TW - Tradeweb Markets: More Brokerage Than Exchange

2024-01-16 18:53:09 ET

Summary

• Much of the global bond market is still traded through analog means, Tradeweb acts as part electronic brokerage, part exchange.
• The competitive landscape of electronic bond trading appears more similar to brokerage businesses, rather than exchange oligopolies in the equity markets.
• There's a huge discrepancy between Tradeweb's valuation and its peers, making it a clear sell.

The global bond market is the backbone of the economy. Bonds have enabled governments and corporations to fund projects for centuries.

The bond markets are much more complex than equity markets. Most equities have a share class or two, while bonds are much more bespoke, with a variety of differing rates and durations across the same issuers. In the US, the ratio of public equities to corporate bonds is roughly 20:1 . Equities trade on centralized exchanges, while most of the bond market is still traded through old fashioned brokers via emails and phone calls.

The $120T global bond market has taken its time moving digital, but trends have moved towards electronic trading in the past several years. In 2022 electronic trading constituted 65% of US treasury volume, 30-40% of corporate bond volume, and less than 15% of municipal bonds.

One facilitator of a significant amount of electronic bond trading is Tradeweb Markets ( TW ). From 2019 to 2022, Tradeweb's revenue increased from $776M to $1.189B, this has been slightly outpaced by growth in the overall e-trading market as evidenced above. It's impossible to predict how this growth curve will take shape. It seems logical that over time the entire bond market would move electronically, given the slow crawl so far it may take decades or longer.

Tradeweb tackled the Treasury market first because they are far more uniform than corporate bonds. Tradeweb then expanded into a variety of different geographies and bond types. Tradeweb is a compelling business because bond trading is an essential function for general economic development. But, its valuation suggests the market fundamentally misunderstands Tradeweb's competitive positioning. The competitive landscape of electronic bond trading suggests Tradeweb is closer to a brokerage business than an exchange.

Competitive Position:

Tradeweb's business is a crossover between an exchange and brokerage, but overall, more similar to brokerages. Tradeweb operates OTC exchanges, their competitive advantage is not as strong as the equity exchanges, which are regional monopolies and oligopolies. The top 25 exchanges represent 97% of the global market cap, led by the NYSE ( ICE ) and Nasdaq ( NDAQ ).

Brokerages on the other hand, aren't particularly compelling businesses. While Robinhood ( HOOD ) and Interactive Brokers ( IBKR ) have different perceptions and user interfaces, the underlying services is essentially a commodity.

While we can expect bonds to move fully electronic on an infinitely long-time horizon, the market share dynamics could be in constant flux. E-Trade was an early pioneer in the brokerage space, taking its parent company's revenue from $850k to $11M in just two years . Now, E-Trade doesn't crack many lists of the top 5 brokers .

Like E-Trade, Tradeweb faces stiff competition. Most notably, Bloomberg, which has a fairly significant competitive advantage in acquiring clients already plugged into terminals. There's a number of smaller players in the electronic bond trading market, with MarketAxess ( MKTX ) also being publicly traded. It's obvious the field is much more crowded than the equity exchanges.

It's challenging to precisely gauge what the competitive advantages are for institutional grade products like Tradeweb without using them or speaking to those that do. Despite this, the proof ultimately shows up in the pudding:

Tradeweb has a relatively short history as a public company, but in that time frame has moderately outpaced MarketAxess's revenue trajectory. It's clear now that Tradeweb is one of the leaders in electronic bond trading and is well positioned to capture industry growth, but given a stacked field of competition it must continue to expand into new markets and capabilities to stay relevant.

Given the vastness and complexity of the bond market there is a clear strategy of continuing to expand operations into new markets.

Capital Allocation & Valuation:

Tradeweb's management team has successfully guided the business towards the top of the heap in electronic bond trading, successfully growing the business in conjunction with overall market growth. They've also done a good job for shareholders by mixing their capital returning policies by paying a small dividend and also repurchasing shares.

Valuation discrepancies between a business and its peers is a good indication of a stock being overvalued, and ripe for underperformance:

Intercontinental Exchange and Nasdaq both trade around 21x forward earnings. Both have made some questionable acquisitions recently, but are objectively stronger businesses than Tradeweb. Interactive Brokers, which is generally viewed as a top-notch brokerage, trades at 14x forward earnings. If Interactive Brokers traded close to 40x earnings, it would also be a very clear sell, even if the underlying fundamentals are strong.

So, consider Tradeweb sitting at 37x forward earnings, it doesn't make much sense relative to where its peers trade. The bulls might argue that the vastness of the bond market and Tradeweb's runway for growth might allow it to overcome its multiple, and that Tradeweb is still a high quality of a business with a strong secular tailwind. Growth in electronic bond trading should enable Tradeweb's growth to continue, but it will be battling for market share with other worthy competitors.

Another consideration to Tradeweb's valuation is cyclicality. On their most recent earnings call, they mentioned that their retail credit businesses have shown strength while their ETF business has struggled because of lower volatility in the equity markets and lack of price dispersion which keeps clients from rebalancing portfolios. The current path of electronic bond trading growth has also been lumpy, Tradeweb could see future periods with little to no growth.

Tradeweb doesn't make much sense to own at these levels. If it traded closer to 20x earnings it must be considered given its growth prospects. But as it stands there are plenty of businesses that benefit from similar economic tailwinds that trade at cheaper valuations.

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