Background
Black Knight, Inc. (NYSE:BKI) is a leading provider of software, data, and analytics solutions for the mortgage and real estate industries. The company offers technology solutions to help lenders, servicers, and investors manage and optimize their mortgage and home equity portfolios.
Intercontinental Exchange (ICE) is a global financial services company that operates a network of regulated exchanges and clearinghouses for various economic and commodity markets, including stock and bond trading, energy and agricultural commodities, currencies, and derivatives. ICE offers multiple data services, analytics, and technology solutions for market participants and investors.
Arbitrage Opportunity
Merger arbitrage is an investment strategy that involves buying and selling the stocks of companies involved in mergers or acquisitions. The idea is to profit from the difference between the current market price of the target company’s stock and the price offered by the acquirer.
I believe the merger between Intercontinental Exchange, Inc. and Black Knight, Inc. provides an uncommon but welcome opportunity for merger arbitrage for potential investors. The $13.1 billion cash and stock transaction values Black Knight at $85 per share, a significant premium to its current trading price of $57 per share.
Besides the arbitrage opportunity, holding on to BKI shares after the deal closes in Q3 2023 could also be justified by the synergies this acquisition will create for ICE’s mortgage technology business. Some of these synergies include:
- Incorporating BKI’s technology solutions, real estate and mortgage-related data assets, top-notch analytics, and a team of professional mortgage and technology professionals into ICE’s portfolio.
- Improving automation and efficiency in the mortgage lending process will lower the cost of obtaining a mortgage and help current homeowners reduce their monthly payments.
- Complementing ICE’s existing mortgage servicing business, providing a comprehensive end-to-end solution for the mortgage manufacturing and servicing ecosystem.
Both boards have unanimously approved the merger of directors. The merger has an anticipated closing date in the first half of 2023, subject to regulatory approvals, BKI stockholder approval, and customary closing conditions.
A notable risk involved in the merger arbitrage strategy for the BKI-ICE deal is the possibility of ICE shares declining post merger, which would affect the value of the stock portion of the acquisition price. Because BKI shareholders can choose to receive either cash or stock, which would be subject to proration, as well as the value of the cash election and the stock election made equal at closing, a decline in ICE shares would reduce the overall value of the deal for BKI shareholders who choose the stock election or who are subject to proration. The decline in ICE shares could happen for various reasons, such as market conditions, regulatory issues, integration challenges, or lower-than-expected synergies from the merger. Therefore, investors who employ the merger arbitrage strategy should consider the volatility and performance of ICE stock as well as BKI stock when evaluating the potential profit and loss from the deal.
In this strategy, investors purchase shares of Black Knight at its current market price of $57 in anticipation of the stock price increases to the acquisition price of $85 upon the completion of the transaction. Given the strategic and synergistic nature of the acquisition and the approval of both companies’ boards of directors, the likelihood of the deal falling through is low, making this a low-risk investment opportunity for merger arbitrage.
Antitrust Regulators Unlikely to Block Merger of Black Knight and Intercontinental Exchange
I firmly believe the merger between mortgage software providers Black Knight and Intercontinental Exchange is unlikely to be blocked by antitrust regulators. Although the Federal Trade Commission (FTC) has launched an inquiry into the deal following a complaint from the Community Home Lenders Association (CHLA), which represents small- and mid-sized mortgage lenders, there is little evidence that this merger would harm competition or consumers. One reason is that BKI’s mortgage servicing software mainly serves large mortgage providers, such as banks and government-sponsored enterprises. Therefore, ICE’s acquisition of BKI would not create significant market power in the small- and mid-mortgage servicing segment, one of CHLA’s primary concerns.
Another reason is that BKI’s mortgage servicing software does not directly compete with ICE’s mortgage origination software. Instead, they complement each other by offering different services along different stages of the housing finance continuum. This means there is no significant horizontal overlap between their products, a critical factor that antitrust regulators consider when evaluating mergers.
According to my analysis, this merger could benefit customers and shareholders by reducing costs and increasing revenues. According to ICE’s estimates, this merger could eliminate double marginalization by lowering software product prices by up to 10%, creating cost synergies of $200 million over five years through operational efficiencies, and raising ICE’s recurring revenue share from its mortgage technology segment from 40% to 60%.
Overall, I strongly believe the lack of significant horizontal overlap and the potential benefits to consumers of the merger makes it unlikely that antitrust regulators will block the merger and that any attempt to do so would likely fail on the same grounds.
Solid Investment Regardless of the Merger
Even without this deal, BKI appears to be trading for less than its intrinsic value based on its earnings, cash flow, assets, and growth potential.
As of December 31st, 2022, Black Knight had total assets of $5.83 billion and total liabilities of $3.21 billion, resulting in a total equity of $2.62 billion. The company had a current ratio of 1.11 and a debt-to-equity ratio of 1.02, indicating an uncommon ability in the industry to meet its short-term and long-term obligations.
Black Knight generated $582 million of free cash flow in 2022, representing a free cash flow margin of 42%. This reflects the company’s strong cash generation and low capital expenditure requirements. The company also returned $186 million to shareholders through dividends and shared repurchases in 2022.
Black Knight had a net income margin of 29% and a return on equity of 17.5% in 2022. These metrics are well above the industry averages of 12% and 10%, respectively. This reflects the company’s high profitability and efficiency in generating shareholder returns.
Black Knight’s valuation multiples are also attractive compared to its peers and the industry. The company’s trailing P/E ratio is 19.1, lower than the industry average of 23.4. The company’s trailing P/S ratio is 9, lower than the industry average of 11.6. The company’s trailing P/FCF ratio is 32, lower than the industry average of 36.8.
Another factor that makes BKI an attractive investment is its high return on equity of 15.6% compared to its industry average of 11.8%, indicating that it is efficient and profitable in using its shareholders’ capital which is another credit to the management.
I would contend that BKI holds a substantial competitive advantage in its niche market with high barriers to entry and switching costs for customers, making it less vulnerable to disruption or competition.
Additionally, I believe that BKI holds a dominant position in its core markets, accounting for over 60% of U.S. mortgages by volume. This gives it a large and loyal customer base with high retention rates and the potential for cross-selling. The company maintains a consistent history of paying dividends and increasing them over time, providing income and stability for investors.
BKI generates revenue from various sources, including recurring software subscriptions, transaction-based fees, data licensing, and professional services, creating a diversified revenue stream that reduces the risk of dependence on any single source.
My analysis shows that Black Knight’s strong balance sheet and financial position support its growth strategy and value proposition. The company has low debt, high cash flow, and high profitability compared to its peers and the industry.
Finally, BKI has a consistent history of impressive growth and profitability, evidenced by its 10% YoY revenue increase to $1.3 billion in 2022 and an adjusted EBITDA margin of 54%.
Michael Burry’s decision to open a position in BKI
Michael Burry is a famous investor known for his successful bet against the subprime mortgage market in 2007-2008, depicted in the book and movie “The Big Short.” He is the founder and manager of Scion Asset Management, a hedge fund focusing on value investing.
In the fourth quarter of 2022, Burry bought 150,000 shares of BKI.
This was a new position for Scion Asset Management, which allocated 19.90% of its equity portfolio to BKI. The stock traded for an average price of $60.78 per share during the quarter.
Burry’s investment in BKI is significant for several reasons:
Michael is taking his classic contrarian stance on BKI, which has underperformed its peers and competitors regarding stock price performance over the past year. I believe it indicates that he sees value and growth potential in BKI’s business model, which provides end-to-end solutions for mortgage originators, servicers, investors, and regulators. I would also presume he expects BKI to benefit from the merger deal with ICE, which aims to create synergies between ICE’s data, technology, and market infrastructure business and BKI’s software, data, and analytics solutions that serve the housing finance continuum. He is likely confident that the merger deal will go through despite potential regulatory hurdles from the FTC, which may have concerns about market concentration and competition.
Conclusion
The merger between Black Knight Inc. and Intercontinental Exchange offers a low-risk investment opportunity for merger arbitrage, with potential gains of 32.5% if the transaction closes at the current price. In my view, this stock is a buy at its current price of $57 and is a worthy investment under $65. The synergies that this acquisition will create for ICE’s mortgage technology business make holding on to BKI shares after the deal closes in Q3 2023 justifiable. Additionally, BKI appears to be trading for less than its intrinsic value based on its financial health and competitive advantage, making it an attractive investment regardless of the merger. Famed investor Michael Burry’s recent decision to open a position in BKI further confirms its potential. The deal is expected to close by June 30th, 2023, making any investments in BKI, and this analysis’ timing is critical. Overall, the merger provides a rare opportunity for investors to profit from the difference between the current market price of the target company’s stock and the price offered by the acquirer while also benefiting from the long-term growth potential of BKI.
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