Interactive Brokers: Complexity Means No Coverage

| About: Interactive Brokers (IBKR)

Several years ago, as a young inexperienced trader, I opened a very small personal account with a deep discount broker. The small amount was everything I owned - and it soon became a much smaller amount - but the lessons learned were extremely valuable and were instrumental in my passion for the markets.

Fast forward to the present day and Interactive Brokers (NASDAQ:IBKR) is now publicly traded. The company earns commissions on brokerage transactions, but makes the bulk of its revenues through market making activities providing liquidity in many different markets across the globe.

Interactive Brokers has faced more than its share of challenges in the very short amount of time it has been trading. While the company has been operating for the last 30 years in some form or another, the stock was listed on the NASDAQ in May in a very non-traditional offering which did not include the typical underwriting firms one might expect. In fact, Interactive Brokers itself was listed among the boutique investment bankers participating in the deal.

The first challenge is the lack of mainstream institutional coverage both in the IPO stages and secondarily as a publicly traded company. I believe the reason most traditional research companies are not willing to cover IBKR is because of the very complex ownership structure that creates a cumbersome legal model. There are many moving parts but the basic premise is that the CEO of the company will retain ownership of an LLC that holds a 90% voting right in the company. This could create a conflict of interest at some point down the road if a situation arose where investors felt they needed to make a management change.

The second major challenge came in the second quarter when a stock manipulation plan wreaked havoc on German markets and caused many market makers to suffer losses. The effect was not only the transaction losses revolving around the particular stock, but also a sudden drawback of liquidity as market makers lost capital and had to decrease the amount of capital they could put into trades. Since that time, Thomas Peterffy, who is the CEO and primary shareholder, bought the legal claim to the loss from IBKR and the payment for this claim reimbursed the company for the losses. This was an extraordinary gesture of goodwill but the effect of the situation still resulted in a decline in the stock price.

Moving to the third quarter, IBKR has rebounded nicely with the fundamentals pointing towards resumed growth in all business segments. While the quarter was challenging for many financial institutions who have had exposure to credit derivatives and have taken write downs, Interactive Brokers thrived on the expanded volatility taking significant gains in market making activities and continuing to provide liquidity to the markets. The company has a very conservative financial structure with excess regulatory capital that allows them to continue to stay involved when many of their competitors became too extended and had to cut back on market making activities.

IBKR believes that its specialty lies within the option contract markets. During 2006 the company was the number one liquidity provider on the Chicago Board Options Exchange [CBOE], the International Securities Exchange [ISE], and the Pacific Stock Exchange [PSE] - all of which represent the largest US option exchanges. A recent independent report noted that 14.9% of all option orders receive price improvement (customers get a better price than the quoted bit or ask) while the industry average is less than 1%. This is a great marketing statistic and the company is trying to leverage this information to bring in new customers.

Despite the attractive growth and strong financial position, the company is getting very little press. This is likely due to the complex capital structure but it is my opinion that many sell side analysts are not willing to do the necessary due diligence on the company to uncover the value being created. This lack of institutional coverage actually works to the individual investor's benefit if one is willing to dig up information on the company using publicly available documents. The multiple is very attractive given the growth rate of the company and when analysts finally get around to covering the stock, it's likely they will generate interest that will propel the price higher. While currently overlooked, I believe this stock offers great potential for investors willing to work a little harder for information.

Disclosure: Author does not have a position in IBKR