While mortgages aren't the first thing most people think about when discussing stock exchanges, Intercontinental Exchange (ICE 1.10%), the parent company of the New York Stock Exchange, touches almost every part of the mortgage value chain. The company has been investing heavily in this business over the past few years in an effort to diversify away from exchange activity.
The result: combining a cash-cow moat with something that can generate above-trend growth going forward. Intercontinental Exchange recently reported fourth-quarter earnings and gave an update on the mortgage business and its place in the company's overall strategy. Let's dig in.
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The analog-to-digital conversion model
Intercontinental Exchange provides exchange services, technology, and data to financial institutions and investors. It has three major segments: exchanges, fixed income, and mortgage. The exchanges segment covers the New York Stock Exchange, its energy trading businesses, and agricultural and financial derivatives products. Fixed income handles data and credit default swaps trading/clearing. The mortgage segment includes Encompass (a popular loan origination system), the Mortgage Electronic Registration System, and other add-on services.
Intercontinental Exchange sees the analog-to-digital transformation of the mortgage industry as the big driver in the future. In many ways, the mortgage origination process is still a largely manual operation, with physical paperwork, ink signatures, and a cumbersome process of gathering documentation. The company estimates that the analog-to-digital conversion market in mortgage origination is a $10 billion addressable market.
Intercontinental's movement into mortgages is more than just a potential growth area. It is about diversifying the company so that it can perform in all markets. On the third-quarter earnings conference call, CEO Jeff Sprecher discussed the overall strategy, saying that it will: "diversify the business and position the company at the center of some of the largest markets undergoing an analog-to-digital conversion" and can make the company an "all-weather name" that can prosper in all market environments.
Energy trading is another growth area
Mortgages aren't the only area that Intercontinental is diversifying into. Energy trading is another big potential growth area, especially if the current spate of inflation remains in place longer than expected. Natural gas is already up 50% so far this year, while West Texas Intermediate Crude oil is up 22%. Rising markets tend to attract assets, and in an inflationary environment, global macro asset allocation funds will almost certainly allocate additional capital to the commodity markets. And the globalization of the natural gas markets will spur more trading in the energy space.
Intercontinental Exchange is trading at 22.6 times estimated 2022 earnings per share. This is a reasonable multiple given that the company has an enviable competitive position as one side of a duopoly in stock trading, along with Nasdaq. Creating a competing exchange for trading stocks is incredibly difficult, given that investors look at both fees and liquidity when determining where to trade. A competing exchange might be able to tempt investors with lower per-ticket fees, but if the liquidity is lousy, any advantage is more than offset.
If the stock market continues to soar, the company will do well in stock trading. If inflation rises, energy trading will benefit, and if rates fall, the mortgage business will do well. Intercontinental Exchange has covered its bases for most markets.
