by David Kim, Scuttle Blurb

Interactive Brokers Group, Inc. (IBKR) began as an electronic market making platform for professional traders at a time when market making was still mostly being conducted via open outcry.  Its foundation of technology and automation ensured transactions at the lowest cost and fulfillment at the best possible price, core capabilities that it later brought to bear in launching its prime brokerage business.  Today, the prime brokerage business, which accounts for the vast majority of the company’s value, charges commissions and financing costs that other discount brokers don’t even come close to matching – the commission rate to trade 100 shares on IBKR is $1.00 compared to $8-$10 on E-Trade, Fidelity, optionsXpress, Schwab, and TD Ameritrade.  And even while charging commissions that are a fraction of its peers, the company’s pre-tax brokerage margins of 65% are substantially better than all of its peers.  AMTD, a very efficiently run broker, has an operating margin of 40%.

Interactive Brokers

Interactive Brokers

This is possible because 1) as a percent of revenue, IBKR spends far less than larger discount brokers on advertising; 2) the company does not have to support physical branches or hire an army of customer service reps; and less appreciated but critically, 3) trading volume is itself endemic to continuously driving down IBKR’s execution costs, since the more trades it does, the better sense it has of the statistically optimal venue to route an order and better execution in turn, leads to more trading volume.

Incumbent discount brokers are both culturally and technologically ill-equipped to compete with Interactive Brokers’s value proposition.  From a competitive standpoint, I probably worry more about high frequency trading shops than I do the incumbents.  The company’s market making business segment, whose profits have been shrinking for years, has been out-competed by HFTs and I wonder if HFT’s speed advantage in market making could somehow extend to brokerage the same way IBKR breached brokerage with its own superior market making platform decades ago, though I think the flywheel effect from “3)” would still make this difficult.

Also, while I think IBKR is a fine company (I own it), I think the addressable opportunity is often exagerrated by bulls.  First, although IBKR should benefit from big banks dropping less profitable hedge fund clients, my sense is that there is a cap on the extent to which IBKR benefits from a hedge fund client’s AUM growth, as larger funds seem stubbornly devoted to brand name primes like Goldman and Morgan.  As I wrote in my last Interactive Brokers post:

…the fact remains, the co. will never do capital introductions, will never bring CEOs in the same room as investors…basically, the co. will never do anything it can’t automate – “we’re a bunch of computer programmers.”

Second, I don’t think stealing client accounts from larger, higher-cost brokers represents a significant opportunity for IBKR, as brokerage accounts are sticky and the Scottrade/Charles Schwab customer, who is looking for personalized support, has different needs than the sophisticated trader who prefers the no-frills austerity of IBKR.  Instead, I think the largest opportunity is acting as a white-labled trading platform for traditional retail brokers, and indeed, “introducing brokers” are a growing mix of IBKR’s client flow.  Petterfy says there are “brokerage firms popping up all over the world” (esp. in Asia and Eastern Europe) and that IBKR has just a fraction of a $1tn opportunity as smaller and mid-sized brokers find it difficult to justify the cost of managing their own technology in response to rising regulatory and operating costs.

The way the introducing broker arrangement works is that IBKR takes all the broker’s client trades and runs them through a volume tier that gives the broker very low rates, and those brokers in turn charge their clients what Interactive Brokers would have charged had those clients come to IBKR directly (the introducing broker keeps 2/3 of what the client pays, IBKR gets only 1/3).  My understanding is that although these accounts generate far lower revenue per trade, they are still quite profitable because they are unencumbered with recurring sales expenses (the introducing broker, not IBKR, interfaces with the end customer).  Still, even if these commissions came on at a 100% contribution margin, we can impute based on IBKR’s brokerage margins that they would still generate far less profit per DART than the average IBKR customer.  Furthermore, the ultimate customer being sourced from these introducing brokers is relatively less active in his trading.  This quarter IBKR’s average customer account transacted 400 times this year vs. 450 times the prior year and the average introducing broker customer spent $463 in annual commissions compared to $1,437 for the average direct individual customer.

OK, as far as the quarter/year goes, outside of a few days proximate to Brexit and Trump, 2016’s ultra-low volatility year (avg. VIX -18% y/y – only 6 quarters in the last 10 years have seen such low average VIX) weighed on brokerage results, so much so that despite 16% account y/y account growth, commissions actually declined for the year and the 12% increase in operating income was more than entirely due to a $98mn increase in interest income.  Another 25bps rise in overnight rates would generate ~$41mn in net interest income (vs. $800mn in segment pre-tax profits) but the impact from hikes beyond that should be far smaller (the interest Interactive Brokers pays to customers is pegged to benchmark rates less a narrow spread).

Valuation: if we back out all the excess capital from market making and brokerage (whether this is the right approach is questionable as Petterfy has made it clear that, at least on the brokerage side where the vast majority of this capital resides, the company has no plans to dividend it out), it looks like Interactive Brokers is trading at ~15x pre-tax brokerage profit (21x if I don’t back out the excess capital).  Lower unit profits from introducing broker customers notwithstanding, the valuation seems compelling given the company’s wide moat and expansive market opportunity.

Article by David Kim, Scuttle Blurb