Interactive Brokers: Getting Richer by Getting 'Broker'

The wild market conditions of 2008 have created unprecedented trading volumes in equities, futures and options. I think it’s time to own one of the healthy ‘transactional’ brokers - the computer-based firms that cater to the trading crowd. They don’t hold inventory of questionable securities and they don’t employ financial consultants to make recommendations to clients.

They do provide traders with direct market access to worldwide markets. My most favored selection in this group is Interactive Brokers Group (IBKR).

The company has a healthy balance sheet with low debt, plenty of cash, solid profits and very low capital spending. Its stock is near its all-time low price despite record or near-record sales, earnings and book value. Here’s why I like it right now.

This ultra-low commission firm offers what appear to be the lowest commission costs of any on-line trading firm while providing an outstanding trading platform suitable for professionals and experienced non-professional investors. They came public in a Dutch auction during spring 2007 at $30.01 per share. They’ve been making money in every quarter since then and posted great year-over-year comparisons in each of the three quarters this year versus 2007. Trailing 12-month EPS are now $2.21 making the current P/E a very low 7x.

Total debt is just 33% of capitalization with almost nothing coming due in the next five years. Book value is over $12/share making the price/book value a quite reasonable 1.2x. When the markets were hot, IBKR shares traded as high as 17x earnings and 3.4x book value.

IBKR holds no questionable paper on its books and earnings are growing in a poor market environment. I predict a big rebound in share price just on a decrease in investors’ flight from risk. Consensus estimates for 2009 now are running at $2.30 - $2.35 so a move back to even 10 times earnings should result in a 12-month share price of at least $23 or up 48% from yesterday’s close. Is that crazy? Hardly. IBKR shares hit highs of $34.25 and $35.93 in 2007 and 2008 and perhaps more importantly, they hadn’t traded below $21 ever until the panic sell-off of the past few months.

At $15.46/share I see very little downside and substantial upside that may be available very quickly once the mood brightens even a little bit.

Here’s a great < 7 month play on IBKR for those of you who are option savvy:

…………………………………………...Cash Outlay ……….. Cash Inflow

Buy 1000 IBKR @ 15.46 ………………. $15,460

Sell 10 June $20 calls @ 1.35 ………………………………….. $1,350

Sell 10 June $15 puts @ 2.45 ……………………………………$2,450

Net Out-of-Pocket Cash ………………… $11,660

Maximum profit would be achieved if IBKR finishes > $20 on Jun 19, 2009.

If IBKR is at least $20 on expiration date (+ 29.4% from today):

• Your $20 calls will be exercised and your shares sold for $20,000.
• Your $15 puts will expire worthless (a good thing for you as a seller).
• You will have no further option obligations.
• You will have $20,000 cash for your $11,660 outlay.

That’s an $8340 gain on $11,660 or + 71.5% on a 29.4% move in the stock.

Suppose the shares are unchanged on expiration date?

• Your $20 calls will expire worthless.
• Your $15 puts will expire worthless.
• You will have no further option obligations.
• Your will still own 1000 shares of IBKR with a value of $15,460.

That’s a $3,800 gain on your $11,660 net outlay or + 32.5% on shares that did not go up.

If IBKR shares are < $15 on expiration date you would be forced to buy an additional 1000 shares due to the $15 puts being exercised.

Here’s a summary of that worst case scenario:

…………………………………………...Cash Outlay ……….. Cash Inflow

Buy 1000 IBKR @ 15.46 ………………. $15,460

Sell 10 June $20 calls @ 1.35 ………………………………….. $1,350

Sell 10 June $15 puts @ 2.45 ……………………………………$2,450

Buy 1000 shares via put exercise ………..$15,000

Net Out-of-Pocket Cash ………………… $26,660

In this case your $20 calls would expire worthless.

Your $15 puts were exercised.

You now would own 2000 shares for a total net outlay of $26,660 or an average price of $13.33/share. That’s $2.13 below the original price point or a drop of 13.7%.

At $13.33 your P/E would be just 6.03x today’s trailing earnings and very close to one times tangible book value.

This combination play offers very good total return potential if the shares go up, or even if they stay unchanged. You are protected against loss even if the shares drop almost 14%.

Disclosure: Author is long IBKR shares and short IBKR options.

Comments

[Paul Price:]

Another similar, debt-free, very profitable discount brokerage stock is OptionsXpress [NDQ:OPXS] now at $11.54 /share and < 7.6x 2008 EPS.

2008 Dec 26 09:40 AM

[claudio.lan...:]

Even though I have never made one of Paul's trades primarily because I have never traded options. His analysis for pros and cons is absolutely great. I feel as though I am losing money every time I read one of his posts and don't take action.
Paul keep up the great posts.. I don't know your email address otherwise I would send you a thanks directly.

2008 Dec 26 11:20 AM

[Zachary Sch...:]

I've been impressed with IBKR's platform in the past and I know they continually work on improving their interface. They have the ability to work with independent investment advisers which should be a profitable business as talent begins leaving large institutions and setting up their own shop (I think this will be a trend in 2009 as well performing teams feel slighted at bonus time due to firm-wide weakness).

A move just taking them back to the 2007 IPO price would be nearly a double. Certainly a good long-term play in my opinion.

Thanks for the great post!
Zach
zachstocks.com

2008 Dec 26 02:10 PM

[SeekingTruth:]

Paul, Thanks for a splendid article.
You are obviously high on Interactive because of their financial condition, operations, etc. How would you rate the various Discount brokers when considering all the factors : financial stability , range of services, customer service, fees , etc. , and which would be your choice for an account, and why? If disinclined to do this, could you at least tell us what you think of ThinkOrSwim, or perhaps a better choice? Thanks in advance for any help you are willing to offer.

2008 Dec 26 06:29 PM

[Glen Bradford:]

Paul,

I just read a few of you're previous articles. You're recommending this strategy for several companies. So, basically, you're "market bullish" with a 1 year time frame. Hopefully you're playing these leveraged up strategies with a portion no greater than 25% of your portfolio. I'm pushing about 20% leveraged north.

Take a look at MTW. Would you advise selling the stock and buying the calls?

2008 Dec 26 09:26 PM

[Paul Price:]

On Dec 26 09:26 PM Glen Bradford wrote:

> Paul,
>
> I just read a few of you're previous articles. You're recommending
> this strategy for several companies. So, basically, you're "market
> bullish" with a 1 year time frame. Hopefully you're playing these
> leveraged up strategies with a portion no greater than 25% of your
> portfolio. I'm pushing about 20% leveraged north.
>
> Take a look at MTW. Would you advise selling the stock and buying
> the calls?


Glen,

Manitowoc looks good at today's price. Even with EPS projected lower for 2009 it's just over 3x EPS and its yield is better than typical.

MTW would be a good candidate for my type strategy.

2008 Dec 27 05:33 AM

[Paul Price:]

Glen,

I typically put no more than 5% of my portfolio in any one position.

I rarely buy options. I sell options regularly.

2008 Dec 27 05:37 AM

[Paul Price:]

This write-up on IBKR was in this week's Barrons Dec. 29, 2008 issue:

OPENING DOORS TO ASIAN MARKETS. Interactive Brokers (interactivebrokers.com) is making a big push into the Asian markets. The firm acquired Moriai Securities, a Japanese broker-dealer, earlier this month. That will make it possible for Japanese institutions to access IB's technology. By early 2009, domestic Japanese customers will be able to trade.

The firm also received Commodity Futures Trading Commission approval a few weeks ago, allowing its U.S. customers to trade the KOSPI 200 Futures on the Korean Stock Exchange. Andrew Wilkinson, IB's director of media relations, notes that the KOSPI is one of Asia's most liquid markets, with an average of 24.5 million contracts traded daily in the first half of 2008. Volume dropped in October and November to about 8.5 million contracts a day, though that's still a lot of activity. Trading KOSPI options is limited to qualified institutional clients at this stage.

Wilkinson says interested clients need a broker with access to the Korean Exchange, either as an individual member or via an affiliate. IB has taken the latter path. Wilkinson also believes IB is one of the few, if not the only, broker offering this service to U.S. customers. We searched our database and couldn't find another one offering this particular contract.

IB has announced the launch of Australian CFDs (contracts for difference) on the Australian Stock Exchange and opened an office in Mumbai, India, where it expects to make its first customer trade in the local market by year-end. It's also begun making markets in Taiwanese equities and is trying to establish a Chinese office. Thomas Peterffy, IB's CEO and chairman, says, "We want to hire more software people -- computer programmers -- and expand our sales force."

2008 Dec 27 03:52 PM

[MoneyPro:]

Paul,

Thank you for your Options ideas. Your strategies are well considered and very helpful.

I hope you will continue to contribute and educate on this worthwhile subject.

Brad

2008 Dec 30 12:20 AM

[Paul Price:]

IBKR reported Q4 earnings today.

$0.49 v. $0.46 or + 6.52% year-over-year for the December quarter.

$2.24 v. $1.69 or + 32.54% for 2008 versus 2007's full year.

At today's close of $16.32 these shares are just 7.3x last year's EPS despite the nice growth.

I'm continuing to accumulate shares.

Jan 22 04:57 PM