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On August 6th, Intercontinental Exchange, Inc. (ICE) a leading operator of global exchanges and clearing houses and provider of mortgage technology, data and listing services, announced that it has entered into a definitive agreement to acquire Ellie Mae, the leading cloud-based platform provider for the mortgage finance industry. The transaction values Ellie Mae at ~$11B.
Summary
- ICE is one of the earliest exchanges to unlock the value of market and asset data and use it to offset declining fortunes within exchange operations.
- It has invested in selling data derived from its valuable data sets within equity and fixed income.
- I view ICE as a vendor of proprietary data and less as an exchange and this is reinforced through its recently announced $11B acquisition of Ellie Mae which provides technology solutions that enable lenders to originate more loans, lower origination costs, and reduce the time to close.
Introduction
Some of you may recall Robert Van Winkle’s (Vanilla Ice) ‘Ice Ice Baby’ which was released in August 1990. When I first heard this tune I thought to myself ‘this ranks up there with the worst songs I have ever heard’. Although I tip my hat to Vanilla Ice’s ability to create a song which was the first hip hop single to top the Billboard Hot 100 and to top the charts in Australia, Belgium, the Netherlands, New Zealand, Ireland and the United Kingdom, I view its success to a testament of how many people have a poor taste in music as opposed to the song being of truly high quality. In fact, I wish Van Winkle had had a similar experience to ‘Rip Van Winkle’.
There is, however, another ‘ICE’ which is of far superior quality. I strongly suspect, however, that a significant percentage of people who propelled Ice Ice Baby to the top of the charts know NOTHING about Intercontinental Exchange, Inc. (ICE), a leading operator of global exchanges and clearing houses and provider of mortgage technology, data and listing services.
In multiple previous articles I have indicated that I try to invest in industry leaders which are highly profitable, which generate strong free cash flow, and which are shareholder friendly. Of particular interest to me are industries where barriers to entry are extremely high and the long-term growth prospects are favorable. One such industry is the Financial Data and Stock Exchanges.
My initial exposure to this industry was through TMX Group Limited (X.TO). Shares were held in a Registered Education Savings Plan (RESP) and I ended up exiting this position under the terms and conditions of the RESP when I withdrew funds to cover some of our daughter’s education expenses. Regrettably, I did not re-acquire the shares I sold!
Fast forward to August 2018, however, and I initiated a position (300 shares) in CME Group Inc. (CME) and disclosed same in this article. I have also recently disclosed the purchase of another 300 shares in CME in this article.
ICE has been on my radar for quite some time and in this article I disclosed it was on my ‘Watch List’. Regrettably I have never initiated a position..even in March/April 2020! Recently, however, ICE has entered into a definitive agreement to acquire Ellie Mae from Thoma Bravo. This piqued my interest and based on my analysis and long-term outlook I have finally decided to initiate a partial position in ICE in an account for which I do not disclose details using a portion of the proceeds from the sale of The Canadian Imperial Bank of Commerce (CM) shares which I disclosed in this article.
Business Overview
Trying to condense the Chairman and CEO’s Letter to Shareholders and Part 1 (Business and Risk Factors) from the 2019 10-K into a few brief paragraphs is futile. To gain a better understanding of ICE, I highly encourage you to read this information which can be accessed from the 2019 Annual Report.
Most recently, however, ICE has made a strategic acquisition for which details are not disclosed in the 2019 Annual report and 10-K.
Q2 2020 Results
Results from the most recent quarter can be accessed here. Since the recent Ellie Mae is transformative I will limit my comments regarding Q2 results to the following:
In Q2, ICE experienced steady growth in the data and listings segment, while there was a pullback in revenue in the trading and clearing segment.
ICE is benefiting from market volatility caused by COVID-19 that has increased trading volumes, and higher trading and clearing revenue split between energy, cash equities, equity options, and fixed income Q2 trading revenue was 11% higher than the 2019 quarterly average and it is anticipated that much of this higher level should be sustainable since cash equity and option trading volume is likely to be permanently higher after retail brokerages cut their base trading commissions to $0.
Ellie Mae Acquisition
On August 6th, ICE that it had entered into a definitive agreement to acquire Ellie Mae from Thoma Bravo for $11B; the August 6th investor presentation can be accessed here. Consideration will be in the form of $1.75B of newly issued stock and $9.25B of cash. At the time of the August 6th announcement, management indicated the plan was to finance the cash component through a combination of commercial paper, short-term bank facilities, and longer term bonds with the weighted average cost of capital for this deal is expected to be less than 3%.
Looking at this August 17th Press Release we see that ICE priced an underwritten public offering of $6.5B in new senior notes. The senior notes comprise $1.25B in aggregate principal amount of Floating Rate Senior Notes due 2023, $1B in aggregate principal amount of 0.700% Senior Notes due 2023, $1.5B in aggregate principal amount of 1.850% Senior Notes due 2032, $1.25B in aggregate principal amount of 2.650% Senior Notes due 2040, and $1.5B in aggregate principal amount of 3.000% Senior Notes due 2060.
At close, leverage will increase to around 4.25 times pro forma 2020 adjusted EBITDA. Since management is committed to maintaining a solid investment grade rating, the current plan is to suspend share buybacks until leverage falls below 3.25 times, which is anticipated to occur at some stage in the second half of 2022.
The long-term leverage target will be a range of 2.75 - 3 times EBITDA and with expected strong cash flow generation, management expects to deleverage even as it continues to invest in the business and to increase the dividend.
Upon the closing of the Ellie Mae transaction and since the 2016 investment in Mortgage Electronic Registration System (MERS), ICE will have invested roughly $11.5B constructing its mortgage business. It expects ICE Mortgage Services, which will include Ellie Mae, MERS, and Simplifile to have pro forma 2020 revenues of $1.1B including $0.9B from Ellie Mae and pro forma adjusted EBITDA of $0.6B including $0.47B from Ellie Mae.
The Ellie Mae investment is expected to achieve a 10% return on investment, which relative to a cost of capital below 3%, should create significant shareholder value. ICE further expects overall return on invested capital, which was 10% in the trailing 12 months through June, to remain 200 basis points above ICE's cost of capital in 2021 with sequential improvement beginning in 2022.
ICE also expects $50 - $65 million in run rate cost synergies to be realized by the end of year three.
What is Ellie Mae?
Ellie Mae is a unique digital platform that serves a vast array of mortgage industry participants and is critical to the production of nearly one half of residential mortgages in the United States.
The US mortgage workflow is in the early stages of an analog to digital conversion. The fragmented and largely paper-based mortgage transaction currently involves around 100 steps, thousands of pages of documents, and can take nearly two months to complete. By combining the existing network at ICE Mortgage Services and Ellie Mae, ICE is expected to establish itself as an industry leader within a large and growing addressable market and one which desperately needs efficiency gains.
In 2016, ICE commenced its journey to help automate the mortgage workflow when it purchased a majority investment in MERS, and a database that currently helps track the ownership and servicing rights of roughly 85% of outstanding mortgages in the US.
ICE quickly applied its technology expertise to rebuild and modernize its database thus allowing industry participants to begin digitizing parts of their closing workflow. Following this modernization, electronic note adoption (e-notes) now represents ~3% of the market, up from only 1% just a few quarters ago.
ICE’s 2019 acquisition of Simplifile added a unique settlement network constructed over two decades and one that currently connects 28,000 settlement agents to over 2,000 counties across the US. This network and the unique data that flows through it is the backbone for digitizing the closing and post-closing process. The acquisition of Ellie Mae complements this in that its core strength is the origination network, which connects brokers, underwriters and lenders. When combined with ICE, the expanded platform will, for the first time, bring together all of the key stakeholders from origination to final settlement in one digital ecosystem.
ICE is of the opinion there is an opportunity to apply this value proposition and unique end-to-end offering to an expanded addressable market that is ~$10 billion in size as customers seek efficient ways to navigate both rising compliance costs and growing origination backlogs as evidenced by the mounting number of refinancing candidates as well as a shift towards greater millennial generation homeownership.
Ellie Mae's platform is critical to customer workflows as evidenced by retention rates in excess of 95% and ICE’s management is of the opinion the combined platform will help accelerate the adoption of ICE Mortgage Services, eNotes and eRecording solutions, and will increase the use of many of other new and proposed digital closing products.
From a competitive perspective, ICE is of the opinion it will be able to cleanse and package unique data sets to produce real-time data and analytics that can assist customers in achieving better pricing, more accurate peer benchmarking and other competitive intelligence tools. This compares the current providers that provide similar data offerings on a 90-day or more lag time.
ICE has also indicated that over the past decade, compliance and mortgage origination costs have doubled, with over two-thirds of these costs related to personnel. Once ICE automates the compliance and mortgage origination costs, it envisions customers will potentially be able to save nearly $3,000 in origination costs per loan.
Ultimately, ICE envisions a significant opportunity to build a more efficient and complete electronic closing offering that builds on its existing Ellie Mae partnership.
Credit Ratings
Credit risk is a key investment consideration from my perspective. I have no desire to invest in a company has a credit risk which is likely to keep me awake at night.
Following the very recent Ellie Mae acquisition announcement I see that Moody’s has lowered ICE’s long-term credit rating from A2 to A3 (the lowest tier of the upper medium grade which is investment grade.
S&P Global has also lowered ICE’s long-term credit rating to BBB+ which is one notch lower than Moody’s rating. It is the top tier of the lower medium grade category but is still investment grade.
Both ratings are satisfactory for my purposes and I expect these ratings to improve over time based on management’s guidance.
Valuation
The mean adjusted earnings for FY2020 based on input from multiple analysts calls for ~$4.40 in adjusted EPS with the low/high range being $4.28 - $.4.81.
If we err on the side of caution and use $4.30, the adjusted PE ration on the basis of a $104 stock price is ~24.2.
Looking at the $11B purchase price of Ellie Mae relative to $0.9B of revenue and $0.47B of adjusted EBITDA it appears ICE is valuing Ellie Mae as a high-growth, technology sector stock at 23.4 times EBITDA. While the purchase price certainly results in an elevated valuation, ICE estimates the total addressable market it will be serving at ~$10B - just over 10% market share with a potentially long-term growth potential.
Although expense synergies of $50 - $65 million are anticipated, the higher market share and the data
products from the digital mortgage business ICE is developing is what is truly attractive to ICE.
While ICE does distribute a quarterly dividend, it is certainly not a stock which will appeal to dividend yield hungry investors. In fact, the Investor Resources section of ICE’s website does not include historical dividend and stock split information.
If you look at external websites for ICE’s dividend history, your attention may be drawn to a $0.85/share/quarter to $0.17/share/quarter drop in late 2016. What is not readily apparent is that ICE had a 5 for 1 stock split in the form of a stock dividend. Shareholders on record as of Oct 27, 2016 received on November 3, 2016 an additional 4 shares for each share held and shares began trading on a split-adjusted basis on Nov 4, 2016.
The current $0.30/share/quarter provides investors with a ~1.15% dividend yield on the basis of a ~$104 share price; the dividend payable September 30th will mark the 3rd quarterly dividend at this level.
As noted earlier, Management has indicated that the current plan is to suspend share buybacks until leverage falls below 3.25 times, which is anticipated to occur at some stage in the second half of 2022. As a result, I anticipate share count will rise over the next couple of years from the Q2 2020 diluted weighted average common shares outstanding level of 552 million shares.
Final Thoughts
Although I do not view ICE’s current valuation as enticing I like the company’s long-term outlook. Looking at ICE’s historical performance, we see that ICE has clearly rewarded long-term investors; I have no reason to expect any different going forward.
Looking at the pricing of the recently underwritten $6.5B public offering, I wish I could borrow under that pricing! Since those rates are clearly out of the question for me, I indirectly get to participate in such attractive pricing by investing in ICE.
I recognize market conditions are somewhat frothy, and therefore, I have only acquired a few hundred shares in an account for which I do not disclose details. Should we get what I think is a long overdue pullback and ICE’s share price gets caught in the downdraft, I intend to acquire additional shares.
I hope you enjoyed this post and I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long ICE.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
