NASDAQ Stays in Neutral Lane

We have reiterated our Neutral recommendation on NASDAQ OMX Group Inc. ( NDAQ - Analyst Report ) based on its efforts to expand in the international markets and build a low-cost trading platform. However, heightened competitive pressure amid weak trading volumes and margins continue to dent our optimism.

The company reported operating earnings of 62 cents per share in the third quarter of 2012, surpassing the Zacks Consensus Estimate by a couple of pennies. However, it fell shy of the prior-year quarter’s earnings of 67 cents a share by a nickel. The year-over-year shortfall reflects a reduced top line based on low industry trading volumes and the unfavourable impact from foreign exchange.

NASDAQ has been making proactive investments to penetrate deeper into the European over-the-counter (OTC) market. The company’s latest plan to launch a new interest rate derivative trading platform NASDAQ NLX in early 2013 also elucidates its strategic move to attain a competitive edge in Europe. Furthermore, the new Globex Family Index is enhancing the Globex platform, accounting for 98% of the global equity investment market with about 24,000 benchmark indices.

Overall, we believe that these factors should create additional sales opportunities once the markets rebound. These growth drivers and improved volumes aided by market stability have the potency to generate accelerated earnings and attract new listings and client activity.

Additionally, increased retained earnings and cash along with the ongoing strategic business initiatives are expected to generate improved earnings and operating cash flow in the long run. NASDAQ’s fair liquidity also helps it return value to shareholders from time to time. This is reflected by the expansion of the share buyback program in August this year and the initiation of a regular cash dividend in April 2012.

Despite this, NASDAQ continues to suffer from an eroding market share and weak trading volumes, which is directly affected by the economic and market conditions, volatility of interest rates, inflation and changes in price levels of securities.These limitations reflect the pressing need to respond to the changing industry dynamics and dig in opportunities for gaining scalecompetitive strength.

Moreover, severe competition from arch rivals such as NYSE Euronext Inc. ( NYX - Analyst Report ) and CME Group Inc. ( CME - Analyst Report ) continues to be a lingering concern for NASDAQ. The upcoming merger of NYSE with IntercontinentalExchange Inc. ( ICE - Analyst Report ) raises the concerns about maintaining a competitive and operating leverage.

This gets more crucial as the fragile top-line scenario has been generating lower earnings, cash balance and operating cash flow, reflecting a cautious outlook on the company’s fundamentals. We do not expect random growth in the top line unless the current market recovery provides resonance to credit quality. In addition, the current initiatives that are being taken up by regulators and governments across the U.S. and Europe could have a material adverse effect on overall trading volumes.

Hence, based on the pros and cons, the Zacks Consensus Estimate pegs earnings for the fourth quarter of 2012 at 61 cents per share, which is about 2% lower than the year-ago quarter. Even for 2012, earnings are expected to decline about 2% over 2011 to $2.48 per share.

Currently, NASDAQ carries a Zacks Rank #3, indicating no clear directional pressure on the stock in the near term.