Business Breakdowns
· Jacopo Di Nardo
[00:00:00] S2: This is a very important question, especially as the business will eventually mature. And in fact, at the moment the only capital return we are receiving is a dividend yield that's usually targeted to be about 0.5 to 1% of the total market capitalization. And there's a couple of things though to keep in mind. I think the company wants to keep a balance sheet that's as strong as it can be, mostly to develop the prime brokerage and hedge funds business. And one of the reasons being that the companies they do compete against, behemoths like Goldman, Morgan Stanley, UBS and Bank of America, are materially larger financial institutions. So to win over customers and hedge funds that manage 1 to 5 billion dollars of assets, they do need potentially stronger balance sheet than what we actually could imagine ourselves. The second point comes actually with the company structure. It is a publicly listed company, but still today, insiders own roughly 80% of the stock, of which most of it, 75%, is still Thomas. But the CEO and CFO also have a significant stake in the business. And therefore launching extremely big special dividends or share repurchase programs is not necessarily doable until the float of a business is increased. So we, like many other external investors, we are looking at the topic. We do believe over time, as Thomas, as he rightly says, is not immortal and he's approaching or above 80 years of age, we will see how that evolves. But it is something that we do like to an extent, because if you think about ways of maturing as a business, the final phase when growth slows down and is not what it used to be 20 years ago. Any business has a choice to make which can be growing again through M&A whenever it is possible, or returning excess cash to shareholders. And we are not even close to there. As Freddie has discussed, there's a potential over time to probably 20x the number of customers on the platform. But once that is done, having excess capital to return to shareholders, as the structure has probably changed by then is an option. But as investors, we do like to have—there's other businesses that are in that situation, I guess Berkshire Hathaway being an enormous one, which is in a similar position with an incredible amount of cash and Treasuries sitting on the balance sheet.
· Zack Fuss
[00:00:00] S0: And so when you're evaluating financial businesses, there's always a debate about how to properly value them. And without asking you guys to opine upon the valuation itself, what do you think are the most important metrics here in IT being return on equity, price to book, PE? How do you go about valuing a business like this?
· Jacopo Di Nardo
[00:00:00] S2: It's really a combination of everything you've mentioned. I think to an extent today the ROE of a business, we can look at it in two ways. One is obviously including the excess capital and one is excluding it. One thing you realize quite quickly is actually how capital-light it is compared to normal financials, especially when you back out the excess capital. So it might make 15 to 20% ROE, including the 19 billions of excess capital, but it might make 10, 15 times as much excluding that. Earnings and price to earnings, normalized earnings are also another way we look at it. So sticking in our own assumptions obviously of accounts growth and trades per account and commissions, and then looking at what a normalized and average net interest income could be given the prevailing rates of interest around the world. But as you say, it is not one of the simplest businesses to value on either of the two metrics. So we do focus really on both and see how both interact with each other at the same time. We do not feel yet confident enough to assume a significant capital return of the excess capital. So we let it build in our model with our mind going 5, 10, 15, 20 years from now, what will that capital eventually earn? But so far I think they've proven to be fairly good stewards of it.
· Freddie Lait
[00:00:00] S1: One other way to think about it is to invert it. Given the competitive advantages, given the demonstrable success across these verticals, which are all very nascent, given the arguments we've made around the sort of the limited reduction in revenue per account, either from NIM Sensitivity, which will bobble around or from the commissions and trading per account, you're making roughly $1,500 an account in revenues at the moment. What's the probability they can get to 10 or they can get to 20, thus making 15 or 30 billion dollars in revenues? And they make a 75% operating margin. I think they make a 75% net margin. It'll probably be around there. It could go up a little higher. But that's with their generous offering back. You're talking about a very profitable, rapidly growing business. And the question one really needs to ask is: who's going to stop that happening? Is there a competitor in the marketplace that will stop that? If not, how fast or how slow will it happen is the bigger question. And something Thomas has said is we can grow at 30% with no advertising. We can probably grow at 40, 50% if we do more targeted advertising. But they're not looking to do that right now. But I do think they could accelerate the account growth if they wanted to because there's a lever they haven't pulled yet.
· Zack Fuss
[00:00:00] S0: Obviously much of what has been said about this business has been overwhelmingly positive. But when you're dealing with a business that interacts with leverage, margin, long and short side of the investment industry, there's inherent risks. I would love to hear about how you guys assess those risks and maybe some of the stress tests the business has faced. Even as recent as a few weeks ago, we saw the broader market sell off 10, 15, 20%. And what that meant for their business, I think, would show kind of the resilience and durability of the model that they have here.
· Freddie Lait
[00:00:00] S1: Yeah, I think one of the key things to remember if anyone else goes away from this and analyzes the business is that this was a market-making business in a large part as well in the past. So it's very different to 2009, and 2014 was the day where they really exited most of that business. So this is now a middleman, a broker, far more than the sort of asset risk. So the risk, as you say, slightly lies in that margin loan piece and their ability to risk-manage and collateralize against those loans. Because obviously when they make these loans or they do the securities lending, they take and hold collateral, and something Jacopo mentioned earlier, these accounts are stopped out automatically now as if and whenever they get too close to that margin limit. And so it's all an automated process they have. They claim to have very good risk management systems, but I've never met a financial business that doesn't claim to have good risk management systems. So your question again is right: How have they fared through the last decade of quite a lot of stress tests? I'd argue whether Covid or big drawdowns in 2022 in the very popular stocks or the recent hit. Their largest loss was really from a very strange sort of move in the Swiss franc 10 or 12 years ago, maybe even 14 years ago, where they lost about 1% of their equity capital today. So a very bearable amount for a business that is multiple times capitalized. And through the recent turmoil of the last three to four or five years, it's de minimis the risks from margin, the losses, the bad account balances. It's not been an issue for the business. So the risk management system ex post has clearly been working.