TW - MarketAxess Is A Sell After Unwarranted Earnings Rally

Summary

• MarketAxess shares rallied 10% Wednesday on the company's Q4 earnings report and the stock is now up more than 30% over the past month.
• This move is overblown; the underlying earnings don't justify this sort of run.
• I'd need to see a share price under $300 to view the stock as a reasonable buying opportunity.

MarketAxess ( MKTX ) is a leading electronic trading platform which specializes in various fixed income and credit products. Investors have often been enamored of MarketAxess stock, with the valuation topping 50 times earnings on multiple occasions.

Back in late 2021, I warned that shares were significantly overvalued , as the stock was trading at 55x earnings even as a key rival, Tradeweb ( TW ) was taking significant market share from MarketAxess. This past spring, I moved to a neutral view on MKTX stock after shares had fallen to around $275. At that price, while risk/reward still wasn't great, you could construct a reasonable bull thesis for MarketAxess from there.

However, as we move to 2023, I am heading back to a negative outlook on the stock. MarketAxess has soared in recent months, including a more than 10% jump on Wednesday following the company's most recent earnings report. With this move, shares have jumped over the $360 mark:

Unfortunately, after taking a deeper look into this earnings report, there is very little reason for shares to be up 10% on these numbers, or for the stock to be close to 52-week highs. Until MarketAxess gets its fundamentals trending more strongly in the right direction, I don't see this recent run-up having much staying power.

Q4 Earnings: A Beat, But Numbers Hardly Inspire

On Wednesday, MarketAxess reported its Q4 '22 earnings. Revenues of $178 million beat expectations fractionally and represented 7.8% year-over-year growth.

Things weren't as good on the bottom line, however. EPS of $1.58 did beat expectations by a penny, and were up significantly from 2021. However, back in 2020, MarketAxess earned $1.91 in that same Q4 period. 2022's Q4 earnings of $1.58 still pales in comparison to where the business was two years ago, which is not typically the sort of thing you see with a company at this high of a P/E multiple.

On a positive note, MarketAxess enjoyed strong transaction growth. This came about thanks to rising demand for credit trading in general, which isn't surprising given the volatility that we've seen in interest rates over the past year. MarketAxess did manage to take some market share from competitors as well, which is a positive. MarketAxess had previously been struggling to hold market share compared to rival Tradeweb, so seeing positive share figures is good news indeed.

All that said, revenues were up just 7.8% year-over-year, which is not particularly impressive. That's especially true both given the inflationary environment and also the elevated demand for fixed income trading services. The company cited lower fees per million as a negative factor which limited revenue growth despite the stronger trading environment and market share gains.

I'd also note that the company saw a meaningful hit from currency translation. Now that the U.S. Dollar has begun to decline, I'd guess that MarketAxess will see a more favorable revenue results from currency translation in coming quarters. So that's a modest positive to overall revenues, but when you're paying 50x earnings for a stock, you generally need more than 8% top-line revenue growth to sustain that multiple, regardless of currency effects.

It's good news that MarketAxess has some momentum again as it pertains to market share. Still, it seems the company may have to accept lower fees in return for its market position. This pressure on trading fees could limit MarketAxess' longer-term growth prospects.

In summary, this was an okay earnings report. There are some positive signs here, especially on trading volume. However, neither the single-digit revenue growth nor the EPS figures that remain far below 2020 levels really get me excited. In any case, it was rather surprising to see MarketAxess rise more than 10% Wednesday following this earnings report.

Tradeweb Is Now More Attractive Than MarketAxess

Investors have typically paid much higher multiples for the bond trading platforms than other brokerage and exchange stocks. This makes sense, as bonds are one of the last major markets to move from physical or phone trading to digital platforms.

As a result, the bond trading platforms should have much more additional growth potential left as markets continue to move to digital venues. That's a favorable outlook compared to, say, equities where almost all trading is already digital today.

Regardless, even with the much better long-term growth outlook, there are still limits to what valuation ratios a stock can support and still achieve satisfactory results going forward.

Let's start with cash flow. On a price-to-free cash flow basis, MarketAxess is now going for more than 50 times. Tradeweb, while hardly cheap, is still under 30 times, which is a dramatic valuation difference:

Turning to earnings, MarketAxess is now back up to nearly 50 times forward earnings following Wednesday's earnings rally. MarketAxess is also trading at 40 times projected 2024 earnings and more than 35 times projected 2025 earnings. Even looking quite a ways out into the future, MarketAxess stock is at a super-premium valuation.

Tradeweb, by contrast, is at a projected 33 times 2023 earnings, 30 times 2024 earnings, and the high 20s on its 2025 earnings. I'm not going to argue Tradeweb is particularly cheap either, but I can at least make a case for owning a fast-growing company at 33 times forward earnings. By contrast, how am I supposed to get excited about MarketAxess at 50 times forward earnings and earnings growth is being curtailed amid a sizable increase in expenses.

Speaking of that, here is MarketAxess' management on the most recent conference call talking about expenses:

"Fourth quarter expenses increased 8%, driven principally by investments to enhance the trading system and our data product offering. Excluding the impact of FX, expenses would have increased 12%. Employee compensation and benefits increased $3 million on an increase in headcount, mainly in technology and customer facing roles to support revenue growth initiatives."

So, expenses grew at the same rate as revenues, and would have grown even faster if not for favorable currency fluctuations. Adding to this, management guided to an additional 10% operating expense growth for 2023.

I don't have a problem with a company investing in its employees and platform to grow the business. That said, when operating expenses are growing as quickly as revenues, I have trouble understanding the 50x P/E multiple.

There should be platform and network effects here; however, the financial results here simply don't reflect the sort of business we usually see at such a high trading multiple. MarketAxess' model and growth strategy make sense. But at this multiple, you need a simply sensational set of financial results to drive further stock price gains, and this Q4 earnings report wasn't close to hitting that threshold.

Look, I get that digital brokerage and market platforms are a fantastic business. Profit margins are tremendous. You have excellent network effects. These check the right boxes from a fundamental basis. This is a business I'd love to own at a reasonable starting price.

But we're talking nearly 50 times forward earnings and more than 50 times free cash flow for a business that is not producing especially compelling results lately. I'd need to see shares under $300 before considering it a fair valuation given current fundamentals.

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