Interactive Brokers Group: The Best Of The Brokers

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About: Interactive Brokers Group, Inc. (IBKR), Includes: ETFC, SCHW
by: Nairu Capital
Summary

Interactive Brokers is one of the highest-rated brokers due to its low commission and fee structure.

Google Trends' interest in the company is steadily rising while falling for many of its competitors.

I expect continued user growth to cause the company's earnings to double again over the next three to five years.

E-Trade looks like a much worse opportunity, so a long IBKR, short E-Trade pairs trade may make for a profitable systemic-risk hedged opportunity.

Admittedly, Interactive Brokers (IBKR) is near a dear to my heart as I am one of the company's many customers. For me, the company is the perfect Peter Lynch-type GARP (growth at a reasonable price) stock. It is a company I know as an end-user, so I have reason to believe that it will become increasingly popular as investors continue to switch to lower commission options. Even more, due to the stock's massive decline last year, it is now trading at a significant historical discount.

Let's dig into the company's growth rates and future earnings in order to estimate the fair value.

Growth Rates and Future Potential

The company is one of the fastest-growing, large broker-dealers and has seen client accounts grow 16% per year over the past six years and 20% in 2018. This growth is supported by the fact that the company has significantly lower margin rates and commissions than its competitors.

Take a look at the price of the stock vs. the company's annual revenue growth:

Chart Data by YCharts

As you can see, IBKR has managed to grow its top line by roughly 90% since 2015 or a CAGR of around 18% per year despite a non-volatile financial market.

Most economic and financial signals point to higher volatility. Volatility is a bit of a double-edged sword for most brokers because it causes them to earn higher commission revenues in the short run, but are often left with account closures thereafter and potential balance sheet risks. Fortunately for IBKR, it caters primarily to "smart money" clients that are far less fickle than E-Trade (ETFC) or other retail-oriented brokers.

If anything, the next major wave of volatility will likely be the catalyst that pushes many investors away from the high commission to lower commission brokers. If you are curious, take a look at their commission schedule as reported on their recent 10-K:

(Source - 2018 Annual report)

Please note, I do not intend to be advocating its product. I am advocating its stock via the value the company provides for its customers and the growth potential it generates.

Like banks and cable providers, brokerage customers tend to be very sticky and not change unless they feel they've gotten a bad deal or see very high value in switching. Accordingly, client growth rates tend to be sticky and it is likely that Interactive Brokers will continue to grow at a similar rate for quite a few years to come as users continue to slowly leave high-cost brokers.

Google Trends Search Interest Analysis

One of my favorite tools when looking at non-B2B companies is Google Trends. It lets us clearly compare public interest in various companies and even estimate customer growth before it is released to the public.

I broke down search interest for Interactive Brokers using the term "(broker) login" (i.e. "interactive brokers login") to estimate usage growth for IBKR, E-Trade, Schwab (SCHW), and TD Ameritrade (NASDAQ:AMTD). After grabbing the search data for each of the four keys, I normalized the data (subtracted mean and divided by standard deviation) in order to fit each on a single chart for comparison purposes and then smoothed the data using an EMA and adjusted it so that all results are positive. Here are the results:

(Data source - Google Trends)

This chart is the cornerstone of my long thesis for Interactive Brokers. There are two key important takeaways from it.

First, Interactive has the highest growth rate. Its "login" search interest has grown 3.5 standard deviations since 2008 while the others have only grown 3 or less.

Second, the "login" interest for IBKR is way more stable than the others, signaling that this growth rate is unlikely to fade anytime soon. By far, E-Trade has extremely volatile search interest. This is most likely because E-Trade clients (which I was years ago) tend to have smaller accounts with higher turnover than those of interactive brokers. Schwab and Fidelity has less search stability than IB, but more than E-Trade likely because they cater to longer-term investors and retirement accounts.

Today, we can see that search interest in IB's competitors has been on a sharp decline while that of IB is back at its peak. To see this outperformance, take a look at the Interactive Brokers line (in red above) minus the average of the other three:

(Data source - Google Trends)

As you can see, IB is skyrocketing in search of interest compared to its peers. Perhaps this is a sign that a "long IBKR, short E-Trade" pairs trade could be a profitable way to bet on IBKR with less systemic industry risk.

It is clear that the Interactive Broker's top line will continue to grow at a high rate. If users continue to switch, I would not be surprised to see the company's revenue and client base to double again over the next five years so long as interest rates do not continue to fall.

Let's jump over to the company's bottom line and try to give IBKR a forward-looking valuation.

The Earnings Perspective

High revenue growth is positive, but for a profitable investment, we need two more factors, earnings growth and a reasonable price. In my opinion, IBKR offers both, but with some caveats regarding interest rates.

The company's revenue comes from two major sources, commissions (32% in 2018) and interest income (59% in 2018). Commission revenue is very stable and predictable while interest income depends a lot on investor risk appetite and interest rates. Take a look at the chart below of the company's net interest income per quarter:

Chart Data by YCharts

As you can see, this metric rises in "red hot speculative" markets (as in 2017-today) and falls in bear markets as in 2008-2010.

Take a look at the same metric as a percent of total operating revenue:

Chart Data by YCharts

As you can see, IBKR is becoming increasingly dependent on interest income as its primary revenue source. In my opinion, this is good because I expect commissions to fall across the industry and expect interest rates to climb. Still, it does pose a risk in the event of an equity crash.

That said, net margins as a percent of client equity have been on the steady decline since 2011 so that risk is mitigated because margin calls are unlikely:

(Source - Interactive Brokers 1Q19 Investor Presentation)

Speaking of which, it is worth noting that the company auto-executes margin calls, which means it is unlikely to be picking up customers' bills in the event of a crash. This is how it safely can charge lower margin rates.

Overall, I expect its earnings growth to be in line with revenue growth. Market shocks and interest rate changes could create wide temporary variances in earnings, but over the long run, I expect the company to see EPS double by 2024-2025.

The Price is Right

Following the recent crash in the company's stock, it is trading at a significant historical discount. Take a look at IBKR's price-to-sales ratio over the past decade:

Chart Data by YCharts

It is higher than in 2013, but everything is higher than in 2013. Looking over its high growth rate years from 2015 onward, the stock is at a roughly 30-40% discount.

Moving over to earnings, take a look at the company's forward "P/E" ratio since 2018:

Chart Data by YCharts

Once again, the stock is at a discount and is trending higher. The company currently makes around $2.3 per year in EPS. I expect this figure to climb to $5 per share over the coming years. The company has a BBB+ credit rating with a positive outlook, so I expect that rating to climb to A. This gives me an estimated equity risk discount rate of 6% or a "fair" share price of $5/.06 = $83 per share or a 66% expected return (over the years).

Pairs Trade Idea

You can bet directly on the stock via a long position but that comes with the risk of an equity market crash. Indeed, a crash would certainly put a dent in broker-dealer stocks even if they are great businesses like Interactive Brokers.

This would likely result in 25-50% declines and, though it would create an amazing buying opportunity, it would pause my growth expectations. If you'd like to hedge that risk, long IBKR, short ETFC (E-trade) could be a profitable lower-risk opportunity. Here is a chart of that pairs trade's recent performance via the total-return ratio:

Chart Data by YCharts

Note: Look at how this ratio skyrocketed in 2008. Of course, that may have been a one-off due to E-Trade's market exposure, but because IBKR is much more defensive than E-Trade, I expect a market crash to boost this ratio again. Even more, you can see that it is around an up-trending five-year low so the pair is trading at a historical discount.

Overall, I like IBKR and give it a "buy" rating. Because markets are in a precarious position, the stock could certainly see declines, so I believe the best opportunity is hedging the position against E-Trade. This leads me to give ETFC a "sell" rating.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IBKR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: May/likely to short ETFC over the next 72 hours.