Style-Box Rotation on NYX Deal Triggers ICE Special Opp.

Simple Summary:
1. Great business – high barriers to entry, FCF machine, high margins, pricing power and economies of scale;
2. Great timing – Since January, fundamentals and market sentiment have begun to rebound from cyclical trough. But the company's recent deal was timed at the bottom of the market;
3. Great management team – Founder and CEO owns $200M stock, acts like a shareholder with strong M&A track record = 17% ROIC
4. Under-appreciated merger creates buying opportunity – investor base is undergoing a “style box” rotation triggered by a merger of a high growth stock with a value stock.
5. Catalysts to re-rate – stock is trading at 12x pro-forma ’13 eps vs. 16-17x historic avg. Clarity on deal synergies and spin-off of unloved businesses in 2014 and 2015 will re-rate the stock as the company repositions itself as a leaner high growth stock.

Background on ICE:
Background on ICE: The Intercontinental Exchange is a leading operator of global markets and clearing houses, including futures exchanges, over-the-counter (“OTC”), derivatives clearing houses and post-trade services. They operate these global market places for trading and clearing on a broad array of products including energy (Brent, WTI), agricultural commodities (cocoa, coffee, cotton), credit default swaps (“CDS”), equity indexes and currency contracts.

ICE charges customers a per contract fee to trade and clear on its platform. Energy is the largest contributor with 62 % of total revenues and dominates the market with 60 % global market share. Brent has continued to take market share from WTI (CME’s competing energy product) partially due to WTI pricing inefficiencies as a result of the supply glut at Cushing, Oklahoma. Geographically speaking, ICE operates in US, Europe and Canada.

Current Background on NYX:
NYX stock has been underperforming due to headwinds in its cash equities business. Low trading volumes and weak IPO market have depressed fundamentals and sentiment leading to trough earnings and trough multiples (ie. high single digit P/E).

Background on the NYX Merger:
On December 20, 2012, ICE announced a deal to acquire NYX for $8.4B or 14x trough earnings. Mgmt expects $450M in cost synergies over next 3 years but have not yet discussed revenue synergies. Given the low take-out multiple, merger is accretive 15% on year 1 and 32% in year 3.

Deal terms include both stock and cash with a 2/3 and 1/3 split at a conversion of 0.1703 share of ICE per one share of NYX. The $2.7B cash component will be financed with $1.8B ICE existing debt facility at 2-4% rate and rest in cash. Deal is expected to close in 2H’13 subject to regulatory approval. ICE is on the hook for a $750M break-up fee otherwise (low probability event).

To make things more complicated, ICE has publicly stated that they plan to spin the Euronext business in middle of 2014 via an IPO. I think that they’ll also spin NYSE in 2015. It is important to note that post-close, shareholder base will be 1/3 NYX and 2/3 ICE shareholders.

To appease NYX’s value-oriented shareholder base, ICE announced that they will be issuing a dividend of $300M/yr post-close. This is the first time ICE has ever announced a dividend in its history. In summary, this special situation is a merger, cost synergies, then spin and then probably another spin all in the next 2 years so there’s a lot for the Street to digest here.

Opportunity:
I believe the primary driver of the deal is two-fold: ICE’s desire to acquire the Liffe derivatives business that NYX owns to fill in a missing piece of its product portfolio and to leverage the use of its own clearinghouses. In 2011, ICE teamed up with NDAQ to try to buy NYX but failed due to regulatory scrutiny (anti-trust due to NDAQ-NYSE tie up).

At that time, the implied price paid for Liffe was $6B. Today, they’re paying only $3B. Same thing, half price. Also, NYX has been trying to build out their own clearinghouse in Europe to clear their Liffe derivatives. A merger allows them to scrap the high risk plan and use ICE’s proven clearinghouse instead. This saves both capex and operating expenses while generating revenue synergies for ICE.

Thesis Details:
1. Great business –
a. High barriers to entry.
b. High margins.
c. Pricing power.
d. FCF conversion.
e. Economies of scale.

2. Great timing –
a. Fundamentals rebounding.

3. Great management team –

4. Underappreciated merger creates buying opportunity. Investor base is undergoing a “style box” rotation triggered by a merger of a high growth stock with a value stock. --

5. Catalysts to re-rate –
a. Clarity on cost synergies.
b. Euronext spin expected mid-2014.
c. NYSE spin.
d. Management on the road.

Valuation:
Stock could double in the next 2 years and the upside/downside ratio is 7.1 to 1.

3 Scenarios: Bear, Base and Bull. Bear Case assumes deal falls through, Base Case assumes deal goes through, synergies are recognized and Euronext is spun while Bull Case assumes that NYSE is also spun. There’s not a lot of ways to lose money here. Also note that the bear case is draconian as it’s below the price at which mgmt was buying back stock ~$133 per share.