Interactive Brokers Group Downgraded: What You Need to Know

By Rich Smith Markets Fool.com

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

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It's been nearly a month since online brokerage Interactive Brokers Group (NASDAQ: IBKR) announced it will be exiting the "market making" market for trading options. This morning, it received its reward: A downgrade from investment banker Wells Fargo.

Here are three things you need to know about that.

Wells Fargo's Interactive Brokers downgrade misses the big picture. Image source: Getty Images.

1. What Wells said

Last year, Interactive Brokers' market-making unit generated $44 million in pre-tax profits on $190 million in revenue -- a not insubstantial 23.2% profit margin, but not quite as good a business as the company's flagship electronic brokerage, where margins average closer to 61%.

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Giving up the $190 million, though, says Wells Fargo, is only the start of Interactive Brokers' problems. According to the analyst, Interactive has been attributing a good chunk of its overhead costs to the market-making unit. Closing it down won't entirely eliminate those costs, but rather shift about $29 million or soin costs to what remains of Interactive Brokers' business -- without the revenue that used to offset those costs.

2. How Wells crunched the numbers

The effect of thiswill be to decrease Interactive Brokers' earnings per share by about 6% going forward. Accordingly, the analyst is cutting its fiscal 2018 earnings estimate -- which was already far below estimates elsewhere on Wall Street -- to $1.55 per share. Positing a valuation of about 21 times those 2018 earnings for the stock, Wells now assigns a value of somewhere between $30 and $34 to the shares, or about $32 at the midpoint.

With Interactive Brokers' stock currently costing nearly $35 a share, therefore, Wells Fargo believes the stock is overpriced -- and is downgrading it to underperform (i.e., sell).

3. Why this is a bad call

But the situation may not be as bad as Wells Fargo fears.

With $1.25 per share in trailing profits, Interactive Brokers currently sells for more than 27 times earnings. If investors continue to pay such high multiples for the stock, then 27 times Wells' posited $1.55 in earnings would work out to a stock price approaching $42 per share next year. What's more, if Wells is wrong, and consensus estimates of $1.80 per share prove correct, the share price could go even higher -- perhaps as much as $49 per share.

Granted, there's no guarantee that investors will continue paying 27 times earnings to own Interactive Brokers stock. But earnings of $1.80 per share next year would be 44% better than what Interactive Brokers is earning today (about 22% annualized). Given this, it's not hard to see how investors might happily continue to pay for such a fast-growing stock. On the other hand, Wells' more conservative $1.55 estimate would represent only 24% growth (12% annualized).

And one more thing...

Final point: Let's not forget why Interactive Brokers is exiting market making in the first place. Last month, CEO Thomas Peterffy explainedthat the market making business is "deteriorating." "Providing liquidity to sophisticated, professional synthesizers of short-term fundamental, technical and big data," said Petterfy, "is not a profitable activity" for the company anymore, while market making for "large order internalizers" presents a conflict of interest for Interactive Brokers that it does "not wish to have."

Given this, Peterffy says Interactive Brokers really had no choice but to exit the business. And given that this business wasn't earning very big profit margins for Interactive Brokers in any case -- at least not relative to its much bigger electronic brokerage business -- I think it was the right call.

Now, does all of this mean that Wells Fargo is wrong to downgrade Interactive Brokers? No. When you get right down to it, I actually agree that Interactive Brokers is a stock to sell, not buy, but for a different reason: While other investors may be happy paying 27 times earnings for a 12% or 22% growth rate at Interactive Brokers, I, personally, think that's too high a price to pay. But I'd come to that conclusion regardless of whether Interactive Brokers kept or closed its market-making unit.

When you get right down to it, this move is a non-issue for me. Interactive Brokers is just plain too expensive to own, with market-making or without it.

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Rich Smith has no position in any stocks mentioned. The Motley Fool recommends Interactive Brokers. The Motley Fool has a disclosure policy.