IBKR - Interactive Brokers: Ahead Of The Pack

2023-07-20 08:27:19 ET

Summary

• Interactive Brokers has the competitive edge to thrive domestically and internationally.
• Their operating margins are unbeatable and their offerings on margin rates and interest on cash balances put them ahead of the pack.
• The valuation is attractive on a Price-to-Sales metric and beginning to get attractive on a Price-to-Earnings metric.
• I believe the market's reaction to the results from the latest quarter is a good opportunity to get in.

Thesis

I like to think of Interactive Brokers ( IBKR ) as a unique business among most brokerage businesses. While retail investors are a big part of its core business operations, multiple institutional clients also use the firm's brokerage services. There are a couple of factors that make this company attractive to invest as a business -

1. Wide international reach and Global penetration

2. Rapid technology adoption

3. Outperforming its competitors on multiple avenues

Global Reach

Some of the facts about their customer reach are truly impressive.

• The company's platform provides access to 150 electronic exchanges and market centers in over 30 countries.
• They have 2.09 million cleared customer accounts that are spread across over 200 countries and territories globally
• A substantial majority of Interactive Brokers' customer base, approximately 79%, resides outside the United States.

• In 2022 and 2021, 37% and 39%, of commissions were generated from operations conducted by its subsidiaries outside the U.S.

Their wide reach could partly be attributed to the US equity market being the biggest, most liquid, and most desirable to trade worldwide . While this size allowed a lot of homegrown brokers (including the big banks that offer equity trading) to become bigger than their international counterparts, only Interactive Brokers was able to successfully expand their operations beyond the U.S.

So the wide reach was most likely the result of regulations making it difficult for firms to operate outside of their own country. Unlike many industries that have gone global (cars, software, etc.) financial industry has remained stubbornly local . Even when the financial industry expands internationally, sooner or later in many instances they end up selling their operations to a local player and exiting the country. Domestic players face the same hurdles when venturing outside of their own country as navigating the regulations of each and every territory starts becoming a complex endeavor. Inevitably, this starts having an effect on the cost of operations and these barriers to entry have prevented other players from becoming as big as Interactive brokers internationally.

What are the factors unique to Interactive Brokers that have contributed to their successful expansion? Also, how well are these being reflected in their latest quarterly results?

Best of Breed

Technology

The company relies on heavy automation to bring down the cost of its operations. Management believes this to be a big reason for their edge over their competitors. Automation simplifies processes and enables companies to adapt quickly to changing market regulations. Even with such a large global operation, management counts low staff as one of its strengths to maintain the competitive cost advantage.

Operating Margins

The proof is in the pudding and as such when operating margins are compared across the board it is clear that Interactive Brokers is the winner. As the US brokerage industry underwent a wave of consolidation in the last couple of years, we are missing the recent data for some of the brokers below but the winner was already decided by a wide margin a while ago. The company didn't just stop there. They have also been improving after that. For 2021 and 2022, they came in at 66%!

Best Margin Rates

The company claims to have the lowest-margin loan rates in the industry. This becomes quite attractive for traders as they can frequently juice their returns using margins.

Earning Above-Average Interest

While many institutions are offering very little interest, Interactive Brokers is offering more than 4% on the uninvested USD cash balance. The company chairman, in his note to investors specifically called this out -

Given rising interest rates and our cautious policy of not investing cash in distant maturities, we are able to offer over 4% interest on uninvested cash in our customers’ brokerage accounts. Since other banks and brokers are offering only a fraction of one percent, this should hopefully bring us many new customers.

Peek Into Their Latest Quarter Results

The results for the latest quarter fully reflected the company's strategy. While commission revenues remained flat over the last comparable quarter, total net revenues still increased by more than 50%, and adjusted EPS was also up by more than 50%!

All of this can be attributed to a rise in the net interest income of 99% due to higher benchmark interest rates and customer credit balances. Also, compared to a year ago, customer accounts increased 19% to 2.29M and customer equity also increased 24% to $365B. This further suggests that the company's strategy of providing the best margin rates and the best interest on the customers' idle cash is paying off.

Valuation

Here too the company fares favorably amongst its peers. If you consider only its competitors with the highest overlap in its business, we would look at only Robinhood ( HOOD ), Charles Schwab ( SCHW ), and Futu Holdings ( FUTU ) while previously independent businesses in the brokerage industry have been acquired (TD Ameritrade and E-Trade). At a Price to Sales ratio of around 2x, the company seems to be the cheapest.

Diluted EPS for the LTM is at $4.9, calculating Price to Earnings multiple for LTM would come close to 17x. This is within the comparable range for this industry and suggests that the earnings multiple is fairly valued. Reaction to the latest earnings report was negative, with the stock down close to 5% at one point. If the stock continues to trend down this year but EPS continues to trend up (as we saw from the latest QoQ), we might see valuations continue to get compressed, making our case for buying stronger.

Short Commentary on a Key Risk

The commission revenue is down for the quarter due to decreased trading volumes. Fortunately, as we saw, the company made up for this through increased revenues from interest income. If the rates indeed end up going down over the short to medium term, we may see revenues from this segment also come down. If the rates go down due to fed intervention of market turbulence, I believe the revenue from the increased trading volume will be able to balance it out. The double whammy would be when the market enters a slow correction, the economy enters a recession and the Fed appropriately intervenes by bringing down the central bank rates. This would be the worst-case scenario for the company. The trading volume may continue to remain muted while interest income may also start to see a significant decrease affecting the company's top line.

Final Call

The company has proved that it has the competitive edge it needs to survive and grow. I rate this company as a buy and will be entering into a small position.

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