CBOE HOLDINGS, INC. First Quarter 2011 Earnings Call Prepared Remarks May 5, 2011 Bill Brodsky, Chairman and CEO I m very pleased to be here today to share outstanding results for the first quarter 2011 at CBOE Holdings, where we experienced significant increases in revenue, operating margin, net income and earnings per share over the prior-year period. Before delving into our first quarter results, I have some brief comments on the proposed bids for NYSE Euronext, as I know that the current state of exchange consolidation remains top of mind for many of you. As a policy we don t comment on what other exchanges may or may not be doing, so my remarks will be confined to the current state of M&A in our space only as it may relate to CBOE. Specifically, I will address three questions we consistently receive: how would either transaction change options competition, how might it impact CBOE s market share; and how might it impact CBOE going forward. First let s take a step back from the considerable noise around the proposed deals to consider how either transaction might impact the options marketplace. First, it is important to note that these proposals are being driven by a recent wave of global exchange consolidation, not by consolidation in the U.S. options market. This is not to suggest that we think the consolidation trend will stop there it is clear that the marketplace continues to view exchange rollups as positive but we do need to clarify that, at least in this current round of proposed consolidation, the options market is not the driver. I would point out that there are currently nine competing U.S. options platforms, which are owned by six exchanges or holding companies. NYSE Euronext, NASDAQ OMX, and CBOE Holdings each operate two options platforms and Deutsche Bourse operates one through its ownership of ISE.
Importantly, we expect that either of the two bids for NYSE Euronext, if successful, would effectively reduce the number of holding companies, but the number of options platforms would remain the same. Regardless of how the deck is shuffled, CBOE and C2 would continue to compete against the same seven platforms in the same way we compete with them today. While we don t expect day-to-day competition to change, either transaction, as proposed, would boost the combined options market share of the newly merged holding company. If NYSE were to merge with Deutsche Bourse, the combined entity would operate three of the existing options platforms. If NYSE is purchased by NASDAQ-OMX, the combined entity would operate four competing options platforms. Assuming either of these transactions is completed in its current form (and this is by no means a given), the combined entity, by virtue of operating more options platforms, would have more market share than CBOE. Now I can t even pretend to like the sound of that, but -- emotions aside -- what would that really mean for CBOE? Obviously, a change in the ranking of our market share would not negatively alter CBOE s actual percentage of market share. More importantly, it would not change the inherent value of CBOE s market share. All market share is not equal. This is particularly true at CBOE, which is unique in the options space. Over the years, as options trading has become increasingly competitive and commoditized, CBOE has continued to exploit its unique strengths in product innovation and trading technology. As a result, we have the industry s most unique products, which trade only at CBOE, on systems that are second to none. These proprietary products are outpacing the growth of the industry s more mature commoditized products, and they tend to command significantly higher revenue per contract as well. 2
Make no mistake: we want every trade to come to CBOE. We are in a virtual dogfight every day for order flow in multiply listed products and we intend to stay in the thick of that battle. We leave no stone unturned in our effort to gain our share of multiply listed options trading, but we are deeply committed to increasing both the amount and the profitability of our market share. This commitment has allowed CBOE to continue to operate successfully and profitably despite increasingly intensified competition. More important, we remain well-positioned to continue to grow profitable market share going forward, regardless of any new business combinations among exchange operators. CBOE is the only holding company that is solely focused on options and equity derivatives products. This singleness of focus has resulted in a concentration of intellectual capital that has fueled innovation after innovation, including what we believe are some of the greatest engines of future growth, such as VIX options and futures and SPXpm. We remain focused on what matters most to our customers and we continue to review and evaluate all opportunities and initiatives that could enhance stockholder value. As a result of that focus, there is good news to report on all fronts at CBOE. Let s turn now to the first quarter of 2011, which proved to be another strong period for CBOE Holdings, and our plans for the second quarter and beyond. Our strong first quarter performance was driven by higher volume across all product lines, increased revenue from access and transaction fees, and disciplined cost control. We are very encouraged that the increased trading volume seen at CBOE in the fourth quarter of 2010 has continued thus far in 2011. CBOE reported volume gains on both a year-over-year and sequential quarterly basis in every product category and reached record volume in both VIX options and futures. CBOE Holdings average daily options volume for the first quarter of 2011 increased 11 percent from the same quarter last year. This slide shows the year-over-year increase broken out by product category: equity options trading was up nine percent, cash index trading increased six percent, and trading in ETF options grew by 21 percent. 3
This slide illustrates the strong growth of volatility trading. Year over year first quarter volume in VIX futures increased over 300 percent and options nearly doubled. VIX futures at CFE had its 18 th consecutive record volume month in March, when trading surpassed the one-million-contract threshold for the first time in CFE history. Trading in VIX options also set a new monthly record in March with 10.7 million contracts and blasted through the one-million-contracts in a single day milestone when trading totaled nearly 1.2 million contracts on March 15. Our market share in the first quarter remained relatively unchanged from the previous quarter, with CBOE Holdings accounting for 27 percent of all U.S. options trading. Excluding dividend trades, CBOE Holdings combined market share for the quarter was 28 percent. This slide shows C2 emerging with one percent of the industry s market share in its first full quarter of trading. In April 2011, CBOE Holdings total market share of U.S. options industry volume was 26.7 percent, and 27.6 percent excluding dividend trading. I am pleased to note that we have maintained our market share in the 26-28 percent range since last September significantly, we have accomplished that without sacrificing RPC. I mentioned earlier that we want every trade to come to CBOE, but we also recognize that not all market share is equal. The following slide illustrates how product diversification can meaningfully drive the bottom line. The volume gains at CFE, home of VIX futures, have become an increasingly important driver for the company. While CFE currently accounts for just one percent of overall trading at CBOE Holdings, its strong growth rate is noteworthy because VIX futures command our highest revenue per contract. Alan will cover this in more detail, but this chart provides an overview on how product diversification at CBOE impacts revenues. 4
This past quarter was the first full quarter of trading for C2, our all-electronic exchange, which launched last October. We are pleased with the steady growth in equity option volume on C2 thus far. C2 averaged 162,500 contracts per day in the first quarter and nearly 175,000 per day in April. Since February, we have nearly doubled the amount of active market makers on C2, and we expect this growth to continue as more firms complete connectivity. Our capture rate on C2 from CBOE linkage volume also continues to increase. We are closely monitoring market quality and adjusting our fee schedules and incentives in order to drive additional volume growth to C2. On February 25, we announced our plans for an electronic version of our SPX index option to trade on C2. SPXpm is almost identical in structure to our flagship SPX index option product, except, as the name implies, it has a p.m. settlement. This is an important distinction as p.m. settlement is a convention often found in the OTC markets, making SPXpm an OTC alternative that also provides the benefits and safeguards of exchange trading. PM settlement also mirrors settlement conventions for popular retail products, such as SPDRs and individual equity options. We expect C2 to broaden our customer reach by providing a point-and-click p.m. settlement version of our most actively traded index product while we continue to offer our traditional SPX product in open outcry. Indeed, we expect to provide our customers with two very deep pools of liquidity, one that favors the convenience of point-and-click, and one that favors the flexibility to negotiate large, complex orders afforded by floor trading. There has been considerable buzz about this contract among our customers, and we are prepared to begin trading as soon as we get the green light from the SEC. As you may know, the SEC exercised its authority to allow an additional 45 days with which to take action on the rule filing. This is not unusual. Assuming SPXpm is approved by the new SEC deadline of June 6 th, we would plan to begin trading immediately following June expiration on June 21st. We continue to work closely with the SEC to bring this much awaited product to market. 5
Turning now to product development. We began 2011 with several new initiatives aimed at leveraging our R&D expertise to further develop the volatility frontier. These initiatives came in the form of new products, the calculation and dissemination of new measures of volatility, and new endeavors with our VIX partners. January 2011 marked another VIX first when we began publishing volatility values on individual stocks. In March, we announced we will launch options on these new Stock VIXes, pending regulatory approval. CBOE is also awaiting approval to list options on the volatility of exchange traded funds, including options on the CBOE Crude Oil ETF Volatility Index (OVX). We also plan to list futures on both Stock VIXes and ETF volatility benchmarks. We continue to work closely with our partner Standard & Poor's (S&P) to bring the VIX methodology to key markets around the world. In March, CBOE and S&P launched the VIX Network, a global network of current and potential users of the VIX methodology. Members will share information about establishing VIX indexes in new markets and will jointly promote VIX as the global standard for measuring market volatility. Moving on to market regulation. Implementation of the Dodd-Frank Bill continues to be foremost on the agenda of our regulators. Chairman of the House Financial Services Committee, Spencer Bachus, recently introduced a bill to delay the implementation of Dodd-Frank by 18 months. Yesterday, the House Agriculture Committee passed the Bill, and the House Financial Services Committee is expected to mark up the Bill next week, before being sent to the floor for a vote. The Senate would then need to adopt the House version or introduce its own. Despite the setbacks in timing, we expect Dodd- Frank will eventually result in more OTC-types of trades being traded on exchanges and/or centrally cleared. We are well positioned for either eventuality. As we look forward to the balance of the year, we are optimistic about the strong volume we have seen during the past two quarters. 6
We expect to improve margins in 2011 and beyond as volumes increase and we grow our top line while continuing to prudently manage expenses. We are confident that CBOE is uniquely and strategically well-positioned to take advantage of the long-term secular growth prospects for the options market. Finally, our strong operating cash flow and pristine balance sheet provide us financial flexibility to invest in our growth while continuing to reward stockholders. With that, I will turn it over to Alan Dean to discuss our financials. Let me begin with a brief overview of our first quarter financial results, which are outlined on Slide 21. We were pleased with our performance which showed significant strength across a number of important metrics. Operating revenues in the quarter were up 23 percent, adjusted operating income grew 50 percent, diluted EPS was up 44 percent and adjusted operating margins of 46.7 percent were the highest in nine quarters. I would point out that in the diluted earnings-per-share calculation, accounting rules require that we allocate a portion of net income to any unvested restricted stock grants on which we pay dividend equivalents. In the first quarter, the amount of net income excluded from the EPS calculation was about $800 thousand. Our GAAP results reported for the first quarter included 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 slide appendix. As shown on Slide 22, operating revenues increased 23 percent or $22.9 million to $124 million in the first quarter, primarily as a result of a $15.4 million increase in access fees and a $6.5 million increase in transaction fees. We also reported higher revenues for regulatory fees and exchange services and other fees, which were largely due to the fee changes we applied earlier this year. And in the case of regulatory fees, higher volume also was a contributing factor. 7
The increase in access fees for the first quarter compared with last year s first quarter resulted primarily from the implementation of a new trading permit program following our demutualization in June of last year. Compared to the fourth quarter 2010, first-quarter access fees declined 5 percent, due to a change in the fee structure, under which we offer a sliding scale for market maker trading permits based on the number of permits used in multiply-listed products, whereby a firm commits to a certain number of permits for the full year. We were very pleased with access fee revenue for the quarter and the initial response to the new fee structure. Now some of you may be inclined to annualize our first quarter access fees of $17.6 million, which would imply performance above the high end of our full-year guidance range of $65 to $68 million. However, I would point out that we are not ready to raise our annual outlook just yet. Since this is a new program, I believe it is more prudent to evaluate these trends over a longer period of time, for the following reasons. First, we expect additional trading permit holders to transition to the sliding scale, which could impact our monthly run rate. Also, we need to take into account the inherent volatility in demand for trading permits, which fluctuate with market conditions. In a robust market where volume is growing at a rapid pace, demand tends to increase. However, the reverse tends to occur in a soft market. Of course, we re pulling for the robust market, but we don t control those dynamics. Accordingly, we are reaffirming our prior guidance. Let me remind you that this guidance does not include any additional access fees we expect to introduce in conjunction with the launch of SPXpm on C2. Our largest revenue item, transaction fees, increased 8 percent for the quarter, driven by a 13 percent increase in trading volume, offset somewhat by a 5 percent decrease in the average transaction fee per contract (or RPC). As Bill noted, we reported volume gains across every product category in the quarter and achieved record volume in both VIX options and futures. Our first-quarter RPC was 28.5 cents compared with 30.0 cents in 2010 s first quarter, reflecting a shift in product mix with lower-margin equity options and ETFs accounting for a higher percentage of contracts traded. In addition, 8
volume discounts achieved through our sliding fee scale were up due to higher trading volume. Looking at RPC by product category you can see that the three-month RPC for our index products was up slightly. As we discussed on our last call, in January, we implemented a firm sliding scale for proprietary products, but we also increased transaction fees for proprietary products, which more than offset the impact of the volume discounts on these transactions. Conversely, the RPC for equity options and ETFs declined, which were the products that generated the highest growth rate for the quarter. The RPC decline in these products primarily reflects the impact of the new firm fee cap implemented in January and higher volume discounts. Looking at our volume mix, as this slide depicts, our higher-margin index options accounted for about 23 percent of total contracts traded in the first quarter of this year, in comparison with 24 percent in last year s first quarter. As we move to a review of operating expenses, this next slide details adjusted operating expenses which totaled $66.1 million, excluding $340 thousand in accelerated stockbased compensation, representing an increase of $3.7 million, or 6 percent, compared with last year s first quarter. We look at our expenses in two categories, core operating expenses and volume-based expenses. Core operating expenses were basically unchanged at $40.6 million for the quarter, reflecting lower costs for outside services, data processing and travel and promotional expenses, offset somewhat by higher employee costs. Employee costs were up due to the recognition of $3.1 million in continuing stock-based compensation expense during the quarter. Excluding the continuing stock-based compensation expense, core operating expenses of $37.5 million decreased by $3.0 million, or 7 percent, reflecting our continuing focus on controlling expenses. 9
While we always take a disciplined approach to expense management, I would caution you not to use our first quarter core operating expense performance as a proxy for projecting future quarters. That being said, we continue to believe that our core expenses, excluding accelerated stock-based compensation expense, should fall in the range of between $173 to $177 million for the year. Volume-based expenses, which include royalty fees and trading volume incentives, increased $2.3 million in the quarter as a result of a $2.1 million increase in trading volume incentives and a $200 thousand increase in royalty fees, which relates to the higher trading volume of CBOE s licensed index products. Trading volume incentives increased as a result of higher costs to link customer orders to away markets under a program that applies to certain multiply-listed options contracts. This increase reflects the higher trading volume in equity options and ETFs, which increased 11 percent and 24 percent, respectively, compared with the first quarter of 2010. First quarter adjusted operating income was $57.9 million, with adjusted operating margins coming in at 46.7 percent, up 840 basis points from 38.3 percent in last year s first quarter. One item not on the slide, but which I want to highlight for you, is our effective tax rate, which was 42.2 percent for the first quarter versus 41.0 percent in last year s first quarter. This rate increase resulted from an increase in the Illinois state tax rate that was effective January 1 of this year and the adjustments to our deferred tax items. The rate did exceed our guidance for the year, due to the higher than expected impact of adjustments made to our deferred tax items. Since these adjustments were recognized on the effective date of the rate increase, they impact the first quarter disproportionate to the rest of the year. We are revising our guidance for the 2011 tax rate to a range of 41.7 to 42.0 percent from 41.0 to 41.4 percent, reflecting our fine tuning of the impact of the Illinois tax rate increase. 10
Looking ahead, as we noted in our press release, we are reaffirming the guidance we provided in our fourth quarter 2010 earnings announcement, with the exception of the revision to the effective tax rate. While certain performance metrics in the first quarter, if annualized, could indicate that we could outperform our annual guidance, I feel that our current guidance is a reasonable gauge of our future expectations based on what we know today. Now turning briefly to the balance sheet, cash at the end of the quarter was $115.7 million, up from $53.8 million at year-end 2010. As you may recall, we utilized significant cash in the fourth quarter to complete our tender offers. Our business continues to generate significant cash, with cash flow from operations of more than $78 million in the first quarter, a 25 percent increase from last year s first quarter. During the first quarter we paid dividends totaling $9.2 million. And, Tuesday we announced that our board has declared a 10 cent dividend for the second quarter of 2011, the fourth consecutive quarterly dividend declared following our IPO. With a solid, debt-free balance sheet, strong cash flows and a more favorable economic outlook, we expect to be in a better position to consider returning additional capital to stockholders in the future through dividends, share repurchases, capital investments or other avenues, while retaining sufficient capital to fund our growth. I look forward to updating you on this topic as the year progresses. Our capital allocation priorities in general will favor initiatives that generate the highest positive impact on our profitability and stockholder value. I'd like to close by underscoring Bill s opening remarks today. We're focused on sustainable profitable growth, and we're confident that our current strategies will deliver on that commitment. We operate in a constantly changing and competitive environment with a shifting market landscape. However we have demonstrated our ability to effectively manage our business under a variety of market conditions. We will continue to leverage the power of our diverse and innovative product offerings to drive revenue 11
growth and profitability, mitigate risk and, most importantly, create value for our stockholders. This presentation may contain forward-looking statements, within the meaning of the Private Securities Litigation Reform Act of 1995. 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: legislative or regulatory changes; changes in law or government policy; increasing competition; loss of our exclusive licenses; decrease in trading volumes; an inability to introduce competitive new products and services; competitive pressures on our existing products, services and trading access fees; changes in price levels and volatility in the derivatives and equity markets; economic, political and market conditions; increases in our fixed costs and expenses; loss of existing customers; difficulty developing strategic relationships and attracting new customers; increased costs related to, or the loss of, intellectual property; rapid technological developments; increases in trading volume and order transaction traffic that we cannot accommodate; our ability to maintain our growth effectively; damage to our reputation and brand name; loss of market data revenue; detrimental changes to our fee structure; failure to effectively monitor and manage our risks; customer consolidation; and changes to the tax treatment for options trading. 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, 2010 and other filings made from time to time with the SEC. 12