IntercontinentalExchange Group Is Becoming A Dominant Play In A Consolidating Industry

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Summary

The consolidation in the asset exchanges market is leaving ICE as one of two dominant companies - this bodes well for investors in the firm.

ICE is likely to end up selling off many of the legacy NYSE assets, but integration of the staid NYSE culture into ICE's entrepreneurial culture is still a risk.

The major unknown for investors though is how the Crisis era regulatory changes will play out for the firm - they could create headwinds or tailwinds.

Electronic exchange company IntercontinentalExchange Group (NYSE:ICE) operates a market for exchange-based and over-the-counter trading in various commodities. Atlanta-based ICE is perhaps the most interesting player in the exchange space right now, not necessarily as a long-idea (though it's not a bad stock as I will discuss in a moment), but simply because of the transformative acquisition of the NYSE last year.

The New York Stock Exchange is of course one of the world's most well-known financial brands, and so it was truly remarkable last year when relative upstart ICE announced that it wanted to merge with the NYSE. ICE has only been around since about 2000, whereas the NYSE has a history that is literally intertwined the financial foundations of the country. Nonetheless, capitalism is not about history or nostalgia but about money and ICE has been on a roll for more than a decade now while the NYSE was hit hard by a variety of factors that reduced the profitability of its core business. In many respects it is fitting then that the entrepreneurial ICE has taken over the classier and more prestigious NYSE. Though technically the NYSE called the transaction a merger, there is little doubt that the ambitious and hungry ICE was the driver in the deal.

Ultimately, I think ICE's goal in joining with the NYSE was to create a stronger position in derivatives products, and that ICE management views the rest of the legacy NYSE business as a likely to be sold-off. In particular, the cash equities units in Europe and even to some extent the US do not make a ton of sense as a strategic fit with ICE which makes me wonder about management's long-term vision for them. While ICE has said that the transaction should be accretive to GAAP earnings in 2014 to the tune of 15%+, that probably relies on getting considerable scale and cost savings. I think the new ICE may be able to achieve such savings, but it won't be trivial, and the execution risks in the deal are real. Management is planning to do an IPO for the Euronext group of Continental European exchanges as a stand-alone entity, and I think that will be the start of the divestiture process.

One major issue facing ICE is the regulatory risk around the Dodd-Frank Act and the Volker Rule. The full impact of both pieces of legislation has yet to be felt, but both pieces of legislation could have positive or negative effects in the end. To the extent that the legislation either stabilizes the long-term financial system or forces previously bilateral transactions into an open market operated by ICE, the rules are clearly positive. There is also a distinct risk though that the new regulatory environment could end up crimping trading volumes particularly in some obscure product categories in the derivatives space which also happen to be very profitable for ICE.

Despite these risks and the complexities associated with integrating the NYSE, ICE has done a good job or keeping and even expanding market share in key product areas. The company is the leading exchange for soft commodities like Brent and WTI crude, gas oil, and North American power futures, as well as providing clearing services in the credit default swap (or CDS) market. This of course makes sense given that ICE as originally formed for the express purpose of being an OTC energy trading venue. Since that time the company has acquired the International Petroleum Exchange (which may be provide a partial blueprint for the firm's plan for the NYSE in the event that selling certain assets there proves infeasible), and then the New York Board of Trade.

The interesting thing about ICE to me, beyond just the acquisition of the NYSE, is the fact that along with the Chicago Mercantile Exchange (NASDAQ:CME), it is now clear ICE will be one of the big long-term players in the exchange space for years to come. Smaller players like the Nasdaq (NASDAQ:NDAQ) and Chicago Board Options Exchange (NASDAQ:CBOE) certainly have their virtues, but these firm's may need to be bought out by ICE or the CME to compete eventually. Other players like BATs and foreign exchanges may carve out a role as well, but they are unlikely to put ICE or the CME in a tough long-term position.

Essentially then, the financial crisis and resulting transactions from the NYMEX/CME merger to the ICE/NYBOT and NYSE deals have created a sort of oligopoly in the market place. Presumably in the medium term (after the acquisitions are solidified and regulatory environment settles down to the new normal), both firms will find a way to earn oligopoly level profits to an even greater degree than they have before. With ICE now operating 16 global exchanges, five clearing houses, and looking poised to be the leader in global capital raising for the second year in a row, it's pretty clear that ICE will be a force to be reckoned with in the future. Even after the Euronext European exchange IPO, ICE will still be a major exchange company, and perhaps the major exchange company with the CME being ICE"s main competitor of course. (As an aside, it is ironic in many ways the NYC has been the financial hub of the country since the time of the Founding Fathers, but time and change have eroded certain competitive advantages so much that the country's two biggest exchange companies are now headquartered elsewhere.)

Based on the NYSE/ICE deal and the most recent figures management has been reporting, I think ICE will probably earn ~$10.80 this year if it executes well on its various cost control initiatives. (Poor execution might lower this figure by 10% in my view, though given its past excellence I have no reason to think ICE management is about to become incompetent now.) In support of this, trading volumes are decent thus far this year from all the numbers I have seen, and ICE has been looking at lot of pretty interesting new OTC products. Cash equities are not doing so hot this year of course (in terms of volumes and margins), but energy products look better, and the shift from CDS OTC trading to exchange trading is definitely an on-going trend that has a while to go yet. Operating margins will probably continue to expand throughout this year and next as the cost controls are put in place, and given that, I think a P/E of 20X is reasonable for the firm. This is roughly in line with the firm's historical levels and similar to peers. Given that then, a fair price for ICE is perhaps $216 a share. Long-term investors might be willing to pay more given the positive future ahead of the company, but it's worth remember that ICE is a fairly volatile stock and opportunities to buy the stock on a pullback are not uncommon.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in ICE over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.