Over the last 18 months, the Federal Reserve has embarked on the most aggressive campaign to raise interest rates in its history. It's an attempt to cool soaring inflation, which hit a 40-year high in June last year. It appears to be working by all accounts, but not without consequences.
The recent regional banking crisis that claimed SVB Financial, the parent of Silicon Valley Bank, was largely attributed to the rapid increase in interest rates (combined with a helping of management missteps). Plus, tighter financial conditions have sent stock prices and real estate prices lower, and have crimped consumer spending in general, which directly affects businesses.
But there's a serious upside to higher interest rates for the world's largest online investment platform, Interactive Brokers (IBKR 1.47%). I'll share the details and explain why its stock might be a great buy right now.
Customers continue to flock to Interactive Brokers
Periods of volatility in the financial markets tend to attract new investors. We need only look back to 2020 and 2021 for evidence of that, when the retail crowd sent so-called meme stocks soaring. With the Nasdaq-100 technology index plunging 33% last year, and now fighting its way out of bear territory, brokers like Interactive have seen a robust flow of new customers coming through the door.
The company just reported its financial results for the first quarter of 2023 (ended March 31), and they showed a 21% jump in total client accounts year over year, to 2.2 million. However, client equity -- which measures the total value of the financial assets and cash that clients held in their Interactive accounts -- dipped 4% over the same period, to $343 billion.
How can the company have more customers but a shrinking asset base? Well, as an example, the Nasdaq-100 is down 8% compared to the same time last year, which pushed the value of clients' stock portfolios lower.
Client equity is important to watch because Interactive Brokers earns commissions based on the dollar volume of its customers' trades. If the value of customer assets declines, they're organically buying and selling in lower volume (in dollar terms), which means less commission revenue for the broker.
Ultimately, Interactive's commission revenue was up by just 2% in the first quarter. It was led by marginally higher contract volumes in options and futures markets, where the firm makes a higher commission than on regular share trading, which was down 22% in the quarter.
But surging interest income offset weakness in trading
Commissions aren't the only source of revenue for Interactive Brokers. It has custody arrangements with a series of banks, so when clients are holding cash in their Interactive accounts, those banks are paying the company interest income.
Interactive pays some of that interest forward to the customer, which it also uses as a marketing tactic to attract new accounts (not all brokers pay interest on idle cash).
And Interactive lends money to clients to buy stocks and other financial assets, which also attracts interest income. This is typically called margin lending.
In the first quarter, the company's net interest margin (NIM) more than doubled compared to the first quarter of 2022, to 2.24%. The NIM is simply the difference between what Interactive pays to borrow money from its funding partners, and what it charges when it lends that money to clients. Or, the difference between the rate it earns on client deposits compared to what it pays forward to those clients.
The result was interest income that more than quadrupled in the period to $1.3 billion! After accounting for interest expenses, the company's net interest income came in at $637 million, which was still a 126% jump year over year.
The result was more than enough to offset Interactive's sluggish commission revenue, and it lifted the company's total revenue by 63% for the quarter compared to the same time last year. Much of that additional revenue flowed to the bottom line, nearly doubling the company's earnings per share (EPS) to $1.42.
Interactive Brokers stock might be a great buy right now
Despite Interactive Brokers stock rising 18% this year so far, it's still cheap on a price-to-earnings (P/E) basis. With $4.42 in EPS over the last four quarters and a current share price of $84.10, it trades at a P/E of 19 right now.
That's a steep discount to the Nasdaq-100 index, which trades at a P/E ratio of 26.7, meaning Interactive Brokers stock will have to gain 40% from here just to trade in line with the broader tech sector. Its P/E ratio is in line with the more diversified benchmark S&P 500 index.
But considering the company's growth rates at the top and bottom lines, one could argue that its stock deserves to trade at a premium to the broader market instead, so it might be a great buy at the current price. Since interest rates are likely to remain high for the rest of this year at least, investors shouldn't be surprised to see more blockbuster results from Interactive.
