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I have recently made IBKR a rather large position.  Before I get into the long thesis, I'd like to ask a question:  How many people on this board use Interactive Brokers?  If you don't, who do you use?

 

The short answer is this:  Any professional investor has no other option except IBKR, especially if they use leverage.  No other broker offers the commissions, direct access, and margin rates that they do. 

 

Why is IBKR interesting here?  Well, historically, they have made 80+% of their money as an option market maker.  The last 2 years the options market making business has been a disaster and the CEO, who owns 90% of the company and started it, has announced that they might wind it all down and just focus on the broker business.  This sparked my eye. 

 

The elevator pitch is this:  There are 400 Million shares, dilluted, outstanding - but only ~42 million float.  $2.8 Billion of capital, or $7 a share, is in the market making business.  $1.4 Billion is in the broker, and it's overcapitalized.  Thomas Peterffy (TP, the CEO) has stated that if the market making business doesn't return to making a decent ROI, they will shut the business down and return all this capital to shareholders.  They returned $1 Billion in Q4 to start.  Note:  The market making business once brought in almost $1b in pre tax earnings! It now only does ~150m a year and still shrinking.  It's basically long vol and needs the vix to be in the mid 20's for ideal conditions.  But, let's pretend it doesn't ever go back to earning a decent ROI and TP returns all $7 to shareholders.  What does that leave us? 

 

We have $8.50 left with a book value of $3 and change.  But it's a pure play brokerage that requires no capital to grow, has tiny cap ex needs, and has 50% pre tax profit margins!  It's all automated, growing new accounts 20% a year, and growing bottom line at 20% a year.  There are no true competitors (take it from me, I wanted to leave them or find a back up account and couldn't) and they currently have 164k accounts and TP estimates the addressable market (savvy financial professionals) to be 2 million globally. 

 

They will do ~55 cents in 2011 in EPS in the brokerage business, so you are paying 16x for this fantastic business.  It is very likely that in 2013 they do close to a $1 in EPS given growth in new accounts and a small uptick in fed funds rate.  Schwab, Ameritrade, etc, all trade at 20x.  This business has literally no need for capital and should not be valued off of book. 

 

The reason I really like it is what's your downside?  Todays book = $10.50 + a funky tax attribute that puts it at $12.  The tax situation is very odd and still trying to get to bottom of it but their effective tax rate is only 12% due to the way it was set up.  My numbers above (55 cents in 2011) assumes 35% tax rate and full G&A hit if they shut down market making.  The street expects them to earn 80-90 cents in 2011 combined with market making.  I think downside is extremely limited and upside is mid 20's in 18-24 months or so.

 

The way I played it is I sold Jan 12 and Jan 13 puts, strike $13.21 (funky cause of the 1 time dividend they paid) at 45 and 85 cents, respectively.  If I am put the stock, I'm put it below book which is highly liquid securities that can be run off in under 3 months.    I then bought Jan 13 18.21/23.21 call spreads for 85 cents which will pay $5 at max return, or almost 6x.  One could just put on the call spread and not sell the puts but I like the combo trade.  I also own the common given how low margin rates are on IBKR and how low the downside is, I have no problem using leverage to own this and have made it a pretty big position in my book, ~25%.     

 

I can answer questions.  In short, the catalyst is that Market Making, a crappy business, is being shut down/irrelevant, while the brokerage business has finally grown to a level where it's making real money.  It used to be <20% of profits and in 2011 will be >50%. 

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Do they have any proprietary technology that allows them to stay low in costs?  What potential is there that other companies will enter their market and potentially be lower cost producers?  I know you stated a target for 18-24 months... but do you see anything beyond that?

 

I really like this idea, and every professional I am aware of uses them.

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Good questions.

 

They have spent absurd amounts on technology.  This is not something that a competitor can just develop.  If you look at the competitors, namely Tradestation, MB  Trading, they can't come close to charging the prices that IB charges and earn a profit.  They don't have the scale and aren't as automated.  I use the term competitor loosely because I could never switch my account to those guys without a HUGE decline in their commissions and margin fees.  I mean huge decline.  Just got to Tradestations website and see.  I pay far less than half a cent a share on IB, more like .25 cents when you factor in rebates.  That's $2.50/1000 shares.  The competitors are leaps and bounds higher.  On margin rates, it's not even remotely close.

 

IB is also the leader in price improvement/execution which is a hidden cost/fee that other brokerages will cost you.  Of course, most investors don't see this.  They talk about it on their website. 

 

Basically, I think they have built a huge moat that is nearly impossible for a competitor to overtake.  The other companies are super tiny (TRAD EV is ~100 million vs IBKR's brokerage biz being valued at over 3b today if you use book for market making). 

 

As a customer, I would not go to a startup competitor that was not extremely well capitalized.  Basically, the only way I'd consider changing is if the commissions/margin were both lower and the company had a huge equity base >$1 billion.  Schwab, Ameritrade, E-Trade, have shown no desire to compete in this manner.  They all have active trader divisions and the fees/commissions are multiples of what IBKR's are. 

 

I have no reason to believe this is an 18-24 month idea then goes flat.  I think the broker will continue to compound for a decade or more at 20%.  The market opportunity is huge.  Imagine if they released a more intuitive trading platform and went after less sophisticated investors? 

 

The other edge IBKR has over competition is it's global.  Half their new customers are coming from overseas.    If you think we have no other options, they really don't.  I think they could develop a HUGE overseas market.   

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So would you look at this almost like a commodity business that is the lowest cost producer?  Doesn't sound to me like they have franchise value but they are in a strong market position.

 

Something I think is very interesting is the lack of tradable shares... maybe they are being missed by analysts because it is difficult to get an sizable investment with them!  I wish I had more time to devote to reading about this, will spend as much time as I can during the week and hopefully be able to take a look further this weekend.  I like this idea!

 

 

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given2invest -

 

I looked at this idea about a year ago and I liked it a lot. I passed as I found other businesses at that time that I liked better (no regret; stock price hasn't done anything in the past year). I remember that I liked the CEO a lot - running the show, very entrepreneurial, strong personality, speaks his mind and very honest. I think that he was in his mid-60s or something. I doubt he is the kind of guy who would retire soon but I wonder if you know about any succession plans? Does he have a strong #2? What would happen if he gets hit by a bus tomorrow?

 

Thanks,

Eric

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I have recently made IBKR a rather large position.   Before I get into the long thesis, I'd like to ask a question:   How many people on this board use Interactive Brokers?   If you don't, who do you use?

 

The short answer is this:  Any professional investor has no other option except IBKR, especially if they use leverage.   No other broker offers the commissions, direct access, and margin rates that they do. 

 

Why is IBKR interesting here?   Well, historically, they have made 80+% of their money as an option market maker.  The last 2 years the options market making business has been a disaster and the CEO, who owns 90% of the company and started it, has announced that they might wind it all down and just focus on the broker business.   This sparked my eye.   

 

The elevator pitch is this:  There are 400 Million shares, dilluted, outstanding - but only ~42 million float.  $2.8 Billion of capital, or $7 a share, is in the market making business.  $1.4 Billion is in the broker, and it's overcapitalized.   Thomas Peterffy (TP, the CEO) has stated that if the market making business doesn't return to making a decent ROI, they will shut the business down and return all this capital to shareholders.  They returned $1 Billion in Q4 to start.  Note:  The market making business once brought in almost $1b in pre tax earnings! It now only does ~150m a year and still shrinking.   It's basically long vol and needs the vix to be in the mid 20's for ideal conditions.   But, let's pretend it doesn't ever go back to earning a decent ROI and TP returns all $7 to shareholders.   What does that leave us?   

 

We have $8.50 left with a book value of $3 and change.   But it's a pure play brokerage that requires no capital to grow, has tiny cap ex needs, and has 50% pre tax profit margins!   It's all automated, growing new accounts 20% a year, and growing bottom line at 20% a year.  There are no true competitors (take it from me, I wanted to leave them or find a back up account and couldn't) and they currently have 164k accounts and TP estimates the addressable market (savvy financial professionals) to be 2 million globally.   

 

They will do ~55 cents in 2011 in EPS in the brokerage business, so you are paying 16x for this fantastic business.   It is very likely that in 2013 they do close to a $1 in EPS given growth in new accounts and a small uptick in fed funds rate.   Schwab, Ameritrade, etc, all trade at 20x.   This business has literally no need for capital and should not be valued off of book.   

 

The reason I really like it is what's your downside?   Todays book = $10.50 + a funky tax attribute that puts it at $12.  The tax situation is very odd and still trying to get to bottom of it but their effective tax rate is only 12% due to the way it was set up.   My numbers above (55 cents in 2011) assumes 35% tax rate and full G&A hit if they shut down market making.   The street expects them to earn 80-90 cents in 2011 combined with market making.   I think downside is extremely limited and upside is mid 20's in 18-24 months or so.

 

The way I played it is I sold Jan 12 and Jan 13 puts, strike $13.21 (funky cause of the 1 time dividend they paid) at 45 and 85 cents, respectively.   If I am put the stock, I'm put it below book which is highly liquid securities that can be run off in under 3 months.    I then bought Jan 13 18.21/23.21 call spreads for 85 cents which will pay $5 at max return, or almost 6x.   One could just put on the call spread and not sell the puts but I like the combo trade.   I also own the common given how low margin rates are on IBKR and how low the downside is, I have no problem using leverage to own this and have made it a pretty big position in my book, ~25%.     

 

I can answer questions.  In short, the catalyst is that Market Making, a crappy business, is being shut down/irrelevant, while the brokerage business has finally grown to a level where it's making real money.   It used to be <20% of profits and in 2011 will be >50%.   

 

I use.  Best value for anyone who doesn't have access to a prime broker.

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given2invest -

 

I looked at this idea about a year ago and I liked it a lot. I passed as I found other businesses at that time that I liked better (no regret; stock price hasn't done anything in the past year). I remember that I liked the CEO a lot - running the show, very entrepreneurial, strong personality, speaks his mind and very honest. I think that he was in his mid-60s or something. I doubt he is the kind of guy who would retire soon but I wonder if you know about any succession plans? Does he have a strong #2? What would happen if he gets hit by a bus tomorrow?

 

Thanks,

Eric

 

Yah, I looked at it a year and two years ago and passed both times cause market making was too big a % of the business and I had no interest investing in that.  

 

The CEO is extremely smart and well respected.  He gets it.  If he died, there would be no real #2 that could come in, however, he owns 90% of the company.  His heirs would almost certainly sell the company and I believe there would be tremendous demand for the broker asset from both PE and strategic acquirers at prices far north of today's valuation.  I'm not concerned about key man risk.  

 

One thing that's good is all the senior management team have been there for many years which shows how much they respect the CEO.  Also, most of their comp is in stock and has long vesting periods (as much as 7 years).  I was told the average employee gets over half of their bonus in stock.   The entire company is highly motivated to get the stock price up and to see the shareholders succeed.  

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So would you look at this almost like a commodity business that is the lowest cost producer?  Doesn't sound to me like they have franchise value but they are in a strong market position.

 

Something I think is very interesting is the lack of tradable shares... maybe they are being missed by analysts because it is difficult to get an sizable investment with them!  I wish I had more time to devote to reading about this, will spend as much time as I can during the week and hopefully be able to take a look further this weekend.  I like this idea!

 

 

 

Yes, there is almost no analyst coverage and the ones that do don't "get it" for the most part.  One of them values it off of book, etc.  The free float is very small compared to the size of the company.  It's more like a small cap than a large mid cap. 

 

I guess it is a commodity business but how many commodity businesses do you know with 50% pre tax margins with absolutely no competition and extremely low cap ex?  Also, switching costs are mildly high - changing brokers is a pain in the ass, especially from tax perspective. 

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they currently have 164k accounts and TP estimates the addressable market (savvy financial professionals) to be 2 million globally.   

 

My numbers above (55 cents in 2011) assumes 35% tax rate and full G&A hit if they shut down market making.   The street expects them to earn 80-90 cents in 2011 combined with market making.   

 

Do you have any other estimates for the size of the market opportunity?

 

Along with that, what is the market size for investors that trade these volumes?  Average annual trades are far higher than the competition, if they continue to grow new accounts will profit growth increase at a far slower pace from less frequent trades?

 

Do you think competition will increase with Schwab's purchase of OptionsExpress?

 

What do you calculate for an EBIT impact as the result of a 25, 50, 100 bps move in rates?

 

I established a position in IBKR at the end of February for similar reasons.  The questions above are some of the things I've been working on.

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they currently have 164k accounts and TP estimates the addressable market (savvy financial professionals) to be 2 million globally.   

 

My numbers above (55 cents in 2011) assumes 35% tax rate and full G&A hit if they shut down market making.   The street expects them to earn 80-90 cents in 2011 combined with market making.   

 

Do you have any other estimates for the size of the market opportunity?

 

Along with that, what is the market size for investors that trade these volumes?  Average annual trades are far higher than the competition, if they continue to grow new accounts will profit growth increase at a far slower pace from less frequent trades?

 

Do you think competition will increase with Schwab's purchase of OptionsExpress?

 

What do you calculate for an EBIT impact as the result of a 25, 50, 100 bps move in rates?

 

I established a position in IBKR at the end of February for similar reasons.  The questions above are some of the things I've been working on.

 

CEO has estimated market size at 2-3 million people.  I have not a clue but know its much larger than their current customer base, especially on a worldwide basis. 

 

Anything above fed funds 50bp is the same and I think its a 30-50 million EBIT bump - not a lot.  10 cents a share. 

 

Optionsexpress prices are 2x (or more) IBKR.  I do not view them as a threat at all regardless of them being rolled into Schwab. 

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  • 4 months later...

Hey given2, do you have an opinion on IBKR's tax expense?

 

From what I understand, IBKR should be taxed on the 11% of pre-tax profits they own of the IBG LLC (11.5% after the share swap?).

 

In Q2, EBT was $149m. Income tax expense was 12.5m and IBG Holdings LLC (NCI) received $127m.

 

10-Q:

"The Company’s provision for income taxes is comprised of two principal components: (1) the Group’s consolidated income tax expense, and (2) the Company’s U.S. Federal and state income taxes on its proportionate share of the Group’s income that is subject to tax."

 

Does this mean that the $12.5m are the taxes on IBKR's proportionate share of the EBT? If so, it would be $12.5m on (149-127)= 22m. That seems a little high..

 

Also, I read their comment on a $1bn step-up related to the IPO. It appears that IBKR pays (or paid) 85% of a tax timing benefit (DTA) to the LLC? As a result they have a $284m liability (payable to affiliates). I may misunderstand this but it strikes me as a bad trade to pay 85% of a tax timing benefit which will inevitably reverse. If anything, it would be appropriate to calculate the NPV of the expected timing benefit and reimburse the LLC for that?

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HFT is the worst thing that happened to their market making segment.  (This is my opinion.)

Interactive Brokers is not in the game of shaving miliseconds off their trades.  This requires a huge investment in high-speed networks.  Because of this, IB is at a disadvantage when they are a market maker.  They will get picked off because they have slow quotes.

 

On the retail brokerage side, payment for order flow is a problem.  Because their competitors take kickbacks for selling out their clients, they can advertise lower rates.

 

On the institutional brokerage side, dark pools are a small problem.  But many institutional investors have figured out that they have been getting screwed by their brokers, exchanges, market makers and other intermediaries on order execution.

 

------------------

 

Peterffy complains about HFT in one of his speeches.  Sorry I don't have the link.

 

Here's a news article where Peterffy talks about HFT:

http://www.huffingtonpost.com/2012/08/28/thomas-peterffy-high-frequency-trading_n_1835802.html

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On the valuation, in the VIC writeup and the writeup just posted, the treatment of a substantial portion of the excess capital as effectively an excess asset seems a bit aggressive. I suppose it is possible that the % excess over regulatory requirements could be reduced over time, but has management shown any inclination to reduce this figure? The assumption here does make a sizable difference in returns on capital today and going forward.

 

I've thought previously about the GEICO comparison which the author obviously is implying. However, based on market cap, IBKR is already substantial enough today that it seems hard to underwrite the level of growth forecasted. Market cap is $13B today, if the business grows at 20%/yr for a decade and the multiple didn't decline, you'd be looking at a $80B business. Schwab, TD Ameritrade, and E*Trade have a combined market cap of $67B today. The business models are obviously very different, but at some point you wonder how much economic market share IBKR could capture. They do have the ability to tap significant markets that the others mentioned do not (smaller hedge funds, for example) but, as great as IBKR's product is, I also don't see your average retail investor being satisfied with the platform vs. the features you get at the higher cost brokerages.

 

Would like to hear other's thoughts especially on the size issue.

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$13B mkt cap is a typo I'm assuming? It's ~1.9 billion as of this morning

 

You're only seeing the publicly traded shares. If you buy IBKR you are buying stock in IBG Inc, which has a market cap of $1.9 billion. IBG Inc is a holding company that owns a 14.5% economic interest in IBG LLC. The rest is held predominantly by Peterffy.

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On the valuation, in the VIC writeup and the writeup just posted, the treatment of a substantial portion of the excess capital as effectively an excess asset seems a bit aggressive. I suppose it is possible that the % excess over regulatory requirements could be reduced over time, but has management shown any inclination to reduce this figure? The assumption here does make a sizable difference in returns on capital today and going forward.

 

Thomas has been pretty clear that the capital in the brokerage is not excess. Having that excess capital is part of IB's competitive advantage.

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