Alex Hughes

Written by Alex Hughes, International Analyst, StocksInValue

Original article first published in StocksInValue


 
The recent market correction has caused our attention to return to Interactive Brokers – IBKR.OQ (view our valuation).
We first came across Interactive Brokers (IB), an electronic brokerage business that is growing rapidly, in April 2015. (Research available in our Research Library).
By adopting technology to automate many processes, and unburdened with high cost legacy systems, IB is able to charge considerably lower prices than its competitors, its key advantage that has facilitated its growth. Over the last decade, IB has grown its client accounts (the key driver of its profitability) at over 18% p.a. In the first nine months of calendar 2015, customer accounts increased 15% over the 2014 closing balance, which suggests full year growth is likely to come in above both long term averages and our assumptions.

Figure 1: Clients accounts, & revenue per account
Source: Company financials
We initially invested 2.65% of the portfolio in IBKR at $34.10, however after rallying above $42, we reduced it to a 2% position. Since then, IB has retreated back to the $34 range, with the bulk of the sell off occurring in the last month. We are hard pressed to find a good reason for the market decline, as core electronic brokerage profitability continues to expand at a decent clip. Further, higher interest rates are actually a positive for IB’s profitability, as 30 – 40% of revenue is derived from interest on margin loans, so the recent increase in rates by the Fed bodes well for an expansion in net interest margins.

Figure 2. Electronic brokerage segment revenue & pre-tax income
Source: Company Financials
We think it is appropriate to use a sum of the parts approach to value IB. This is because the market making business and excess regulatory capital IB holds has the effect of masking the tremendous profitability of the core electronic broking business, and hence they should be valued separately.
We have updated our estimates, and as we display below, we value the electronic brokerage business at $32.90 per share. Our key assumptions remain unchanged from our April 2015 report: 15% revenue growth over the forecast period, pre-tax margins increasing to 65% by 2017 and a terminal value of 17x 2018 earnings. At the current price of $34, this suggests investors are paying a fair price for a market leading discount broker, with the potential to continue compounding at rates north of 15% annually, plus a market making business worth $4.10 per share and $5.60 of excess regulatory capital thrown in for free.
Electronic Brokerage Value

201520162017
Revenue1,0951,2591,448
NPBT657787941
Tax164197235
NPAT493590706
Terminal Value14,334
PV44848811,300
Value12,236
Value per share$32.9
Assumptions201520162017
Growth15.0%15.0%15.0%
Margins60.0%62.5%65.0%
Tax Rate25.0%25.0%25.0%
Forward Multiple17
Discount Rate10%

 

Sum of the Parts Value
Our sum of the parts valuation is $42.50 as displayed below.

Total Value15.7% OwnershipPer Share
Electronic Brokerage$12,236$1,921$32.9
Market Maker$1,513$238$4.1
Excess Regulatory Capital$2,076$326$5.6
Total$15,825$2,485$42.5
Less Minorities-$13,340
IBKR$2,485
Class A shares (m)58.4732
Class B shares (m)0.0001
Total shares58.47
Value Per Share$42.5

 

IB reported its 4th quarter results on January 19 (US time), with EPS of $0.36 expected. We have submitted a bid to add an additional 1% of IB to our international model portfolio, essentially repurchasing the shares we sold $8 higher. If prices continue to stagnate, we are likely take the opportunity to expand IB into a 5% position, highlighting our conviction in the business.