(NDAQ) Neutral on NASDAQ

We maintain our Neutral recommendation on NASDAQ OMX Group Inc. (NDAQ) based on its current sustainability factor. The company’s first quarter earnings beat the Zacks Consensus Estimate driven by strong revenue growth across the board coupled with moderate expense management. However, new listings and order intakes continued to be on the downside.

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. This includes both product and price competition and has continued to increase as a result of the creation of new execution and listing venues in the U.S. and Europe.

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 NASDAQ’s size and global footprint.

NASDAQ’s top-line growth has been marred by a decline in order intakes and market data exchange revenues that remain sluggish due to lower average net fee per share, decreasing trading activity and market competition. Besides, most of NASDAQ’s derivative revenue comes from stock options, as opposed to the more-lucrative futures business, contributing only 19% to net revenues.

The company’s OTC derivatives clearing 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).

Alongside, the company’s debt burden has also driven the rating agencies, Moody’s and S&P’s, to lower their outlook on NASDAQ from stable to negative in April 2011. Going ahead, increased competition can severely hamper growth in trading activities, pricing adjustments, listings and the markets for the company s products, thereby adversely affecting the operating results.

On the flip side, NASDAQ continues to drive its operating leverage through a strong expense management, headcount reduction, lower taxes and fewer charges. Additionally, successful integration efforts associated with NASDAQ’s business combination with OMX and the Philadelphia Stock Exchange acquisition also drove expense reductions.

This is also reflected in the company’s conservative expense outlook for 2011 although some additional expenses are projected on account of the recent SMART group and FTEN acquisitions.

Furthermore, NASDAQ’s options business continues to reflect strong performance despite the weakness experienced in equity trading in recent years. The company’s organic growth is helped by the increase in market technology 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 to the US dollar.

Additionally, the company’s net derivatives trading and clearing exchange platform continue to perform on a strong base. Going forward, these revenue drivers have the potential to generate growth and accomplish management’s target of $2 billion of annualized revenue by 2013.

NASDAQ’s outstanding technical performance coupled with the latest SMART Group and FTEN acquisitions has enabled the company to enter new markets at a low cost and on a highly flexible platform, offering value addition to its clients and creating additional sales opportunities. Besides, NASDAQ enjoys strong capital leverage that provides scope for stock repurchase and acquisitions.

On account of these factors, the Zacks Consensus Estimate for the second quarter of 2011 is pegged at 61 cents, surging about 17% year over year. Meanwhile, no analysts have made any upward revisions in the stock over the last 30 days, although 3 out of 17 analysts have lowered their estimates for the upcoming quarter. This further reflects the operating and competitive risks attached to the stock.

Overall, NASDAQ’s diversified business mix, cost, revenue and technology synergies will enable it to benefit from improving economic conditions in future. Furthermore, an improved outlook for equity investments and the number of recession-proven private companies seeking capital is expected to add to the IPO pipeline in 2011. However, increased competition, product pricing and government regulations continue to be headwinds for the company’s market share and liquidity.

On Tuesday, the shares of NASDAQ closed at $24.28, reflecting a 1.9% increase.

CME GROUP INC (CME): Free Stock Analysis Report

NASDAQ OMX GRP (NDAQ): Free Stock Analysis Report

NYSE EURONEXT (NYX): Free Stock Analysis Report

Zacks Investment Research

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