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ISE: Another Red-Hot Exchange

The International Securities Exchange (NYSE: ISE  ) must be a mighty attractive option for investors looking to cash in on the consolidation trend in its industry. After all, it is the only publicly traded exchange that does not have a dance partner -- the Chicago Mercantile Exchange (NYSE: CME  ) recently announced its merger with the Chicago Board of Trade (NYSE: BOT  ) , and the Nasdaq (Nasdaq: NDAQ  ) exchange has been sniffing around the London Stock Exchange with limited success. Of course, the NYSE (NYSE: NYX  ) is attempting to merge with the European exchange Euronext. The times, they are a-changin'.

Red-hot quarterly results never go out of style, and the ISE has that in spades. Revenues rose 30% to $50.1 million, and net income climbed 66% to $13.9 million year over year. Daily average trading volumes were up 30%, which resulted in a 42.8% operating margin.

Make no mistake -- exchanges are extremely profitable businesses. This company in particular has been able to consistently raise fees over the past year and still retain about 30% of the options exchange market. That's evidence of a competitive moat of sorts for the company, even though the long-term picture has been weaker: The company peaked in the third quarter in 2004 with 34.4% market share.

There are some clouds lying ahead, too. With all of the merger activities going on, some of ISE's competitors are itching to get into the action and become stronger competition. The Chicago Board Options Exchange filed registration statements in preparation for the demutualization process, while the NYMEX has filed registration statements in preparation for a possible IPO. With exchanges dependent on building strong pools of liquidity for investors to fend off competitors, more exchanges flush with IPO cash might mean difficult times ahead for the lonely ISE.

Keep in mind, though, that investors are being asked to pony up a rich price for this potential prom partner. At a price-to-sales ratio of more than 10 and a P/E of 40-plus, clearly investors are expecting strong growth for some time to come. The company's valuation ratios are fairly close to the CBOT's and the Merc's ratios, with all three P/E ratios being in the 45-55 range, although the price-to-sales for the ISE is the lowest at 10 times sales, while the CBOT and the Merc trade at 13 times and 15 times sales. It doesn't seem as though there is too much upside, at least in an acquisition scenario for ISE shareholders. Investors thinking about investing in this company with the expectation of a hefty merger premium might want to revise those expectations.

NYSE became aRule Breakersrecommendation after it merged with Archipelago Holdings. Check out Rule Breakers free for 30 days to learn about investing in the hypergrowth stocks of the next decade.

Fool contributorStephen Ellis does not own shares in any companies mentioned. You can see his holdings foryourself. The Motley Fool has an electronicdisclosure policy.

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