CME Group Q3 2013 Earnings Conference Call Transcript

November 4, 2013 1:15 pm | By More
CME Group Inc (NASDAQ:CME)

Q3 2013 Earnings Conference Call
Event Held on November 4, 2013 9:00 a.m. Eastern Time     

 

Section I: Management Presentation

Operator

Welcome to the CME Group Third Quarter 2013 Earnings Call. Your lines have been placed on listen-only until the question and answer session. (Operator Instructions) At this time I will turn the call over to Mr. John Peschier . You may begin sir

John Peschier – Investor Relations

Thank you and thank all of you for joining us this morning. Bill and Jamie will spend a few minutes outlining the highlights of the quarter and then we will open up the call for your questions. Terry, Bryan, Kim and Bob Zagotta, Head of Products and Services are on the call, along with Sean Tully, our Head of Rates and OTC, Derek Sammann who is in charge Options, FX and Metals.

Before they begin, I’ll read the Safe Harbor Language. Statements made on the call and in the slides on the website 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 the Investor Relations section of our website.

Now I’d like to turn the call over to Gill.

Phupinder Gill – Chief Executive Officer

Good morning and thank you for joining us this morning. I am going to highlight CME Group’s third quarter and then turn it over to Jamie to review our financials. Our focus this morning is about what’s new and relevant during the quarter. We’ve made some good traction since our last earnings call, in terms of the core business and expanding our OTC clearing activity. Within our core futures complex, third quarter average daily volume was up 11% compared to the same period last year, driven primarily by continued strong growth in interest rates and metals. We drove strong growth in electronic trading volumes outside the U.S. in our entire business.

For the third quarter, Latin America volumes were up 23%. Asia volumes were up 22%, and in Europe, activity rose 15% compared to third-quarter 2012. We have been investing considerable time and effort in these areas, and I am glad to see it driving volume and revenue growth. In addition, we are making a concerted effort to drive growth in our options business globally. This business increased by 31% in third-quarter 2013 versus last year. Both interest rate and equity options were up 54%, and FX options rose 32%. In September, our treasury options reached an all-time high of 57% electronically traded on CME Globex.

Overall, in October, approximately 48% of our total options volume traded electronically, compared to 35% in all of 2012. Additionally, options trading from European clients jumped by more than 100% in Q3 to more than 100,000 contracts per day. Asia and Latin America were each up over 70%.

Lastly, within Natural Gas Options, our market share jumped above 70% in September, compared to a range of 50% to 60% for most of the year. As I mentioned, one of the main drivers of the top line growth this quarter was interest rates. Average daily volume was 5.8 million contracts per day in Q3, up 29% versus Q3 2012, and OI to date through October is up more than 60% since the beginning of the year. All four of the major components of our rates business, Eurodollar futures and options, and treasury futures and options, were up more than 20% in Q3. Eurodollar options volume had particular strength, up 56%, with volume rebounding in the front month of the curve during September, which we haven’t seen in a long time. That is illustrated on slide 10 in our earnings deck.

Turning to interest rate OTC clearing, we continue to see a dramatic increase in our cleared swaps business. Our market share in the dealer to client business has grown from 5% in Q1, to 14% in Q2, 31% in Q3, and 33% so far in Q4. We averaged $81 billion per day in the third quarter, doubling the activity from the second-quarter 2013. So far, the fourth quarter is up 26% sequentially to $102 billion.

Now that the three waves of the Dodd-Frank clearing mandate are behind us, the market is shifting from a compliance phase to an optimization phase. This is a common theme we hear from market participants in our meetings. With increasing client demand for greater capital efficiencies, we now have six clearing members live with portfolio margining of cleared OTC interest rate swaps and interest rate futures, including a few who started offering this solution to customers within the last month.

In addition, product expansion has also played a key role in market share gains. During the third-quarter 2013, we launched the Singapore Dollar, which is our 17th interest rate swap currency and puts us in line with our competitor. Open interest within OTC is something we and market participants are monitoring closely, as we move closer to 50% market share. Interest rate swap open interest is currently north of $7.4 trillion, and has increased by more than $3.2 trillion since our last earnings call. During this time, our main competitor has added about $500 billion. Clearly, we have done extremely well attracting phase 2 clients, made up primarily of asset managers, insurance companies, and GSE’s, and we are pulling in more high turnover customers as well.

The bottom line is winning the dealer-to-customer OTC business strengthens our overall franchise, and opens up avenues for core revenue growth. Although it is very difficult to quantify and is still in the early stages, we are seeing evidence that our interest rate complex is benefitting from a migration of activity from OTC into futures. Since May, we have seen a more than 20% growth in our interest rate complex each month when compared to the same month of the prior year. This year, we have seen a significant shift in the use of treasury futures versus cash treasuries as evidenced by cash market penetration, which you can see on slide 13. Our interest rate non-member percentage, which tends to be driven by the so called real money clients, rose nicely from Q2 to Q3, which helped the rate per contract.

In addition, if you look at the CFTC commitment of traders report on our website, it shows a noticeable increase in asset manager participation within Eurodollars increasing from 11% of the open interest to more than 15%.

Lastly, our deliverable swap futures activity continues to grow. We had the strongest roll month in September. Building on that, in October, we had the strongest non-roll month to date. During the turbulence of October, we performed relatively well, despite the market uncertainty related to the debt ceiling and the government shutdown. During several weeks, economic data was not readily available, and in some cases the market adopted a wait-and-see approach as the situation developed. Nonetheless, we did what we do best, which is to continue to provide an avenue for our clients to manage risk and express their views.

In October, our total average daily volume was up 12%, with rates up as well as equities, which benefitted from heightened volatility during an interesting month. I am very excited about the growth trajectory of the company and our entire employee base has done a tremendous job focusing on execution in the midst of a challenging macro backdrop and low interest rate environment.

Now, I will turn the call over to Jamie to discuss the financials.

Jamie Parisi – CFO

Thank you, Gill, and good morning everyone. Q3 was a solid quarter in many respects. Average daily volume was up 11% compared to the third quarter last year, outperforming our major peers. Adjusted EPS came in at $0.75, excluding FX related benefits and several tax impacts. We have seen a drop in our overall tax rate this quarter, and the benefit will be ongoing, which I’ll touch on later.

Now let’s get into some of the details; starting with revenue. The rate per contract for the third quarter was $0.762, up from $0.748 last quarter. The main driver was strong non-member participation during Q3, relative to Q2, particularly in interest rates and energy. OTC swaps revenue for the quarter was up almost $5 million sequentially, to $11.5 million, driven by a 100% jump in interest rate swap clearing activity. In addition to our success in attracting real-money clients, we have also been successful in executing our strategy to attract high-turnover clients, primarily large hedge funds, which on a sequential basis led to a contraction in the average rate per million. I want to clarify that although the rate we capture has declined due to an increase in the mix of higher turnover participants, we have been able to substantially grow the higher paying customer base as well, which includes asset managers and insurance companies.

During the third quarter, the total notional amount cleared by this customer segment was up 115% sequentially, with revenue up 94%. In comparison, during the same timeframe, the total notional amount cleared by the high turnover participant base was up 138% and revenue was up 125%. Overall, as Gill noted, we are pleased to see IRS dealer-to-client market share jump from 5% in Q1 to 33% so far in Q4.

Our Q3 interest rate product line revenue was up 32% to $181 million, and if you add the incremental interest rate swap revenue, the total rates related revenue was up 40%. That is how we’re thinking about this business — the OTC clearing business is strengthening our overall interest rate franchise.

Moving on, total third-quarter operating expense was $314 million, which included a foreign exchange benefit of $12 million, reversing the Q1 FX expense of the same amount. Excluding the FX benefit, as well as other items noted in the reconciliation, expenses would have been $325 million. As you recall, I guided to a higher expense level for the second half, and that is playing out.

A couple different areas impacted us this quarter. The primary contributor to the sequential increase was in professional fees, which tends to have more variability than other expense lines from quarter to quarter. This was up $7.7 million versus prior quarter due to an increase in IT and legal consulting fees, higher market studies expense, and higher public relations and brand consulting fees.

Within the compensation line, we had $3.2 million of deferred comp expense based on the strength of the equity market during the quarter. Keep in mind that this expense is offset 100% in the interest income line. Lastly, in Q3, license fees did not fall as much as would be expected from the seasonal decrease in equity volumes, as we are now recording our OTC revenue share expense in this line item.

Turning to non-operating income, the main thing to point out is interest expense dropped from $39 million to $35 million based on the pay down of $750 million of debt in August. We expect that to increase back to $40 million in Q4, based on the full quarter impact of the debt we took on in early September, and an increase in our clearing house credit facility. The total interest expense and borrowing costs line is expected to drop by $30 million in 2014 to approximately $123 million from $153 million this year.

We had put in place an interest rate lock in August of 2012, which generated $128 million, which is included in our current cash balance, and which also reduces the all-in accounting effective rate on our recent 30 year bond issuance by 50 basis points to 4.8% per year.

With respect to taxes, excluding the FX impact and non-cash deferred tax items, as well as other prior year tax benefits, the effective tax rate was 35.6% this quarter.

Turning to the balance sheet, we had almost $1.4 billion of cash and marketable securities along with an additional $750 million held in cash for the February 2014 debt paydown. During the third quarter, capital expenditures net of leasehold improvement allowances totaled $36 million, bringing us to $91 million so far this year.

In terms of guidance, I said last quarter we expected 2013 expenses to range from $1.25 billion to $1.26 billion, and I anticipate that expenses in Q4 will be close to $325 million, which means we expect to be near $1.26 billion, including $6 million of deferred compensation expense year-to-date. In terms of CapEx, I expect between $130 million and $140 million for the year, which is down from my prior estimate.

Within market data, we recently announced to clients we are expanding our fees per professional screen from $70 per month to $85 per month, beginning in January 2014. We are making very good progress in the sale of our building in New York City. Contrary to some media reports, we have not yet closed the transaction, although we are working diligently to complete it by year end. Assuming we close it, we plan to include the net proceeds in our annual variable dividend. For modeling purposes, you should know our cost basis for tax purposes is fairly low, so apply our tax rate to whatever you assume we will sell the building for to arrive at estimated cash flow. In contrast, there will likely be a loss for GAAP purposes as the building had been re-valued on our balance sheet at the time we merged with NYMEX.

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Category: Markets

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