IBKR - Interactive Brokers: Operational Excellence Scale Meets Falling Net Interest Income

2023-12-26 10:54:44 ET

Summary

• Interactive Brokers is a prominent brokerage that works with both retail and institutional investors, offering unique global trading capabilities.
• The rise of options trading, particularly 0DTE options, has contributed to increased trading volumes at Interactive Brokers.
• The company has a strong moat in the international brokerage space, generating significant revenue from international clients and maintaining a stable operating margin.

Interactive Brokers is One of the Few Remaining Brokerages That are Still Able to Charge for Commissions

Interactive Brokers ( IBKR ) is another one of my focus list names that I routinely trade when a dislocation hits the stock.

The Finance sector, which includes Goldman Sachs, Morgan Stanley, American Express, JPMorgan, and Interactive Brokers, is one of my favorite Sector Rotation targets when the macro and technical context is appropriate.

IBKR has been range-bound for a few months and will take further time to break out. I view the company very favorably from a fundamental standpoint and believe the stock will have additional entry points to be determined once the context is right.

The Catalysts for IBKR and Fundamental Outlook

Interactive Brokers is one of the most prominent brokerages among retail and professional investors. Their business model is unique in that they work with hedge funds, mutual funds, as well as financial advisors in a larger capacity than traditional brokerages such as Schwab, TD Ameritrade, or Robinhood. The current mix between retail and Wall Street institutional clients is roughly 55% retail and 45% institutional. Interactive Brokers' global offerings to allow U.S. citizens to trade Europe and Asia, and allowing the rest of the world to trade the U.S. Market which may not be readily available in their home countries is an attractive feature to users.

For instance, I personally invest in H-Shares from the Hang Seng and occasionally European megacap stocks such as LVMH (Euro Ticker MC) or Schneider Electric (Euro Ticker SU). This is not possible in my previous brokerages, TD Ameritrade and Charles Schwab.

The key variable that has driven IBKR's upside for much of 2023 was the narrative that rates would remain "higher for longer" from the Fed's hawkish rhetoric. The brokerage derives significant net interest income from the Fed keeping the Fed Funds rates at 5.5%, and we can see that shares peaked around the time the market believed that short-term rates most likely reached a top earlier this Fall.

IBKR earns interest income from its clients' margin balances which are tied to short-term rates and its larger retail and institutional clients which employ heavy leverage are big sources of steady recurring revenue for the brokerage side of the business.

Because of the robust features offered in both their retail products IBKR Lite and IBKR Pro, Interactive Brokers also earns income from commissions, which is something that the brokerage industry has unsuccessfully been able to charge for. The brokerage industry has seen significant consolidation with the Charles Schwab and TD Ameritrade merger, but IBKR has continued to strengthen its client acquisition efforts during this period of time as options trading has become more popular, and IBKR is a major brokerage for best execution in options.

I believe that the rise of 0DTE Options introduced by CBOE is a catalyst that lifts options trading volumes at all brokerages. IBKR recently discussed in the latest quarter that while equity trading volumes were down 22% compared to a year ago, options trading volumes actually went up by 19%. The rise of 0DTE options trading in high-volume ETFs such as SPY and QQQ are reported to be among the biggest activities in their daily order flow.

Investors in IBKR will be focusing on client account growth, and last quarter's figures put this key performance indicator at the low to mid 20% region compared with 30% a year earlier. This is primarily due to a softer U.S. market environment up until October of this year, before a sudden Fed Dovish Pivot catapulted equities higher.

The scale of Interactive Brokers' business has allowed them to generate an operating margin of 60% which is higher than Charles Schwab's (40-45%), TD Ameritrade's (40-50%), and E-Trade's (35-45%).

What I find most attractive about IBKR is that it has developed a moat in the international brokerage space, which is very fragmented and difficult to create a presence in due to local regulations and thinner liquidity. After the global recession in 2008, many U.S. brokers exited the international brokerage business, but IBKR doubled down on their automation infrastructure to grow in Europe, Asia, and the Rest of the World. Today, international clients represent almost 1/3 of its revenue and 1/5 of its operating income. Its larger International Clients such as European clients generate about 1/5 of commission revenue, and Asia Pacific generates about 30%. European and Asia clients value being able to get access to U.S. stocks and other non-U.S. stocks through IBKR's global trading platform. This moat will likely keep their operating margin stable in the foreseeable future.

Risks, Thoughts on Entry and Valuation

The biggest risk in the near term for Interactive Brokers' shares is the Federal Reserve making an abrupt further Dovish pivot to cut rates more than the 3 times in 2024 that they discussed in the last December FOMC meeting.

Although IBKR has a positive beta to the S&P 500, they are also at the same time sensitive to directional moves in short-term rates such as 2-Year Yields as their net interest income is pegged to the Fed Funds Rates. Fundamentally, IBKR benefits from economic growth tied to the S&P 500, but they also do not want rates falling too fast as that will compress their net interest income. Compared to Charles Schwab, IBKR pays a high interest rate on idle cash in client accounts, just about 50 basis points under the Fed Funds Rates (FFR). Charles Schwab typically pays interest rates a couple of hundred basis points less than the FFR.

IBKR will also likely accelerate momentum in acquiring new clients in their business if interest in options trading increases due to new Daily Expiries for popular stocks. Any SEC regulation on additional innovation in the Options Trading community may slow their growth for client onboarding. Slower account growth on their platform may limit investors' appetite for valuation expansion.

90% of Interactive Brokers' clients pay commissions for their transactions, so any fee compression to stay competitive with other brokers is always a focal point given that commissions are an integral part of IBKR's business model. But given that other brokerages don't have the trading capabilities (routing, execution, efficiency, speed) that institutional clients often look for, and IBKR also offers to pay interest on idle cash - for now - I don't see this to be a material threat.

IBKR's valuation relative to its own history is fair as we can see the Price to Book is 2.6X and its Forward P/E is 14.2X, which is in line with its historical levels. This suggests that any factors that drive Yields higher, customer acquisition figures better, or increased market share in international segments may give investors a case to go for valuation expansion.

Interactive Brokers continues to be on my focus list for trading opportunities when dislocations hit the stock. It is a Hold in long-term portfolios, based on my understanding of their business relative to the current macro context.

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