AGB 2021.6 - Intercontinental Exchange (ICE)

Analog to Digital in Financial Networks

Mar 22, 2021

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Intercontinental Exchange

Intercontinental Exchange (or “ICE”) owns and operates 12 regulated financial exchanges and 6 clearing houses globally. The founder and current CEO, Jeff Sprecher, saw an opportunity to trade energy digitally and acquired a failing start-up to do so in 1997. After shoring up the technology to trade energy, ICE officially launched in 2000 with the backing of large financial and energy institutions. The company quickly thereafter expanded to offering energy derivatives, data services and clearing by acquiring more exchange assets.

ICE is a serial acquirer of assets in financial markets where there is still an ongoing conversion from analog to digital. Whether it’s cash equities, interest rates, fixed income securities or mortgages, the company is willing to make bold bets to gain a leadership position in a particular market. With better operating practices and leveraging the acquired assets to offer new products to customers, ICE is consistently able to achieve high returns on its capital.

Exchange assets typically generate most of their revenue from transactions and that alone can be a decent business, depending on the competitive environment for a particular asset class. As an exchange gets more established, more transactions occur on the exchange, leading to best execution of trades (and higher liquidity) for customers. This is particularly the case with futures, options and other derivative contracts that have high counter party risk. ICE still leads the market in energy futures and options trading and its benchmarks are used to set pricing for many leading contracts.

After the company had successfully established itself as a leader in energy and commodities trading as well as a leading participant in cash equities (NYSE acquisition in 2012), ICE saw an opportunity in fixed income. Interactive Data Corp (or “IDC”) was acquired in 2015 to establish ICE as one of two leading places (Bloomberg being the other) to get fixed income pricing data for more than 3M fixed income securities. The company also clears 90% of the global CDS market.

The latest series of investments for the company has been in mortgages with the acquisitions of the MERS database (2018), Simplifile (2019) and Ellie Mae (2020). The company views the market opportunity in mortgages as $10B of the $11T mortgage market. ICE has spent over $11.5B to acquire these companies to establish 10% market share and expects to introduce new services on top of the existing businesses.

Over the past 10 years, ICE has diversified away from transaction revenues to more recurring revenues by offering customers data packages and services that are made possible by the exchange business. For example, the trading data created from the exchanges are sold to customers that want pricing, order book and transaction data. In FY11, transactions made up 89% of revenues for ICE with market data representing 9% and other 2%. In FY20, transaction made up 44% of revenues while market data, listing, and other made up 42%, 8% and 6%, respectively. Transactions revenues should make up an even smaller amount in FY21 as Ellie Mae is integrated into the business.

Why is it a good business?

ICE benefits from network effects for some of its exchange businesses and intangible assets for its NYSE brand + data assets. The company’s energy and commodity exchanges/clearing have decent network effects. Competition is minimal and as discussed before, liquidity for customers is achieved at the exchange with the highest volumes. These segments continue to grow between 2%-9% annually in aggregate.

While the company is probably best known for owning the NYSE, it is actually the company’s weakest business. Cash equities trading is a competitive market (almost 20 stock exchanges in the U.S.) with each exchange having little differentiation which leads to price competition in the form of rebates. However, there is a benefit from having the 2nd most order book volume on the NYSE (NASDAQ is #1). The data and technology offerings on top of the NYSE exchange business are very sticky, subscription businesses. Corporate and ETF listings as well as data and connectivity services continue to grow annually between 1%-5% annually.

Within fixed income, the pricing and trading data are valuable to its customers. Other than Bloomberg, it’s difficult to find this data elsewhere. ICE has built new offerings on top of its fixed income data set, one of which is the ETF Hub. Through the ETF Hub, the company can easily administer the creation/redemption process for ETFs for both equities and fixed income. 87% of Blackrock’s fixed income ETFs are run through the ETF Hub.

As for the mortgage business, we’re still in the early stages of the conversion from analog to digital. Post the acquisition of Ellie Mae, the company has a complete end to end offering for the mortgage industry. From lead generation to underwriting to closing and servicing, ICE has offerings for all parties in a mortgage origination. Customers used Ellie Mae to close over 45% share of the residential mortgages in 2019.

Returns on capital?

Over the past 10 years, ICE has deployed almost $18B in capital mainly in the form of acquisitions. Capex was 9% of capital spent, capitalized software 6% and acquisitions net of divestitures 85%. The acquisitions are lumpy in size, but ICE has been consistently acquiring on average of 2 companies per year. The company has stated that it uses a barbell approach for its acquisition strategy, either buying small growth companies at higher valuations or large underperforming companies at lower valuations. The company stated that it would not buy a large growth company at higher valuations, although Ellie Mae probably fits that profile.

The three largest acquisitions over the past decade have been the NYSE, IDC, and Ellie Mae. NYSE was acquired in FY13 for $1.11B for an implied multiple of 10.6x EBITDA or 7.4x with synergies included implying a 13.5% return. At the time of the acquisition, NYSE was actually larger than ICE by 75% in revenues and 8% in EBITDA. With the NYSE came the Euronext assets, which the company ended up divesting a year later, leading to even better returns. The cash equities business has been negatively impacted by the competitive environment and regulation, and the listings business hasn’t grown much due to the shrinking universe of public companies. However, the data business has grown nicely.

IDC was acquired in FY15 for $5.2B for 13.8x EBITDA or 9.8x with synergies, implying a return of 10%. This acquisition doubled the company’s fixed income data set and allowed the company to leverage the pricing data on 3M securities and 33M reference data points. The company also improved IDC post the acquisition, increasing annual growth rates from 3% to 5%-6% by streamlining the product offerings, going after larger accounts with the existing sales force and selling enterprise wide data packages.

Ellie Mae was acquired in FY20 for $11.4B for 24.3x EBITDA or 21.6x with synergies included, which implies less than a 5% return. This was the largest acquisition that ICE has made to date but it can be argued that the company needed the acquire Ellie Mae to establish a real presence in the mortgage market. The company is already adding ancillary services on top of its existing mortgage offering like eClosing and eNote. The company anticipates that even with a slowdown in the mortgage market in both purchases and refinancings, ICE’s mortgage business can achieve 8%-10% for the next few years.

We estimate that ICE has returned 20%-50% on its capital invested over the past 5 years. Because the acquisitions have been so large compared to reinvestment back into the existing business (capex + software development), the returns are lumpy. But similar to other serial acquirers that improve the acquisitions targets, the lower return years are offset by higher reinvestment rates, leading to a smoother increases in the intrinsic value.

Reinvestment potential?

While there are always software and technology costs related to the exchange business, it’s the most mature of the three business segments. Growth of the segment is expected to be lowest of the three at low single digits. The bright side is that the business has low capital intensity and high margins.

The two other segments, fixed income and mortgages are expected to be the growth drivers over the next few years and will get most of the reinvestment dollars. Within the fixed income market, execution of trades is still mostly done manually through RFQs, with many securities having missing or incomplete pricing data. Many markets within fixed income lack liquidity. Over $40B in corporate and muni debt securities are traded daily and only 15%-20% is done electronically.

With ICE’s database of fixed income pricing and trading platforms, the company expects to gain markets share within fixed income at a mid to high single digit % rate. The move towards passive indexing within fixed income has also resulted in pricing data becoming more valuable than ever. ICE participates in that trend through its ETF hub, its fixed income ETF offerings and sales of its relevant pricing data.

It’s likely that the most reinvestment potential is in ICE’s mortgage business as the company integrates Ellie Mae with Simplifile and MERS. As we all know, the mortgage origination process is very labor intensive and has many inefficiencies. The company expects that the current TAM is $10B with the company already having 10% market share. Data and analytics are a big part of that opportunity and with the transactional data created through mortgage origination and servicing, the company has opportunities to package and sell that data to customers. The mortgage segment will see some near-term volatility since 2020 was a big year for both purchase loans and refis. Even with the expectation of declining volumes of 20%-30% the company expects its mortgage business to grow 8%-10% over the next few years.

With returns on capital between 20%-50% and reinvestment rates ranging between 25%-60%, we estimate that the company has increased intrinsic value between 11%-12% annually for the past 5 years. We would like to point out that the Ellie Mae acquisition should result in a very high reinvestment rate for FY21.

ICE has financed most of its smaller acquisitions with cash (and debt) and its three largest acquisitions with a combination of cash and stock. While it’s preferable to pay all cash due to the lower cost of capital, the company has pushed its debt/EBITDA ratio has high as 4.3x for the NYSE and Ellie Mae acquisitions. The company expects to bring that multiple down to 3.25x by 2022.

What else is important?

Covid impact

ICE was well prepared for the pandemic and the company has been operating mostly remotely since last March. Similar to other financial technology companies, exchanges and data companies require very little onsite personnel to run their businesses. One anecdote the CEO mentioned at a conference in June 2020 was that the company had been ready for a pandemic since 2014 because right after the company had purchased the NYSE in 2012, Hurricane Sandy hit, which resulted in the NYSE having to close for a few days.

Stay at home orders due to the pandemic with three stimulus packages in less than a year coupled with the introduction of zero cost trading has resulted in the rise in retail trading volumes, both for equities and single options. ICE has benefited from this trend somewhat, but much less than other publicly traded exchanges like Nasdaq and CBOE. Cash equities and listed options only account for 6% of total revenues for ICE, compared to NASDAQ at 21% and CBOE at 23%. Compares will be difficult this year, but the overall business will be minimally impacted by this phenomenon.

Acquisitions always adding value?

The big question for ICE is whether its acquisitions are that additive to value. At first, it may seem like the company has been acquiring inferior assets vs. the original energy and commodity exchange business. I think that if the company weren’t able to improve the acquired assets and/or add additional revenue streams on top, it could be argued that this is the case.

The NYSE is clearly an inferior business to the energy and commodity exchange businesses, but ICE was able to add data and technology revenues later on. IDC on its own is a lower margin business that requires an enterprise level sales force to grow but the addition of ETF Hub, expanding ICE’s fixed income ETF offerings and improving the scope of ICE’s fixed income dataset made it well worth it. Similarly, Ellie Mae may seem like a dilutive business, especially because of the high multiple paid, but we have to believe that ICE will add ancillary services and data packages on top of the current mortgage offerings to make it well worth it.

The market is well aware of the possibility of a large dilutive acquisition in ICE’s future and the company’s short-lived attempt to acquire eBay is a clear example of this fact. The WSJ reported on February 4, 2020 that ICE had made an offer to acquire eBay for $30B. You can read the article here. While the discussions weren’t even in preliminary stages, the market soured on the prospects of the deal and ICE traded down -7.5% that day. eBay wasn’t expensive by any means trading at 12X P/E at the time, but the market couldn’t agree that operating an eCommerce marketplace was the same as operating a financial exchange.

Bakkt

Bakkt is a financial services company offering custody and trading (futures and options) of digital assets like cryptocurrency and gift cards. The technology was internally developed within ICE and raised outside capital from Microsoft, Boston Consulting Group and other VCs. Bakkt is going public via a merger with a VPC Impact Acquisition Holdings (VIH), a SPAC managed by Victory Park Capital. ICE will own 65% of the combined entity upon closing.

It’s nice to see this type of spinout of an asset from the company. It will reduce opex (it is estimated that Bakkt loses $50M-$60M annually) and value can be realized immediately.

Optionality

For ICE, future optionality will likely come in two forms: (1) acquisitions of new technologies and marketplaces, and (2) internally developed new technologies and marketplaces. Ellie Mae is a good example of the former and Bakkt is a good example of the latter. What we have to be concerned about as investors is the price paid for these assets, but management has been good about that so far.

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