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Why Intercontinental Exchange Thinks Energy and Mortgages Will Drive Earnings

By Brent Nyitray, CFA - Feb 21, 2021 at 9:12AM

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This financial industry stalwart has much more going for it than its ownership of the New York Stock Exchange.

Last year was tumultuous for most of the financial sector. Bank stocks were hit as the COVID-19 pandemic began due to fears that the ensuing recession would lead to massive credit writedowns. Shares of real estate investment trusts (REITs) also sank over concerns that tenants would be unable to make rent.

However, one set of companies within the sector didn't suffer during 2020: stock exchange operators such as Intercontinental Exchange (ICE 3.19%). The turmoil meant more business for institutions like the New York Stock Exchange (NYSE), Intercontinental Exchange's highest-profile holding. Overall, the company reported 16% growth in revenue and earnings both last year.

But equity market volatility will ebb and flow, so Intercontinental Exchange has been diversifying its business portfolio into mortgages and increasing its presence in the energy markets. While neither segment has the name value of the NYSE, both are well worth watching for the impact they could have on Intercontinental Exchange's fortunes.

A picture of the New York Stock Exchange

Image source: Getty Images.

Major changes in the mortgage origination business

Mortgage technology is becoming a big driver of Intercontinental Exchange's growth. The company bolstered its presence in the mortgage business last year by acquiring Ellie Mae, a provider of software that helps mortgage originators handle the loan production process. Intercontinental Exchange's mortgage technology segment also includes the Mortgage Electronic Registration System (MERS) -- a centralized system for recording mortgage servicing data and the beneficial ownership of loans secured by residential real estate -- and Simplifile, which helps streamline the closing process.

This segment's revenues rose by 324% to $595 million in 2020, and its operating income increased by 124% to $152 million. These jumps were due primarily to the addition of Ellie Mae. However, on a pro forma basis, revenues still grew 56%. This is the true apples-to-apples growth rate. Pro-forma revenues would have come in at $1.2 billion. 

Intercontinental Exchange is taking advantage of a major change in the mortgage industry -- its conversion from analog and labor-intensive to digital and more automated. While their compliance and regulatory costs have risen, mortgage originators are under intense pressure to cut costs and increase output. Mortgage technologies like Encompass (Ellie Mae) and Simplifile address those needs directly. Intercontinental Exchange estimates the total addressable market for its offerings in this arena to be something like $10 billion, so it has plenty of growth potential.

If inflation returns, energy trading should benefit

Energy trading has been another area of growth for Intercontinental Exchange. A cornerstone product of the company is the Brent Oil Contract, which is one of the biggest benchmarks for the energy sector. It's based on prices for North Sea Brent crude, and is the primary contract used overseas. Intercontinental Exchange is also active in facilitating the trade of natural gas, liquefied natural gas, and all sorts of refined product spreads. Finally, ICE has the Environmental Exchange, which allows people and businesses to trade carbon contracts to hedge climate and regulatory risks. 

Over the past year, energy trading revenues rose by 13% to $1.1 billion. Total volumes increased by 15%. Natural gas volumes increased 22% in 2020 due to higher demand and lower shale oil production. Intercontinental Exchange is also launching ICE Futures Abu Dhabi, a partnership with the Abu Dhabi National Oil Company and nine other energy trading firms. The new exchange will include futures on Asian crude benchmarks as well as other contracts based on spreads to other energy benchmarks. 

While cash equity trading revenue from the New York Stock Exchange will continue to be the dominant source of revenues for Intercontinental Exchange, the mortgage and energy businesses will be big drivers of its growth, especially if inflationary pressures attract more money to the energy markets.

Intercontinental Exchange is trading at 23 times expected 2021 earnings per share, which is a reasonable price given that it has a built up a portfolio of assets that would be hard to replicate. The company's $0.30 quarterly dividend comes to about about 27% of last year's earnings per share, which is a pretty good payout ratio.

Investors who are worried about the prospects of further market volatility may find a company that would benefit from it a good addition to their portfolio. 

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