I have recently made IBKR a rather large position. Before I get into the long thesis, I'd like to ask a question: How many people on this board use Interactive Brokers? If you don't, who do you use?
The short answer is this: Any professional investor has no other option except IBKR, especially if they use leverage. No other broker offers the commissions, direct access, and margin rates that they do.
Why is IBKR interesting here? Well, historically, they have made 80+% of their money as an option market maker. The last 2 years the options market making business has been a disaster and the CEO, who owns 90% of the company and started it, has announced that they might wind it all down and just focus on the broker business. This sparked my eye.
The elevator pitch is this: There are 400 Million shares, dilluted, outstanding - but only ~42 million float. $2.8 Billion of capital, or $7 a share, is in the market making business. $1.4 Billion is in the broker, and it's overcapitalized. Thomas Peterffy (TP, the CEO) has stated that if the market making business doesn't return to making a decent ROI, they will shut the business down and return all this capital to shareholders. They returned $1 Billion in Q4 to start. Note: The market making business once brought in almost $1b in pre tax earnings! It now only does ~150m a year and still shrinking. It's basically long vol and needs the vix to be in the mid 20's for ideal conditions. But, let's pretend it doesn't ever go back to earning a decent ROI and TP returns all $7 to shareholders. What does that leave us?
We have $8.50 left with a book value of $3 and change. But it's a pure play brokerage that requires no capital to grow, has tiny cap ex needs, and has 50% pre tax profit margins! It's all automated, growing new accounts 20% a year, and growing bottom line at 20% a year. There are no true competitors (take it from me, I wanted to leave them or find a back up account and couldn't) and they currently have 164k accounts and TP estimates the addressable market (savvy financial professionals) to be 2 million globally.
They will do ~55 cents in 2011 in EPS in the brokerage business, so you are paying 16x for this fantastic business. It is very likely that in 2013 they do close to a $1 in EPS given growth in new accounts and a small uptick in fed funds rate. Schwab, Ameritrade, etc, all trade at 20x. This business has literally no need for capital and should not be valued off of book.
The reason I really like it is what's your downside? Todays book = $10.50 + a funky tax attribute that puts it at $12. The tax situation is very odd and still trying to get to bottom of it but their effective tax rate is only 12% due to the way it was set up. My numbers above (55 cents in 2011) assumes 35% tax rate and full G&A hit if they shut down market making. The street expects them to earn 80-90 cents in 2011 combined with market making. I think downside is extremely limited and upside is mid 20's in 18-24 months or so.
The way I played it is I sold Jan 12 and Jan 13 puts, strike $13.21 (funky cause of the 1 time dividend they paid) at 45 and 85 cents, respectively. If I am put the stock, I'm put it below book which is highly liquid securities that can be run off in under 3 months. I then bought Jan 13 18.21/23.21 call spreads for 85 cents which will pay $5 at max return, or almost 6x. One could just put on the call spread and not sell the puts but I like the combo trade. I also own the common given how low margin rates are on IBKR and how low the downside is, I have no problem using leverage to own this and have made it a pretty big position in my book, ~25%.
I can answer questions. In short, the catalyst is that Market Making, a crappy business, is being shut down/irrelevant, while the brokerage business has finally grown to a level where it's making real money. It used to be <20% of profits and in 2011 will be >50%.
