MarketAxess Holdings Inc. (MKTX) Earnings Call Transcript & Summary

For important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. With that out of the way, good afternoon, everyone. I'm Mike Cyprys, Morgan Stanley's equity analyst covering brokers, asset managers and exchanges, and welcome to our fireside chat with MarketAxess. Well, from MarketAxess, here we have Chris Concannon, President and Chief Operating Officer; and Chris Gerosa, the Chief Financial Officer. As many of you know, MarketAxess is an electronic fixed income trading venue that started with a primary emphasis on credit markets and has since expanded into new geographies and new asset classes. So Chris and Chris, thank you for joining us today.

Thanks, Mike. Thanks for having us.

Great. Why don't we start off with the current macro environment here, I think, very topical? We're entering a more challenging environment with inflation, volatility, rising rates, Fed unwind, just to name a few. So I guess how is the market holding up in credit markets compared to prior stress events? What's similar? What's different?

Sure. Well, first of all, thanks for having us here. And obviously a great day and great participation from investors. As an investor, this market is obviously very challenging. As a market operator, these are the types of environments that we thrive in. Electronic trading is a wonderful solution where volatility is on the rise, portfolio turnover is increasing, not decreasing, lots of asset shifts, inflows and outflows from equities into fixed income. And then obviously we haven't had rates rise in many years. So it's a changing dynamic and one that's favorable for MarketAxess because we see credit spreads widening in this market, obviously from volatility, but the increase in rates and everyone is trying to predict where the Fed comes out tomorrow, adds a great deal of volatility. So really winds at our back in this environment, particularly around the current market environment. And with that widened credit spread, our all-to-all solution is producing great trading outcomes in terms of price savings on execution quality.

And when you think about back to maybe March of '20, that was a volatile challenging market environment and you kind of look at today. Anything kind of stand out, I mean, clearly, not the degree of spread widening as we had then. But just as you think about more challenging backdrop today versus then, what kind of -- what lessons maybe have we learned from them? What's new? What's different today?

It's a great question. In March of 2020, we saw some dealers actually either widen price or step back from pricing in an automated way. We also saw some of our clients turn off a lot of our automation solutions. In this environment, particularly in the first quarter and even in the most recent events over the last couple of days, dealers continue to price across a broad spectrum of instruments, the algo pricings that they are using continues to be quite aggressive and firm. And then our automation solution, clients are maintaining their normal levels of utilization of automation. It's obviously a key ingredient for how they execute long lists of bond activity in the market. So it's a very different environment. It's obviously a favorable environment, but more favorable than what we saw in March of 2020.

And I think it's a good segue maybe to talk about liquidity in the marketplace. I guess, how would you characterize liquidity in the markets today? How do you see that evolving? And maybe you could touch upon some of the initiatives that you have at MarketAxess to really help clients access better liquidity and ultimately better execution?

In these environments, whether you're trading equities or bonds, liquidity is challenging. Whenever volatility spikes, there's uncertainty around the macro environment. Liquidity becomes more challenging. Things that are challenging are when bank balance sheets become stressed and they're less willing to provide liquidity or warehouse risk on their balance sheet. We haven't seen a great deal of that like we saw in March of 2020. But if this is prolonged and continues, you could expect more challenges around bank balance sheets. We're trying to solve liquidity, one, by allowing all markets provide liquidity into this market. So not only banks and dealers, but also alternative dealers. People like ETF market makers come through our all-to-all solution are able to price bonds on a regular basis and provide alternative liquidity. We also see in environments like this, investors taking advantage of price disruption and stepping into bonds and being the other side, providing price back to other investors looking for opportunities where assets have moved dramatically, and they see a pricing opportunity to step into the market. We've seen that in high-yield last month and we continue to see it across both high-yield and high-grade. In the treasury market, we're introducing a new solution where clients can actually rest orders on an order book, which is not the traditional method of RFQ. So we're seeing clients engaged in trying to be a liquidity provider even when they're demanding liquidity at the same time. So all of these new protocols allow for a lot of different options to trade, whether you're trading the front-end of the curve or the back-end, you may use different protocols for each end of the curve.

Now you've spoken about introducing technology to help clients avoid crossing spread. Where would you say we are today on that journey? And what are some of the hurdles that investors face that are resulting in them crossing spread today? How do you kind of overcome that?

I would say we're not even in the first inning. We're still warming up for the first inning, largely because it's traders in the credit market, even in the treasury market, even though it's more advanced and more evolved from an electronic standpoint, they continue to request price, which by definition is crossing a spread. We really want technology to help solve, finding the opportunities to avoid crossing spread and being in the market ready and waiting to respond to another RFQ. We're resting on an order book. So we have all the different protocols that help avoid crossing spread. It's really marrying technology solutions to the opportunity to avoid crossing spread. The big question for traders is how much time do I have to spend avoiding spread before I need to cross spread? And that's really a critical component in developing technology around the bond market to avoid crossing spread.

Now as markets have electronified, there's been an expectation that turnover and velocity should increase in the market, that volumes should go higher meaningfully. But that hasn't quite played out just yet even over the last 12 to 18 months as electronification kind of continue to go higher. I guess why is that? And what's the risk that markets are more electronified in 3 to 5 years and yet velocity maybe hasn't changed much?

I think if you look at turnover as a percent of the overall market, historically, we've seen unprecedented new issue like this market has never seen. So the overall notional market size grew dramatically and the capacity for velocity or turnover has been moving along with that. And so when you look at that market, the market grew, the overall turnover stayed the same. But I think our market now has the capacity to increase turnover on a daily basis with all the electronic and automation solutions that we see. I think the other challenge that we've seen more recently in the first quarter where volatility in rate rises, you would obviously expect more turnover. A lot of the institutional market was well positioned for the rate rise. And so turning over their portfolio wasn't ideal to their investment strategy. And so we just saw a lower portfolio turnover and that ultimately impacted the velocity of our market. But if you look at end of May, end of quarter end, end of last week, we're seeing in this volatility, higher volumes as a percent of the overall market.

Got it. So it's the new issue that perhaps resulted in that…

New issue clearly fed the market with product, but it did dampen turnover as a percent of the overall market.

But now it's starting to change in the recent weeks?

I do think, as you see further rate rises, over the next few months, portfolio turnover is going to have to increase. The new issue market is no longer there to deliver ALFA in the fund complex. So actually trading the portfolio will be something that many managers will have to do.

Right. Now as markets become more electronified in the years ahead, you've mentioned before that you're not seeing much pricing pressure now. But I guess the question always comes about, okay, well, if the market is more electronified, what's the sort of risk that pricing could come under pressure, particularly as larger size trades get digitized? And I know we saw this in other asset classes, but some would point to the fact that you are more a direct-to-customer marketplace, and that gives you some more insulation than other markets and other asset classes that are more exchange traded. But I guess how do you think about the competitive landscape just in terms of other players in the marketplace and the sort of risk that as volumes go up, other competitors could use pricing as a lever?

Do you want to take that?

Yes. So the pricing, we're not seeing any pricing pressure as we spoke about on the last earnings call. And to the extent there's increased velocity, we feel that there's going to be additional turnover that the additional trading volume would offset any fee reductions that we need to make because the value proposition for us and which is the real differentiator is the deep network that we provide in Open Trading, and they're getting the best price of execution by accessing the Open Trading network, best price available for fixed income trading when bid offer spreads are wide. That's a very valuable proposition. As bid offer spreads tighten, we may have to revisit those fee plans, but not in the near-term. We expect that's a longer-term solution.

So the thing people should be looking out for is perhaps the bid offer, spread being a key piece there?

Yes, and we're early days of this cycle. I mean, spreads have gapped out in absolute terms, but the bid offer spreads, we haven't seen that really widen much. And the volatility in the markets in the last few days, we've seen that bid offer spreads starting to widen out to levels that will make Open Trading very attractive.

And the key for us is, we're solving 2 things for the end client. We're providing an electronic solution for their execution needs. And then we're also providing a liquidity benefit for their execution needs. So things like all-to-all do produce a better price outcome. And so as long as that value in terms of the spread that they're achieving, the cost that their savings continues to be positive, they're going to continue to benefit from our service and not be inclined to look for a better priced service. But as Chris mentioned, the network effect of our liquidity has a bit of a moat around it. There's value in that network effect. And so clients are certainly in this environment willing to pay a premium to access that alternative liquidity pool.

Why don't we shift and talk about data? You guys have made some announcements in recent months around data ETFs. How should we think about these announcements? And to what extent do they represent incremental revenue streams versus driving trading-related activities?

So we continue to see data as a key component to growing our trading business. Obviously, we want to continue to grow when you look at us as a percent of the overall bond, global bond market, we're still relatively small. But data in terms of commercializing the data on the platform is a very attractive business for us. We have that data. It's already produced, so there's no cost to it. And then it's just organizing it in a format and a form that can be consumed by both dealers and clients. I'd say our CP+ real-time data feed is probably a premium product in the U.S. credit space. It's consumed by most dealers that are providing price in our market. And it's also being consumed by our largest clients. The next, we announced some new endeavors in the index space. I would think of that as data as well. We're organizing our data into forming what I'd call very tradable indices. And if you look at where that indexation of the fixed income market is headed, it's only up. And we had that recent study by BlackRock that they put out where we're headed to $5 trillion in terms of ETF AUM. And that is all an index, further indexation of the space. We view the index business as not only the sale of an index, but also sale of data. So our index and any of our index relationships like our MSCI relationship that we recently announced, that all comes with it a data solution as well. And those are all attractive incremental revenue opportunities for us from a data perspective.

So when we look at the credit market, it's about 30%, 35% electronic today. I think in the past, you've mentioned client behavioral preference is perhaps the reason why it hasn't moved a lot faster. So maybe we could talk about some of the trading automation tools that you guys are building out, how that can be an accelerate for digitization of the marketplace?

Sure. I mean, if you look at how clients use our platform today, it's a trader using our platform to do a traditional RFQ. So it really replicates phone and chat on the platform. And it's in an all-electronic form, but it produces an outcome that is more efficient than an individual trader trying to trade individual tickets. You can do long lists of RFQ with a single RFQ solution. Our automation solution allows clients to connect via API and just download lists of bonds that they need, either need to buy or need to sell. And it allows them to, with no touch, trade bonds on our platform in an automated way, highly reliant on our CP+ data feed. So it is a premier product. It allows traders to step away and fully automate the trading outcome. It still leverages all the network and the Open Trading solution. So they get the best price benefits that exist, whether you're trading on our platform manually or you're trading in an all automated fashion. What's interesting is about just under 20% of our total trade volume is now in our automation suite. So it's a growing part of our business and will continue to grow. Last year it grew 33%. So it continues to grow as we see large investment complexes adopting automated solutions to trade long lists of bonds. So it's an exciting area for us and it will continue to grow.

And when you think about the uptake from customers there, I guess, are you seeing more from the dealers? Or is it more from the institutional clients? How do you see that taking shape?

So it's really a tool for institutional clients. So we tend to target the largest fund complexes because they have a long list of trading challenges to get through. Many times it's small to medium-sized tickets, so it's not a 20 million block. It's more like 10 million -- 5 million and under is what we're seeing with under a million being obviously the most popular. What typically happens is clients will adopt under a million and move all their trades into that automation suite. And then as they get comfortable, they'll increase that size to 2 million and then even above. So we typically see clients continue to increase the size of the tickets going into the automated suite. And we have some clients at obviously more mature levels than other clients. What's interesting is we have some very large complexes that haven't even adopted the automation suite and are still using traders to manage long lists of tickets. So we see -- that's why we see a lot of growth opportunity for that automation suite. We're also seeing clients that are using what we call our Auto-Responder solution, which allows you to put an order in, apply a limit price and just wait for someone else's RFQ to come along. It's a sizable savings because you don't cross the spread, the client actually crosses the spread and hits your price. And that's a big savings for large institutions across a great number of bonds.

Maybe just following up there, to your point on some of those large institutions that have not yet adopted it. But what are some of the hurdles to adoption? How do you think about penetrating and kind of bringing them on board?

I mean, large institutions typically respond to stories about competitors that have adopted tools that they haven't. And so just when we look at their peers and what they're doing, they tend to be very responsive to what peers are doing. More importantly, the sale of automation is getting both compliance and the trade desk comfortable with the data that is going to be used by the automation tools, getting comfortable with outcomes. And once you're through that, there's a testing phase and then ultimately an expansion phase. So we've seen this with many different clients and it's really -- it's driven from the top down to adopt and outsource their trading to an automated solution.

And you recently announced a partnership with Virtu and others in the industry around an RFQ hub. So can you just talk about the opportunity set that you see there?

Sure. I mean, the ETF, particularly the fixed income ETF market is growing rapidly. If you look at turnover in that market, it's higher. It's at historical highs right now. Yesterday and Friday, we've seen ETF, fixed income ETF hit record numbers. We still see our institutional clients have demand for using ETFs. So it's really a tool to get exposure in the bond market. The fixed income ETF is a very nice way to deal with inflows of capital that you need to expose to the bond market and trading the underlying bonds over a period of time takes a little bit longer. So they can get instant exposure through a large block of an ETF and then slowly unwind that exposure and wind themselves into the underlying corporate bond market. And so that's the strategy that's been deployed and it's becoming a more popular strategy among our clients.

Staying with the data sort of ETF theme, you recently announced the launch of your own fixed income index and you partner with MSCI on that. I guess, what's the opportunity set there and how does MSCI help?

Well, MSCI is a great partner because obviously they have a brand name in the index space. They also have expertise across kind of the globe and emerging markets in particular. And so part of our partnership is around providing unique data that we have to help portfolio selection for building a true tradable index. Many of the indices on the market today, many of the underlying bonds in those indices are not available to trade. So it's very hard to get exposure, perfect exposure to those indices and obviously working with MSCI and their brand is very attractive to us. There's another component to the MSCI relationship and that's around portfolio construction, where we're providing very similar data, but in real-time to their portfolio construction tool that allows bond portfolio managers to pick bonds that are more liquid, easier to trade and actually can result in a better outcome, execution outcome when they're engaging the market. And that's something that is just, I think, at the beginning of our data journey where not only can we provide institutions with real-time data to trade bonds, but we can help their selection process by telling them what the underlying bond market looks like at the CUSIP level, what's liquid, what's not liquid? When they look at their overall investment theme, there are a number of bonds that can solve that investment theme, not just on CUSIP. And so it's very different than the equity market where your thesis is a single name. In the bond market, you can get exposure through a variety of different bonds. And so picking that right bond based on the real-time liquidity in the market is a key ingredient to getting a better execution quality.

And what would you say your vision is for that part of the business? Do you envision a whole suite of ETFs looking out 5, 10 years?

We want the indexation of the fixed income market to continue. We actually benefit from that market environment. And so whether we're doing direct indexing or partnering with index providers, that's our vision. Ultimately it involves creating better tradable products that needs real-time data to price and obviously real-time data to price the index itself at the end of the day. And so we see that market as still early days in the indexation of the overall market and a great opportunity for us to go direct or partner with folks like MSCI.

Great. And about 2 years ago, you guys introduced Live Markets as a protocol for trading some of the newly issued bonds. So maybe you could just give us an update on the progress there and also the pipeline of additional dealers that you are looking to bring on to that platform?

So Live Markets continues to grow month over month and we're getting great feedback from the clients and continue to see more clients sign up to trade Live Markets. The key ingredient for Live Markets is it allows an institution to leave a resting bid or offer. So whether they're a buyer or a seller of a bond, they can actually rest in the market and wait for someone to cross the spread and hit them, which is a unique attribute in the bond market. The dealer community has embraced Live Markets. We've got a long list of dealers that have committed to being liquidity providers on the platform, designated market makers, as we would call them. And then there's a long list of dealers that are on the platform, providing liquidity on a regular basis. But we're excited about having a live order book in the credit market and believe that it will continue to grow over time.

Great. I want to shift gears and talk about investments you guys are making for growth, expense growth and such. You have guidance out there for, I think, 10% or 11% so expense growth this year at the midpoint. You've commented in the past that about 60% to 70%, I believe, of the growth is focused on investing in the platform when we think about kind of the composition there. So maybe you could just elaborate on what are the largest contributors to that investment spent? And which sort of line items are we talking about in particular?

Yes. So the one thing we have working for us is we have a very healthy pipeline of cash flow, so averaging about $300 million of free cash flow per year. And when we prioritize how we're going to invest that cash, the #1 investment continues and remains to be improving the trading platform. Now that can be through system enhancements, by adding developers and continuing to enhance the functionality across all of our product offerings and protocols, geographical expansion, which means adding sales force to expand in local emerging markets that we're looking to penetrate. And there may be opportunities to expand through small M&A activity. You've seen that in the last few transactions with Reg Reporting Hub and MuniBrokers where those were bolt-on acquisitions to enhance our post-trade and muni bond offering. The final return to capital strategy is returning capital to the shareholders and that's always been in the form of dividends and share repurchases. And given the stock price action this year, we've been more active in the market repurchasing our shares in the first half of the year. The Board authorized a $150 million repurchase program. So those are the 3 main themes of when we think about our capital management strategy and how we're investing in the business and returning capital to the shareholders.

Great. Speaking of investments in the business, why don't we talk about some of the newer initiatives as well? You guys have been focused on in recent years such as emerging market bonds, munis and treasuries to name a few. Maybe just starting with those 3?

Well...

Obviously that's follow-up to begin further.

Yes. Well, munis is exciting. It's obviously crossed over that $100 million mark in terms of a new product. And it's an opportunity for us because the competitive landscape is literally the phone. So when we look at who are we competing against, it's actually people still trading on the phone. We have a wonderful position in the emerging market, the hard dollar market, the U.S. dollar-based market because our largest clients trade that actively, and so we're well-positioned for that. Looking at the treasury market, that's more of a new entry for us with our acquisition of LiquidityEdge. We've just now integrated that platform, extremely important in terms of seamless delivery of orders into the platform. What's exciting about that platform is we are bringing a new alternative market structure to the treasury market. If you look back at the Fed report recently, where they called for an all-to-all market in treasuries. That's what our offering does. It brings all-to-all into the treasury market, which doesn't exist today. Today it's just a fully disclosed dealer-to-client RFQ solution. We're bringing both streaming liquidity all-to-all as well as RFQ all-to-all to the treasury market. So it's definitely something that our clients have asked for. It also leverages technology that allows clients to rest limit orders, again, another theme of not crossing spread. So it's a pretty novel approach to the treasury market and obviously a competitive environment that we think is compelling.

Great. Why don't we dig in a little bit on some of these here? So maybe starting with emerging market. That's one of your fastest-growing products. It also has a heavy user base of all-to-all trading embedded in there too. And I believe the revenue is nearly approaching the magnitude of high-yield bond revenue. So I guess, do you think it can surpass the revenue contribution of high-yield? And then maybe you could talk a little bit about some of the initiatives underway to unlock the next wave of growth in your emerging market business?

Yes. The addressable market for emerging markets is it's very compelling. We put a slide in the earnings deck to size up what the total addressable market looks like. And you're talking about $50 billion ADV across the emerging market product offering. And we're about 5% market share across that entire addressable market. So very early innings for us in emerging markets. And that's why when we talk about the near-term excitement, it's about penetrating those local markets where we may need to expand our physical footprint by adding people with sales force, developers, but it's something that we're mindful of what the costs are for entering into those local markets because as we expand our Open Trading deep network to those local markets, will be a counterparty to the middle. So that brings additional regulatory considerations. So we're going to be very selective on where we decide to open our Open Trading network in the various local markets that we're looking to penetrate.

Great. And then maybe talk a little bit about munis, that's another fast-growing business for you guys. How is the integration progressing with MuniBrokers? And how does that enhance your capability set?

Sure. MuniBrokers' integration was well underway in the first quarter, integrating their liquidity needs into our Open Trading network. We're very comfortable with how that integration played out and what we can do with that asset class. Obviously our muni volume and our muni market share continues to go up, which is exciting. And with an increasing rate rising, that could make munis attractive to the average investor again. And so we're -- from a macro perspective, the muni market is in a great position to see more inflows, not fewer. And that muni market is quite a diverse market in terms of product and a fairly inefficient market structure that we're solving for. And we're seeing great uptake from our largest institutional clients coming in and really demanding liquidity from banks in the muni market to help support their adoption of electronic trading. So we're seeing great progress in the muni market.

And I think in the past you've mentioned that you're just over 4% electronified today in munis. I guess, what's the path for that going higher? Clearly you see an opportunity, but like how do you overcome some of the key hurdles that are in place today?

When we look at the client adoption that we've seen from large, again, larger complexes, we see favorable outcomes for them from just the adoption of electronic trading and getting access to alternative liquidity. In the muni market, our all-to-all platform is close to 49% of that market. So alternative liquidity providers are in that market, providing certainly price benefits. And so the -- really it's getting other clients to adopt the electronic solution that we offer in munis across all of their trade ticket sizes. Obviously the muni market is a much smaller ticket size traditionally. So our electronic solution is ideal for that size ticket and the all-to-all market can certainly provide price at those sizes. So overall we're seeing continued adoption among the muni market. We also are seeing more dealers stepping into our platform and providing price in that muni market in a fully electronic way.

Great. Maybe we'll see if there's any questions in the room? Any questions? I guess maybe just final one for me. We have about 2 minutes left here. So maybe just bringing it back to the P&L to the stock. How should investors think about your growth algorithm looking out over the next couple of years? And what's the opportunity for margin expansion as you're investing back in the business for growth?

Yes. We're continuing to invest today because there's a long agenda of opportunities for us and we don't want to pull back on the investments. And so we're all focused on how can we invest to grow revenue? That's going to come with an expense. And the last 1.5 years have been challenging in terms of the market conditions for particularly our core U.S. credit products. But with the return of volatility and bid offer spread and credit spread widening, we're in a very productive, favorable environment, and we're excited about the second half of 2022. But getting to your point, we'd expect our operating margins to expand as we approach more favorable market conditions. And longer-term, our revenue CAGRs, we'd expect to achieve mid-teen revenue growth and our goal is to maintain an expense base growth rate of around 10% to 12%.

So mid-teen is still achievable?

Longer-term.

Longer-term.

Yes, we're trying to -- last year was a challenged year, but we all need to recognize that 2020, 2021 was essentially a 1-year period because we expanded our growth in 2020. That was representative of a long-term average 1-year growth rate of 15% when you average it out over 2 years.

Great. I [indiscernible] there. Great. Thank you very much.

Thank you.

Really appreciate it.