Interactive Brokers: Complexity Means No Coverage

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 (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

Comments

[borisb]

another well done article by the ZACH.

[WinstonKotzan]

i concur!

[Reinko]

This is a very interesting article, for example it says that Interactive Brokers provide 'liquidity to the markets' while they are listed on those markets themselves via a weird LCC construction that has 90% of the stock voting rights in it...

It sure is brilliant, after all these years I know why so often when major stuff is there, the DOW & friends end the week on a positive note in just the last 2 hours of trading.
For example: World wide all stocks go down hefty and there is panic in the air. The Footsie closed over 2% down on Friday but weirdly weirdly enough in the last hours of trading we have strong buying on the DOW & friends...

Please inform the CEO of IBKR the next: Combined debt of the US economy on itself runs at something like 50+ trillion so the interest is at least 2.5 trillion while this interest is constantly not paid all these years. The yearly interest is just over 18% of the gross domestic product of the real US economy. But no no no, the total debt only grows.

So you CEO from IBKR, you 'market maker' why don't you make your markets while I make mine?

Deal?

[DanielJacome]

good stock -- you forgot to model the incredible operating leverage the firms enjoys when things are good and they can keep their retention rates going.

Most of the costs are fixed, so the margins get nice and fat as the top line continues to propel forward. There is a tight institutional demand for the stock, given that there are only 40M shares out.

In the last quarter (ending Sept 07), we saw fund ownership jump from 35 to 53 - a 51%increase!!

The sell side is missing the 70% gross margin story and EPS in 08 is closer to 2 bucks, we think. The Street is modeling $1.68

[ZacharyScheidt]

Boris and Winston - Thanks!

Reinko - I'm not sure I connect the dots quite the same way you do, but I agree that our national debt and the personal side of that is a statistic that deserves more attention and could cause some very big problems over the next decade.

Daniel - You are right about the leverage available to the company. There is a lot of misunderstanding as to the earnings level of this company. $2.00 for 2008 may not be out of the realm of possibility at all.

Thanks for the comments!
Zach

[Reinko]

Hello Zach,

Just before the partying starts here in Holland let me give you a short answer:

I really do not have a clue if the company you report about is what I am looking for but in short it goes as next:

A few years back when the stockmarkets tumbled wouldwide and the DOW fell from 10500 to almost 7000 it occured to a lot op people here that the relative fall on the US stock markets was far smaller compared to all other stockmarkets.

It was found out that this was best explained via 'weird behavior' in the sense that US stock markets went up (often broadly) while all other markets fell (often in a kind of panic). Very often this was at the end of the trading day; suddenly stocks start to rise without any signinficant news.

The journalists from Radio Tele Luxembough (business version) also stumbled on that detail; one of the even said 'It must be the FED' but I thought that was a bridge too far: The hypothesis that the FED is actively supporing stock values belongs to the realm of weird conspiracy theories as far as I know.

But then what else?

You can argue that US stock traders are far more optimistic compared to other nations, but that carves no wood either.

So these 'weird behavior' of the US stock markets is still not explained properly and Zach: A kind of company that you described above could do it if it's pockets were deep enough.

__________

What about the debt, the Z1 release from the Federal Reserve makes very good reading, here is the link:

www.federalreserve.gov...

Go to the one last column, look at the total debt of the entire US financial sector. Annualize the Q2 to Q3 debt growth and calculate (estimate) that in 2008 the entire US financial sector needs about 2.5 trillion more debt...

That is a staggering number Zach.

Well, with some luck and via via I could lay my hands on a future estimate of M3 money stock from the Federal Reserve; And yes, the future 2.5 trillion was indeed included in it!

Ha, now I understand why they no longer publish the M3 money growth...;)

Have a nice year change in a few hours, where I live there is so much illegal fireworks that it sounds like a war zone (without the bullets).

Greetings & a nice 2008.

[ZacharyScheidt]

Reinko - you are more of a detective than I. Thanks for the insight.

Hope you had yours have a great start to 2008!