According to Wall Street lore, a New York broker was at the harbor with one of his clients and was pointing out the various ships in the harbor. "Over there is our CEO's yacht, and there's our top broker's, and there's our economist's yacht." The client then uttered the legendary reply, "But where are the customers' yachts?" It makes one think: Perhaps it'd be very Foolish to invest in the brokers themselves.
As any gambler knows, it's better to be the house than to play against it. Whether it's high-end brokers like Merrill Lynch (NYSE:MER) or JPMorgan (NYSE:JPM), or discount brokers like E*Trade (NASDAQ:ETFC) or TD AMERITRADE (NASDAQ:AMTD), one thing is clear -- brokers make a ton of money.
Recently, Interactive Broker (NASDAQ:IBKR) went public in a monster $1 billion-plus IPO offering. Since its debut at a high of $34, recent struggles have caused the shares to slide nearly 30% to $24. I thought it'd be great to peek under Interactive Broker's hood and see what we've got.
Company snapshot
Interactive Broker is an automated electronic market maker and broker. It routes orders, executes and processes trades for securities, futures, and foreign currencies on more than 60 global electronic exchanges.
Most of Interactive Brokers' revenues come from market making; the rest comes from its brokerage operations. The difference between the two is that as a market maker, Interactive Broker buys and sells shares for its own account, whereas as a broker, it will buy or sell your shares to someone else and collect a transaction fee.
In essence, the company sells liquidity. As a market maker, it tries to collect a tiny bid-ask spread millions and millions of times. As a broker, it hopes that you trade a lot and pay it plenty of commission fees.
All about the algo
At its heart, Interactive Brokers is a technology trading firm, because customers use brokers that can get them the best execution at the quickest pace with the lowest costs. Thus, Interactive Brokers is somewhat of a black box in that they've engineered some of the best algorithms, which I won't even pretend to understand. According to the company's prospectus, Interactive Broker tries to calculate quotes at which supply and demand for a particular security are likely to be in balance a few seconds ahead of the market and execute small trades at tiny but favorable differentials.
Although it's tough to put much stock in an economic moat based on "better algorithms," it's clear that the company's results speak for themselves. The company was founded in 1977, giving it three full decades of algorithmic tinkering. Since the inception of its market making division in 1982, the company has lost money only twice. Interactive Broker's share of U.S. options exchange volume went from 13% in 2004 to 22% in 2006. The company believes that its role as a dual provider of market making and broking allow for substantial synergies.
The company also noted that in 2006 it had over $1 million of pretax income for its 500 or so employees, which it believes is the highest rate in the industry and gives it low-cost provider status.
The company also has lots of industry tailwinds, simply because securities markets inexorably become more complicated and involve larger and larger amounts of volume, the perfect conditions for a seller of liquidity. The company noted that over the past five years, trading volume in global equity options, futures and options on futures, and ETFs grew 18%, 23.9%, and 37.7% annually.
Valuation
With Interactive Brokers, individual investors should be aware that they are just along for the ride. The company was set up with dual share classes, so that public shareholders only own 10% of the company. If we assume all shares (including privately held shares) were public, the company is worth about $9.6 billion.
In 2006, the company pulled in $1.2 billion in revenues and $760 million in pre-tax income, up from $930 million and $570 million respectively. Although roughly 12.5 times trailing pre-tax income doesn't get me super excited, Interactive Brokers might warrant a richer valuation because of its track record of growth and high returns on capital.
Although the company has posted roughly flat sales and earnings in the first half of 2007, the company has historically been a fast grower, as evidenced by the 25% annual growth in shareholder equity over the past five years. The company has tremendous operating leverage, as many of its operating expenses are relatively fixed and don't grow as fast as sales. Interactive Brokers also earns healthy returns on capital -- I calculate the company earned a 27% pre-tax return on equity -- and has almost no capital expenditures.
Again, I'll admit I'm not qualified to understand the difference between Interactive Broker's or Citadel's algorithms and ability to capture bid ask spreads -- just as I don't understand exactly how Wal-Mart's distributional advantages work. I just know it does. I think it's pretty clear, however, that the company has a credible track record of growth, profitability, and high returns on capital.
Related Foolishness:
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
