Description

I recommend buying shares in Intercontinental Exchange (ICE).  ICE is a high-quality company, and I think now is a good time to initiate a position – derivatives trading volumes naturally ebb and flow, and ICE’s relative multiple has come down due to sluggish trading volumes in recent months.  Such times tend to be buying opportunities for exchanges, and in ICE’s case, I think its pending acquisition of Ellie Mae adds a further catalyst to drive multiple expansion from here.

Company Description
ICE is the world’s second largest derivatives exchange operator (CME is #1).  On a legacy basis, roughly half of their net revenues come from volume-dependent trading & clearing activities, and half come from more stable market data and listing activities.   ICE just announced the purchase of Ellie Mae however, which changes the pro forma revenue mix somewhat. 

PF for the Ellie Mae deal, I estimate ICE’s revenue mix as follows:
35%: Market data (pricing & analytics, exchange data feeds, etc.)
27%: Derivatives trading & clearing (Brent oil and other energy futures, agricultural and metals futures, European interest rate futures, etc.)
10%: Transaction-based mortgage revenues (Ellie Mae, MERS, and Simplifile revenues tied to mortgage volumes)
7%: Recurring mortgage revenues (Ellie Mae subscription revenues not tied to mortgage volumes)
7%: Listings (ICE owns the NYSE)
5%: Cash equities and options trading
9%: Other (CDS trading & clearing, and other businesses)

The majority of ICE’s revenue comes from high-quality revenue streams (see the “Exchanges 101” section at the end of this writeup) and relatively little from more commoditized revenue streams like cash equities trading.

Mortgage-related revenue streams will now comprise ~17% of the total – this is not a typical “exchange” revenue stream, but I view it as a high quality one.  These revenues will vary somewhat with mortgage origination volumes, but the revenue streams are high margin (>50% EBITDA margins) and come from businesses with differentiated offerings that are likely to take share over time.

Ellie Mae (the bulk of ICE’s pro forma mortgage-related revenue) is the dominant provider of software used in the origination of mortgages with 44% market share (biggest competitor to Ellie Mae is the in-house software of mortgage originators).  Ellie Mae generates revenue both from recurring per-user subscription fees and per-mortgage transaction fees.  Ellie Mae has been a double-digit revenue grower over time, and they’ve been gaining market share (from 38% to 44% over last two years).  Despite a likely fall in refinancing volumes in 2021, ICE is guiding to 8-10% revenue growth from Ellie Mae both in 2021 and for the foreseeable future.

In addition to Ellie Mae, ICE also operates two other mortgage-related businesses called MERS and Simplifile.  MERS is a national electronic database of mortgages (~85% of newly originated loans registered on MERS, which allows companies to keep track of who owns various mortgages and mortgage servicing rights) and Simplifile is an e-network used at mortgage closing that facilitates electronic document submission and payment of recording fees to over 2000 US counties.  Both of these businesses generate revenue primarily tied to mortgage volumes.

ICE is a High Quality Company

• Attractive revenue mix, with majority of revenues coming from high-quality revenue streams (~80% of revenues from market data, derivatives trading & clearing, and Ellie Mae and ICE’s existing mortgage services businesses; less than 10% from more commoditized cash equities and options trading)
• Track record of compounding earnings:  Since 2014 (first full year of ICE operations after their acquisition of NYSE Euronext), ICE has compounded EPS at 16% annually (14% on a pretax basis)

  

Best time to buy an exchange?  When volumes are depressed
With roughly half of its net revenue coming from volume-dependant trading & clearing revenues, ICE’s revenue growth and earnings can be volatile from quarter-to-quarter depending on the market environment.  For exchange operators like ICE, this usually leads to the following dynamic: in periods where derivatives volumes are running hot, sell-side analysts raise earnings estimates, sentiment improves, and the stocks outperform due to a combination of increasing earnings estimates and expanding multiples.

Conversely, in periods where derivatives volumes are running low, sell-side analysts cut earnings estimates, sentiment worsens, and the stocks underperform due to a combination of lower earnings estimates and contracting multiples. 

This is exactly what has happened with ICE in recent months – volumes slowed considerably in 2Q20 and ICE has underperformed the Russell 3000 by about 10 percentage points since 3/31/20:

Month-to-month fluctuations in volumes are completely normal, and historically it’s been better to buy ICE (and other exchange operators) when volumes are running below trend rather than when volumes are running above trend.  If we compare 1-year forward total returns for ICE since 2015 versus the Russell 3000, the average 1-year forward alpha from buying ICE when volumes are below trend (based on the chart above), is 7% (vs. 4% avg alpha when volumes are running above trend).

Right now, ICE trades at about 21x consensus 2021 earnings – for a high-quality, recession-resistant business that has continued to grow earnings during COVID, I think that’s too low.  Most other similarly high-quality businesses I look at right now trade at much richer multiples, often over 30x. 

Something that has likely weighed on ICE’s multiple recently has been the multiple compression seen in CME and CBOE, two of ICE’s closest exchange comps.  Like ICE, CME and CBOE have seen weak derivatives trading volumes in recent months and have seen their multiples compress accordingly.  While I’m also positively disposed toward CME and CBOE, they face some concerns that ICE doesn’t.

In CME’s case, there is a risk that the recent decline in volumes is not just temporary.  Interest rate derivatives account for ~50% of CME’s LTM trading volumes and ~25% of LTM revenue.  If the US has “Japanified,” and interest rates are destined to remain near zero indefinitely, then the trading activity in CME’s US interest rates franchise may not rebound from current low levels (why bother hedging your interest rate exposure if you don’t expect rates to ever rise?)  A secondary concern for CME is that US shale oil production may have permanently reset lower, which could impact trading in CME’s WTI oil price franchise (~8% of CME revenue).

In CBOE’s case, there is concern about its proprietary VIX and SPX futures and options products (which represent 43% of LTM revenue).  Prior to 1Q18, VIX volumes were running unsustainably high before several short-vol ETFs blew up.  With another VIX spike in 1Q20, CBOE’s volumes were very high in the quarter, but volumes have been running much lower since April.  The market worries that CBOE’s VIX franchise has another leg down, similar to what happened in 1Q18.

ICE doesn’t face the same potential secular concerns with its key products.  Only ~5% of ICE’s revenue comes from interest rate derivatives, and most of that is for European interest rates (where Japanification has already happened).  Like CME, ICE also has oil derivatives exposure (~8% of revenue), but its Brent crude franchise is better positioned right now than CME’s WTI franchise, since US shale oil production is likely to face a steeper drop than international production (where the Brent crude price is the more relevant benchmark).  And unlike CBOE, ICE doesn’t have the same concentration on any one derivatives product type, so worries about CBOE’s VIX franchise aren’t an issue for ICE.

Ellie Mae acquisition likely to result in multiple expansion
Reasons why the Ellie Mae acquisition is likely to be a catalyst for multiple expansion for ICE:

• LSE and NDAQ examples:  5-6 years ago, LSE and NDAQ were among the cheapest global exchange stocks with forward P/Es under 20x in LSE’s case and under 15x in NDAQ’s case.  As both companies have improved the mix of their revenues (more market data revenue), both of those companies saw relative multiple expansion.  Now NDAQ trades in line with CME and ICE, and LSE trades >30x.  I see the same dynamic likely to happen for ICE.
• Ellie Mae is a higher multiple business than ICE:  ICE is paying 23x 2020 pre-synergy EBITDA for Ellie Mae, whereas legacy ICE trades at 17x EBITDA.  The purchase price for Ellie Mae isn’t cheap, but ICE is still guiding the deal to be accretive to EPS in the first full year after closing, and Ellie Mae’s closest comp, Black Knight, also trades at 23x EBITDA and 35x 2021 EPS.

Exchanges 101
Exchanges make money in several different ways, including traditional cash equities and options trading, derivatives trading and clearing, listings, market data, and custody activities (see below for more discussion of these revenue streams). 

IMO, derivatives trading & clearing and market data are the two best revenue streams for an exchange to have, as they are growing revenue streams where incumbent operators have pricing power.

Cash equities and options trading

Derivatives trading & clearing

Listings

Market Data

Custody

Risks

• Regulation: VIC_Member2015 advocated shorting ICE in a September 2018 writeup based on a regulatory reform thesis.  In particular, there’s been scrutiny on the fees that operators of US equity exchanges (which includes ICE due to its ownership of NYSE) charge brokers and other market participants for access to equity market pricing data.  US equity exchanges in the past have had to request approval for pricing increases on these data feeds, but the approval was a rubber stamp process.  Now these fees are being scrutinized and future pricing increases are likely to be harder to come by.  That said, this is a relatively minor issue for ICE (<5% of total EPS), and the likely outcome is not that this revenue goes away, just that it becomes harder to raise prices on this subset of revenues going forward.  That said, that is not the only regulatory risk ICE faces.  The one that is scarier is a potentially Financial Transactions Tax in the US, especially if one were applied to derivatives trades, although I think such a regulation is unlikely.
• Acquisition/integration risk: ICE has been flirting with non-core acquisitions recently.  Earlier this year they explored a potential deal for eBay – when news of talks on that deal leaked, ICE’s stock price fell and management was compelled to hastily abandon further discussions.  The Ellie Mae deal is arguably a non-core acquisition as well.  Non-core acquisitions are concerning both because integration risk is higher and also because of potential signaling: if management is so eager to consummate deals in non-core areas, it could be a sign that management’s outlook for its core business is dimming.  I’m willing to give ICE the benefit of the doubt on the Ellie Mae deal because I view Ellie Mae as a good asset and because ICE management has created plenty of value with acquisitions in the past.

Catalyst

• Rebound in monthly derivatives trading volumes

• Successful closing and integration of Ellie Mae