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NYSE Dips to Underperform

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We downgraded our recommendation on NYSE Euronext Inc. to Underperform from Neutral, based on the current sustainability factor amid weak trading volumes. The company’s second-quarter 2012 operating earnings per share of 51 cents were a penny higher than the Zacks Consensus Estimate of 50 cents, but were much lower than 61 cents recorded in the year-ago quarter.

Resulted reflected a weak top line driven by reduced volumes and revenues across segments, which was partially offset by decreased expenses and lower tax rate. Alongside, unfavorable currency fluctuations and lower average revenue per contract added to the woes, resulting in deteriorated operating margin.

Over the past few quarters, NYSE has been affected by weak trading volumes, which is directly based on the economic and market conditions, volatility of interest rates, inflation, changes in price levels of securities and the overall level of investors’ confidence. Furthermore, the current initiatives taken up by regulators and governments, such as restrictions on high frequency trading and taxes on securities transactions are liable to have a materially adverse effect on overall trading volumes.

Additionally, NYSE has been facing intense market pressure and that was evident from its inability to culminate significant business developments. Recently, the company scrapped its European launch of a new electronic retail derivatives market, which was slated to commence in the first quarter of 2013, to tap the multi-billion Contracts for Difference (CFD) market, thereby eliminating a strong long-term revenue potential. We do not expect any radical growth in the top-line unless the current market recovery provides resonance to liquidity and credit quality.

Moreover, as a result of higher capital expenditure related to other projects and debt, NYSE’s debt-to-EBITDA ratio deteriorated to 2.1x at the end of June 2012 from 1.6x recorded at the end of 2011. Higher debt and lower working capital in the first half of 2012 also impelled ratings agency S&P to downgrade its outlook to negative from stable in August 2012.

At such a juncture when heavy capital expending is lined up at least until mid-2013, consistent dividends and share buybacks amidst declining operating margins and operating cash flow only augments business risks.Meanwhile, NYSE has also been facing intense competition from strong players, such as CME Group Inc. (CME - Analyst Report) and IntercontinentalExchange Inc. (ICE - Analyst Report), which tends to reduce market share and leverage of its business.

However, NYSE continues to grow organically as well as through mergers, acquisitions and alliances. Alongside, the technology will remain the fastest-growing segment for the combined entity and the company’s enhanced investment into the non-core space of this segment should also enhance long-term earnings accretion.

NYSE also aims to augment long-term growth strategies by developing clearinghouse in Europe as well as enhancing technology and risk-management services, among others. Management projects a double-digit revenue growth from the information and technology segment for 2012 along with an increased internationalization of client base.

Concurrently, NYSE continues to drive its operating leverage through strong expense management, headcount reduction and lower taxes. Moreover, annual cost savings from new business initiatives worth $250 million and additional profits from the retail derivative market by the end of 2014 are also expected to drive margins in future.

Hence, based on the pros and cons, the Zacks Consensus Estimate pegs NYSE’s earnings for the third quarter of 2012 at 46 cents per share, which is about 35% lower than the year-ago quarter. For 2012, earnings are expected to dip about 21% over 2011 to $1.95 per share. However, the stock is expected to rebound in 2013.

NYSE currently retains a Zacks #5 Rank, which translates into a short-term Strong Sell rating and indicates a strong downward pressure on the stock in the near term.

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