CME Group Inc.
Q2 2016 Earnings Call Transcript

Published: 31 Jul 2016

[Operator:]

Good day and welcome to the CME Group Second Quarter 2016 Earnings Call. I would like to turn the conference over to John Peschier. Please go ahead, sir.

[John Peschier:]

Thank you for joining us this morning. Gill and John will spend a few minutes discussing the results and then we will open up the call for your questions. Terry, Bryan, Derek, and Sean are on the call as well and will participate in the Q&A session. Before they begin, I will read the Safe Harbor language. Statements made on this call and in the slides on our website that are not historical facts are forward-looking statements. These statements are not guarantees of future performance and involve risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or implied in any forward-looking statements. More detailed information about factors that may affect our performance may be found in our filings with the SEC, which are available on our website. With that, I would like to turn the call over to Gill.

[Phupinder Gill:]

Thank you, Mr. Peschier, and thank you all for joining us. It was another solid quarter for us, average daily volume in Q2 rose by 13%, the same close rate as our record first quarter. We had double-digit growth again from each of our bankside client groups, including asset managers, hedge funds, proprietary trading firms, corporate and retail. Despite the recent slowdown in volatility post-Brexit as measured by the VIX, we are trading up 10% compared to last year. We were pleased to set an open interest record in the second quarter of over 115 million contracts, and we are near peak in our large open interest holding data in several product areas. This morning, I will start with our secular drivers and then I will shift to a few product highlights. We have consistently expanded our global participation in spite of the challenging macro environment. We saw robust electronic trading activity outside the U.S., with Asia up-trending 1% versus Q2 last year. Latin America rose 16% and Europe rose 12%. Following the Brexit announcement, we had significant activity from outside the U.S., with 5.3 million contracts traded in Europe, and 1.9 million contracts traded from Asia the day after. In Q2, the electronic volume from outside of the U.S. was 24%. In July, that had jumped to 27%, and the day after Brexit 29% of the activity was outside of the U.S. In Europe, volumes in five of our product areas grew by more than 20%, with the strongest growth in energy and equities, and the year-to-date ABV up 38% and 35%, respectively. In Asia, Q2 ABV and energy rose by more than 140% and metals volumes jumped more than 80%. Latin America growth was also led by energy. In addition to the country of origin information that we share with you, we also track electronic volume for our 24-hour trading day. In Q2, volume during the Asian rounds grew by almost 40%, from 260,000 contracts per day last year to 360,000 this quarter. During European rounds, from 11

[John Pietrowicz:]

Thank you, Gill, and good morning, everyone. Our team has been intensely focused on driving global revenue growth, operating our business as efficiently as possible, and returning excess capital to our shareholders in a consistent manner. As Gill mentioned, we had another excellent quarter. Total revenue was up 11% compared to a very strong quarter in Q2 last year, with four of our six product areas delivering more than 20% revenue growth. Our adjusted expenses, excluding license fees, were flat with the second quarter of last year so almost all of the incremental revenue drop to the operating income line. Our adjusted operating margin extended by 3 percentage points from a year ago, and adjusted EPS was up more than 15% for the second quarter in a row. This quarter we removed amortization from our adjusted results, and we provided a summary of the impact on prior quarters, both in our earnings, presentation deck, as well as in the income statement print file we post on our website. This change puts the reporting of our adjusted results in line with our U.S. exchange peers. Our rate per contract for the second quarter was $0.782, up from $0.756 in Q1, due primarily to a positive shift in product mix, which was slightly offset by the member/non-member mix. Market data revenue was $103 million, up slightly from the prior quarter. Moving to expenses, excluding license fees and adjustments, our total expense was $270 million, exactly where we were in Q2 2015, which I am pleased to report, along with a solid topline growth. For the first half of the year, on this basis, we were at $534 million, up about one-half of one percent. For the second half, I would expect expenses to be about $548 million. The increase from the first half is based on our heavier spend on customer-related activity in Q4 and the acceleration of product development, which Gill alluded to. We will be lower than our initial guidance at the beginning of the year, which included amortization and excluded license fees by $4 million. Instead of being up 1%, we are guiding to a half percent increase on that basis. We are ending the quarter with approximately 2,640 employees, up 40 from last quarter, driven primarily by entry level hires and hires in lower-cost locations. Our compensation ratio for Q2 came in at 14.5%, and is down from 17% in Q2 of last year. Looking at the non-operating income and expense line; our ownership in the S&P-Dow Jones joint venture drove more than $27 million in net earnings from unconsolidated subsidiaries, up slightly from Q1. Turning to investment income, we received $2.6 million in dividends from BVMF [ph]. In addition, our investment returns rated through reinvestment of cash performance bonds and guaranty fund contributions during Q2 decreased sequentially, to $5.2 million, from $7 million in Q1. This is a result of lower average daily investment balances from the prior quarter and our net return during Q2 was 9 basis points. While we have been approved to establish an account with the Fed for house cash, it is not live yet and we continue to work through the operational details. Turning to taxes. For the quarter, we ended at an adjusted 36.5%, which is where we guided. And now to the balance sheet. At the end of the second quarter, we had $1.34 billion in cash, restricted cash and marketable securities. During the second quarter, capital expenditures net of leasehold improvement allowances were $20 million, as we continue to leverage more software and infrastructure as a service, which is included in expense. We originally guided to $115 million to $120 million for the year. I'm going to reduce that by $15 million, to $100 million to $105 million based on efficiency efforts and timing. One final item I want to outline today is the new program we have available for equity members. These firms are required to hold shares in CME Group Class A common stock in addition to seats to receive equity membership privileges. Under the terms of the program, participants may substitute the assignment of their required shares by paying us a monthly subscription. Currently, there are 370 institutions that are required to hold CME Group Class A common shares as part of their equity membership. A typical equity member's required to hold 20,000 shares per exchange in addition to seats. For most of the equity members, the subscription rate will be $7,500 per month per exchange. This will provide choice for the firms and potentially allow them to free up capital to deploy in other ways. Each of the 370 firms will have full discretion on whether or not to participate in the program. The timing on their evaluation and decision to participate is expected to lead to an orderly share lease over time and should be easily absorbed by the market. As it is unclear on the participation level, we will update you next quarter on the uptake. At a 50% participation level, we would generate an estimated $20 million of incremental annual revenue and up to $40 million if all equity members switched to the monthly subscription. In summary, I'm very pleased with the hard work this quarter across the entire business. Our secular growth drivers continue to deliver results, with or without volatility, our efficiency on expenses has been excellent, and since the first of the year, we have returned $1.4 billion in dividends. With that, we'd like to open up the call for your questions. Given the number of analysts who cover us, we ask that you limit yourself to one question, so we can get to everyone. Please feel free to get back into the queue if you have any further questions. Thank you.

[Operator:]

Thank you. [Operator Instructions] We'll take our first question from Ken Worthington from JP Morgan. Please go ahead.

[Ken Worthington:]

Hi, good morning, thank you for taking my question. I'm still very interested in this account for house cash concept. So can you share maybe some of the operational details that you're working through? I can't really tell if they'll be interesting or not, but thinking they may be. And then when would you expect that to go live? This year? Next year? How quickly does that go fully operational?

[Kim Taylor:]

Hi Ken, it's Kim. The operational details are not very interesting, actually. What we're working with the Fed on the setup for the account. I think we would anticipate that we would have the account active before the end of this year, probably in like a two- to three-month time frame. And right now it's available for house accounts only, and so that would be the amount of cash that we would have available to invest in it potentially.

[Ken Worthington:]

Okay, great. Thank you very much.

[Operator:]

Thank you. We'll take our next question from Rich Repetto from Sandler O'Neill. Please go ahead.

[Rich Repetto:]

Yes, good morning, Gill. Good morning, John. Thanks, Gill, for the -- you know, you did an extensive product volume and even geographic review of how you're doing, how well you're doing. I guess my question is, do you guys target or -- what new products can actually impact your volume or your revenue, in a year's time frame if you assume -- I know this isn't reality, but if you assume a similar environment, what do you try to expect to get from these new products as a company, as an exchange? And then I guess the follow-up would be -- which are the big ones, which products are most impactful for that?

[Phupinder Gill:]

Rich, I'll start and then ask Derek and Shawn to comment if they want to. I think when you talk about product innovation here, you are always facing the uncertainty if it will be successful or not, but what we have started doing, particularly in the last six to seven years, and they've had a comprehensive plan, and part of that plan is talking to clients on a very broad basis. So in previous calls, we've spoken to you about the number of folks that tune into spend seminars that we put on, and that's an indication to us. And one example is the Ultra 10 ten-year bond that we launched and enthusiasm behind the bond and the corresponding volume that we got since launch has been great. And so we've got a pipeline on both the commodities side and the financial side, and our guys are pretty excited about some of the prospects there, so, I'll tell you, though, if Sean could comment on some of those things and then Mr. Sammann can talk about others.

[Sean Tully:]

Sure. In terms of the bottom line -- Gill on that since we were doing 60,000 contracts a day. So you can look at our rates, our PC, which will be available, and see that we're running at currently as several million dollars a year in terms of revenues, in terms of the run rate. If you look at Mexican pesos, so in our interest rate swaps clearing business, we now offer 19 currencies relative to the large competitor offering 17 currencies, so we've got two now unique value propositions in terms of currencies, both the Mexican peso and the Brazilian real. In terms of the Mexican peso, we have 1.5 million a month, is our current run rate. So while it is a small-time fee, it's actually having a significant impact on that business. If you look at the Brazilian real, as Gill mentioned on the call, we're hitting critical mass in the month of June. To put it into perspective, a launch takes time for the new products to gain traction relative to building a critical mass of participants. In the month of June, we had a $5 billion equivalent total volume cleared. In the month of July -- sorry, that was in the month of May

[Derek Sammann:]

Yes, I think it's -- from a product launch perspective, you know, Rich, we try to look at this in terms of either client need, market structure shift, and what is changing in the environment that provides an opportunity for us to provide a service that is not offered by someone out there. Another thing about product development opportunities is where there are global benchmarks that might be in disrepair or broken benchmarks, the client's not able to manage the risk the way they could. Those are market entry opportunities for us. For example, our move into aluminum 18 months ago was a result of customers not being able to access their structural aluminum, get it out of their warehouses. So the growth in market share and revenue generation in our copper business has been largely helped by our entry in the aluminum market. In fact, Miller Coors announced just last month that they're going to be shifting their price benchmark from their North American aluminum procurement to the CME-based product that we launched 18 months ago. Looking forward, another area of product opportunity in development is where we can add products to our overall portfolio. So as Gill mentioned, we expect record revenue generation in our agricultural products business. We announced last month that we will be launching European wheat contracts this year, and that's filled out what is already a globally utilized contract with a product that addresses any shortcomings in the current product. So great opportunities there getting into our product portfolio services, making it easier from a capital perspective or a corporation operational aspect perspective for our customers to manage all their risks, that's been our focal point for product development.

[Rich Repetto:]

Okay, thanks for that 3% time, Sean. I'll get back in queue.

[Operator:]

Thank you. We'll take our next question from Chris Allen from Buckingham. Please go ahead.

[Chris Allen:]

Good morning, guys. I'm just kind of curious. I see some great strength in agriculture and metals this quarter, and I think, Gill, you alluded to some of them driven by weather. I was trying to also kind of think about moving forward

[Phupinder Gill:]

Chris, as you pointed out, there's a regional growth starts story here, particularly outside of the U.S. and on the commodities front, it's been particularly strong coming from Asia, in both the energy and metals front.

[John Pietrowicz:]

Yes, I think we're particularly excited about the numbers we've been sharing with you guys about the commodities still current that we're growing in Asia. If you look at the energy revenues regenerated year-to-date, energy revenues is now representing almost 35% of the total revenues we're generating out of China and greater China as a whole. Our business in greater China being Hong Kong, China and Taiwan is up 227%. The metals, that specifically is our second biggest revenue source in the same region, and that's up 61%. So the opportunities that we've got when we own the -- on the metals side, our ability to position ourselves as a global benchmark in region with the sales efforts Brian and his team have been putting forth in region to make sure that we're attracting a customer base with global liquidity by time zone as well. That's how we see the opportunity continues to build international community. I'll also add that if you look at the importance of the commercial customers to the commodities complex as a whole, we continue to focus on them being a primary driver of our access, because as you address those end user customer needs, that brings the other market participants across the bank, the others don't want to be where the end user customers are. So whether you look at the revenue growth of the franchise as a whole, the record level of large open interest versus the record level of the open interest as well, layered on top of the China growth, it tells a story of globalizing participation in our markets and globalizing access to those global participant bases on the commercial side.

[Operator:]

Thank you. We'll take our next question from Michael Carrier from Bank of America Merrill Lynch. Please go ahead.

[Michael Carrier:]

Just a question on the cash. So if we look at it unsequentially, it seems like -- as much. I know that dividends increase in a year or two. I just wanted to get a sense if there's anything from a timing standpoint, or maybe from the CAPEX standpoint. It just seemed a little bit less than expected.

[John Pietrowicz:]

Sure, Mike. It's not unusual for our cash balance to grow slower in Q2. The primary reason is that we have two tax payments in this quarter, and for this quarter, it was $416 million. And we also have our regular dividend of $202 million that happened this quarter, so it's not unusual for Q2 to be slower on quarter in terms of cash bill. So we have tremendous leverage in our business model and we've been able to return $1.4 billion in dividends year-to-date, so obviously that is a cash impact.

[Michael Carrier:]

Okay, that makes sense. Thanks.

[Operator:]

Thank you. We'll take our next question from Brian Bedell from Deutsche Bank. Please go ahead.

[Brian Bedell:]

All right, thanks. Just anything you can cover about market data in terms of what the prospect is for some more pricing increases in that for 2017 and then other programs -- and then also the program that you talked about, John

[Brian Durkin:]

Hi, I'll take the market data; this is Brian. First of all, we've been monitoring closely our subscriber base since we implemented the full fare back in January and we're pleased to see we're not seeing any substitute reductions or consolidations in that regard. With that in mind, we've really been focused on developing new opportunities for revenue. One of the areas that we have increased emphasis on is our development of dry data and it's representing a very nice revenue stream for us. So you can expect to see more activities on that end. While we haven't announced any time of price increase in 2017, we will be expecting an increase that will impact certain segments and offerings associated with our market data.

[John Pietrowicz:]

So Brian, in terms of the new subscription plan, the purpose of the program is to provide our members flexibility. So the members either can hold our shares or they can free up those shares and pay us a subscription fee, so this gives our members a choice on how to deploy their capital and ultimately may make it easier for potential new members, especially those international members who may find holding CME shares prohibitive. So it's good for our current members, it's good for our potential new members, and it's good for CME because we will be generating recurring revenue from that payment and it's likely going to show up in our Other revenue line, not necessarily in the Market Data line. And obviously this is all incremental to our bottom line.

[Brian Bedell:]

And the range is $20 million to $40 million, based on your estimate.

[John Pietrowicz:]

Yes, is about a 50% take-up. It's about $20 million, and if all members chose to do this program it would be $40 million. We don't have a clear line of sight in terms of what uptake will be, so we'll be able to update you next quarter, or as it rolls out.

[Brian Bedell:]

Okay, great. Thanks very much.

[Operator:]

Thank you. We'll take our next question from Warren Gardiner of Evercore. Please go ahead.

[Warren Gardiner:]

Great, thanks. Just going back to the last question on market data; derived data. I was just curious how interested you guys are, or to what extent you kind of explored adding to that business and, organically, just additional analytics or other clues that some of your peers have? Just maybe broaden and maybe improve your overall value added to that offering?

[Brian Durkin:]

We're certainly open to any opportunities that can augment or enhance the strong and robust business that we have with respect to market data. As I've indicated, there are tools that we have at our disposal right now as we're developing new products internally that we really haven't leveraged to the degree that we believe that we can. Part of that is in the derived data space and developing new products as a result of that. So we're certainly happy to look at any opportunity to map the great robust business that we have today.

[John Pietrowicz:]

Just to add to that, one thing to remember is we do have a data investment in RJV with S&P. So that's an area that is also looking to grow and we're looking at nonorganic opportunities as well. So we're not only participating directly through, as Brian indicated, our data business here, but we'll also be participating with our S&P partners with the joint venture.

[Warren Gardiner:]

All right, great. Thank you.

[Operator:]

Thank you. We'll take our next question from Kyle Voigt from KBW. Please go ahead.

[Kyle Voigt:]

Hi, good morning. Thanks for taking my question. I just have a question on pricing. So it looks like you began charging for brand trading in July for non-market makers. Can you give us more color on why you thought it was the right time to make this move? Whether or not you see any material difference in client trading activity since you made the change? And lastly whether there are any plans to end the incentives for market makers in the future? Thank you.

[Brian Durkin:]

Hi Kyle. I think we've been building our market share in Branson [ph], really building our global participation in Branson. When you build markets you enter where the companies are, already present, you need to answer by providing incentives to make it easier to access and make it not too economically painful. So what we've done over the last probably 24 months or so

[Kyle Voigt:]

Thank you.

[Operator:]

Thank you. We'll take our next question from Rob Rutschow from CLSA. Please go ahead.

[Rob Rutschow:]

Hi, good morning. I believe the other exchanges in the excluded amortization of purchased intangibles argue that they're acquisitive and doing acquisitions as part of their business model. So I'm wondering if the change in the disclosure for you guys is a reflection of the change in your outlook on doing deals, or if it's just a change -- or just a belief that the market's not appropriately accepting the earnings. And if it's the latter, I believe the former CEO said that large deals are very unlikely. I don't believe we've heard Gill say that, so is large scale still very unlikely or are you looking to do some more acquisitions moving forward?

[John Pietrowicz:]

Hi Rob, this is John. Our view on M&A hasn't changed. We will be looking at all potential M&As to create shareholder value and grow in our strategic point of view, so we'll evaluate all opportunities. With regard to why we changed PI amortization, all our other U.S. exchange peers have taken amortization out of their earnings. Bath[ph 39;55] came out last quarter, excluding it, TIVO removed it from their results. We thought it was important to exclude it so the investing community can have an apples-to-apples comparison with the other exchanges.

[Rob Rutschow:]

Okay, thank you.

[Operator:]

Thank you. We'll take our next question from Andrew Bond from RBG Capital Markets. Please go ahead.

[Andrew Bond:]

Thanks, good morning. So when we look at your energy business, there is obviously a lot of positive takeaway that is fundamental and innovation on your part. The gross income that you're now seeing in competition from hedge pack and effect will continues to grow with interest rate lower priced. I'm wondering if you can give us your take on the factor as well from what you're hearing from customers, do you believe they're more likely to becoming more significant direct volumes or pricing generally?

[Derek Sammann:]

Hi Andrew, it's Derek. I'll take that. I think if you start to look at the franchise as a whole, energy's business up 25%, we're seeing significant growth uptake on the WTI side. You're also seeing significant growth on the electronics side of our business. So when you're coupling that with the huge growth we're seeing in the core franchise we're seeing large open interest order, record levels, were seeing commercial participation and revenues generation from the commercial participants at record levels. We actually find that our business as a whole is beyond just any singular particular product slice. But when we talk about individual views on natgas itself, our natgas franchise year-to-date is up 12% and revenue is actually down 4% to natgas and we'll go to a pre-natgas launch, we are about 65% of the natgas auctions market natgas is about 35. If you look at the rolling 60-day average, we've actually increased our market share since FX was launched, with 68% isis and 20%, and FX is about 12%. So when you actually look at in our two-man race, we were 65% of the market and in the three-man race, we're 67% of the market; that's a bigger market. So when you talk to our customer, what's important to them is a full range of products and services inside the asset class. So when you think about it at 76% market share, we have in the natgas futures the growing percentage of market share, which we're getting paid by our customers to deliver, on top of this fact that our overall franchise and TI -- I mean, if you talk about the footprint we're generating in China right now

[Andrew Bond:]

Thanks, Derek.

[Operator:]

Thank you. [Operator Instructions] We'll take a follow-up question from Rich Repetto from Sandler O'Neill. Please go ahead.

[Richard Repetto:]

This is for John. In your CAPEX guidance, I guess $105 million, you've only done $36 million in the first half, so this definitely implies a big ramp in the second half. I just wanted to see where -- what that's targeted at and -- I know there's the treasury refill platform etc., is that a significant component, can we get some more detail on it?

[John Pietrowicz:]

There's just a couple of things to point out as it relates to CAPEX. On a year-over-year basis, CAPEX is down but that's primarily driven by our New York City staff's space buildout after the sale of the ninemax [ph] building. So if you exclude all the real estate, our technology expense for the first quarter is slightly at or higher than the second quarter last year, and about $4 million higher than the first half of last year. So we're continuing to invest in our technology footprint and I think the second half, we are making investments and continue to make investments in our technology platform through guidance we may refer to things like Repo, things like improving our capacity. So if you take a look at our slide -- Slide 8 in our deck, you see that the day after the Brexit vote, we had the highest message traffic in our history and it was -- it did not impact our speed whatsoever. So I think keeping our platform robust and keeping our platform improving with technology and improving its functionality, so that guidance that we'll be investing in in the second half of the year as we continue the trend.

[Richard Repetto:]

Okay, thank you.

[Operator:]

Thank you. We'll take our next question from Alex Kramm from UBS. Please go ahead.

[Alex Kramm:]

Good morning, everyone. I came on late so I apologize if this was answered already, but I wanted to just touch base on Brexit for a minute but, not so much in terms of the risk here, but wondering if you're thinking about any opportunities coming out of it. I guess the way I would think about it is, you currently are the best house in the neighborhood right now with regulatory certainty in the U.S. whereas in Europe, there might be as lot of changes down the line. So is there an opportunity for you to engage with clients, say like listen, we are launching some new products here, you know exactly what you're going to get, for two, three, five, ten years. You could do more business with us or, is that not really the way to focus this?

[Phupinder Gill:]

Alex, there is opportunity. As you know, Europe is a very large part of our French and global basis. Yes they are, and yes we need -- there are opportunities and we are in full engagement mode with our client base regarding deeper participation into our marketplace and some of the opportunities that can market themselves fit very nicely in what we are seeing to be shifts or evolving client demands and client needs. And so one of the things we refer to in the earnings call and my former remarks was the opportunity that lays ahead of us. So Derek, Sean, Brian and their respective staffs are talking very intently to our clients to understand what their needs are. As you point out, the certainty of the U.S. regulation is a very large driver there, too.

[Alex Kramm:]

Excellent. Thanks very much.

[Operator:]

Thank you. And it appears we have no further questions at this time. I'll turn the call back to our speaker for any closing remarks.

[Phupinder Gill:]

Thank you for joining us today. The entire team at CME is focused on driving the topline for the future and operating the business as efficiently as possible. Let me illustrate that for you. When you compare the first half of 2014 to the first half of 2016, we have organically grown the topline by $332 million. At the same time, our expenses, including license fees and amortization, is down $14 million. So thank you very much for joining us today, and we look forward to speaking with you next quarter.

[Operator:]

Thank you. That concludes our program. You may now disconnect your lines, and have a wonderful day.