IBKR - Interactive Brokers

[Lowlight]

I own IBKR shares and was a buyer in 2015 as well.  While I won't say they are categorically cheap, I do think the company is currently undervalued by the market.  I show the brokerage division doing about $700 million in 2015 EBT given current run rates (this excludes the loss due to the Swiss franc).  If you assume a 25% tax-rate, you get NI of $525 million for the brokerage business.  At 25x earnings (significantly less than SCHW trades for), the brokerage business is worth $32.40/share.  The market maker division isn't easy to value so I assume they should be valued around $1.2 billion (roughly book value) or $3/share.  I do provide some value for the excess capital but assume that it isn't all available to be paid out as a dividend.  Therefore, I use $2/share.  This gets me to a value for the existing assets of $37.40 or ~4% higher than the current stock price.  Obviously no one is writing home to tell their family about this price discrepancy.

I believe there are three other elements attracting investors to the name. 
1) Margin expansion - The brokerage business runs at 60% operating margins but these should expand another 10% as revenues grow due to operating leverage.  Roughly $1.2 billion in run-rate revenues will produce another $120 million in pre-tax income if margins expand 10%.  At a 10x multiple this is another $3/share.
2) Pricing Power - IBKR is obviously the low cost leader.  The company has the capacity to raise the cost to use their brokerage platform at some point in time.  Today they are focused on growing the number of users and the products they offer to these users (I am perfectly happy with this focus).  At some point they will have a density and product offering large enough that they (or whomever they sell to) can price services significantly higher.  While they aren't really comps, think about the pricing power of Bloomberg and Intex.  Both currently exploit this pricing power to a meaningful degree and I think IBKR is building something (with admittedly much lower pricing power) that has value to a growing niche market throughout the world.  But admittedly, I can't begin to place a value on this pricing power.
3) Margin Costs - IBKR will benefit from rising rates as their customers are consistent users of margin and borrow on floating rates.  The spread over LIBOR IBKR charges could probably be increased fairly significantly without causing the typical margin account to leave.  I estimate they could raise the spread another 100bps without losing many accounts.  At $20 billion in margin balances, this equates to a $200 million pre-tax boost worth about $5/share.  - I know this is a form of pricing power, but it is one for which I can value...

Even with these other elements, to get to a 20%+ IRR you need to envision 1) a sale in the near term that unlocks value (highly unlikely in my opinion) or 2) high growth rates continuing.  With the growth in accounts in Asia and IBKR's cost structure being so much lower than competitors in China, I think it is fair to assume high growth rates continuing.  At 25x earnings for the brokerage division, I am assuming fairly healthy growth rates myself.  But I can see the case for an even higher multiple of earnings than that.  I think Peterffy expects brokerage to do $1 billion in EBT in 2016.  This implies ~20% growth if you assume no margin expansion. 

While I am not going to back the truck up at today's price, it wouldn't surprise me if I come to regret this 3-5 years down the road.

[kab60]

Thanks for the insight. I like the business, business model and management after doing some more reading, but I'm not so fond of the valuation. Will keep following. It might be a positive if company structure was simpler and there was more float but on the other hand exactly that might be one more reason to get in.

[benhacker]

I think IBKR is probably fairly valued under a reasonable analysis, but I think I can imagine several scenarios where they create new revenue streams that increase their value a lot.

1) maybe market maker stops sucking (I know I know... but maybe)
2) Check the last con call... Covestor acquisition looks real interesting...
3) Scottrade deal looks kind of game changing to me (not necessarily for immediate $$$, but what it represents)

At the end of the day, it's a well run company, that looks (as I've said before) to have a pretty unassailable position.  From that safe base, the company is leveraging itself into new areas which could grow for a long time. 

Future areas that may increase revenue - speculating on potential changes:
1) Bonds moving from dealer traded to exchange traded - I think this could be huge for IB
2) exchange traded IR Swaps, CDS, etc
3)

It's a great company, run by a smart operator with a history of absolutely killing it with capital allocation.  I wouldn't *bet* that amazing stuff will keep coming, but I wouldn't bet against it...

Ben - Still long and strong...

[kab60]

Their numbers, prices and deal with Scottrade does indicate that their brokerage business is superior but can anyone explain in plain English why and what stops other from copying? I understand the massive operating leverage but not how they got there.

[60°North Investments]

Their numbers, prices and deal with Scottrade does indicate that their brokerage business is superior but can anyone explain in plain English why and what stops other from copying? I understand the massive operating leverage but not how they got there.

From what I understand, it's about the software/infrastructure that they've built over the years. I'm not sure at all whether it's doable to copy and/or whether some comp is seriously considering that option or not. Having the whole system online gives them a cost advantage that would be very hard/expensive to replicate for comps that already have a large offline base. Still, how likely is it that this advantage will be threatened? I honestly don't know. It seems quite telling though that Scottrade wanted to use their platform.

[Lowlight]

Their numbers, prices and deal with Scottrade does indicate that their brokerage business is superior but can anyone explain in plain English why and what stops other from copying? I understand the massive operating leverage but not how they got there.

For me it comes down to the cost and channel used to execute trades. At other online discount brokerages the order flow is sold and therefore price execution is worse.  The online brokers don't mind because they sell the order flow and make money on the order, not just on the discrepancy between the cost for them to execute and what they charge their clients. Their models are designed to attract retail clients who don't calculate the cost of executing an order for $9.99 (and usually don't think about what kind of price execution they received).  IBKR's clients are very aware of their total cost to execute and therefore seek out the lowest cost provider.  They trade more frequently and price execution is often critical to success.  Additionally, IBKR's customers need little in the way of back office support on a day-to-day basis so they cost far less than the retail accounts at other brokerage firms. 

IBKR designed and built their infrastructure out of the needs of the market maker business.  So the platform seeks the probabalisticly lowest cost avenue to fill an order.  This therefore nearly ensures their clients better execution than elsewhere (at least against order flow being sold).  I think the software and systems they provide are also miles ahead of anyone else's.  It is possible that someone could build a platform that completes with IBKRs but it would require a new entrant to do so.  I just don't think the online brokers have the ability to spend what would be necessary to compete.  And since IBKR isn't going after their customers, it seems more logical that they might do what Scottrade did and just route their active trading account orders through IBKR. It allows Scottrade to retain accounts while cutting down their cost to service these trades.

Also as someone who manages a bond portfolio in my day job I can attest to the idea of bonds moving onto an electronic platform being a real concern for brokers.  There are many things occurring in fixed income that make me think this is likely to happen at some point.  Prices are far easier to discover now than just a few years back and consolidation is occurring to try and combat this. 

I don't that was all in plain English but hope it is somewhat helpful.

[Schwab711]

In less than 12 months IBKR has increased their US FX Broker market share by >3% from 7% to 10.2%.

http://www.financemagnates.com/forex/brokers/cftc-fcm-data-us-retail-forex-funds-drop-2-august-interactive-brokers-steady/
http://www.financemagnates.com/forex/brokers/interactive-brokers-retail-fx-funds-spike-11-8-in-march-cftc-data-shows/

Also, they were rated the best online broker in 2014 by Barron's:
http://online.barrons.com/articles/SB50001424053111904628504579433251867361162


What is the best estimate of their US equity broker market share? Can IBKR realistically realize 20% compound growth in earnings over a 10-20 year period? What is the implied 2025 or 2030 market share of the US equity/FX broker markets? IBKR is pretty close to the GEICO Warren Buffett described as it is the low-cost provider in a commoditized, large market and their cost advantage is significant. However, 25x takes away too much of the upside in my opinion. You need extremely optimistic expectations to expect returns >10% unless you feel you will get substantially more than 25x at time of sale.

https://docs.google.com/spreadsheets/d/1Vw7vtF-lhbLP3hXqcA9dxJz5i6NQELNu3XBuBismnx0/edit?usp=sharing
Assumptions:
* Price multiple at sale = purchase
* 20% compounded growth in earnings is sustained for 15 years

[Lowlight]

In less than 12 months IBKR has increased their US FX Broker market share by >3% from 7% to 10.2%.

http://www.financemagnates.com/forex/brokers/cftc-fcm-data-us-retail-forex-funds-drop-2-august-interactive-brokers-steady/
http://www.financemagnates.com/forex/brokers/interactive-brokers-retail-fx-funds-spike-11-8-in-march-cftc-data-shows/

Also, they were rated the best online broker in 2014 by Barron's:
http://online.barrons.com/articles/SB50001424053111904628504579433251867361162


What is the best estimate of their US equity broker market share? Can IBKR realistically realize 20% compound growth in earnings over a 10-20 year period? What is the implied 2025 or 2030 market share of the US equity/FX broker markets? IBKR is pretty close to the GEICO Warren Buffett described as it is the low-cost provider in a commoditized, large market and their cost advantage is significant. However, 25x takes away too much of the upside in my opinion. You need extremely optimistic expectations to expect returns >10% unless you feel you will get substantially more than 25x at time of sale.

https://docs.google.com/spreadsheets/d/1Vw7vtF-lhbLP3hXqcA9dxJz5i6NQELNu3XBuBismnx0/edit?usp=sharing
Assumptions:
* Price multiple at sale = purchase
* 20% compounded growth in earnings is sustained for 15 years

As the people I work with can tell you, I am a little slow at understanding excel files.  And I think I am missing something in the one you provided.  This feels like a stupid question and I will preface it by saying I haven't thought through this enough, but if earnings grow 20% per year and you sell at the same multiple as your purchase, why wouldn't your return be 20%?  For instance, if I buy a company for $20 today ($1 in earnings) and it earns 50% (using to make the math simple) and I sell at a 20x multiple 1 year later, I earn 50% as well ($30 divided by $20 initial price).  I believe the math would keep working the same way years into the future but I am typing on a phone so I'm not going to test it out.

To the point on IBKR, I think you have to take into account the fact that the pie is growing. Market share is one thing if the market size is constant but if the market grows 8-10% a year (given foreign market growth and prospects switching to online prime brokers), IBKR doesn't need to steal all of the business from someone else.  They can steal some and capture the growth in the market itself.  Now, I have no idea what the market growth rate will be but I suspect the pie will be much larger 20 years from now and IBKR will own a significantly larger piece of that pie.

I don't have my notes at hand but will come back to you on IBKR's current market share tomorrow.  Also, I like the GEICO comparison.  I think it is apt in many ways. If memory serves me correctly people didn't think BRK got a steal when they acquired the remaining 50% of GEICO.

[Schwab711]

In less than 12 months IBKR has increased their US FX Broker market share by >3% from 7% to 10.2%.

http://www.financemagnates.com/forex/brokers/cftc-fcm-data-us-retail-forex-funds-drop-2-august-interactive-brokers-steady/
http://www.financemagnates.com/forex/brokers/interactive-brokers-retail-fx-funds-spike-11-8-in-march-cftc-data-shows/

Also, they were rated the best online broker in 2014 by Barron's:
http://online.barrons.com/articles/SB50001424053111904628504579433251867361162


What is the best estimate of their US equity broker market share? Can IBKR realistically realize 20% compound growth in earnings over a 10-20 year period? What is the implied 2025 or 2030 market share of the US equity/FX broker markets? IBKR is pretty close to the GEICO Warren Buffett described as it is the low-cost provider in a commoditized, large market and their cost advantage is significant. However, 25x takes away too much of the upside in my opinion. You need extremely optimistic expectations to expect returns >10% unless you feel you will get substantially more than 25x at time of sale.

https://docs.google.com/spreadsheets/d/1Vw7vtF-lhbLP3hXqcA9dxJz5i6NQELNu3XBuBismnx0/edit?usp=sharing
Assumptions:
* Price multiple at sale = purchase
* 20% compounded growth in earnings is sustained for 15 years

As the people I work with can tell you, I am a little slow at understanding excel files.  And I think I am missing something in the one you provided.  This feels like a stupid question and I will preface it by saying I haven't thought through this enough, but if earnings grow 20% per year and you sell at the same multiple as your purchase, why wouldn't your return be 20%?  For instance, if I buy a company for $20 today ($1 in earnings) and it earns 50% (using to make the math simple) and I sell at a 20x multiple 1 year later, I earn 50% as well ($30 divided by $20 initial price).  I believe the math would keep working the same way years into the future but I am typing on a phone so I'm not going to test it out.

To the point on IBKR, I think you have to take into account the fact that the pie is growing. Market share is one thing if the market size is constant but if the market grows 8-10% a year (given foreign market growth and prospects switching to online prime brokers), IBKR doesn't need to steal all of the business from someone else.  They can steal some and capture the growth in the market itself.  Now, I have no idea what the market growth rate will be but I suspect the pie will be much larger 20 years from now and IBKR will own a significantly larger piece of that pie.

I don't have my notes at hand but will come back to you on IBKR's current market share tomorrow.  Also, I like the GEICO comparison.  I think it is apt in many ways. If memory serves me correctly people didn't think BRK got a steal when they acquired the remaining 50% of GEICO.

You are completely right on the first part. My assumptions are wrong and I didn't include terminal growth. Luckily it's worthless despite those mistakes.

I was attempting to find the expected returns for a given earnings yield and growth. I still don't have an adequate answer. Maybe a better idea is to calculate expected earnings for various traded vol, margins, and market share inputs to estimate the range of potential earnings power?

Look forward to whatever you have on IBKR market share or other facts. Haven't found anything on equity broker share yet.

As to what stops others from copying IBKR, there's a Buffett MBA talk floating around where Buffett mentions that he estimated it would cost $100b to have KO's market share in the soda industry at the time of his purchase (they had ~$1b in profit at the time). This meant a potential competitor would need $100b in capital just to earn <1% returns (KO is not going to sit idly as you fill every airway with your new soda ads). IBKR is using a business model that is initially capital intensive and heavily reliant on operating leverage/volume. Buffett's KO purchase rationale is not perfect since the broker market is much more complicated than beverages.

Another possible risk for IBKR is that the broker market could fracture over time as competitors become better at identifying their customers and tailoring their prices to dominate these sub-broker markets. Also, is the current record-low market volatility influencing IBKRs recent success since IBKR tailors to large-block trades?

[merkhet]

I'm reading the most recent conference call, and the Scottrade discussion is very interesting. Peterffy mentions that:

Our business is growing faster now than it did in the past several years and I believe that this will continue to grow faster.

Why? Let's look at the following developments during the quarter. Scottrade chose to use our platform to service their more sophisticated option trading customers. These are customers who maintain a complex set of option position and want to trade several different series on the same underlying in one order. The broker realized that it's less expensive for them to use our platform than to develop and maintain their own. We maintain each of their customers' accounts separately in the customers' name and they get the same technology as our direct customers get.

Why don’t they worry that their customers will come to us directly? Because our commissions are based on volume and we charge Scottrade as though their customers came to us from one account. This setup allows them or for that matter any of our introducing brokers to charge their customers the same lower rate we will charge them if they came to us directly. And yet keep the bulk of that commission for themselves and pay us less than it would cost them to maintain their own technology around those accounts.

If the broker also provides live contact and assistance as Scottrade does so well, they may even charge a service premium that many customers are happy to pay. This is a milestone event for us because it is the first big household name to decide to use our technology. The fact that Scottrade chose us to provide this service is a vote of confidence in our platform that we are proud of. We think it is an example that other brokers will follow and that eventually we will become the industry utility providing exceptional technology to brokers and advisors at a very low cost cheaper and better that they could do it themselves.

It's like they're changing the front-end brokers over to an MVNO system. My only problem is that I have no idea how to handicap the additional/accelerated growth.