I was at Interactive Brokers' (IBKR) annual meeting in New York on Thursday. I enjoyed seeing Thomas Peterffy (the founder and now Chairman) in action, answering questions from the audience.





Below are some notes from the meeting and thoughts on IBKR generally…





We own IBKR in the Woodlock House fund. Fair warning: We can sell at any time and we don’t have to tell you, so do your own due diligence, yada yada. See our disclosures here .





First, I have to say, the people at IBKR seem to be having fun with the “rabbit.”

It all started on the April 16 conference call when Nancy Stuebe, head of IR, read the following:





“I must tell you that any way we slice it, new account growth at Interactive Brokers over any 12-month period peaked in April 2018 at 27.8%, and has been declining since, reaching 20.3% in March of 2019.





20.3% would still be very good, but annualizing our sequential quarter account growth from the end of December to the end of March shows it leveled off at 16.2%, which is not so good.





We would like to see this rate go back to over 20%, but for that, we will have to pull a rabbit out of a hat . For the last 9 months, we've been working on just such a rabbit that we plan to introduce at a test location near the beginning of the third quarter and in other locations, gradually, over time.





For several good reasons, we are not prepared to say much about the rabbit at this time. We can say it will be a new product development in an area only tangentially related to our traditional business but, if successful, will expand the opportunity to grow our customer base.”





Well, that’s very interesting. And it kicked off speculation about what that rabbit might be. Later in the call, an analyst tried to get some clues:





Macrae Sykes, Gabelli Research, LLC - Research Analyst

“My follow-up, just on the rabbit, is there any way to provide a little more color, perhaps a certain -- whether it's around certain asset classes, product ranges, GLOBAL versus domestic, just anything to sort of give us a – ”





Thomas Peterffy, Interactive Brokers Group, Inc. - Founder, Chairman & CEO

“I am sorry, you have to be patient. It's just -- give us another 2 or 3 months and the rabbit will be there.”





I don’t know if the rabbit idea was intentional or an accident, but as most things do these days, it kind of took on a life of its own. Here is a picture I snapped at the meeting: Thomas Peterffy… and a stuffed rabbit:









Somebody asked Peterffy how certain he was that the rabbit would reignite account growth. Peterffy didn’t hesitate: “87.25%!”





It was that kind of meeting, as Peterffy seemed to be in good humor. Asked what he worries about the most, Peterffy said, “Old age.” (Peterffy is 74).

But there were also serious answers that gave you some clues as to how he’s thinking.





Somebody asked him what happens when growth slows? Would he do buybacks or pay a dividend? Peterffy said he “can’t accept” that growth is slowing. His focus is on getting growth back up.





But he also said he would not consider buybacks or dividends until he got to $10 billion in equity, which he said was 3-4 years away.





Peterffy said they are looking to “scale up the [IT] system” so it can handle 10 million accounts. (IBKR has 600,000 as of Q1). He expects to have the system ready in six months.





I asked him what IBKR would look like in 5 years, in terms of customer mix, accounts, etc. He simply said he envisioned IBKR with lots more accounts in many more countries.





I specifically wondered what might happen as IBKR got larger, would it mean lower commissions per account? IBKR’s customer base does lots of trades. It seems to me, as they get bigger, this aspect might dilute itself it out a bit. But maybe that is still several years away.





Another person followed up to ask what countries he was most excited about, besides China. He said Southeast Asia and South America – listing Brazil, Argentina, Colombia and Ecuador and “all over the place.”





You get global exposure with IBKR: 68% of its customers are outside of the US, in over 200 countries. Over 50% of new customers come from outside the US.





China: Tiger Brokers





There was a lot of talk about China and Tiger Brokers (TIGR), which trades on the NASDAQ. Tiger is a broker in China. Since their launch in August 2015, they have added customers at an absurd rate and already have over 500K accounts:









Source: https://ir.itiger.com/static-files/62a10077-def2-4245-9cee-8e16e339c0af





IBKR invested $20 million in TIGR in June of 2018. Tiger priced its IPO at $8. On its first day of trading (March 20), TIGR closed at $10.94, a 35% gain. It hit $23 on April 16. And closed on Thursday at $15.52. Wild ride. In the first quarter, IBKR reported a $103 million gain on its investment. That’s a six-bagger in about ten months.





IBKR must mark its TIGR to market every quarter, so we’ll see some noise in the quarterly earnings going forward. IBKR says TIGR is a long-term investment. (They have a six-month lock-up on their shares). Not only does IBKR have an investment in Tiger, but it also handles Tiger’s trades. Eventually, Tiger will clear their own trades. On the call, Peterffy said IBKR’s revenues from Tiger come to less than $25 million.





Over time, as Tiger grows, this could become a big investment for IBKR. Right now, it’s still relatively small. For perspective, IBKR reported a $1.1 billion pre-tax profit last year.





Interactive Brokers: Cash Flow Machine





IBKR is a stock I’ll likely own for a long time. It seems like IBKR could continue to grow at least 15% annually for many years yet and should generate a lot of cash.





Let’s look at the operating cash flow (OCF) at IBKR. The OCF line below is right off the cash flow statement. But balance sheet items have added to cash flow in the past two years, so I created a new line of OCF ex-balance sheet items. (In 2016, IBKR had a market making business, since discontinued. That added some more noise around the financials, but the last two years are good ones to work off of).





There is minimal capex, which leaves a healthy free cash flow (FCF) figure of $1.2 billion last year, a 31% increase from 2017:









So on Thursday’s closing price of $54.80, you’re paying about 19x trailing FCF:





That does not seem too demanding for a business with no debt, a 60%+ pre-tax profit margin and what seems like a long runway of growth.





What will drive future cash flow? More accounts, more trades and higher customer balances. For IBKR’s customer base, trading activity correlates strongly with volatility. Interest income makes up about half of net revenues. Net interest margin is thus important. While there are offsets to rising rates, generally higher rates are good for IBKR’s earnings. (From the 10K: “Increases in benchmark rates have generally led to higher net interest income and wider net interest margin.”)





IBKR’s net interest margin widened to 1.67% in Q1 from 1.55% in the first quarter of last year. IBKR pays higher rates than their competitors as has been gathering assets. This should mean even more earnings from interest-sensitive assets in the years ahead.





On the call, Stuebe said:





“We believe our continued success in asset gathering should lead to larger contributions from interest-sensitive assets going forward. Our FDIC Insured Bank Deposit Sweep Program has grown steadily to $1.9 billion. Margin lending and segregated cash management continued to be the most significant contributors to our net interest margin. Average margin loan balances fell 13% versus last year. However, higher interest rates versus last year led to margin interest growth of 25%.”





Interest rate risk is something you have to accept here. I have no idea where rates are going. But it seems higher rates have helped IBKR overall. The net interest margin in 2018 was 45% higher than it was 2 years ago.





I suppose there is a risk, then, that if rates go lower it will put pressure on IBKR’s net interest margin. Over the long-term, I’m not particularly concerned. I think IBKR could double the size of its business in the next 5 years. The stock should follow suit. Even if we have some margin compression, we should do very well.





Besides all that, there is... the rabbit.





Thanks for reading. Write me at info [at] woodlockhousefamilycapital.com





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Published April 19, 2019

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