ICE Holds on to Neutral

We have reiterated our Neutral recommendation on IntercontinentalExchange Inc. (ICE - Analyst Report) based on strong fundamentals, which are partially offset by the expected negative impact of regulations and uncertain industry trends.

The company’s second quarter operating earnings of $1.69 per share were substantially ahead of the Zacks Consensus Estimate of $1.60 and $1.51 reported in the year-ago period.

IntercontinentalExchange’s competitive strength lies in its diverse array of products and broad range of risk management services including trade execution, market data, pre- and post-trade processing and clearing services on an integrated platform.

The company has demonstrated immense growth potential in its futures and OTC markets, thereby gaining a competitive leverage. Over the past several quarters, the company has launched multiple new coal, natural gas and gas oil futures contracts, in order to extensively penetrate the rapidly expanding energy sphere.

IntercontinentalExchange’s organic growth is also significantly driven by strong growth in contract volumes, average daily commission and transaction fees, among others. Despite the global downturn, the company’s markets have shown resilience due to the consistent client demand for its products and risk management services.

Further, IntercontinentalExchange has a sturdy balance sheet with strong cash, receivables and capital position. While treasury cash exceeds the total debt position, total interest coverage also remains healthy, reflecting minimal capital expending and solid operating cash flow growth. These factors also pave the way for efficient capital deployment, primarily through share repurchases.

However, IntercontinentalExchange’s credit business that required heavy investment for start-up initiatives has significantly weakened from the historical highs due to the ongoing sluggish markets that reduced liquidity.

Also, trading participation in certain markets has become limited based on extraordinary volatility coupled with a sustained period of uncertainty relating to creditworthiness of the counter-parties and inadequate availability of credit. These adverse conditions have resulted in credit-freeze, outflows of client funds and investments, reduced market liquidity losses due to declining asset values and loan defaults.

Additionally, IntercontinentalExchange’s operating performance has been modestly hampered by the financial downturn in 2008 and the company’s expenses have also been increasing, thereby reducing the operating and competitive leverage.

Moreover, IntercontinentalExchange is liable to be marred by new laws that impact its market operations. In July 2010, the U.S. Commodity Futures Trading Commission (CFTC) determined that certain contracts traded on IntercontinentalExchange perform significant price discovery functions and, therefore, must be traded in compliance with the statutory provisions applicable to significant price discovery contracts.

With respect to this, in July 2011, the company had to lower its adjusted net capital requirements from CDS clearing members, thereby receiving a shot in the arm.

Later, in October 2011, CFTC further proposed that swaps clearing houses will be required to open access to companies with at least $50 million in capital to allow more participants and manage defaults. IntercontinentalExchange could incur additional costs for infrastructural modifications required for the same.

As a result, the Zacks Consensus Estimate for IntercontinentalExchange’s third quarter earnings currently stands at $1.77 per share, up about 25% year-over-year. Of the 16 firms covering the stock, 14 revised their estimates upward, while no downward revisions were witnessed in the last 30 days.

For 2011, earnings are expected to be about $6.85 per share, up 21% year-over-year.

IntercontinentalExchange competes with CME Group Inc. (CME - Analyst Report) and NASDAQ OMX Group Inc. (NDAQ - Analyst Report). The company currently caries a Zacks #2 Rank, implying a short term Buy rating.