CME CME Group Inc

Last week, we reiterated our Neutral recommendation on NYSE Euronext Inc. (NYX) based on the current sustainability factor. The company’s second-quarter operating earnings per share of 61 cents came in a penny higher than the Zacks Consensus Estimate of 60 cents but lagged 64 cents recorded in the year-ago quarter. Consequently, operating net income dipped 4% year over year to $160 million from $167 million in the year-ago quarter.

Results reflected muted top-line performance during the quarter, given reduced trading volumes and lower derivative revenue. This was partially offset by lower-than-expected fixed operating expenses and favorable currency fluctuations.

NYSE’s latest merger with Deutsche Boerse will be the strongest merger in the history of stock exchanges. The merger is further expected to create cost synergies worth $740 million by the end of 3 years coupled with substantial opportunities for incremental revenue.

Management has also accelerated its cost savings timeline to 30%, 65%, and 100% in the next 1–3 years, respectively. The goal for this business for NYSE on a standalone basis is $1 billion of revenue with a 25–30% operating margin by 2015. The merger will also enhance capital flexibility.

Management also stressed on the balance sheet strength of the combined NYSE-Deutsche Boerse entity and its ability to return capital to shareholders post closing.

The debt-to-EBITDA ratio is expected to be 1.0x, one year post culmination, with access to liquidity through excess cash and incremental operational and competitive leverage against prime operators such as NASDAQ OMX Group Inc. (NDAQ) and CME Group Inc. (CME). Lower capital expenditures and continued deleveraging helped the debt-to-EBITDA ratio to decline to 1.7x in the second quarter of 2011, the lowest since the inception of NYSE.

The merger is also set to provide exceptional shareholder value. At the current dividend rate, management has also committed that the combined entity would be paying out almost $910 million in special dividends to shareholders upon the culmination of the merger and still have significant periodic capital deployment potential.

While the merger has cleared its first lap by receiving approvals from the U.S. regulatory bodies and the majority shareholders of both the parties, it awaits approval from the European regulatory commission. Assuming all factors move positively, the merger is expected to culminate after 2011.

Besides, NYSE continues to drive its operating leverage and margin expansion through strong expense management, headcount reduction and lower taxes. These reflect increased momentum in its business model.

As a result of the cost reduction programs launched in 2009, the company’s total operating expenses declined about 37% year over year in 2009 followed by a 19% cut in 2010. While maintaining the same trend into the first half of 2011 along with consistent headcount reduction, NYSE has also lowered expense and capital expenditure guidance for 2011, thereby driving up margins.

Meanwhile, the launch of the NYPC platform, new data centers and IRS futures on U.S. Liffe are expected to enhance revenue opportunities. Alongside, modest capital and operating leverage boost NYSE’s long-term growth strategies of developing clearing houses in London and Paris by the end of 2012, among others.

On the flip side though, the ongoing multi-phase regulatory probe by the European Union Commission (EUC), into the NYSE-Deutsche merger, could create a snag in the process since the fusion of NYSE Liffe and Deutsche Boerse’s Eurex derivative markets provides ample scope for a monopolistic model in future.

Hence, given the antitrust concerns, the deal could face a delay on grounds of regulatory hurdles arising out of extensive reviewing. Additionally, expenses related to the merger are also likely to weigh on margins at least in the near term.

NYSE continues to suffer from 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 investors’ confidence. Weak volumes have been witnessed across equities, bonds, ETFs and structured products of the company.   

Moreover, NYSE’s top-line growth has been marred by a consistent decline in market data along with transaction and clearing revenues that plummeted on lower listing fees and rate per contract, foreign currency fluctuations, decreasing trading activity and market competition.

Further, the global economic crisis experienced in the last couple of years has also led to a decline in the size of securities offerings, new listings, trading volumes and related revenues. We do not expect any growth in the top line unless the current market recovery perks up liquidity and credit quality.

Therefore, considering all the pros and cons, the Zacks Consensus Estimate of earnings for the third quarter of 2011 is currently pegged at 64 cents per share, up about 39% year-over-year. For 2011, the earnings estimate is expected to increase about 23% over 2010 to $2.57 per share, indicating market optimism over the proposed merger.

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

 
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