in individual country risks but pan-European risk, but not requiring the customer to house those positions in 3 different current CCPs. So being able to express French, German or pan-European risk at EuroCCP, cleared at EuroCCP with offsets in the efficiency of one, risk model, is hugely important to us when we're building the vision for offering derivatives in Europe. So that's coming along nicely too and right on schedule for this year. But I want -- the big takeaway, Alex, and we'll continue to -- so let me say it every time we get the opportunity to talk about our derivatives offering in Europe that this is not a pure share gain. We are not after -- if you're benchmarked to pick your favorite country-specific index, that is not a customer that's inbounding to us and saying, I need something to change. Think of a U.S.-based customer or an Asian-based customer that wants exposure in France, but doesn't want the dial up method of looking at a screen seeing an indicative pool having to negotiate a one-off of everybody other than Goldman. But having to negotiate a one-off price discovery mechanism, they like the U.S. market, where you are one component of many, Alex, that's trying to make the bid offer better. And it's transparent, and it's successful, and it's clickable, and it's all in one CCP. That's the inbound. That's what we're trying to do. We're trying to grow the pie. So I want the existing businesses to grow in double and triple, and we will be trying to appeal to the rest of the world. We've not benchmarked to the incumbent with a highly correlated, very close notional exposure from the incumbent indices. That's the goal. That's what we're after. That's what our liquidity providers have come to us and said that they're willing to offer competitive markets day-in and day-out. We will reward that with customers who cross the bid ask. This is not a pure block trading mechanism. This is a new global liquidity provider, are going to put a bid and offer up there for everyone to see and everyone to touch all day long. We want to reward you with trade at the end of that next quarter. So that's the model, not a pure share gain, with wealth -- trying to grow bigger. Cboe will take part of that bigger pie, Brian.

Yes. I'd say the build-out, and it's also right on track, just like we thought. Ed mentioned that our timing of delivery is exactly when we thought it would be. Again, it's more of a reminder that when we announced the transaction that it would have a negative short-term impact on the P&L and really it should be called investment because those expenses are going to lead the revenue generation. Not a lot of revenue generation in '21 but the expenses with -- in form of incremental technology fees, incremental professional fees, all those things that take to ramp up both the exchange and the clearing entity to be able to basically facilitate the derivatives effort is going to happen before the revenues occur. So it's more of a timing, but the dollar amount and everything else is right on track, as we talked about previously.

Got it. Great. Let's shift gears a little. Let's talk about cash equities. Obviously, it's been much more of a topical area for you guys as well as everyone since the MEMEX launch and a lot of people obviously watching that fairly closely. I guess the question for you is around the notion of cap trades and market share and really understanding the fact that you guys are saddling for revenues as you should, right? At the end of the day, there's a trade-off between market share and the capture rate and the SIP revenue you're generating. But maybe, a, help us understand how the capture rates have been shaking out for you guys in U.S. cash equities in Q4, there's been volatility in the last couple of months there. Just so that we can put some sort of a ring-fence around it. But the bigger picture question is, when I think about the combination of the equities trading revenues plus the SIP business, how do you grow that organically? What is the -- again, constant volume, whatever, right, things that are outside of your control, things that are within your control, can the combination of those 2 still grow? And what do you guys do to achieve that?

Brian, you want to start?

Yes, I'll take that. So I'll start with that, is that I think -- I appreciate that understanding that we are looking to what's that kind of that efficiency and optimizing the revenue number versus it has to be ex market share, it has to be ex capture. And those obviously have the implications, as you mentioned, with the SIP. And frankly, it also has, we think, a value on our access capacity fees as well as our own proprietary market data, that there's a certain level of scale that's important as far as the overall trading and the receipt of those products and the value, and we're the price leader when it comes to proprietary market data as well. So all of that is one platform and one ecosystem that is very much kind of reflects on each other. And so when we look at that, that's involved, and it's very dynamic. And I would say that we continue to tweak that. We'll continue to continue to try and find that golden lock scenario that ultimately, what you'd like is the highest market share and the highest capture, and we'll continue to try and seek for that solution and make those tweaks to incentives, as we talked earlier, to basically continue to drive that up. So that's an important part. As far as what do we do to continue to grow that revenue, assuming a static volume or, let's say, SIP doesn't continue to grow, although we've seen a nice growth SIP in '20 because of the incremental participation is that's where the innovation starts to come in is you look at what we've been successful with the retail priority order has been very, very successful and continue to capture share. You've seen us put in a pending regulatory approval for periodic auctions of everything that we've leveraged already in our European business and working with Dave and bringing Dave Howson and bringing those learnings in and incorporating some of those best practices. You've seen us when we originally put in place the auctions alternative, midpoint discretionary. So there's things that we're continue to try to do to innovate, providing incremental analytics to continue to capture that share, pulling things in also off-exchange, on-exchange. So all those efforts, we think, actually set up nicely, and we are seeing positive and more positive growth. If you look at you watch the intraday market share, for example, within the exchanges. Cboe, many times throughout the day, is actually leading among the exchanges, excluding the auction volume, intraday market share. So those efforts are going to continue. And to date, they've been very effective.

Great. That all makes sense. Why don't we switch gears a little bit. I want to touch on the nontrading part of the business. It's been a solid revenue grower for you guys. And even this year, despite the pandemic and everything that's going on. It's been kind of a mid- to high single digit grow organically, sort of like excluding the impact of the acquisitions. And you talked about the path for that to continue like. So help us frame the sort of once you've added all these other assets into the nontrading part of the model, how does that change at all this kind of mid- to high single digit organic growth profile in those revenue lines? And anything you can do to sort of dissect the mix of growth between the new customers and any sort of pricing dynamics that you could also enhance?

So I would say we haven't given -- provided guidance beyond this year-to-date. But we felt very good. We feel really good -- look at our last quarter, the organic growth rate of, I'll call it, our proprietary nontransaction revenues. That high single digit, low double digit. And we feel -- and we've seen that growing momentum such that where we end up in the year, independent of the incremental revenues that are being added. So we're still very, very excited about this on an organic basis. And I have to remind everyone that the bulk of that growth is not pricing driven. So do we think that there's pricing opportunity there? Probably. But that's not where our interest lies. Our interest lies in growing the numbers, growing the subscribers. To date, it's been 3 quarters to -- 80%, 90% of the growth has been more units and/or depth of wallet or wherever that is, it's going. So we continue to see a positive growth trajectory in that in and of itself. And what we're seeing is we're seeing across multiple asset classes, whether it's the traditional data coming out of our U.S. equities markets and hitting new geographies or it's the enhanced market data that we're seeing coming out of our derivatives business as we, a, get new customers, but b, provide incremental analytics to from our ISG group and what they're doing. And so we're seeing that natural growth. And then of the revenues that were acquired early on with ISG, we're still starting to see that grow on top of itself. So all those things set us up nicely that -- I guess that, we haven't put a number on it yet. We will, obviously, as we head into the next year, we finish our planning efforts that we continue to see this as a nice trajectory and like I said, I'm no less optimistic about it today than I was 2 years ago when we really continue to put more and more resources into this.

Great. Well, sticking with Brian on the numbers question, I wanted to talk a little bit about expenses and again, recognizing that we're probably not going to get the full picture for 2021 yet. But I was hoping, given the time of the year, you can help us with the framework of how to really think about expenses in '21 because there's a lot going on, right? We have multiple deals. Some have already closed. Most have already closed, obviously. There's COVID, there's COVID-related savings that are in the run rate. There's different comps and volumes up. There's a lot going on. So if I think about the Q4 run rate, so the guidance on a pre bid expense base, is that a good -- use it maybe that as a starting point? Can you kind of help us think through the framework for '21 expenses up at that level?

Yes. Absolutely. I think, Alex, the way you asked the question about a framework is appropriate just given where we are, and you're right, finishing up the '21 business planning efforts. So you'll have the 4Q run rate as a base. I think that's a solid start. But here is then the incremental items that we'll provide more full guidance on as we -- normal time of the year what we do is that you're going to then have some mid-4Q efforts that were started that may not be fully baked for the entire quarter, that will grow the full year. You'll have the incremental investments in the derivatives that we've talked about that weren't fully in place in 2020, that will be incremental in '21 as we continue to have that build out. You mentioned the COVID expenses. And not only are they going to be the direct expenses of -- I didn't travel or I didn't pay for that meal. You have some, I will say, deferral of investment that we're reinitiating because of just -- like let's make sure we understand where we are and then you launch that investment. And then you'll have the -- there's usually, I'll call it, some inflationary adjustment, with respect to either wages, supplier invoices, things of that nature, that is going to have a little bit of a natural progression to it. And then the last one, which is our investments. What are we doing incrementally that says, here's what we're doing, whether it be the educational efforts, whether it be on the marketing side, whether it be in some incremental tech spend that we're doing to help continue to drive the growth of this business, in particular, proprietary suite of products. So all of those elements are going to be a critical part of establishing that framework as we look at the '21 expense base. And again, this is, as we've always done, is we are going to continue to try and maintain that expense discipline as we have, sometimes investments like the EuroCCP and the derivatives launch, investments are going to lead the revenue growth. Sometimes that happens. But you know what, but we're compensated on growing revenues. And so we intend -- and that's obviously what we're here to do, again, to grow the overall value of the company. So -- again, so I think that's, I guess, a reasonable framework to start out with expenses for '21.

Got it. Okay. All right. We've got a couple of minutes left. So I'm going to take a look at maybe one of the online questions is around capital. So maybe we'll hit on that. So you guys have obviously been delevering, I think your debt to EBITDA is around 1-ish now. So at a fairly low level. And maybe we keep acquisitions aside from this part of the conversation since we already sort of talked about the outside deals there. But outside of the deals, how should we think about the free cash flow generation of the business? Is 100% of free cash flow, reasonable payout to think about, and obviously the preference between accelerating the buyback versus dividend growth?

Yes. I would say in today's environment, and it's a -- for those who have either new to the story or they've heard our view on capital allocation is we don't like sitting on cash, feel like that's investors' cash. We're going to return that and put it to -- most importantly, put it to good use. And I think our leverage ratio is appropriate in the sense that an incremental dollar to delever given where -- either -- our view on the valuation of the stock price, there's usually a better return on capital. And when we evaluate that stock price versus delevering further because as Ed mentioned, is that balance sheet flexibility is important to us. If you look at the overall scope of capital allocation, we've always said we're going to grow that dividend, and we continue to do that. You've seen double-digit increases in dividend growth rate for multiple reasons, over the last 3 years, we continue to maintain that. You've seen us buy back shares opportunistically. And you've seen us being able to obviously support anything we need from a working capital standpoint. Again, that speaks to the efficiency of our overall network that it just doesn't take that much and you've been -- you've seen us been able to fund acquisitions that have been relatively small at this point. But again, very strategic in helping us grow the top line. So again, same capital allocation framework that we want to continue to return that. Now do you get to a point when you look at free cash flow, does it all go back in the form of dividend, share repurchase, given where we are at the leverage ratio, absent any, like you said, M&A, that's not an unreasonable scenario to occur depending on what we see in the market.

Great. Awesome. Well, that gets us pretty much at the end of our session. So thank you, guys, both very much for joining, Ed, Brian. Always a pleasure to have you here. Hopefully in person next year. Hopefully, that will add a little bit to your travel budget. Would love to see you here in New York at the conference next December.

We'd love to be there, Alex. It's great to be with you. Thank you.

Absolutely, Alex.

Awesome.

That's it.

Thank you, guys. Bye.