Interactive Brokers Group Inc (IBKR) 2007 Q3 法說會逐字稿

Good day, everyone and welcome to the Interactive Brokers Group third-quarter financial results conference call. Today's conference is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to Mr. Alexander Ioffe, CFO of Brokerage. Please go ahead, sir.

Thank you. Thank you for joining us today for our third quarterly conference call as a public company. As usual, after remarks reviewing our performance by Thomas Peterffy, President, CEO and Chairman of the Board and Paul Brody, CFO of the Group and the Director, we will be happy to answer your questions.

At this time, I would like to remind everyone that today's call may include forward-looking statements. These statements represent the Company's belief regarding future events that, by their nature, are uncertain and the outside of the Company's control. The Company's actual results and financial condition may differ possibly materially from what is 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 would also direct you to read forward-looking disclaimers in our quarterly earnings release.

Now, I would like to return the call over to Thomas Peterffy.

Hello and welcome, everybody. As you have seen our published results, the summertime credit crisis and the resulting market turmoil and heavy trading volumes were very positive developments for us. Our technological advantage clearly prevailed in the month of August. I

In the earning packet, you see a detailed breakdown of how our volume figures evolved over the quarter relative to previous periods in the various products. But as you know, it is the listed option volume that is most important to us because, above all, we specialize in listed options and it is that market segment that we are most closely associated with.

To give you a bird's eye view of the option business and our place in it, worldwide volume year-on-year for the third quarter grew from 802 million contracts to 1.242 billion contracts. That is an increase of 55%.

Overall, Interactive Brokers Group's share of the worldwide volume has slipped from 15.8% to 14.4%. We have three kinds of volume -- market-making volume, cleared brokerage volume and non-cleared brokerage volume and I would like to go over each of these three pieces.

Our market-making volume went from -- our market-maker share of the volume went from 10.7% to 10.1%. As I have explained before, an ever increasing share of the volume in the US, which by the way accounts for 61% of the worldwide volume, is due to large [crosses] for dividends and interest that we do not participate in.

While we do not know the exact numbers that are involved here, we do believe that our share of the volume -- of the kind of volume we do compete for has in fact increased slightly from the previous periods. This increase was in part due to our larger share of the penny classes and in part to the fact that the second half of August -- in the second half of August, many of our competitors temporarily disappeared from the marketplace. I can give you additional information on this during the Q&A, especially about the pennies that I'm sure I will have several questions about.

Our cleared brokerage business -- in our cleared brokerage business, our volume grew very nicely at a rate of 74%, which is 19.19% faster than the worldwide volume and we are very proud of that. Our share went from 0.9% to 1.1%. It is no longer a question in the option trading community who is the best broker for listed options both from the point of view of cost and even more importantly from the point of view of execution quality, which really means price.

It is years and years of technology building that now enables us to provide truly best execution in an ever more complex environment and reduce so at a very low cost. We had TAG, an independent firm, audit our executions and they determined that we provide price improvement to 14.9% of our marketable orders compared to an industry average of less than 1%. And since we are part of the 14.9% is part of the less than one, we practically provide all the price improvement in the industry. We are advertising this fact on television and you may have seen the commercial.

It is the non-cleared brokerage business where we fell behind in marketshare and this happened intentionally. We went from 4.7% to 3.2% of the worldwide volume because our volume grew in this segment only by 6% year-on-year. We have given up a lot of paid for order flow business at marginal profitability and replaced it with institutional execution-only business with very good profit margins. That is part of the reason that while our cleared brokerage, option, futures and stock volume grew at a compound rate of 63%. Our net profits from the brokerage business grew by 115%.

The other reason, of course, is the scalability of our proprietary technology that we employ, namely that while brokerage income grows in proportion to volume, our expenses do not. I can return to this in more detail during the Q&A if you wish.

During the quarter, we have added a number of new products to our brokerage offerings, including Swedish and Australian stocks and options, New York Board of Trade soft commodities, [ISC] currency options and [YSCR] (inaudible) and the alternative investment market products on the London Stock Exchange.

We made several upgrades to our trader work stations that we provide to our customers. The most significant of these upgrades and also the most popular are the volatility orders where a customer can specify a buy or sell order for an option in terms of volatility. In addition to simple outright orders, this also works for complex combination orders and commodity options. We have also introduced the first set of [upgrade] (inaudible) orders for option traders.

This quarter, we released our flexible account statements. With this offering, our customers can custom create the content and the format of their account statements they wish to receive. As always, we kept working on new modules for our trading system and further automate our stock lending and borrowing operations across European and Asian securities.

In general, during the quarter, we kept focusing on building our brokerage systems. When markets come under stress, our competitors tend to become preoccupied with business issues. It is during these periods where we can make long strides increasing our technological lead. I would now like to turn it over to our CFO, Paul Brody.

Thank you, Thomas and welcome, everyone. I am first going to review our summary results and then I will discuss the segments before we take questions. As Thomas stated, we had record results in this quarter in both electronic brokerage and in market-making. The business was driven by high volume and volatility, especially during the period of market stress brought about by the credit crunch.

We position ourselves to thrive in this environment because our automated platform, which ordinarily operates with excess capacity, continues to service customers and generate market-maker quotes just as it does under normal market conditions. In these periods, we find other market-makers often widen their quotes or stand on the sidelines until the market quiets down. And this gives us more opportunities to trade.

We also focus on the importance of maintaining reliable systems and in recovering quickly when other systems on which we rely, such as exchange systems, fail to operate 100% of the time.

Finally, we keep large reserves of excess regulatory capital to make sure that in times of high volatility when risk-based regulatory requirements are on the rise, we have the flexibility to trade effectively.

Turning to our operating data, trading volumes were the story in the quarter. Average trade volume reached 796,000 trades per day in the quarter, up 57% from the third quarter of '06. Market-making trade volume was up 60% and options contract volume was up 47% compared to the third quarter of '06.

In electronic brokerage, total customer DARTs, daily average revenue trades, were up 46% and cleared customer DARTs were up 52% from the year-ago quarter. Our net revenues were $445.1 million, up 31% quarter-over-quarter and by that, I refer to the current quarter versus the third quarter of '06. Trading gains were $289.2 million, up 26% in the same period in '06. Commissions and execution fees were $69.5 million, up 62% and net interest income was $64.8 million, up 33%.

Non-interest expenses were $137.2 million, up 15% quarter-over-quarter driven primarily by higher trading volume. Compensation expenses were $31 million, up 10% quarter-over-quarter. As a percentage of net revenues, the total non-interest expenses were 31% and out of this number, execution and clearing expense accounted for 19% and compensation expense accounted for 7%.

At September 30, '07, our total headcount was 586 and that is an increase of 13% from September 30 of '06 and a 5.6% increase from June 30 of '07.

Pretax income was $307.9 million, up 40% from the same period last year. Between the segments, market-making represented 80% of pretax income and brokerage represented 18% with the remaining 2% in corporate and eliminations. And these proportions compared to 88% for market-making and 12% for brokerage in the third quarter last year. Our overall pretax profit margin was 69.2% as compared to 64.8% in the third quarter of '06 and 55.8% in the second quarter of '07. Market-making pretax profit margin was a steady 74%, while brokerage climbed to 50% of pretax margin leveraging our scalability.

Diluted earnings per share were $0.53 as compared to $0.40 on a pro forma basis for the third quarter of '06. Our balance sheet remains highly liquid. Our long-term debt to equity at September 30, '07 was consistent at 11.2%. And maintaining a strong and liquid capital base served us quite well during the recent period of credit tightening. Our consolidated equity capital at September 30, '07 was $3.26 billion.

Now I'll turn to the segments starting with market-making. Trading gains for the third quarter of '07 were $281.5 million, up 22.5% quarter-over-quarter. The market turmoil brought us more opportunities to trade and in some cases less competition as other market-makers temporarily stepped aside.

Net interest income for market-making, which accounted for 68% of total net interest income, grew to $44.2 million, an increase of 36% quarter-over-quarter. And this is driven by the continuing integration of our market-making systems with our securities lending systems. Net revenues for market-making were $329.5 million, up 24.5% from the third quarter of '06.

Higher trading volume pushed up the variable cost of execution and clearing, our largest expense category by 21% from the third quarter of '06, to $57.1 million. Pretax income for market-making was $245.1 million, up 26.8% quarter-over-quarter and this demonstrates that our low fixed cost base allows increased trading gains to flow to the bottom line.

In electronic brokerage, our brokerage operations are firing on all pistons. Customer accounts grew by 22% over the total of September 30, '06 and by 5% for the current quarter. Trade volume is the primary driver for the brokerage business and total customer DARTs grew to 270,000, 46% over the third quarter of '06 and 15% sequentially.

Our cleared customer DARTs which, generate direct revenues for the brokerage business, grew to 228,000 and that is a 52% increase quarter-over-quarter and a 21% increase sequentially. In addition, the average number of DARTs per account on an annualized basis was 652, up 26% over the 2006 period, which reflects our highly active professional customer base.

Customer equity grew to $8.3 billion, up 54% from the third quarter of 2006 and up 12% sequentially. The higher trade volumes drove revenue from commissions and execution fees to $69.5 million, an increase of 62% quarter-over-quarter and 15% sequentially. Net interest income rose to $21.8 million, up 48% from the third quarter of '06 and up 6% sequentially.

Interest income in our brokerage business is primarily a function of customer cash and margin loan balances. While customer balance growth was robust in the quarter, we faced certain challenges during this period of credit tightening in the market as short-term interest rates became quite volatile.

We responded by shortening the target maturity on our investments of customer funds and as a result, we were able to continue to give customers rates that we believe are the most favorable in the industry.

Net revenues from brokerage were $111.7 million for the quarter, up 48% from the third quarter of '06 and up 11% sequentially. As with our market-making segment, execution and clearing fees account for the majority, about 52%, of our non-interest expenses in brokerage.

Despite the increase in trade volume, these variable costs declined to $28.6 million for the quarter, down 3.7% quarter-over-quarter and down 11% sequentially. We continue to benefit from the reduction in volume from payment for order flow customers mentioned earlier and while that has some dampening effect on payment for order flow income that we received from options exchanges, this strategy has resulted in net benefits to our overall operations. Pretax income from electronic brokerage was $56.3 million for the third quarter, up 115% quarter-over-quarter and up 26% sequentially. And now I will turn it back over to the moderator before we take questions.

(OPERATOR INSTRUCTIONS). Rich Repetto, Sandler O'Neill.

Good evening, Thomas. How are you?

Good.

I guess my first question is you had significant operating leverage here. Just looking at the revenue from the last quarter, the increase, you had 94% incremental margins. I guess the question here is what -- is there anything that can be taken that you did differently? You know you had a great environment in 3Q. If it is not as good in 4Q, what were some of the things you did that can continue -- you can continue to do to improve profitability even in less volatile and high-volume periods?

Well, first of all, the great improvement sequentially is partly due to the fact that the preceding quarter had an unusual event in it as you remember. We had an extraordinary loss and even though we collected the money, we had to put that money under the line. So that's part of the reason. Obviously the heavy activity in the market was very beneficial. You are asking me what do we do if in the next quarter there will not be such heavy activity, well, our results will not be that good. It's very simple. We have an underlying growth to our business that obviously is not 92% quarter-to-quarter. So if we have a slow quarter now, our results will be slower.

Okay. And just about the environment now, the volatility of the [fixed] is bouncing around 20. How would you categorize the environment thus far in this quarter?

Richard, you know we like to give -- we do not give guidance so -- -- I notice what you are up to.

Thanks for the question, Rich.

Say what?

Thank you for the question.

Okay. Last question then. You did say that some competitors disappeared, I don't know whether permanently or temporarily.

Temporarily I said.

And I am assuming that is because -- well, could you I guess give further background on that I guess?

Well, I think -- well, we have two types of competition. One is from quote copiers who are basically not market-makers, but hedge funds and professional traders who take advantage of the fact that they are customers and therefore they get priority and payment for order flow and so they copy our quotes and even if they just breakeven, they make a little bit of money. So obviously when you do that every now and then, you make a mistake and when the market is very illiquid, it is not so easy to get out of mistakes. So as it is usually, so we had less of that in the third quarter.

And secondarily, we have other market-makers who have their market-making systems that I suspect, although I do not know, they are not as versatile as ours and they do not adjust as easily to the type of markets that we had in the course of the third quarter. Both of these tough competitors are back in the market today, but I will later, if I have questions, I will talk about the new make-or-take market model, which will have an impact on this.

Okay. Congrats on an outstanding quarter.

Thank you.

[James Howard], [JB Howard Investment Co.]

Thank you. I wondered if you have an idea of what your optimum debt-to-equity ratio ought to be. I think you said it was 11.2%. Is that about where you want it or what is your target?

I do not have a target. I mean we fairly well -- we're happy -- we wouldn't mind to be up say 20%. Go ahead, Paul.

The fact is that the facilities that we maintain are primarily as a backup capability for excess regulatory capital. We like to keep a large buffer of regulatory capital, as I mentioned before, so that when the market goes into the kind of turmoil we saw in August that we are relatively unaffected and we can continue to make markets, which is the exact time that we want to continue to operate at peak performance. So while we might want to expand the facility somewhat, they are primarily used as backup, not as working capital. A very liquid business.

I mean would you feel more comfortable if you were 100% equity?

No, I mean that percentage is almost nothing. The issue here is that when we go out to borrow money, we have to have covenants and the covenants usually say that if such and such happens, we have to repay the money and when we do need additional capital, it is always when such and such happens. So the kind of money that is available to us would not be available as good capital for haircut purposes. So we have been around and around this over the last 10, 20, 30 years. We always come back to saying, you know what, we are just better off with our own money on the line.

Last question is about capital spending. Could you give me a figure on what your capital spending might be this year and whether or not it has changed from where it was say at the beginning of the year?

We do not run the business by making budgets. We run the business by pinpointing the kind of software that we would like to build and we spend whatever we need to to build it. We do not believe that, as other firms we watch who build software by assigning X number of dollars to the project because what usually ends up -- they usually end up with is, at the end, they don't have the kind of software they set out to build.

Could you disclose how your capital spending was -- the total for the first nine months?

Well, the standard definition -- the more standard definition of CapEx would refer to, for instance, building our hardware and network infrastructure and ours is quite a low percentage of our -- certainly of our net revenue. It will be probably a little higher over the next 6 to 12 months because we are building -- we are in the process -- in fact, in the process of completing a disaster recovery site, which will involve somewhat more spending, but these are not significant numbers out of the total.

But the fact is that, in my judgment, we spend about 40% of our total expenses on developing software.

Edward Ditmire, Fox-Pitt Kelton.

Good afternoon, guys. I have got a couple of questions here. First of all, on the brokerage side, you seem to have a very big pickup in client assets per account. Can you kind of expound on what is driving that?

Well, you see we go -- we try to go after financial professionals. We try to go after their personal and their institutional accounts and they are usually larger than the kind of customers that we used to have initially. So our average balance per account keeps rising and that is exactly what we intend to do. As we become better established in the prime brokerage business, you will see this continuing to rise.

Okay. Can you contrast in the third quarter what your experience was with portfolio margining versus second quarter?

Yes. Portfolio margining equity in the second quarter was 9% of our total and in the third quarter, it was 15% of our total. In other words, of the $8.3 billion, $1.3 billion was in portfolio margining and another interesting piece of data is that over 1000 of our accounts are under portfolio margin.

Okay. Thank you. Can you talk at all about variable costs in the market-making business? It seems like, on a per contract basis, that they were under recent trends. What is behind that?

Well, that will change even more in that direction. First of all, there is competition among the exchanges and they do cut deals even though that's not very public. In some exchanges have dropped their fees, but what is going to be even more important of an issue, in fact already has happened, is the make-or-take model where for the penny classes, our kind of box, have changed their model to make-or-take, which means that the maker of the quote receives $0.30 a contract and the taker of the quote pays $0.45 on box, $0.50 on (inaudible). The maker of the quote has priority and everybody is treated the same way whether it is independent or whether they are customers or market-makers. So as market-makers, when we make a market on a make-or-take exchange, we will now receive $0.30 instead of paying say $0.20.

Second, we will no longer be charged for order flow. As a result, we are comparatively roughly $0.70 better on a make-or-take exchange than on a conventional exchange and accordingly, we are likely to make many of our quotes a penny better on the make-or-take.

And now if you look at this from the side of the brokerage business, you see that, as the broker, we will have to pay $0.45 or $0.50 to take the quote. We will also forgo the roughly $0.20 of payment for order flow, so we are roughly paying $0.70 comparatively on the make-or-take exchange, but, in exchange, our customer gets $1 better.

Now $0.45 to $0.50 of this $0.70, we will pass through to our Customers. So the net result is that the customer is about $0.50 better off. Ultimately, this customer -- ultimately, this $0.50 comes from our pocket, but, in exchange, we get to trade on the quotes we make.

Okay, great. And is there -- one last question. Any update on your progress during the third quarter on doing more currency trading?

We are doing more currency trading, but it is not something that we are deriving a lot of revenue from yet.

Okay, thank you.

We are still holding our systems.

Got you. Thank you.

[Bob Johnston], WR Hambrecht.

Hello, Thomas, Paul and Alex. Great quarter and just wanted to get an update on penny increments, if you saw any change. I guess in the last conference call, you talked about how your profitability was coming down, but not as much as you thought, volumes increasing pretty much as expected. Has that changed and where are we going forward and is there any move into doing that internationally or is it just in the US at this point?

Okay. Just to bring everybody up to date, penny trading started in February on certain classes, which, at that time, comprised 18% of the US option volume. Starting in September, an additional 22 classes moved over to pennies and the pennies now comprise 38% of the option trading in the US.

At the end of March, a further group of options will join these classes and at that time, over 50% of the US volume will be trading in pennies. The data that we are looking at suggests that industrywide volume increased by 57% in the penny classes and our market-maker volume increased 113%. Simultaneously, our profitability per contract declined 45%. We are here comparing the three months preceding the pennies to the seven months subsequent to the pennies.

That is basically it in a nutshell. You have to put this together with what I just explained about the make-or-take model and even I find this pretty confusing, but I hope that this gives you some data.

Great. Thank you very much.

[Robert Niewieuk], Katana Capital.

Hi, guys. Just a question on what you are doing for prime brokerage. What services and capabilities are you offering that you didn't used to and why do you think people should pick you?

Well, what we are offering is basically the standard package. Namely, you can execute through us and clear through us, you can execute through us and clear as well. You can execute as well and clear through us and you can execute through us and allocate your trades among many different clearers.

The reason why you should clear through us -- sorry -- the reason why you should do this through us is because, on the one hand, we do this less expensively than anybody else. Secondly, we provide better execution than anybody else and thirdly, we believe that we pay more on your credit balances and charge you less on your debit balances than anybody else.

Okay. That's my only question. And then my comment is great quarter. Keep it up.

Thank you. We hope to do your business.

Thank you.

[Jennifer Bullard], SIG.

Hi, thanks for taking my question. Congratulations on the quarter. I was wondering if you could possibly just give us some color on the profitability of the market-making business, specifically in August. I am just trying to get a better sense for how that business performed kind of at the height of volatility and credit concerns in the market.

Well, what happened at the height is that we were practically the only market-makers that we could see in the market and so we were operating on (technical difficulty) with some offers than we normally do and therefore we thought it a good time for us.

Could you give any color just in terms of August versus the other months in the quarter?

Well, July was not that interesting, August was very interesting and September sort of slowly went back to things being as usual.

Okay. And then I just have one follow-up question. What is your average trade size? I don't know if I'm looking at it properly, but it looks like you did about 450,000 trades per day on average on two million option contracts. Is it correct to say it is about a four to five lot or is it -- or am I thinking about it completely incorrectly?

Well, you see, we do -- you see, it is not our -- we do not determine our average trade size. We make a quote and say we make a quote for 500 contracts, (inaudible) could be for one or two or seven or all 500, right? So I think -- I don't know what the average comes out to, but if you just take the total volume and divide it into the number of trades, you will get it.

Okay. Thank you for taking my questions.

Thank you.

[Brian Tullerine], [LPL].

Hi, guys. Congratulations, great quarter. My question is on the brokerage side. I see the market-making, you have got the superior platform. It is going to be affected by something that is outside of your control quarter-to-quarter, but what is really intriguing me now is the brokerage side. If I remember correctly from the prospectus, it's about 20% of your revenues, so I have got two questions there.

What is -- what is the vision there? I mean how big do you see the brokerage side becoming and along with that, has there ever been a discussion of spinning that off in an IPO where Interactive Brokers, the parent, would maintain controlling interest, but seeing that trade as a separate entity?

Well, to answer your second question first, we -- the brokerage business receives huge advantages from the fact that we have a market-making business because the way we expand the brokerage business to new markets is that we go into those new markets as market-makers first. So we are completely familiar with the technology and the model by the time we turn our customers on.

Secondly, since we continuously exercise our systems as market-makers, if anything goes wrong anywhere, we know it first and we can correct it. As we enter more and more different markets, it would be difficult to keep on top of all of these things if we didn't have our own money on the line, only the customer's money.

Secondly, obviously the costs of the technology are being shared between the market-maker and the broker. This technology is becoming more and more expensive. We have over 150 people who are full time occupied with developing this technology and about another 50 or so who are managing it and operating it. So the fact that we can distribute the costs among the two operations is very beneficial.

Now where does it go in the future is the big question. You have to see that we have 91,000 customers that are connected to our platform and they come from 153 different countries. It's a truly global community of financial professionals. They pay stocks, options, futures, forex, bonds. They are denominated in 10 different currencies on 70 exchanges and trading venues around the world. Accounts may be funded in one of 10 currencies and they can trade products across different currencies seamlessly.

So we have a solid foundation, a backbone from which we can continue to build our global electronic brokerage. All we need to do now is to have more exchanges, more products, more currencies, trading and portfolio management and more customers. We are already the lowest cost provider of brokerage services and we are becoming better known as such. Even our compulsive emphasis on efficiency through automation. We are faced with diminishing marginal costs and increasing marginal returns. As we add services, lures products and customers to the platform, so you can get from that where we want to go.

Do you anticipate that if there was a spinoff and an IPO that based on your answer to the first part of my question that some of those synergies, those cost savings, that relationship would be altered in a negative way?

That's correct.

So that would not be something that you are seriously considering at that point because of that fact?

That's correct, but we are also saying that the brokerage business is going to continue to grow so much faster than the market-making business that in five years or 10 years, that will not be an issue.

I see. Okay, thank you. Again, congratulations.

Thank you.

(OPERATOR INSTRUCTIONS). Rich Repetto, Sandler O'Neill.

One quick follow-up. When you went through the make-or-take model, which do you prefer? Which do you think you could be more profitable in?

We prefer the make-or-take model because, as I explained before, part of the issue in the market-making space is that we have competitors who are disguised as customers and they can copy our quote and trade ahead of us on our own quotes. With the make-or-take model, they cannot do that for two reasons. Number one is whoever makes the quote has priority and secondly, the quotes are tighter so it is not as lucrative to copy them.

Great. Thank you. That helps. Thanks.

Ladies and gentlemen, that does conclude our question-and-answer session for today. I will turn the conference back to our speakers for any closing remarks you may have.

We would like to thank you for participating today. This call will be available to replay on our website in a couple of hours. Thank you again for your time. Good night.

Thank you all.

Ladies and gentlemen, this does conclude our conference. We appreciate your participation. You may disconnect at this time.