The Security I Like Best: Interactive Brokers

“I always have been attracted to the low cost operator in any business and, when you can find a combination of (i) an extremely large business, (ii) a more or less homogenous product, and (iii) a very large gap in operating costs between the low cost operator and all of the other companies in the industry, you have a really attractive investment situation.” – Warren Buffett

 

Interactive Brokers (IBKR) currently offers a rare opportunity to invest in an extremely high-quality, fast-growing compounder operating within the large, secular growing electronic online brokerage industry. IBKR is a fully-automated electronic online discount broker and market-maker that was founded by billionaire Thomas Peterffy in 1977. The thesis is pretty simple: 1) The e-broker business is massively under-earning WRT its true earnings power and 2) due to IBKR’s extremely deep and durable moat which allows the e-broker to operate with the lowest-cost structure in a largely commoditized industry, the business (with considerable operating leverage) should be able to grow after-tax earnings at 30%-35% per annum over the next 3-5 years or more.

If that isn’t enough for you, then we also have several free “call options” that I have not fully priced into my base case valuation.

1) Tremendous earnings accretion from having a steadily growing margin lending business being leveraged to rising interest rates,

2) Under-appreciated enormous untapped pricing power in the brokerage business, and

3) At this stage of the cycle, the business is a great hedge against rising market volatility based on the rather subdued daily average revenue trades (DARTs) per average account metric

 

Pricing is by far the most important driver within the global electronic brokerage industry, and IBKR is by far the price leader in margin lending and commission rates since the business operates at an enviable position at the low-end of the industry cost-curve.

Figure 1: Comparing IB’s margin and commission rates with its largest US competitors

IBKR’s deep moat is sustainable not because its intellectual property can’t be replicated[1], (although it will be an extremely difficult and time-consuming process) but because its main competitors largely operate with a different ethos. In the US market, Schwab, TD Ameritrade and E-Trade primarily target the mass online retail market and employ a more asset-intensive distribution and sales model by deploying physical branches and large sales forces; their services are tailored to less financially sophisticated, lower-value accounts. In order for IBKR’s competitors to profitably price their services even remotely close to IBKR’s levels, they would have to cut an enormous amount of fat in their cost structure. Think about all the branches[2] that will need to be closed down, the firing of thousands of employees, the difficulties in hiring a ton of smart developers and technical staff (that are currently in short supply) in order to automate a large portion of their operations that will take a very long time, and the courage needed from senior management to drastically change a long traditional corporate culture that is focussed on sales, marketing and distribution to a technologically-driven culture. Let’s just say the execution risk and opportunity cost will be enormous. It has literally taken IBKR decades to develop their full suite of technologies[3] that continue to improve year after year, similar to how Google has consistently perfected their search engine algorithm. In fact, I believe even Google would have a better chance of replicating IBKR’s technology than IBKR’s main competitors.

 

In terms of prime brokerage competitors such as Morgan Stanley and Goldman Sachs that focus on the institutional market, they offer inferior trading execution and uncompetitive commission rates relative to IB, and also operate at a large cost disadvantage by employing expensive labour all the way from the front-to-back office. So it’s no surprise that IBKR’s operating and pre-tax margins are roughly double the US industry average, and with reasonable top-line growth should approach or exceed 70% over the next 2-3 years.

 

“I think in 10 years we could be the biggest broker in the world, and I am not kidding, because our technology is way ahead.” – Thomas Peterffy, Chairman and CEO – from IB’s Q3 2014 earnings conference call.

 

IBKR has an extremely long runway of secular growth in end markets powered by an increasing geographic mix-shift to the under-penetrated, higher-growth Asian market and a rapidly growing attractive core customer profile that consists of emerging hedge funds, independent financial advisors, proprietary trading groups, and introducing brokers among other institutional clients. Just in the US alone, IBKR’s market share is a miniscule 1% in terms of customer accounts and total online brokerage assets. WRT customer economics, IBKR has the lowest customer acquisition costs in the industry; for perspective, Schwab and TD Ameritrade each spend ~$250MM on marketing and advertising annually (~5% and ~8% of their total revenues, respectively), and E-trade financial spends ~$120MM (~6%-7% of revenues). IBKR has a near fully-automated customer registration process and spends almost nothing on marketing and sales yet the business is growing high-value customer accounts and customer equity 3x-4x faster than its closest competitors. Why? Because the most efficient operator – not the most well-known franchise or sales organization – will be the long-term winner in this industry. A referred customer incurs no marketing spend and is typically a stickier and more valuable customer over the long-term, and roughly 1 in 4 of IBKR’s new accounts are generated through customer referrals.

 

To size up IBKR’s growth prospects in greater detail, we have to account for the discount brokerage industry growing faster than traditional higher-cost brokerage, the trend of emerging small institutional investors such as financial advisors and hedge funds migrating to higher-value proposition brokerage services, and in general above-average growth in global wealth creation in excess of long-term global GDP rates (especially in Asia where 60% of IBKR’s business is now coming from at current run-rates). Finally IBKR’s wide moat will allow them to continue to take market share for a very long time. All-in-all it is no surprise that IBKR is growing customer accounts and equity at near 20% with little marketing spend, compared to mid-single digits growth for the rest of the industry. Due to these industry dynamics and IBKR’s sustainable moat, above-average earnings growth should easily be sustainable in the double-digits or more and be measured in decades – not years – out.

 

IBKR has an extremely scalable business model due to the breadth and depth of its automation of many functions all the way to customer acquisition to client risk controls which should lead to improving returns on equity for the brokerage business as it continues to grow at a rapid clip over time. IBKR’s growth in DARTs, margin lending, customer accounts and equity comes with very low marginal costs because of the business’ automated trading infrastructure.

I believe backing out 75% of excess capital in my ROE estimate for the brokerage business is reasonable.  Remember, this is basically idle capital that is in excess of regulatory requirements, and based on the size of rather large client account blow-ups over the past few years, I believe this is a conservative assumption in light of IBKR’s superior risk management controls. I’m not saying that larger client account losses are not possible, but the $2.5 billion in excess capital set aside creates a fortress balance sheet which has no debt.  Furthermore, all margin loans within IBKR’s margin lending business are basically recourse debt, so IBKR can go after customer assets[4] if they’ve suffered large losses on margin.

 

Unlike other large online retail-focussed brokerages that sacrifice client order execution for better brokerage economics, IBKR does not sell its customer order flow to the highest bidder, which has spurred considerable controversy in the industry. The founder, Mr. Peterffy, has been an outspoken proponent against high frequency trading (HFT) and its negative implications for the industry. I’m also comforted by the fact that Mr. Peterffy was an industry pioneer in electronic trading, and has structured IB in a way that puts its customers’ interests first. He’s also quite shareholder friendly, with a record of returning excess capital from the market-making segment in the form of special dividends. Although I typically almost always prefer share buybacks over dividends as a superior tax-efficient method of shareholder return, I understand Mr. Peterffy’s interest of increasing the public float over time. With an ~75% stake in the total capitalization of IB and founding the business itself, Mr. Peterffy is an archetypical “owner-operator” – a special class of management that I typically favour partnering with given their propensity to act in the long-term interests of all shareholders. The only concern I have is the current pricing of commission and margin rates. I actually believe IBKR’s rates are priced excessively low, well below rates that they can charge where the incremental value created will vastly outweigh any marginal decline on total DARTs, margin lending, or customer equity growth. With such a large gap between the operating costs of IBKR’s model vs. competitors (with pricing ranging from 10%-20% the industry average levels), and vastly superior pricing execution[5], the vast majority of clients would not even consider switching brokers and trading volumes and total margin loans should be marginally affected due to the vastly uncompetitive alternatives. Even a reasonable 50%-100% increase in average commissions and margin lending rates will flow straight to the bottom line, which should create nearly the same amount of incremental shareholder value. That’s why I believe IBKR has tremendous untapped pricing power. Although I assume it’s not in the cards for Mr. Peterffy to raise prices since he is overly focussed, in my view, on volume growth, (a negative given that he could literally raise prices tomorrow to maximize the value of the business), a sale of the entire business to a strategic buyer should reflect this untapped pricing power. Due to easily realizable synergies and a takeover valuation reflecting higher rational economic pricing, we could easily arrive at a present value of $75-$100 per share on the back of IBKR’s unique franchise under this upside case. And I assume Mr. Peterffy is not stupid enough to not recognize the enormous untapped pricing power in his business. In fact I believe this scenario will increasingly become more probable over time as he ages and looks for an exit.

 

What is Mr. Market Missing?

Complex accounting and holding structure, obscuring the true profitability of the e-broker business and making the headline earnings multiple misleading. The business is also very under the radar, and almost never gets mentioned in industry reports. Due to the stock’s small public float (~14.5% of all shares outstanding worth ~$1.9 billion) and IBKR’s lack of business with the Street, sell-side research coverage is extremely limited with around 2 boutique broker-dealers actively covering the name (I don’t think they’re doing a good job, by the way). The market also typically doesn’t do a good job valuing 2 divergent cash flow streams (the market-maker vs. the e-broker).

 

So why now? Aside from the huge margin of safety at today’s stock price, I believe we are at or near an inflection point where outsized share appreciation will be driven by 1) increasing investor awareness of IBKR’s electronic brokerage growth story along with the market-maker business becoming irrelevant and/or 2) We should be near or at the sweet spot of the interest-rate cycle where the market will begin to appropriately price in earnings accretion from higher rates. The market is certainly already partially pricing in higher rates for Schwab, TD Ameritrade, and E-Trade Financial.

 

On the cost front, despite the sizable volume growth in brokerage cleared trades, the exchanges have been pressured on transaction fees due to heavy pricing competition from dark pools, leading to a large decline in IBKR’s variable execution and clearing fees.[6] Long-term fixed costs should be roughly 50% of total non-interest expenses, providing plenty of operating leverage. After netting out the market-making business’ ~$1 billion in equity conservatively at 1x tangible book value, we are effectively paying slightly less than 18x my estimate of 2015E after-tax earnings for the phenomenal, high-growth brokerage business. My conservative implied valuation of this business is 30x my estimate of 2015 earnings. Because of the business’ largely untapped pricing power and the depressed current interest-rate environment, even if growth rates temporarily slow down, the smoking gun is that the brokerage business is massively under-earning which de-risks my thesis to a large extent. In fact, aside from spiralling deflation, I can’t think of anything else that can tank my thesis.

 

The stock is conservatively worth $45 today, and $50 per share by 2015YE on the back of a multiple re-rating, providing more than 50% upside 1-year from now: Although this is my short-term forecast, I’m much more excited about the high likelihood that the growth in intrinsic value per share will exceed the share price growth for many years to come, implying a potentially very long-term holding period. Another way to think of valuation is that if we assume a 30%-35% annually compounded growth in the brokerage business’ intrinsic value over the next 3-5 years, an 18x multiple throughout the holding period is very reasonable for a business with such an attractive long-term, predictable earnings growth profile and very high returns on equity.

 

Interactive Brokers is the Security I Like Best: It is what Buffett would call an “inevitable[7]”, a high-quality, long-term compounder where I can reasonably predict its earnings power 10-20 years from now.

 

-Richard

 

Disclaimer: I hold shares of IBKR and may buy or sell shares at any time without notice.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer’s securities.

1) All content of this blog, including correspondence between the author and readers, represents only the authors’ personal opinions and is neither investment advice nor a recommendation to buy or sell a security. No information presented on this blog is designed to be timely and accurate and should be used only for informational purposes.

2) The authors are likely to transact on securities mentioned on this blog without notice to the reader. Disclosure of the authors’ holdings of any securities mentioned will be done on a best effort basis.

3) The reader agrees not to invest based on information presented on this blog and should conduct his or her own due diligence with respect to the securities mentioned before initiating a position.

 

Here’s my shameless promotion: I’ve used IBKR’s trading platforms for the past 4 years now and absolutely love it, and so does everyone else I know that uses it. I highly recommend it to anyone.

 

 

 

[1] Feel free to ask any competent computer engineer how difficult and time-consuming it would be to develop all the algorithms and test and fix all the bugs that will be required to scale and automate all the processes involved in providing customers with the best execution across all significant worldwide exchanges and products

[2] Schwab, TD Ameritrade, and E-Trade have over 300, 100, and 30 branches, respectively

[3] I believe the most important pieces are their fully-automated IB smart routing and risk management algorithms

[4] Based on the size of future potential losses, I believe most would come from institutional customers, which are more likely to have valuable assets that IBKR can go after vs. retail investors

[5] Largely due to IB’s SmartRouting technology

[6] My research suggests that pricing may be starting to firm up again from the exchanges, especially in their cash equities business. I’ve conservatively assumed growth largely in-line with volumes.

[7] A business which will be much more valuable 10-20 years from now