Description

As we are in the midst of an increasingly value starved world thanks to a host of reasons, I thought this would be a good asymmetric pitch for the VIC community with potential near-term catalysts. To begin, Interactive Brokers is a cheap stock. At $14.98, it is trading at 1.1x TBV, 11x earnings, and has a 2.7% percent dividend yield ($.40 per share). It has never broken through book value since going public at over $30 in May 2007, and the multiple of this business should be trending up over time not down. On a consolidated basis, this looks like a junk business with mediocre ROEs, but it is really a tale of two businesses that are swimming in excess capital and one day probably won’t even be looked at on a book multiple. More to come on this later, but most importantly this capital is not stranded, there are catalysts to increase ROEs, the businesses are independently capitalized and easily severable, and the far superior brokerage business is growing so fast that it is now well over 50% of the earnings and will continue to grow much faster than the market maker.

Taking a step back, IBKR is a fully automated broker dealer and market maker that was started by billionaire Thomas Peterffy in 1977. Peterffy was born n Hungary and ultimately found his way to the US. As a computer programmer, he felt he was at an informational disadvantage to traders on the floor of the American Stock Exchange, and he figured out early that trading was ripe for disruption through the use of technology and automation. He left his job and started IBKR as an automated market maker. After having great success with this, he saw that all the floor traders would be obsolete so he created another division, opening up his system to serve disenfranchised floor traders. This is how the online broker business started. A couple of more fun facts on Peterffy before we get into the businesses: he hates inefficiency and middlemen (think Jeff Bezos) and is still fully engaged in the business. If you read articles about him and IBKR’s annual reports/transcripts or listen to his interviews, it is clear that he is a brilliant guy.

The first business, the legacy market making entity is the less interesting of the two and is in quasi-liquidation phase currently. This business has been around for over thirty years and has made money every single year. It trades over 350k listed products on over 30 exchanges and makes money through bid/offer spreads. This was historically the larger business but profits have shrunk considerably. That said, off the $5.15B in IBKR equity, $3.3B is still in this business. As everyone knows, high frequency trading has proliferated, significantly eroding barriers and depressed profitability of HFT firms. Algorithms used to matter, but not it seems to come down to speed/milliseconds.

The ROEs in this business were satisfactory in the mid-teens a few years back but are now bouncing around sub 10%. Over the past few years, Peterffy has become decidedly bearish on the business if you read his language in the transcripts and has put in place a plan to automatically wind down the capital in the business to the extent it does not generate at least a 10% pre-tax ROE. There is a mechanism in place that automatically dividends out the spread between 10% pre-tax and the actual ROE. If it happens to sustainably earn over his ROE target it will retain capital but that will be a classy problem. Importantly, this capital is not stranded. Peterffy is a capitalist and says they do not need to be in the business if it doesn’t earn adequate returns. Here is a quote from him on his concern during the 2^nd Q 2012 call:  “the sad fact is that market making business is in trouble. It is being squeezed among four unfavorable trends that are not likely to reverse in the near future.”

The good news is he is a very smart, entrepreneurial billionaire and you can usually count on such people to do smart things. He paid out a $1B special dividend at the end of 2010 and is clearly considering doing another one before year end given the likely changing dividend tax rate. He says he is not making up his mind until December but here are some comments from his 2^nd Q 2012 call:  “we will keep our options open, sure. Yes, we could. We will consider. If it looks like, if it looks like dividend rates are going to go up, we will consider.” On the same call, there were a few more questions on why not a more aggressive return of capital and he responded “I think if you ask this question at the next conference, next earnings conference, I think maybe we will be able to tell you something more.” On the 3^rd Q call, the questions continued. His responses this time were: “There is a possibility that we are considering potentially making a dividend from the market -- a special dividend from the market maker. But that we consider along with the certain potential business expansion and we are still working on what would make more sense. And since we have until the end of the year to decide, there is no -- we don’t feel in a special hurry.” And, “It depends on how close you want to go to the fence, right. It’s I don’t know -- we probably would have at least a $1 billion that we could do without if we really wanted to go as slim as we could and still do the business. On the other hand, it’s a great deal of comfort to have extra money and as we have seen for example in last August, when the markets go crazy and everybody has to liquidate because they are coming close to their requirements as volatility explodes and option prices increase. If at that time you had extra money, you can take over other people’s positions that they feel squeezed. So, there are several sides to the story.” The stock went up 10% the day they announced the special dividend two years ago.

The key variable is whether Peterffy thinks that new regulations and a more volatile world might cause the market making business to get better. It seems he has become more negative recently though he has not set any concrete plans. It is also worth mentioning that this business is effectively slightly long volatility so if the world gets shaky earnings will likely actually go up rather than down for a couple of quarters. It is impossible to predict, but I bring this up to point out that this is not a company you should be terrified of if there is a European meltdown or financial contagion-they made a ton of money in 2008 and 2009. Finally, this business is not a complete waste, as the broker gets to leverage all the technology and scale so customers benefit from it significantly.

The brokerage piece is the much more exciting business of the two, and it has grown like a weed over the last decade significantly outpacing Schwab, Ameritrade, and eTrade. From a higher level, IBKR has leading trading tools, execution, and pricing and sells to individuals, hedge funds, financial advisors/RIAs, prop traders, and smaller brokerage houses. They are continually ranked the top online broker by a number of publications and their fees are 75% lower than competitors. We are talking $1 to trade 200 shares. The business appeals to sophisticated financial professionals and traders, and even though they only have circa 1% of US accounts they are the largest broker by number of daily average revenue trades. Additionally, people can trade stocks, options, futures, bonds, and foreign exchange in tons of countries, exchanges, and currencies. In fact, they now have customers in well over 100 countries. New account growth has continued at a CAGR of 20% since 2008 and over 10% in 2012, while revenue bounces around due to volatility in DARTS.

This is a phenomenal business driven by technology and scale in which they are the natural winner. They have one of the best platforms, the widest range of tools and options yet they have the lowest costs. Hence, they are able to offer the lowest prices by a significant degree and maintain the highest revenue per employee and margins. In the words of Peterffy, “we are the most profitable broker, and yet, we are also the least ex­pensive broker. If our competitors try to match our pricing, they would be running at a loss.”

Although this business has already grown a lot over the years, it still has legs. For instance, IBKR is growing rapidly internationally and in the institutional space. 43% of their accounts are international customers, and they are growing aggressively overseas by appealing to their frequent trading niche all over the world. As they are just a large technology platform and already do market making in so many different countries, their products scales easily. Schwab and Ameritrade haven’t been able to scale well internationally as they need to sell bundled financial services for their model to work, so IBKR has open runway. IBKR is also gaining share in the financial services industry, both in the RIA space and hedge fund industry. They are quick to tell you they have an A- credit rating which is higher than Morgan Stanley and want more funds to prime broker with them. They have gone above and beyond industry regulations to ensure customers the security of their funds and even segregate customer accounts daily. Right now, they are finding success in the $50mm size space who get ignored by the big brokers. IBKR is already the largest non-bank broker, and Peterffy wants to be seen in the leagues of Goldman and Morgan down the road. Interestingly, the only reason Peterffy says he took IBKR public was to get more credibility in the institutional brokerage space. He believes clients feel more comfortable with a broker who is public, files quarterly financials, and is under public scrutiny.

As much as the market maker is overcapitalized, so is the broker. They need about $200k of regulatory capital but currently have $1.8B in the business. They claim they want to hold at least $1 billion so people feel they are a pillar of strength, and I am not predicting they return any of the capital in the segment today but they do not need to retain any additional capital. On the 2nd Q 2012 call, he was asked about this and said “what is the kind of brokerage business where brokers need more capital than we have? I can't see it.” Because of this excess capital, the brokerage business is shockingly only reporting a 12% ROE. This is destined to go up.

Peterffy cares about making money, and he cares about the stock price. The only reason this is public is because he cares about the growth of the business. To the extent, IBKR is seen as a larger and more stable public company, the brokerage business will benefit similar to how Schwab has over the years. He is getting older and likely wants to sell down his stake over time but he clearly does not like the current price (it IPOd at $30 a few years ago so perhaps he is waiting for that number or higher now). We know and he knows that it would be very easy to get the stock price up by distributing the excess capital, and he seems to be heading that way. The reason he is not distributing the excess capital today is that he feels a 10% pre-tax return with limited risk is appealing given alternatives in the world and if that changed I think he would change. He is not an empire builder, but if he can make more in the market making business than in other investment opportunities he will continue to do so.

So, why is this stock cheap and not just another financial? Most importantly, this has incredible downside protection. You are obviously protected by the tangible book in liquid securities, but the greater point is that you could literally pay out a $12-13 dividend and still have the brokerage business running for free as it doesn’t need the capital in it. This is not going to happen, but it means you get the broker for circa free today. What if the market maker has a computer problem like Knight did? Well, since the two subsidiaries are independently capitalized in a worst case scenario you would still be left with the $1.8B of excess capital in the broker and the brokerage business which combined is worth more than the stock price. This is not a stock you should worry about if the world melts down; it is incredibly overcapitalized and has a growing platform.

The more interesting question is how is this likely to play out and what is the upside? One scenario is that this is a totally blah investment that just pays out the 2.7% dividend yield, hoards capital, continues to grow on the brokerage side but maintains mediocre high single digit ROEs that trend up as the broker grows and the market makers shrinks some. In this scenario, assuming no multiple expansion (though you should get a higher multiple as the broker grows to a bigger percentage of the earnings), you would likely get a high single digit return with enormous downside protection.

What seems more likely to play out is that there should be a special dividend at some point in the next few years that increases the ROE as it places more emphasis on the broker. If the market maker pays out say a $1B special dividend and then just earns a 10% ROE from here, the broker grows revenues at 10% over the next few years (could be higher or lower depending on trading volumes), the broker pays out any incremental capital it generates over the $1.8B of excess capital it already has, and then you value the overcapitalized broker at 10x EBIT out a few years you get a three year double comprised of a few dollar dividend, a dollar a year of paid out earnings, and $20 of value left in the out years. Arguably, this is not a blue sky scenario as in this scenario the broker will still be enormously overcapitalized and only earnings a high teens ROE. Also, 10x EBIT/7X FCF for a non-capital intensive, high barrier to entry growth business is not a lofty multiple. The bottom line is the multiple of the consolidated entity should follow the growth of the broker business over time.

There are plenty of reasons this stock is cheap including limited float, minimal sellside coverage, a misunderstanding of the capital structure and business, an extrapolation of the last few years of ROEs, and it’s a financial. That said, buying this at a trough multiple on trough ROEs with a dramatically changing business mix, a bulletproof balance sheet, a brilliant and aligned billionaire CEO, and an easy glide path to higher consolidated ROEs with imminent catalysts seems interesting. To be clear, if your time horizon is very short, they may or may not pay out a special dividend and this could be mediocre over the next couple of years. I believe it’s incredibly asymmetric with a lot of ways to win. In summary, safe, asymmetric and cheap with an aligned CEO who likes to grow, make money, and wants to sell down stock at a much higher price. Don’t know the timing, but time is on your side and the book multiple should melt up as the business mix shifts.

Risks and Other Section:

On Peterffy, he clearly cares about shareholders. There is a somewhat complicated tax structure that you can read through the 10K about (it basically just allows him to maintain favorable personal tax treatment though does not harm shareholders), but he did the special dividend two years ago thinking of tax rates for minority investors and is considering one right now. More interestingly, there was a market manipulation issue a couple of years ago with a company named Altana that lost traders $1B. IBKR lost $37mm on it (their biggest lost ever), and Peterrfy reimbursed the $37mm to the company and took on Altana himself so shareholders weren’t subject to the loss. He clearly cares about his reputation and making money for shareholders, and he deems IBKR’s reputation as a public company vital to the growth of the broker. He wants IBKR to be considered in the leagues of Goldman and Morgan Stanley and says as much on calls. It is my belief that he cares about making money, cares about his stock price, and wants to ultimately sell down his stake some to get more liquidity which will help IBKR’s notoriety and the stock price.

On risk in the market maker, Peterffy is clearly risk averse and he discloses their VAR is $10-20mm (take with a grain of salt obviously). They make money every year and he is extremely paranoid about what can go wrong in the market maker with software and technology. The business is not that levered, has highly liquid securities, and no long term debt. Nothing is a given here, but I consider it very unlikely he would have a blowup after all these years but there is no way to put a probability on it. Given that the two subsidiaries are separate and the broker and the excess capital in it are worth more than the stock, I believe you are well protected.

Another risk would be what about trading volumes. I have no idea and don’t care to take a guess, but I would say it does not seem like we are in a relatively frothy volume environment right now. Again, as you could liquidate for above the stock price, we are just talking about upside here.

On interest rates, there seems to be about $.10 EPS of float upside if rates go to 100bps so it is not as much as other brokers but is something.

On acquisitions, Peterffy might buy something if he got a phenomenal/distressed deal and given they are hoarding excess capital this wouldn’t be a bad thing. He hasn’t really done anything historically but has looked during times of distress to various financial firms. Given the excess capital position, this would be very accretive to earnings. On the flip side, he could easily sell the broker off to a lot of companies for a ton of money and liquidate or privatize the market maker. This seems unlikely but I guess it could happen.

Catalyst