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ICE Stays in Neutral Lane

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We reiterated our Neutral recommendation on IntercontinentalExchange Inc. (ICE - Free Report) based on its fundamental strength generated by new initiatives, acquisition and alliances. However, intense competition and ongoing market volatility deter the desired upside in the stock.

The company’s second-quarter 2012 operating earnings of $1.95 per share were a couple of pennies ahead of the Zacks Consensus Estimate of $1.93 a share, and also outpaced the year-ago quarter’s earnings of $1.64 per share.

The quarterly results of IntercontinentalExchange benefited from favorable futures markets, strategic initiatives in clearing, execution and record market data and other revenue, which in turn led to modest top-line growth. The upside was also attributable to capital efficiency, strict expense control lower tax rate and growth in the company s core businesses.

Further, significant progress triggered by new initiatives led to margin expansion. However, this was partially offset by lower revenue from the over-the-counter (OTC) segment and credit default swap (CDS) business.

Despite the global downturn, IntercontinentalExchange’s markets have shown resilience due to the consistent client demand for the company’s futures and OTC products along with its clearing and risk management services. Additionally, strategic acquisitions and alliances in the emerging markets and rapidly developing product-areas such as energy, oil, gas, grains and oilseeds, are enhancing the company’s competitive strength.

IntercontinentalExchange continues to be cost-effective given its disciplined expense management. This is reflected by its controlled mid-single-digit total expense growth in the past couple of years and is further validated by management’s projection of flat growth in 2012.

Moreover, the treasury cash and new credit facilities vigorously exceeds the company’s total debt-funding position. The total interest coverage also remains healthy along with a debt-to-EBITDA of 0.9x at the end of June 2012, reflecting minimal capital expending and solid operating cash flow growth that accelerated at a CAGR of 25% for 2007–2011 along with 34% year over year improvement in 2011 and 13.9% growth in the first half of 2012.

On the flip side, IntercontinentalExchange has 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, 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. In the future, the company may even have to resort to price reductions and margin contractions amid intense competition.

Additionally, IntercontinentalExchange’s operating leverage continues to be marred by low interest rates and demand for low-priced products that hinders the desired growth in trading volumes. The adoption of the ongoing global regulatory reforms would further add to the cost for infrastructural modifications, while the regulatory constraints on block trading and margin requirements on derivative securities would adversely hamper the volumes growth and capital position of the company.

Overall, based on the pros and cons, the Zacks Consensus Estimate pegs earnings for the third quarter of 2012 at $1.83 per share, which is about 2% lower than the year-ago quarter. For 2012, earnings are expected to grow about 9% over 2011 to $7.73 per share. IntercontinentalExchange is scheduled to release its third quarter financials before the bell on November 5, 2012.

Currently, IntercontinentalExchange carries a Zacks Rank #3, implying a short-term Hold rating, indicating no clear directional pressure on the stock in the near term.

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