One company with huge potential that may fly under the radars of some investors is Interactive Brokers Group, Inc. (NASDAQ: IBKR). Interactive Brokers began as an electronic options market maker and later developed an electronic brokerage service in the '90s, which now provides the lowest costs in the brokerage industry at only $0.01 per share on equity trades (with a $1 minimum). Another attribute Foolish investors might like is the company is majority-owned by its founder and CEO Thomas Peterffy, whose limited liability company owns 82.9% of shares. Interactive Brokers has had several good earnings reports and positive product announcements this summer, and the stock is up strongly. Here's what management wants investors to know.
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Some may look at the headline metrics for Interactive Brokers and think it is crazy expensive, trading at 41 times earnings while growing its revenue only 1.7% year over year -- and with declining earnings growth, to boot. However, those headline numbers don't tell the whole story.
Brokers make money off of commissions, which means they make more money when more trades happen. More trades usually occur when there is high volatility. Last quarter, the volatility index, or VIX, was 11.45 on average, down 27% from 2016 and near a 10-year low. Despite that headwind, the company was able to grow its total daily active revenue trades (DARTs) by 3%, due to customer accounts increasing 20% and total client equity up an even higher 42%. The fact that Interactive Brokers can attract so many new clients indicates that the company's product and technological automation speaks to a younger, tech-savvy (and frugal) generation. Should volatility increase, revenue and earnings will likely shoot upwards.
Peterffy has offered his own reason for the low-volatility environment. In this low-interest rate environment many investors are pursuing a covered call strategy, whereby one buys large dividend stocks and sell calls against them. As the market goes up or down, these traders -- who get big discounts from brokerages due to the amount of trading they do -- simply adjust their allocations, keeping stocks mostly range-bound (at least for the moment).
Shutting a business down
Another reason for the high price-to-earnings ratio and lower net income is that Interactive Brokers is actively shutting down its options market making business. While the options market making business only contributes a small portion of revenue and essentially breaks even these days, the company took a $22 million one-time charge this quarter. That lowered operating income by about 10% on its own.
On the bright side, management said the now-defunct segment had many talented software engineers. As a tech-focused brokerage firm, management also claimed finding talented software developers has been the biggest bottleneck for "all of the ambitious projects we have for the Interactive Brokers platform." Since the company already knows these developers and the developers know IB's systems, many will be transferred toward the large and growing brokerage business.
One new product management may have been talking about was the new integrated financial management account, unveiled in mid-August. This account combines brokerage, banking, and lending into one account, rather than having to move money in between accounts as one must do at most banks. From the single account, customers can:
- Invest in stocks, bonds, foreign exchange, and options in over 120 countries.
- Borrow against their stock portfolio at ultra-low rates -- from 1.41% to 2.66%, depending on the amount borrowed.
- Earn better interest on cash balances (over $10,000) than they could at a bank.
- Lend out their shares to short-sellers, and Interactive Brokers will split the interest with them 50-50.
- Spend directly from the account with the new Interactive Brokers Debit Mastercard.
Interactive Brokers seems to be doing lots of things right, which is why stock has had such a strong run. As the world moves increasingly toward automated and cheaper solutions, Interactive Brokers stands to benefit with its tech focus and low-cost infrastructure. Moreover, the stock may be an attractive hedge against a future pickup in volatility or if the Fed raises interest rates, both of which are likely at some point in the future.
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