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MarketAxess ($MKTX) - Follow Up: Financials, Management, and Valuation
We wrote about the company approximately a month ago covering its Q4 2022 earnings and we provided a high level introduction of the firm's large addressable market given the global bond's electronic trading low penetration and how MKTX all-to-all platform addresses this opportunity, alongside other services like data providing and post-trade compliance reports for example.

The full post is available here.

In this post we will focus on a review of the company's financial condition, the management, and a valuation assessment. As usual, we truly believe we can all learn from each other, so please let us know your thoughts in a comment!

Thesis

  • The company disrupted an industry with an innovative product and is now the leading electronic trading network for the institutional market in US credit products. MKTX's main competitive advantage resides in its platform and network of buyers and sellers resulting in an interesting network effect. However, the strength of the latter is likely to be tested by major finance companies in the future, and starting by Bloomberg (network of institutional investors twice bigger than MKTX), which launched a competitive product last year.
  • Large fixed income market undergoing major structural shift due to regulatory and market trends with electronic trading still enjoying low market penetration and with potential for MKTX to gain market share. The company is focused on increasing penetration of existing and new markets, promoting its A2A trading platform and continue to invest in and grow its international business. However, the current capital allocation does not reflect earnings' reinvestment to invest in future growth as being the priority since almost 90% of 2022 NI was distributed to shareholders through dividends and buybacks.
  • The company's exhibited a strong financial performance in the last decade with significant revenue growth and better than competition profitability with no use of debt. However the above is tainted by an significant rise in accounts receivable as a percentage of revenue since the pandemic. As of FY2022, accounts receivable represented almost 70% of revenue (from a stable 13% pre-pandemic).
  • To conclude and from a valuation point of view, the stock is fairly valued using historical multiple but overvalued using relative multiples and various DCF models.

Financials

MKTX operates a commission-based business and it is not surprising to see that, in 2022, commissions represented 89.3% of total revenues, and 90.12% on average over the last 5 years. Information and post-trade services accounted for the rest.
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Source: company fillings, SLT Research

Other credit is mainly composed of US HY, Eurobonds and emerging markets. Total trading volume surged 5x during the period to $8.4tn in 2022, helped by the Covid-19 pandemic as institutional investors turned to electronic trading platforms.
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Source: company fillings, SLT Research

The average transaction fee is obviously different for each type of bonds and is as low as $4/mn for US Treasuries and can be more than $200/mn for other credit trading. The significant increase in volume and decrease in the average variable transaction fee per million for rates products from 2018 to 2019 was primarily attributable to the inclusion of US Treasuries.
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Source: company fillings, SLT Research

  • Income Statement

We can see that the revenue has increased 3x from $238.7mn in 2013 to $718.3mn in 2022, representing a 13% CAGR over the period.
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Source: company fillings, SLT Research

The YoY Growth line in the above chart shows the year-over-year growth rate of revenue. We can see that the company experienced significant growth in revenue from 2013 to 2020, with a YoY growth rate ranging from 9.69% to 34.77%. For the last two years there was only a slight increase of revenue, growth rates were below 3% for both years. Overall, the company experienced significant revenue growth in the earlier years, but this growth rate slowed down in recent years.

The recent slowdown of the company's revenue growth, and despite a 27% trading volume increase over the last two years, is simply due to lower transaction fees. The explanation for the later is twofold.

First, fees tend to be highly (positively) correlated to the average bonds' duration traded on the platform. When investors prefer lower duration bonds, the average transaction fee is lower.

Theoretically, when yields are trending lower (higher), investors will increase (decrease) duration. Taking the Moody's Aaa Corporate Bond Yield of the last 5 years, the correlation is explicit. When yields where declining from 2018 and bottomed in 2020 (excluding March spike), MKTX's average variable transaction fee increased and topped $194.06. However, starting in 2021 but mainly in 2022, yields rose and investors sought to reduce their portfolios' duration. The impact on MKTX's average variable transaction fee is observable with the latter reduced by c.14% over the last 2 years.
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Another reason is the migration of some broker-dealer clients from an all-variable fee plan to a plan that incorporates a monthly distribution fee. While the latter plan enables MKTX to collect a minimum fee from its clients on the platform, it offers lower variable fees. The below table is an example showing the relation between fees and duration, security type, and monthly minimum fees amount.
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Source: company fillings, SLT Research

SG&A expenses, as a percentage of revenue, have been relatively constant over time with a dip in 2020 (function of the high average variable transaction fee). It includes mainly employee compensation and benefits, technology and communications (software subscription and cloud hosting costs), and consulting fees (acquisition-related integration fees). Even if the latter is directly linked to the several acquisitions in the recent years, I would adopt a conservative stance assuming these fees will be lower but persist going forward due to the management's willingness to keep invest in and grow the business through product and geographic diversification.

The second category of operating expenses is depreciation and amortization (D&A) expenses, which also show an increasing trend over the years. However, the percentage of revenue represented by D&A expenses has remained relatively stable until 2021 and 2022, where it increases significantly. D&A expenses mainly include amortization of software development costs and acquired intangibles. It is fair to associate this expense item with business development costs.

The growth in operating income and the relatively stable operating margin suggest that the company has been able to manage its expenses effectively while generating higher profits, especially by reducing SG&A expenses and despite the increased development expenses (both as % if revenue) during the period.

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Source: company fillings, SLT Research

The company's level of debt is unsignificant ($82.68mn as of FY2022), hence taxes are the "only" expense deducted from the EBIT in order to derive the net income.
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Source: company fillings, SLT Research

EPS increased 3.25x over the period and was $6.68 at then end of 2022 after reaching $8.01 in 2020.
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Source: company fillings, SLT Research

Looking forward, consensus expects revenue to grow c.12% p.a. over the next years, surpassing the $1bn mark in 2025.
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Source: koyfin

In terms of expenses, the management provided us with a $418-446mn expected range for the next FY. If we use the above estimated revenue, we can derive an EBIT within a $363-391mn range, representing a mid-range EBIT margin of 46.6%, slightly higher than in 2022, and aligned with consensus estimates.
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Source: company Q4 earnings presentation

EPS is expected to grow faster than revenue thanks to margin improvement, exceeding its 2020 peak in 2024 and reach $10.4 by 2025.
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Source: koyfin

With regards to profitability metrics, they have been mainly driven by the company's posted margin but it is important to note that ROA significantly decreased over the period, from c.20% in 2013 to 13% for the LTM, implying an drop in MKTX assets' efficiency. Total assets have been multiplied by 4.54 (significantly more than earnings) over the period and the increase was driven by higher non-productive assets such as cash, STI, and receivables.
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If we compare MKTX to its closest competitor Tradeweb ($TW), we can clearly observe that MKTX exhibits a better profitable however has lower FCF yield. FCF specifics will be discussed later.
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Source: koyfin, SLT Research

  • Balance Sheet

From a liquidity point of view, the company’s balance sheet appears solid. Current and quick ratios (no inventory) are both 3.56 and cash represents more than 30% of total assets. It is important to note that receivables account for almost 40% of current assets and as revenue ramped up, the amount got bigger. However if we look at receivables as percentage of total revenue, it is more surprising to see that they evolved from a stable c.13% before the pandemic to 68% as per the last financial statements. Days of sales outstanding more than quadrupled during the period to 226 days in 2022.
Although we could not find an explanation in 10Ks or earnings transcripts we decided to ask IR directly about that drastic change (no answer). In addition, MKTX's closest competitor Tradeweb's receivables represent 13% of total revenue and where as high as 38% during the period but never comparable to MKTX.

From a solvability point of view, as discussed earlier, MKTX's debt level is not significant with a net cash position of $422.48mn.

  • Cash Flow

Operating activities generated close to $290mn in cash in 2022, aligned with the net income (NI). Depreciation & amortization, combined with SBC added $C.90MN from the NI. The aforementioned significant increase in accounts receivable impacted the cash generation ability of the company but was partially offset each year by an extension of the accounts payable, resulting in a mild impact to CFO.

Investing activities are very low since MKTX does not operate in a capital intensive business and used only $86.27mn during the last exercise, mainly spent on purchases of marketable and equity securities. CapEx of $13.14mn represented less than 2% of revenue.

Financing activities used another $242.38mn in 2022 and has been consistently negative and allocated between buybacks and dividend payments over the period. Both are almost evenly weighted resulting in a total shareholder yield of 1.64% (0.8% from dividend yield and 0.84% from buyback yield).

FCF is relatively close to MKTX's NI for the following reasons: low amount of D&A, CapEx, and because change in receivables are mainly offset by an opposite change in payables, resulting in reasonable change in working capital. However, if receivables continue to grow and the impact is no longer mitigated by the accounts payable, it could result in a significant reduction in FCF going forward.

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Management and ESG considerations

Over the last 5 years, the stock significantly outperformed the S&P500.
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Richard M. McVey is the Chief Executive Officer and Chairman of MKTX. He was instrumental in founding the company in 2000 and led it through its IPO in 2004. McVey has extensive experience in the financial services industry, including leadership roles in the fixed-income business at J.P. Morgan, and has been named to the Institutional Investor Tech 40 list 15 times. He has deep knowledge and understanding of all aspects of the business and operations of MarketAxess, however, he will be stepping down as the company's CEO in April this year.

Current COO, Chris Concannon, will take over as CEO and has over 20 years of experience as an executive in the exchange industry, including at Nasdaq, Virtu Financial, Instinet, and CBOE. He has expertise in automated trading, the delivery of innovative technology solutions, market structure and clearing operations.

This transition does not raise any specific concerns to us, especially given the fact that McVey will become Executive Chairman where his focus will be on "supporting Chris in his new role, further developing corporate strategy, and working closely with key clients and our Board of Directors."
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Source: Yahoo! Finance

Based on the median value of CEO compensation by company size (revenue), the current total compensation (included exercised stock options) appears low. Despite being still led by its co-founder, less than 3% of shares are held by insiders, mainly by McVey.
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Source: Yahoo! Finance

The company’s mission is as follows: "transforming how the global fixed-income marketplace connects and transacts. We feel it's important that the world's capital markets be as open as possible."

With regards to capital allocation, the company acquired small brokers and complementary businesses but at the margin. The bulk the capital has been allocated between investments in future growth, shares buybacks, and dividend payments to shareholders.

It is fair to say (and maybe because of the finance background of the founder and executives), that MKTX's management has a strong focus on returning capital to shareholders with constant dividend payments and shares repurchase programs over the period. As already mentioned when we first wrote about the company, we are surprised by the amount of capital returned to shareholders especially given the growth potential ahead for MKTX.
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The above screenshot from the investors presentation highlights the growth strategy of the company which involves increased penetration, market share, and geographical and product diversification through investments. However, with a LTM dividend payout ratio of more than 40% and share buybacks slightly higher than dividends, it is almost 90% of NI that has been distributed to shareholders last year.
Even if paying dividends sends a message about a company's future prospects, performance, and financial strength, a company that is still growing rapidly usually won't pay dividends because it wants to invest as much as possible into further growth. The below trend in capital returned to shareholders raises a question on the management's perception of MKTX's future growth potential.

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Source: company fillings, SLT Research

  • ESG Considerations/ Glassdoor Review

The company is committed to grow its business in a sustainable manner and exposed an ESG strategy/initiatives plan in its last annual report.
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With an ESG risk score of C+, the company exhibits satisfactory relative ESG performance and moderate degree of transparency in reporting ESG data publicly. The company's rating is mainly impacted by low environment and governance pillar scores. We usually like to see scores above 50%.

The relatively poor score is confirmed by IBKR ESG Principles score:
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Source: IBKR

The good social scores from both above sources are further confirmed by strong Glassdoor reviews. More than 75% of employees who gave a review would recommend to a friend to work in the company and 90% approve MKTX's (soon to be replaced) CEO.
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Valuation

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Looking at historical multiples, the company trades slightly below average and above -1 std deviation from the last 5 years average. The value derived from the average of the above multiples imply an intrinsic value of $C.397 per share, logically very close to the actual trading price of $C.369.
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Source: koyfin, SLT Research

On a relative basis, after trading at a discount for most of the last 3 years, MKTX is today more expensive (P/E)
than its closest competitor Tradeweb.
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Not to rely solely on absolute/relative multiples, we ran a DCF model to assess MKTX intrinsic value.
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Source: koyfin, SLT Research

We used a FCFF forecast period of 10 years, using consensus estimates for the revenue during the first 3 years of
the period and then a revenue gradually reverting back to the long-term global online trading platform revenue growth rate of 5.1% for the 7 remaining years.

The DCF model implies that MKTX shares are currently slightly overvalued, at a premium of more than 8% and with an IRR actually lower than the company's WACC. As noted earlier, the historical net change in WC is not a conservative approximation in our view, because if the expansion of accounts receivable were not offset by an increase in accounts payable, the company's FCFF would be significantly impacted, and therefore the
valuation would be even lower.

As an extra layer in our valuation process, we decided to cross check with a reverse DCF model, please see below.
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Source: koyfin, SLT Research

Based on our reverse DCF model, the current market price implies an FCF annual growth rate of c.19.17% for the next decade and 3% perpetually which appears not achievable based on the growth perspective of the company.

Even if the company experienced significant growth over the last 20 years, we believe that during the next decade, MKTX will be closer to a 5-10% growth rate p.a. than the almost 20% implied by the current market price. As a conclusion and based on the above valuation methods, we believe shares of MKTX are currently overvalued.

Risks:
Clients will be able to launch Request for Quote (RFQ) tickets for applicable securities or respond to an RFQ to seamlessly execute a trade, supported by dedicated Goldman Sachs intermediation desks. The service Bloomberg Bridge went live last year and is designed to offer users the ability to source a deep pool of liquidity from Bloomberg’s global network of institutional investors and dealer firms, which currently number over 3,700 (2x more than MKTX).
  • Commission based business model, highly correlated with the attractiveness of the fixed-income market and hence makes MKTX's earnings cyclical.
  • We have not received an answer from the IR team but we believe that whatever the cause, major increases in accounts receivable as a percentage of revenue is a danger sign.

Disclaimer: The information provided in this post is for information only and solely on the basis that you will make your own investment decisions after having performed appropriate due diligence.
Bloomberg L.P.
Bloomberg Launches Global All-to-All Bond Trading Service | Press | Bloomberg LP

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