Intercontinental Exchange – Consistent Growth and Value Creation

Some investors make investment decisions based solely on share price behaviour. These investors, however, are not truly investors but rather speculators (gamblers?).

Benjamin Graham and David L. Dodd’s 1934 book ‘Security Analysis – Principles and Technique’ includes the following passage contrasting a voting machine versus a weighing machine:

In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

Security Analysis – Principles and Technique

Intercontinental Exchange, Inc. (ICE) is one such example of where share price behaviour does not accurately reflect the true value of a company that produces consistent growth and value creation.

Business Overview

In the late 1990s, the founders acquired Continental Power Exchange, Inc.. Their objective was to develop an Internet-based platform to provide a more transparent and efficient market structure for over-the-counter energy commodity trading.

ICE was subsequently founded in May 2000 thus increasing price transparency, efficiency, liquidity, and lowering costs. Initially, ICE’s focus was energy products (crude and refined oil, natural gas, power, and emissions). Subsequent acquisitions, however, expanded ICE’s activity into commodities such as sugar, cotton, and coffee, foreign exchange, and equity index futures.

On November 16, 2005, ICE became a publicly traded company. We see from the following that it has evolved over the years.

This evolution has translated into an impressive 16% adjusted diluted EPS CAGR over the 2006 – 2022 timeframe.

Intercontinental Exchange now provides market infrastructure, data services and technology solutions to a broad range of customers that include financial institutions, corporations, and government entities. Its products span major asset classes including futures, equities, fixed income and residential mortgages in the U.S..

These product offerings provide ICE’s customers with access to critical tools that are designed to increase asset class transparency and workflow efficiency.

Intercontinental Exchange consists of 3 reportable business segments.

• Exchanges: ICE operates regulated marketplaces for the listing, trading and clearing of a broad array of derivatives contracts and financial securities;
• Fixed Income and Data Services: It provides fixed income pricing, reference data, indices, analytics and execution services as well as global credit default swaps (CDS), clearing and multi-asset class data delivery solutions; and
• Mortgage Technology: It provides a technology platform that offers customers comprehensive, digital workflow tools that aim to address the inefficiencies that exist in the U.S. residential mortgage market, from application through closing and the secondary market.

In the first half of FY2023, the segments reflected above generated 66.8%, 23.1%, and 10.1% of $4.808B Total revenues. On $3.784B of Net Revenue (excludes $0.175B Section 31 fees and $0.849B Cash liquidity payments, routing and clearing fees), $1.908B was recurring and $1.876B was transaction-based.

A good overview of the company is found in Item 1 – Business in the FY2022 Form 10-K.

Black Knight (BK) Acquisition

On May 5, 2022, ICE announced the proposed acquisition of Black Knight (BK), a leading provider of integrated software, data and analytics solutions that facilitate and automate many of the business processes across the homeownership life cycle.

Management had identified significant growth opportunities from what it considered to be a ~$14B total addressable market.

Details regarding the acquisition, including the strategic rationale, are reflected in the May 5, 2022 presentation. I also recommend you review the September 28, 2023 ICE + Black Knight Closing Call presentation.

The Federal Trade Commission immediately stepped into the equation alleging the combination of the two top mortgage technology providers, would drive up costs, reduce innovation, and limit lenders’ choices for mortgage origination tools.

To resolve the FTC’s concerns, ICE and Black Knight agreed to divest Empower and Optimal Blue; Constellation Software has acquired both.

• Empower is an industry-leading loan Origination System that offers the advanced functionality required to improve efficiency, speed, operational costs, and home buying experience. Terms of the Empower sale are found here.
• Optimal Blue is a pricing engine, that stores all loan rates offered by the lender. Loan officers can search the database of fees based on the criteria of the application.

The following reflects the terms of the Optimal Blue sale.

When the BK acquisition was first announced, the transaction’s market value was $13.1B. After satisfying the FTC’s concerns with the divestiture of Empower and Optimal Blue, the transaction’s market value was $11.9B.

Despite the divestitures, ICE’s solutions will address the entire mortgage workflow.

While Encompass and Optimal Blue have been divested, the services will still be fully available to ICE’s customers; ICE will continue to capture value with a revenue share arrangement for existing and new customers through a 10-year commercial agreement with Constellation Software. ICE, however, plans to maintain and invest in its own product and pricing engine. Given these plans, I suspect ICE intends to reduce its reliance on Constellation Software.

Black Knight (BK) Acquisition Financing

Financing of the BK acquisition consisted of 90% cash on hand and 10% in the form of ICE shares.

In May 2022, ICE received ~$6B in proceeds from the issuance of long-term notes with an average coupon rate of 4.24%.

It also issued ~$2.5B of commercial paper and drew down ~$2.4B in the form of a term loan. The average rate for these two forms of financing was ~5.5% – ~6%.

CEO and NEO Compensation

Investors would be wise to review a company’s Proxy Statement, and in particular, the section about CEO and Named Executive Officers (NEO) to determine if their compensation structure is aligned with shareholder interests.

The section regarding CEO and NEO compensation ICE’s 2023 Proxy Statement commences on page 28 of 86.

Based on my review of ICE’s Executive Compensation, I am comfortable that the compensation structure is closely aligned with my interests as a long-term shareholder.

Financials

Q2 and YTD2023 Results

ICE released its Q2 and YTD2023 (as of June 30) on August 3 and the Q3 results (as of September 30) are scheduled to be released on November 2. I, therefore, dispense with a review of ICE’s historical results. However, I provide this link if you wish to review the material related to recent quarterly earnings releases.

Furthermore, ICE has just closed the BK acquisition; focusing on ICE’s historical results is akin to driving while looking in the rearview mirror.

Investors need to consider that ICE has incurred expenses related to the BK acquisition and the divestiture of Empower and Optimal Blue. It has not yet, however, generated any meaningful revenue from the addition of BK.

We also need to consider ICE’s financial picture at the end of Q3 differs from the end of Q2 now that the BK acquisition has closed. At the end of Q2, ICE’s adjusted debt-to-EBITDA leverage ratio was 2.7X. On the September 28, ICE + BK Closing Call, however, management stated that the gross leverage at the end of September 2023 was closer to ~4.3X pro forma EBITDA.

We also see from the Opportunities Post BK Acquisition image provided earlier that BK’s contribution in Q4 2023 is materially different from that in Q3.

Free Cash Flow (FCF)

FCF is a metric I closely monitor since it provides an indication of what funds are available for reinvesting in the business, debt reduction, share repurchases, and dividend increases.

In FY2013 – FY2022, Intercontinental Exchange generated (in millions of $) 556, 1,264, 1,034, 1,784, 1,728, 2,253, 2,354, 2,471, 2,671, and 3,072.

ICE’s adjusted FCF in the first half of FY2022 and FY2023 is reflected below. ICE includes the net value of Section 31 fees in its FCF calculations but this amount is generally nominal.

Because the SEC fee is a provision under Section 31 of the Securities Exchange Act of 1934, it is often referred to as the Section 31 Transaction Fee. The fee is based on the volume of shares traded and applies to the sale of stocks, but not the purchase of stocks. The fee is 1% of one eight-hundredth of the dollar value of the equities sold.

FY2023 Guidance

Included with the release of Q2 2023 results on August 3 was ICE’s FY2023 guidance:

• Mortgage Technology recurring revenue growth is expected to be in the low-single digits;
• GAAP operating expenses are expected to be $3.675B – $3.725B. Adjusted operating expenses are expected to be $3.04B – $3.06B;
• Q3 2023 GAAP operating expenses are expected to be $0.91B – $0.92B. Adjusted operating expenses are expected to be $0.76B – $0.77B;
• Q3 2023 GAAP non-operating expense is expected to be $80 – $85 million. Adjusted non-operating expense is expected to be $70 – $75 million; and
• Diluted share count for Q3 is expected to be 560 – 564 million weighted average shares outstanding.

Now that the BK acquisition has closed, we can likely expect the November 2 earnings release to reflect several changes to FY2023 guidance.

Credit Ratings

ICE’s leverage is elevated following the BK acquisition with gross leverage at the end of September 2023 being ~4.3X pro forma EBITDA. ICE, however, continues to target 3.25X by 2025 and 3X as its normalized leverage level. Once the 3.25x level is attained, the plan is to resume share repurchases; share repurchases were suspended when ICE announced the BK acquisition.

ICE has successfully deleveraged following previous acquisitions and I have no reason to doubt management’s outlook.

Details of ICE’s debt commence on page 17 in the Q2 2023 Form 10-Q.

ICE’s current senior unsecured long-term debt credit ratings and outlook remain unchanged from my prior review.

• Moody’s: A3 (stable and affirmed on August 31, 2023)
• S&P Global: A- (stable and last reviewed on September 5, 2023)

Both ratings are at the bottom of the upper-medium grade investment-grade category. These ratings define ICE as having a strong capacity to meet its financial commitments. It is, however, somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.

ICE’s ratings are acceptable for my purposes.

Dividends, Share Repurchases, and Stock Splits

Dividend and Dividend Yield

Intercontinental Exchange’s dividend history is accessible on the NASDAQ website; ICE does not maintain its dividend history on its website.

In FY2020 – FY2022, ICE distributed dividends of $669, $747, and $853 (in millions).

On February 2, 2023, ICE announced a ~10.5% increase in its quarterly dividend from $0.38/share to $0.42/share commencing with the dividend payable at the end of March 2023. This increase extends ICE’s 10-year track record of double-digit dividend growth, allowing it to become a Dividend Contender.

Using the current ~$110 share price, the new dividend yield is ~1.53%.

The low dividend yield will likely dissuade some investors from investing in Intercontinental Exchange. However, the focus should not be on dividend metrics but rather on the total potential return.

Share Repurchases

ICE’s weighted average diluted shares outstanding in FY2012 – FY2022 (in millions) are 365, 396, 573, 559, 599, 594, 579, 565, 555, 565, and 561.

In FY2022, ICE repurchased ~5 million shares totalling $0.632B. Details of ICE’s Stock Repurchase Program are found in the FY2022 Form 10-K commencing on page 124.

As noted earlier, ICE suspended its share repurchases on May 4, 2022 until its leverage falls below 3.25X. This is anticipated to occur in 2025.

Stock Splits

ICE’s stock split history consists of one stock split which took place on November 04, 2016. This was a 5-for-1 split.

Valuation

ICE’s diluted PE in FY2011 – FY2022 is 18.52, 16.46, 29.52, 66.86, 24.11, 23.09, 25.66, 17.00, 25.15, 31.76, 25.23, and 37.52.

Intercontinental Exchange has undergone a significant transformation over the years and the BK acquisition will result in a vastly different ICE from several years ago. As a result, investors are cautioned not to compare historical PE levels to Intercontinental Exchange’s current PE ratio.

Some investors may look at ICE’s 42.6X PE ratio ($110/$2.58 FY2022 diluted EPS) and question whether ICE is grossly overvalued.

Rather than look at historical results, we should try to gauge ICE’s valuation based on future earnings estimates.

Using the current ~$110 share price and forward adjusted diluted EPS estimates from the brokers which cover ICE, we get:

• FY2023 – 15 brokers – mean of $5.62 and low/high of $5.38 – $5.83. Using the mean estimate, the forward adjusted diluted PE is ~19.6.
• FY2024 – 15 brokers – mean of $6.06 and low/high of $5.78 – $6.42. Using the mean estimate, the forward adjusted diluted PE is ~18.2.
• FY2025 – 10 brokers – mean of $6.59 and low/high of $6.25 – $7.05. Using the mean estimate, the forward adjusted diluted PE is ~16.7.

Broker estimates will undoubtedly be revised following the November 2 earnings release.

Based on current estimates, however, I consider ICE to be attractively valued.

Intercontinental Exchange – Consistent Growth and Value Creation – Final Thoughts

Intercontinental Exchange is a very different company from a decade ago. Its sources of revenue are far more diversified and a greater percentage is expected to be recurring (11% in 2012, 51% in 2022, and 56% targeted following full BK integration). With a significantly higher degree of recurring revenue, ICE’s financial results should become somewhat less volatile.

Although ICE’s leverage is elevated, it has a track record of successfully deleveraging following previous acquisitions. I have no reason to doubt that ICE’s leverage will be restored to its normalized EBITDA leverage level of 3x within the next 24 – 36 months.

I currently hold 200 shares in a ‘Core’ account and 200 shares in a ‘Side’ account within the FFJ Portfolio. In addition, I hold a larger number of shares in a retirement account for which I do not disclose details. It was not, however, a top 30 holding when I completed my Mid-2023 Investment Holdings Review.

While ICE appears to be richly valued if we merely rely on historical results, I consider shares to be somewhat undervalued when I look at the long-term growth potential. Nevertheless, I have no immediate plans to add to my exposure.

Author Disclosure: I am long ICE. I disclose holdings held in the FFJ Portfolio and the dividend income generated from the holdings within this portfolio. I do not disclose details of holdings held in various tax-advantaged accounts for confidentiality reasons.

Author Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

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