Neutral on IntercontinentalExchange - Analyst Blog

We reiterate our Neutral recommendation on IntercontinentalExchange Inc. (ICE) based on immediate concerns regarding regulatory ambiguity, increased operating expenses, weak credit quality and sluggish market activity. However, the company's strong product portfolio, consistent cash generation, disciplined investment and limited balance-sheet risk bode well for long-term growth.

IntercontinentalExchange's third quarter operating earnings of $1.42 per share surpassed the Zacks Consensus Estimate of $1.36 per share and grew 20% year over year from $1.18 per share reported in the year-ago period. Results benefited from favourable over-the-counter (OTC) execution and record futures trading that led to strong top line growth.

The upside was also attributable to growth in the company's core businesses, fruitful new initiatives and increasing demand for commodities. However, this was partially offset by higher operating and interest expenses.

IntercontinentalExchange has demonstrated immense growth potential in its futures and OTC markets. Moreover, the worldwide market for futures, commodity and credit derivatives appear to be in an expansion mode, which bodes well for the company.

Organic growth has also been significantly driven by strong growth in contract volumes, average daily commission for IntercontinentalExchange's OTC energy business and transaction fees. This gets pronouncedly reflected by the strong performance of ICE Brent Crude and ICE Gas Oil futures markets, among others.

Not only does IntercontinentalExchange continue 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.

Enhancing the company's long-term growth strategy across technology, clearing and operations, the latest Climate Exchange plc acquisition, in July 2010, is expected to increase IntercontinentalExchange's capital efficiency, cross-selling and product development opportunities. Although the acquisition is expected to adversely impact earnings in 2010, IntercontinentalExchange projects earnings accretion from 2011 onwards, also adding momentum to the company's operating and financial leverage.

Further, IntercontinentalExchange poses a sturdy balance sheet with strong cash, receivables and capital position. While the treasury cash vigorously exceeds the total debt position, total interest coverage also remains healthy, reflecting minimal capital expending.

However, IntercontinentalExchange's operating performance has been modestly on the slack side due to the financial downturn in 2008. While the Creditex business performance remains muted on a sluggish volume trend, the company's expenses are increasing, thereby reducing the operating and competitive leverage.

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. Strong competitive pressure continues to threaten the exchange with the entry of new players such as CBOE Holdings Inc. (CBOE).

Moreover, IntercontinentalExchange could be marred by the new laws that impact market operations such as the recent financial overhaul consumer protection Act signed in July 2010 that puts regulatory constraints on derivatives trading in the U.S. The imposition of new commodity market conditions that fail to prohibit prop trading by the U.S. regulators is another such instance.

In July 2010, the U.S. Commodity Futures Trading Commission determined that certain contracts traded on IntercontinentalExchange perform significant price discovery functions and, therefore, must be traded in compliance with the statutory provisions, including core principles, applicable to significant price discovery contracts. These impediments and uncertainty related to regulations could adversely affect the volumes growth and capital position of the company.

Overall, IntercontinentalExchange has a history of developing innovative products and services while the ongoing investments and successful execution of newer initiatives such as OTC clearing have also advanced growth. The company is avid on tapping new growth opportunities both organically and through acquisition.

However, higher core operating expenses, stringent regulations, integration risks and tapered growth especially in the OTC derivatives market and energy futures market are some of the near term challenges the company has to cope with. Yet we believe that once the markets restores its buoyancy and clarity regarding legislation improves, IntercontinentalExchange will out beat its peer group.