Interactive Brokers Group To Benefit From Electronic Trading And Bank Regulations

Apr.30.12 | About: Interactive Brokers (IBKR)

Electronic trading is gaining ever bigger presence and one of the companies to benefit from this trend is Interactive Brokers Group (NASDAQ:IBKR). The company is based in the hedge-fund capital Greenwich, Connecticut and is constantly ranked at the top by Barron's. I believe that at current price level its stock is undervalued, and is a good investment for the next few years given its leadership position and growth prospects.

Second, Interactive Brokers has a better profitability measurements by its competitors, most notably Knight Group (NYSE:KCG). Third and finally, Interactive Brokers Group seems to be gaining following the recent failure of MF Global, the financial derivatives broker, and investment banks decrease in market share in the brokerage industry, particularly Goldman Sachs (NYSE:GS). Due to regulations, political pressures, and geographical restrictions, investment banks are more restricted than ever. I think that pure play electronic trading companies, such as Interactive Brokers, will benefit from the loss experienced at investment banking.

Interactive Brokers has 46 million shares outstanding for a market capitalization of about $700 million and pays a quarterly dividend of $0.10 per share for an annual yield of about 2.5%. The company went public in April of 2007 at about $30 per share, only to see its shares nosedive as the financial and economic crisis of 2008-2009 unraveled. The stock price never recovered, and I believe its valuation level is attractive. Currently, the shares trade at a price to earnings ratio of about 13 based on an annualized first quarter earnings of $0.30 per share and I believe it should be closer to 20.

The company earned $1.39 per share in 2011 and I expect it will earn $1.35 to $1.40 per share in 2012, which is slightly higher than the average estimate of $1.32 per share. This gives a forward looking price to earnings ratio of about 12, which for a high-tech financial services company is very low. My earnings estimate is slightly better mostly due to the company's business model which is scalable in strong and volatile markets such as the one we are witnessing now.

For example, in 2011, the company outperformed each quarterly estimate. While in the first quarter of 2012 the company reported net income slightly below estimates, I think in the remaining three quarters it will revert to outperforming. I think that outperformance will come from the following areas: continued strong performance of brokerage, recovery in trading volume of options, as the company continues to explore growth initiatives in the financial advisor area, and as the new trading interface, Mosaic, gains more traction.

Interactive Brokers has a global reach with offices in the USA, Switzerland, Canada, Hong Kong, UK, Australia, Hungary, Russia, India, China and Estonia. After the financial meltdown in 2008-2009 and the subsequent increase in regulation of investment and other banks, I believe Interactive Brokers is well positioned to grow and reward its shareholders. The proliferation of electronic trading will also contribute to this technologically oriented and innovative company.

Interactive Brokers was started in 1977 by an Eastern European-born immigrant who emigrated to America at the age of 21, Thomas Peterffy. Now the company employs over 800 people, most of them in the United States. In addition, the company automates trading and provides significant advantages to investors at home and abroad by replacing most of the tasks performed by overpaid traders. In a recent interview for The Wall Street Transcript [subscription required], Thomas Peterffy stated that Interactive Brokers charges approximately 75% less for its services than other brokers in addition to offering other benefits such as superior trade execution and exceptional breadth and depth of products.

In terms of profitability, Interactive Brokers has one of the best margins. Its earnings before interest, tax and depreciation margin is almost 50% compared to 14% for Knight Capital Group (KKG), a smaller competitor. While Interactive Brokers Group margins are three times higher than these of Knight Group, Knight Group has a forward price to earnings ratio for 2012 of about 10, only 20% lower than the price to earnings ratio of Interactive Brokers.

I do not think that Knight Capital is overvalued, so it seems that Interactive Brokers Group is significantly undervalued. In addition, due to its tax advantaged structure, Interactive Brokers tax rate is less than 10% (lower even than that of Presidential candidate Mitt Romney) compared to a tax rate of 38% for Knight Group giving an additional benefit to shareholders. While Interactive Brokers pays back 85% of tax savings to the holding company, it still keeps 15% available to current shareholders.

During 2011, Interactive Brokers was able to increase its brokerage-cleared trades by 20% and market making in options by 16%. This gain in derivative and brokerage businesses is mostly due to a trend of investment banks participating less and less in these activities. For comparison, Goldman Sachs reported over 12% decline in market making revenues in the first quarter of 2012 compared to the same quarter last year. This followed declines of 32% and 38% for the full 2011 and 2010 years, respectively. In addition, as the Interactive Brokers CEO confirmed during the first quarter earnings call, the company is also benefiting from the failure of MF Global.

I believe all of these factors will help the company to grow and will reward investors who own Interactive Brokers stock. At current price levels, investing in shares of Interactive Brokers Group, the second-largest non-bank broker-dealer by equity capital, makes a lot of sense.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.