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S&P Wary of NYSE-ICE Merger

ICE

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Immediately after the announcement of the $8.2 billion acquisition of NYSE Euronext Inc. by IntercontinentalExchange Inc. (ICE - Analyst Report) last week, Standard & Poor's Ratings Services (S&P) has cast a concerned outlook on the merger, which is expected to culminate by the first half of 2013, subject to the fulfillment of regulatory compliances in the U.S. and Europe. The ratings agency is skeptical about the raised debt amid weak fundamentals.

Accordingly, S&P assigned an issuer credit rating of “A+/A-1” on NYSE. The company has also been kept under the CreditWatch with negative implications. A CreditWatch acts as a red flag and allows a company to monitor its actions before causing a detrimental effect on ratings.

S&P’s concern hovers around NYSE’s inflated debt position, which the company plans to carry in the merged company as well. Higher debt and lower working capital in the first half of 2012 also impelled the ratings agency to downgrade NYSE’s outlook to negative from stable, in August 2012.

Further, with a long-term debt of $2.5 billion at the end of the first nine months of 2012, NYSE bears the brunt of higher borrowing costs, which further constricted the operating margins to about 33% during the same period from 9% in the year-ago period. At present, higher debt and capital expenditure has led NYSE’s debt-to-EBITDA ratio to deteriorate to 2.4x at the end of September 2012 from 1.6x at 2011-end, which again underscores ample financial and operating risks.

The rating agency is wary of NYSE’s liquid assets, which may hardly cover the operating expenses for three months. At such a juncture when heavy capital expenditure is expected until at least mid-2013, consistent dividends and share buybacks amidst declining operating margins and operating cash flow only augment business risks. Hence, S&P does not expect any rating upgrades over the next two years.

The financial risks from the higher debt obligations do not make this potentially strong merger any less risky.  This is due to the fact that IntercontinentalExchange plans to squeeze all of its cash of $1.0 billion and raise another $1.8 billion from its revolving credit facility. This leaves the combined entity with a debt burden of about $4.7 billion and debt-to-EBITDA ratio of 2.2x, according to the S&P, which remains in a perilous state.

Nevertheless, the ratings agency is optimistic about ICE Clear Europe providing clearing services to NYSE Liffe, as part of the merger. This clearing pact allows NYSE to diminish the cost and risk of building its own clearinghouse in London and mutually benefit from the diverse product portfolio. Moreover, S&P believes that NYSE is making efforts to reduce its debt obligations through refinance and other activities. Even post merger, the joint entity has the potential to improve its operating cash flow and produce cost synergies worth about $300 million by 2014.

However, these actions would take quite a long time given the company’s capital and other extraordinary cost requirements of about $150 million in 2013. Hence, a risky financial and operating leverage could also shake investor confidence, and call for an appropriate check and control system instantaneously.

IntercontinentalExchange carries a Zacks #3 Rank, which implies a Hold rating in the short term, while the long-term recommendation remains Neutral. However, NYSE holds a Zacks #4 Rank, which translates into a short-term Sell rating, while the long-term recommendation remains Underperform.

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