TW - MarketAxess: Still Not Cheap Enough Given Industry Slowdown (Upgrade To Hold)

2023-06-20 06:53:15 ET

Summary

• MarketAxess shares have slid 29% over the past three months, and underperformed the S&P 500 by about 40% in total over that period.
• MarketAxess has long been a strong earnings growth story in an attractive industry.
• Its notable divergence from the broader market might seem like a compelling opportunity.
• I suspect earnings estimates are too high, and that shares aren't a bargain yet. I'd prefer an entry point closer to $210.

MarketAxess ( MKTX ) is a leading digital credit and fixed income trading platform. This has been a much-faster growing business than equities and options trading because bonds tend to be less standardized, and thus relied on phone-based trading for longer. However, digital trading is now sweeping the credit arena as well, offering large opportunities for MarketAxess and key rival Tradeweb ( TW ).

MarketAxess shares have had a wild ride over the past five years, rising from $200 to $600, and then giving back nearly all of those gains by late 2022:

In April 2022, I gave the company a hold rating with the stock at $275, suggesting that shares were finally low enough to be at a defensible valuation after coming down more than 50% from their all-time high. However, I moved back to a sell rating on MKTX early this year as shares advanced to $370 in what I saw as an unwarranted rally .

MKTX stock is now down a quick 25% since January, however, despite a large rally in the overall stock market. Given the significant underperformance of MarketAxess shares lately, it's time to figure out why they have cooled off and at what price they might be worth buying.

Sharp Near-Term Dip In Trading Activity

MarketAxess started of 2023 on a strong note. In Q1, it reported record levels of average trading volume across nearly all of its product categories. The company also reported its fourth consecutive quarter of strong market share gains. This was a welcome improvement from the past few years where rival Tradeweb had been significantly outpacing MarketAxess in market share performance.

However, as the abrupt downturn in the firm's stock price would indicate, the company's operational momentum has now abated. Thanks to the banking industry crisis that came to the forefront in March, bond trading volumes have markedly cooled off.

On a conference call on April 26th, MarketAxess CEO Chris Concannon said that:

"The impact of the rapid rate rise in 2022 has now filtered into the broader market, resulting in the banking sector market dislocation in March. While we have seen a retracement in industry volumes over the last several weeks, we believe this is a temporary pause as the markets digest the events of March and their impact on the trajectory of rate hikes for the Federal Reserve."

However, it appears the situation has worsened beyond that initial expectation for a "temporary pause". MarketAxess reported a sequential 3.9% decline in activity for the month of April. However, this accelerated to a more concerning 18.5% year-over-year decline in trading activity for the month of May. Trading levels were marginally higher than in April of 2023, however, the lack of a larger sequential recovery indicates that the banking shock from earlier this year is having an ongoing impact on trading volumes.

The central question to the near-term outlook for MarketAxess' stock price will be how deep and how prolonged this trading pause ends up being. Analysts are still upbeat on the company quickly returning to strong revenue and profit growth. I'm less sure.

Indeed, I believe analyst estimates for MarketAxess are too high given the above information. Here's how analysts see this going forward for MarketAxess:

If the company can grow earnings 12% this year and 17% next year on top of that, it would put MarketAxess at 32x estimated 2024 earnings. That's not a terrible price given MarketAxess' admirable long-run track record of revenue and earnings growth.

That said, this is hardly a compelling valuation for MarketAxess shares even if the company does hit these projections. And with trade volumes down sharply year-over-year in May, I'd be very cautious about penciling in double-digit revenue and earnings growth for full-year 2023. We'd likely need to see a rapid reversal of the recent industry slowdown for the company to hit these ambitious 2023 targets.

Is MarketAxess Undervalued After The Recent Pullback?

There are some people making bullish calls on MarketAxess once again. Now that shares have pulled back from the overblown rally earlier this year, I'd agree that MKTX stock is selling at a defensible valuation. However, I still struggle to get there on the outright bullish outlook for the stock from this price.

Here's Morningstar's Michael Miller, giving the reasoning for an optimistic price target :

"Our fair value estimate for MarketAxess is $350, which is 46.5 times our 2023 earnings estimate and translates into a 2023 enterprise value/EBITDA ratio of 29.3 times. Our fair value estimate uses a 7.5% per cost of equity."

If you are comfortable with paying 46 times earnings and nearly 30x EBITDA for MarketAxess shares, then indeed there is some upside from here. That said, both of those multiples make me uncomfortable.

Let's zoom in on EV/EBITDA in particular for MarketAxess. Here is how the company has fared on that metric over the past decade:

30x EBITDA is around the firm's median over the past decade, and thus Morningstar's call is understandable on a reversion to the mean thesis. That said, I'd ask if we know that MarketAxess is really worth such a high price, or if the 2019-2021 period of extreme valuation was an aberration that is distorting the data set.

Up until 2016, MarketAxess traded at or under 20x EBITDA, and it hit that again at the lows last year. Additionally, MarketAxess is far larger today than it was a decade ago, meaning that growth should be much slower in the future than it could be in 2013. Now, much of the market has already adopted digital bond trading platforms, and Tradeweb has established itself as a larger and more capable competitor. All this means MarketAxess is now a more mature business and as such should see its multiple fade rather than expand over time, all else held equal.

MarketAxess Stock Bottom Line

I've covered MarketAxess since 2021 at Seeking Alpha . My rating has fluctuated between hold and sell depending on just how high the valuation ratios have been at any given time. I'm moving from my prior sell call back to a hold given the significant decline in MarketAxess' stock price over the past quarter.

Trust me, I'd love to get to a buy rating one day. I follow this company because the appeal of the business model is clear. I love exchange-style businesses where you tend to get high profit margins, network effects, and steady predictable growth. This is exactly the sort of firm I want to own if the price is right, and thus I keep close tabs on it.

And yet, even with the recent pullback, I still don't see the upside from here. Look at that Morningstar take again to see why. To get significant stock price upside from here, we should assume that the P/E ratio expands to 46 and the EV/EBITDA multiple moves back up to 30. That could certainly happen -- MarketAxess has a long history of supporting large valuation ratios -- but I'm not comfortable making that my base case assumption in order to own the stock.

While this is a company I'd really like to own, there is only so much I'm willing to sacrifice on valuation to take a position. I'd be interested in buying at 30x forward earnings or less, which would be an entry price of $224 today. And given that I think those 2023 earnings estimates will come down a bit given the sharp deceleration of trading activity, I'd feel more comfortable at an entry point closer to $210.

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