Making Sense of The Exchange Earnings Tsunami
Industry breakdowns, company-specific reviews, and more
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The Earnings Tidal Wave Arrives
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In case you hadn’t heard, Q3 earnings season is in full swing this week, and that includes most of the public exchanges & market data providers. I’ll dive into my thoughts on the industry first, then move into company-specific performances.
Let’s get to it:
Industry Commentary
(Industry metrics as of 10/29 - Source: company IR presentations)
The term “K-shaped recovery” aptly applies to more than just America’s economic situation during the pandemic. 2020 has either been extremely kind or downright vicious to the exchange industry, depending on which company you’re talking about.
On one hand, we have the data-centric companies who are enjoying the fruits of their label. Whether it be ESG demand, the explosion of passive index investing, or the work-from-home technology demand, there’s something for everyone to impress investors. Companies like MSCI, S&P Global, Moody’s, Nasdaq, and FactSet fit into this category. You also have the continuation of the secular “analog-to-digital” narrative helping MarketAxess & Tradeweb overcome the low interest rate environment to post strong growth figures this quarter.
On the other hand, you have the macro-driven exchanges like CBOE, CME and Deutsche Boerse, who are getting shellacked by low interest rates and unhealthy volatility that has kept traders out of the market. Investors are looking for signs that performance will rebound in 2021, but right now there isn’t much to hold on to. These companies are focusing on improving their businesses in areas they can control - either with selective M&A, successful integration of past deals, or new products that can pay returns in the years ahead.
Company Specific Commentary
CME - The destruction of CME’s interest rate franchise was seen in full force this quarter. Their largest market saw its worst quarter since Q4 2013 as the Fed’s “lower for longer” policy drove marginal traders out of the virtual rates pit:
Shares were hit hard as analysts & investors reacted to the bleak results. The question now becomes - where do we go from here? Analyst questions focused on integration benefits in the short term. BrokerTec (a cash fixed income platform bought with NEX) is scheduled to be migrated onto Globex later this year. CME management said there should be positive liquidity impacts of putting cash products & futures on the same platform, along with more expense synergies throughout 2021.
Analysts also asked what could spark a rebound in demand for CME’s futures products. When will rates & energy futures come back? Management responded by touting ballooning US & global debt levels and the need to manage the larger associated risks of this debt, even at low rates. They also gave election uncertainty and the potential for inflation next year as catalysts for rates to rise & demand for futures to grow.
As an owner of CME, my opinion is the stock is in “show me” mode and will bounce around post-COVID lows until the market becomes convinced rates could tick up again. There are no immediate catalysts to send shares back towards all-time highs, but the business is making progress on integration & launching new products that make the long-term narrative more hopeful. A 2021 economic re-opening story helps energy futures, and rates volumes could snap back quickly if we do get warnings that inflation is on the rise.
Deutsche Boerse - DB1 saw a decline in revenue, EBITDA and earnings per share in Q3 driven by weak trading volumes at Eurex and shrinking collateral revenue. A global lack of interest rate volatility is to blame for the sluggish results, hurting DB1’s flagship Euro-Bund and other fixed income futures markets. The exchange is also facing a “CBOE problem” - its VSTOXX index (think the VIX for Europe) saw huge volumes in Q1 and deafening silence since, as many traders were blown out of their positions and haven’t come back:
(DB1 VSTOXX volume & open interest. Source)
The potential for M&A has always surrounded DB1’s strategy & go-forward narrative. The coming quarters are no different, and if anything the pressure to do a deal may be even greater amid weak volumes & their main European rival (LSE) in the process of pulling off the biggest transaction in exchange history. Barring a rebound in interest rates, the best path forward for Deutsche Boerse seems to be continuing to bolster its investment fund services (IFS) and Qontigo analytics units, adding a level of diversification that will shield performance from macro environments like the present.
ICE - At a consolidated level, ICE reported mid single-digit revenue growth and a decline in EPS in Q3, with a plethora of moving parts underneath the headline. The company’s core futures franchise struggled in Q3 as energy ran up against poor compares vs. a volatile 2019, and financials were hurt by a low interest rate environment. Data revenue had an encouraging quarter underpinned by growth in fixed income & index analytics, with management signaling acceleration into Q4.
This was also the first quarterly report since ICE completed its blockbuster acquisition of Ellie Mae for $11 billion. On a pro-forma basis, mortgage technology revenue grew an impressive 62% driven by refinancing activity & demand for more efficient, digital solutions.
I consider ICE to be one of the only exchange “conglomerates” - with so many acquisitions & company verticals, it can be difficult to track progress clearly & build an accurate outlook. Management did say they would be reorganizing segments later this year to better align financials around the new mortgage tech units, which is a good start. Going forward, the stock will react primarily to changes in the mortgage electronification story. While the Ellie Mae purchase price was steep, initial results signal 2021 could be even better than expected for the business. I’m currently long ICE and am positive on the 2021 outlook - consistent growth in data services combined with acceleration in the mortgage space is worth the added investments & complexity of the business.
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MarketAxess - The narrative around MarketAxess’s current trajectory began in the early 2010s with the advent of “Open Trading”, a way for bond market participants to trade electronically with counterparties other than the legacy banks & dealers. Open Trading was a way for electronic liquidity to build more momentum and add to the value proposition & efficiency vs. voice bond trading.
Open Trading volume now represents over a third of all volume traded through MarketAxess, and that % is quickly growing. Next in the liquidity lifecycle is “Live Markets”, an active central limit order book for fixed income - the deepest & most liquid form of market structure today. The more participants commit to Live Markets and the more MarketAxess improves the platform (like adding market makers), the more market share will grow.
In conjunction with recent success in Open Trading & Live Markets, electronic market share in both investment-grade & high-yield corporate bonds hit all time highs in Q3. With all this in mind, it becomes easy to see why the market gives the company such a premium multiple. MarketAxess is firing on all cylinders this year, and the growth trajectory doesn’t look to be slowing down. If you’re willing to pay a sky-high PE multiple, you’ll have exposure to the clear & attractive medium-term growth story in corporate bond electronification.
Moody’s - Like S&P Global, Moody’s reported 9% revenue growth driven by impressive ratings & data business performance. Higher than expected levels of debt issuance caused management to sharply increase 2020 guidance & give upbeat commentary on the 2021 outlook. On the data front, instead of customers cutting data services to save costs, Moody’s is seeing retention increase as clients place higher value on their compliance tools & analytics to improve efficiency. Margins improved nicely this quarter as SG&A costs stayed muted in a virtual work environment.
2021 looks to be a promising year for Moody’s. COO Robert Fauber will soon take over as CEO and has the necessary experience to keep performance strong and shareholders happy. Moody’s is in a prime position to capitalize on both the global debt binge and the rising demand for ESG data and KYC compliance products to combat changing regulations, all while controlling costs and expanding margins in the process. Shares have sold off modestly this month, but a recovery seems likely as investors accept this narrative and the new CEO’s vision going into next year.
MSCI - Given the nature of MSCI’s entrenched subscription business, changes in the company’s long-term narrative take many quarters to play out. The star of MSCI’s results this quarter were ESG products, boosting both its Index segment and the fast-growing “Other” segment. MSCI is considered the first mover in ESG with S&P Global a close #2, licensing ESG indices to both asset managers for ETFs and exchanges for futures products. EBITDA grew 13% and EPS grew 31% YoY as the company benefitted from favorable 1x tax items in addition to broad-based subscription growth.
A potential headwind discussed during the earnings call centered on client consolidation. With asset managers like Franklin Templeton & Legg Mason combining and Morgan Stanley buying Eaton Vance, the risk that synergies & cost cutting efforts hurt future results is a real one worth watching.
Overall, MSCI’s close proximity to secular trends like the takeover of passive ETF investing and the increasing focus on ESG justify the premium valuation. Subscriptions have been growing in the high single to low double-digits for at least the last 20 quarters, and clear trends to keep this growth going are still in place.
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S&P Global - Q3 results kept the debt issuance gravy train going for S&P Global’s largest segment: ratings. While Q3 investment grade issuance was down YoY, high yield issuance popped an impressive 94%, which are charged at a higher rate. Interestingly, Asian issuance outpaced US issuance this quarter for the first time since 2018. The company also provided their 2021 issuance forecast, and while they expect some return to normal issuance levels next year, they did acknowledge activity will be elevated vs. historical averages with opportunity for upside surprises like we saw in 2020. The company played catch-up with its earnings guidance all year, lowering ranges when COVID first hit in Q1, then raising throughout the year as issuance beat all expectations:
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S&P Global’s index unit brought a more mixed story this quarter. Overall index revenue grew 1% YoY in Q3, but underneath the results saw ETF-linked revenue grow mid-single digits offset by modest declines for derivatives volumes. S&P’s two biggest exchange clients - CME & CBOE - had rough quarters from a transaction perspective as liquidity still hasn’t recovered from the March COVID chaos. Lower trading volumes in CBOE SPX options drove most of the decline in index fees, slightly offset by higher CME S&P 500 micro e-mini volumes.
Tradeweb - Similar to CME, Tradeweb’s largest markets are interest rate dependent - particularly US Treasuries, mortgages, and swaps. The macro headwinds certainly dampened performance - this was the first quarter under double-digit revenue growth since their IPO - but the company did well despite the challenges. Tradeweb management talked about how their rates franchise is quite diverse and growth is supported by more than just macro factors.
Like MarketAxess, Tradeweb is in a position to grow electronic market share in fixed income markets through advances in technology, with a long runway of potential growth ahead. In corporate bonds for example, the company reported an impressive ~20% market share in investment grade block trading. While the figure is not “fully electronic” (the trade is negotiated over the phone & processed electronically), it signals Tradeweb is winning over customers and improving efficiency in an area where MarketAxess has had trouble making headway. It’s worth noting that credit products (primarily corporate bonds in the US, Europe and China) accounted for almost all of the revenue growth this quarter.
I think that as long as Tradeweb can show the market that electronic share is on an upward path in its core markets, the stock can overcome macro challenges and continue higher.
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Chart(s) of the Week
The well-known, age-old mantra in the exchange space is “higher volatility equals higher trading volumes”. There are some situations where this rule doesn’t hold, but the below chart (at least for the cash equity market) confirms the relationship between the VIX (a measure of volatility) and US equity market volumes:
This is an important relationship to keep in mind when trying to build a forward-looking view of exchange performance. It’s near-impossible to predict future volatility with much certainty, but exchange investors can use VIX futures to gauge what the market is currently pricing in. Below chart shows the current VIX futures curve - where the market is betting the VIX will be over the next ~9 months:
The current futures term structure implies the VIX will be above 30 through the end of 2020 and above 26 through at least 1H 2021. These levels are much higher than historical averages and imply most exchanges are due for a volatile (and profitable) first half of the year from a transaction standpoint.
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Disclaimer: I am not a financial advisor. Nothing on this site or in the Front Month newsletter should be considered investment advice. Any discussion about future results or projections may not pan out as expected. Do your own research & speak to a licensed professional before making any investment decisions. I am currently long ICE, CME, CBOE, NDAQ and VIRT.