Bear markets aren't fun. Like most people, I prefer it when my net worth goes up in an almost uninterrupted straight line. However, that's not how markets work, and that's a good thing. If it weren't for sell-offs, we wouldn't be able to buy great stocks at attractive valuations. One of the stocks I've been bullish on throughout the 2022 bear market is Intercontinental Exchange (NYSE:ICE). The company behind the ICE ticker is a well-diversified player in the exchange industry, offering an increasing number of fast-growing financial products, it increases recurring revenues, and it is rapidly expanding its mortgage business. While a rapidly slowing housing market is pressuring its existing mortgage business, I believe it's a blessing instead of a curse. The valuation has dropped to attractive levels. I believe that ICE shares make for a fantastic investment the moment the market presents us with another move lower.
In this article, I will tell you why that is.
While I am writing this, ICE shares have lost a quarter of their value from their all-time high. This includes a 17% rally from the October lows, fueled by expectations that the Fed may take its foot off the brake sooner than expected.
There are essentially two major reasons why ICE shares are down. The first one is the most obvious, which is that market weakness has caused investors to de-risk their portfolios. This is hurting every company that isn't benefiting from strong demand in other areas (like oil and gas companies).
The second reason is a bit more specific. ICE has, in addition to its transaction-based business, a lot of housing (mortgage) exposure.
On a full-year basis, the company generates roughly 15% of its money in its mortgage technology segment. This segment has roughly 50% recurring revenues.
If we exclude the pending acquisition of Black Night (expected to close in the first half of 2023), we're dealing with a company that has significant exposure in consumer engagement suites (the early stages of the mortgage loan supply chain), processing and underwriting of loans, and everything related to closing, funding, and compliance.
In other words, ICE doesn't lend money, but it supports the entire process with its technology.
In its third quarter, mortgage technology did very poorly, which makes sense as buying conditions for homes have reached the lowest level since the 1980s. On a side note, guess what happened in the early 1980s? Back then, conditions were terrible as central banks were forced to hike into economic weakness due to high inflation. That sounds very familiar.
Anyway, in the third quarter, total mortgage technology revenue came in at $276 million, a decline of 25%, driven by a steep decline in pagination tech and closing solutions. Yet, the good news is that recurring revenue improved by 14%, bringing total recurring revenue to 60% of total segment revenue. After the Knight acquisition, total recurring mortgage revenue is expected to be 55% (based on a recovery of non-recurring revenue).
Moreover, while the company does see customer weakness, it is mainly focused on the fact that it is outperforming the industry thanks to the solutions it brings to the table:
In the third quarter, our Mortgage business once again outperformed the broader industry driven by strong recurring revenues. The strength and resiliency that we've seen in recurring revenues has been driven by our new customers continuing to adopt our digital solutions, increased demand for our data and analytics tools and continued strong retention. Our customers remain focused on automation and efficiencies. This focus has led to increased interest in our data and analytics products, contributing to a 22% growth year-to-date in our data and analytics business.
The good news is that the company's core business continues to do well. After all, ICE is not known for its mortgage business, but for its operations in exchanges where the company owns the NYSE, major energy, agriculture, and financial futures, as well as fixed-income services.
These segments helped the company to generate $1.8 billion in third-quarter revenue, which was in line with expectations.
In its exchange segment, the company reported 4% higher revenues - 8% higher on a constant currency basis. Growth was reported in every single segment, except for energy, which saw 16% lower revenues. In this segment, the company generated $266 million in revenue, which is more than a quarter of segment revenues. This is caused by major energy contracts like ICE Brent and volatile contracts like Dutch TTF Natural Gas. This decline is mainly caused by volatile trading in the prior year, which makes it hard to beat those numbers.
Operating expenses in this segment were down 8%, allowing the company to boost operating income by 10%, which shows what its asset-light business model can achieve in this environment.
In fixed income and data services, the company reported 12% revenue growth (14% when adjusted for currency fluctuations).
According to the company:
Transaction revenues increased by 84%, including 122% growth in ICE bonds and 75% growth in our CDS clearing business. Similar to last quarter, this strong growth was driven by market volatility and rising interest rates, customers allocating additional capital to CDS trading and our continued efforts to build institutional connectivity to our bond platforms.
Recurring revenues, excluding the Euronext migration, grew by 4% in the quarter driven by demand for additional capacity on the ICE Global Network as well as double-digit growth in both our consolidated feeds business and our derivative analytics.
One issue was lower bond issuance, which reduces the number of bonds available for pricing. However, if the macro environment doesn't see a major deterioration, fourth-quarter results are likely to be in line with third-quarter results, which is overall very satisfying news.
Year-to-date, the company saw a record recurring revenue growth of 7%. Total recurring revenues account for more than 50% of total revenues. Excluding the pending Black Knight acquisition, I expect that number to drop below 50% again as the company saw some weakness in non-recurring revenues this year.
Moreover, operating income was up 10% as the company did not witness higher expenses, which is truly unique. Adjusted free cash flow rose by 7%, allowing the company to more than double capital returns for its shareholders. On a side note, if you want my view on ICE as a dividend stock, feel free to read this article.
The good news is that this is likely going to continue:
Despite dramatically different macroeconomic environments, over a 3-year period, you will see a similar story of compounding growth with ICE revenues increasing at a CAGR of 8%, operating income at 11% and EPS of 12%, again, a testament to the resilience and durability of our platform and the all-weather nature of our business model.
As we look to the balance of this year -- of the year, we're excited about the many growth opportunities in front of us and remain focused on creating value for our stockholders.
Now, the good news continues as ICE is attractively valued and expected to continue high growth.
Intercontinental Exchange is expected to maintain adjusted EBITDA margins of 65% going forward. Next year, the company is expected to boost EBITDA to $5.0 billion. These expectations have been unchanged in the past few months despite the further deterioration in economic growth expectations.
ICE is currently trading at 14.2x 2023E EBITDA of $5.0 billion. This is based on a $71.2 billion enterprise value, consisting of its $58.5 billion market cap and $12.7 billion in enterprise value.
Moreover, the implied free cash flow yield for 2023 is 6.2%, which is a terrific deal and a clear sign that ICE is trading well below what I consider fair value.
Over the past 10 years, ICE shares have consistently outperformed the market. I expect that to continue.
That's also one of the reasons why I wrote this article. Investors looking to buy the market on weakness might like to dip their toes in this financial giant.
Intercontinental Exchange confirmed my bull case. While mortgage technology is struggling in this environment, there is no reason to believe that there's trouble on the horizon. Recurring revenues were strong - even in mortgage technologies. Transaction volumes improved, and fixed-income-related services did well despite very weak global bond transactions.
Even more important is that ICE was able to manage high inflation. Its asset-light business model is expected to maintain high margins.
Unfortunately, the company was not able to discuss the Black Knight deal in greater detail due to an ongoing FTC review. This deal is expected to close in the first half of 2023. I do not expect any obstacles.
With regard to the valuation, I have to say that ICE remains a great bargain.
However, macroeconomic conditions are terrible. My strategy is to refrain from buying large positions until the market offers us a new opportunity. That strategy is risky as it could mean I miss some upside if I'm wrong and there's no double-dip.
To avoid this, investors can start buying a small position and add on a regular basis. If the stock sells off, investors can average down. If the stock takes off, investors have a foot in the door.
(Dis)agree? Let me know in the comments!
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Disclosure: I/we have a beneficial long position in the shares of CME either through stock ownership, options, or other derivatives. 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.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.