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What Does the Merger With NYSE Mean for ICE's Moat?

Jeremy Glaser
Gaston F. Ceron

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Gaston Ceron. He is an equity analyst. We are going to look at the IntercontinentalExchange and New York Stock Exchange merger and what it could mean for their moats.

Gaston, thanks for joining me.

Gaston Ceron: Thanks Jeremy. Glad to be here.

Glaser: So, let's take a look this merger. Why did ICE want to take over New York Stock Exchange Euronext? What was the impetus behind this deal?

Ceron: ICE had actually tried to take over the NYSE Euronext before. They had tried, they had attempted to do so earlier in a joint bid with Nasdaq that was unsuccessful. So this was really another attempt by them to come at the company, this time just by themselves, not with another co-bidder.

What ICE is most interested in, in this property, in my opinion, is that ICE is primarily a derivatives exchange; that's pretty much what they do. And so the NYSE Euronext has an attractive derivatives exchange property in Europe called NYSE Liffe, and that's what ICE, in my view, is really interested in. They will also get some other pieces of the company, such as the equity side, which we can talk about further, but the real impetus for the deal as I see it is for ICE to get this NYSE Liffe derivatives piece in Europe.

Glaser: Let's take a closer look at the moat around these businesses. I know exchanges can have a classic network effect. How does this help ICE's moat? What is it before the deal? What does it look like after?

Ceron: Right. I would say in the short term it's somewhat mixed. We generally think that ICE has a wide economic moat. The reason we think that is because ICE is a futures exchange, and therefore they enjoy more control over their products than, let's say, an equities exchange would, because typically what happens with futures--and especially with a futures exchange like ICE that also owns a clearinghouse--is that you basically have to work through that exchange if you want access to those products. So, you open a position there, it gets cleared there, and then you have to close it there. That is not the case, for instance, with equities. Equities are often traded in multiple venues and you can buy a share here, you can buy it there, there's very little difference for many equities.

Futures in that sense are more exclusive, if you will, generally speaking, and so that's why we tend to think that ICE has a wide economic moat, because as long as you offer attractive products that people want to trade, they have this degree of exclusivity that is not available to other exchanges that are not futures exchanges. In getting NYSE Liffe, they will get another futures business, and so in that sense, that part will augment their moat, because that futures business will now be bigger and it will also expand into an area that ICE has been wanting to expand in, which is these financial derivatives, specifically interest rate futures. And so that part will make their wide moat moatier, because, again, you are taking a company that specializes in futures, you are adding more futures to it, that will get moatier, if you will.

The reason I say it's a little bit mixed is because something else that comes with the deal is NYSE Euronext's U.S. equities business. They have an equities business actually in the U.S. and in Europe, but the company has indicated that they will contemplate spinning off the European portion at some point. So, I'm assuming that does go through at some point in the hopefully near future after the deal closes, but they are still left with this U.S. equities piece. And that piece we think is not a wide-moat business, that's more of a narrow-moat business. There are some network effects and there are scale advantages and things there that do help that business, but equities in general, in the U.S., equities trading for exchanges is certainly less moaty than futures because equities are typically fungible products, which means that other exchanges can trade them, there is little exclusivity, and so there is more of an all-out fight for market share.

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Glaser: So, New York Stock Exchange might be iconic but doesn't necessarily--that equity trading business doesn't sound like it has the advantages that you get in futures.

Ceron: Right.

Glaser: Let's look at the regulatory picture here. You know, the regulators have been somewhat skeptical of some exchange mergers in the past. Do you expect any roadblocks to this combination?

Ceron: Generally speaking, I think that this combination should face fewer roadblocks than some of the other ones, because there doesn't seem to be as much overlap between these companies….NYSE itself, as viewers may remember, try to merge with another exchange, Deutsche Boerse, which is a German exchange, and that combination ran into big regulatory problems in Europe and that's why it was ultimately not successful.

In this case, well, I am sure that regulators will take a close look at the company. These exchange mergers are very high profile, because exchanges, as you said, are iconic and very high-profile companies, so regulators tend to scrutinize them. I'm sure it'll get a share of scrutiny but I do not expect it'll face the same kind of roadblocks that other exchange mergers faced.

One interesting corollary to that question is, is this merger because of its specific nature more of a one-off deal, or does it signal kind of a breakthrough in this logjam--it's not really a logjam, but for lack of a better word--of exchange mergers that we've seen because of regulatory and related issues? And I think the jury's still a little bit out on that. I tend to view this is more of a one-off specific situation rather than a signal that the dams are about to burst open and we'll see more exchange mergers, but that is more of an open question.

Glaser: How about valuation? How much is ICE paying for this business and what does that mean for their shareholders?

Ceron: It's a combination of cash and stock, and basically our fair value on NYSE was at $29 and it's still at $29, and when the deal was announced it was, I believe that if you were to work out the math on the part that was going to be ICE stock and the part that was going to be cash, around the time of the deal NYSE was valued at around $33, give or take, so that was certainly above our fair value but not dramatically above. Now, with the runup in ICE stock, that gap has widened. So now, NYSE is valued somewhere higher in the $30s as a result of the merger. And so, as ICE stock moves higher, NYSE stock kind of falls along to a certain degree, because again there's a stock component to the deal in ICE stock.

As with all mergers, one thing you have to keep in mind is that our fair value of $29 for NYSE is really more, is really a stand-alone fair value, where we look at the company in its present setup and kind of assume that it continues into the future, whereas when ICE or any other buyer buys the company, typically they must incorporate things like cost synergies and any revenue synergies they can get out of it. That's why companies often think they can justify paying a higher price than a stand-alone fair value. So that has to be taken into account.

Glaser: So, do you think it makes sense for investors to look at ICE shares today if they look attractively valued?

Ceron: That's also kind of an interesting question, because as of now we are also still valuing ICE shares on a stand-alone basis, and because ICE stock has seen a runup, it also has gone above our fair value. I think what we would say is that on a stand-alone basis, it's difficult to call the company a compelling value at these levels, given the runup that the stock has seen. And I would assume that some of that runup in that stock has got to be due to people kind of anticipating some of these merger benefits flowing through ICE after the merger closes--kind of being anticipatory, in that sense. However, if you take a step back from the valuation for a second and you look at the company's merits, I think that ICE does have some interesting things going for it, especially for a financial.

So, we think that on a strategy perspective, if you will, we think that it's a very interesting combination of a wide-moat company with reasonable growth prospects and what we think is a pretty strong management team, and we think that combination is relatively rare for a financial. So while the valuation does not make it a compelling value, if you look at it more from a quality-of-business standpoint, we do think that for enterprising investors that want exposure to the financial sector, perhaps it's something that they might want to consider. But it's true that the valuation again has gotten a little pricey.

Glaser: Gaston, thanks so much for your thoughts on the merger today.

Ceron: Thanks very much.

Glaser: For Morningstar, I'm Jeremy Glaser.