CBOE HOLDINGS, INC. Second Quarter 2011 Earnings Call Prepared Remarks August 4, 2011 Bill Brodsky, Chairman and CEO I m very pleased to be here today to share the outstanding results for CBOE Holdings in the second quarter 2011. Revenues were up seven percent, net income allocated to common stockholders increased 32 percent, and earnings per share grew 33 percent over the prior-year period. The company s operating margin was at its highest level in 10 quarters. Significantly, this strong performance was posted despite a general slowdown in the economic recovery in April and May that made for sluggish markets and depressed trading levels industry wide. CBOE Holdings averaged 4.4 million options contracts per day in the second quarter of 2011, a significant decrease from the second quarter of 2010, when ADV spiked to 5.29 million contracts as a result, primarily, of the May 6 th 2010 Flash Crash. As mentioned, U.S. markets generally languished in the second quarter 2011, further compounding the challenging 2010 comparison. However, we were pleased to see trading volumes begin to pick up toward the end of the quarter when, in June, total options ADV at CBOE Holdings increased 10 percent over June 2010. Increased trading activity continued into the third current quarter, when options ADV in July rose 19 percent over the same period last year. As a result, YTD options volume through July at CBOE Holdings is down just 2 percent from the close of July last year, despite the extraordinary volume spikes in May 2010. Given the recent uptick in trading activity, we are optimistic that we can make up more ground during the remainder of 2011. 1
The benefits of product diversification at CBOE play out against virtually any market backdrop. Even amidst overall dampened volume levels in the early second quarter, we still saw noteworthy bright spots. In the second quarter 2011, trading in VIX futures increased 190 percent and trading in VIX options increased 34 percent over the previous year. Daily volume in VIX futures surpassed 100,000 contracts for the first time in June and, more recently, monthly ADV in VIX futures set a third consecutive record in July. The company s success in growing profitability, even in periods of relatively low volume, reflects our ability to leverage the industry s most diversified product line while adhering to disciplined cost management. This approach has also enabled us to continue to fuel engines of future growth, such as C2 and new product innovation. CBOE Holdings accounted for 26.1 percent of all U.S. options trading in the second quarter, down 1.1 percentage points from the previous quarter. Excluding dividend trades, CBOE Holdings combined market share for the quarter was 26.9 percent, down 1.3 percentage points from 1Q 2011. I am pleased to note that the dip in market share began to reverse in June, when market share at CBOE Holdings increased month-overmonth by 2.1 percentage points and remained essentially unchanged in July. Through the end of July, the company s total options market share stood at 26.5 percent. CBOE Holdings has maintained an overall market share in the 26-28 percent range since last September significantly, we have achieved that stabilization without sacrificing revenue per contact. CBOE is deeply committed to increasing both the quantity and quality of our market share. VIX futures, which command our highest revenue per contract, represent a key metric in the company s performance. While accounting for just one percent of overall trading at CBOE Holdings, VIX futures accounted for five percent of our second quarter transaction fees. VIX options are a feature of our premium index options product line, 2
which generates our second highest rate per contract -- highlighting the significance of the double- and triple-digit gains that we continue to enjoy in VIX options and futures trading, even in periods of low market volatility. C2, our all-electronic exchange continues to gain traction in the options marketplace, posting consistent volume gains since its launch in October 2010. C2 volume in the second quarter averaged about 191,000 contracts per day, an increase of 18 percent over the first quarter 2011, C2 s first full quarter of trading. The upward trend continued into July, when volume averaged more than 220,000 contracts per day and accounted for 4.8 percent of all options trading at CBOE Holdings. As mentioned in last quarter s call, we continue to closely monitor the quality of our markets and to adjust our fee schedules and incentives in order to drive additional volume to C2. In February, we modified transaction fees in five classes, including Spider options. As a result, C2 market share in this highly competitive class grew from 1.5% in January to 3.8% in July. We expanded the modified fee schedule to all C2 classes in May. C2 s market share in QQQQ, another highly-competitive ETF option, rose from 1.8% at the end of April to 2.2% in July and overall market share of U.S. options volume grew from 0.8% to 1.3% over the same period. I should also note that last week C2 introduced complex order functionality for all listed classes. We expect automatic execution of complex orders, coupled with C2 s opportunities for price improvement, to further enhance the user experience and attract more business to the C2 marketplace. Now an update regarding SPXpm on C2 There has been considerable buzz among our customers about this much-awaited contract, and we are prepared to offer it for trading as soon as we get the green light from the SEC. We had hoped to receive an affirmative decision by early June. 3
However, on June 3, the SEC announced an extension of its review period to include a new 30-day comment period followed by a 15-day rebuttal period, which ended on July 25. The SEC must now act by September 6 to either approve or disapprove the proposal or to extend its review for an additional and final 60-day review period. Although disappointed by the delay, we remain cautiously optimistic that SPXpm will ultimately be approved. The SEC s extended review focuses on PM settlement. CBOE has responded with extensive data documenting the long-established use of PMsettlement in many exchange-traded products, including index options, Spiders and equity options. We have also noted that PM settlement is a common feature in OTC trading, making SPXpm an alternative to those trades and thus aligning it with the Dodd Frank mandate to bring more OTC trades onto exchanges. Further, we reiterated our view that launching SPXpm as a pilot program enables the SEC to prudently monitor this product without stifling customer demand or impeding innovation. We are confident that after reviewing the facts of the matter, the SEC will concur. We very much look forward to launching this highly anticipated product. We continue to roll out new initiatives to leverage our expertise in R&D and investor education to further develop the volatility frontier. Last Friday, we introduced the CBOE VIX Tail Hedge Index, which tracks the performance of a portfolio based on one-month out-of-the money VIX calls. Our research team created the index to provide investors with a benchmark for VIXbased tail hedge strategies. CBOE may also use the index to create a tradable product or license it to others for trading. We have a number of new equity and ETF-based volatility products in the pipeline, which we plan to roll out in the months ahead. On the educational front, I am pleased to note that due to strong customer demand, the CBOE Options Institute has launched a new class devoted to VIX trading. The class, 4
which will be offered several times over the year at the Institute, will also be webcast to online participants. In addition, the Institute last week published a book devoted to trading VIX options and futures. In other product development news, CFE announced plans on April 19 to offer futures contracts on several Radar Logic 28-Day Real Estate indexes (RPX) daily spot market equivalents for housing asset valuations covering major U.S. metropolitan centers pending regulatory approval. As announced earlier this week, CBOE s Board of Directors authorized a new share repurchase program for up to $100 million of unrestricted common stock, and the company raised its quarterly dividend by 20 percent. These actions reflect our strong commitment to returning capital to stockholders as well as our confidence in the long-term growth of CBOE Holdings. We remain confident that CBOE s unique focus on options and volatility products leaves us strategically well-positioned to take advantage of the considerable secular growth prospects for the options industry. As we look forward to the balance of the year, we are encouraged by the volume rebound we have experienced during the past two months. We expect to improve margins in the second half of 2011 and beyond as volumes increase and we grow our top line while continuing to prudently manage expenses. Specifically, we will continue to build on the initial success of our C2 platform, work for approval to launch SPXpm, expand our product offerings, including our VIX product line, and position CBOE to benefit from regulatory reform. Finally, our strong operating cash flow and debt-free balance sheet provide us financial flexibility to continue investing in innovation and growth while continuing to reward stockholders. With that, I will turn it over to Alan Dean to discuss our financials. 5
Thank you Bill and good morning everyone. As you saw from this morning s second quarter earnings release, we achieved another strong quarter, highlighted by a 33 percent increase in diluted earnings per share to $0.36, and increased cash flow from operations over the second quarter of 2010. This continued solid performance, along with the previously discussed actions to return significant cash to stockholders, is consistent with our optimism about CBOE s prospects, and demonstrate our ongoing commitment to deliver value to stockholders. Now let me begin with an overview of our operating results. For the quarter, operating revenues were up 7 percent, operating income grew 35 percent and operating margins increased by 980 basis points to 46.9 percent, the highest in the last 10 quarters. Looking at the P&L in more detail, as shown on Slide 18, operating revenues increased to $120.3 million in the second quarter. This improvement resulted from a $14.7 million increase in access fees, offset somewhat by a $7.8 million decrease in transaction fees. In addition, other revenue increased primarily due to higher revenue from licensing fees and other miscellaneous items. The increase in access fees compared with last year s second quarter resulted primarily from the implementation of a new trading permit program following our demutualization in June of last year. Next quarter will mark the anniversary of the new access program so the numbers will be more comparable. However, the year-over-year comparison will be impacted by the sliding fee scale we implemented in January for market maker trading permits used in multiply listed products, whereby a firm must commit to a certain number of permits for the full year. We are holding our full-year guidance of $65 to $68 million for access fees. As I pointed out in our previous call, the demand for trading permits fluctuates with market conditions, resulting in inherent volatility. Based on the slow and uneven economic recovery and choppy markets, we believe it prudent to continue to take a conservative stance regarding these fees. 6
Again, I would point out that this guidance does not include the additional access fees we expect to introduce in conjunction with the launch of SPXpm on C2. We experienced a $7.8 million, or 8 percent decrease in transaction fees in the quarter driven by a 16 percent decline in trading volume that was offset somewhat by a 10 percent increase in the average revenue per contract. As Bill noted, we were up against difficult comparisons with last year s second quarter when in May 2010 the Flash Crash resulted in record trading volume. While volume was down, our revenue per contract (or RPC) increased to 30.8 cents compared with 28.1 cents in 2010 s second quarter, reflecting a shift in product mix toward higher-margin index options and futures contracts, which represented a greater percentage of contracts traded in the quarter. In addition, volume discounts achieved through our sliding fee scale were down due to the lower trading volume. As this slide depicts, our index options accounted for about 25.1 percent of total contracts traded in the second quarter of this year, in comparison with 23.8 percent in last year s second quarter. Futures contracts, our highest margin product, accounted for one percent versus last year s second quarter when it was not material enough to note. This next slide details our operating expenses, which totaled $63.8 million, a decrease of $7.0 million, or 10 percent, compared with last year s second quarter, and reflect our continued cost discipline. Breaking this number down, we look at our expenses in two categories, core operating expenses and volume-based expenses. Core operating expenses of $41.8 million were down $2.8 million, or 6 percent, primarily reflecting lower costs for outside services and travel and promotional expenses, offset somewhat by higher employee costs. Employee costs were up due to a $2.5 million increase in continuing stock-based compensation. Last year s second quarter only included about two weeks of stock-based compensation expense versus a full quarter 7
this year. Excluding the continuing stock-based compensation expense, core operating expenses of $38.7 million decreased by $5.3 million, or 12 percent. With regard to operating expenses, we remain focused on diligently managing our cost structure and aligning resources as best we can with trading volume trends. For the full year, we are adjusting our guidance for core operating expenses to a range of $170 to $173 million from our previous guidance of $173 to $177 million. This takes into account our year-to-date performance and our decision to pull back on discretionary spending in light of the uncertain economic outlook. Volume-based expenses, which include royalty fees and trading volume incentives, decreased $6.0 million in the quarter as a result of a $4.8 million decrease in trading volume incentives and a $1.2 million decrease in royalty fees, which relates to lower trading volume in CBOE s licensed index products versus last year s second quarter. Trading volume incentives decreased $4.8 million primarily due to lower trading volume in equity options and ETFs, which were down 25 percent and 7 percent, respectively, compared with the second quarter of 2010 and changes in the criteria for quantitybased fee waivers. Second quarter operating income was $56.5 million, resulting in an operating margin of 46.9 percent, up 980 basis points from 37.1 percent in last year s second quarter. Our effective tax rate for the quarter was 40.7 percent compared with 40.1 percent in last year s second quarter, due to an increase in the Illinois state tax rate that was effective January 1 of this year. While our tax rate has and will continue to vary quarter to quarter, we are maintaining our full-year guidance range of 41.7 to 42.0 percent. We are reaffirming our full-year 2011 guidance provided in our February 10 and May 5 earnings press releases, with the exception of the downward revision to core operating expenses, which I noted earlier. Slide 25 provides a detailed outline of our guidance. 8
Now let s turn briefly to the balance sheet. As shown on this slide, our cash balance was down slightly to $106.5 million compared to $115.7 at the end of March. This decrease primarily resulted from our payment of income taxes of nearly $49 million. In addition, we used cash for capital expenditures of $11.2 million; dividends of $9.2 million and stock purchases of $3.1 million. The stock purchased consisted of unrestricted common stock surrendered in the quarter to satisfy employees' tax obligations upon the vesting of restricted stock. The vesting of restricted stock grants during the quarter resulted in a net addition to shares outstanding of just over 413 thousand, bringing total shares outstanding to 90.5 million, of which all are unrestricted common stock. Of course, the share count will change as we execute our share repurchase program. We will provide updates on share purchases in our quarterly earnings reports. We generated cash flow from operations of $14.3 million in the second quarter and $92.6 million year to date, increases of 63 percent and 30 percent, respectively, over the same periods last year. We expect to continue generating cash from operations that will provide enough resources to fund our ongoing growth initiatives. Since it is difficult to predict future market conditions and their impact on trading volume, we stay focused on what we can control and will adapt our cost base to the evolving market environment, while simultaneously making investments to position ourselves for continued long-term success. In conclusion, I believe we are prudently managing the company with the right balance of short-term earnings performance, while driving long-term stockholder value. So with those comments I'll hand the call over to Debbie so we can get started taking your questions. Thanks. At this point, we would be happy to take questions. We ask that you please limit your questions to one per person to allow time to get to everyone. Feel free to get back in the queue and if time permits we ll take a second question. 9
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. 10