|Shares Out. (in M):||573||P/E||21.5||19.3|
|Market Cap (in $M):||42,945||P/FCF||16.7||14.9|
|Net Debt (in $M):||6,384||EBIT||2,694||2,921|
|Borrow Cost:||General Collateral|
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We believe the US exchanges are extraordinarily attractive shorts (the headline idea above is ICE, but the thesis also extends to CBOE and NDAQ). Especially so in the near-term and when viewed from a risk/reward perspective.
Our view is that the chances of regulatory reform of the U.S. Exchanges are quite high, a fact the market has failed to appreciate. As we describe below, (1) the Exchanges have been raising prices on their clients for the past decade; a fact which on its face seems odd because their clients are some of the biggest companies in the world with significant market power – clients like Goldman Sachs, JPMorgan and Fidelity; (2) this has occurred due to a unique combination of antiquated exchange rules; significant consolidation among the exchanges (12 of the 13 exchanges in the US are now owned by just three companies) and regulations that have yet to catch up to technological change; (3) Companies that become Monopolies rarely stay that way, especially companies that have extensive regulatory oversight like the U.S. Exchanges do; (4) customers and competitors of the Exchanges have begun a unified and significant public campaign challenging this fact and (5) the SEC, one of the primary regulators of the Exchanges, has recently named regulatory reform of the Exchanges as one if its most significant priorities.
In short, as displayed in more detail below, when the financial data, public statements by the CEOs of the Exchanges, sell-side analysts and SEC Commissioners all publicly state that the exchanges have become a monopolies, it’s unlikely they stay monopolies and investors should be wary that the earnings power they’ve ascribed to the companies will continue unabated, especially when this is a rare instance where there has been bi-partisan support across both political parties to begin extracting change.
The likely result of these actions, or even the market’s realization that the threat that these actions may occur, will be to lower the earnings power of the Exchanges, downgrade their multiple, and inject significant uncertainty into the stocks driving their valuations down considerably. Or to think about it inversely, it’s highly unlikely that the combination of these effects can increase earnings power or the multiple of the Exchanges, making the upside reward of owning these stocks significantly disproportionate to the downside risk.
We have seen this story play out multiple times: we saw this occur in the pharmaceutical industry just three years ago when it was uncovered that they had been raising drug prices for years on unsuspecting patients. The pharmaceutical index returned 188% from 2011 to 2015 as investors watched rising drug prices drive significant earnings power, only to have unified customer outcry significantly effect the pharmaceutical companies’ earnings power and valuation multiple; as a result this same index has decreased 25%, underperforming the S&P by over 85%. We saw it again this year, most recently and prominently with Facebook, where not even has a single regulation been enacted; in fact there has not even been a specific regulatory proposal proposed. But the mere threat of regulatory reform inevitable causes significant uncertainty, inevitably driving down multiples and stock valuations. Even with absolutely no regulatory reform enacted, Facebook’s stock has decreased 25% since July. In situations of uncertain regulatory reform and public outcry, we’ve learned companies always follow the same playbook: They self-regulate to appease the regulators and influence public opinion; this self-regulation inevitably involves changes to the company’s business model to structurally lower profits addressing concerns. For example, following the threat of negative press and regulatory scrutiny, the largest pharmaceutical companies in the world: Novartis, Pfizer, Merck, Sanofi and Roche all independently announced they would no longer raise drug prices (thereby lowering earnings and multiples) and as described, valuations dropped significantly causing the companies to significantly underperform their prior performance. Similarly, in order to be proactive and get ahead of regulatory scrutiny, we saw Facebook follow suit: announcing voluntarily actions to increase disclosure (“we took major steps to make advertising…more transparent.), guide to revenue declining year over year partly to give increased data privacy choices to customers, and perhaps most importantly, guiding to a major decrease in their long-term profitability lowering consensus margins nearly 10 points. What should be obvious is it is clear the will follow the same self-regulating playbook – in the face of what we believe is significant pressure, which we go into detail below, we expect the Monopoly model that has driven a 20% EPS CAGR to cease to exist as they take steps to address the biggest concerns - for example, we would expect their next earnings guide to remove the 30% price increase planned on customers, in addition to other reforms that have been aiding their inflated guidance in order to get in front of increased scrutiny. Investors can play with various scenarios, but to help frame risk, a 10% decrease in earnings guidance and even just a one or two multiple reduction can easily result in similar 20%-25% price declines that we saw occur in similar situations.
For purposes of this writeup, we’ll use ICE’s earnings to illustrate our points, though as stated above, the crux of the short thesis applies generally to the US exchanges as a whole.
ICE’s revenue is approximately broken down as 51% Data & Listings and 49% Trading/Clearing. The exchanges are trading at or slightly above their historical trading range with consensus estimates implying the Exchanges outsized monopoly profits continue in perpetuity. Below are the forward p/e ratios over the past 5 years of the exchanges:
Today, those multiples remain roughly intact, i.e. ICE continues to trade 20x forward P/E while recently trading to its 52-week high.
The US exchanges should not be trading in-line with their historical value, given significantly increased regulatory risk that has transparently been signaled to be a near-term event. Historically, exchanges were not-for-profit organizations formed to oversee trading of the public markets. In the last decade, this changed where they have become publicly traded corporations whose primary function has changed from equitable oversight of the public markets to one designed to maximize profits. Further, recent consolidation among these companies means that while we have 13 public stock exchanges, 12 of them are now owned by just three companies. This is a large reason why the exchanges have begun to have the ability exert unusual and undue pricing power over their customers and develop monopolistic tendencies that have become increasingly questioned by a broad swath of market participants across the political spectrum, including buy and sell side firms, brokerage firms, journalists, customers and even federal courts themselves – a universal consensus from market participants with varying financial and political incentives not usually seen. The SEC has come under increasing and universal criticism as failing to adequately oversee the Exchanges and ensuring that regulations keep pace with technological change in the markets. This criticism has understandably drawn the attention, and embarrassment, of the SEC, and as we demonstrate definitively below, we believe they have taken a renewed, intense and immediate focus on prioritizing regulatory reform of these exchanges that will have serious ramifications to their business model.
We’ll begin with a brief overview of the company’s financials and commentary demonstrating their increasing pricing/monopoly power from the US Exchanges over market participants and the indications from their largest clients and the SEC that they blatantly recognize this issue and have displayed a clear intention to begin regulatory reform. We’ll also address why this has become a pressing issue now and therefore makes the trade timely today versus sometime in the past or future, thereby indicating near-term action is likely, as well as a number of leading signals that further verify the likelihood of action. Finally, we’ll address the counter narrative that the companies have begun to push to sell side analysts and investors to protect their stock prices and attempt to minimize concerns, and why we believe these narratives are naïve or lazy as to their practical effects on the business and stock price, and how we think about potential regulatory reform on the business.
Monopolies are defined as an advantage obtained by an entity or entities over the commercial market in a specific area. Common elements that signal monopoly power exists is pricing power over customers (the ability to raise prices on customers and their inability to resist these increases or go to a cheaper competitor), when there are limited suppliers of certain products or data or an ability to exclude competitors.
ICE has grown its Data business from 12% of revenues in 2012 to over half the business today. In their 2017 analyst day presentation the previous 10 year period showed Data revenues went from $35mm to $2b, an incredible 50% CAGR. Going forward, they continue to guide 6%-7% growth in this business. Of this growth, they explicitly guide that 30% of this growth will come from increasing prices on their customers. There are many factors we think of when we think of pricing power, but a large number of ICE’s customers are some of the biggest companies in the world. For example, JPMorgan has a market cap of nearly $400b; Citi’s market cap is nearly $200b; and Goldman Sachs, Morgan Stanley and Blackrock have market caps between $75b-$100b. These are not ordinarily the type of companies that we think of as being unable to negotiate with their suppliers or are forced to eat price increases, yet not only have they been doing so all decade, they have been guided that they will continue to do so. In fact, it appears the pricing power is strong as ever. Just a few months ago on their Q1’18 earnings call, ICE’s CEO stated, “We’ve been very open…with our customers that we think we can grow this data market at high to mid-single digits. We think it’s going to grow like that for quite a while…and when we sit across the table and negotiate we basically say to people this is the kind of return that we're looking for if you want to do business with us… it's really been successful. We've really done a very good job, getting 11 out of the 13 top managers onto this platform.”
This is fairly incredible – it’s not often a company sits across the table from the 13 largest managers in the world, tells the those managers that if they want ICE’s business, they’ll take the price dictated to them, and have that strategy result in (some may say monopolistically) getting 85% of the largest customers to not only sign and become customers, but to take the price dictated to them. And then it’s really a special kind of pricing power that allows the CEO to follow that up with going on the next earnings call to tell the world that’s how it works “if [they] want to do business with us”.
There are few reasons these monopoly conditions exist; a combination of consolidation, lax SEC regulation, historical rules and significantly, an interesting interplay between firms needing to follow SEC regulations to be SEC compliant and the exchanges being the only companies that can provide them with the systems and data needed to do so. In a research note titled “Not all Market Data…are created Equal”, UBS describes these exact monopolistic conditions for the exchanges, stating, “It also helps to have a must-have product or set of data, such as a virtual monopoly on proprietary market data [such as ICE or NDAQ]...We believe ICE and NDAQ's unique access to data generated by operating exchanges puts them in an enviable position to provide must-have data [to their customers]".
The CEO of ICE himself has alluded to the same fact pattern: in November 2015, SEC/FINRA released a Regulatory Compliance Release updating its Best Execution rules where they instruct firms they need to continue to have the most updated technology to best comply with trading rules (then using regulatory releases like these, the exchanges sell the “new and best” data and “proprietary technology” to their customers). Until this release, much of the SEC’s regulatory focus was on equity markets. This particular release, beginning on page 7 titled “Additional Considerations for Best Execution for Fixed Income Securities”, the SEC acknowledged in the first sentence that the fixed income market “has evolved significantly in recent years” and goes on to say that a firm must take into account market and technology changes that might alter its best execution analysis. The SEC recognized that fixed income securities do not have as transparent pricing as equities, and as a result make a number of recommendations firms should follow to be compliant with their Best Execution rules in fixed income markets. Coincidentally (or, not), just one month after this SEC release describing new best execution rules for the fixed income market, ICE purchased IDC in December 2015 for over $5b, a company that specializes in “pricing and valuation on fixed income securities”. Of course, combining IDC’s services with the SEC’s November updated notice makes the sales pitch to customers quite easy, and of course they will have to pay almost any price you charge them in order to remain SEC compliant. In fact, the CEO went ahead and said so himself. On the very first earnings transcript after purchasing IDC (4Q’16, Feb 2016), the CEO begins by validating that the value of the business comes from mandatory regulatory reform, and follows that up by stating that promptly upon purchasing IDC, they immediately raised prices on their customers. From the aforementioned earnings transcript:
Page 8: CEO of ICE: “In my mind, a lot of the opportunities set that we're seeing really comes from the fact that the buy side was able to rely on certain services that were relatively informal. But today, due to regulatory reform and internal audit practices, need to be more rigorous. [and] the regulators and the auditors want an independent validation, increasingly, as people are taking the obligation to get best execution seriously as the SEC is paying more attention to best desk requirements in the fixed-income space, asset managers and others are [forced to] make investments to make sure that they are compliant.”
Regarding their pricing power, the CEO followed that up with: “What we've always seen in data is that…people are happy to pay more for it. And so, in that regard, we don't get a lot of pushback on our [increased] pricing. And yet, we've been able to really raise the profitability of these businesses. The AllianceBernstein product that I mentioned in the prepared remarks is [another] deployment that results in financial gain for us.”
Further, the economic evidence also supports this thesis: in an article by Forbes last week describing a speech SEC Commissioner Jackson's speech gave, they say, "Jackson complained the exchanges have morphed into monopolies—with monopoly profits to match. Of the 13 stock exchanges, 12 are owned by three corporations: the New York Stock Exchange, Nasdaq and Cboe. Since it went public in 2006, the NYSE’s parent, the Intercontinental Exchange (ICE) has had total annual returns of 24.1%. He continued on to say, “Its 54.3% net profit margin last year was the fourth highest of any company in the S&P 500."
Additionally, we’ve mentioned that we have 13 exchanges with 12 of them owned by three companies. One might ask why do we have so many exchanges, if they are owned by only three companies? We understand why companies acquire competitors with the same business model. It becomes harder to understand what would drive a company to acquire, and then to continue to operate, virtually similar businesses. The answer, of course, is that they charge investors to connect to each exchange individually, incentivizing them to keep them all. You may also recall the SEC’s embarrassment at allowing the Exchanges to become monopolies, which in turn is partly why they are urgently motivated to reform them. It turns out that regulations state the exchanges have to ask the SEC when they want to increase the fees they charge to their customers for connecting to the exchanges. Note that the cost to the exchanges for connecting to electronic connections drop every year. Yet despite declining costs, 95 times in the past three years the exchanges have asked the SEC for a price increase. The SEC granted the price increase all 95 times. I should note that they asked a 96th time just last week: and for the first this SEC said no, a leading indicator for what’s to follow.
We’ve shown that the financial data, CEOs of the Exchanges, the regulators and sell side analysts all believe these companies are monopolies. Below we will display further examples from Congress and other market participants. But in a remarkable indication of overwhelming consensus, even the White House has reached exactly the same conclusion.
Treasury Secretary Mnuchin released a comprehensive report on his assessment of capital markets last year. In the section of the report aptly named “Market Data”, he specifically says “Many broker-dealers report that they feel compelled to purchase these enhanced data feeds from the trading venues both to provide competitive…services…and to meet their best execution obligations. Broker-dealers interpret their best execution obligations as requiring them to use the best available data…[as a result the] firms [are forced to] employ proprietary data feeds to identify the best prices…In addition, the market for proprietary data feeds is not fully competitive…[therefore] limited constraints on exchange pricing power has allowed exchanges to regularly raise prices. Consequently, exchange data fees made up nearly a third of exchanges’ $28.3 billion in 2016.” In this same report, Treasury explicitly recommended that the SEC issue guidance that broker-dealers do not necessarily have to subscribe to proprietary data feeds. He goes to state “This should help to eliminate the need for broker-dealers to defensively subscribe to these costly data feeds to ensure that they meet…their best execution obligations…Treasury [also] recommends that’s the SEC also recognize that the markets for…data feeds are not fully competitive. The SEC has the authority under the Exchange Act to determine whether fees charged by an exclusive processor for market information are “fair and reasonable” [and] “not unreasonably discriminatory” when determining whether to approve…data fees”.
Given the Exchanges monopoly power, one wouldn’t be surprised that their customers are unhappy. One has to look no further than Customers’ recent reaction to the Exchange’s price increases. As a further indication that public pressure will increase on the Exchanges, the customers are unlikely to remain silent as we display below.
Instead of JPMorgan, Goldman Sachs, etc using their market power to lower prices as they do other suppliers, as we detail below, they instead delegated their top executives to take significant multi-million dollar cuts from their salaries at these banks to temporarily become top executives at the SEC to exert regulatory influence in order to have reforms enacted to remove this monopoly pricing power from the Exchanges (and therefore lower Exchanges earnings power). So these customers didn’t threaten to go elsewhere; they didn’t threaten to use a different part of their business; they didn’t create the data themselves; they didn’t even get together with the other banks like they did when they created Zelle to compete against Venmo – they have been eating price increases from this magical pricing power the exchanges have, and unable to exert pricing power back, they resorted to having their top executives move to the SEC for one goal only: to reform the Exchanges. This, along with the majority of the SEC’s backing and significant bi-partisan support, is why reform, and the noise around regulatory reform, will pick up now.
There are a number of examples of the above, but here are just two:
Brett Redfearn, who was the head of all Market Structure at JPMorgan, recently left JPMorgan to become the Head of the SEC’s trading and market division. ( As the article states, Redfearn’s main goal as head of the SEC’s trading & market division is to reform the exchanges and lower prices. Quoting from the above article:).
“Redfearn will likely have significant sway at the agency because of his expertise. Redfearn, a JPMorgan employee for more than nine years, expanded his role at the bank earlier this year. He went from just overseeing equity market structure strategy to running market structure for all asset classes. He’s advocated for a regulatory overhaul. In April, he said Regulation NMS -- a landmark SEC rule approved in 2005 that accelerated a shift to electronic trading in the U.S. stock market -- is “.” The pick may set up a clash with stock exchanges, who are among the most influential voices in Washington around financial regulation. Redfearn has emerged as a critic of the increasingly costly fees that U.S. stock exchanges charge traders who want access to vital data on prices.”
Here’s another example from Goldman Sachs. Note first that the Chairman of the SEC has had an extensive relationship with Goldman Sachs as his client prior to joining the SEC. He has just recently hired a former Goldman Sachs executive as his Senior Policy Advisor.
Note that this same article also discusses the hiring of the SEC’s newest commissioner, who has been leading the charge in taking the Exchanges head on.
SEC Commissioner Jackson last week gave a significant policy address, titled, “Rethinking Exchange Regulation” where he specifically addresses all the points made above. The reaction to this speech by customers was applauded, rapid and swift:
For example, JPMorgan wrote a letter to the SEC supporting reform. Business Insider wrote about their letter, stating, ”For example, an especially important aspect of our proposal was to include a "no-rebate" bucket that will allow us —and, more importantly, investors — to observe how markets respond to the absence of rebates," Jackson said in a speech at George Mason University in Virginia.
One market observer said JPMorgan's submission of a letter "is like an 800 pound gorilla wading in." "Plus they're a NYSE issuer breaking ranks," the person added"
Similarly, within hours of SEC Commissioner Jackson’s speech, SIFMA, the Securities Industry's largest trade group representing 75% of all broker dealers, released a statement explicitly commending Commissioner Jackson's recommendations on these issues: ()
Congressional Reform and Bi-Partison Support
In SEC Commisioner Jackson’s speech, he also specifically addressed bi-partisan support for reform of the Exchanges, stating, “"This is not a partisan issue: Commissioners of all stripes, Members of Congress and our current Chairman have all said it is time for us to take a hard look at the structure of our stock markets. We have a rare bipartisan opportunity to move this forward—and, for reasons I’ll explain, we owe it to American investors to take it.”
The Chairman of the SEC, Jay Clayton, in a speech laying out the SEC’s priorities to the Economic Club of New York stated, “I am also pleased to note that this week, Chairman Hensarling and Chairman Huizenga of the House Financial Services Committee and its subcommittee on Capital Markets, Securities, and Investment…I look forward to working with Congress on these issues.”
Of course, as laid out above, Treasury Mnuchin also backs reform. Further, there are numerous other recent examples of Congress beginning to take focus of this issue:
See, e.g., Letter of Sen. Charles Schumer to Hon. Mary Schapiro, Chairman, SEC (arguing that exchange rebate structures “create a conflict of interest, as brokers may be incentivized to execute trades on a particular venue even if that venue is offering the best price”); see also Letter of Sens. Mike Crapo and Mark Warner to Hon. Mary Jo White, Chair, SEC (noting, over two years ago, concerns about the “pace of reform efforts” in market structure); Letter of Sen. Carl Levin to Hon. Mary Jo White, Chair, SEC (“Conflicts of interest erode public confidence in the markets and have the potential to harm investors and I believe the SEC should take prompt action to eliminate these conflicts of interest.”); Letter of Sen. Edward E. Kaufman to Hon. Mary L. Schapiro, Chair, SEC (“[S]everal areas of current market structure lead me to be concerned about the performance of the markets for investors and companies seeking to raise capital.”).
Recent Actions Signaling Prompt Regulatory Action
We believe we’ve addressed most of these points as incorrect, but will briefly address them again here. First, potential regulation is clearly not restricted to equity markets. Commissioner Jackson in a separate speech in July specifically focused on the importance of fixed income market reform as part of overall regulatory reform, which encompasses a far greater portion of revenues than the Exchanges would have you believe. For example, he states, “Despite the progress in our stock markets, fixed-income markets—where millions of Americans are now shifting their investments as they prepare for retirement—remain rife with conflicts of interests and hidden costs. For years, Members of the Commission and finance scholars alike have worried that fixed-income markets do not provide the level playing field that American investors deserve, but we have not yet moved forward with reform in that area…Because we’ve invested so much time and Commission energy in our stock markets over the past decade, the investor benefits of turning our attention to fixed-income markets would be significant. That’s why it’s so important that today’s rule includes a clear commitment to review our approach to fixed-income electronic trading platforms.”
Secondly, “regulation takes a long time” should be a worrisome answer. It implicitly admits there’s an issue and that the investor should perhaps only own the stock until closer to regulation. It ignores all empirical evidence above around the urgency of the issue, and most importantly, as discussed above, public scrutiny and potential regulatory reform generally not only cause structural business changes that affect earnings power and valuation, but there are numerous examples of the threat of regulatory reform affecting the stock price. We find this answer inadequate.
Finally, an argument that investors shouldn’t only worry about the SEC because there are other regulators we believe not only understates the SEC’s influence, but demonstrates a misunderstanding of regulatory reform. We have already discussed that both chambers of Congress have written letters addressing this issue. Further, despite the Exchange’s narrative of the limited scope of the SEC’s regulation, Treasury Mnuchin himself stated “The SEC has the authority under the Exchange Act to determine whether the fees charged by an exclusive processor for market information are ‘fair and reasonable’” which would significantly broaden this bucket. We also believe this demonstrates a misunderstanding of how regulation works. Regulators are not boxed off but constantly talking to customers and assessing data; and those market customers are unhappy and the data is unfavorable to the exchanges. But despite all of this, even the White House has asked other regulators to coordinate in reform. In the report cited above, Treasury Secretary Mnuchin explicitly calls for the CTFC to coordinate with the SEC on regulatory reform, further negating lack of coordination among regulatory agencies.
As Reuters describes the report, “Christopher Giancarlo, chairman of the Commodity Futures Trading Commission (CFTC) and Jay Clayton, chairman of the Securities and Exchange Commission (SEC), said in statements on Friday they had provided extensive input to the “thoughtful” report and supported its recommendations…The Treasury also waded into the long-running debate over equity market structure, proposing the SEC review share-tick sizes, order types, exchange fee models, and how exchanges themselves operate and are governed.
To reduce regulatory duplication and bring the United States more in line with other markets, the report calls for the SEC and CFTC to work more closely and harmonize their rules, but stopped short of recommending a merger of the two - something policymakers have called for in the past.
…Friday’s report, in contrast, outlines a broad range of 91 technical fixes aimed at boosting stock, bond and derivatives markets. All but nine can be put into effect by the country’s federal regulatory agencies, who were consulted on the report.
The recommendations were met with quick praise from financial industry groups, who said capital markets regulations were also long overdue for a review.”
Trading and Risk/Reward
Even if one continued to remain unconvinced of the above, a large percentage of investors hedge their portfolio with the S&P index against their individual long stocks. The correlation between the exchanges and the S&P is 0.94. With no near-term upside catalysts (i.e. earnings), the exchanges could be viewed as a portfolio hedge, where investors replace portions of their index hedge, retaining optionality on increased newsflow and regulatory reform to retain the ability to earn outsized returns on a short position, with limited upside risk. We believe this allows an investor to size the shorts at a bigger size as they act as a portfolio hedge while neutralizing timing risk.
Liquidity: All the exchanges trade with plenty of liquidity and extremely low current short interests, ensuring trading technicals also rest in the short investor’s favor.
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