IntercontinentalExchange's Upside Is Hampered by Heavy Investment and Regulatory Concerns

IntercontinentalExchange Inc. (NYSE:ICE) develops and offers a diverse array of products and a broad range of risk management services. Also, the company demonstrated immense growth potential in its futures and OTC markets, thereby gaining competitive leverage.

Its intermittent restructuring programs through acquisitions and spin-offs have driven robust inorganic growth. The company possesses a sturdy balance sheet with strong cash, receivables and capital position.

However, these positives are somewhat dwarfed by heavy investment for start-up initiatives and regulatory constraints. Hence we maintain our Neutral recommendation on the company.

IntercontinentalExchange’s offering include trade execution, market data, pre- and post-trade processing and clearing services on an integrated platform. Additionally, the company’s electronic trading platform benefits the market participants with price transparency and achievement of price improvement over alternate means of trade execution.

Electronic trade execution also offers time and cost efficiencies by providing firm posted prices and reducing trade-processing errors and back office overheads. This enhances new product development and also provides a competitive advantage to the company.

The company’s inorganic growth is reflected in increased assets and global expansion. Enhancing the company’s long term growth strategy across technology, clearing and operations, the CLE acquisition is expected to increase IntercontinentalExchange’s capital efficiency, cross-selling and product development opportunities.

The company’s strong balance sheet with strong cash, receivables and capital position, pave the way for efficient capital deployment, primarily through share repurchases. At the end of the first quarter of 2011, the company had $210 million worth of stock available for buyback.

On the flip side, over the past years, IntercontinentalExchange’s operating performance has been modestly hampered by the financial downturn in 2008. The Creditex business performance remains muted. The company’s expenses are also increasing, thereby reducing the operating and competitive leverage. Going forward, compensation and benefits expenses are expected to increase from current levels.

In the current volatile market, IntercontinentalExchange could be marred by new laws that impact market operations such as the Financial Reform Act signed in July 2010 that puts regulatory constraints on derivatives trading, primarily the OTC swaps market in the U.S.

IntercontinentalExchange’s credit business, which required heavy investment for start-up initiatives, has significantly weakened from the historical highs due to the ongoing sluggish markets that reduced liquidity. Also, trading participation in certain markets has become limited based on extraordinary volatility coupled with a sustained period of uncertainty relating to creditworthiness of the counter-parties and the inadequate availability of credit to facilitate trading.

These adverse conditions have resulted in freezing of credit, outflows of client funds and investments, reduced market liquidity losses due to declining asset values and defaults on loans are expected to continue in the near term.

IntercontinentalExchange posted first quarter earnings surpassing the Zacks Consensus Estimate, reflecting modest performance in its core business and higher volumes that drove operating margins and cash flow.

The Zacks Consensus Estimate for second-quarter 2011 is 79 cents per share. For full years 2011 and 2012, the Zacks Consensus Estimates are respectively, $3.48 and $2.93 per share.

The quantitative Zacks #3 Rank (short-term Strong Buy rating) for the company indicates no clear directional pressure on the stock over the near term.

Based in Atlanta, Georgia, IntercontinentalExchange Inc. owns and operates an Internet-based global electronic marketplace for trading in futures and over-the-counter (OTC) commodities and derivative financial products. It competes with CME Group Inc. (NASDAQ:CME).