38% Upside To Black Knight Shareholders If Intercontinental Exchange Closes (NYSE:ICE)

Intercontinental Exchange, Inc. (NYSE:ICE) announced a deal for Black Knight, Inc. (NYSE:BKI) on May 4, 2022. Initially, BKI traded up on the deal, but it has started to slide. Since the day before the deal announcement it has lost nearly as much as the S&P 500 (SPY). Black Knight creates software, data, and analytics for the mortgage, home equity loans, and credit market. Market participants are skeptical this deal is ultimately going to close or at least believe it will take a very long time.

If the deal closes, Black Knight shareholders would receive $68 per share in cash and 0.144x ICE shares. At ICE’s current share price of $102.57, that means another $14.77. If you add it up, you get to $82.77. Possibly, some of the share value can be received in cash (it gets prorated). Meanwhile, BKI currently trades at $59.93. If the deal were to close as planned, that means 38.11% upside from here.

I like this merger situation because: 1) it has received a lot of regulatory attention and the market is doubting it will close; 2) the downside may not be as pronounced as is typically the case IF it doesn’t close, and 3) there’s a lot of upside if it does close.

It was reported on Seeking Alpha, the FTC is looking into this deal.

After weeks of talks with third parties, the antitrust agency started out sending civil investigative demands, according to a Dealreporter item from late Monday, which cited sources familiar.

The FTC is said to be inquiring with customers and bankers and the review is said to be in the very early stages, according to the report.

The main concern seems to lie with the Encompass/Empower combination:

A Raymond James analyst said at the time that the deal poses “significant” antitrust issues and there aren’t any simple remedies. The acquisition could see antitrust concern as ICE’s Ellie Mae’s Encompass platform is the largest provider of loan origination software and Black Knight’s Empower is the “clear #2,” according to Raymond James analyst Patrick O’Shaughnessy.

The market is currently quite concerned about regulatory intervention. There are other deals where I’m involved as well that are also under regulatory scrutiny but where the downside may not be all that horrible (in case of a deal break).

In both cases, I do believe the merging parties have anticipated regulatory scrutiny and have credible stories for why their deals are not anti-competitive. Here, ICE and BKI are arguing that ICE will drive a push for modernization of the mortgage industry, opening up data access and driving down costs and expenses related with this antiquated process. They’re emphasizing an improved result for end users which is a key point in U.S. antitrust regulation. I’m not sure it is going to fly, but I believe there is a chance and there might be opportunities to mitigate regulatory concerns by divestments. The company just sold a small division to Fidelity, for example. I’m not sure how it helps, but it is a bit unusual to sell parts while a deal is in progress unless it helps to get it across the finish line.

To get an idea of the likely downside, I pulled the price changes of 12 of the companies mentioned in the valuation opinion in the merger docs:

The average result is negative ~8%. The S&P 500 and BKI itself did only slightly better over that timeframe. I also pulled up EPS revisions and they’re showing a clear downwards trend:

although consensus estimates still show quite a bit of growth through the upcoming years.

It is worth mentioning that in the “background of the merger” paragraph of the merger agreement it shows other interested parties and a private equity bid in the $73 – $75 range:

On April 4, 2022, the Sponsor Group submitted a revised non-binding indication of interest, which we refer to as the “2022 Sponsor Proposal,” to acquire Black Knight at a price in the range of $73 to $75 per share in a cash transaction, corresponding to an implied market premium of 26% to 30% based on the closing price of Black Knight common stock of $57.78 on April 1, 2022.

On April 5, 2022, Bloomberg L.P. published an article, citing unnamed sources, reporting that Black Knight was exploring a potential sale of the company after receiving interest from private equity firms. The trading price of Black Knight common stock closed at $66.27 per share that day, an 11.8% increase from the closing price the prior trading day. Following this media report, Black Knight received informal inbound inquiries from several additional private equity firms and technology companies. These inquiries were preliminary in nature and did not reference any specific proposed transaction terms. Preliminary discussions with these parties, and with the other private equity firms that had made preliminary inquiries regarding a potential transaction in March, did not (other than with respect to the 2022 Sponsor Proposal) result in the submission to Black Knight of any proposal for a business combination transaction.

Finally, I pulled up a set of historical multiples for Black Knight over the past five years. The spikes around 2020 should probably be discounted, as these were highly unusual times:

It is trading at the higher end of its free cash flow range.

At the lower end of its earnings range.

And at the low end of its EV/EVITDA range.

Importantly, if regulators shut this merger down, Black Knight receives $725 million in cash from ICE. The company currently has a market cap of $9 billion, and on a deal break this will be a significant cushion. I have to say that big break fees have not always saved me from taking a tremendous bath on deal breaks. I much prefer this to close.

Conclusion

There is a clear path to 38% upside from here. If the deal fails, I believe the downside will greatly depend on market circumstances at the time. As it currently stands I’m hard pressed to see it fall more than 20% for an extended period of time. There is always some turmoil on arb exiting.

The merger was announced on May 4 2021, and although it is likely to be scrutinized closely by regulators I can see it close in Q1 2022. However, there are extensions possible (under the agreement) until November 23′ to deal with regulatory objections.

Sometimes it is really bad if things get dragged out for an extended period of time. In this case, I don’t mind as much because of the large break fee and the strong underlying business. If a bad business is being acquired it is a blessing I want to get over with asap. If it is a good business, the downside gets mitigated further as time progresses.

Even if it closes end of 2023, 38% upside is still really good. I expect to achieve that result around 70% of the time and see some kind of adverse outcome 30% of the time. The blended expected value of all possible outcomes is very attractive in my mind, and that’s why I’m long. For what it is worth, I don’t have the short leg hedged (by selling ICE shares). Unrelated to this deal, I already owned Intercontinental Exchange, Inc. shares as I think it is a great and attractively valued company as well.