Today's Buy Opportunity: Interactive Brokers

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CNBC junkies will immediately recognize the ads: Central bank buildings atop piles of money, spitting out an endless supply. A sonorous voice pleading for you to compare their currency prices to their rivals. If tight currency spreads and low margin loan rates don't grab your attention, don't worry: You're not Interactive Brokers' (Nasdaq: IBKR  ) target audience.

But even if you've never heard of IB before, pay attention to this: This low-cost, high-tech broker is shaking up the discount brokerage business, dominating a profitable niche, and today's stock price -- masked by temporary factors -- is as attractive as its tiny commissions.

Fast Facts on Interactive Brokers

Market Capitalization

$676 million

Industry

Online brokerages and market making

Price-to-earnings (TTM)

36.5

Price to tangible book value

1.1x

Key competitors

Market Making – Goldman Sachs (NYSE: GS  ) , Citadel, Getco. Brokerage – optionsExpress (Nasdaq: OXPS  ) , Charles Schwab (NYSE: SCHW  ) , TD Ameritrade (Nasdaq: AMTD  )

Source: Capital IQ, a division of Standard & Poor's. TTM=trailing 12 months.

For more than 30 years, Interactive Brokers' founder, CEO, and 90%-owner Thomas Peterffy has used cutting-edge technology and a strict risk management focus to build a finely tuned market-making and brokerage machine. Today, IB's brokerage customers can trade in 11 base currencies on more than 100 global stock, option, currency, and derivative trading venues around the world, all from a single account. That global and multi-product access, along with low commission and lending rates and rapid trade execution, makes IB the first stop for the highly active professional traders that brokerage businesses covet most. Just take a look at the charts below which show not only its growth, but how frequently its users trade:

Source: Company presentation. Normalized to 100 at Dec. 2007.

Source: Company presentation. Normalized to 100 at Dec. 2007.

 

Source: Company presentation.

With fewer than 200,000 accounts, IB may look like a small fry. But it's growing faster than the rest, while maintaining its focus on their active trader target niche. Trades per account remain an order of magnitude higher than competitors, driving total trading volumes that rival the largest of their peers, and margins other brokers can't touch.

Interactive Brokers maintains this growth and profitability in two ways:

  1. Automation: IB's focuses on using technology to keep employee count low and the business highly scalable.
  2. Low-cost provider: This scale contributes to the low fixed-cost structure and means IB can provide extremely competitive rates on commissions and margin lending, rates that attract ever more clients, creating more scale -- a cycle that all low-cost providers benefit from, which also creates a powerful moat for the company.

Temporary problems masking long-term value
The success in brokerage would normally have Wall Street donning premium valuations on the company's stock. But that growth has been masked by the poor results at Timber Hill, the market making operation that's been a millstone around IB's neck for the past year. After posting over $1 billion in pre-tax profits in 2008, Timber Hill mustered only about $5 million in market making pre-tax profits over the past three quarters combined. Declining volatility and increased competition from high frequency trading hedge funds were the main culprits.

But last quarter marked a turn in the market making business, and few have paid attention. That's because the headline remained ugly, with 5% operating margins and pre-tax profits down 97% year over year for this segment. That result, though, was almost entirely due to the dollar's unusual strength in the quarter: separate out the currency impact, and we see that market-making produced 49% margins and $75 million in pre-tax profits -- well on its way back to form and ample evidence that the last few quarter's results are not the new normal for this piece of the business. Further, given the quick move of the dollar back to weaker levels since June 30, much of that currency translation loss should reverse this quarter, setting up a potential upside surprise for the headline figures that draw so much of Wall Street's attention.

CEO Peterffy will gladly accepting lumpy earnings -- and even leave market share and short term profits on the table -- in exchange for keeping business risk in check. He's shunned counterparty risk since day one, only trading in products listed on an exchange and avoiding the intertwined links between banks across the world that nearly brought them all down like dominos. And his decision to keep the company's net worth not in dollars, but in a diversified basket of currencies they call "the GLOBAL," is another striking example that he's working to insure that Interactive Brokers will survive in the event of "financial collapse, nationalization, repudiation of debts or other economic catastrophic events." 

Is there a single other CEO out there treating these very real risks so seriously? Peterffy's focus on these things may have hurt earnings this quarter, but his efforts should provide benefit in the long run, particularly if you are concerned about the long-term health of the dollar.

This highlights both an opportunity and a risk for shareholders. Peterffy simply doesn't play the Wall Street earnings game, meaning IBKR is perennially treated as the brokerage industry's Rodney Dangerfield, getting limited attention and even less respect. That gives us a cheap stock to buy , at 1.1 times tangible book value, but means we probably can't rely on Wall Street "selling the story" for our returns. That's fine if you're thinking like a long term owner of the business – you can rely on earnings and book value growth to take care of your investment returns.

I think a more relevant concern is the potential for a cultural shift away from investing in stocks. The Great Depression (and to a lesser extent the 1970s bear market) produced an entire generation of risk-averse savers who swore off investing in stocks. A long-term deflationary environment globally, similar to Japan's experience in the last generation could create a similar emotional shift today. If that happens, IB's business might not grow as I expect.

Bottom line
About 14 months ago, Tom Gardner and I first made Stock Advisor members aware of this fast-growing and profitable online broker catering to high-volume traders across the globe. Its market-making and brokerage businesses combine to provide big scale advantages, and its highly automated operations further give this low-cost provider a natural moat, one that should deepen as global financial markets increasingly automate and intertwine. As the market-making business returns to normal profitability, the market won't overlook this growing gem forever. And at $16, you still have the chance to buy near book value, with ample margin of safety.

In our world of intertwined global economies and too big to fail banking institutions, we'd all be better off with a few more Thomas Peterffys running Citigroup, AIG, and the bankrupt financial firms that so obviously lost sight of prudent risk management. The financial landscape still seems scary -- but as we all know, fear can bring out the best investment opportunities.

Don't forget to hop in and ask a question or leave a thought on Interactive Brokers in the comments box below. We're giving away a subscription to Stock Advisor for the best comment on each"11 O'Clock Stock" pick this week! To see rules for the Stock Advisor giveaway, click here.

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Alex Scherer owns AIG debt, but no companies listed above. Interactive Brokers Group, optionsXpress Holdings, and Charles Schwab are Motley Fool Stock Advisor picks. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (21) | Recommend This Article (34)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 25, 2010, at 11:30 AM, tekennedy wrote:

    I was actually reading through the annual of optionsXpress yesterday and thought there were a few things worth mentioning which apply here. An easy benefit in the future is interest rate increases. Brokers are able to invest cash balances and pay out a rate to customers to earn net interest. IBKR's has been reduced from $227 to $53 from 2007 which when rates evenutally rise will add a bit to the bottom line.

    One thing which had me worried was the increased competition in the industry. OXPS had a rediculous rise in customer acquisition costs which seems a symptom of this competition. OXPS would seem to be most similar as far as competition as they target a similar niche, how has this company fared in this regard?

  • Report this Comment On August 25, 2010, at 11:41 AM, TMFEnochRoot wrote:

    Howdy Fools,

    I hope you find the above article useful. I'll be around to answer questions, please post away!

    Fool on,

    Alex

  • Report this Comment On August 25, 2010, at 11:41 AM, MyunderratedLife wrote:

    I like interactive broker (IBKR). They offer very competitive 'per-share' commissions which amount to much less than other discount brokerages. I find that interactive broker also has "more" shares available for shorting than rivals (such as Etrade). I think they definitely have a captive base with the trading crowd (the most profitable). And what better way to profit in the market than by assuming the role of the intermediary?

    As for the cultural shift, I think todays' business students are largely "unaware" of the severity of the subprime crisis. Black swan events fade from memory pretty quickly when one isn't actually invested.

    I do wonder what was the cause of the 'turn-around' in the market making business? It seems more and more hedge funds are sprouting into existence, and Bulge bracket banks are desperately looking for new/additional ways to maximize revenue with Financial regulation around the corner.

    Would the turnaround be contingent upon the relative strength (or weakness) of the dollar?

  • Report this Comment On August 25, 2010, at 11:44 AM, MyunderratedLife wrote:

    Another thing I seem to noice however:

    Interactive Broker doesn't seem to market as aggressively as other retail brokerages. And its rivals are definitely gearing to compete (e.g. Etrade Pro 2.0)

  • Report this Comment On August 25, 2010, at 12:06 PM, TMFEnochRoot wrote:

    @tekennedy,

    Agreed, interest income in a zero interest rate environment is gonna be quite subdued to say the least. I think this is true for the whole brokerage industry - my colleague Todd Wenning highlighted this recently in regards to both IBKR and another little broker TRAD: http://mot.ly/aBQ8uZ

    This is one more area where the current environment is masking tremendous growth. customer cash balances increased by 40%, to $11.95 billion in the latest quarter, and yet interest income is in the doldrums as you pointed out.

    As for customer acquisition, IBKR doesn't give much specifics - they don't break advertising out from G&A, and haven't really talked much about customer acquisition costs on their earnings calls. Peterffy has said on numerous occasions in the past that they rely heavily on word-of-mouth, sort of letting the service sell itself. Though those CNBC ads are pretty darn constant in the morning! But account growth has been tremendous without any notable spending so far as I can see.

    Cheers!

    -Alex

  • Report this Comment On August 25, 2010, at 12:28 PM, TMFEnochRoot wrote:

    @MyunderratedLife - Peterffy has spent a lot of time on past calls walking through the changing dynamics of the market making business and the competitive position they occupy versus the competitive position of the market makers. I've discussed this on the Stock Advisor message boards in some detail, if you're a member you can see here:

    The long and short of it: The status quo of the past year or two is not only bad for IBKR's profitability, it is also bad for the profitability of the exchanges. And since the exchanges are the ones with the power to change policies that currently favor HFT's over market makers, they are taking steps that will ultimately level the playing field. Most notable , they are forcing HFTs to denote their orders as such and thus give them equal priority to market makers, rather than greater priority they have had in the past since they were considered 'customers' and not market makers.

    The dollar's move is in my opinion of little relevance to the long term profitability of the business, although it will from quarter to quarter impact reported results, and potentially mask (as in the current quarter) or burnish (potentially next quarter) results for those short term periods. IBKR's stance of keeping their net worth in "GLOBALS" will only really be relevant in a black swan scenario where the dollar or euro or yen or etc. collapses, a scenario Peterffy seems acutely sensitive to.

    Cheers!

    Alex

  • Report this Comment On August 25, 2010, at 12:29 PM, TMFEnochRoot wrote:

    woops, meant to link to the Stock Advisor IBKR board, for SA members who want to read more on the market making unit: http://mot.ly/a3HBu4

  • Report this Comment On August 25, 2010, at 5:30 PM, kenjotto wrote:

    Interesting recommendation. I have seen the commercials and have considered checking them out as a brokerage.

    As an investment, I understand why P/tangible book is a relative valuation. But shouldn't we look at that and some of it's RO metrics? It's ROE, ROA and ROI don't seem very strong.

    I guess I'm struggling with how to value a brokerage. It's P/E is high, and while P/tangible book is excellent, it's only one metric.

    Thanks,

  • Report this Comment On August 25, 2010, at 6:36 PM, MichaelHamilton wrote:

    earnings for the last quarter were still only 0.09, so the trailing p/e ratio of approx 30 still represents too high a risk for my liking. Until I see some solid eps growth from this company that justifies the high p/e I wouldn't be interested. I don't see anything that justifies such a high p/e at this stage. The statement 'The success in brokerage would normally have Wall Street donning premium valuations on the company's stock' is invalid as we are not in a normal market cycle.

  • Report this Comment On August 25, 2010, at 10:38 PM, asutin56 wrote:

    I think it's safe to say that this particular market is one that is NOT recession proof. Obviously, when we hit a bear market, people just don't get involved much. However, one thing that I've learned from reading up on the teachings of Benjamin Graham is to buy when people are scared. That's when you'll start to find the underpriced bargain companies. With a relatively low price to book, the company could be undervalued in today's market condition. I believe once things pick up, and earnings increase, the price will go right along with it.

  • Report this Comment On August 25, 2010, at 11:17 PM, wallie123321 wrote:

    I disagree with you on your thesis. They are much better stocks to buy than IBKR. The reasons I dislike the stock are

    1. Trading volumes are light, Since late last year investor confidence has fallen off a cliff and the May 6th flash crash did not help matters. Until we get some investor confidence this stock will be stuck in the mud.

    2. A price war in the broker sector. When you go to financial website or watch CNBC you see lots of advertisements for different brokerages. from Scottrade, Fidelity, TD, Ect. The competitors keep lowering their prices Schwab to 8.95, Fidelity to 7.95 and offering free etfs. Not to mention having to compete with brokers like GS and MS This gives IBKR no pricing power as they might have to lower fees in the future. The sector as a whole reminds me of airlines.

    3. Terrible Customer Service. I am friends with a lot of people who use IBKR and the one thing they always say is the customer service is terrible and some of them left to go elsewhere.

    In conclusion, I am bearish on this stock until trading volumes pick up, the pricing subsides and they improve the customer service. In all fairness I have heard great thing from people who use them. They have great fills, great technology, and probably one of the best brokers for active traders.

  • Report this Comment On August 25, 2010, at 11:58 PM, RaptorD2 wrote:

    Hi Alex,

    Good writeup. I agree with your general assessment of the business but my personal doubts regarding the company as an investment could be summed up with one short question: Why now?

    Many can spot good companies, but much less frequently, good investments. The two are not always the same due in part to the issue of timing. A great company is often not such a great investment when the price is relatively high (admittedly not the case with IBKR.) With the global economy still on shaky ground, with China slowing, retail investors leaving the party for who knows how long and finally with so many political shenanigans continuing to plague the business environment, what reasoning do you employ for investing in IBKR * TODAY *?

    Unlike my neighbor Mr. Buffett, I don't have the problem of too much cash, so I must deploy what I do have ever so carefully. I see shorting the S&P 500 as a much safer investment than going long on IKBR today.

    I think someday IKBR will be a productive investment but right this minute? Probably not as productive as many alternatives. So IKBR remains on my watch list--where, in my opinion, it firmly belongs. I'm open to persuasion, however, so feel free to give it your best shot. I think we have months, if not years, before the gears of this one become fully synchronized, so please take your time. (Or, convince me I'm missing an opportunity by waiting with patience and stealth.)

    Thanks,

    Dan

  • Report this Comment On August 26, 2010, at 12:41 PM, TMFEnochRoot wrote:

    @kenjotto - agreed, ROE/ROA etc look terrible the last year, that's because the market making unit has performed so poorly over that period. I don't think market making is a 0 ROE business, and looking through the currency translation this quarter shows that profitability there is real even in this massively competitive period.

    A return to normal profitability at Timber Hill, even if it's only ~300mm and stagnant (current run rate ex the currency translation losses) rather than 1 billion, should put the firm's overall pre-tax earnings power at the 600mm level and growing 10%+ annually because of the 20%+ growth in brokerage unit. That also triagulates to ~10-12% ROE, depending on what you think is a sustainable tax rate (it's very low now, around 10%.)

    Cheers,

    Alex

  • Report this Comment On August 26, 2010, at 12:57 PM, TMFEnochRoot wrote:

    @MichaelHamilton - If you agree that the dollar strengthening that lead to translation losses isn't a permanent phenonmenon, then looking through to the operating income ex-currency translation should be a meaningful figure. By that calculation, IBKR's earnings would be closer to 24 cents this past quarter, rather than the 9 cents reported.

    Will those mysterious missing 15 cents ever reappear and benefit shareholders? I think so, in fact given the dollar's decline since June 30 I think most of it will show back up this quarter. That's why I think the trailing P/E is misleading, and why I think there's good value here despite the high ttm p/e figure.

    cheers,

    Alex

  • Report this Comment On August 26, 2010, at 1:05 PM, TMFEnochRoot wrote:

    @wallie

    1) I agree, though I think the time to buy a stock is not when the world is working in it's favor, but when things look bleak - so long as the bleakness is something you are sure is temporary. Trading volumes being weak could be cyclical (bear/bull market driven) in which case I they will recover and an IBKR owner will benefit. Or they could be secular (sea change in the "investing culture" away from equity/options onwnership) in which case IBKR's growth will be underwhelming. If the latter IBKR won't perform as I hope, that's why I point it out as a significant risk in the above article.

    2) The price war has been long-standing phenomenon in the broker space, ever since commissions were deregulated in 1975 and the discount broker arose as a competitor to full-service brokers. I think IBKR's position as a low-cost provider is a competitive advantage that's reinforced in an environment like this.

    3) Agree. I am a user, and I find customer service to be brusque and unfriendly at times. Part of the give and take - low commissions because they keep their costs tight, they give up on touchy-feely customer service because it's less important to the professional trader crowd than to ma and pa investor who want handholding from Schwab or Fidelity. This is one reason I don't think their model is something they could leverage into a "broker for the masses" business, and why they remain vigilant in focusing on the active trader/professional niche.

    Thanks!

    Alex

  • Report this Comment On August 26, 2010, at 1:09 PM, TMFEnochRoot wrote:

    @Dandroid - no good answer for you, I tend to not really focus on "why today", rather look for a good risk/reward and then go for it. I don't think i'm great at identifying short-term catalysts - others with better access to information/people will be able to suss out whether this quarter or next will beat expectations and therefore makes a stock a hold this week or a sell next week.

    I do think there's something in the recovery of the market making ops last quarter that seems to be off folk's radar, it shows me the start of a trend of recovery in that unit that's under appreciated and maybe makes for a good answer to "why now."

    Cheers,

    Alex

  • Report this Comment On August 26, 2010, at 6:38 PM, scanlin wrote:

    Yesterday (Aug 25) someone made a huge bearish bet on IBKR buy buying 100,000 Jan '11 14 puts and then sold 50,000 Jan '11 15 puts, tied to a sale of 350,000 shares of stock at 15.90. It was a premium neutral trade (sell 50K Jan 15s for 60 cents and then buy 100K Jan 14s for 30 cents). At 14 the trade loses $4.3M; at 13 it makes $1M, at 12 it makes $6M. At least one person with deep pockets thinks it's going down by Jan.

    MikeS

    http://www.borntosell.com

    covered call investment tools

  • Report this Comment On August 26, 2010, at 11:43 PM, bermuda999 wrote:

    @wallie

    I won't argue with you about this stock as a good investment - I've actually wanted to buy it for a long time, but it never really seemed cheap enough. The jury's still out in my mind on that score.

    As for the price wars...I doubt they'll put any competitive pressure on IBKR to lower their prices. They currently charge a penny a share (or a half penny if >= 500 shares). ...so, for example, it would cost me $2 in commissions to buy 200 shares of a $50 stock ($10,000 investment). For me, this might be a typical investment, so the fact that the other brokerages are "competing" by lowering their commissions to 4x what I'm currently paying doesn't really seem very threatening to their business model.

    And as for their customer service, I wouldn't call it terrible. I've been a client for over 9 years now, and any time I've needed to contact them, they've always responded to my satisfaction. (But no, they won't hold your hand).

    I'm likely not their typical client - I don't really trade stocks. I just find that I do seem to buy and sell stocks often enough that their ultra low commissions really make a big difference.

    my 2 cents.

  • Report this Comment On August 27, 2010, at 10:22 AM, TMFEnochRoot wrote:

    @scanlin

    I saw an article about this trade here http://mot.ly/crP6Ig but this commentator thinks the 350,000 shares were purchased, not sold, at 15.90. Would that change your reading of the trade? A colleague of mine with much more experience in the options universe related to me that this actually looks like a bullish trade (long 350,000 shares), with a sort of free disaster insurance attached (the 2x1 put spread protecting, or even profiting, from a tanking of the stock below 13.) That would make sense to me, since I feel book value of ~14.25 really is a solid floor on IBKR, barring some earth shattering calamity (hence the free disaster insurance.)

    Cheers,

    Alex

  • Report this Comment On August 27, 2010, at 12:20 PM, bigdrive11 wrote:

    I have been a professional trader for over thirty years and I can tell you that the savings in commissions at IB are VERY substantial. Between their low commissions and low interest rates they are unbeatable. On the negative side - I have used many, many different software packages for analyzing and trading the markets. I have even designed many of my own systems. Far and away, IB's software is the most difficult to use that I have encountered. The software at IB is very quirky and hard to use. It has a steep learning curve and primarily focuses on trading and execution - not analysis. Many tasks and functions are hard to find and diffcult to use, even simple things like getting your statement can be a challenge. They do save a lot of money on customer service as their agents are barely adequate.

    On a scale of 1 to 10 (10 being best)

    Software 1

    Customer service 3

    Commissions and rates 10+

    I like the analysis Motley Fool has done but, and this is the potential limiting factor on their growth, while the savings are great, the average investor may find using IB's software too difficult to be comfortable. At the present, IB really appeals to active, very sophisticated and determined investors. I personally am willing to deal with the frustration of using their software to save hundreds or THOUSANDS in commissions. If they ever revamp their software and make it user friendly - their growth could become exponential.

  • Report this Comment On August 27, 2010, at 7:45 PM, lesailes wrote:

    Ahh perspective is everything! I come from an environment where brokerage is very high and customer service is good (in the sense that they are nice to you) I am a long term investor, so not a typical client, and I have been with them 5 years.

    What I a joy IBKR are to deal with! I almost never have to contact them. They almost always send me advice before/when I need to know it on rights issues or dividends. They almost always respond to my occasional queries in a timely fashion (on how to make that FX trade for example.) The Help section is excellent.

    If we define customer service as looking after the interests of the customer IBKR is one of the best. (I own shares and expect to own more)

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