Description

I usually write long, detailed write ups but this one will be shorter and high level, a departure for me. I completely screwed up and did not know about the rule that you can’t post on a company within 6 months of someone else posting about it. I wrote a long, detailed write up on a company that had already been posted on and I can’t use it – and I have my posting deadline today and I just don’t have the time to do a second detailed write up. That abandoned idea was a super cheap (5 P/E) consumer company that is down 60% this year despite putting up strong first quarter earnings (for the curious, the company I did a long write up on that I can’t post was CROX).

 With the market having sold off like it has this year, I am mainly interested in buying three types of companies:

• Traditional deep value (like CROX)

• Great businesses at a fair price (like Munger would say) – there are a bunch of stocks that are usually too rich for my blood that I can now consider

• Lottery tickets – deeply out of favor tech and consumer names, generally unprofitable, that are down 80% or more but where I think there is a 50% or greater chance that they make it

I wouldn’t post a lottery ticket here – there’s not a lot of traditional value in them and they are best done in a portfolio, like venture capital. My best deep value idea is apparently already taken, so I’ll give you my best idea from the second bucket…

I would argue that Intercontinental Exchange (“ICE”) isn’t just a great business – it is really an exceptional one. It has all the hallmarks of an exceptional business… extremely high margins (adjusted operating margins have exceeded 50% in recent years), high free cash flow conversion, leading market share, big moats around its businesses, a history of exceptional capital allocation… yet right now it is trading less than a point above the market multiple of around 16.5 P/E (on 2022 estimates). This is a much better business than the average one in the market, yet it is being priced like it is average.

ICE is a financial technology company best known for operating exchanges which enable the trading and pricing of futures, stocks, and bonds. Beyond that, ICE provides tools to the fixed income market that allow for the pricing and analysis of bonds and the clearing of credit default swaps – where it has more than 90% share. It also is the second largest fixed income index provider in the world.

On the mortgage side, its Encompass loan origination system is a SaaS-based platform for the information gathering, analysis, and rule enforcement crucial to generating mortgages. In the mortgage space, ICE provides several other tech solutions relating to closing and servicing loans.

What unifies these seemingly unconnected businesses is a relentless focus on using technology to add efficiency and transparency to financial markets through automation.

The quality of this business is apparent in its exceptional earnings growth and stability. In the last 16 years, ICE has grown EPS every year and has an exceptional 17% EPS CAGR – it even grew earnings slightly in the dark market days of 2008-2009.

ICE last appeared on VIC in August 2020 in a write up by Par03. Par03 offered details on ICE’s business mix as well as its then-pending deal for Ellie Mae, so I am going to skip repeating what was shared comprehensively and concisely there. This slide from the company’s recent investor day gives a good picture of what the revenue mix looks like now not only across divisions, but also how it breaks down in terms of recurring versus transactional revenues…

Having recurring revenues make up half of the business mix is yet another sign of a very high-quality company and should be especially valuable in uncertain economic times like we sit in today.

There is some concern out there right now that bearish markets and higher interest rates will lead to a contraction in transactional fees in the exchanges business, although so far trading volumes have been holding up.

The bigger concern – and the primary reason ICE shares have underperformed the broader index year to date is trepidation over what will happen to transactional fees in its mortgage businesses. Low rates obviously prompted record activity in mortgage and refi originations. With the easy days of low rates over and the climb in mortgage rates steeper than anything seen in a generation, the refi market is DOA and the new loan market is slowing down massively as affordability is plummeting with the rise of rates.

There’s good reason for the market to be worried – the transactional piece of ICE’s mortgage business more than doubled from 2019 to 2021…

It’s important to keep this headwind in perspective… even if $500 million of transactional mortgage technology revenue goes up in smoke, this is only 7% of total 2021 ICE revenues. Even assuming an extremely high contribution margin on that lost revenue of 80% (which is probably a little draconian), this would create a 50-cent hit to earnings, or about 10% of TTM EPS. Assuming this worst case hit and assuming none of the other businesses grow – which is also a draconian assumption given the exchange and fixed income businesses grew 4% in the first quarter - EPS could drop to $4.73.

In this worst-case scenario, with EPS of $4.73 versus consensus $5.42 for 2022, ICE shares are trading a P/E of 20x 2022 earnings versus 17x based on current consensus estimates.

Beyond the risk posed by the mortgage business, I am sure there are some people out there who think this is the 1970s redux. We’ve got rising inflation and slower economic growth (stagflation!), plus we’ve got a Tech-heavy Nifty Fifty to deflate. Some people would make the argument we’re about to see people lose interest in the equity markets for up to a decade, like in the 70s - which would obviously hurt ICE’s NYSE business, among others. Even if that all were to unfold, I’m still not sure this wouldn’t be a better place to wait it out than a lot of other stocks.

20x for a company with 50% margins, big moats, 50% recurring revenues, running into a likely cyclical trough sounds pretty good to me. It’s important to remember that if the mortgage technology business does take a major hit… it’s not gone forever. Someday, rates will again trend lower (it’s just not easy to imagine when that will be right now!). When that happens, ICE should be able to recapture any lost mortgage technology business as the secular trend to digital workflows in mortgage origination is well established.

Meanwhile, ICE has other secular tailwinds to its business that should benefit it in the current environment, primarily its strong position in the trading of energy futures and derivatives.

It’s interesting that ICE shares are down 5% since that 2020 write up versus the S&P 500 up 12% over the same time period. Not only have ICE shares underperformed the S&P 500 materially, but they have also undergone about 6 points of multiple contraction. Trailing twelve-month earnings are nevertheless up 20% from the time of that last write up ($5.23 now versus $4.36 then). This company has performed financially, but its stock isn’t reflecting that. 

You rarely get an opportunity to buy a business this good “on sale.” ICE is a free cash flow machine, generating over $2.8 billion in free cash flow during 2021, representing a nearly 40% conversion of revenue into free cash flow – it’s hard to find better than that.

Beyond the risk posed by rising rates on its mortgage business, the other big risk out there is that ICE has been a serial acquirer. Roll-ups make me nervous usually, but CEO and founder Jeffrey Sprecher has been an excellent capital allocator and the company has done some great deals over the years.

This is one of the better businesses I have seen based on financial metrics, competitive positioning, and capital allocation. In a lot of ways it reminds me of a premier, cash-flowing enterprise software company – crazy high margins, high free cash flow conversion, high percentage of recurring revenue, monopoly or oligopoly markets with big moats, etc. but not entirely immune to elements of the economic cycle nipping away at its revenue or EPS growth rate at the margin.

Something has to trade at a premium to the market – and companies with financial characteristics and competitive positioning like ICE’s actually deserve that premium multiple.

This company is your classic steady earnings growth compounder, and right now it is at a bargain multiple.

Roll out three years and this company is probably earning $7. Return to a 23 multiple (like it had in August 2020 at the time of the last write up), and it’s $160, up 70% from here. Even without any multiple expansion, just earnings growth should get you a return of about 10% per year. 

Catalyst

Visbility on the end of rate hikes and where the mortgage market will bottom