CME CME Group Inc

We reiterate our Neutral recommendation on NASDAQ OMX Group Inc. (NDAQ) based on its current sustainability factor. The company’s second quarter earnings came in a couple higher than the Zacks Consensus Estimate driven by improvement in new listings and order intakes, coupled with moderate expense management. However, higher expenses along with reduced cash equity trading and average fee were the downside.

NASDAQ continues to suffer from an eroding market share and weak trading volumes, which is directly affected by economic and market conditions, volatility of interest rates, inflation, changes in price levels of securities and the overall level of investor confidence.

The current initiatives that are being taken up by regulators and governments across the U.S. and Europe, such as the restrictions on high frequency trading and taxes on securities transactions, could have a material adverse effect on overall trading volumes.

Moreover, NASDAQ has been facing intense competition with the recent wave of M&A activities in the stock exchange industry that tends to reduce the market share and the leverage of its business. While exchange operators across the globe are expanding their operating efficiencies through significant M&A, NASDAQ is desperately seeking a business combination in order to diversify beyond product and geography.

The recent failure of NYSE Euronext Inc.’s (NYX) takeover bid further threatens to diminish NASDAQ’s size and global footprint.

NASDAQ s top-line growth has been marred by a decline in cash equity trading revenues and U.S. market data revenue that remains sluggish due to lower average net fee per share, decreasing trading activity, muted growth in annual renewals and market competition. Although order intakes improved in the second quarter of 2011 after consistent decline, it is too early to see a positive trend.

The company’s OTC derivatives business in the US, International Derivatives Clearing Group (IDCG), has failed to generate any growth impetus in interest rate swaps due to very few members and intense competition from NYSE and CME Group Inc. (CME). We do not expect any random growth in the top line unless the current market recovery provides resonance to liquidity and credit quality.

On the flip side, NASDAQ continues to drive its operating leverage through strong expense management, headcount reduction, lower taxes and fewer charges. This is also reflected in the company’s controlled expense outlook for 2011, although some additional expenses are projected on account of the recent SMART group and FTEN acquisitions.

Despite the weakness experienced in equity trading in recent years, NASDAQ’s options business continues to reflect strong performance. As well, the company's organic growth is helped by the increase in market technology as well as issuer and access services revenues primarily due to the increased deliveries of contracts, increased demand for co-location services and changes in the exchange rates of various currencies as compared with the U.S. dollar.

Additionally, the company’s net derivatives trading and clearing exchange platform continue to perform on a strong base. Besides, the steadily rising demand for ETFs is also enhancing the Globex platform. Going forward, these revenue drivers have the potency to generate growth and accomplish management’s target of $2 billion of annualized revenue by 2013.

Besides, NASDAQ’s outstanding technical performance coupled with the strategic acquisitions such as SMART group, ZVM and FTEN and the X-stream INET technology are well positioned to contribute to growth as the industry is becoming more focused on solutions for effectively managing risk. NASDAQ also enjoys strong capital leverage that provides scope for stock repurchase and acquisitions.

As a result of these factors, the Zacks Consensus Estimate for the third quarter of 2011 is pegged at 62 cents, surging about 19% year over year. While 5 of the 17 analysts covering the stock have raised their estimates for the upcoming quarter, 7 downward revisions were witnessed in the last 30 days. This reflects the operating and competitive risks hovering around the stock.

Additionally, the quantitative Zacks Rank for NASDAQ is currently #3, indicating no clear directional pressure on the shares over the near term.

On Monday, the shares of NASDAQ closed at $20.98, down 1.04%.

 
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