CBOE HOLDINGS, INC. First Quarter 2013 Earnings Call - Prepared Remarks Friday, May 3, Debbie Koopman

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1 CBOE HOLDINGS, INC. First Quarter 2013 Earnings Call - Prepared Remarks Friday, May 3, 2013 Debbie Koopman Good morning and thank you for joining us for our first quarter earnings conference call. On the call today, Bill Brodsky, our Chairman and CEO, will discuss the quarter and provide an update on our strategic initiatives for Then, Alan Dean, our Executive Vice President and CFO, will detail our first quarter 2013 financial results. Following their comments, we will open the call to Q&A. Also joining us for Q&A will be our President and COO, Ed Tilly, and our Executive Vice President and Chief Business Development Officer, Ed Provost. In addition, I'd like to point out that this presentation will include the use of several slides. We will be showing the slides and providing commentary on each. A downloadable copy of the slide presentation is available on the investor relations portion of our website. As a preliminary note, you should be aware that this presentation contains forward-looking statements, which represent our current judgment on what the future may hold, and while we believe these judgments are reasonable, these forward-looking statements are not guarantees of future performance and involve certain assumptions, risks and uncertainties. Actual outcomes and results may differ materially from what is expressed or implied in any forwardlooking statements. Please refer to our filings with the SEC for a full discussion of the factors that may affect any forward-looking statements. We undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise, after this conference call. Now, I'd like to turn the call over to Bill Brodsky. William Brodsky Good morning and thank you for joining us today. Before I begin my remarks on our first quarter performance, I will take a moment to touch on last week's trading outage. First and foremost, I would like to reiterate that we very much regret the inconvenience to our customers, with whom we have been in very close communication since the trading delay on April 25. We are grateful to the many customers who have expressed their understanding of the issue, as well as their overall confidence in our systems capability and reliability. We intend to live up to that trust. Preliminary systems work related to extended trading was identified as the catalyst of last Thursday's outage. Therefore, as part of our ongoing review, we are in the process of retaining an independent systems consultant to thoroughly evaluate the roll-out procedures of 1

2 our extended trading hours initiative. As a result, we are delaying the timetable to begin implementation for extended hours to accommodate this input. We have also been in close contact with the SEC. Anytime there is a trading disruption delay there is detailed protocol on sharing information and working with the SEC. We maintained realtime communication with our regulators from the time we realized we would have to delay the start of trading on the 25 th and throughout the afternoon as trading resumed. Immediately after, we began a detailed review of our data to understand exactly what happened, how it happened, and how to prevent it from happening again. Everything we learned in this process has been shared with the SEC. Our priority now is to make CBOE Command even stronger going forward. We are using what we learned to reduce both the occurrence and length of any future disruptions, including a faster alternative back-up for our proprietary products. While there are alternative products to use in place of SPX, and customers were able to trade VIX Futures on CFE, the length of the delay in opening CBOE was unacceptable to us. Our Disaster Recovery system is available for back up, but it takes time to bring it up and for firms to switch routing to it. We have begun to develop a plan for a more immediate back-up for trading our proprietary products, and we will be taking that plan to the SEC for input and review in the near future. Now, on to a look at the first quarter of 2013 Despite lower trading volume industry-wide and at CBOE, we posted strong first quarter results driven by the strength of our proprietary products, which generate our highest revenue rate per contract. Adjusted diluted EPS increased by 35 percent to $0.50 per share, while operating revenue increased by 18 percent. Alan will take you through the results in more detail in a moment. CBOE market share in multiply-listed options, excluding dividend trades, experienced significant fluctuation in the first quarter of 2013 due to intensified fee competition. After CBOE's multiplylisted market share dropped to 15.3 percent in January, we responded with an enhanced VIP schedule in February, followed by an enhancement to our complex order VIP schedule in March. Subsequently, CBOE's market share grew to an industry leading 18.5 percent in March, but fell to second place in April when market share decreased to 17.6 percent. Obviously this is a very fluid arena; we continue to keep close watch on it and to adjust our competitive incentives accordingly. Turning now to an update on our proprietary products. 2

3 As you know, CBOE and S&P Dow Jones Indices sealed an agreement, effective March 8, extending CBOE's exclusive rights to create and trade options on the S&P 500 (SPX), the S&P 100 and other derivative indexes through We were thrilled to have reached an agreement that spans 20 years, building on the previous 30 years in which we've successfully collaborated on expanding the brand and use of S&P index options and VIX futures and options. We look at the CBOE/S&P relationship as much more than a licensing agreement. S&P Dow Jones is the leading name in market indexing, and CBOE is the world's leader in index option and volatility trading. The products resulting from the unique strengths of each company and the collaborative nature of our partnership have revolutionized the investment landscape. More important - as the long-term nature of the extension would suggest - we share a very optimistic vision for future expansion of the index option and volatility spaces. In other index licensing news, we were delighted to continue our long-standing partnership with Russell Indexes under a semi-exclusive agreement. CBOE brings important liquidity to Russell Index options users. Options on the well-known Russell 2000 Index of small-cap U.S. stocks were previously listed on several U.S. exchanges. It is very gratifying to now have this semiexclusive agreement. Now for an update on trading in CBOE's S&P 500 Index Complex, where we have seen notable upticks thus far in First quarter ADV in SPX options, CBOE's most-actively traded contract and the flagship product of our S&P 500 Index options complex, was up 22 percent over the first quarter of last year. SPX ADV in April rose 21 percent over April It should be noted that the SPX volume gains were spurred by robust trading activity in the SPX Weeklys product. As discussed in our previous earnings call, SPX Weeklys represented one of CBOE's fastest growing products in 2012, which saw ADV increase 69 percent over the previous year. Trading has further intensified in First quarter ADV in SPX Weeklys more than tripled compared with the same time period one year ago, while April's ADV increased 235 percent over April VIX futures and options volume continued to reach record levels in the first quarter of VIX futures ADV for first quarter increased 131 percent over the same quarter one year ago. April marked the fourth consecutive month that total monthly volume in VIX futures reached a new all-time high. Year-to-date, VIX futures ADV is 128 percent ahead of 2012's pace. 3

4 VIX options ADV during the first quarter rose 48 percent over the first quarter of April ADV increased 13 percent over a year ago. Year-to-date, ADV through the end of April was up 45 percent over April was the busiest month in VIX futures trading and, thus far in 2013, there have been three new single-day volume records in VIX futures trading and two new single-day volume records in VIX options. Despite historically low market volatility, we continued to see growing interest in VIX trading thus far in New money flowed into VIX-linked ETPs, new VIX-linked products were created, and new traders began using VIX futures and options to implement a variety of sophisticated strategies. The most recent surge in VIX futures trading appears to be the result of new users in the form of hedge funds and proprietary trading firms employing strategies designed to capture volatility risk premia and small pricing anomalies between VIX futures and options, VIX-linked ETPs and other related instruments. Increases in VIX options trading continue to be driven by increased VIX futures trading, but the greatest source of growth we see today comes from increased participation from retail customers. Additionally, we see greater sophistication generally, including the ability to finetune specific risk exposures. Spread orders account for over half of all VIX options activity, ranging from simple directional strategies to very complex term-structure and skew trades. We look forward to announcing in the near future a revised start date for the implementation of extended trading hours for VIX futures. We expect that the first phase of expanded trading hours will add an additional 45-minute trading session after the current close of VIX futures at 3:15 p.m. CT. The new session, from 3:30 p.m. to 4:15 p.m. CT, responds to customer demand for expanded time to transact end-of-day trading as well as react to late afternoon news. The second phase of extended trading hours is expected to expand VIX futures trading by an additional five hours. Trading will begin at 2:00 a.m. CT, which matches the 8:00 a.m. open of the London markets, and continue until the current open of 7:00 a.m. CT. Expanded trading hours will allow European-based customers to access a longer trading session in their local time zone and will meet the overall demand from both domestic and international customers for additional time to trade VIX futures. 4

5 We also look forward to boosting global awareness of and trading in VIX futures and options with our second annual European Risk Management Conference this September 30 through October 2 near Lisbon, Portugal. In March, nearly 300 investment professionals convened in Carlsbad, California for the 29th annual CBOE Risk Management Conference. RMC is an industry leading educational forum where sophisticated practitioners and users of equity derivatives discuss new products and the latest strategies. The majority of RMC's sessions featured our SPX and VIX product lines, as well as CBOE's options-based strategy benchmarks such as the CBOE S&P 500 BuyWrite Index (BXM). Next month we plan to make changes to our S&P 500 Variance futures contract, which we designed as an exchange traded version of OTC variance swaps. Based on customer feedback, we plan to change how we convert volatility points to futures prices so that the quoted price of our variance futures contract will be more directly comparable to prices in the OTC swap market. Post-launch contract adjustments like this one can be the key to a new product's success. Our Variance futures contract was designed to provide the same quoting conventions and economic performance of OTC variance swaps while providing the advantages of exchange-traded contracts -- transparency, price discovery and counterparty clearing guarantees. We believe the change in pricing will bring the product even closer in line with OTC Swaps, without reducing the benefits of exchange trading. Going forward, we maintain a positive outlook on the future growth prospects for the options and volatility space. Despite the overall dampening of equity options trading in the first quarter, we were pleased that our company continued on its very profitable growth trajectory. Moreover, we believe 2013 holds further growth opportunities for CBOE, given the continued migration of many forms of OTC trading to exchange markets and the unabated growth in volatility trading. Last week we celebrated the 40th anniversary of CBOE and the listed options market. This year also marks the 30 th anniversary of CBOE's creation of index options and the 20th birthday of VIX. There is a nice symmetry to our 40/30/20 milestone year, and I hope you won't mind if I take a moment to touch upon it. CBOE launched the options industry on April 26, 1973, by trading 911 contracts on 16 stocks in the former smoking lounge of the Chicago Board of Trade. CBOE ended that year with about 1.1 million contracts traded. Last year CBOE alone traded 1.1 billion contracts as part of an industry that now includes 11 U.S. options exchanges and dozens more around the world. In 1983, CBOE created the CBOE 100 Index and began trading options on the Options Exchange Index, or OEX. Through our partnership with Standard and Poor's, the CBOE 100 5

6 became the S&P 100 Index and, a few months later, CBOE launched options on the S&P 500 Index (SPX). In 1993, we introduced the CBOE Volatility Index (VIX), which came to be known as Wall Street's fear gauge. A little over a decade later, we created VIX futures and then VIX options. Today, volatility trading has emerged as a dynamic new asset class. We commemorated our anniversary year by producing CBOE 40, a video documentary chronicling our history. If you haven't already done so, I invite you to watch the video, which can be accessed through our website. Our entire team is justifiably proud of CBOE's legacy, but we do not view innovation as something for the history books. People come to work each day at CBOE believing they will be part of the next great new product, system or service. CBOE's spirit of innovation is as alive today as it has ever been - a factor that while difficult to quantify, should never be underestimated. On a personal note, I wish to thank everyone for joining us today on what is my final earnings call as CEO of CBOE Holdings. As you know, following our annual meeting on May 23, Ed Tilly will assume his new role as CEO; Ed Provost will take over as President and COO; and I will move into my new position as Executive Chairman. This transition process has been a very measured and successful one. Ed Tilly, Ed Provost, Alan Dean and I have worked closely together to ensure that our company's leadership is wellpositioned to begin the next great chapter in CBOE's history. I could not be more confident in their vision, leadership ability and dedication to CBOE. I look forward to working with them and the CBOE community in my new role. With that, I thank you for your attention and will now turn it over to Alan Dean. Alan Dean Thanks Bill. Good morning everyone and thank you for joining us. This morning, I will review our financial results for the first quarter and update you on our outlook for the remainder of We are off to strong start this year, posting record first quarter financial results. Operating revenue for the quarter was $142.7 million, up 18 percent compared with last year's first quarter. Adjusted operating income was $72.6 million, which equates to 50.9 percent of operating 6

7 revenue. This adjusted operating margin represents a 340 basis point improvement over the same quarter last year and our second-best quarterly margin. Adjusted net income allocated to common stockholders was $43.9 million, up 33 percent compared with the first quarter of 2012, resulting in adjusted diluted earnings per share of $0.50, which matches our all-time high set in the third quarter of Before I continue, let me point out that our GAAP results reported for the first quarter of 2013 and 2012 include certain unusual items that impact the comparison of our operating performance. These items are detailed in our non-gaap information provided in the press release and in the appendix of our slide deck. Turning to the details of the quarter, as shown on this chart, the growth in operating revenue was driven by increases in transaction fees, regulatory fees and exchange services and other fees, offset somewhat by lower market data fees. Transaction fees increased $14.3 million, or 17 percent, from the first quarter of last year, due to a 35 percent increase in average revenue per contract (or RPC) compared with last year's first quarter, offset somewhat by a 13 percent decline in trading volume. While total trading volume declined for the quarter, trading in our exclusive products, VIX options and futures, posted record volume, resulting in higher RPC and transaction fees for the quarter. Our blended RPC, including options and futures, increased to 37.8 cents, primarily reflecting a shift in product mix toward our highest-margin index options and futures contracts, as well as an increase in the revenue per contract for index options. The RPC in our options business increased 28 percent to 33.3 cents compared with 26.1 cents in last year's first quarter. The increase was a result of index options accounting for a higher percentage of total options volume, as well as a slight increase in revenue per contract for index options to 67.1 cents. Keep in mind, this rolling-three month RPC does not reflect the full impact of the changes we made to VIP at the beginning of February and again in March. VIP credits increased significantly in March as CBOE's dividend adjusted market share in multiply-listed options increased to 18.5 percent from 15.3 percent in January. Assuming CBOE's market share in multiply-listed options holds or increases, the rolling-three month RPC for the second quarter is expected to decline compared with first quarter as a result of higher VIP credits and other fee changes. On the plus side, the impact of multiply-listed options on our financial performance continues to diminish with the explosive growth we are realizing in our proprietary products. 7

8 The contribution from CFE, our futures exchange, continues to increase exponentially as we reap the benefits of the high RPC it generates. For the first quarter, the RPC for futures contracts was nearly $1.62, down slightly compared with last year's first quarter, reflecting the impact of discounts provided on certain trades. As depicted on this slide, in the first quarter of this year index options accounted for 34.4 percent of total contracts traded, up from 24.0 percent in last year's first quarter, while futures contracts accounted for 3.5 percent of total volume, more than double its contribution of 1.4 percent in last year's first quarter. As I noted earlier, this shift in the mix of trading volume towards our highest-margin products fueled the growth of transaction fees for the first quarter of Index options accounted for 61 percent of transaction fees and futures contracts accounted for 15 percent, up from 56 percent and 8 percent, respectively, in the first quarter of The $5.0 million increase in regulatory fees resulted from CBOE raising its options regulatory fee on January 1 and August of last year and C2's implementation of an options regulatory fee in August of As we noted on our last earnings call, these fees are only available to cover higher expenses we are incurring to carry out our obligations as a regulator. Exchange services and other fees increased by $1.7 million compared with last year's first quarter, primarily reflecting positive response to a new network access option we added at the beginning of this year. The decrease in market data fees is a result of CBOE's lower market share in the low-rpc, multiply-listed category compared with the first quarter of Moving down the income statement to expenses, this next slide details total adjusted operating expense of $70.1 million for the quarter, up $6.3 million or 10 percent versus last year's first quarter. This increase primarily reflects higher expenses for outside services, employee costs, and royalty fees, offset somewhat by lower trading volume incentives. Adjusted operating expense for the first quarter of 2013 excludes accelerated stock-based compensation of $3.2 million. This represents the recognition of the full value of stock awards granted to certain executives due to provisions contained in their employment arrangements. Core operating expense of $47.6 million increased $6.0 million, or 14 percent, compared with the first quarter of 2012, primarily due to increases in outside services and employee costs. Outside services increased due to higher legal expense, primarily relating to litigation activity. Employee costs were up due to increases in incentive compensation, stock-based compensation and salaries, compared with 2012's first quarter. The increase in incentive 8

9 compensation is aligned with our higher pre-tax income while stock-based compensation reflects grants issued in the first quarter of this year. The increase in salaries was primarily due to staff additions in our regulatory services division. Overall, core operating expense for the quarter was in line with our full-year guidance. Taking a look at the balance sheet, we finished the quarter with cash and cash equivalents of $210.5 million, up nearly $75 million from where we ended in The increase in cash was the result of strong cash flow from operations during the quarter. In the first quarter, we generated approximately $95 million in cash from operations, paid over $13 million in dividends and used over $6 million for capital expenditures. While there were no share repurchases made under our share authorization in the first quarter of this year, let me assure you that our Board continues to believe that returning excess capital to stockholders by repurchasing our shares is an attractive way to enhance stockholder value. We have $103.3 million outstanding under our existing share repurchase authorization. A few days ago, we announced that we declared a dividend of $0.15 per share for the second quarter of Our priorities for cash remain the same; invest in our business to fuel organic growth, show steady, consistent growth in our annual dividend and utilize free cash flows in excess of investment and dividend needs to repurchase shares. As noted in our press release, we are reaffirming our full-year guidance that we provided on February 8 as shown on this slide. Before I close, let me point out a few items to keep in mind as you look ahead. Based on first quarter depreciation and amortization expense of $8.3 million, our annual guidance may appear to be high. This is due to the timing of our capital spending, which we expect to be more skewed towards the second half of the year. In our last earnings call we pointed out that our continuing stock-based compensation expense will fluctuate a bit quarter to quarter this year due to the timing of stock grants. Again, we have a slide in the appendix that details the guidance for stock-based compensation by quarter. As I mentioned earlier, next quarter we will see the full impact on RPC of the changes to VIP and other fee modifications implemented in February and March. Also, the second quarter will be the first full quarter of the S&P licensing fee increase that went into effect on March 8th. However, as we stated when we announced the extension 9

10 of the agreement, at the beginning of the year we raised the SPX surcharge in anticipation of this fee increase. Moreover, these changes should be neutral to our bottom line going forward. On May 1, we introduced a new market-maker affiliate access credit and a floor broker access rebate, which allows each to reduce their trading permit fees based on meeting certain trading volume criteria. This change is expected to reduce access fee revenue by approximately $200,000 per month. There were a number of positive developments in the first quarter that bode well for our future growth initiatives, including the extension of our licensing agreement with S&P and our new semi-exclusive agreement to trade Russell Index options. In addition, ISE conceded to an adverse judgment in its patent suit against CBOE, cutting short what could have been a lengthy trial. As a result, I expect legal fees to moderate, barring any unforeseen litigation. We are off to a solid start in the second quarter, with the positive trading momentum in SPX Weeklys, VIX options and VIX futures all continuing. We remain diligent in our expense management as we strive to fully leverage revenue flowing to the bottom line. As Bill mentioned, last month marked CBOE's 40th anniversary. I consider myself very fortunate to have been part of something for the past 33 years that has been a game changer in the world of finance. It has been a stroke of luck on my part to work with people who share the same vision and who I can also call my friends that makes this such a special place. It gives me great pride to see how far we have come and strong confidence in our ability to continue to build long-term value for our stockholders. This presentation may contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of Forward-looking statements are those statements that reflect our expectations, assumptions or projections about the future and involve a number of risks and uncertainties. These statements are only predictions based on our current expectations and projections about future events. There are important factors that could cause actual results to differ materially from that expressed or implied by the forward-looking statements, including: the loss of our right to exclusively list certain index option products; increasing price competition in our industry; compliance with legal and regulatory obligations; our ability to operate our business, monitor and maintain our systems or program them so that they operate correctly, including in response to increases in trading volume and order transaction traffic; decreases in the amount of trading volumes or a shift in the mix of products traded on our exchanges; legislative or regulatory changes; increasing competition by foreign and domestic entities; economic, political and market conditions; our ability to operate our business without violating the intellectual property rights of others and the costs associated with protecting our intellectual property rights; our ability to maintain access fee revenues; our ability to protect our systems and communication networks from security risks, including cyberattacks; our ability to attract and retain skilled management and other personnel; our ability to maintain our growth effectively; our dependence on third party service providers; and the ability of our compliance and risk management methods to effectively monitor and manage our risks. More detailed information about factors that may affect our performance may be found in our filings with the SEC, including in our Annual Report on Form 10-K for the year ended December 31, 2012 and other filings made from time to time with the SEC. 10