Interactive Brokers Group, Inc. (IBKR) Q4 2010 Earnings Report, Transcript and Summary

Good day, everyone, and welcome to the Interactive Brokers fourth quarter 2010 earnings results conference call. (Operator Instructions). At this time, for opening remarks and introductions, we would like to turn the call over to Ms. Deborah Liston, Director of Investor Relations. Please go ahead.

Thank you. Welcome, everyone, and thank you for joining us this evening to review our results of the fourth quarter of 2010, which we just released after the close of trading. Joining me today on the call are Thomas Peterffy, our Chairman and CEO, and Paul Brody, Group CFO. This conference call is also being broadcast on the Internet and available through the Investor Relation section of our website at www.interactivebrokers.com. An archive of the call will be available for 90 days through the same link. Before we begin, I'd like to remind you that during the course of this call we will discuss some non-GAAP measures in talking about our company's performance. You can find a reconciliation of those measures to the nearest comparable GAAP measures in our press release. In addition, management may make forward-looking comments based on our current expectations and assumptions, which involve risks and uncertainties. Our actual results may differ materially from those indicated in these forward-looking statement due to certain risk factors that are described in our filings and made with the Securities and Exchange Commission. I also encourage you to review the forward-looking disclaimers in our press release. With that, let me turn the call over to Thomas.

Good afternoon, everyone. As you see from the text of our release, the past quarter's and year's performance is clouded by accounting conventions. I'm going to attempt to clear this up for you in as simple a manner as possible. Our CFO will give you the more thorough version after I'm finished. First, where do the losses come from? As you know, we paid $1 billion dividend about a month ago. The public company received its share of those dividends from accumulated retained earnings of Timber Hill in Europe, which is a Swiss company. These earnings have not been previously taxed in the US and, therefore, we have to pay taxes on this dividend. The tax was deducted from the dividend that our shareholders received. Nevertheless, since the tax needs to be accounted for as an expense, we must report it as such and that drives our GAAP earnings into negative. Second, as far as currency effects are concerned, our hedging strategy that translates our continuously changing currency exposure to a basket of currencies, that we call the GLOBAL has worked very well this year in spite of the turbulent currency markets. The value of the GLOBAL in US dollars ended up unchanged for the fourth quarter and changed only slightly, decreasing by 0.3% for the year. Thus currency fluctuations had no net effect on our non-GAAP earnings as reported in dollars for the last quarter and that presented approximately $13 million loss for the year. But as you know, we have many subsidiaries that around the world and they must account for their activities in the local currencies. We hedged these local currency balances to the GLOBAL and the hedging trades become part of our trading income. On the other hand, the corresponding changes in the value of these balances have to be reported as other comprehensive income, or OCI. Due to this reporting requirement, $148 million shifted from GAAP earnings to OCI for the year and the corresponding number for the quarter was -- .

$62 million.

-- $62 million. Adding the $148 million plus another $10 million related to the dividend of unvested employee shares, to the reported $341 million brings our earnings for the year to $499 million, which is worse but not by a great deal worse than 2009. This would suggest that our business has declined moderately from 2009 to 2010 but the fact is that there are much more momentous changes that have occurred and continue to proceed underneath these numbers. Namely, our market making business is suffering while our brokerage business is prospering. Overall for the entire company, our non-GAAP profit margin was 47% for 2010. Our total equity capital, built solely on retained earnings, GAAP or non-GAAP, is $4.2 billion even after the $1 billion special dividends we paid out on December 21. Now I will review each of our businesses starting with market making. Our non-GAAP market making profits for the year were $238 million with a profit margin of 45% but the fact is that in the last quarter we only made $38 million in market making. In other words, market making performance declined from the preceding year to the current year and it also declined throughout the year. We achieved peak results in 2008 and since that time we have been witnessing a gradual decline in market making performance that is still going on. By now, 95% of listed option classes are trading in pennies. This, together with a surge in HFT activity, has continued to dampen our trading gains. HFT competition does not only tighten bid offer spreads but also exposes us to the many different schemes they use to take advantage of our quotes when they are in a liquidity-taking mode. We expect some increased regulatory scrutiny over HFTs in the near future but do…

Thank you, Thomas. Welcome, everyone. As usual, I'll first review the summary results and then discuss the segments before we take questions. As you can see in our earnings release, there were two items affecting our 2010 results that we view as non-operating in nature. The first is the substantial dividend we paid during December, which increased the reported income tax expense but had no net effect on income. The second is the reporting of our currency translation gains and losses under GAAP which effectively shifts a portion of our currency hedging results from the income statement to the balance sheet. The currency reporting issue has been discussed in a number of prior occasions and we felt that the time was right to include it in our regular offering of financials. We have isolated these items in our reporting so as to give a clearer presentation of the state of our operating businesses. We will refer to these adjustments and the resulting financial amounts as non-GAAP measures and on today's call I will primarily be referring to these non-GAAP measures. The first item, in December we affected a series of dividend payments culminating in a dividend of $1.79 per share, which was paid to holders of IBKR common stock. In total, the company paid out about $1 billion. Funding for this dividend originated with our Swiss company, which paid a dividend to IBG LLC, its parent company. IBG LLC in turn paid a dividend to its share holders including Interactive Brokers Group, Inc, the public company. On a consolidated reporting basis, these dividends had no effect on the company's reported income. However, the original dividend from the Swiss company was made from earnings that were not previously taxed in the US. As a result, this triggered a US federal income…

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(Operator Instructions). Your first question comes from the line of Niamh Alexander - KBW.

Paul, if I could just touch on the FX because before mainly -- there's two components to it as you've said. One is kind of a slow P&L item as respect to the trading gains. The other is traditionally the OCI, which is just the change in valuation of your foreign subsidiaries. I'm just curious as to why you've now decided to put that kind of a balance sheet item through the non-GAAP adjustment. Is this the kind of new methodology going forward?

Well, as you know, we've been discussing this for many quarters going back and it seems to be something that everyone always wants explained. It seems that the time is right to put it in writing. The way we manage our currency exposure is such that we consider it all to be P&L and it's only the conventions of GAAP that arbitrarily separates it into an income statement component and a balance sheet component. We think that from a management standpoint it's clearer if it were all in the income statement.

So do I understand it correctly that theoretically the change in value of your international subsidiaries is now a flow item on a non-GAAP basis? You are going to report it as an income or a loss.

Yes, that's right.

Then, if I could switch over to market making, please -- Thomas, thanks so much for your color. I know it's been painful for you as you've kind of gone through all the market structure changes. But you kind of -- some new commentary from you suggest that instead of kind of maybe withdrawing registration from certain [inaudible], as you said before, about you maybe withdrawing being a market maker and joining the high frequency traders. It sounded like maybe you're getting closer to just getting to break even in the market making business and even just pulling back entirely and just allocating the capital or paying out the capital. Do you think we're pretty close to that? Am I hearing you correctly there?

No. I can't see into the future. I think that if the trend continues in the direction that it has been going for the past two years, then a year from now we'll get there. But I don't think that it will continue because why would so many people participate in this business when there is no profits to be had?

So I guess we've got maybe a few more quarters before you get to that decision and to where you kind of change. It's still mostly US-centric that the trends have come so negative, right?

No, definitely not, no. It's a worldwide phenomenon.

Just on the brokerage business, can you help me understand maybe you're far outpacing all your competitors in terms of the customer growth -- congrats -- and the margin growth. Is there kind of a difference here in that you are more international? Are you seeing a bigger proportion of your new customers coming in from the international markets and do you see opportunity to continue the growth at this pace?

No, it is proportional. International has been steady, has been for 1.5 years now.

Then lastly, if I could, on the brokerage side of it, we talked -- I asked you last quarter about acquisitions in the space, maybe acquiring some lower valued brokerage businesses with the same types of customers and we're seeing you kind of increase your stake in, well, sort of a similar business. How have your thoughts progressed on acquiring accounts through M&A rather than organic?

As I always say, we find that it is easier to build than to buy.

Your next question comes from the line of Rich Repetto - Sandler O'Neil. Rich Repetto - Sandler O’Neil: I guess the first question is as we go from GAAP 66 to operating a 15, can you break out what was the component of the tax -- just for the quarter, what was the component of tax and what was the component of the FX OCI adjustment?

The OCI adjustment was about $0.71. I think it's what I reported already. I'm sorry. The dividend adjustment was $0.71. The dividend was a one-time event, therefore, its impact was the same for the quarter as the year. The remainder would be OCI -- in other words, about $0.10 for the quarter and $0.24 for the year. Rich Repetto - Sandler O’Neil: $0.10 for the OCI for the quarter?

Yes. Rich Repetto - Sandler O’Neil: Then another question, Thomas, is when you said that you're pulling back in certain areas, the market share decline reflected pullbacks in certain areas, I’m sure some I would assume is geographic but could you also tell us -- ?

I'm not going to get into this, Rich. I'm sorry. We have been severely penalized for being so transparent. Rich Repetto - Sandler O’Neil: Then when you said that you're looking at dividending -- I’m just -- I heard the conversation just from the other question but are you saying in one year? Is that sort of the timeframe that you would seriously consider dividending more of the $4.2 billion that's in equity or is it sooner?

Look. I have said if it looks like the market making does not improve and if we look out into the future there is no promise, then we will continue to dwindle out our excess capital. Rich Repetto - Sandler O’Neil: I was trying to get a clearer picture on what -- .

Actually when we would pay it out? We would probably pay it out sometime in the course of the year, some of it. Rich Repetto - Sandler O’Neil: So it's within a year then that you could consider this seriously.

That's right, yes. Rich Repetto - Sandler O’Neil: Then I guess my last question is that some of the metrics are pretty awful in regards to the actual -- I'm talking about the environmental metrics.

They are horrendous. Rich Repetto - Sandler O’Neil: So I'm trying to get a feel for -- you have tough metrics here actual to implied. You’ve got low volatility or -- here's the question. What do you think is attributable to high-frequency trading, some of the issues that you think can get resolved, and then what are more attributable to just the market environment that's giving you conditions of 0.61 actual to implied ratio of volatility?

I'm sorry. I don't have a number for you but if you look at -- as long as volatility keeps going down it can't go down forever because it cannot go below zero. So I think that we have gone from over 40 to wherever we are right now, 17, I think that most of what could be, what the volatility could drop by. So it's got to be a little better going forward. Rich Repetto - Sandler O’Neil: But we have seen extended periods where the volatility's been in the low teens as well and you -.

Rich Repetto - Sandler O’Neil: I think I get it. It's just that it sort of seems like when we have periods of high volatility it's sort of -- .

The issue is that when volatility is low it's easier for HFTs to compete with us and so it -- where volatility is low, market makers do not have too much of a risk, so the bid offers that come then -- and traders lose their appetite to trade because nothing much happens in the market. Rich Repetto - Sandler O’Neil: Just I guess summing it up, it seems like the best period for you is rising volatility with a long-vol position but periods of low volatility or declining volatility, it seems like these are significant headwinds to the model. It's as simple as that.

That's right.

Your next question comes from the line of Robert Niewijk - Katana Capital.

Why not carry through on your previous warnings to just give up your Market Making designation and actually do your own high-frequency trading?

Well, we don't think that we would make more money doing high-frequency trading as long as we would stick to the rules and we would continue to do what we believe is right and would not do anything that we believe is manipulative. I don't think that our high-frequency trading would be so much different than our market making. Operator (Operator Instructions). Your next question comes from the line of Mac Sykes - Gabelli & Co. Mac Sykes - Gabelli & Co: Do you think you could just provide the amount of capital between the two segments currently?

I do. The brokerage is currently about $1.2 billion, $1.4 billion. Then it leaves $2.8 billion for the rest. Mac Sykes - Gabelli & Co: Do you think you could use more capital at the brokerage unit?

No. Mac Sykes - Gabelli & Co: Then I guess before you answer that -- no? Then just to follow-up, could you see a time where, in the future, where your growth might be faster than your ability to produce capital organically where you'd want to have excess -- or access to that, or do you just think that your capital -- ?

If opportunities arose in the market making segment, yes, then we could use -- I mean, that would be wonderful news. Mac Sykes - Gabelli & Co: I guess on the brokerage side, so maybe growth of assets?

I don't see how to use more capital on the brokerage side. I don’t see how to use the capital we have on the brokerage side. The most of the reason for the capital is to be a credible broker.

There are regulatory minimum requirements but there -- .

Well, they are tiny. Mac Sykes - Gabelli & Co: I guess if the model -- if your brokerage, if you got some bigger clients, I was just thinking there might be an opportunity in the future where you would want to have access to more capital and that might be an issue if you dividend it out because of market.

You mean for huge margin loans to specific people? Mac Sykes - Gabelli & Co: Maybe not those kind but bigger actual clients or something like that.

Sorry, I don't foresee such an event.

Your next question comes from the line of Edward Ditmire - Macquarie.

First, a bookkeeping question -- I'm sure you mentioned this earlier but what was the FX impact that ran through the GAAP EPS, not the OCI component but the other FX?

For the year, $30 million.

For the quarter?

Zero.

Then secondly, any update on growth in emerging markets?

Any update on emerging markets? We are -- what?

Apologies, I’m at an airport.

We are doing some things in emerging markets but we are not ready to talk about it.

Rich Repetto - Sandler O’Neil: Rich Repetto - Sandler O’Neil: I guess my one question is, on this OCI component, wasn't that a component in prior -- once you started disclosing the FX adjustments, wasn't one of them -- wasn't OCI one of the FX components?

Yes, we have talked about it on many occasions. In fact, last July, if you recall, we put out a release explaining it more fully and how it's an arbitrary split between the balance sheet and the income statement. We're sort of somewhat more formalizing that presentation now to make it easier for you folks to understand. Rich Repetto - Sandler O’Neil: But these were the adjustments from the past quarter that had the two -- the past two quarters, correct?

What do you mean by these? Rich Repetto - Sandler O’Neil: There was the hedging as well as the OCI component.

It's the same thing. You see, hedging trades turned out to be losses that were offset by the appreciation of the value of the capital in the foreign subsidiaries. Rich Repetto - Sandler O’Neil: I mean, either way, these numbers were numbers you had given out in the past two quarters.

It's actually the same numbers that apply to previous quarters, you mean? Yes. Rich Repetto - Sandler O’Neil: Yes. I am just trying to see whether we came up with a new -- .

Right, not a new concept; we're just explaining how GAAP requires this arbitrary split between the income statement and the balance sheet.

(Operator Instructions). I'm showing no further questions in the queue.

Great. Thanks, everyone, for your participation and, just a reminder, a replay of this call is going to be available on our website shortly. Thanks again and have a great evening.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect. Everyone have a great day.