IBKR Business Overview:
Interactive Brokers’ [IBKR] two primary businesses are electronic brokerage and market making with revenues equally split between the two segments. In simple terms, every time you want to trade a security you need a broker to execute the trade. You can’t just call the New York Stock Exchange and buy a 100 shares of Wal-Mart. As a market maker, IBKR offers to buy and sell securities and earns a profit from the spread.
The company was started by Thomas Peterffy who is a staunch supporter of the Republican party. He spent $8 million of his own money on ads in support of Romney. Mr. Peterffy owns all interest in the Class B common stock of IBKR which has 88.5% of the voting power over IBKR therefore exerting full control over the business. As the founder, Chairman, CEO and largest owner, Mr. Peterffy has the biggest incentive to deliver results and he has proven that he can run the business very efficiently.
On its brokerage side IBKR competes mostly with TD Ameritrade, Schwab, E*Trade, and optionsXpress (purchased by Schwab in 2011). Companies compete on price, technology, services offered, and customer service. Barron’s does an annual ranking of online brokers, and Interactive Brokers won the overall first place for 2012. On cost, IBKR ranked 3rd out of the 27 companies that were ranked, but beat handsomely its four aforementioned competitors in that same category. In recent years, all five companies have built up technologically sophisticated trading platforms to attract more trader-type account holders who transact more frequently. IBKR boasts better price execution which is especially important for higher frequency traders. Lastly, it offers the widest range of trading products from a single account, excellent portfolio reports, and low margin rates, but lacks in customer service.
Below is a monthly comparison between Interactive Brokers, Charles Schwab, TD Ameritrade, and E*Trade using some of the main monthly matrixes they publish. You can obtain the monthly numbers by going to the investor relation section for each company. The first sections lists the client assets in $Billions, and clearly shows that IBKR is the underdog with only $32 billion in client assets as of Oct 2012. The second section shows the number of accounts and IBKR is again the smallest player. However, looking at the cumulative growth rate for that period it is beating the competition. It is interesting to see that despite the small amount of client assets, IBKR has high average account sizes. It is much easier and more efficient to service 1 big account as opposed to 5 smaller ones. The next section, Daily Average Revenue Trades (DARTs) is a very important metrics to follow since revenues are derived from trade executions. You can see that for the period covered, trading has gone down significantly and alarmingly IBKR has registered the biggest drop.
Trading as a percent of total revenues is 50%, 18%, 40%, and 30% for Interactive Brokers, Charles Schwab, TD Ameritrade, and E*Trade respectively. Since DARTs fluctuate significantly, IBKR is most exposed to trading volatility. Its competitors have other businesses that can soften the blow from reduced trading.
The company is known for its highly automated systems which helps keep pre-tax profit margins consistently higher than its competitors.
In the market making business the competitors are the large broker-dealers such as Goldman Sachs, UBS, Morgan Stanley, etc. The fight for business is mostly dependent on who has the superior technology. A bright spot in the market making business is IBKR’s leadership in the options market which has grown significantly over the last few years.
Both of IBKR’s businesses are highly dependent on transaction volume and volatility irrespective of market direction. Over the last few years trading volume has gone down, negatively impacting brokers as illustrated in the table above. Also, the company is extremely dependent on its sophisticated technology so any mishap can be very costly.
Over the last 30 years, there has been a very significant shift in the way people save for retirement. Companies used to promise a certain amount to their employees and set aside money each year to cover those future pension obligations. The burden was on the employer to reserve enough money and manage it prudently to meet its promises. More and more companies are switching out of the “defined benefit” model and going to the “defined contribution” plan. The employee is the one setting aside money for retirement and in most cases the employer also contributes certain percent. How the retirement account is invested is entirely up to the employee and upon retirement he/she transfers the 401K balance to an IRA account which generally offers lower fees and greater flexibility. This is where I see the opportunity for a company like Interactive Brokers. According to a 2008 Time’s article, there are more than 65 million 401K accounts in the US with a total balance of over $3 Trillion and growing (since 2008, the S&P has been up over 60%).
As the Baby Boomer Generation which tends to be more “do-it-yourself” is retiring, some assets will shift to the independent brokers such as TD Ameritrade, Schwab, Fidelity, and to some extent to Interactive Brokers. Without a doubt, the majority of assets will go to the larger brokerages which offer more hand-holding and larger investment funds offerings. The more cost-conscious and technologically savvy investors will choose Interactive Brokers. I have seen IBKR’s adds exclusively at CNBC, Barron’s, and other TV Channels and magazines where the audience is more engaged in investing. On the other hand, TD Ameritrade and Schwab advertise on almost any channel, website, or magazine. I think there are both different and good ways for brokers to approach this. IBKR is a niche player in the automated low-cost trading space and it shouldn’t necessary try to attract every potential investor. It actually has a $10,000 minimum requirement to open a regular account which is the highest I have seen for any online broker. Some retirees will decide to use a financial advisor and currently about a quarter of IBKR’s customers are financial advisers. Schwab, TD Ameritrade, and Fidelity are still the largest players in the RIA (Registered Investment Advisor) business so they are due to benefit from this secular trend as well.
IBKR Dividend Checklist:
1. How does the dividend yield of the stock compare to the yield of its sector – The current dividend yield of IBKR is 2.6% and the current dividend yield of the financial sector is 1.9%. The dividend yield is higher than Schwab’s and TD Ameritrade’s, but on an absolute basis it is not all that attractive. This is an example where the yield is not necessary the driving force behind the investment decision.
2. What is the company’s payout ratio, and how does it compare to the competition – The ratio is currently at 40% which is a little bit higher than the payout ratios of its closest competitors.
3. Historical progression of the payout ratio – IBKR first started paying regular dividends in 2010 and during that year the company had negative earnings. For Fiscal Year 2011, the ratio was close to 30%, and using the trailing 12-months (09/30/2012-09/30/2011) the ratio was 41%. The increase in the payout ratio can be a cause of concern since further dividend increases will be more difficult to sustain.
4. For how long has the dividend been in place – In 2009, IBKR paid a special dividend in the amount of $1.79 and in 2010 and 2011 it paid regular dividends at $0.40/share. I think there is a chance that IBKR will announce a special dividend before the year is over. Taxes on dividends are most likely going up in 2013 and so far a lot of companies with large cash balances have announced special or accelerated dividend payments to take advantage of the 2012 tax rate. Mr. Peterffy is a large owner of IBKR stock so a special dividend in 2012 should be tax advantageous for him. In addition, as a proponent of “capitalism” he probably believes that individuals can allocate capital more efficiently than governments. I don’t advocate buying a stock just because it can pay a special dividend because after the dividend is paid (actually a little bit earlier than that), the stock price will drop by the amount of the dividend.
I think Interactive Brokers is an excellent run company, with high profit margins, operating in a sector that has had some challenges in the last couple of years. As a matter of fact, IBKR became publicly traded company in 2007 at around $30/share and is currently trading at half that price – $15.18 (as of 12/06/2012). This is a very remote possibility, but if I was Mr. Peterffy and had a net worth in the billions, I might be at least thinking about taking the company private. I want to be clear that I am NOT suggesting buying the stock on such a small possibility.
Due to the current state of the economy, and the political and fiscal uncertainly I see more hurdles in front of IBKR and its competitors in the short-term. There are a few ways to cautiously buy the stock:
1. Do not buy any shares now, but put it on your watch lists and accumulate shares when the price drops. I think in the long-term $15/share is a good entry price, but it doesn’t hurt to try to get a better price on days when the stock is down. I don’t see a short-term catalyst that will propel the stock price and make you kick yourself for sitting out completely.
2. Slowly accumulate some shares starting now. For example, if your plan is to eventually invest $2,000 in IBKR, then buy $400-500 now and wait for pull-backs for the rest. Be aware of how much trading costs you, so that you don’t end up spending too much in execution cost thus not deriving any benefit from dollar-cost averaging the position.
3. Sell naked puts. By selling put options you take on the obligation to buy IBKR at a pre-determined prices for a specific time period. Let’s look at the specific numbers.
I have highlighted 2 possible put option contracts – both have a strike price of $15 but different expiration dates – March and June of 2013. Let’s look more closely at the March option. It is trading between $0.6 and $0.75, so we can conservatively assume we can get $0.65 per contract. In essence, we are promising to buy 100 shares of IBKR at $15/share, and in return we are receiving $0.65, so our cost basis will be $14.35 which is 5.4% lower than the current price. If we like IBKR at $15.18, all things equal we would love to be able to buy it for $14.35. There are two negatives in selling the naked put options. First, if IBKR’s stock price keeps climbing up we would not get assigned to buy the stock thus missing out on all of the upside. At least we will still get to keep the $0.65 consolation prize. Second, it is likely that your broker will set aside $1,435 of your cash [($15-0.65)*100] for every 1 contract you sell so you cannot use it to buy any other security . Your broker wants to make sure that if the price of IBKR drops you have enough cash in the account to buy it for $15/share as promised. Different brokers and different account types (IRA, regular, etc.) have different margin requirements so make sure you know how your cash will be impacted by selling the put.
Sources: Barron’s, Time, Morningstar Office, Interactive Brokers, Charles Schwab, TD Ameritrade, E*Trade, Standard and Poor’s, I-Metrix
A couple of days after I wrote about the potential for Interactive Brokers to pay a special dividend ahead of 2013, IBKR announced a $1/share dividend payable at the end of December. Pre-announcement the stock was trading at around $15.16 and after the announcement was made it dropped to around $15. As expected, the special dividend itself didn’t significantly impact the stock price.