Description

Extremely undervalued, widely misunderstood and fast-growing compounder with enormous growth runway trading with an implied mere 10-12x implied brokerage P/E.  Shares worth $48, or 100%+ premium to current price using conservative 2015 assumptions on a standalone basis.  Those looking to 2016 could easily support a mid-$50s price.  Due to huge potential cross-selling synergies, IBKR shares are likely worth $60+ to a strategic buyer if/when IB’s founder and controlling shareholder should choose to exit.

Based in Greenwich, CT, Interactive Brokers (“IB”) is a fully-automated electronic broker-dealer and market maker that was founded by Thomas Peterffy in 1977.  Peterffy, as you may recall from the 2012 election season, personally paid for and starred in a prominent television commercial telling his story of emigrating from Hungary to the United States and founding IB, the company that has made him a multi-billionaire and which he still controls through his ~75% ownership stake.  The company presently has a $9.5 billion market value, however the publicly traded float is only $1.3 billion.  IB has no long term debt.

IB provides the sole truly global brokerage platform, which allows investors to trade all security types 24 hours/day on >100 market centers in 24 countries, in 19 currencies (incl. Chinese Renminbi) and in 9 languages from a single universal account.  Due to its technological leadership and automation, IB charges the lowest commissions ($0.0005-0.005/share, $0.075-0.7/option contract), has the lowest margin rates (0.5-1.59%), yet generates the highest profit margins in the brokerage industry (60% heading to 70%) while providing industry best execution and unprecedented transparency to its customers.

February 2008:  98k accounts, $9bn customer equity, $35 stock price, 3.4x TBV

Today:  265k accounts (+170%), $54bn customer equity (+500%), $23.44 stock price (-33%), 1.8x TBV (-47%)

*Anecdotal:  I feel particularly qualified to discuss IB as we solely prime both of our funds (having moved from a large bank) and maintain multiple family retirement accounts with IB, so I am speaking from personal experience as a very happy customer.  While not necessarily surprising, I believe it is worth relaying that in my conversations with senior members of the hedge fund sales team, they have struck me as unusually bullish about their market share gains, which is clearly showing up in the data.  I have personally found IB’s technology, reporting and customer service to be outstanding.*

Why Does the Opportunity Exist?

Theoretically, IB should be top-of-mind for the hedge fund and discretionary long-only community, yet the company and its shares are perpetually ignored for several reasons:

• Brokerage – the Invisible Juggernaut.  The electronic broker is a juggernaut with incredible growth and a massive runway, yet virtually nobody is paying attention.  Since 2007, total accounts have grown from 95k to 265k, a 17% CAGR.  Customer Equity has grown from $9bn to $54bn, a 32% CAGR.  IB is – by far – the low cost and low price leader in global electronic brokerage.  Pre-tax profit margin is running 60% currently, and Peterffy said on the Q2 call that he expects it to reach 70% in 2-3 years.

• Investors Unaware of the Global Growth Runway and Trends.  Schwab, Ameritrade and E*Trade have 35x, 23x and 12x the number of accounts as IB.  IB could literally quadruple in size with few even noticing, which is what has happened in recent years.  As Peterffy said after Q1:  “We finished the quarter with 252,000 accounts, which represents a 16% year-over-year increase or 21% annualized. I'm optimistic that we can sustain this rate of growth for several reasons.  First, over 60% of new accounts are coming from outside the U.S., in countries where we have only scratched the surface in terms of market penetration; and second, nearly 1/4 of new accounts this year came from client referrals. This is a testament to the volume of our platform and a powerful trend that I expect will multiply as our customer base continues to expand.” 

• Market-Maker Dynamics.  High frequency trading and lower market volatility have reduced the size and the profitability of the market-making subsidiaries, however this unit remains significantly profitable ($135mm pre-tax in 1H14 vs. $1.1bn equity for an annualized pre-tax ROE of 23% despite near record low volatility).  The company currently pays a $0.40 annualized dividend (1.7%) from the market-maker, and special dividends of $1.79/sh and $1.00/sh in 2010 and 2012, respectively.  It can be valued as a liquidation as a multiple of book value or as a going concern as a multiple of earnings.  As this division is compounding capital at 10-15% on an after-tax basis, and represents a large free option on the return of volatility and curbing of HFT, I think an 8-12x P/E is quite reasonable.  It doesn’t really matter for our analysis, but I value it both ways. 

• Low Float.  The corporate structure is such that 85.9% of the company’s equity is owned by IBG Holdings LLC, which is largely owned by Peterffy, along with certain senior management.  Peterffy’s decision to sell a small stake in IB to the public was driven by his belief that being a public company added transparency and credibility; however he had no interest in giving up control or ownership.  Peterffy currently owns >75% of the company via his IBG Holdings stake.  Notably, we have heard that several large institutional investors have asked Peterffy to sell them a stake directly, and Peterffy has always declined. 

• Misplaced HFT Concerns.  Investors tend to assume that all electronic brokers sell their customer order flow to the highest bidder.  This appears to be true for all electronic brokers but IBKR, which sells no order flow to internalizers (HFT firms).  Order routing practices for Schwab, Ameritrade and E*Trade are stunning.  Rather, IB customer execution is by far the industry-best, owing to the fact that its order flow is routed directly to the exchanges or internally matched.  Peterffy has been an outspoken critic of HFT for 15 years (see many letters and a great speech), and in July voluntarily began disclosing customers’ total execution cost and sent a pointed letter to the SEC imploring the requirement that all brokers do the same.  As Peterffy said on the Q1 call regarding the HFT crackdown:  “I want to be very clear on this.  This is going to be a positive and may even be a very big positive for us.  First, we have always been a strong and outspoken advocate for fair and orderly markets, and believe that such a scrutiny will be beneficial to our customers and will ensure a more level playing field…  We have decided early on that this is a conflict we should not have.  Therefore, we do not trade against our customers' orders and do not sell our customers' orders.  We go to a great length to provide our customers the best possible price at the lowest transaction cost.  This will maximize our customers' returns.  This is how we have been branding and marketing ourselves.  As our results indicate, this is a winning strategy that we will continue to follow.”

• Off Hedge Fund Radar.  Only two hedge funds (Kylin and Teton/Ancient Art, both extremely smart concentrated investors with outstanding track records) own significant positions in IBKR.  The vast majority of investors have yet to recognize IB’s powerful dynamics of being an extremely scalable, lowest-cost, lowest-price provider, with the best technology and longest runway for growth.  IB’s brilliant management team with an 85% stake in the company adds to my confidence.  

Thesis

• Price and Cost Leader – By Far.  There is simply no comparison between IB’s commission and margin structures and the competition.  IB’s pre-tax profit margin is presently running at a remarkable 60%, and due to the company’s continued rapid growth and operating leverage, Peterffy stated on the Q2 earnings call that he expects margins could reach 70% in 2-3 years.  I can personally attest to the fact that execution is dramatically better with IB than with our former prime broker, and that our orders virtually always execute between the displayed bid and ask.  By comparison, commission structures in Hong Kong, for instance, are orders of magnitude higher:
  • HSBC:  0.25% of amount ($12.90 minimum commission), 0.50% of transaction amount for settlement in USD ($30 minimum commission).
  • CITIC:  $28 minimum commission.

• Long Growth Runway.  IB’s brokerage market share is tiny (sub 1%).  Schwab has 35x the number of accounts of IB.  As noted above, Ameritrade has 23x the number of accounts of IB.  E*Trade has 12x the number of accounts of IB.  These firms are largely U.S. focused.  IB is globally focused, is dramatically cheaper and should compound growth at 20%+ for many years to come.

• Far Superior Execution, and No HFT Intermediaries.  As Peterffy said in his August 1 letter to the SEC, “For 2014 to date, on $571.5 billion in Reg NMS equity trades, our customers paid a total execution cost of 0.008% (0.8 basis points).”

• Rapid Growth in Asia and with Financial Advisors / Funds.  Asia represented 20% of commissions in Q1 2014 compared with 15% in 2010, while the pie as a whole was expanding rapidly.  As Thomas Peterffy said on the Q1 2014 call: “I don’t want to be specific on that, other than to say that Asia is growing faster than other places.”  On the Q1 2013 call, Peterffy said:  “More than 50% of our new accounts are outside of the United States [note, this is >60% now] and the fastest growing region for both, for new account growth and customer deposits and commission revenues is Asia.”  Financial advisors, hedge funds and prop trading groups represent 49% of customer equity as of Q1 vs. 43% in 2010 (not counting introducing brokers, which are also growing).

• Accretion from Higher Interest Rates.  While I do not forecast higher rates, IB would benefit tremendously from rising interest rates.  Low interest rates compress the spreads earned by IB’s brokerage unit.  As IB’s CFO said on the Q1 call:  “With the growing customer asset base, we believe we are well positioned to benefit from a rise in interest rates. Based on current balances, we estimate that a general rise in overnight interest rates of 25 basis points would produce an additional $55 million in net interest income annually.”

• Potential to Raise Commissions.  Although as an IB customer I am not necessarily advocating it, I can honestly say that IB could raise our commission rate 50% or more and we would not even consider moving our business.  I have spoken with other funds who agree.  The fact that IB charges the same commission today that it charged with stocks at 50% of the price in 2008-2009 augurs for significant pricing power.  Peterffy is highly focused on growth, however any increase in commission would likely be pure incremental profit. 

• Fortress Balance Sheet.  As of 6/30, IBKR had $40 billion of assets, 98.9% of which were liquid.  Zero long term debt.  Credit rating of A- with Stable outlook, which is superior to BAC, C, GS and MS.

• Conservative Risk Management.  On a 24 hour/day, 7 day/week real-time basis IB calculates margin requirements for each of its customers across all asset classes and currencies, and customer accounts are automatically liquidated on a real-time basis to satisfy margin requirements.

• Potential Sale of Company.  While I am not predicting an imminent sale, I suspect that there would be – at a minimum – 10-15 aggressive bidders for IBKR should Thomas Peterffy ever be interested in exiting.  The most likely buyers would be the largest global banks, while it is possible that technology firms would also be interested (effectively, IBKR is a technology company as much as it is a financial company).  To say that the cross-selling synergies available to a large global bank would be substantial would be an understatement (in 2012, WFC reportedly paid $100mm for Merlin, which reportedly had only 500 hedge fund clients).  Peterffy ~70 years old, has no children in management and in 2011 purchased a home in Palm Beach for $22.7mm, so it is not far-fetched to think he could be a seller at the right price.

Valuation

I have based my analysis on 2015E earnings, which I derive conservatively based on 1H annualized earnings.  Inputs are as follows:

• 15% growth in brokerage profits from 1H 2014 annualized.
• 0% growth in market maker profits from 1H 2014 annualized.
• Value broker at range of comps (SCHW, ETFC, AMTD), which range from 25-31x P/E.
• Value market maker in two scenarios:  1) going concern valued at 10-12x P/E and 2) liquidation valued at 1.2-1.6x equity assuming equity grows 15% over the next 1.5 years.  Recall market maker equity is compounding equity at 10-20% currently in a market of severely depressed volatility and earnings. 
• Apply fully public estimated tax rate of 25%.  This level is likely quite conservative, as IBKR enjoys a tax shield from the IPO structure and also benefits from a significant, but unknown, portion of its profits in low-tax jurisdictions.  As Peterffy said on the 3Q08 call, “To the extent our earnings derived from the US, Australian or Canadian territories, our tax rates are high. When they come from Europe or Asia, they are much lower.”  Asia is the fastest-growing segment of the business, and a significant portion of the company’s business is in Switzerland.
• Value excess regulatory capital at 75% of total.  While 100% of excess regulatory capital would be value accretive to shareholders in a strategic sale, IBKR is dramatically overcapitalized, allowing us to apply conservatively a 25% discount.  Also noteworthy is that IBKR has $0 long-term debt, while other companies borrow at the holdco level to meet capital requirements.
• Conservatively estimated (standalone) equity value/share of $39-48, representing 67-105% appreciation potential from current price of $23.44.  In a highly pessimistic scenario, valuing broker at low end of comps, market maker at only 1.0x equity and applying $0 value to excess regulatory capital leads to a valuation of $31, which is 33% above the current price.
• Regardless of how you choose to value the market maker or excess regulatory capital, the brokerage segment alone is worth 21-32% more than the current quote (more if you use 2016 numbers), and that very conservatively assumes that the much faster growing IBKR is valued in the same multiple range as much slower-growing comps.  While I am not arguing for a premium multiple in this analysis, I firmly believe that IB’s brokerage segment is worth a premium multiple due to its industry-leading growth, cutting-edge technology, low market share, and long growth runway.

Key Statistics

Document Links

• Latest investor presentation:  https://investors.interactivebrokers.com/download/IB_Sandler_ONeill_Presentation_6_4_2014.pdf
• Letter to SEC imploring broker disclosure of all-in trade execution cost:  https://www.interactivebrokers.com/download/execution_stats_comment_letter.pdf  
• Monthly brokerage metrics (Excel file):  https://investors.interactivebrokers.com/download/2014-07-Monthly-Brokerage-Data.xls
• NYT article on brokerage conflicts (not IB):  http://dealbook.nytimes.com/2014/06/17/trader-who-called-markets-rigged-tempers-his-critique/
• NYT article on hidden cost of trading stocks (not IB): http://www.nytimes.com/2014/06/23/opinion/best-execution-and-rebates-for-brokers.html
• Peterffy explains the “Magic” of his business:  http://www.fool.com/investing/general/2014/05/10/interactive-brokers-group-inc-ceo-explains-the-mag.aspx

Key Risks

• Further declines in market volatility, further depressing trading volumes.
• Shareholder unfriendly decision-making (highly unlikely given Peterffy’s historic shareholder friendliness and 75%+ ownership stake).
• Limited daily volume in shares, which averages ~360k.
• Deflationary spiral.

Catalysts

• Investor awareness of the company, its growth trajectory and runway.
• HFT regulations and publicity causing widespread migration of accounts from other brokers to IB.
• Improved corporate marketing – in my view, this is IB’s weak point.  I am a big fan of Peterffy’s, but he does the company commercials and he can be hard to understand.
• Divestiture of the market maker – Peterffy is sure to do whatever is in shareholders’ best interest here.  Presently, he seems to think there is good profit and great option value.
• Increases of regular dividend - the company can certainly afford it.
• Additional special dividends, which have been paid in 2010 and 2012, so time could be right for another.
• Strategic investment by large fund.
• Sale of company to large global bank.

Disclaimer:  The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice.  The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.  Please do your own work.

Catalyst