I will try to keep this write-up short and to the point. IB is a deep-moated company, with stable and well-understood capital requirements, a long runway ahead of it, and a fairly acyclical business model that trades for 8x EPS.

IB has two businesses: (1) market making in equity options (and equity) worldwide and (2) Reg T brokering of listed products.

IB's stock price has gotten crushed despite the fact that its business model is constructed to do better in this environment and that its results have demonstrated this.

The CEO, Thomas Peterffy, is by all accounts, one of the smartest people in the business. He does not suffer fools gladly, but he is sharp. He owns 80% of the company as only 10% of the stock floats.

Moat

IB differentiates itself and forms its moat via (1) superior technology, (2) scale, and (3) risk management. It automates almost everything. This technology then feeds into its second moat, superior scale. In worldwide options market making, IB is the largest (with Citadel, Susquehanna, and Citibank (Knight Trading) forming oligopoly. In the market making business, the combination of technology and scale allows it to reduce its transaction costs below competitors. And this is the key to the business. Everyone has similar valuation models. The key is making a half penny more than competitors on the same trade. And IB's technology and scale allow it to do this. Several other firms have attempted to take market share away from IB and have failed. It will take a lot of time and money for anyone to replicate the systems that IB has in place.

In the broker business, the technology and scale enable IB to offer extremely low fees. Comparing ETrade fees to IB fees is a joke. And IB offers the best execution engine in the business. Many large hedge funds, who do not broker with IB, trade through IB in order to use the execution engine. IB can offer all investors, from individuals with $100k to large hedge funds the same technology and super-low fees. And IB offers real-time access to foreign exchanges (Spain, Mexico, Australia, etc.) not available on retail platforms and many institutional platforms.

The third competitive advantage is its risk management. Peterffy does not just talk about risk management. IB made several conscious efforts to deal with the crisis before the crisis began. For example, they stopped making markets in long-dated options because the marking of these options can get squirrelly in troubled times. And the broker has set margin requirements far in excess of Reg T rules. For example, there is no margin call. Once margin requirements are not met, the account is liquidated in real time. And the company has eliminated margin on small cap stocks.

Business Drivers

The options market making business is driven by three major factors: (1) volume, (2) realized volatility versus implied volatility, and (3) spreads. IB has stated many times that it builds its portfolio by always being long market gamma. This means that in the event the market jumps higher or lower, IB will profit. As well, it normally ends up long vega, which means that it profits when realized volatility exceeds implied volatility. And obviously, as a market maker, if spreads get wide, they do better. Note that they never take directional risk. When they buy a call, they delta hedge immediately.

In the current environment, volumes have soared and spreads have blown out. The implied vs realized vol has been a mixed bag. In Q1 and Q3, it worked in IB's favor, but in Q2, the month started with high implied vols but realized vols came in much lower. So Q2 was a poor quarter even though volumes were fairly high.

Note that historically, volumes have fallen after bear markets. People who lost money become un-interested in markets and do not speculate as much. Thus, although IB does not have direct exposure to market levels, we can expect the secular growth of worldwide exchange volumes to stall for a year or two after the selloff ends.

The broker business is driven by two major factors: (1) volume and (2) assets under management. Clearly, the current environment has been good for volumes but poor for assets under management as customers have lost money. Net inflows remained strongly positive in Q3'08, but customer losses meant that AUM fell. On the other hand. brokers that only deal with exchange traded products have gained significant market share versus Wall Street brokers. The Lehman fiasco demonstrates why that is. IB is a much safer place for assets than Goldman Sachs for the reasons outlined below. IB has been running an advertising campaign with this theme.

Capital Issues

This is the key section because who wants to buy a financial company at 1.5x tangible book in this environment.

IB trades only listed products (and currencies) so its margin requirements are set by the various exchanges. As of 9/30/08, it had TBV of $4.2bn while only $2.3bn was needed to meet regulatory capital standards. Every single one of its products (both the market maker and broker) are exchange traded and marked each night. And the vast majority of its positions involve options three months and shorter. Thus, the balance sheet naturally rolls every quarter. If they did nothing but dynamically hedge existing option positions, the balance sheet would dissolve to TBV of cash in about a quarter. Imagine saying this about Goldman Sachs or Citibank.

As for its broker, remember that it only trades exchange traded products and only operates Reg T accounts. As well, it does not make margin calls. Once an account is below the maintenance margin, the account is liquidated in real time. No exceptions.

Imagine a world where Reg T accounts cannot receive financing. Truly guns and gold at that point. But even if this scenario hit, IB would simply liquidate its clients margin accounts. Obviously, this would hit the profitability of the broker business, but it would not result in a loss of capital.

Thus, even in a true disaster scenario without government aid, IB would still be able to maintain its capital and liquidate to TBV.

Valuation

As I am writing this, the stock price is $16.75. There are 399mm shrs. Note that only 41mm float. So the market cap is $6.7bn.

IB produced $2.30 LTM (thru Q3'08) EPS. Due to the favorable market conditions (volume, spreads, realized volatility), this was a bit higher than a "normalized" EPS. Although the company does not explicitly state it, Thomas has described each quarter as above or below average. Based on his analysis, normalized EPS is certainly above $2.00 and below $2.20. Let's use $2.05 as normalized LTM EPS. Thus, at S=$16.75, IB trades at 8.2x.

Note that the $2.30 EPS contained no one-time windfalls. This was all regular operations. I am simply reducing to account for the favorable environment. There are not many financial stocks today where we need to reduce earnings to normalize them.

IB has a Tang Book Value of about $11 per share. Note that if you simply take shrhldr equity divided by float shares, you will get $12+/shr. This is a bit off due to a hyper-technical tax issue due to the ownership structure of IB.

We have a stock whose fundamentals are not correlated to the economy or the market. It has a solid moat (technology and scale) on both its businesses. In terms of growth, the broker business was growing at 25+% before the recent turmoil. There is no reason to think this will not continue or even accelerate. Of course, AUM will fall as customers lose money. And the market making business has a 10+% secular growth wind behind it. The marginal capital requirements for this growth are marginal. And due to technology, there will be increased operating leverage.

Even in this environment with cheap valuations all around, I still believe this stock deserves a 15x multiple, and should trade at $30.

Catalyst

There is an interesting technical situation developing. The float is 40mm shares. The company has initiated a buyback of 8mm shares. Fidelity (5.5mm shrs), AXA (2.9mm shrs), Artis Capital (2.6mm), and TRowe Price (4.4mm) have filed 13d/g's. This is 39% of the float. Even the float is closely held, and IB may have already bought up to 20% of the float.

The real catalyst though is IB completing its 20% shr buyback and implementing a new buyback. At S=$17, IB could easily buy back all its float. It has made more than that in earnings this year, and it does not need the capital. Thomas has grown increasingly frustrated with the market's valuation of IB, and he believes his company is worth well over $30 per share. I would not be surprised to see him continue to buy back shares. If he does this and the large holders stay in place, there would be no stock left.

Also, Q4 thus far has been a strong quarter for option market makers. Realized vol has been high (even compared with astronomical implied vol), volumes have been high, and spreads have continued to remain high as marginal market makers leave the market. And I expect the flight of accounts from traditional prime brokers (Goldman, Morgan Stanley, etc.) to exchange-traded-only brokers (IB, S3 Partners, etc.) to continue unabated. I believe Q4 is headed for a $0.60+/shr quarter. October was almost as strong as September for market makers. And November has been strong thus far.

Risks

The only balance-sheet risk I see out there (other than fraud) is a Volkswagen scenario, where a large cap stock jumps fourfold and IB is short gamma on the stock. Let me explain why this is especially unlikely in the case of IB. First, IB has maximum risk limits in any given name. They do not report the actual risk limit, but we have some clues from 2007 when traders (with insider info) illegally bought call options on companies about to be acquired. IB lost $10-20 mm per name on these jumps. My educated guess (based on these losses) is that they have a $50mm (or lower) limit of jump risk on large cap names. In other words, if a stock were to double or go to zero overnight, they would lose less than $50mm. Also note that in the case of Volkswagen, the stock did not jump up fourfold. It traded up so that IB, if it was short gamma, would have had plenty of time to delta-hedge. Make no doubt that anyone short Volkswagen gamma lost money, but I would be very surprised if they lost more than a dime a share.

Earnings growth risks do exist: Market microstructure debate. There is a fight going on regarding the market microstructure of the options market (i.e. where all these fractional-pennies go). We can discuss the details in a subsequent chain, but the short is that IB is opposed to the pay-for-order-flow model. In this regard, it is the good guy fighting a clearly sub-optimal, kind of shady, model. Citadel is the bad guy now that it owns E*Trade. It is not clear how this will end up playing out. My guess is that we will see a bifurcated market. IB can compete in either market. They simply do better in one versus the other.

The economics of the business do have an indirect relationship to the market as volumes fall after a bear market and customer assets will also fall. But at 8x, this seems more than priced into the stock.