Interactive Brokers Group Stock: Price Is Too Much For The Prospects (NASDAQ:IBKR)

Interactive Brokers Group (NASDAQ:IBKR) is an interesting business because it is probably one of the least-discussed broker-dealers out there, despite having a very successful business model. I wanted to give it a look for this reason.

While I think the business is sound, I think the offer on the market isn’t great for the long-term investor. Given the recent rally, the shares seem like a good Sell, and I’ll lay out my case for why.

Company History

The company was founded in 1977 by Thomas Peterffy, initially as a lone market maker on the American Stock Exchange. During the 70s and 80s, he made great strides to develop computer-driven methods to trade stocks and options more effectively. As he and his team grew, the business was registered as a broker-dealer in the U.S. in 1993. In the years that followed, they developed an electronic trading platform and expanded the business and its trading services into other countries’ exchanges.

IBKR had its IPO in 2007, in which it shared a partial stake in the company with Peterffy (explained below). By 2012, they began offering advisory services.

With this increasingly comprehensive system they developed, the company enjoyed consistent, growing profits.

As we can see, net income has grown several times what it was a decade ago. While there was a spike in 2021, mostly attributed to COVID and the trading fad that emerged when folks were under lockdown and had stimulus checks to invest. Following that, earnings are still higher, showing some level of retention of that growth.

Yet, some of this was due to interest rate hikes. As management mentioned in their 2023 Form 10K (pg. 42):

Net interest income on customer cash and margin loan balances increased significantly compared to the prior year as the average federal funds effective rate increased to 5.03% in the current year from 1.68% in the prior year. During an extended period prior to and including part of 2022, the interest we paid on customer cash balances and earned on customer margin loans and investment of customer segregated funds resulted in spreads that were compressed at low benchmark rates. Now that benchmark interest rates are over 50 basis points and spread compression has been eliminated, we earn higher net interest income.

Corporate Structure

When you buy shares of IBKR, you aren’t exactly buying direct ownership in IB. There’s a peculiar structure that determines the ownership of this business that is worth understanding. Thankfully, the business provides a diagram to explain it in its Form 10K

As we can see above, there are three key components of IB here: the Group (which IBKR owns), the LLC (which is the business operation itself), and Holdings (which has most of the voting interest in the Group and the same proportion of membership in the LLC). You may also notice that, through his 91.3% stake in Holdings, Peterffy individually has a controlling interest in the Group through Holdings’ Class B shares.

Additionally, the financial reports need to be read such that owners of IBKR know what their share of the business is. The financial data, which I showed above, do not yet take that into account.

Business Model

Interactive Brokers provides a variety of brokerage, trading, and advisory services for hedge funds, mutual funds, institutional investors, and individual investors globally. Customers can trade most any type of asset, to include crypto (as recently as 2021).

The table above shows that the commissions earned from their brokerage business and interest income are their leading sources of revenue, with net interest income (earned on segregated cash balances and margin accounts) increasing substantially after interest rates were hiked. Commissions are a more stable source of income, despite the different market environments each year posed.

In addition to commissions, there are adjacent income sources that their trading platform offers, such market data and PFOF. Most of non-interest income derives from their American operations, but International is still significant.

Meanwhile, net interest income proves to be more cyclical, with higher rates generally earning the company more through most of their interest-bearing revenue sources.

A Look to the Future

I think this will continue to be a growing, successful business, given the company’s deep history in developing and pioneering electronic trading and brokerage services and its ability to grow organically into other markets. Still, we need to talk about the good and bad of what to expect going forward.

Diversified Income Sources

While net income mainly derives from two sources, IB has some level of diversification here with a decent international position that gives it coverage to the market cycles of other economies and the interest rate cycles of other currencies.

It’s still anchored on the U.S. and the dollar, but I believe this should allow for smoother cash flows over time, especially as other economies develop and all for expansion to covering their exchanges as well. (For example, no African or Latin American exchanges are covered yet.)

Interest Rates

In the nearer-term, I believe the Fed’s rate hikes will cause net interest income to be higher and that, as rates eventually begin to decline, there will be a diminishing effect on net interest income.

Yet, it’s important to remember that, as the number of customer accounts has grown, so has the pool of segregated cash and margin activity on which IB earns interest. Don’t let interest rates alone dictate your expectations on how interest income can grow.

Crucially, I think IB’s low loan rate for its margin accounts will be a competitive advantage for that service over time. Chances are, however, that it will not be casual but sophisticated investors who make use of this feature.

Limits on Growth

While I like that IB has an advisory segment, I think more than a decade of results shows that this is unlikely to be a significant source of income for the company. The advisory space is saturated, and it seems that the incumbents likely have too much of an advantage.

The broker-dealer space, where they are stronger, is also saturated and very competitive. While they have been enjoying growth in accounts, listen to this remark by CEO Milan Gilak in their Q4 2023 earnings call:

Interactive Brokers has been successful in attracting smaller hedge funds. These are typically the hedge funds that the bigger primes declined to do business with because of the higher cost structure that they have. And then what we find is as the hedge funds get bigger, they start to look around and consider these larger competitors of ours. We would obviously like to reverse that trend, but it’s not going to be easy.

Part of the problem that we are dealing with is that the large primes are banks that have been in business for 100 years or more and they have created a very significant brand recognition.

Now, I would think that, given advantages they have in brokerage execution and margin rates and what those would mean to more advanced traders (like hedge funds) that this shouldn’t be a problem. Certainly, it doesn’t suggest brand recognition is sufficiently strong that they would be well positioned to pick up individual accounts in the existing market either.

While growth has been happening and continues, I would caution against ambitious expectations of growth.

Concerns for the Class A Shares

One thing I want to address is the way that value is returned to IBKR shareholders. First, consider how much the total number of shares outstanding has grown.

Now, that might look like a hefty amount of dilution, but we have to remember the corporate structure I mentioned before. Part of the LLC’s operating agreement is that the Group can acquire more membership interest in the LLC from Holdings, in exchange for IBKR shares. Since 2014, the Group’s interest in the LLC has grown from 14.5% to the 25.4% I mentioned earlier.

This is why, although distributions to common shares rose from $22.7M in 2014 to $42M in 2023, the dividend per share has remained $0.40 per share during that period (except for $0.50 in 2018 and $0.30 in 2019).

Furthermore, management clarified in Q4 earnings:

Finally, we are well aware that we have now reached $14 billion in equity on our balance sheet. We are considering possible opportunities in the space that would help us grow the business. Our public float is small, so we are unlikely to buy back shares, and personally speaking I would hope that an opportunity presents itself, as raising the dividend is not something I think helps a company grow in the long run.

Overall, both the history and these remarks don’t indicate that much value will be returned to shareholders any time soon. We are left to trust that management will achieve attractive growth in spite of the competitive hurdles.

Valuation

We’ve covered enough that we can perform a valuation. I will use a Discounted Cash Flow model, based on the reported Net Income attributable to the Group, as I believe its components are a reliable indicator of the company’s value. We’ll use the following assumptions:

• $600M in baseline earnings
• 3% annual growth over the next decade
• Terminal multiple of 5

$600M is 2023’s net income, and given the consistent growth, I think it’s a reliable indicator of the company’s current capacity. 3% growth is assumed to keep it conservative, given the competitive space in which they operate, while acknowledging that IB does grow. Lastly, a Terminal Multiple of 5 is the lowest I foresee such a quality company going.

That produces us an intrinsic value of about $5.8B for the Class A’s market cap, about $54 per share.

I did not factor for continued dilution because that’s being used to gain more interest in the LLC and thus isn’t true dilution. Stock-based compensation, meanwhile, is small and already baked into net income.

A More Positive Case

Since this valuation is cautious, let’s consider some things that could help it going forward.

Gains in a Harsh Market

I’ll quote CFO Paul Brody from Q4 earnings call again, as he points out one key strength:

We maintain a balance sheet geared towards supporting our growing business and providing sufficient financial resources during volatile markets. We have no long-term debt.

This is an important advantage for a broker-dealer in a time of market crisis or unusual activity. Robinhood, for example, had to halt trading on GME during its short squeeze in order to meet collateral requirements, something that isn’t as much of a problem for a strong balance sheet. This naturally offended a lot of traders cost Robinhood their loyalty.

In the context of something bigger like a financial crisis, it’s the well-capitalized businesses like IB (it survived 2008, after all) that will capture market share and ultimately enjoy faster growth for it.

Opportune Acquisitions

In Q4 earnings as well, management indicated a desire to acquire other brokers, namely to expand their international footprint. The issue, they found, is that they cannot get a good price on those brokers or that the target’s own systems are less adept and would take significant work/cost to integrate into IB.

Since this is the case, I didn’t factor it for likely growth, but if better M&A offers were to present themselves, this would accelerate the growth for IBKR’s valuation.

Conclusion

While Interactive Brokers is a quality business that started on a simple idea (boasts over 40 years of innovation and growth), there is an upper limit on that. The brokerage space is a highly competitive one, and while I believe they will continue to grow, they are up against more prominent brands that are better able to leverage their advisory segments with individual investors. IB’s strength is more so in its ability to appeal to more sophisticated investors and traders.

In addition to overvaluation, shareholders today have to accept a low dividend yield and low payout ratio against what are modest growth prospects at best. Given that, I think long-term investors would benefit more from a better entry price, and that’s why I think IBKR is a SELL.