Interactive Brokers Group, Inc. (IBKR) Q3 2011 Earnings Report, Transcript and Summary

Good day, everyone, and welcome to the Interactive Brokers Third 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 today. Just after the close of regular trading, we released our third quarter financial results. We’ll begin the call today with some prepared remarks on our performance that complements the material that is included in our press release and allocate the remaining time to questions. Our speakers’ today are Thomas Peterffy, our Chairman and CEO, and Paul Brody, our Group’s CFO. I just like to remind everyone that today’s discussion might include forward-looking statements. These statements represent the company’s belief regarding future events that by the nature are not certain and outside the company’s control. The company’s actual results and financial condition may differ possibly materially from what’s indicated in these forward-looking statements. For a discussion of some of the risks and factors that could affect the company’s future results, please see the description of risk factors in our filings made with the SEC. I’d also direct you to read the forward-looking disclaimers in our quarterly earnings release. With that, I’ll turn the call over to Thomas Peterffy.

Thank you and welcome. As you all know in the third quarter trading volumes were at their highest levels since the Flash Crash and for two thirds of the quarter, the volatility index stayed north of 30 and spent several days in the 40’s. While the outlook for the global economy is troubling, this environment has been positive for our brokerage business, as sophisticated investors need to rearrange their portfolios and traders look to profit from choppy markets. New customers are seeking lower commissions and financing rate, better executions in a more sophisticated trading platform to maximize their returns. Market conditions have also been favorable for our market making segment. We experienced a boost in trading gains this quarter although this was partially offset by unfavorable currency movements due to the decline in the value of the GLOBAL, our self-defined basket of currencies in which we hold our equity capital. During the quarter, the valued of the GLOBAL expressed in U.S. dollars declined by 2.5% driven primarily by the strengthening of the U.S. dollar. The decline of the GLOBAL had a negative impact on our income, and net worth by roughly $109 million. This was mostly offset by the effects of the OCI or other comprehensive income that added $86 million back to our reported regular earnings while subtracting the same from comprehensive income. This is exactly the opposite of what happened in the previous quarter when our regular earnings were less than our comprehensive income. We know that this is complicated, so I’d like to call your attention to the fact, that year-to-date for the first nine months, all these currency effects happen to largely cancel each other, and our regular and comprehensive income come fairly close to each other, and reflect the change in our net worth and…

Thank you, Thomas. Thank you everyone for joining us today. As we usually do, I’ll review summary results and then give some segments highlights before taking questions. Earnings were strong in both the Brokerage and Market Making segments, proving that our systems are well positioned to take advantage of the kind of high volume and high volatility periods that we observed in August. Net revenues were driven by increases in brokerage commissions, trading gains and net interest income this quarter. The Brokerage business set records in a number of different metrics, including DARTs and in commission revenue. And market conditions were more conducive to generating Market Making profits, even after some headwinds from currency translation. As we discussed in the second quarter call, our financial statements now include the new GAAP accounting presentation known as comprehensive income. Comprehensive income reports all currency translation gains and losses, including those that reflect changes in the U.S. dollar value of the company’s non-U.S. subsidiaries, known as other comprehensive income or OCI, as Thomas mentioned. These are included in the statement of comprehensive income which replaces the traditional income statement. Previously OCI was reported only in the balance sheet. In light of the strengthening U.S. dollar against a number of other currencies, adding OCI to net income decreases diluted earnings per share by $0.15 for the quarter. The other notable impact on earnings per share this quarter is the tax benefit that we recognized during the preparation of the 2010 tax returns. In connection with the special dividend paid by our Swiss operating company in December 2010, we were able to capture additional foreign tax credits, which resulted in an estimated $0.12 increase in the earnings per share, which is reported in the third quarter. Overall, operating metrics this quarter were up across the…

Thank you. (Operator Instructions) And our first question comes from Chris Allen with Evercore. Christopher Allen – Evercore Partners: Good morning, guys. I’m sorry, afternoon guys, a nice quarter. I guess just a one quick question, just on the corporate line, net revenues were a negative $10.4 million in the segment, was there a write-down there?

There are a number of things reflected in the corporate line including some net interest and some, not from operating businesses, and there are some investments there on which there was some write-down. Christopher Allen – Evercore Partners: Okay. And then I was wondering if you could provide any update on some of the initiatives you announced last quarter in terms of the stock lending, the capital introduction, whether you’re starting to see traction with those initiatives?

Well, I’ll tell you frankly, I haven’t been keeping track completely. I’m embarrassed, I know that some customers have signed up to some of these hedge funds, but I don’t have the numbers at hand. Christopher Allen – Evercore Partners: No problem. And this is one last question, Thomas any thoughts in terms of the MIFID II proposal that came out, how that may impact your business, see positive developments in a competitive landscape over in Europe?

I feel that those things, they have to crystallize before – because whatever the words say… the practice becomes sometimes quite different. So we prefer not to be the first ones that go at these things and wait to see what other people do and then we see if we can do it better. Christopher Allen – Evercore Partners: Okay, thanks a lot. I’ll get back in the queue.

Our next question comes from the line of Rich Repetto with Sandler O'Neill. Richard Repetto – Sandler O'Neill & Partners: Good evening. Thomas, I could tell these regulatory changes are coming so fast and furious, I don’t think anybody can keep up with all the proposals and changes and so forth, but anyway I have a question. Paul, it looks like there was some shares issued in the quarter and I guess it’s pretty interesting, it looks like its average, there is a leverage effect in regards to the EPS, before the non-controlling interest used to be about 93%, now its 89% this quarter as a percentage of your full net income, could you just go through the movements in the share count and the non-controlling interest for us?

Sure, Rich. Firstly, the non-controlling interest started at 90%, because in the IPO we’ve floated 10%. It has very gradually gone down since then due to shares being issued under our stock incentive plan for employees and this year that was accelerated a bit because as you know each year we laid out a schedule for the former members of the company who are members of the holding company, called the IBG Holdings, and that was an 8-year schedule under which members are permitted to redeem a certain amount each year of their share. In the past, the company redeemed those for cash and this year, the company chose to redeem those for in the form of stock and that stock was issued, which have caused the public company to require somewhat greater interest than it had before. We filed an S-3 shelf-registration for this purpose back in beginning of August, and it has some details on this. Richard Repetto – Sandler O'Neill & Partners: So currently the public company-owns 11.4 or 5 percent of the group, right?

Yeah, up from the original 10 and that was already gradually moving towards the current number with each year’s distribution under the stock incentive plan.

And the reason we decide that for the company not to buy those shares that the employees wanted to share is that, we would like to see however minute an increase in the public float because we believe that the shares would be followed more closely if the float where larger. Richard Repetto – Sandler O'Neill & Partners: Understood, understood. I guess like last quarter, if you just look at the non-controlling interest as a percentage of your net income, it was 93%, it went down to about 89%, that sort of 11% ownership of the public. Do you agree, yeah, I understand there is a leveraging effect here on EPS at all?

Understand that the as part of the income tax expense, there is a piece that only goes to the public company in the reporting. So you may be seeing, I'm happy to look into details further for you but you may be seeing the fact that you can’t take a straight allocation on pre-tax income, because EPS is based on after-tax income, and some of the tax is the corporation’s tax, total company corporate tax. Richard Repetto – Sandler O'Neill & Partners: Got it. Okay. And then, next question Thomas, on the electronic brokerage, it appears that your customers, as you know is way more up than Schwab, E-Trade, Ameritrade, but it appears that they’ve been deleveraging as far as margin balances goes over the last four or five months. And has there been – is this purely, can you sort of explain that and purely on their, and has there been any change in rates or aggressiveness in marketing to margin business, correct?

That is correct. And yes, to some extent there have been deleveraging in response to the decreasing market prices. And also many of these folks were carrying different currency positions, which they decided to liquidate. And currency positions are carried at high leverage. Richard Repetto – Sandler O'Neill & Partners: Got it. And I guess the last question, Thomas, you did say that it can’t, really no one can predict the market making conditions in the future, but I guess my question is, given what went on in August in the high volatility in a much improved, but are there any, and I’m not talking about conditions, but is there anything you saw, do you think has any lasting impact on the industry, like did it shake out potential some – the less economically strong Market Makers, is there any lasting impact to the good conditions that you’re experiencing this quarter?

I’ve heard some rumors that some market making firms have gone out of business, but that is of course a thing that happens all the time, the question is how many new ones come in to replace them. This is a thing where people come and go as far as HFTs are concerned. So I really can’t tell. The big question will be whether the SEC makes any new rules, which I’d love to see them do, and if this November 30 deadline has any teeth as far as stricter credit controls that those brokers who sponsor the HFTs will have to exercise. Richard Repetto – Sandler O'Neill & Partners: Okay. That’s all I had. And congrats on this very strong quarter.

Thanks.

Our next question comes from Ed Ditmire with Macquarie. Ed Ditmire – Macquarie Research Equities: Good afternoon. My question is on the broker rules proposal, one, the first part of the question is if you can foresee any change to the competitive dynamics in the current areas that you focus on? And two, maybe more importantly, as a non-SIFI institution, not subject to a Volker rule, not a deposit-taking bank, do you think there is any possible advantages that you would have that would have you anxious to put capital to work in new products?

All I can tell you is that capital reserves that people have to make in conjunction with the, our competitors have to make in conjunction with the leverage they have, I would think that their least profitable businesses will fall away. And those businesses would be free for us to get into. Now again, I tell you frankly, I have not read the Volker rules and I’m hoping to, I mean all I know is what I read in the paper, which I believe thoroughly, but I haven’t read the 700 pages of rules, and even if I were to read it I wouldn’t understand it properly. So once I get a summary of the rules from our legal team, we’ll have a more intelligent answer to your question. Ed Ditmire – Macquarie Research Equities: Okay, great. And then maybe one follow-up on the tax gain for Paul.

Yeah. Ed Ditmire – Macquarie Research Equities: So just to confirm, you guys benefited $0.12 from a one-time tax gain related to the 4Q special dividend last year. Is that right?

That’s right, yeah. Ed Ditmire – Macquarie Research Equities: And so it’s ultimately is it the case that you paid a substantial amount of taxes to repatriate that money that were inaccessible that was ultimately required?

So when the tax returns for 2010 were being prepared, we went through all the final computations and determine that we could actually recognize greater foreign tax credits than previously and since taxes are all, they’re paid on an estimated basis up until the time when they are finalized for the year, they are finalized for the year right around now. Ed Ditmire – Macquarie Research Equities: And could you say what the tax rate was exempting that item?

Without that item? Ed Ditmire – Macquarie Research Equities: Yes.

Our effective tax rate on the income in tax is 36.8% roughly as we always maintain from quarter-to-quarter. The effective rate including that benefit we achieved from our holding company structure and from the IPO as we’ve talked about in the past, varies from quarter to quarter because the benefit is a fixed amount and it becomes a bigger benefit on lower income and a smaller benefit on higher income. So it’s a little bit of a moving target. Ed Ditmire – Macquarie Research Equities: Okay. Thank you.

Our next question comes from the line Macrae Sykes with Gabelli & Company. Macrae Sykes – Gabelli & Company: Hi good evening, gentlemen. Thomas, it’s a good looking horse from in the journal this morning.

Thank you. You’ve seen that horse before right? Macrae Sykes – Gabelli & Company: Could you, just want to also keep it short, what was the shares outstanding at the end of the quarter?

At the end of the quarter? Macrae Sykes – Gabelli & Company: Yeah. You have the weighted average, so just one capital. Just for your book value.

We’ll publish that by the 10-Q. Macrae Sykes – Gabelli & Company: Okay. And then I guess you sort of highlighted this with the diluted share count in your comments before. But in light of Mr. Buffet’s buyback of Berkshire at 110% of the prices of the book value, had you thought about it, when the stock price got down to 13 a couple of times this quarter buying back shares? I know you’ve stated that you haven’t done below book, but you would have only bought below book in the past, but just considering some of his initiatives I thought maybe that might be incentive for you?

Well, I don’t know, I guess we could borrow money and buy the shares back, right? The public company could buy the shares back. But I don’t know if we only get into this because as you see we are trying to sell shares, not buy shares. We would like to – the fewer the shares the public company has outstanding, the less liquid the stock is and the less interested people are into getting into it. So our objective on the long run is to drive the profits high enough so that the stock price eventually responds, and then we would sell more shares rather than buy back. Macrae Sykes – Gabelli & Company: Did you ever instead of the cash dividend issue shares instead to increase liquidity that way?

We have not considered that. Macrae Sykes – Gabelli & Company: Okay. And then just my last question, I'm wondering if you could give us any highlights from the international pieces where you are seeing an uptick in traffic in Asia or China or India? How are those tracking?

Our customer business is increasing in Asia slightly faster than anywhere else. And as far as our commission income is concerned, the commission income that we derive from advisors, prop traders, and hedge funds are increasing and the commission income that we derive from individuals and introducing brokers is increasing at a decreasing rate. In other words, the total composition of our commission income has increased on the advisor, prop trader, and hedge fund side and decreased on the individual and introducing broker side. Macrae Sykes – Gabelli & Company: Okay, thank you.

Our next question comes from the line of Niamh Alexander with Keefe, Bruyette & Woods. Niamh Alexander – Keefe, Bruyette & Woods: Congrats on the quarter. If I could just understand, Thomas and maybe Paul, the new account growth we talked a little bit last quarter how you’re kind of increasingly seeing bigger accounts come on board, are you still seeing that trend as it mostly came from the new accounts are growing from?

Well, the way we are looking at that is we would take our total customer deposits and divide it by the number of accounts and that has been increasing more than the market price, but now that the market has turned around in the last quarter that is no longer the case. So while there is anecdotal evidence with larger accounts, we get more larger accounts and fewer smaller accounts, I don’t have any statistics on that. Niamh Alexander – Keefe, Bruyette & Woods: Okay, fair enough. Thanks. And then did we see during the quarter that in the margin lending portfolio, you had kind of substantially increased the margin requirements for the small cap stocks, is that kind of a permanent change, is that something kind of you’re moving away to try and encourage margin lending for those less liquid stocks?

Well, we decided not to make margins loans on stocks of companies that had a market capitalization under $300 million. And we intend to continue to keep it that way in the future. Niamh Alexander – Keefe, Bruyette & Woods: Okay, fair enough. Were there other changes as well, are they just a very small cap, that you changed.

There were some changes as far as the Chinese stocks were concerned, and we have a number of customers who had high leverage in that area. Niamh Alexander – Keefe, Bruyette & Woods: And they’re no longer there?

That’s right. Niamh Alexander – Keefe, Bruyette & Woods: Okay, fair enough. And I guess lastly, on the FX, just to kind of make sure I understand it correctly, and that P&L impact was $23 million, before you’ve started to put the kind of fully comprehensive or the new GAAP statements. I guess you used to try and adjust the entire market making, and revenue line for all of the FX or the OCI as well as the GAAP, is it kind of an adjusted number, is that still a good way for us to think about in terms of the core P&L going forward?

We like to think, we’ve always liked to think of putting all of the FX effects into the income statement. We already said it was arbitrary that GAAP required sort of arbitrary portion it to be put into the balance sheet. So if you want to continue to look at the way we look at it, then obviously we agree with you. And this quarter that means that the originally reported number that’s under the old method has $23 million impact and there is an additional $86 million impact in OCI that in the new comprehensive version gets brought into the income statement and that’s where we get a total impact of $109. Niamh Alexander – Keefe, Bruyette & Woods: :

Well, GAAP might attribute it to market making. The fact is that the definition of OCI is the change in the value of our non-U.S. subsidiary as so denominated in other than U.S. dollars, so some of the subsidiaries are in fact part of the brokerage business although most of them are part of the market making business. Niamh Alexander – Keefe, Bruyette & Woods: Okay, fair enough.

That’s a little bit of a tough allocation. Niamh Alexander – Keefe, Bruyette & Woods: Okay, fair enough. And then just lastly, you redefined your hedge, is that business make shift or is it just that you’re feeling like there is just too much volatility in the GLOBAL composition right now?

It’s both, but the fact is that we do business and are required to maintain balances in all those currencies. So our total hedging activity and hedge position will decrease in the new circumstance, for example, if we do something in Singapore or Korea or then we do that against the amounts of money we keep in those currencies rather than having to hedge it back to the previous GLOBAL basket. Niamh Alexander – Keefe, Bruyette & Woods: Fair enough, I guess another way of asking too, is that presumably, you probably did some back testing, can you maybe share with us did that kind of eliminated lot of the volatility we’ve had from the FX?

Well, most of the volatility on the FX was expressed by the dollar’s move against all the currencies, and the larger basket is against the dollar is somewhat less volatile, but not appreciated. Niamh Alexander – Keefe, Bruyette & Woods: Okay. Fair enough. Thanks for taking my questions.

Our next question comes from Rob Rutschow with CLSA. Rob Rutschow – CLSA: Hi, good evening. Just a quick housekeeping item, the increase in comp expense this quarter, is that mostly non-cash comp or did you start to do a little bit more hiring?

Well, in good quarters we like to set aside a little more and in bad quarters a little less. Rob Rutschow – CLSA: Okay. I don’t know if you can answer this question, you know you’ve had good growth in the RIA space recently. Were those new customers… did they see a similar pickup in activity relative to sort of your legacy customer base?

Sorry, I didn’t get the question. Again? Rob Rutschow – CLSA: So the RIA customers you’ve been adding, they tend to be higher balance with a little bit lower turnover, were they more active than what you’ve seen previously in the third quarter?

Where the RIAs more active in the third quarter than in the preceding quarters? Rob Rutschow – CLSA: Right.

All I know is that total commission income derived from RIAs in the last quarter was significantly higher than the preceding quarter. Now, to what extent it’s due to new RIA accounts and to what extent due to the activity, I cannot tell you. Rob Rutschow – CLSA: Okay, thanks a lot.

At this time, I’d like to turn it over to our speakers for any closing remarks.

Okay. Well, thanks for everyone for joining us today. And just a reminder, we’ll have our webcast available for replay on our website. Once again, everyone have a good evening.