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ICE Melts as Competition Heats Up

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We have downgraded our recommendation on IntercontinentalExchange Inc. (ICE - Free Report) to Neutral, based on its slow growth momentum during the first quarter coupled with intensely emerging competitive pressure. However, fundamentally the stock continues to remain a long-run player.

The company’s fourth-quarter 2011 operating earnings of $1.76 per share topped both the Zacks Consensus Estimate of $1.68 per share and $1.35 per share reported in the year-ago period. Excluding certain net acquisition-related costs, net operating income of $129.3 million surged 29.4% year over year in the reported quarter. IntercontinentalExchange’s total revenue escalated 14.8% year over year to $327.2 million and came almost in line with the Zacks Consensus Estimate.

The quarterly results of IntercontinentalExchange benefited from favourable over-the-counter (OTC) execution and record futures trading that in turn led to strong top-line growth. The upside was also buoyed by lower tax rate, growth in the company’s core businesses, significant progress triggered by new initiatives and increasing demand for commodities. However, this was partially offset by higher-than-expected operating expenses.

IntercontinentalExchangehas demonstrated immense growth potential in its futures and OTC markets, thereby gaining operating leverage. The company offers more than 700 cleared OTC energy contracts, including more than 608 new cleared OTC contracts since the launch of ICE Clear Europe in November 2008. Besides, the clearing of foreign exchange OTC contracts, scheduled to start in the second quarter of 2012, should further refine IntercontinentalExchange’s business model and aid in complying with regulatory standards.

Moreover, IntercontinentalExchange not only continues to drive organic growth, its intermittent restructuring programs through acquisitions and spin offs have driven robust inorganic growth, which are reflected in increased assets and global expansion. Going ahead, management also seeks for more strategic acquisition opportunities in order to gain scale and counter the changing industry dynamics.

Further, the company poses a sturdy balance sheet with strong cash, receivables and capital position. Its treasury cash and new credit facilities vigorously exceeds the total debt-funding position, which is also reflected by the company’s operating cash flow that accelerated 34% in 2011. These factors also pave way for efficient capital deployment, primarily through share repurchases along with business development.

However, on the flip side, IntercontinentalExchange’s Creditex business performance remains muted, declining 21.1% year over year in 2010 and 5.4% in 2011, on a sluggish volume trend based on reduced demand for portfolio hedging, fewer credit default events and significant regulatory uncertainty. Besides, the company’s operating leverage faces risks from higher capital expenditure and other expenses, which are necessary to stay competitive. Management has already guided a total of $90–100 million of capital and other costs for 2012, which could likely trend upward given new product launches in the upcoming quarters. Going forward, compensation and benefits expenses are expected to increase from current levels, primarily due to additional employees, variable performance bonuses and non-cash compensation expenses.

Over the past few months, IntercontinentalExchangehas been facing a challenging global operating environment as most of the arch-rivals are rapidly evolving through new and innovative product and service launches in order to gain market share and stay ahead in the competition. This has also relatively slowed down the growth momentum of IntercontinentalExchange. The recent outlay of growth plans by dominant players such as NYSE Euronext Inc. and CME Group Inc. (CME - Free Report) through acquisitions and the setting up of clearinghouses along with new product and service initiations in the derivatives market have already pointed out the swiftly changing dynamics of the exchange industry.

Such aggressive industry efforts are not only keeping the company’s management on its toes but are also directly threatening its operating and competitive leverage. In future, the company may even have to resort to price reductions and margin contractions amid intense competition. Hence, we believe that management should make productive endeavours as well as manage cash and liquidity position proactively, in order to retain and grow its industry position.

Nevertheless, a high earnings visibility, strong product portfolio, consistent cash generation, disciplined investment and limited balance-sheet risk enable IntercontinentalExchange to be one of the most dynamic companies in the industry. However, a limited upside compared with its peers in the near term validates our Neutral recommendation for now.

Based on the pros and cons, the Zacks Consensus Estimate for the first quarter of 2012 is currently pegged at $2.02 per share, escalating about 14% over the prior-year period. In the last 30 days, the stock witnessed downward estimate revisions from 9 of the 16 analysts, while only a couple of analysts raised estimates. IntercontinentalExchange carries a Zacks Rank #3, implying a short-term Hold rating and a long-term Neutral recommendation.

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