The year 2020 has been difficult for financial companies, especially banks and real estate investment trusts (REITs). With COVID-19 depressing the economy, credit risk has taken center stage. The exchanges have historically been good places to hide out in tough economic times, since lousy economies and market volatility seem to go hand-in-hand. Some of the exchanges, especially those highly leveraged to bond trading, have struggled, while the ones with the most exposure to stocks have performed best.
Intercontinental Exchange (ICE 0.11%) recently reported strong earnings with a big contribution from a recently bolstered secret weapon: mortgage technology.
Building a mortgage presence
Intercontinental Exchange is most known for the New York Stock Exchange, but it has been steadily building a presence in the mortgage business. Early in September, Intercontinental Exchange closed its $11 billion deal to acquire mortgage technology company Ellie Mae. While there were eyebrows raised about the price paid, the timing couldn't have been better, as the mortgage industry is having a record year.
For the third quarter, net revenue rose 5.6% from the same period last year to $1.4 billion, primarily driven by a 6% increase in data services revenue. Adjusted earnings per share (EPS), which exclude some of the expenses associated with acquisition activity, fell 3% to $1.03. Mortgage revenue rose 62% on a pro forma basis, which was attributable to the addition of Ellie Mae. Since the transaction closed late in the quarter, Ellie Mae will have more of an effect on subsequent quarters.
Ellie Mae will provide a big boost to revenue
Trading and clearing revenue rose 6% compared to a year ago, as the addition of Ellie Mae more than offset weakness in energy trading. The third quarter of 2019 was volatile in the energy markets due to the attacks on the Saudi Aramco oil fields, which made year-over-year comparisons look weak. Data revenue rose 6% to $589 million. ICE Mortgage Technologies contributed $140 million to revenue, of which $73 million came from Ellie Mae. The company guided on the earnings conference call that Ellie Mae revenue would come in between $220 million and $235 million in the fourth quarter.
ICE is betting that the U.S. mortgage market is undergoing an "analog-to-digital" transformation similar to what happened in commodities 20 years ago. The mortgage origination business is fundamentally at capacity right now, and mortgage originators are earning record margins on record volumes. ICE sees its mortgage technology segment as a way to address the mortgage industry's pain points, given that between Ellie Mae, Simplifile and MERS, the company touches all parts of the mortgage value chain. ICE estimates that the addressable market in mortgage technology is worth a $10 billion per year. With Ellie Mae and MERS, ICE Mortgage Technology should own about 11% of that market. This represents a lot of potential future growth, and makes ICE much less dependent on the vagaries of market volatility, but it will be more leveraged to the mortgage market, which means interest rates.
The Street estimates for ICE might be too low
ICE is trading around 21 times expected 2021 earnings per share, and the Street is expecting EPS growth of about 6% between 2020 and 2021. This would be a deceleration from 2020 EPS growth of 14%. This seems like the Street expects limited growth from the mortgage arm, which doesn't make sense given the demand for refinancing (roughly 75% of the U.S. mortgage market can save 0.75% on their mortgage rate) and the Fed's commitment to keep interest rates low. Annualizing the fourth-quarter guidance from ICE on Ellie Mae's expected contribution, revenue would incrementally increase by $910 million next year. The 2021 estimates for ICE don't seem to take that growth into account. It is possible that the refinance boom peters out in early 2021, but doesn't seem likely unless interest rates rise rapidly and dramatically.
ICE probably has some upside to 2021 estimates, which means that the stock is cheaper than it appears.