Quality ICE, But Pricey

Summary

• ICE's business continues to hit on all cylinders based on their last annual report.
• Organic growth and acquisitions will drive ICE to become a prominent player in a consolidating market.
• Both business segments are high-grade, although Trading and Clearing seems to be more profitable.
• I value both segments separately and come up with a range of valuations for ICE.
• The valuation model suggests that ICE is currently close to fair value, and I recommend a $60-$65 entry.

The ICE

Intercontinental Exchange, Inc. (NYSE: NYSE:ICE) is a holding Company. It consists of a bunch of different subsidiaries that it has acquired through the years. With these acquisitions is provides stock exchange related services, products, infrastructure, clearing and data services.

Source: ICE 2017 Anual Report.

It continues to provide growth for its shareholders through investment in organic growth and acquisitions. So management's ability to recognize and seize expansion opportunities through acquisitions and strategic alliances will remain of vital importance going forward. So far they have managed to perform up to expectations.

In fact, ICE keeps gobbling up smaller exchanges and competitors as a means of expansion. This strategy serves threefold, 1) it eliminates competition, 2) it consolidates pricing power, 3) it opens up new markets (like with the Chicago exchange deal, it might open up national exchange securities licensing, which ICE can use through NYSE).

Another example of growth through acquisitions was the purchase of Bond Point from Virtu Financial. ICE bought the firm to provide liquidity and better executions in their fixed income services. Virtu Financial is known for their market making algorithms, and Bond Point most likely offers some of those capabilities to ICE and its subsidiaries. All in all, it is an expanding financial empire that somehow flies under the radar of most investors.

Business

“ICE is the leading global operator of regulated exchanges, clearing houses and listing venues, and a provider of data services for commodity, fixed income and equity markets.”

Source: ICE 2017 Anual Report.

They offer support, Pre-Trade, during Trade, and Post-Trade. Desktop and Connectivity solutions help users Pre-Trade, and then their Exchange Data, Pricing, and Analytics helps investors with their Trades and Post-Trade support.

Source: ICE 2017 Anual Report.

Broadly speaking the company operates in two distinct segments, both of them are complicated and quite extensive in their descriptions. Nevertheless, a general summary for both is as follows:

• Trading and Clearing: Generates revenue from execution commissions and clearing services. It accounts for 46% of their total revenues. This segment includes financial derivatives, commodity and index futures, agricultural and energy contracts, equity options and credit default swaps.

Source: ICE 2017 Anual Report.

• Data and Listing: Here ICE generates revenue by selling data from global financial markets and their different traded products. Data and listing consists of mainly three components: Pricing and Analytics, Exchange Data and Desktops and Connectivity.

Source: ICE 2017 Anual Report.

Under this structure, ICE continues to achieve growth quarter after quarter. My impression of the sector is that despite its highly competitive nature, the space for differentiation and different niche products and services creates an opportunity for many competitors. Naturally, a more prominent player has better chances at seizing opportunities, and so an acquisition-driven growth strategy makes sense from that point of view.

It is worthy of note that this sector within the financial industry is ripe for consolidation. ICE is in a fantastic position to keep buying different companies and achieving growth this way, but also it gets closer to becoming a dominant player in the industry. I foresee that in the future, this sector will concentrate significantly on 3-5 big companies (holdings of exchanges), much as it happened to US banks in the past couple of decades.

Another point I would like to mention briefly is that it looks to me that although the exchange business might seem very straightforward and simple, in reality, is very complicated. For instance, ICE has different future contracts in oil, but it is primary product its future brent contracts (one type of oil), where it is the number one exchange on volume traded. However, in WTI, it is only number two on volume traded. Moreover, it happens that WTI is usually the benchmark for oil pricing, so although ICE is somewhat of a runner-up in WTI, it still retains leadership in brent. Also, volume begets volume, because buyers will flock to places where there are sellers, and vice versa, and so these niches are bound to persist.

Incidentally, it is also evident that growth and demand for these services will continue to increase in the future. I believe ICE will keep reaping success from its current growth strategy since there's ample room for growth at the moment.

Segments

Before I continue, I would like to attempt to run a quick valuation model on both parts. Then, add both segment valuations together and come up with an estimate for the company as a whole.

So, let’s dive into ICE’s financials:

Source: ICE 2017 Anual Report and author’s elaboration.

The first thing that's noticeable is that Trading and Clearing is not growing its sales by too much. It presents a CAGR of only 1.59% from 2015 to 2017. This increase dwarfs by the 40% CAGR of the Data and Listing sales segment. In other words, top-line growth came mainly from selling data rather than actual trading and clearing fees.

Nevertheless, it is to ICE's merit that it was efficient in its costs. Regardless of lacking growth in its Trading and Clearing segment, it grew its operating income at a faster pace than its top line. This growth suggests to me that ICE is being cost efficient in its operations.

One caveat though. From ICE's 10-K I read that their method of reporting costs for each segment is based on criteria that they impose. They do this because it is hard to tell which expenses belong to each division, so they assign them based on empirical experience. I suppose that is possible that the bulk of costs belong to the Data and Listing segment (probably servers storing and transmitting data), rather than processing fees for their Trading and Clearing segment.

Still, from their reported numbers it looks that Trading and Clearing is more efficient than Data and Listing in their costs. In my opinion, you should take that with a grain of salt. At any rate, if anything it makes my valuation model price the last segment at a lower multiple because it attributes to it a more moderate growth (lower than it might be).

Source: ICE 2017 Anual Report and author’s elaboration.

Regarding their operating margins, ICE performs better in the Trading and Clearing segment than in their Data and Listing segment. Again, I think it might have something to do with how they spread overall costs over the two sections. Nevertheless, we will take ICE data and work with it.

Source: ICE 2017 Anual Report and author’s elaboration.

Finally, I would like to point out that despite T&C being smaller than D&L; it contributes to a more significant share of total operating profits.

Source: ICE 2017 Anual Report and author’s elaboration.

Valuation

With the previous information, I can gather growth rates (and furthermore their multiples at a PEG ratio of 1) for both segments. Also, I will be using the interest rate charged on their debt emissions. I have chosen their senior notes rate, which comes in four different numbers. For convenience, I have used the average of them in my calculations.

Source: ICE 2017 Anual Report and author’s elaboration.

I have performed two valuations. One valuation model assumes a PEG of 1 each segment's growth. The other method discounts the last results as a perpetuity. The rate used for the perpetuity is 3x the Debt rate charged to ICE for their bonds. The rates were 2.35%, 3.10%, 2.75% and 3.75% (average of 2.99%).

Source: ICE 2017 Anual Report and author’s elaboration.

Finally, I have to compute those valuations given the shares outstanding. Furthermore, I can compare the results to its current share price and come up with a potential upside or downside.

Source: ICE 2017 Anual Report and author’s elaboration.

Last but not least, I add all can summarize all of these valuation ranges in one table. The ending column assumes a 50% margin of safety over 4% yielding 10-year treasury bonds. I picked the 10-year bonds because they are usually a good benchmark for a risk-free rate, although they currently sit at 3%. I chose a 50% margin of safety over 4% because it is the highest credible interest rate forecast I could find for it by EOY 2018. In a worst-case scenario, it is an additional safety for my valuation model.

Conclusion

I think ICE is a fantastic company. It will continue to expand both organically and through acquisitions in the future. I do not expect margins to vary that much going forward, and organic growth should probably slow down as well. Especially in its Data and Listing segment, the 2015 to 2016 jump in revenue inflates the CAGR from '15 to '17 a lot. In other words, there wasn't as much growth in from 2016 to 2017.

From a value standpoint, I think ICE stands currently at or close to fair value. You could make an argument for a momentum play on the stock, but it is hard to make a case for it as a value investment right now.

However, if it were to have a 10% price cut, then I would become very interested. As I said, it is a remarkable holding company. It has many assets that are very valuable together, and I think it will become an even more prominent financial empire through acquisitions.

If you have been riding ICE stock for the last few years, the stock is a HOLD. However, right now it is not the time to add to your position. If the shares were to pull back to the $60 - $65 price range, then it would become desirable.

Lastly, if you were to assume no growth going forward and value ICE as a perpetuity, then $45 a share would be your floor. This price is what I think it is worth at the very least. Anything on top of that will come from your optimism regarding their future growth.

In my opinion, at $65 the stock’s growth begins to justify its markup. Thank you for reading and good luck in your investments.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.