Interactive Brokers' (IBKR) stock is down 28% since my bullish article on Seeking Alpha. The volatility on the stock has been substantial, hitting a low of $19 on 9/17 and since recovering to close $24 on 9/26. I’m still bullish on the company.
Reasons behind the fall
In addition to overall market issues, the stock underperformance has been driven by the following two main reasons:
- On July 24, the company reported Net revenues of $395.4 million and income before income taxes and minority interest of $259.3 million for the quarter, compared to net revenues of $294.7 million and income before income taxes of $164.5 million for the same period in 2007 (a 58% increase). Reported diluted earnings per share of $0.44 for the quarter ended June 30, 2008 but the analysts, who hadn't received guidance from the company, expected 50 cents a share. The Company’s earnings were down sequentially from Q1 by about 5.5% due to a drop in market making profits. The stock traded down 19% from $32 to $26.
- US retail investors dramatically reduced their trading activity during August. Ameritrade reported that client trades during last month were down 7% from August 2007 and down 17% from the prior month of July. Schwab's August trading fall off was 20% from July, and down 12% from the same month last year. These bad numbers prompted an online broker sell-off, IBKR included, amid investor fears that an industry-wide slowdown was now underway.
The market does not understand the company well
In my view the market reaction to Q2 results was largely unjustified and resulted from a misunderstanding of the company’s business. The company does not provide guidance for analysts. This is something that I like a lot. Like Berkshire it is not interested in playing Wall Street's myopic short term earnings game. While the more stable electronic business showed healthy q-on-q gains, the market making gains declined slightly q-o-q. Analysts and the market in general do not appreciate the fact that the market making business of IBKR (largely on derivatives) is highly profitable but lumpy. Tom Petterfy the company’s CEO, founder and controlling shareholder explained:
Market maker business performance depends on three things volumes, competition, and implied versus actual volatility.[…] Now as far as actual words as implied volatility is concerned, while actual volatility was 98.6% of implied in the first quarter, it sneaked to 86.6% in the second quarter. This is a substantial change and it reflects – and it is reflected in our results going from Q1 to Q2. It is important that you follow this, so let me repeat. During the first quarter of ’08, actual volatility was 98.6% over implied. So they are almost the same. In the second quarter, actual volatility was 86.6% over implied. So, it was substantially lower than they implied. As I said on occasions, implied volatility tends to lag actual volatility. Lower actual volatility while the implied volatility remains high is not in our favor. In the first quarter, we saw the opposite. Actual volatility moving up over implied. That was good for us. The reverse is what happened in the second quarter. That is not good for us. Active periods followed by quite ones is a regular pattern in the markets, this makes our Market Making results going from quarter to quarter bumpy. You will see fluctuations along the long-term trend. The fluctuations are not important, the long-term trend is important, and you must be able to determine. I hope you can.
It remains to be seen what the impact of the nuclear winter that’s setting in the financial markets will be on the brokerage business of a company like IBKR. Clearly global volume growth is likely to slow down or even shrink.
However IBKR’s customers are not the lambs who are being slaughtered in the markets, rather it's the high volume experienced traders (individuals or smaller institutions) who use derivatives and play both short and long and who understand the impact of minimizing execution costs on their returns and who invest across borders and asset classes. These are sophisticated investors who may well be thriving in the current environment. In addition IBKR continues to spread its operations internationally; over half of new customers are currently coming from outside the United States.
As a survivor, the company should also benefit from the troubles that Wall Street and other brokers are having. Although the bulk of prime-brokerage business, having shifted away from the Lehmans and the Morgan Stanleys of the world, may go to larger players, some hedge funds may decide to diversify and give some of their business to an institution like IBKR, that they know is not investing in toxic garbage and that has a reputation for acute risk management.
The Company is fighting back
In March and again in September the company has been running page-wide adds on the WSJ to encourage worried clients to move their accounts to IBKR. Following Lehman’s collapse, IBKR offered to step up and take over Lehman’s OCC clearing accounts (Options Clearing Corporation is the largest clearing house for listed derivatives in the world), although Barclays (BCS) ultimately ended up doing this.
The company came out last Thursday 9/25, after market close, and pre-announced strong expected income before income tax and minority interest of between $325 million and $375 million (diluted earnings per share to be between $0.55 and $0.65) for the quarter to end on September 30, 2008, and the approval of a share buyback program of up to 8,000,000 shares of the company's common stock (about 20% of the float). This was after having scrapped in May a follow-on offering of 50,000,000 shares. This indicates the company believes the shares are trading at a substantial discount to fair value. The Stock jumped almost 15% a result of this.
Although this stock is in the SEC shorting ban list, it still has a very substantial open short interest (pre-dating the ban), representing about 20% of the float. If the Company’s results are confirmed to be strong and the company executes the repurchase, it will be interesting to see how it plays out. I suspect it could be the beginning of a tremendous short squeeze. As the old Berber saying goes “the dogs bark but the Caravan moves on”.
DISCLOSURE: LONG IBKR.