• This post expresses a bullish view on IntercontinentalExchange Inc. (ICE), an operator of futures exchanges and OTC markets
• Futures exchanges and derivatives clearinghouses are exceptional business models, and ICE’s mix of derivatives products is particularly good. The current valuation is sufficiently attractive.

In this post, I’m going to write about the derivatives exchange IntercontinentalExchange Inc., which goes by the ticker ICE on NYSE.

I think ICE is undervalued. While there could be adverse regulatory changes over the long-term, this post will discuss how the current stock price is nevertheless attractive from a risk-reward perspective. Accounts managed by Kerrisdale currently hold ICE, and we may buy or sell shares at any time. We will not disclose our sale if and when we sell, and we will not necessarily disclose that we have changed our thesis if we discover something faulty with our analysis at a later date.

ICE is a derivatives markets operator, operating futures exchanges and over-the-counter (“OTC”) markets in such products as oil futures, natural gas futures, sugar, cotton, Russell index futures, etc. Derivatives exchanges are generally great businesses, operating mini-monopolies in some cases and exhibiting strong barriers to entry because of their clearing operations. Equity exchanges merely match buyers and sellers, such that a given stock listed on the NYSE can be traded on Nasdaq or on alternative trading systems like BATS or DirectEdge. Futures contracts, on the other hand, are cleared through a clearinghouse, and specifically through the clearinghouse owned by a given exchange. For instance, ICE’s Sugar No. 11 futures contract, the world’s benchmark for raw sugar, can currently only be bought on the ICE exchange and cleared through ICE’s clearinghouse. This clearing aspect of futures exchanges shields them from competitors and provides them with a unique competitive advantage.

The long-term regulatory risk is that the government at some point legislates that futures contracts be fungible across different clearinghouses, thus enabling the Sugar No. 11 futures contract to be cleared at clearinghouses other than ICE’s. We’ll discuss this risk later in the post, as well as address potential concerns about the company’s current valuation. At 25x trailing PE, the Company is not priced like a typical value stock, but given the company’s growth trajectory, I think ICE deserves a multiple north of 30x.

Historical spreads on ICE can be downloaded here.

Business Description

ICE has two main business segments: (i) its futures exchanges and (ii) its OTC marketplace. The futures business is 41% of revenue; the OTC business is 48% of revenue; and a separate market data segment is 11% of revenue.

In the futures business, ICE operates three regulated futures exchanges in the United States, the United Kingdom and Canada. In the UK, ICE trades a variety of energy contracts, including futures contracts and options tracking Brent crude oil, WTI crude oil, gas oil, various emissions allowance derivatives, UK natural gas, various coal contracts, gasoline, heating oil and others. In the US, it trades sugar, coffee, cotton, cocoa and orange juice; futures and options contracts based on the Russell equity indexes; a U.S. Dollar Index (USDX); and certain other financial indexes. In Canada, ICE offers contracts on canola and western barley. Each exchange clears contracts through its domestically owned clearinghouse.

In its OTC segment, ICE operates global over-the-counter markets through its electronic platform and through brokered markets for energy and CDS. Underlying commodities include natural gas, power, natural gas liquids, chemicals and crude and refined oil products. There are thousands of different types of contracts, depending on combinations of commodities, product types, delivery “hub” locations and terms or settlement dates for a given contract. As of last year, ICE also makes OTC markets in credit default swaps, and so far dominates that burgeoning market. The company clears many of its OTC contracts through its clearing houses.

The Company has grown both organically and through acquisitions. ICE was established in 2000, with the founding shareholders representing leading energy companies and global financial institutions. The initial mission was to transform OTC energy markets from the prior fragmented, opaque, voice-brokered marketplace into a transparent, 24-hour, electronic one. In 2001, the Company acquired the International Petroleum Exchange of London, renaming it ICE Futures Europe. ICE Futures Europe now accounts for approximately 50% of the world’s crude and refined oil futures. In 2005, the Company did its IPO. In 2007, it purchased NYBOT, now known as ICE Futures U.S., which is the futures exchange for certain agricultural commodities such as sugar and coffee. In 2008, ICE purchased Creditex, an interdealer broker and electronic marketplace for the execution and processing of credit derivatives, and in 2009, it purchased The Clearing Corp, a regulated clearing house. These acquisitions were made to position ICE as a major contender for the trading and clearing of credit default swaps, and although CDS clearing is in early stages, ICE is the ‘clear’ leader.

The Company generates revenue mainly via commissions on the trades that goes through its exchanges and OTC platform. Organic growth therefore comes from offering new products and increasing overall trade volume. ICE has proven amongst the most innovative at introducing new contracts. In 2007, for instance, ICE acquired an exclusive license to offer futures contracts based on the Russell equity indexes; in 2009, its Russell revenue was $31m. Last year, the Company introduced 200 new OTC energy contracts. Examples of new contracts include its introduction of coal contracts in 2006, or its recently introduced iron ore contracts, the first ones of which were cleared in February.

Historical and Future Growth

Historical financials of the company can be downloaded here. The Company has generated strong cash flow growth over the past 5 years, with cash flow from operations growing from $50m in 2006 to $486m in 2009. EBITDA has grown from $90m in 2005 to more than $600m in 2009. While part of that growth has come from its NYBOT acquisition in 2007, the bulk has come from the introduction of new contracts and higher volume in current contracts.

The Company’s strong cash flow growth is a testament to its high operating leverage and barriers to entry. ICE has a somewhat fixed cost base, though broker and sales commissions do vary with revenue, and can add incremental volume to its exchange and OTC platforms with low incremental costs. It’s also worth adding that capex is low with exchanges, and working capital has historically been a source of cash.

In terms of barriers to entry, there certainly are other companies that would like to enter the futures exchange space, but the prospect of establishing the necessary clearing houses; implementing the IT infrastructure; and tackling the Herculean task of displacing long-established contracts has been too daunting a prospect for anyone to try. Few things are more prized in trading than liquidity, and it’s unclear how a new entrant could convince all of the nation’s cotton farmers to hedge their harvests via a newly introduced and initially illiquid contract when NYBOT’s alternative is working perfectly well. Futures contracts are sticky products, and as long as the government doesn’t force futures exchanges to allow contracts to be cleared at 3rd party clearing houses, the economics for trading them will go to the current established exchanges.

In terms of the market landscape, the dominant global futures exchange is the CME Group, Inc., which has a 98% market share of all futures traded in the United States (ICE’s main futures exchanges are in the UK, aside from NYBOT). CME is a great business, but I just like ICE more at current valuations. Other major futures exchanges include the London International Financial Futures and Options Exchange of NYSE Euronext and the Eurex exchange owned by Deutsche Borse AG (accounts managed by Kerrisdale also currently hold shares of Deutsche Borse, though we may buy or sell shares at any time). After that, the landscape begins to thin out.

With such few players and the inherent protections offered by unfungible clearinghouses, it’s clear why ICE’s EBITDA margins are greater than 60%, which is all the more impressive when considering the company’s minimal capex and working capital needs.

Future growth is expected to come from a variety of sources. The key area is in credit default swaps, where ICE has jumped out to an early lead. The other players are CME, Euronext Liffe, and Eurex. ICE intelligently set up its CDS clearinghouse in concert with major financial institutions including Bank of America, Barclays, BNP, Citi, CS, DB, Goldman, HSBC, JPM, Morgan Stanley, RBS and UBS. ICE shares 50% of the economics in clearing CDS with these dealers. As a result, it currently dominates that dealer-to-dealer CDS market. Trades have been primarily in CDS indexes, but ICE began clearing single-name contracts in December. For 2010, management has forecasted $60m to $80m revenue with 16% to 20% net margins. CME has positioned itself to win share in the dealer-to-buyside market by establishing relationships with buyside clients. It remains to be seen the degree to which they can materially cut into ICE’s current head start.

ICE’s other products continue to grow well. Their Brent crude futures revenue, about 10% of revenues, grew 20% in 2009, driven by increased hedging by customers in Asia. North American natural gas OTC contracts, about 20% of revenue, slipped 13% in 2009, but should rebound with the recovery in natural gas prices. Their Power OTC contracts continue to surge and all of their agriculture contracts should post positive revenue gains in 2010.

Long-term, futures exchanges are benefiting from certain trends. One of the outcomes of the credit crunch was a desire on the part of regulators to move over-the-counter derivatives contracts in interest rate and credit default swaps off of opaque, over-the-counter marketplaces and onto either exchanges or a cleared OTC market. Currently, ICE is not a notable contender for interest rate OTC clearing.

But the general trend of central clearing will help the Company over the long-term. Currently, the OTC derivatives market is approximately 10x the nominal value of the exchange-traded derivatives market. Less than 20% of OTC derivative trades (by notional value) are currently centrally cleared. It’s unclear what percentage of OTC derivatives will move to a cleared market in the future, but Morgan Stanley estimates “~60% of total OTC derivatives outstanding will be centrally cleared in two-to-three years” (“IntercontinentalExchange”, 12/15/09).

Second, increased hedging, particularly in developed countries, is on a secular growth trajectory. ICE’s growth in its ICE Brent and Gas Oil futures in both 2008 and 2009 are cases in point. Despite recessionary headwinds, revenue increased in both contracts due to increased hedging from Asia. ICE’s European contracts are well-suited to Asian firms that seek to hedge their energy exposure, and the growth in demand for ICE’s hedging products should continue.

Third, high frequency and algorithmic trading is a long-term potential growth avenue for OTC markets in CDS, and other OTC markets that ICE is able to penetrate. Currently, algorithmic traders account for 45% of volume for CME’s OTC volume. Due to liquidity constraints for many CDS contracts, we’re still several years away from seeing high frequency trading in those products. But it’s conceivable that technology and liquidity will ultimately improve such that algorithmic and high frequency traders find it profitable to begin applying their strategies to OTC derivatives that are just beginning to become standardized and cleared.

Regulation

If ICE’s current business model can proceed uninterrupted, the Company should continue to post healthy revenue growth for the foreseeable future. However, it’s no secret that ICE and other futures exchanges are highly profitable enterprises that benefit from exceptional margins. A pillar supporting these margins is the fact that futures exchanges do not allow their contracts to be cleared at third party clearing houses. As a result, they remain the only parties executing and clearing their listed futures, whereas equity exchanges have faced fierce competition from alternative trading systems.

Two forces could undo futures exchanges’ current competitive advantage and replace the current vertical clearing system with one of “horizontal clearing”. First, regulators could require that futures contracts be fungible across different clearing platforms. From a consumer protection standpoint, such legislation could make sense, since it would reduce futures exchange commissions and fees in the long-term. But reducing systemic risk is regulators’ priority right now, and introducing fungibility could actually increase systemic risk. CFTC Chairman Gary Gensler has raised the fungibility question at a number of hearings, but the issue is on the backburner for now.

Second, the dealer community could coalesce to find creative ways to break the monopolistic power of futures exchanges over long-established contracts. For instance, on March 10, NYX closed the sale of minority ownership stakes in NYSE Liffe US to several buyside and sellside firms. LIFFE seeks to break the CME’s virtual monopoly in the US futures market and has promised horizontal clearing to major market participants if they get on board. CME is NYX’s main target for now, but if it successfully introduces horizontal clearing in CME’s markets, it could target ICE next.

Alternatively though, it could be ICE that benefits from horizontal clearing in the US, to the extent it steals share from CME, which currently dominates the U.S. futures landscape. Discussions of horizontal clearing in Europe, where ICE is relatively stronger, has been more muted than the U.S.

I don’t have any particular insights into the threat of horizontal clearing encroaching on ICE’s business model. It’s a risk, and I haven’t been able to quantify what the damage could be. At the least, horizontal clearing in ICE’s markets is probably years away.

The second regulatory threat to ICE is that of position limits. I’m not particularly concerned about potential position limits regulation. Volatility in commodity markets was a major concern in the 2007 to 2009 period, and regulators have questioned whether speculators were the culprits behind the massive moves up and down in futures markets. To address this volatility, regulators are exploring whether position limits should be established in energy markets. Earlier this year, the CFTC proposed position limits that would apply to all CFTC-regulated exchanges. The proposed regulations would cover four reference energy commodities: Henry Hub natural gas; light sweet crude oil, also known as West Texas Intermediate (WTI); New York Harbor No. 2 heating oil; and New York Harbor gasoline blendstock. The CFTC has opened a public comment period until April but has not provided a timetable for when the proposed limits would be put into effect.

I don’t think the impact on ICE will be very material, for the following reasons:

1. If the UK and Europe don’t simultaneously impose position limits, traders will move to overseas markets, which benefits ICE. While European regulators have not officially commented on the CFTC’s recent position limit proposal, in the past, the UK has chosen to take a hands-off approach to position management.

2. Even if Europe does cooperate, traders will find other contracts to trade. They may move substantial trading to the second-to-last-month contract, instead of the last-month contract.

3. During public hearings, several CFTC commissioners have already exerted push-back, citing a variety of problems with current position limits proposals.

4. ICE management has stated that it’s not concerned about position limits legislation. On their Q4 conference call, they said “We have position limits today in a lot of our ag markets. We have position limits on our WTI contract. We’ve always had position monitoring through our compliance functions at our futures exchanges. Fundamentally, the discussion around position limits is really about ensuring that you don’t have a single concentrated position that’s driving the market. As a market operator, we have that same objective and have had that same objective. And so we don’t expect that would — and we’ve said this publicly numerous times: We don’t expect that would have any meaningful impact on our business at all.”

Valuation

It’s not particularly difficult to make a case that ICE is a strong company with a promising near-term and long-term outlook. The tougher question is whether it’s worth the current valuation multiple.
ICE trades at 20x 2010 consensus P/E and 11x consensus 2010 EV/EBITDA. Comparing ICE with other exchanges isn’t very helpful – ICE trades in line with CME, but is more expensive than equity or hybrid equity-derivatives exchanges. NYX and NDAQ, for instance, trade at around 10x to 11x 2010 PE. Given that ICE has a more defensible business and healthier growth prospects, it makes sense that it trades at a premium to other exchanges.

I did a back-of-the-envelope DCF, taking current free cash flow, growing it by 15% in the next four years, 10% in the subsequent 6 years, and then 5% indefinitely after that. I got a $10bn enterprise value (using a discount rate of 12%), compared to an $8bn enterprise value today. If I change the growth in the next four years to 20%, we get an enterprise value of around $11bn. By these numbers, ICE is worth $138 to $155 per share, compared to the current $111 stock price as of March 29, 2010.

Next, I’d look at historical multiples. CME is the most comparable company, given that it’s the only other pure play futures and derivatives exchange in the U.S. I’d give ICE a slight premium to CME; although their business profile is similar, I’d argue that ICE’s growth profile off its current base is more attractive.

Also, when considering EBITDA multiples with ICE, I’d note that capex is less than 10% of EBITDA, and working capital is typically a source of cash.

The historical multiples for ICE and CME were as high as 30x+ EV/EBITDA in the 2006-2007 timeframe. One can argue that multiples were inflated in those periods. But even if that’s the case, the current 12x EV / EBITDA multiple is a fraction of the 37x average EV/EBITDA multiple ICE achieved in 2007. I’m not sure that the outlook for futures exchanges is any worse today than it was then. With the economy back on track, thus far, and the regulatory environment providing more of a headwind than a tailwind, ICE’s growth profile looks as promising as it did back in 2007.

Ultimately, all valuation methodologies have weaknesses, whether it be comparable company analysis, DCF or an analysis of historical multiples. At the end of the day, I often rely on my general sense of where companies with certain cash flow growth profiles should trade. And I think 12x is cheap for a company with ICE’s cash flow growth trajectory. A more appropriate trailing EBITDA multiple would be 15x+, and a more appropriate trailing P/E multiple would be 30x+. On a forward multiple basis, a more appropriate EV/EBITDA multiple would be around 12x-13x and a more appropriate P/E multiple would be around 24x-26x. Using these numbers, we get an approximately $135 implied stock price.

I think $135 is an appropriate target price for ICE, with an upside target price of $150-$160. At $135, we’re looking at a 22% premium to the current price, and at $155, we’re looking at a 40% appreciation.

While a 20% to 40% target return does not leave us a high margin of safety, I view ICE as somewhat of a low-risk investment given that it’s an unlevered company with attractive near-term visibility and long-term growth potential.

As usual, this email does not constitute investment advice or a recommendation of any sorts. Kerrisdale Capital may buy, sell or short any of the stocks mentioned at any time. I may be wrong; it would not be the first or last time.

LEGAL:

THIS COMMUNICATION IS FOR INFORMATIONAL AND EDUCATIONAL PURPOSES ONLY AND SHALL NOT BE CONSTRUED TO CONSTITUTE INVESTMENT ADVICE. NOTHING CONTAINED HEREIN SHALL CONSTITUTE A SOLICITATION, RECOMMENDATION OR ENDORSEMENT TO BUY OR SELL ANY SECURITY OR OTHER FINANCIAL INSTRUMENT OR TO BUY ANY INTERESTS IN ANY INVESTMENT FUNDS OR OTHER ACCOUNTS. THE AUTHOR HAS NO OBLIGATION TO UPDATE THE INFORMATION CONTAINED HEREIN AND MAY MAKE INVESTMENT DECISIONS THAT ARE INCONSISTENT WITH THE VIEWS EXPRESSED IN THIS COMMUNICATION. THE AUTHOR MAKES NO REPRESENTATIONS OR WARRANTIES AS TO THE ACCURACY, COMPLETENESS OR TIMELINESS OF THE INFORMATION, TEXT, GRAPHICS OR OTHER ITEMS CONTAINED IN THIS COMMUNICATION. KERRISDALE CAPITAL MANAGEMENT, LLC OR AFFILIATED ENTITIES MAY OWN SECURITIES OF OR OTHERWISE HAVE AN INVESTMENT RELATED TO ANY COMPANIES MENTIONED IN THIS COMMUNICATION. THE SENDER EXPRESSLY DISCLAIMS ALL LIABILITY FOR ERRORS OR OMISSIONS IN, OR THE MISUSE OR MISINTERPRETATION OF, ANY INFORMATION CONTAINED IN THIS COMMUNICATION.