Intercontinental Exchange: Great H1 2024 Performance, Still Demanding Valuation

It’s been only a month since I wrote my first article on Seeking Alpha about Intercontinental Exchange (NYSE:ICE), and while the long-term thesis hasn’t changed, the stock price has changed considerably, justified by very positive signals seen in Q1 2024 and confirmed in Q2 2024. With renewed market confidence, current or potential investors are willing to pay a higher valuation multiple.

The stock price has gone from $150 to $160 in just one month, a performance that annualized equals 122%.

Key points of the thesis

In this section, I will summarize the key points of the thesis.

Intercontinental Exchange is a company with a highly diversified revenue structure: 56% in Exchanges, 29% in Data and Fixed Income, and 15% in Mortgage Technology. Looking ahead, the company is expected to rely less on the exchange segment and increase the contribution of Mortgage Services, which would lead to an increase in recurring revenue.

Through NYSE, it holds 40% of the market share in the Exchanges sector, with its main competitor being NASDAQ, which holds a 32% market share. There are two points I want to highlight here: on one hand, the industry is not a ‘winner takes all,’ so there isn’t excessive price competition, and coexisting in a duopoly has allowed both to maintain high ROIC. On the other hand, ICE is diversifying more effectively, making it a company with greater resilience in times of crisis.

ICE has a great management team, well-aligned with shareholders, and makes good capital allocation decisions to maximize growth opportunities. In the last conference call, I observed positive signals that I will mention in the next section.

The competitive advantages mentioned in my previous article (economies of scale, high switching costs, and network effects) remain solid; we can even see an increase in the network effect in the Mortgage Technology sector with new clients and cross-selling.

Q2 2024 Earnings

In this section, I will share my conclusions and second-level thoughts on each segment of the company based on the ICE Q2 2024 conference call.

Considering the company as a whole, compared to Q2 2023, I observe a 7% growth in sales accompanied by only a 1% increase in operating expenses, resulting in a very interesting 11% YoY growth in operating sales.

Regarding debt, management continues with its plan not to repurchase shares in order to reduce debt. This decision seems correct to me and is clearly reflected by the reduction from 4.3x EBITDA in Q3 2023 to 3.7x in Q2 2024.

Lastly, the company did not provide guidance this quarter as it did in Q2 2023; however, the CFO mentioned that adjusted operating expenses will be around $955-$965M. This implies a 1% increase compared to the previous quarter, but an 18% increase compared to the same quarter last year.

I want to highlight two phrases from the conference call that I really liked from the CEO and which are the reason I decided to analyze the company:

“Our approach to overlaying organic growth on our strategic acquisitions is deliberate and comprehensive, allowing us to construct a platform that not only generates strong returns and healthy cash flows, but is also positioned to continue to leverage our core strengths to generate future growth”

“Our evolution has been intentional, diversifying across asset classes and geographies, and increasing our mix of recurring revenues, with a goal of building a business that today generates compounding earnings growth.”

Amidst so much uncertainty and volatility in the markets in 2024, the vision of this leader, coupled with an execution that justifies it year after year, makes the company a good candidate for a long-term portfolio.

Exchange

I observe substantial growth in energy derivatives sales of 32% and Financials with 26%. These two sub-segments are the most important within the revenue mix, which explains the +14% YoY sales growth in the segment.

The energy subsegment has been growing at a rate of 20% annually over the past 5 years and is expected to continue this way due to its diversification from oil to new clean energies. Although this sector is very cyclical, it has little impact on the company’s performance since it acts as an intermediary, and its income comes from transaction commissions, which remain constant both in crises and in booms.

Regarding the ‘Financials’ sub-segment, I can only comment that it is a real revenue-generating machine as it depends on transaction volumes, which, in times of volatility like the current one, only tend to increase.

Fixed Income & Data Services

Sales in the segment have grown normally, by 4%, resulting in a 9% increase in operating income, once again demonstrating economies of scale. This shows the predictability of these revenues for the company due to their recurrence and the ability to slightly increase prices without losing customers. Additionally, the double-digit growth in the index business, which has increased sixfold since 2017, is sustained.

Looking ahead, it would not be unreasonable to consider greater efficiency to further reduce marginal costs with all the emerging options, such as generative AI.

Mortgage Technology

I consider this to be the segment with the most potential for the company, which is going through a challenging period. However, this semester has shown positive signs, and the market has valued that.

As we can see in the 2Q 2024 Earnings Press Release, the Origination Tech sub-segment has not generated revenue, and the Closing Solutions sub-segment has only generated a +9% increase. From my point of view, these results are far from my expectations but are entirely reasonable given the high interest rates, which imply a high cost for executing new mortgages. Since my last article, the U.S. government has not changed interest rates.

However, and here we have a fantastic sign of the beginning of a recovery, the Data & Analytics sub-segment has grown by 163% YoY. Despite being, along with Closing Solutions, the sub-segments generating the least revenue, we should look into this in depth. First, the increase is due to 29 new clients driven by the need for new infrastructure and digital modernization, which demonstrates that not only will the business continue to grow, but actors have begun to reinvest because the mortgage sector should recover soon. And second, the synergies between ICE and Black Knight (the latest acquisition we discussed in my previous article). These have generated +200 cross-data sales in the first half of the year.

Additionally, I would like to mention that the market expects 8 interest rate cuts over the next 12 months, which would obviously activate the accumulated demand in the mortgage sector.

Although this data seems a bit optimistic to me, I believe the market has chosen to value the company at a multiple higher than its historical average because it sees the company not only as a safe haven during potential crises but also as an interesting way to ride the wave of housing demand in the U.S.

Brief Financial Overview

I don’t have new comments to make regarding the company’s annual fundamentals since we have only gone through the first half of 2024 and the company has not provided guidance for the rest of the year. It’s curious that they haven’t done so, as they did last year, but as a long-term investor, this is not something I expect or am disappointed by.

However, I will highlight certain points from the financial statements for the first half of the year:

• Reduction of debt from 4.3x Net Debt/EBITDA to 3.7x. This point will not only reduce interest expenses for the second half of 2024 but will also restore market confidence.
• The exchange sector appears very solid, growing mostly at double-digit rates, demonstrating that the price increase in 2023 has not had an adverse effect and highlighting its economies of scale.
• The data sector continues with moderate growth and difficulties in improving costs. Although the decreasing marginal cost is very strong and its percentage of recurring revenue is high, it is an area that is facing challenges in growing at a mid-to-high single-digit rate, which is the company’s target.
• Despite seeing good signs in the mortgage technology sector, it still generates GAAP operating losses of $32M (-6%).
• Operating margins are generally very solid, showing a 75% margin in the exchange segment compared to 73% in the same period in 2023, a 45% margin in Fixed Income and Data Services compared to 43%, and a 36% margin in Mortgage Technology compared to 40% from the previous year. The latter is explained by its still low activity, which prevents it from taking full advantage of its economies of scale.

Valuation

Regarding valuation, I would like to show the following image, which illustrates that the stock price has been driven mainly by multiple expansion. At the time of writing my previous article, the company was valued at 24x P/E, and currently, it is valued at 25.3x P/E. One of the highest valuations in the last 5 years.

I believe these situations occur because many investors do not analyze the company in depth and base their projections on analysts’ opinions, which often underestimate the company’s results.

In my previous analysis, I set a fair price for the company between $130 and $143. This corresponds to a P/E ratio of 21x-23x for the year 2024 and a ratio of 19x-21x considering the projected EPS for 2025. This price seems reasonable to me as it not only provides a margin of safety but also offers an expected return greater than 12%. At current valuations, I do not consider there to be a margin of safety.

If I think about the long term, I have no doubt that ICE is a very solid company with a high terminal value. However, at these valuations, my expected returns (based on an annual growth rate of 9%, maintaining margins, and continuing share buybacks starting in 2027) for the next 5 years are approximately 8%. From my perspective, this projected return does not meet the requirement I expect as a private investor, who is looking for a higher compensation that justifies the entire analysis conducted.

Associated Risk

To be honest, the long-term risks have not changed. The potential for poor execution of acquisitions, future difficulties in price increases, or the possibility of technological disruption are considerations we need to focus on for this company.

However, from my perspective, the company is currently at demanding valuations as the market expects a substantial decrease in interest rates over the next 12 months. If this does not materialize, the Mortgage sector could suffer and delay its profitability, generating concern among short-term investors.

To this end, I would like to quote John Bogle to my readers:

‘Don’t let the volatility scare you away from the market. Volatility is a distraction that prevents many people from investing.’

Thinking long term, a potential negative market reaction turns this last risk into an entry opportunity.

Conclusion

Considering the strong execution of management, the resilience demonstrated by the company in the Exchange and Fixed Income segments despite market volatility, and the strength of the ICE Mortgage Technology segment despite the prolonged crisis in the sector, the company has all the characteristics to be included in my portfolio.

However, due to the valuation points discussed, I still do not find it reasonable to incorporate it at this time. As a private investor, and given the time commitment involved, I expect a return on my investments of no less than 15% to ensure a margin of safety. For these reasons, I maintain my rating on the company as ‘Hold’.