Tale Of Two Stories At Interactive Brokers

Interactive Brokers (IBKR) is comprised of two businesses: (1) an electronic brokerage and (2) a market maker. I wrote in September that I thought shares were 20 to 30% undervalued, and included a potential catalyst in the form of a liquidation of the market maker business. The market maker currently holds ~$2.5 billion in excess capital, of which the public float's share is worth some $310 million. Note that the IBKR shares that trade publicly represent 12.4% of the enterprise, the remainder of which is largely held by CEO Thomas Peterffy. For more information, see the Q3 2013 10-Q.

Earlier in January, I advised readers to take some gains off the table in IBKR because the shares had run up to my estimate of fair value, and certain negative catalysts existed, namely losses related to certain margined customer accounts that made ill-timed and concentrated bets in Singapore.

According to Mr. Peterffy, the trading losses were as a result of the following (courtesy of Seeking Alpha transcripts):

Now I will explain these items in further detail. The unusual item is a $73 million loss we have reported on our books for the Singapore incident that we discussed - we disclosed in October. As a reminder, certain of our brokerage customers took large positions in a few related stocks listed on the Singapore Stock Exchange last year. In the beginning of the fourth quarter, these stocks lost over 90% of their value in a very short period of time and we are able to liquidate only a small portion for the exchange of the trading.

We are pursuing legal actions to recuperate our loss base and have secured freeze orders in Malaysia and Singapore, but this process will take a long time. We said in October, that the maximum loss would be $84 million. However, because we were able to take the stocks onto our books at a value of about $20 million to offset the margin call, we have a $64 million that has been recorded in bad debt in the Brokerage segment. These stocks have lost about half their value, so we've also recorded a loss of $10 million in the Corporate segment bringing the total impact to $74 million.

The way I read the transcript is simply that there is, indeed, risk in the brokerage business, especially when margin is employed by brokerage customers.

To that end, IBKR indicated that margin balances are at all time highs, up 38% year-over-year to $13.5 billion, so investors should require a larger "margin of safety" - a lower price - before investing in these shares. On the flip side, the margin lending business should perform well in a rising interest rate environment as IBKR can pass through higher rates to its customers. All else being equal, I prefer lower margin exposure given the adverse effects of a poorly timed trade and resultant effort required to recover what is owed.

(click to enlarge)

Tale of Two Businesses

The Interactive Brokers story, as it were, is a tale of two businesses, one that is prospering (the brokerage) and one that is floundering (market maker).

Broker

The brokerage segment reported sales up 22% year-over-year and $391 million in pretax income, up 15% in 2013. A large part of the improvement was due to a broadening customer base (up 14% year-over-year), larger balances (up 39% year-over-year) and increasing trading activity, with daily average revenue trades (up 18% year-over-year).

Excluding the "Singapore Incident," the brokerage business continues to scale beautifully. I still believe pre-tax margins can improve to the low 60s% as the broker spreads more revenue across its fixed cost base. In my mind, the broker is the reason to own IBKR, as it provides the opportunity for both revenue and margin expansion if IBKR can capture more share or if trading activity ticks up generally.

Market Maker

The market maker, on the other hand, continues to underperform. Because of the divergent operating performance between the businesses, I believe that IBKR management must seriously consider spinning out, selling or liquidating the underperforming market maker segment.

Management's stated hurdle rate for the market maker is 10% return of capital. In 2013, IBKR only generated a return of 1% on capital, which is inadequate given the risks incurred.

Tellingly, IBKR noted in the conference call:

We plan to continue monitoring the Market Making environment as we consider our future in this business, but in the meantime we have reduced our participation in less profitable markets and products and have been working to reduce our overhead costs in this segment as well.

Reading between the lines, if IBKR is unable to meet its hurdle rate, I believe they will take action to divest the unit. To that end, I believe investors can expect a large return of capital, and be left with a pure play on the crown jewel asset, the electronic brokerage.

Conclusion

I continue to believe that IBKR is a high quality franchise. However, I don't particularly want to invest in a low margin and declining market making business, therefore I remain on the sidelines at the current valuation.

However, I do believe that any announcement related to a transaction in its market maker would provide a significant boost to the share price. While Mr. Peterffy has indicated that he believes there continues to be opportunity to grow the market maker, I think if IBKR is unable to generate 10% returns in this business that they will be forced to take action. I think investors will continue to apply a discount to IBKR until they are given a pure play on the high margin, and fast growing brokerage business.

To that end, I will start to get interested again in IBKR at a sub $1 billion valuation (for the public float) or if there is an announcement related to selling, spinning off or liquidating the market maker.

Source: Tale Of Two Stories At Interactive Brokers

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

This entry passed through the Full-Text RSS service — if this is your content and you're reading it on someone else's site, please read the FAQ at http://ift.tt/jcXqJW.