Insights

Does This Company’s Acquisition Make It a Sell?

Intercontinental Exchange (NYSE: ICE), known as ICE, recently announced that it would acquire Black Knight (NYSE: BKI) to expand its mortgage technology business. The move was announced ahead of rising interest rates telegraphed by the Federal Reserve. Will rising interest rates harm its target company, or will ICE have the last laugh?

Is now the right time?

On May 4, ICE said it had agreed to buy real estate company Black Knight. ICE made the bold move to fill in the gaps in its mortgage technology segment, which it built by acquisitions of loan origination software company Encompass and closing funding, compliance, and record-keeping companies Simplifile and MERS.

Image source: Getty Images.

In 2020, before agreeing to be acquired, Black Knight bought out Optimal Blue in a $1.8 billion deal. Optimal Blue added secondary mortgage solutions and data analytics to Black Knight’s legacy real estate services, loan origination, bankruptcy services, and data businesses. The combined company would be one of the first end-to-end mortgage loan platforms.

Sounds great, but the timing seems questionable. Black Knight’s Software Solutions segment accounted for 85% of overall revenue in 2021. The segment derives its revenue from the number of loans it services and the loans that originate on the platform. By the time the ICE/Black Knight tie-up was announced, the Fed had signaled rate hikes that would lead to higher mortgage rates and a slowdown in mortgage industry.

The big picture

On the other side of the coin, Black Knight also has recurring and stable revenue sources. For instance, 57% of Black Knight’s 2021 revenue came from software servicing, where rising mortgage rates will likely slow the rate of growth of the loans that generate revenue. More importantly, though, rising rates will also significantly deter seasoned loans from refinancing and coming off the books. The segment now appears more like a growing annuity business, albeit growing slower than in the recent past.

Black Knight’s data and analytics segment provides customers with a vast amount of data regarding everything from property values to prepayment and default information to mortgage performance. The company’s data covers nearly 100% of the U.S. population. Revenue from its data and analytics segment comes from recurring licenses and subscriptions, and represented 30% of 2021 revenue.

Despite adding some transactional revenue at a questionable time, the combined company’s mortgage technology segment will increase its recurring revenue from 50% of segment revenue to 70%. The impact on the overall combined company is meaningful. Recurring revenue for ICE after the acquisition should increase from 48% to 55%.

Outside its mortgage tech segment, ICE operates 13 regulated stock and commodity exchanges, including the New York Stock Exchange and six clearing houses. Its fixed income and data services segment is a platform that provides bond pricing and execution for its customers. These segments provide ICE with a steady flow of transaction-based revenue and profit.

Mainly based on the perceived impact of rising mortgage rates and the Black Knight acquisition, ICE stock is down 29% this year. Investors worried about the adverse effects of the mortgage rates have more to put their minds at ease. ICE believes that adding Black Knight will increase its total addressable market to $14 billion and accelerate the penetration of its existing $10 billion market. In addition, the merger could reduce costs by $200 million, and provide $125 million in cross-selling opportunities.

With ICE stock down this year, it trades at an adjusted price-to-earnings ratio of 13.8, significantly lower than its five-year average of 33.5. Long-term investors may find value in the stock as the company moves toward a more recurring-revenue business model.

BJ Cook has no position in any of the stocks mentioned. The Motley Fool recommends Intercontinental Exchange. The Motley Fool has a disclosure policy.

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