Business Breakdowns
· Freddie Lait
And I think this is probably one of the greatest misunderstandings in the business and it was certainly what gave us the opportunity to invest in it 18 months ago is the actual sensitivity. If you think about the alternative, if you think about a business like Schwab, which only a couple of years ago almost needed effectively a wholesale rights issue because it had what was effectively a run on its funding source because they weren't paying anything on their customers cash. And customers, when interest rates went up, started saying we'd better go to a bank or we better go to a money market fund. And they robbed Schwab of that source of cash and funding. The arrangement between interactive brokers and their customers is just far more honest and it's very transparent. And it's, as I said, on any large balance, more than $10,000, which is about two thirds of their entire customer cash, they just pay the local market base rate less 50 basis points. That results in a far lower risk. Firstly, to the point about Thomas Peterffy's risk conservation, clients are probably not going to leave because they get 50bps more elsewhere, even if they could. But secondarily, it's actually less interest rate sensitive than you think because if rates go down by 50 basis points, they still just take 50 basis points on a spread. And so they do disclose that overall interest rate sensitivity and for 100 basis point move down in interest rates around the globe. And again, this is a global business, probably 40% US. Jacopo's nodding at me, but it's global in nature. But if global interest rates fell 100 basis points, NIM would fall by 10%. And again, that's NIM per account. So if you're growing your accounts at 30, 35%, it will more than offset a multiple of times that net interest sensitivity. So that's why we focus so obsessively on the business model and the potential for account growth.
· Jacopo Di Nardo
[00:00:00] S2: From a NIM perspective, Zack, what's also pretty interesting is obviously margin loans tend to be higher yielding products maybe pay 100 basis points more than what they get on cash on the asset side. And these tend to be cyclical, but move in the opposite way of interest rates. So for example, if interest rates were to go back down to levels that we observed in 2019 or 2020 or 2021, the amount of leverage that investors are usually willing to take slightly higher. So the margin loan per account was materially higher back then. And so in the mix as interest rates fall, we would also expect margin loans to pick back up, helping a little bit with a NIM fall. If you go back in time, 2019, 2020 were pretty difficult years for whoever was exposed to rising interest rates and the company was still making maybe 30 basis points less than today net interest income, they have proven themselves in a way through cycle to be able to earn fair, attractive spread on assets and liabilities.
· Zack Fuss
[00:00:00] S0: And so you guys had mentioned the international opportunity here and where some of the growth is coming from. Obviously we've seen through the COVID backdrop, participation in capital markets and investing exploding, perhaps the advent of Robinhood as an on-ramp for that, but also just the financialization of western economies. What are the growth opportunities for this business? And I ask that in the context of on their earnings calls, they're very often asked if there's any M&A opportunities. And because they operate such low costs and they provide such attractive margin loans to customers, the pro forma earnings of acquisitions make the math very difficult for them. And so I guess weighing organic versus acquisitive growth, where they're going to see their business continue to expand?
· Freddie Lait
[00:00:00] S1: Interesting, you picked up on that comment too because it's one we've discussed in the past, which is this idea that if we buy a business but then we take it to our spreads and our offering, the underlying revenue and profits would collapse in that business. So they're not able to pay what the owner thinks they can pay. Because if they give back to customers as much as they give back in their main business, it would be a very different profit level. And so that to us is incredibly telling. They are open to acquisitions. They have done them in the past, but there's nothing out there which would make sense. And so they're going to grow organically. They have one of the lowest advertising budgets of all of the online brokers. And despite that, have outgrown anyone we look at. They're growing organically. They're growing because their rates are just better than everybody else's. And if you are trading any meaningful amount of capital, I'm not here to sell it. But I'm sure some people listening to this will be trading their own shares. And it's worth a look because it's a meaningful saving to go to a business like this. And I think at the moment what they're getting asked more about is this sort of potential for growth in the more B2B channels that we've discussed, the RIAs, the hedge funds and the introducing brokers. But notwithstanding that, individual accounts are growing very rapidly too. So the mix isn't changing very quickly. And when we think about growth potential, I mentioned earlier a few different sort of big, hairy, audacious goals for the management team. Schwab have I think 25 million accounts principally in the US. I think fidelity is something around that level. They are smaller on average, so there's a tail of those accounts which would be less profitable for this business. But three and a half or four million accounts that we have today is still a fraction of that domestically. And they talk about 20 million globally as a sort of first stop in their growth story. And then at a sort of later stage they talk about this 80 million number because in a couple of countries where they operate, they are already at sort of 1% of the population. And that would be that sort of level of penetration. And the key thing to that potential is people will still continue to trade a lot.
· Freddie Lait, Jacopo Di Nardo
Whatever happens with markets becoming more digital and outsourcing within the B2B channel will probably continue for the next 5, 10 and 20 years. Big question is, can someone compete with this? Can someone come away to stop them organically growing share? Given the counter positioning and that first comment about acquisitions and the competitors to reinvest, to try to build the direct market access and to invest in prices and cost and automation like this business has, everyone's folding and using this business instead of trying to compete with it. [00:00:00] S2: To your comment of more participation into financial markets by all sorts of individuals, especially after Covid, we believe that to be a pretty good tailwind too because as we said at the beginning, someone who is inexperienced and might have a smaller account balance, he might start a Robinhood account or eToro or whatever else he can get his hands off depending on the jurisdiction. But after a certain period of time, after becoming more accustomed to trading and honestly after having increased his own disposable income, we do believe the proposition of joining Interactive, especially as an active trader, is so much better than anything that's around there. But we do see a lot of his customers eventually dropping to Interactive over time as soon as the account balances reach $100,000 or $200,000.
· Freddie Lait, Zack Fuss
[00:00:00] S1: And if I can just add one more thing you mentioned earlier, some people are upset with the customer service. We see a lot of analogies between this business and other low-cost businesses that we look at. One would be sort of Ryanair. And I think it's really compelling to see that business, another business we like, where Michael O'Leary said, "I didn't realize looking after customers would make me so much profit." And he started making the customer experience more pleasant. I think they're doing that at Interactive too. They've had this obsessive focus on costs and automation for 50 years, including in their prime brokerage business. But they've just rolled out what they call the sort of white-glove service, which is a very manual, independent director looking after your account as a hedge fund. And I expect a bit more of that over time coming back into the business on the customer service too, which slightly opens up their market. One final thing they're doing as well is really relaunching their app, which will come in and help that customer acquisition that Jacopo said of those who are out there learning the ropes in apps like eToro and Robinhood, but may want to grow up into Interactive later. [00:00:00] S0: And so we touched upon it in relation to M&A. But clearly a business that's generating as much excess free cash flow as this one, capital allocation becomes increasingly important. What is their demonstrated strategy as it relates to redeploying the cash that they're generating on an ongoing basis if M&A is not available to them?