Interactive Brokers Group, Inc. (IBKR) Q1 2011 Earnings Report, Transcript and Summary

Good day everyone and welcome to the Interactive Brokers first quarter 2011 earnings results conference call. This call is being recorded. At this time for opening remarks and introductions I would like to turn the call over to Ms. Deborah Liston, Director of Investor Relations. Please go ahead.

Thank you. Welcome everyone and thanks for joining us this morning to review our results of our first quarter of 2011, which we just released before the markets opened. Joining me today on the call are Thomas Peterffy, our Chairman and CEO, and Paul Brody, Group CFO. This conference is also being broadcast on the Internet and available through the investor relation section of our Web site 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 statements 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, I’ll turn the call over to Thomas.

Good morning. Our earnings are bolstered by the weak dollar in the first quarter and I would like to present you with a very clear picture. Adjusting for currency movements our pre-tax profits would have been $90 million from brokerage and $80 million from market making. Even though we employ a great day more capital in market making than brokerage, going forward we expect our brokerage results to ever further outdistance market making results. This puts us firmly in the camp of brokerage companies although I must dismiss rumors to the opposite and tell you that we will continue to remain in the market making business for two reasons. First, the quality of executions we are able to provide is perhaps the strongest driving force in the growth of our brokerage business. Taking the other side of customers’ orders is a benefit to our benefit and to the detriment of our customers or selling our order flow to others who would do so and as other brokers do goes only part of the way towards that. In order to be able to secure the best execution prices we must maintain a very fast, complex and smart order routing network. Being a registered market maker on exchanges helps us to keep this network finely honed for the benefit of our brokerage customers as well as ourselves. Second, although our market making returns are far lower than they were during the preceding 30-some years, the pre-tax return of around 10% per annum, they are still acceptable. Viewing the competition from HFTs, the regulatory environment and market structure changes that allow for more and more internalization without competition, we do not expect our market making business to get much better. On the other hand, we think that as long as we keep on…

Thank you Thomas. Good morning everyone and welcome to the call. Since we’re holding this call during the trading day in the interest of saving some time I’ll present our results in a somewhat abbreviated format. I’ll review our summary results and then give segment highlights before taking questions. Following the practice we began last quarter we are again reporting currency translation as an item as material to our operating results. As we described previously, reporting of our currency translation gains and losses under GAAP effectively shifts the portion of our currency hedging results from the income statement to the balance sheet. We have included this item in our reporting so as to give a clearer presentation of the state of our operating businesses. We refer to the adjustment and the resulting financial amounts as non-GAAP measures. I’ll briefly give background on this non-GAAP measure. In connection with our currency hedging strategy we have determined to base our net worth in globals, a basket of major currencies in which we hold our equity. Pursuant to GAAP convention, a portion of our currency translation gains and losses is reported as other comprehensive income in the balance sheet. More specifically it is the change in dollar value of our foreign subsidiaries. This income is in effect shifted from our reported earnings to the balance sheet. Given our approach to managing our currency exposure globally, this shift is arbitrary and it tends to make our operating results more difficult to understand. The purpose of recognizing this non-GAAP measure is to report all currency translation gains and losses as if they were included in the income statement. Please note that this analysis contains certain assumptions about tax rates and should therefore be considered an estimate. Incorporating this item in the income statement would increase…

Thank you sir. Ladies and gentlemen, if you have a question at this time please press star then 1 on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue please press the pound key. Our first question comes from Niamh Alexander with Keefe, Bruyette & Woods.

Hi. Good morning. Thanks for taking my questions. Thomas, could I go back to your new disclosure on the dividend as it relates to the market making business first? If I could just understand it correctly, you said you’re targeting paying 10 cents out of the market making business. So how much capital kind of is allocated to that business now? It sounds like it’s a steady state and quarters that you don’t generate the earnings you eat into that capital. Am I understanding that correctly?

Correct. That’s roughly 2.8 billion.

2.8 billion and you know, this particular quarter was very strong. But I guess you’re saying the FX benefit and you also had some unusual spikes in volatility. But you expect that to kick off a run rate 10 cents in earnings that you’re going to pay out and follow?

You see, in order to be able to pay out 10 cents we would have to generate $70 million pre-tax per quarter. And $70 million pre-tax is roughly 10% on 2.8 billion because 70 times 40 is…

I appreciate that Thomas. I guess we have come through several years of market pressures, market structural changes that aren’t necessarily going to reverse. So how do you get to that point where you feel like you’re comfortable saying we can pay a regular dividend and this is where we are?

Well, if there is nothing we will still pay the dividend and just deplete the capital. So that’s the way. If the market making business does not work we will gradually pay it out in dividends.

Okay. Fair enough. And then does this rule out the potential for an additional special dividend this year, Thomas?

Probably not unless something unexpected happens.

You’re probably not going to pay one unless something happens, is that fair?

That is correct.

Okay. Fair enough. Thanks. And then if I could just touch on the brokerage business, congrats. It was a very strong quarter especially in the account growth. But we have seen in our base two acquisitions and one kind of interesting to you because it’s Trade Station being acquired for cash for 975 just announced last night. Help me understand how you think about that. You owned Trade Station stock for starts. Are you happy enough to see a competitor get acquired by overseas or is it something that you need to take a look at strategically from your perspective?

Well, you see as I keep telling everybody, we keep track of account transfers to and from other brokers to Interactive Brokers and vice versa. And what we have seen is that with the exception of one broker, we get more accounts from every other broker than we give to them. So we like especially when other e-brokers or online brokers get more business because roughly 60% of our new accounts come from other online brokers. 40% comes from the bulge bracket firms. So when Trade Station sides up with a Japanese broker, I assume that they will be getting a lot more accounts and some of that will run off on us. So we like it when we see other online brokers doing well.

Your preferred strategy for growth is still very much organic?

We keep going over this and we always find that when we focus on building our platform we do better than trying to integrate somebody else.

Okay. Fair enough. Thanks. And then if I could go back to the organic growth that we’re talking about, can you help me understand, you’re seeing more and more RIAs and hedge funds come on board maybe compared this year versus last year. Can you just give a sense of where the growth is coming from and how do you size the market opportunity?

Yes. We see ever more institutional professional accounts and that grows much faster than our individual accounts.

And do you have any sense of sizing the market opportunity there?

You know, I always say that eventually we’ll have 5 million accounts.

Okay. I’ll get back in the line. Thanks for taking my questions Thomas.

Thank you.

Thank you. Our next question comes from Rich Repetto with Sandler O’Neil.

Good morning Thomas. I just have two questions. The first would be was there an auction process with Trade Station?

I can’t talk about this.

Okay. The second question - this goes to your remarks on the market maker. So Interactive Brokers has been known for its technological capabilities, the algorithms that you have developed over the years in market making. And I guess my question comes from if you’re thinking of letting this business sort of resuscitate on its own here that is there any way else to extract value from these capabilities that have been so prominent and rewarding in the marketplace, just not over the last couple years?

Well, that’s not any more than we are trying to extract value from it. I’m transferring some of these capabilities to the brokerage. It’s what gives us special what is this device that pushes Superman into special Krypton or whatever it’s called? The device that puts Superman into the air? We don’t know. Anyway, I don’t know - whatever it’s called.

Krypton?

Krypton, right. Yes. Okay. Sorry.

Kryptonite. That’s it.

Next question please.

Thank you. Our next question comes from Rob Rochelle with CLFA.

Good morning. Thanks for taking my questions. I guess the first thing I was hoping to get a little bit more clarity on the options market making business. It seems like the fundamental drivers were a little better but it seems like the rate that you’re earning per contract traded is maybe more in line with what we saw in sort of early 2009 when volatility levels were a lot higher. So first is that calculation correct? And then secondly, what exactly were sort of the ins and outs this quarter that helped the market making revenues be so high?

I don’t know if they were correct or not and the ins and outs as I went over it, it’s the volatility, it’s the ratio of actual volatility to implied volatility, it’s the volumes and most of all it’s the spreads in the market. I’ll tell you honestly that I’m somewhat frustrated that on this call everybody keeps focusing on the market making and nobody cares about the brokerage. The idea behind this company is the brokerage business.

Okay. One other question on - it looks like the net yield that you’re earning on your customer liabilities has ticked up over the last couple of quarters. First, do you get a benefit from change in rates in say Europe? And then secondly, is there any shift in customer behavior that is allowing you to get a little bit better spread or any change in philosophy there?

We get little benefit from rising rates because it is our policy to pay our customers whatever we can get on their money less 1/2%. So when the rates are up 1/2% or higher that benefit goes to our customers.

Okay. So you wouldn’t benefit from higher European rates?

No. What I said was no.

Okay. Thank you.

Our next question comes from Patrick O’Shaughnessy with Raymond James. Patrick O’Shaughnessy: Good morning Thomas. I have brokerage related questions for you.

Wonderful. Patrick O’Shaughnessy: So the first question is your pricing ticked up this quarter and your commission per trade ticked up and you discussed that a little bit already. But do you have a sense for what the long-term trend of that might be or is it just going to fluctuate based on what the trading behavior is in any given quarter?

I’ll tell you frankly I’m not proud that our commission per trade ticked up. We’re not trying to couch that in any way because we pride ourselves charging as low commission as we can. What the trend will be on that we cannot tell. It basically has to do with the mix of products that our customers trade and the size of the trades. The larger the trades, the larger the commissions because we don’t charge by trade. We charge by for example on stock trades by number of shares in the order. So but what was the other question? I’m sorry. Patrick O’Shaughnessy: Do you think over time that maybe a mix shift in order flow would potentially impact that one way or the other? So if you get more options trades and more CFDs or foreign exchange, would that have any impact?

Well, it would have some to the extent the orders are larger. Yes, that would have some impact. But I don’t really expect this to change drastically because nowadays people who care about execution use our various ways of breaking up larger orders into smaller pieces so they can get them a better price. Patrick O’Shaughnessy: Understood. And then talking about the competitive environment for online brokerage, when I speak with the bigger well known online brokerage firms that are publicly traded they tend to state that they think your customer base is different from theirs. They don’t think that there is a lot of overlap. The appeal that their products have is different than what your platform offers. Do you think that’s a fair statement or do you think you’ve created a new niche?

I think they are largely correct because their customers probably care more about convenience and they don’t want to - they really don’t even understand the fine details of how an order is executed and why a few dollars difference in an order matters because it doesn’t matter to them if they trade only once a month. $3 or 4 either way doesn’t matter. Patrick O’Shaughnessy: Understood. And then one more question on the market making segment if you can indulge me, regulatory wise I think the SEC is poised to make a decision pretty quickly on the step up trades and potentially fee caps as well. I was curious if you have any sense as to how those decisions might play out and how it might affect you guys?

I really haven’t the faintest idea what they will do. You know. I have tried to explain our position and what we thought would be best for the markets even in cases when it’s not necessarily the best possible thing for us. They listened, they seemed to understand. They sound like maybe they would consider it. But then I really don’t know if they will. Certainly I tried to talk to them about the circuit breakers and suggest a different circuit breaker and they did not go in that direction even though it was very clear that that would do away with - my suggestion would have done away with all of the complexities. And they didn’t go with it. So I really don’t understand what drives them. Patrick O’Shaughnessy: All right. Fair enough. Thank you.

Our next question comes from Ed Ditmire with Macquarie.

Good morning. First I was going to ask Paul if you could add a little bookkeeping. In past calls you detailed precisely what the net interest income contribution was to each of the brokerage and market making units. Do you have that information?

I don’t think we discussed it on the call, Ed. It’s definitely detailed when we come out with the 10-Q.

Is there any chance?

Well, suffice it to say that the large majority was in the brokerage business because it’s a reflection of the bigger balances that we interacted because of the good financing rates.

Okay. So the reason why I ask is because in the past we’ve been told that in market making trading gains and interest income should be considered interchangeable. And so I was just wondering if we could get the net interest income so that we could get a good view for exactly what the trading profits were.

Almost all of it came from brokerage.

Okay. And then on the new dividend policy, will there be a time when that dividend is reevaluated maybe if the amount of equity in the market maker was substantially different in say eight years’ time?

I don’t see the dividend going down. I see it possibly going up in the future.

Okay. Great. Thank you.

Our next question comes from Mac Sykes with Gabelli.

Good morning Thomas. Just circling back to your comment about 5 million potential accounts and where your account balance is now and your global reach, can you see any constraints for not growing the brokerage account growth above the recent trend whether it’s customer service or advertising? Are there any things that you’re holding back on that might be able to accelerate the growth?

Well, if we went for less sophisticated accounts we could increase the number of our accounts. But that’s not in our interest. We would like to if anything - we would like to go after accounts that trade even more than our average customer trades now.

And just getting your market wisdom on the market making, the spreads have widened a little bit as you mentioned. Could you provide a little color on why they might be doing that from that? Do you think it’s less competition? Is it more favorable volatility recently? Just any color on that would be great.

Well, you know, I assume that when we’re barely breaking even so are other people. And some people say well, forget it. We’ll go and do something else. So even at 10% I don’t think that it’s a very lucrative business. So I do not think that we will have that increase in competition going forward as we have had in the past.

And just my last question - obviously we’re all waiting for the New York Stock Exchange deal to unfold. But assuming in the future we did see some kind of universal stock exchange, have you begun to think about the impacts of online brokerages and potentially distinguishing your trading services and how that might change under a universal stock exchange?

With a universal stock exchange the average broker would have to do less work to avail itself or its customers of all the services that are available. So I don’t think that’s necessarily a favorable thing for us because we distinguish ourselves by being very nimble programming to all the various exchanges and taking advantage of the variously differentiated rules of how creating an order to an order.

Thanks for the color.

Our next question comes from Richard Growth with the University of Wisconsin.

Good morning Thomas. A couple questions for you - first of all, would you be willing to talk a little bit more on the distribution of your client base in terms of the hedge funds and the financial advisors versus the trading accounts?

Let me say this. Of the roughly 160 - how many customers did we have at the end of the quarter? 167,000 roughly - of those 107,000 were individuals and the rest were either financial advisors or institutions such as hedge funds or proprietary traders.

Okay.

I don’t want to break it down any more than that.

No, that’s good. And then kind of following up on that, I notice in the past you made a comment that the majority of your customer accounts are below 25,000. Is that smaller base of the institutionals and the financial advisors what is really driving the majority of your brokerage revenue?

The end of your question I didn’t understand.

Basically I was kind of wondering if it was the financial advisors, hedge funds, the larger accounts that are really accounting the biggest driver in terms of your brokerage trading revenues.

Of course yes.

Okay. And then one last question I had for you - I noticed in your financial - your last financial report you had a $3 million investment in the Quant Fund. Is this a new kind of strategy that you guys might have going forward in terms of placing investments in some of these hedge funds and getting them on your platform?

Well, okay - but this is a good question. We are going to come out with something in the next month or two where we will in a way be working with certain hedge funds. And that investment into the specific fund is to work together with them to evolve this scheme that we are going to come out with in the near future.

Okay. That’ll be interesting to see that. That’s all I have for today. Thank you.

Scheme - schema - it’s a model.

We have a follow up question from Niamh Alexander with Keefe, Bruyette & Woods.

Thanks for taking my follow up. Thomas, you had kind of - I know you wanted to focus on the brokerage because that’s certainly a fantastic growth part of the business. But the market maker can still be a big driver of earnings. And it certainly is a lot of your capital. So that’s why we have to focus on it. But historically we have understood your business model that you lead into the market with the market making operation and it gets (more of) the market and then you kind of follow in with the brokerage business. And they are pretty well integrated in terms of the technology base and things like that. But I guess to Rich’s earlier question and things that you’re a little frustrated that we spend too much time on the market maker, are we getting closer to a point where it’s feasible to completely separate the two businesses and maybe look at strategic alternatives for the market making operation? Or do you still feel that both are kind of crucial to the integration of the operation of the unit?

I think I explained that the market maker is crucial to the continuing build out to our brokerage offering.

Okay. Fair enough. Thanks.

Thank you. Our next question is a follow up from Rich Repetto with Sandler O’Neil.

Hi Thomas. So a question on the broker - so has the mix changed between options and futures over the last year materially?

I think we published those numbers. And to tell you frankly, I do not spend a lot of time looking at them. So I think the futures business - both businesses picked up some. We generally make the least amount of profit on futures because as you know, the futures exchanges charge the greatest amount in exchange fees. And so when we execute the futures contract then we charge say $1.40 for that only 25 cents goes to us and $1.15 goes to the futures exchange. So even though it looks like our commission is high, but in fact it’s very tiny. So I think the futures business did pick up a bit but I do not believe that the long-term success of our business is tied to futures in any way. It’s much more tied to stocks and options and ForEx and bonds.

Okay. Then the second question is I was interested to hear you say that 40% of the new brokerage accounts come from bulge brackets. And I would consider since you’re a very active trading platform that I wouldn’t consider it that many that their first move from a bulge bracket would be to some of the other online brokers.

No I wouldn’t.

Say what?

No. They would certainly not go to other online brokers, no.

Well, when you say 40%, that’s full TOA. I guess the question is that transfer account we’re talking about, are we talking about new accounts or full trade TOA?

No. We’re talking about electronic account transfers only because the other accounts I cannot tell where they come from because they come via wire.

Okay. Last question - again one more on the market maker. When you said that the dividend, you would only see it going up from here, was that from a profitability standpoint or the other way you could look at it? If you had to pay out 280 million on 2.8 billion, I can do that math. 2.8 billion divided by 280 is 10 years. So I guess the question is did you say that out of you expect your profits going up? Or do you expect at some point you’d wind it down faster?

Ideally we would like to get started with this dividend and we’d like to go along and raise it gradually every year whether the business is good or not. Whether the market making business is good or not - the brokerage business is going to be great and that is going to throw out a lot of money either way.

Okay. And just stepping back, my previous question was if you look at your capabilities, 2.8 billion with your proven algorithmic technology capabilities, I know probably ten other PE firms that would be interested in trying to shape the opportunity what you could do with 2.8 billion and your technology capability.

What’s the question?

The question is looking at other - I’m not saying you immediately down the market maker but you have capital and you have technology. Looking at other opportunities and to see whether you have or not I guess other than just options market making?

We stick to what we know. We know brokerage, we know market making, we know computer programming. That’s about all; we don’t know much else.

Okay. Thank you.

One more.

Our next question comes from - is a follow up from Ed Ditmire with Macquarie.

A follow up question - are there any updated thoughts on broadening the ownership of the partnership or doing any kind of new share sales, things like that?

It’s not at the price where I’d like to do that. And the more it seems like the more time I spend on this call, the lower the price goes.

Okay. Any hints as to what kind of metrics you’d find more attractive?

For my part maybe if it doubled maybe I would. But other shadowers may see the future less rosy than I do. I don’t know.

Okay. Thank you very much.

Thank you. I am showing no further questions at this time. I would like to turn the call back over to Deborah Liston.

Great. Thanks everyone for your participation. And just a reminder, a replay of this call is going to be on our Web site shortly. Thanks again and have a great day.

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the conference and you may now disconnect. Everyone have a wonderful day.