IBKR - Interactive Brokers: Industry-Leading Brokerage With Potential For Strong Returns

2023-11-21 09:03:08 ET

Summary

• Interactive Brokers trades at a 10-year low forward P/E multiple, despite total accounts and client equity growth remaining strong.
• Its low-cost, tech-enabled platform is scalable and well-liked with multiple growth avenues.
• Its topline sensitivity to rate cuts is also overblown.

Potential For Strong Returns

Interactive Brokers ( IBKR ) has continued to achieve strong growth in total accounts and client equity, but the market seems to be overly focused on a potential compression of its net interest margin. I think IBKR is a high-quality business with an attractive growth profile. Even with rate cuts and a more normalised growth in total accounts and client equity, the company is substantially undervalued.

Company Overview

IBKR is a global electronic broker that allows its customers to trade in a multitude of financial products like stocks, options, and futures through over 150 exchanges worldwide.

Revenue Segments

Their revenue is made up of non-interest income (which is mostly commissions earned from their customers' trading activities) and net interest income (which is mostly made up of interest on margin lending to customers and interest earned on customers' cash balances). As shown above, the share of revenue from net interest income, which tends to be less volatile than trading commissions, has increased from 23% in 2013 to 54% in 2022.

Focus On Automation

What stood out to me about this business is their relentless focus on automation which is very distinct from their peers. A Tegus expert call transcript I read mentioned that 90% of their software is built in-house. They thus have the flexibility to adapt to customers' needs, merge platforms, and fix any issues. Their employee base is also very small. If we compare to the brokerage SCHW, IBKR's revenue per employee is about 6x that of Charles Schwab ( SCHW ).

Their lean cost structure allows them to offer a better interest rate (for instance, for margin loans and cash balances) to customers, which attracts new customers and prevents them from switching to other brokers. Overall, this leads to their industry-leading margins as shown below.

Furthermore, unlike other brokers, they do not need to sell their customers' order flow to market makers (which is often lucrative but against customers' interests) to achieve their margin profile and profitability. Selling order flow is only done for IBKR Lite customers who only make up 6% of their accounts and a smaller percentage of their trades. This means that the bulk of their customer base opts for IBKR Pro, who will enjoy better trade execution and lowest "all-in" cost of trading.

Investment Thesis

Sensitivity To Interest Rate Cuts Is Overblown

With higher interest rates, brokerages are enjoying a boost to their top line. If they earn a higher interest on customers' cash balances for instance, and keep a large proportion of the economics to themselves, the net yield on client equity (net interest revenue divided by average client equity) that they earn will be very much higher than it previously was.

For IBKR, rate hikes have led net yield on client equity to increase from 0.5% in 2022 to an estimated 1.1% in 2023. This will likely cause net interest income to become ~70% of net revenue in 2023. With potential rate cuts as inflationary pressures ease, the market seems to be overly concerned about the compression of this net interest income boost. I make the case later that IBKR remains undervalued regardless of how drastic we assume rate cuts will be.

Huge Growth Runway For A Scalable, Well-Liked Platform

Since 2015, the fastest growing customer segments are Individuals, Introducing Brokers and Hedge and Mutual Funds, as shown above. The growth runway for these segments is still very large.

Hedge Funds

The assets under management in the hedge fund industry is valued at ~ $5trn according to Statista . Average client equity from hedge and mutual funds has been growing at a 23% CAGR since 2015 and yet IBKR has only captured 0.5% of the market. With IBKR's access to markets and quality of execution, there's reason to believe that this will continue. A former IBKR executive highlights this in a Tegus transcript (sign-in required):

"I really can't see how any other broker or competitors are able to copy that, plus the rest of the world. And also in terms of speed of execution, those are all proprietary algos, which most brokers cannot compete with. And we see that it was very difficult for Interactive Brokers to sell that to clients because they say, "It's $0.01 different. I don't care about that." But now the clients are getting more and more, let's say, finance knowledge. They're getting more interested and they will see that over time. If you're trading, this does have a significant impact."

Introducing Brokers

Another growth opportunity is introducing brokers. These tend to be localised brokers who white-label the IBKR platform such that IBKR manages the back-office operations while the brokers can acquire their own customers. IBKR's lean cost structure allows them to charge lower prices than other solutions. The arrangement with IBKR is very compelling for such brokers - as the founder Thomas Peterffy puts it at a Sep 2023 conference (sign-in required):

"Now for introducing brokers, we take all of their accounts as though as it was one account, right? And so the brokerage charges are substantially less. And that's why we can say to introducing brokers, you don't have to worry about us competing with you because you can charge exactly the same amount as we charge to each individual account. And you make about 40% of the total charges."

The introducing brokers get to profit from the difference between the brokerage fees charged by IBKR to them and the fees charged to these introducing brokers' customers. Furthermore, IBKR onboards these brokers quickly (within 6-12 months) which is faster than other alternatives such as banks whose systems are old, and who are subject to more regulations.

Individuals

IBKR's individual users tend to be relatively sophisticated retail investors. They tend to understand the importance of execution quality and look for low-cost commissions as well as interest on cash balances. According to World Economic Forum and BCG estimates , retail assets under management are ~$50trn and IBKR has captured only 0.3% of the market. Some of these individuals tend to go to IBKR as their second broker after using a more retail-oriented platform like Robinhood before switching over. It's not hard to believe that this will continue especially with the attractive interest rates offered by IBKR and the movement away from platforms with higher "all-in" fees. Considering how Charles Schwab has over 30m brokerage accounts and IBKR has under 2m, there remains a large opportunity to grow.

Valuation

For non-interest revenue, I assume Daily Average Revenue Trades (DARTs) per account remain constant while commission revenue per DART declines by 5% annually in line with the 2015-22 CAGR.

For net interest revenue, I assume that the net interest yield on client equity decreases gradually to 0.4%, which is below the net yield in the past.

For client equity growth, I make conservative assumptions for the total accounts for each customer segment as shown below. I assume client equity per account remains the same.

For pre-tax margins, I assume that they gradually decrease from 70+% to normalised levels of 60%+ as the high-margin net interest revenue from higher interest rates reduces due to rate cuts.

The FCFF margin I assume is also in line with the 2018-2019 period, which was a more normalised environment.

With a WACC of 9%, I get an exit price of $204 with a 4-year investment timeline. That represents over a 2x opportunity and an IRR of 27%, as shown below.

I think this is a highly compelling opportunity given that we are assuming a pretty aggressive decline in the net yield on client equity. If it were to decline at a slower rate, the stock would be even more undervalued. Moreover, IBKR is trading at ~13x forward P/E, which is the lowest it's been in the past 10 years.

Key Risks

Account growth could turn out slower than projected. I would expect this to be attributed to lower demand from introducing brokers. It could be that white-labelling isn't as scalable as thought to be because of localised regulations or specific needs that a global broker cannot offer.

After rate cuts, the net yield on client equity could also be lower than expected. This could be from a smaller spread between the gross and net yield on client equity, which I think might arise from the way IBKR is providing more economics to customers nowadays. However, I think my assumptions take this into account already as I project the net yield to decline to levels lower than before the rate hikes.

Conclusion

IBKR provides a compelling investment opportunity in a fast-growing global electronic broker whose growth runway is huge. IBKR's topline sensitivity to interest rates is overblown and as I've shown, the aggressiveness of rate hikes isn't a big risk. With an IRR of 27% and at the current multiple of ~13x NTM P/E, the risk-reward skew is very attractive.

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