Luis Sanchez lays out the $IBKR thesis (Podcast #132)

Luis Sanchez, founder of LVS Advisory, discusses his bull thesis for Interactive Brokers (IBKR). IBKR is a major beneficiary of rising interest rates, and on top of that Luis thinks the company will continue to experience significant account growth thanks to their business to business efforts and low cost structure.

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Transcript begins below

Andrew Walker: All right. Hello, welcome to Another Value Podcast. I'm your host, Andrew Walker. If you like this podcast, it'd mean a lot if you could rate, subscribe, and review it wherever you're getting it from. With me today, I'm happy to have for the second time, my friend Luis Sanchez. Luis is the founder of LVS Advisory. Luis, how's it going?

Luis Sanchez: Good, man. Thank you for having me again, Andrew.

Andrew: Hey, thanks for coming back on. I'm really excited. I guess I'll do the pitch for a second, but let me start this podcast the way I do every podcast. First, a disclaimer to remind everyone nothing on this podcast is investing advice. On your first appearance, we talked about Endor which is a very small, very E-liquid German company if I remember where their trade correctly. This time to stocks it's going to be a little bit bigger, a little bit more liquid so, probably a little bit less there but please just remember, do your own diligence, consult a financial advisor, not financial advice.

Second pitch for you my guest, people go listen to the first one if they want but it's been great getting to know you for those who don't know, we kind of share what we work so we've gotten to know each other, and play some games to that. And as soon as you publish the research report in IBKR I was like, "Oh this would be a great podcast", so just really happy to have you on and really happy to have gotten to know you more over the past couple of months. But all that out the way, let's change this talk we're going to talk about. The company is an interactive broker, a lot of our people might be buying and selling, and a lot of our listeners might buy and sell on their platform. The ticker is IBKR and I'll just post there. What's so interesting about interactive brokers?

Luis: Yeah, absolutely. Thanks for that great intro. And I think the fact that last time we covered Endor and this time we're covering IB is a pretty good reflection of the kinds of stocks that I like which is basically anything and everything. I run two strategies, but the theme is more on the growth-oriented strategy, and we were looking for high-quality companies with long competitive advantages, and long-term growth runway. So sometimes as it is just the micro caps, but sometimes there's a pretty good example that is made in large caps. So I think IB is a good example of that.

Effectively, the 32nd pitch is that I believe that IB is a very durable business with a lot of growth runway. The company is an electronic broker, so it's primarily helping people buy and sell securities. It's primarily a retail broker but it does also have some B2B aspects of its business which we'll get to. But over the last 10 years, it's 10x its client base. It currently has about 2 million accounts. And 2 million accounts that's a fair scale number. Other players have more than 10x that account base. So over the long term, I see IB continuing to rapidly grow its account base, and it's continuing to do that even in 2022. The company is a low-cost leader, it has some interesting competitive advantages and niche areas that it caters to. It has a niche leadership position for more sophisticated retail investors and anyone who's doing international trading.

The reason why I think IBKR is such an interesting stock to look at today is that it has a couple of distinct earnings catalysts; namely, the first is just that its account base is still growing very rapidly. The second is that it is one of the rare companies that uniquely benefit from higher rates. The way that I think about IBKR is there are two parts to the pitch. There's the durable long-term compounding of the business, which I think you're only paying for that today. And then, what I would call as it's like interest rate call option, which I think is very mispriced which is, if rates stay elevated for longer, or if rates don't immediately go back to zero, this is just straight cash flow that goes down to IB's bottom line that the market isn't ascribing much value to it. So that's more or less the 30-second pitch.

Andrew: We'll talk more about interest rates obviously because I think that's an interesting story. And they gave me some numbers on the queue to call and my notes are so disorganized I'm having trouble finding them. But it's so funny because, on the Q2 call, they were talking to the Fed funds rate was, I don't know, like 1.5 or 2. And here we are 3 or 4 months later in the Fed funds rates are going to be approaching 4%. So the numbers they gave, as you're going back and reading their most recent earnings call are just so stale. And it's so funny just how quickly things have moved just on that interest rate thing, it's been insane. Let me start with the first piece of pushback. The markets are very competitive places. And the first question I always like to ask is, what are you seeing that the market's missing? I'm going to ask that, and then I have a follow-on that's kind of unique to IBKR that I'll follow up with.

Luis: Yeah. It's funny, I have a list of four or five things that I think the market isn't really, or at least, I have maybe a very few on. The first one is that IB clearly benefited from what happened during the pandemic; namely that there was a retail stock trading mania, and the number of accounts they opened accelerated significantly as of the whole industry. And now, we're in that hangover portion of the pandemic, where for most of the industry, if you look at Robinhood, they're not growing their accounts anymore. The IB is still growing its accounts at a pretty nice clip. But the trading activity per account is significantly down. There are a couple of like KPI trends that are negative. And I believe that the market is over-extrapolating the recent negative trends in some of these KPIs, where a lot of people will push back to me and say, "Okay, yeah. Well, the trading activity per account is never going to get back to what it was in 2021."

And what people need to realize is that it doesn't have to and the current level of trading activity and the current level of KPIs on a per-account basis, is reverted back to 2018 levels. So now, we're kind of at a point where people are continuing to extrapolate the unit economics on a per-account basis, potentially getting worse. Now becomes an increasing probability that some of the KPIs could get better which is really interesting. The second major area that I think people get wrong is if you look at this company on like a 10 or 15-year basis, it screens terribly. Basically, it doesn't look like they've compounded EPS at an attractive rate. It looks very volatile and there are a couple of reasons for that, namely that the business mix is just complete, it's a very different business than it was ten-fifteen years ago. They had a market-making business which was 80% of its business in 2007 and is now basically not a material, it doesn't exist anymore.

In different interest rate regimes, the margins and mix can look different, and effectively, we're at a point where I think the business is at now if you look at the core business. The core business based on what exists today, it actually compounded at a very nice rate. And I think sets it up for future financial characteristics that are going to be very attractive. I think the last two areas that I'll quickly highlight are a lot of people believe that there's a higher probability of a blow-up here. For example, IBKR is a broker, and if the underlying account holders blow up their account equity during a financial crisis, that creates counter-party risk for a company like IBKR. And given what I just said about how the financials are really weird, if you look back at 2008-2009, I think people have the wrong takeaways from what happened in the last cycle and I don't really see a lot of risk of a negative scenario and I can talk about that a little bit more.

Finally, it's just the interest rate call option, which I think is really mispriced. We were just talking before the pod, IBKR on street numbers trades for about 14 and a half, 15 times, 20-23 EPS, which is historically a very cheap multiple for this company and it trades at a discount to the market, which I think is interesting given that I believe this is an above average quality business. Depending on your view of rates, we can get into more in detail later, on my numbers, IBKR could be as cheap as 10 times next year's earnings if you ascribe some value to interest rates. The way that I believe this, is the stock market is currently looking at this company. Is it saying, "Oh hold on, this is acyclical? Historically, it's been more volatile, and the metrics don't look that great. It's had a couple of quarters, the last year and a half that KPIs have turned negative, we don't know when that's going to reverse. This could blow up if things run off the rails here in the next couple of quarters. And then, people are just assuming interest rates are going to immediately go back to zero. Therefore, we shouldn't describe any value to their interest rate tailwind. There's a lot of interesting stuff to kind of dive into there. But I think those are the common areas that I think people maybe I have a different view on.

Andrew: That's great. Those are all areas that I wanted to touch on. But I just want to touch on one more thing, the markets, and competitive place. How is this going to outperform? I've looked at IBKR in the past, this has always been a popular company for kind of value investors, compounders, and pitch. And guess what? They've been right. It's done pretty darn well, a lot of the things that we're going to talk about I think people will see why it's been so popular. The founder-led, the guy sells loans like 75% of the stock, he's a billionaire, he's a boss. I'll give some quotes from him later.

But just to go back to the alpha thing, 19 times this year's earnings, let's call it 14 or 15 times next year's earnings on the street number may be a little bit better than that if the interest rates come through, and all that sort of stuff though. You do have certain interest rates go up. Those are crazy expensive multiples. We're not talking 20 times sales or something, but they're also not crazy cheap multiples. I was doing a little work on Facebook yesterday for a post just because a friend posted them and they looked interesting. That's like 10 times the price to earnings on this year's number, which are probably a little sickly depressed and that includes a massive investment into the Metaverse which if it doesn't pay off at some point, probably stops. And they've got cash on their balance sheet. So obviously, you don't have to compare Interactive Brokers to Facebook, which markets are down 25% this year. Like there's a lot of stuff that looks cheap 15 times next year's earnings, not expensive, but not the cheapest out there. And I think a lot of people might look at it and say, "Hey, how are you really going to drive alpha with something that's to maybe fairly priced, especially for this environment?

Luis: Yes. Okay, to just really boil it down into kind of two things here. The first is that I think my view of the business quality is above what the current multiple implies. I actually do believe this should be above-market multiple businesses, long term. And the second is that I believe that the street estimates just need to go up.

Andrew: Yeah.

Luis: On my numbers, it's 10, 11 times, 20-23 EPS. And it could be even cheaper depending on how much value you want to ascribe certain moving parts of the business. So I think that multiple could be too cheap, but I also think that street estimates need to go up. I think that's where potentially, there could be some alpha if I'm right, which I may not be right.

Andrew: I found the number just so people know. So the shares outstanding, if you do it, they've got this weird structure, where they have about a hundred million shares outstanding but there's another 300 million at like the LLC level[?] that the shareholder control. I think the right numbers about 400 million shares out if I'm remembering correctly. Is that about right?

Luis: Oh, that sounds about right.

Andrew: That's rough math, that's about right. On their Q2 call, they said every 100 basis points increase in the Fed funds rate is about 230 million dollars in net income. So, that's pretty simple. That funds rate up another 1% that's over 50 cents per share and earnings. That's a pretty meaningful number on a $67, $70 stop[?]. Just on the business, so they're going to make money from two places. They're going to make money from giving margin loans to people, that's their net interest line and they're going to make money from trading commissions. People are buying and selling a lot of stocks. Those are their two main lines. When you look at Interactive Brokers, are they more of a trading business? So they're making all their money and then the margins of those are nice supplemental? Or are they more of a margin loan business? They just want traders to come on, take margin loans, and where the real juice is, is actually on the net interest income.

Luis: Yeah, they're a bit of a balanced play here. I think historically, the mix in the zero-interest rate environment has been about two-thirds non-interest revenue, and about a third interest-related income. And in 2019, when there was a higher interest rate regime, in the past, that's been more 50/50. And now, we're talking about interest rates that are higher than in 2019. I would actually expect that to flip next year depending on how high rates stay. Although it's important to note that the interest-earning component of their business is not purely based on the absolute level of interest rates because even in a zero interest rate environment, they're earning about a one-and-a-quarter net interest margin.

They do that because they monetize customer cash, and they do securities lending in addition to margin loans and other forms of credit that they have on their balance sheet. Relative to like Schwab, Schwab is almost purely a balance sheet-related play. And that's kind of been the direction of the industry over the past five to ten years where we've moved into zero commission trading business model. Whereas, IB has that product offering, more than 90% of their customers use the model that still charges a low-cost commission. And yeah, I do want to add one bit of context though, and maybe we can get into this in a minute.

Andrew: Yep.

Luis: But I actually was surprised about some of the B2B aspects of their business. I just wasn't aware even though I've been an IB customer for over 10 years.

Andrew: Do you mind if we go to B2B after? I just want to ask some more basic questions about the business. But I did have a lot on it. Yeah, we'll talk about those in a second because it almost turns them into a tech business. But I just want to focus on, on their earnings call, there was this really interesting quote. They said, "Hey, we do things that we think are interesting and really what we're trying to do is we're trying to make a platform that's really attractive for people to come trade on. It doesn't sound like they want people to come and buy and hold. They wanted people to come to trade on and they say, we want great execution, low commission rates so that people can trade actively and they're really pumping like if you're a trader, margin rates." We want you to come and use margin, that's where we're going to make money. And we're also going to incentivize you with, they've got a little.

In their September deck, they said, "Hey, if you're borrowing $300,000 in a margin, we're going to charge you 3.5% for it. If you go to E-Trade, they're going to charge you 10%, and Schwab, Fidelity, and TD Ameritrade are 9-10%. It's so much more economical for you to go to Interactive Brokers if you're going to use margin. That's great, but it does strike me as, "Hey, you're attacking an active trader, if you're cutting commission, really focus on getting people trading, focus on getting margins. And that does present other risks where markets get super non-volatile, people stopped trading as much and not just people stop trading but your active traders really lose interest. There are other risks too, but I just wanted to ask you about that active trading focus, if that makes sense.

Luis: Yeah, okay. I see where you're going with it. There's one important part that you're missing a bit of that piece though. It's not only are they offering, actually, but this is also a really common question I get, which is, okay IBKR sells its value prop is we're going to offer like value to investors by lower cost. Given that there are zero commissions, is that value prop still valid? Who cares if you're charging $1 per trade when Robinhood's free and Trops[?] free, which is actually, they're not free but we can get into that. The important piece is that IB is also offering the highest interest rates on cash. So, there's the value prop for IB in a zero commission business model that has actually shifted more to the value prop of, hey we're going to offer you the best margin rates. We're also going to offer you the highest interest on your cash balances.

We're also going to share with you the proceeds from stock lending. And we're going to also do all sorts of interesting ways to sweep your cash, to give you the best accounting. That gets into more of the ethos of the company, this is really a scale economy shared business model. And I would say, you are 100% correct, they have a niche, where more sophisticated and more active traders, we use IB because, it's because, on a per trade basis, they're effectively offering wholesale rates. Half a penny per share or dollar per derivative contracts, etc. And the net result of that is the revenue per customer for IB is about 10x the revenue per customer of like Schwab. So that's the net result.

I actually view that as shifting over time as they've been expanding into more, I would call it mass market customer base. I believe that the value proposition and what is going to help them gain market share is the fact that IB is very uniquely positioned because A, is low-cost, and B, will get to this, but on the balance sheet, it has all of its liquidity and T-bills which means that it can more quickly adjust its interest rates than its competitors that have duration in their portfolio. And that's going to allow IB in this cycle to work. Customers are now a lot more focused on interest rates. What is my bank yielding? What has my margin loan cost? I believe that's actually a new value prop that they're going to be able to really push going into the next couple of years.

Andrew: You mentioned blow-up risk earlier and we'll probably talk about blow-up risk. But one way they could blow up is, as you kind of said, interest rates rise and they have to pay their clients more on their deposits, and they've invested in, it's the classic, you borrow short to lend long. They've invested a lot of long-duration stuff to reach for yield interest rates rise, and they get murdered, and they've been so clear. A direct quote, "We do not take that risk. We invest in T-bills and Repose". Like, that's how we get our interest income and then we pass a lot of that onto our thing.

Just one more thing on their focus on more kind of professionals active. Because the next step is E-Trade got bought by Morgan Stanley, these guys are merging. And I do worry, if your whole value prop is, hey, professional traders, active traders, whatever it is, come to us, we offer better margin loans, we offer wholesale pricing. That can be matched. Interactive Brokers is only monetizing at that. Like E-Trade, I know that they've got Morgan Stanley out there trying to pitch wealth management, all this sort of stuff. Could you see an E-Trade, JPMorgan, all these guys at some point they just say, look, we're not making that much money. Let's just give wholesale pricing to anybody who we think is the third[?] client. And then we'll make the money up by getting their client invoked for wealth management. Or all this other stuff like these bolts ones. It's the old one product versus somebody who in turn your product into kind of the lost leader to get you into a bigger ecosystem.

Luis: Yeah, I don't think so. Two reasons why maybe even three reasons why. But fundamentally, all of IB's competitors have just much more bloated cost structures. They've invested a lot more in customer service. Frankly, they're just a lot less efficient. The ethos of IB and the way it was founded 40 years ago was, it was founded as an electronic market maker.

Andrew: Yep.

Luis: So, the skeleton foundation of this company is routing orders, and not only routing orders but connecting markets all across the world. Which is another thing where IB has like 3 or 4x the amount of markets and products available to trade. So for a lot of competitors, they can't even match on price, they also can't match on the product. There's a different cost structure. Trying to think, I lost a train of thought.

Andrew: It's fine.

Luis: You're saying why can't they just offer a holistic, okay, sorry. Now I regain the train of thought. There's a fundamentally different cost structure but secondly, like what you're basically saying is cross-subsidization where you're using one thing as like a loss leader to promote another thing and that sounds like exactly the cycle we just went through where Robinhood was giving free trading and Schwab was doing free trading. And what we've actually seen is the opposite. Well, obviously, I don't know what's going to happen to prop[?] Robinhood. They're going to have to figure out a way to make money. But we've actually seen the competitors now that the market's consolidated raised prices.

Andrew: Yep.

Luis: So, in my business, I use IB for some accounts. I also have a relationship with Schwab for some other accounts. And I can tell you Schwab has been adding incremental fees in all sorts of sneaky ways over time. IB is actually done the opposite, IB is actually introducing fees and all sorts of interesting ways over time. Fundamentally, I think that there's a different philosophy around what the value prop is. Where Schwab, they don't even feel that they need to pay. They don't even feel that they need to pay the same level of interest rate as IB, because their customers value their customer service and value a different user interface and value brand.

Whereas, IB is a full-value prop is around. No, like come to us for value, we're going to do the best we can on customer service but a lot of people don't expect the best customer service from IB which I actually do, is potentially a long-term opportunity for them. But fundamentally, their value props are a bit different. They serve different market niches, they serve the more active traders, they serve the more international trader, they serve an investor who is more self-service, more focused on the numbers, and less focused on having a customer service rep walk them through...

Andrew: Yep.

Luis: ... how to place an order.

Andrew: Let me ask one more risk on IB and then I do want to switch to the B2B side because it's very interesting. It can drive a lot of growth and it seems like it already has, but it does seem like there could be an inflection point coming up there. Just on blow-up risk. There are two ways that these types of firms will up. I think we already addressed interest rate risk and they have been very clear they're doing T-bills and Repose. So they're not exposed to dramatic interest rate risk. Probably be a benefit if interest rates go up. I don't think we need to address that. The other way that trading firms will off[?] is they do margin lending, and if your account has $100,000 in equity and $100,000 in loan, and you lose 75% overnight because you were betting on phase 3 trial and it went to zero and your account goes negative 50,000 equity, well, guess what? Interactive Brokers is going to have to eat that, and that might sound dramatic, but we have seen time after time, once every five years, someone blows up.

There was currency trading, like five or six years ago. I think it was the Swiss dollar or whatever, the Swiss franc, broke parity and a couple of FX exchanges blew up. Knight Capital blew up, and Robinhood almost blew up when GameStop was going straight up. These things do happen. So let's just talk blow-up risk. Why are you not concerned Interactive Brokers is going to have that?

Luis: Yeah. Okay, there are several interesting ways to frame it depending on which aspect you want to focus on. I mean, the first fundamental thing that I would point to is just that IB's been around for 30-plus years. It's already survived the Asian financial crisis, the S&L crisis, and the 2008 financial crisis. The various crises that we've had over the last two years, whether it's negative oil prices or retail trading mania. So I'll just point to the fact that IB has proven to be a survivor. The majority of owners of the company are extremely conservative as reflected in the way that they position their balance sheet. IB has over ten billion dollars of equity capital. They have in dollars of cash on hand. They have zero corporate debt. They have access to financing markets. They have in the past had the bond markets, but they are debt free right now. They're very conservatively capitalized and obviously, this is one of the key risk factors and one of the things I've asked the company a lot about. And basically, every time there's like a wiggle in the market, I'll ping the company and says, hey, how does this impact[?]? How does this impact your positioning? And they'll kind of give me some color on that. Maybe let's start with retail, like what happened in like Robinhood trading Mania.

Andrew: Sure.

Luis: Robinhood had to be bailed out by its investors, it had an interesting issue, where...

Andrew: Just correct me, but one of the issues with Robinhood was they had extreme customer concentration in GameStop and AMC specifically, in meme stock[?]. So their margin requirements for trading and collateralization I would think, went up. I understand it's interesting, but if I cut to the end I think it would just be, hey, Interactive Brokers has like 30 years of customers and everything. They don't have a massive concentration in anyone's stock. I don't think you have any worries about the Robinhood-specific issues but tell me if I'm wrong.

Luis: Well, okay. I think it is valid though just because the majority of IB's accounts are retail-oriented.

Andrew: Okay. Yep. Perfect.

Luis: And the way that I would frame it to you is that basically, Robinhood had to be bailed out, I think for a sum of about three and a half billion?

Andrew: Yeah.

Luis: That was a very extreme market environment and Robinhood had a very extreme situation in terms of the concentration of positions. And given what I just said, IB has that cash on hand. They have more than three billion dollars on hand. So, if that were to somehow replay in the next year and the company continues to build this equity. The company is very focused on this kind of thing and they have this cash for that kind of rainy day, to put it that way. The second thing is that I have to look at my notes to give you the exact figures, but there is a material segment of IB's accounts that are either CTAs or hedge funds, prop Traders, effectively. And so, it does have exposure to like, folks who are trading futures and folks who are trading commodities. The biggest issue that IB actually had was in 2020 when the price of oil would be negative and IB...

Andrew: Yep.

Luis: ... actually ended up paying about 120 million dollars because what effectively happened with IB is that, there was a glitch in the software because whoever designed the software didn't think they had to account for negative oil prices which was clearly a huge oversight.

Andrew: It's a huge oversight but it's one I can completely understand why you'd be like, yeah nobody's going to pay people, but it makes sense. If you have to take literal physical delivery boil at a pipeline, I'd be like, well I can't. I can't put it in penny's kettle[?] I think you know why. Somebody else takes it.

Luis: What effectively happened was the glitch prevented IB's customers from closing out their positions when the price of oil went negative. And because IB couldn't allow them to close out their position, IB effectively took care of everyone's losses that were experienced. And that was 120 million dollars and that was the biggest issue that has led to IB paying out a margin debt, and 120 million dollars is not a lot of money for IB.

Andrew: Yep.

Luis: The next thing I would point out is that when you really focus on where the risk, like the more systematic risks, are in terms of counterparty risk, it's typically not from retail investors, aside from what Robinhood went through. You're typically looking at situations where a prime broker has a lot of exposures to hedge funds that have a lot of leverage...

Andrew: You're looking at Archegos. Archegos from early 2021...

Luis: Yeah.

Andrew: ... where they're levered up 5 to 1. It's in 5 stocks. It turns out that they were driving all the five stocks off and the stocks collapsed, and brokers look around and say, oh shit.

Luis: So there are two things here. The first thing is that relative to IB's prime brokerage competitors, IB does not have the same risk tolerance in terms of allowing its hedge fund clients to take on 6x leverage and...

Andrew: Yep.

Luis: ... so that's one thing. It's just in terms of a gross amount of leverage that allows positioned[?] customers to take on. The other thing, this may be a consideration. One of the reasons why they're building up their equity capital here is they do want to do more business with hedge funds. They do want to be more of a prime broker. That's actually not part of my investment thesis, I don't actually think they're really a competitive prime broker because of what I just said, hedge funds want[?] leverage. But the other thing is that IB has very tight risk management systems. And a lot of their risk management systems are algorithmic where they're running all these algorithms of exposures. One of the things they do is if a client or a hedge fund has some exposures that they deemed risky, they'll start charging them extra fees like a risk management penalty.

Andrew: Yep.

Luis: And if it's really extreme, they'll just automatically close those positions algorithmically and that really irritates sophisticated funds. On the negative side, that's one of the reasons why, IB's not going to be the custodian, the prime broker to like millennium tomorrow. But on the other side, it kind of shows more on what you're talking about is it reduces the blow-up risk because they have all these much stricter than a credit Swiss[?], much stricter than those types of firms, risk management controls, in addition to the really conservative way the companies capitalized. I'm really not that concerned, but it's a valid question.

Andrew: I was just trying to find it. I can't remember when. But I do remember that the CEO who we should probably talk about him in a second because he's a baller, but he published a letter that was like, hey, we looked at our shareholder register and we've got like 5,000 mutual funds, and hedge funds that are in our stock but we only have 3,000 hedge funds that trade through us. Like guys, if you own our stock, why don't you trade through us? The opportunities are enormous. I just thought that was cool sales, but you might remember that roughly correctly.

Luis: Yeah, I believe so.

Andrew: Yeah, I can't find the letter, but I thought that was so cool. I think we covered a lot of the risk cases. We can go into some more risk cases in a second. I want to talk business-to-business opportunities and I wanted to talk about the CEO a little bit, but any other risk? I think we hit most of them at least, at a high level, any other risk people should be aware of or that you're thinking about?

Luis: Yeah. What I'm really focusing on and we haven't really discussed this yet is one of IB's key areas where it's really dominant is on opening accounts and all sorts of different International markets.

Andrew: Yep.

Luis: IB is available in nearly 200 countries, and the positive side of that is North America and Western Europe are the most competitive brokerage markets in the world. Yet, IB is still doing pretty well here and it has a solid value prop. IB is in places like Indonesia, and Romania, which like more niche places where there's basically no competition. Charles Schwab does not exist in Indonesia to my understanding. And it's competing against full-service offerings and that's one of the reasons why it's able to have such strong account growth. But the negative side is, that does come with some incremental compliance risk, it's something that I've been really focused on. And I've asked the company a lot of questions about it and I've done a lot of research in that area. I'm really comfortable with the level of compliance sophistication they have and the level of risk management that they have on that side. But it definitely is one of these things where, if there was like an Achilles heel potentially, it could just be some kind of lapse and compliance just because it's really hard to do like AML. It's really hard to know your customer outside the US.

Andrew: Correct me if I'm wrong, but it would probably be something along the lines of like, one of these emerging markets, all of their customer's accounts get nationalized or something would be a big risk. And I don't think that would be blow up because I don't think they've got enough equity in any of these counts where like it would be hits earnings, but it wouldn't be a blow-up.

Luis: So, yeah. I mean, that's an interesting point. And in addition to that, I would say capital controls and some of these other countries too.

Andrew: Yep.

Luis: If IB does have customers in Hong Kong and it has customers in some of these other countries that have seen their currencies get hit quite a bit and the governments may view ideas like a conduit that helps people aid capital flight. I mean that's certainly a way that some countries could view brokers. IB has to facilitate money transfers.

Andrew: That's an earnings hit, not a blow-up the business risk unless the country's going to go and hit him with like a 500 million dollar and have to be bigger than that at a 500 million dollar fine for helping to evade capital controls or something, right?

Luis: Yeah. Fundamentally, North America is about 60% of their current business, Western Europe is another 20-30%. So 70+ percent of their business is developed markets where rule of law is a lot more predictable and understood. Their business in Asia, their business in Latin[?], their business in Africa, and Southeast Asia is growing very rapidly. Over time, that's going to increase as part of the mix. IB has a really interesting long-tail opportunity. But yeah, I think the good thing is that in those other markets, IB is quite diversified from the market-to-market.

Andrew: Yep.

Luis: So if any one of those markets failed, something happened, it wouldn't be good for IB. Russia is a good example. If a situation like IB had a divest[?] from a market like Russia, that wouldn't be great but wouldn't be something that would cause a stock to collapse.

Andrew: Let's get to one of the upside cases. And I think the biggest upside case it kind of ties into its new account growth. And that ties into business to business, would you start alluded[?] earlier? I am just going to give one quote, so the CEO and chairman were at a conference recently and he said, hey, somebody asked, hey, you said you want to get to 80 million trading accounts across the world, that's about 1% of the global population. Isn't that kind of crazy? How confident are you in that prediction? And the CEO just said, "My confidence is very high because I always get what I aim for in the long term." The man owns 75% of this company. It's worth, I don't know, 15 billion dollars or whatever. Like, just what a boss should be like, look, I'm a 15-billionaire. I built this company up from nothing and I'm going to get what I want in the long term. But part of getting to that 80 million number, it's not 80 million people who are going to have an Interactive Broker branded account. It's this business-to-business partnership that they've been rolling out, that I think is really interesting. So I'm just going to pause my ramble there and ask you, business to business, what is it, why is there upside, all that type of stuff?

Luis: Yeah, absolutely. So, business-to-business in the context of IB means IB has a bunch of retail accounts where people open accounts in their own name. They also service hedge funds, they also service registered investment advisors like myself. And so like the way that I want to use IB is I have like a master account and all of my clients open up sub-accounts under my account. Or if you're a hedge fund, you could be dozens or hundreds of LPs who are in a fund and you're dealing with IB. That's a pretty nice chunk of their business and the important thing to know about and I'm going to get to this other thing they have, which is introducing brokers, regardless of where the accounts are, what type of account it is, what country it's in, it's all monetizing the same way. All the commission rates are the same. B2B customers don't pay any platform fees. They don't pay anything extra like a retail account holder is paying. They'll don't get anything. They also don't get any discounts, which is nice too. So for like an RIA[?], all the sub-accounts, they pay their commissions. The IB collects their interests the same way as if they all had direct accounts. What's nice for IB, for like a B2B relationship is that there's like an intermediary between IB and the end customer who's helping them with customer service and who's also basically adding customers on their behalf.

Andrew: You are their salesforce, right?

Luis: Exactly.

Andrew: You've got on their platform and you're going to go try your economically motivated to go, get people to sign up with you, and that will get new people on to the Interactive Brokers platform.

Luis: Right. So, they have this other thing called Introducing Brokers, which effectively is a white-label version of the entire brokerage platform. So if you think about IB as this really cool, technological stack that's connected all the markets across the world and has a really attractive low-cost commission and attractive financing rates. In addition to IB, it's supplementing the back office in terms of helping other brokers be in compliance checks, know your customer, and negotiate wholesale rates with other partners, it's plug-and-play. So, if you and I wanted to start a brokerage company, we could use IB's backend platform.

And then all we would have to do is, we'd have to do the front end, we would have to do the marketing, customer service. We could choose to white-label the UI and UX. So that customers just use an app that's white-label branded. Customers don't even know that they're on the IB platform. And the way it works for an Introducing Broker is that they pay IB the regular commissions and they could mark it up. So if IB is charging half a penny per trade, or half a penny per share, then the brokerage partner can charge a penny per share and pocket the half-penny difference or it can charge double the margin rate.

Andrew: Just to be clear, on my Interactive Brokers personal account, I pay half a penny per share. If somebody goes and gets a white label, they're going to pay half a penny per share, like it's truly Interactive Brokers when they say we give our customers wholesale rates. Like, they're not kidding. These Introducing Brokers who might bring hundreds and hundreds of millions of dollars in trades or whatever onto the account are going to pay the same amount basically as somebody who has a hundred thousand dollar account balance.

Luis: Absolutely. And it's a really great value prop for introducing purpose because it's not easy to build this infrastructure...

Andrew: Nope.

Luis: ... obviously. One of the interesting things about IB and one of the strongest value props that they have is in international markets in developing countries. There is a very strong desire to invest in the US and European, or even like develop a market in Asia with high-quality companies like everyone wants to own. It doesn't matter if you're...

Andrew: Apple, Google. Yep.

Luis: It doesn't matter if you're in Florida, or if you're in Bali, you want to own Tesla.

Andrew: If somebody asked them about the international risk on their last earnings call and they were like, what are you talking about? Like our international customers, all of them buy Apple, Tesla, whatever. They're loving it because the US dollar is up 20%, and they bought American companies in their home currency. They absolutely crushed it.

Luis: If you're one of these local brokerage companies in Bali, it is not easy for you to have to create a system that connects to the US market. All of IB's local competitors, while some of them don't even offer access to these Western markets just makes them a non-starter for a lot of customers. But a lot of them that do, don't provide good trade execution, charge really high costs to do it. So, IB is a really attractive option, not just for the retail end customer but also for these platforms that just want to connect to IB. And maybe IB probably doesn't have the best marketing. I mean, IB doesn't do a whole lot of marketing period, but it probably doesn't have the best brand and some of these smaller countries. It probably doesn't have the best customer service in some of these countries. But this Introducing Brokers can kind of step in and fill that void. And I've spoken to some of these Introducing Brokerage customers and they're providing a very premium level of customer service. That's actually very complementary to the other aspects of IB's platform.

Andrew: If you are in one of these Introducing Brokers, using the B2B platform and a customer takes out margin, Interactive Brokers are they only providing the trading platform, or are Interactive Brokers handling the margin as well?

Luis: They're getting the margin too.

Andrew: Okay, so they're getting the margin.

Luis: And then, if you're the Introducing Broker and IB is charging 3.5, you can mark it up. So you can say, okay IB will have its 3.5 and we're going to get another two points for us.

Andrew: Look that's a big markup, obviously. But if you remember back to the very start, when we talked margin loans, like Interactive Brokers, $300,000 margin loan, they'll charge 3.5, E-Trade will charge 10. Like, hey, we're talking the US too, it's mainly international, but you could probably charge five or five and a half or six percent and still, actually, that would be 2%...

Luis: You're still matching the market, [crosstalk] you're still competitive in the market. So, IB is so cheap that you can mark up its rates and you're still cost-competitive with other options.

Andrew: And that's free money to you, right? It's literally free money because you're just getting that 2% spread, Interactive Brokers I'm guessing is having the risk of negative equity balance, risk management, and all that. So you're just getting your 2% for free.

Luis: Yeah. There's another really important aspect to this story that I should probably mention and very fundamental to why I think this is a durable business. So fundamentally, brokerage accounts, even more so than checking accounts are very, very sticky deposits. So, the turn rates on the IB accounts are sub 1%, they're minuscule. And especially in this environment where we have higher rates, nobody really wants to keep their money in banks. They want to deposit their money into IB and try to earn yield off of that or wherever they go to invest their money. Now, when you add the B2B element, now you're also adding a very sticky relationship with the B2B partners. So for me, as an RIA[?], with dozens or hundreds of sub-accounts, it would be a complete nightmare for me to try to switch to another platform. It's possible but it would be a total and complete nightmare.

Andrew: I can understand why as an RIA with multiple customers and everything underneath them it would be very sticky to move this thing. Not only would it be a massive headache for you but your customers are used to logging in and checking balances and everything on one end. But I am curious, you said brokerages in general are lower turn than banking accounts and just using my own personal thing. Like, yeah, I don't love to switch anything, but if I switch my banking account, like all my credit cards are linked there, and my direct deposits linked there, my bill pays are linked there, like everything. Whereas, if I switch my brokerage account I'm literally just transferring money from one money and maybe some stocks[?], but that's doable from one account to another. I'm surprised that brokerage accounts are stickier than checking accounts under that scenario. Am I missing something already? You tell me.

Luis: It's a sticky deposit in the sense of the cash that you put in that checking account doesn't stay there. But the cash that you put in your brokerage account, not only stays there but it grows over time.

Andrew: Okay.

Luis: Because you're adding value to the account.

Andrew: Okay.

Luis: And yeah, the relationship that you have with your broker, relative to other consumer products is much lower trim[?].

Andrew: One angle that we haven't talked about yet, which six months ago might have been what we kind of let off with, or went second is crypto. And Interactive Brokers does have some crypto offerings. In the current crypto market I don't think people care, I don't know if it's ever going to be anything but just wanted to quickly address, how is Interactive Brokers attacking crypto?

Luis: Yeah, so they were late to really adding crypto. I think the first thing they didn't really do anything with crypto until the Futures were traded on the exchange, which was a plug-and-play to their existing exchange offerings. Eventually, they realized that they should add it to their platform because there was enough customer demand, but the way that they did it was they partnered with Paxos to offer it. So they're doing it through partnership. They don't have a lot of direct exposure. Crypto investors don't really come to IB to do crypto for the most part. So, for better or for worse, IB kind of missed the crypto wave, it kind of goes to their philosophy of like, if customers want to trade something, they're going to eventually find a way to add it to their platform. But crypto was one word they were not on the leading edge of that wave.

Andrew: Perfect. Before we wrap up or talk about any last thoughts, I did want to quickly touch on management and the management seen here. Peterffy, I believe that's how you say his name, Peterffy, a billionaire, classic, founder, owner, operator who owns 75%. I find the management teams take refreshing like, they're very clear. I think they think about risk management well. The queue to call I highlighted in their notes. Look, the first thing they do is they come out with all the bad news that's happened to the business. The businesses were producing near record results and they come up and they'd just say, here's the bad news, China crackdown, war in Ukraine affected mood, new account openings dropped by 40% because equity markets are down. They just hit you with all the bad news, and they tell you the risk management. They tell you they're going to be conservative. I rambled a little bit there, but I do just want to address it because he's a founder-operator and it's probably a pretty key piece of the book pieces here.

Luis: Yeah. So Peterffy transitioned, he started the company in the '70s originally as a market maker. In the '90s, they started offering retail brokerage. In the mid-2010 they exited the market making business for the most part. And so, what I was alluding to earlier was in 2007, 80% of the business was market making and today the mix is very different. They did that for a number of reasons, like fundamentally to address the question on Peterffy. His background is very technical and he started off as a programmer. He's been keener to hire and promote people who are also technical. So, the CEO that was transitioned in 2019, was Milan Galik. He also started as a programmer. And my read is that Milan is like a carbon copy of Peterffy just younger, and that's on many levels.

But these guys have real skin in the game, both Milan and Peterffy, this is the vast majority of their net worth. From what I understand, not just them, but also the extension of their management team, they work really hard, they work very long hours, and are always on. This is their life's work. I would argue that they're some of the most sophisticated market participants out there because they understand the plumbing of the market. And also have one of the largest troves of account data. So I think I view them as very sophisticated where I would give them a knock. I think that the platform has room to improve is that while they've been extremely good about keeping costs low and making really interesting investments in the technology side, they have lacked some of like the product vision to make the UI and UX best in class.

Andrew: Yes. I'm laughing because if anybody who has an Interactive Broker account, you open that thing up and it's weird to get used to man. It's weird to get used to.

Luis: Yeah. So, if I had to give them a knock, it's that they've been maybe overly technical and they've been so focused on like execution and connectivity, it's come at the expense of ease of use. So, there's just one thought a lot of people wonder, okay, what's going to happen to the company after Peterffy's gone, like it's sold, is something going to magically happen? My base case here is I think Milan is a very close resemblance to Peterffy. There have definitely been some indications that on the margin, he's tried to do things. If you look at the direction of the platform, it's definitely gotten a little bit more UX-friendly and more user-friendly.

We'll see, maybe they also don't do a lot of marketing. I think the interesting thing that could happen is if the company tries to make a play to be a bit more mass market and be a bit more user-friendly and to really try to capture and try to close the gap between Schwab which has 33 million brokerage accounts and Interactive, just two million. There is a really big opportunity for IB. And look at Robinhood, I mean, Robinhood has 25 million accounts and it wasn't even a thing 10 years ago.

Andrew: Yep.

Luis: So, there is an opportunity for IB to capture and it's just a question of like, does Milan kind of lean into the more sophisticated, the more global niche that they dominated. Or do they kind of steer the ship a little bit differently and go for more of like a mass-market play in addition to retaining the existing business that they have.

Andrew: Let me wrap up with one, just kind of switched tax completely and wrap up with one question which I always like SAS and that's capital allocation here. And the company, unless I'm completely mistaken, I mean, they bought back the tiniest amount of shares. They don't really buy back shares and I think anybody who looks at the company inside our ownership is not a problem. Again, they own like 75%, but Thomas has been selling 40,000 shares per day, every day for basically the past two years. That's 2 to 3 million dollars worth per day. It must be nice to be able to sell that, and basically make it not even have a dent in your share ownership.

But I think a lot of people look and say, hey, these guys are very astute, this stuff doesn't trade that cheaply as we talked about the headline price earnings number earlier. You've got the CEO selling 40,000, the chairman selling 40,000 shares every day and they're not buying back shares despite a really nice capital position. So, isn't that cheap? Just toss it over to you capital allocation, all that type of stuff.

Luis: Yeah. It's been an area that I've pressed the company on. Schwab, which is just full disclosure, we're also long[?] Schwab, it has recently announced a massive buyback program, and that's at the tail end of building capital for a long period of time.

Andrew: Yep.

Luis: IB continues to be in capital-building mode. And when I've asked the company, well, why don't you do buybacks? And the first answer is actually pretty logical, which is, okay well, our flow isn't that great.

Andrew: That's always going to be the first response, right?

Luis: Yes. A lot of their investors[?[, that's really need the flow[?].

Andrew: It's 25% of the shares are outstanding.

Luis: Right? So then the next question is, well why don't you just directly buy Thomas' stock since he's selling it every day? And then the answer is, well, we don't want to do anything that wouldn't look above board, right?

Andrew: Yeah.

Luis: And it's like, okay. Well, there are interesting questions that you had there. But really, the real answer that they seem to be coming back to, and I think actually the answer could change depending on the interest rate environment. But the real answer they keep coming back to you is, hey, we are growing our account based at 30% per year, we intend to keep growing our account base at a 20 plus percent rate per year sustainably. As we grow our account base, we need to keep building our equity. I believe that they're earning an excess of 20 to 30 percent return on equity on incremental accounts that they're adding. That's a very good investment for them to make.

And they do have this in the back of their head, where it's like, we want to make sure we have a very conservative capital structure such that worst comes to worst, we could survive the next financial crisis or we can survive the next run on the bank. So, their view on capital allocation is, they're basically investing for growth by building their equity capital simultaneous with the fact that they're very very conservative. Now, if rates stay at high for an [inaudible] immediately go back to zero. There's going to be a cash flow machine, they're going to have to wait, they're going to generate a ton of excess capital. I think that they would probably do a special dividend or do something...

Andrew: Yep.

Luis: ... to return capital. But yeah, I'm pretty happy with reinvesting in a business when it has a very attractive long runway. So I'm okay with capital allocation here. I think eventually, Thomas is going to transition. He's approaching his 80s. At some point, I think the story on capital allocation could shift if the float changes. So, we've seen what other companies in the industry are doing. I think Schwab is kind of leading the way there.

Andrew: And I'm just going to give everybody a tip, obviously, I think this idea is interesting if anybody goes and does work on it, the first thing that jumped out to me, and I'll short-circuit it for you. If you go back to 2015, you'll say, oh there were 64 million shares outstanding. And then you come today, you'll see a hundred million. You'll be like, this company has no compounder, they're issuing shares left and right. And the answer is, no, they're not. What happens is again that LLC structure as Thomas continues to sell down his stake, though share shift into the public market. So, if you look at Bloomberg or something, you're going to see share count increasing, but the economic shares outstanding, if that makes sense, have stayed flat or shrunk over that time. Just to kind of alleviate those concerns. Do you want to add anything to that or did I miss [inaudible]?

Luis: No, I mean, the net benefit of that is that as the flow becomes more widely available, it gives institutional investors more access to the company, which has the potential to help support the stock.

Andrew: Perfect. Hey, I think we've covered a lot. We're a little bit over our hour but just want to make sure, any last thoughts or anything we didn't hit hard enough that you wish we had hit harder or anything? Or anything that I kind of glossed over that you think [inaudible].

Luis: Yeah. There is one thing that I really like about this which is just the fact that I think the risk-reward is very good regardless of if rates go up or rates go back to zero. So effectively, if rates go back to zero I think you see a lot of the KPI metrics kind of revert. I think people start trading more again, I think people get more excited about the markets. I think there's valuation support. If rates stay high, it's a pretty massive tail, it's a pretty massive bump. One of the reasons why I think the constraint a call option is fundamentally mispriced is because there's a scenario where rates go down but they don't go to zero. Let's say inflation is somewhat sticky but the economy is still in a recession. Do interest rates go to two or do they go to one? Anything above zero is actually a significant tail when relative to the historical...

Andrew: Yep.

Luis: ... metric[?] for this company. And I do like just in the context of a portfolio where most of my investments are beneficiaries of lower interest rates.

Andrew: I've been surprised how many of my investments, it turns out that [inaudible] thing, so interest rate dependent. I absolutely hear you there.

Luis: I don't mind having something that could actually benefit if rates don't immediately go back to zero.

Andrew: It is an interesting way to think about it. Look, we're not talking about the interest rates, what if interest rates aren't zero anymore? Like they're not zero anymore. So these guys, this quarter especially in Q4 you'll see the real full run rate of it. They're going to make a lot more net interest margin from that. So you get that benefit and then if you said, oh what if rates go to back to zero, as you said, okay they're just going to go back to what they did in net interest last year. But you should be talking about multiples across the board going up. As we've seen, multiples are really interest rate dependent, so you do kind of get some good from both worlds here. I think that's a really interesting [inaudible].

Luis: The problem I have with most interest rate stories here is that if interest rates go back to zero, I have no interest in owning the security. But in this case, first of all, you're not paying for that interest rate call option. Secondly, if interest rates go back to zero, there are actually things that benefit them too. That's pretty well-hedged in my opinion.

Andrew: Fantastic. Cool. Wait, this has been great. We've done two. You sit two desks away from me at the WeWork. So I'll have to badger you back on about having you on for a third time here, but this has been fantastic. Thanks so much for coming on. I'll be sure to include a link to your write-up which I believe the write-up was public on your ITS Review, right? You do a review, not a subset.

Luis: I have it. I have a version of the write-up on my website.

Andrew: Okay, so I'll be sure to do that. I'll link to that in the show notes. I'll be sure to include a link to your Twitter. So if you will go find you on there, if they want to talk more about Interactive Broker. But Luis, thank you so much for coming on and we'll chat soon.

Luis: Thanks, Andrew.

[END]