MarketAxess Holding Inc. (MKTX) operates an electronic platform for fixed-income trading. This includes investment grade corporate credit, high yield, emerging markets and Eurobonds. Additionally, it also entered the treasury market through a 2019 acquisition, and is making inroads in the municipal bond market.
MKTX has a fantastic business model, and high expectations to go along with it. As the leading electronic platform, it is well-positioned to capitalize as the bond market moves into the 21st century. However, the P/E of 74 seems to price in the best-case scenario and provides little margin of safety.
Revenue and Cash Flow
Between 2014 and 2019, revenue grew at a 14% CAGR and operating income grew at a 16% CAGR. Cash flow has been growing steadily, and MKTX has so far managed to balance investing in growth with returning capital to shareholders.
The following charts show growth in capex, cash flow, and quarterly dividends.
(Source: Investor Presentation)
COVID-19 has been very good to MKTX because it drove a surge in trading volume. In 2020Q2, the company set records for revenues, operating income, operating margin, and EPS. Not only is the business growing, but it’s becoming more profitable. Revenue is up 47%, but diluted EPS is up year over year 73%.
The sudden surge in trading volume earlier this year is temporary, but COVID-19 also accelerated key longer-term trends favoring MKTX.
Long-Run Trends Favoring MKTX
The credit markets have been slow to adopt to modern technology. Most companies have only one issued stock but dozens of unique bonds. Large blocks of debt are difficult to buy and sell without some human intervention. In January 2020, the Wall Street Journal noted that only ⅓ of investment grade bond trades occurred on electronic platforms, although that percentage has been growing steadily as trading platforms improve and traders get more accustomed to them. Post COVID-19, the growth rate has accelerated.
Any market moving from analog to electronic has increased turnover and trading volume in the process. This is especially true in the credit markets, where growth in electronic trading has coincided with the growth of credit ETFs. Electronic trading in the credit markets means investors can use credit ETFs as a way of effectively trading the underlying assets. Market makers in the ETF space also need to hedge their exposure. There is a positive feedback loop between the growth of electronic trading and the growth of ETFs that leads to higher trading volume for MKTX.
Closely related is the push towards automation. Narrower spreads are driving the industry to automate trading. Additionally, the existence of platforms like MKTX make it feasible for algorithmic traders to use bonds as a systematic hedge. Automation has also proved critical in dealing with heightened volatility. Dealers were forced to work from home and break up block trades into smaller orders using automated systems.
Regulatory pressures have also made electronic trading necessary. Post-financial crisis regulations made it more difficulty for banks to hold inventories of bonds and provide consistent liquidity to the market. This drove efforts to find more efficient ways to trade on platforms such as that owned by MKTX.
MKTX is well-positioned to take advantage of all these trends.
Market Share Growth
The company is increasing its share of a rapidly growing market. A recent investor presentation highlighted how favorable the environment has been:
(Source: Investor Presentation)
Credit market volumes were up dramatically on all trading platforms in early 2020. However, as the chart above shows. MKTX’s volume in every category is up much more than the total market.
According to an investor presentation, every 1% gain in market share of overall credit markets leads to $33-39 million in additional revenue. 2020 has merely been an acceleration of a trend where MKTX’s market share of total credit trading volume grinds higher.
(Source: Author’s Calculations based on MKTX and FINRA data)
Note that the monthly chart above goes through September, so we already know how market share changed in the third quarter. Looking at quarterly numbers, 2020Q3 market share of all trading volumes will show an improvement over 2019Q3. Investment grade market share was 22%, up from 20% a year ago. High yield market share is 16%, compared to 12% a year ago. Note that these figures are for the overall bond market, of which only a small portion is electronic. Of US bond trading that is conducted electronically, MKTX has a market share above 80%. Although emerging markets and Eurobonds are a smaller part of MKTX’s overall business, it is also gaining share in those areas as well.
MKTX faces two main risks. First, there is a risk of a new entrant suddenly coming in and taking market share. So far, this seems like a less of a concern, because network effects favor it in US high yield and investment grade. As more bond traders switch to electronic trading, they are likely to go with the dominant platform. What is likely, however, is that a competitor like Tradeweb (TW) will prevent MKTX from gaining market share in government bonds and in European markets, where it is less dominant. This would slow down long-term expansion.
Second, there is the risk that the broader growth in electronic trading will stall. If it ends up taking several decades for bond markets to catch up to stock markets in terms of electronic trading, then MKTX will likely trade at a lower valuation.
What To Watch For In Q3 Earnings
The market is understandably expecting great earnings when MKTX reports next week. According to Seeking Alpha, consensus estimate for EPS is $1.76, up 24% from the third quarter of 2019. Consensus estimate for revenue is $161 million, up 23% from the third quarter of 2019. Regardless of whether they meet or beat earnings, for a high-growth, long-term investment like MKTX, it’s important to look beyond a single quarter and see how broader trends are playing out. Here are three things I’ll be looking for next in the company’s earnings:
Are dealers that traded electronically when they were forced to work from home continuing to do so when they get back to the office? It will be interesting to see how much of the sudden surge in trading volume can be sustained longer term.
Do they expect to keep growing market share in emerging markets and Eurobonds? Continued in growth in these areas could help support an elevated valuation.
What type of integration costs can we expect from their acquisition of a munibond trading platform? Do they anticipate municipal bond trading becoming an important part of their business? This also impacts long-term growth estimates.
MKTX is a great business, but the stock is not selling at a great price. It trades at a forward P/E of 74. At this price, basically nothing can go wrong. I find it psychologically difficult to hold a major position in a stock at such a high valuation. High expectations are built in to the stock price, although, MKTX has a decent chance of meeting or beating them. If the company has a negative earnings surprise, but the longer-term trends favoring it continue, it would represent a major buying opportunity.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.