Interactive Brokers: Strong Buy, As Margin Lending Boosts Earnings

Interactive Brokers (NASDAQ:IBKR), once a pioneer in the field, has now grown to dominate the market for electronic trading and brokerage services, today boasting close to 2.1 million customer accounts (32% CAGR since 2017). These accounts predominantly comprise seasoned and highly active investors, traders, and institutional portfolio managers, collectively managing approximately $120.6 billion in assets. While IBKR has shown strong market presence and growth potential for a long time, the attractiveness of an investment is now more attractive than ever. Specifically, with higher interest rates, the company's margin financing business stands to capture significant profits from lending, on track for a net interest income run-rate of $3-4 billion in the fiscal year 2024.

In assessing the investment potential of Interactive Brokers, I use a residual earnings model broadly anchored on analyst consensus expectations. My analysis suggests an estimated fair implied share price of $98.08.

Leading Brokerage Firm

Interactive Brokers is a well-known brokerage firm that serves both retail and institutional clients. The company's business model is primarily focused on electronic trading and brokerage services.

In the context of electronic trading, IBKR offers clients a low-latency trading platforms that allow for real-time execution of trades, spanning access to more than 159 market centers around the world. This includes major stock exchanges, commodity markets, options and futures exchanges, as well as forex markets. That said, one of the hallmarks of Interactive Brokers is its competitive pricing structure. Throughout the years, IBKR has consistently offered some of the lowest commission rates in the industry. In a broader framework, IBKR also offers research and education, including access to market data, research reports, and educational webinars, as well as risk management tools.

The strong offering in e-trading has allowed IBKR to expand customer account numbers at a 34% CAGR from 2017 through 2022, bringing accounts to 2.1 million. That said, it is important to understand that IBKR is a platform mostly for seasoned, professional traders/ investors. These investors are less likely to be shaken out during times of market stress, buffering cyclicality like for example seen with Robinhood (HOOD), and more likely to sustainably trade on margin (remember this, as this will be important for later arguments on why IBKR is attractive).

With regard to brokerage services there are a few things to consider. Overall, Interactive Brokers acts as an intermediary between investors (retail and institutional) and various financial markets, allowing clients to buy and sell a wide range of financial instruments. In other words, it is the trading platform discussed above. However, IBKR also provides prime brokerage services for sophisticated institutional clients such as hedge funds. Prime brokerage can be best understood as a collection of services such as securities lending, trade execution, trade clearing, as well as margin lending.

Having covered the business model and product offering, we are now ready to dive deeper into Interactive Brokers' financials, and discuss why I think the company is such a great investment.

How IBKR Makes Money

Throughout the past decade, IBKR's fundamentals have closely trended in line with the company's commission income. Because with low interest rates, margin financing in trading was not really an attractive business for brokerage firms. But this has changed aggressively. Now, with higher interest rates benchmarks, IBKR's margin financing business is booming. Margin lending basically allows clients to borrow money to trade larger positions than they would be able to with their own capital. This comes with risk for the client, as leveraged positions bring the potential for outsized losses. For IBKR, however, margin lending is what financing underwriting is for normal banks. While there is some small risk of "non-performing" loans, the loans are usually to a large extent secured and covered by assets that are bought themselves. For brokerage, when leveraged securities portfolio drop below a margin maintenance level, IBKR has the right to liquidate positions to cover its own equity. This has worked very well in the past, with IBKR suffering only $2 million in losses for the trailing twelve months as of September 30.

That said, with higher interest rate benchmarks, lending is very lucrative for brokers. In Q3 2023, IBKR reported $733 million in interest income, which is 55% higher than what the firm achieved a year ago in Q3 2022, and about 170% higher than the comparable metric in Q3 2021. For context, IBKR's lending business is now more than 2x the size of the commissions business, and still increasing: In Q3 2023, IBKR customer margin loans increased 8% YoY, to $43.6 billion. Extrapolating Q3 2023 net interest income numbers, IBKR's margin financing business is set to capture significant profits from lending, with a projected net interest income run-rate of $3-4 billion in 2024.

While IBKR does not disclose operating income on a product/ segment basis, it is highly likely that much of IBKR's growth in margin financing has flown and will continue to flow directly to the company's bottom line. Investors should consider that lending in brokerage does not require sales representatives, or retail outlets to drive volume. In fact, higher margin lending requires almost no additional operating overhead, except very limited investments for risk management. This argument is well reflected in the company's eye-watering margins. In Q3, IBKR posted a 73% pre-tax net income margin. What other company can post such a margin? Lastly, I would also point out that the income from the margin lending business has some features of predictable subscription income, reducing the company's exposure to volatile, discretionary trading activity of clients.

Residual Earnings Model

Let's try to understand what IBKR stock could be worth. To test this, I am a great fan of applying the residual earnings model, which anchors on the idea that a valuation should equal a business' discounted future earnings after capital charge. As per the CFA Institute:

Conceptually, residual income is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company's capital.

With regard to my Interactive Brokers stock valuation model, I make the following assumptions:

• To forecast EPS, I anchor on the consensus analyst forecast as available on the Bloomberg Terminal 'till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework. But for 2-3 years, the analyst consensus is usually quite precise.
• To estimate the capital charge, I anchor on IBKR's cost of equity at 8.75%.
• For the terminal growth rate after 2025, I apply 2.25%, which I believe is a reasonable estimate post-2025 (approximately in line with U.S. nominal GDP growth).
• Investors with different assumptions regarding IBKR's cost of capital and terminal growth may take reference from the sensitivity table enclosed.

Given the above assumptions, I calculate a base-case target price for Interactive Brokers of about $98.08/share.

My base case projection for IBKR's target price implies upside. However, it is crucial for investors to evaluate the risk and reward ratio of investing in a company based on a 'scenario' view. To assess different scenarios based on various assumptions, I have created a sensitivity table that analyzes IBKR's cost of equity and terminal growth rate. See below.

Conclusion

Interactive Brokers has grown over the years to now be a dominating force in the e-brokerage market, with more than 2.1 million customer accounts (most of which are sophisticated, highly active investors and traders, as well as institutional portfolio managers), and about $120.6 billion of total assets. With such a strong presence, and further growth expected, the company is poised to enjoy a windfall profit from margin financing, which is trending towards a $3-4 billion net-interest income run-rate in FY 2024.

Exploring the attractiveness of an investment, I value IBKR with a residual earnings model and calculate a fair implied share price of $98.08, seeing approximately 20% upside for the stock. As a function of both valuation and commercial excellence, I initiate coverage on IBKR with a "Strong Buy" recommendation.

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