Pembridgecap

A Wealth Creation Journal

Category: Investment case

Notes on IBKR’s November results and Peterffy at the ’18 Goldman Sachs conference

Disclosure: both a happy investor and client of Interactive Brokers.

Improve your net returns by massively saving on costs (i.e. the only thing you have 100% control over as an investor) now and become an Interactive Brokers client.

It is a well-known human bias to neglect large absolute trading commissions because we look at them relatively to the even bigger amount of money we invest. I am a big believer in minimizing any friction in the investment process (trading less which lessens commissions and frees up time to think long term; paying less for trades by being an IBKR client, although the cheapness creates a “casino effect” of wanting to trade more frequently).

Intro

We will cover IBKR’s November month results that were released this week. Founder Mr. Peterffy had interesting comments about them on the Goldman Sachs 2018 conference that took place yesterday.

First I’ll explain how I go about thinking about the IBKR’s monthly metrics in general.

Executive summary

  • most important monthly KPI to track: user account growth (it drives LT equity growth which is IBKR’s most important value driver)
  • November user account growth was “disappointing”, yet still in line with the last 10 year historical pace of 18% CAGR. The disappointment was driven by China curbing remittances to stellar grower – and intro broker to IBKR – Tiger Brokers
  • IBKR will start paying interest on smaller accounts
  • Israel markets will be added to IBKR
  • important question for the thesis: will exchange volumes keep on losing share to internalizers?

Let’s get started…

IBKR’s monthly metrics mental model*

*Hate using this snobby term but it made for the shortest title.

Although equity growth is the value driver for IB going forward (driving interest income) , account growth is the most useful reported number to gauge future LT equity growth, as

  • monthly equity growth numbers are affected by short term stock market movements
  • equity growth lags account growth because people only start depositing large chunks of money into their account once they are familiar with the platform (i.e. half of end-of-first-12-months money only arrives after >6 months)

Commission growth is also very noisy ( ~f(volatility)) and only 1/3rd of earnings.

In short, closely track MoM account growth to know if IB is on pace for LT equity growth.

Account growth + (ST NOISY= Clients adding deposits + asset inflation) = LT Equity growth

So I observe account growth and know that (ST NOISY) was historically 10% and should be at least 4% on avg. going forward, i.e. observed account growth + 4% =  conservative LT equity growth.

Let’s discuss the latest results and the interesting conference.

November numbers & Peterffy on the GS Conference

  • On the November numbers, IB swung up 8% intraday & ended slightly down on the day
  • I agree with the directional close-to-closing price given the numbers
    • Short-term value driver commissions were great (market volatility) while
    • accounts growth disappointed at +1.3% MoM (vs huge growth last months of course, even the annualized disappointing MoM pace is still 17%, +- on par with the 10-year CAGR of 18%)
      • Peterffy revealed on the GS conference that MoM account growth was affected by special measures by Chinese govt that constrained mainland Chinese customers to deposit money into their Beijing-based intro-broker Tiger Broker app accounts (i.e. IB bank accounts in Hong Kong). Probable reason: Yuan is under pressure and growing money outflows put further pressure on Yuan
        • Tiger Brokers grew at a stellar rate last years (now processing >200BUSD in trading volume p.a.) & has a great app with local support, advertising and investors in the mainland (the Robinhood of China but with a smarter client base as unsophisticated Chinese retail investors are not interested in global investing) but back-end of the app is 100% IBKR and the bank account is with IBKR HK
        • My take: a yuan devaluation event should be positive as the restraint can be more easily lifted afterwards & as more Chinese would consider investing outside China after a deval

Notwithstanding current market correction, IB’s LT equity growth (main value driver) should be at least 4% p.a. above account growth as clients deposit more money into their existing accounts and asset prices rise in long haul. In fact, historically the equity CAGR was 10 %-points above account CAGR. As interest rates rise and IB pays even more interest on client cash than competition, there is no reason the pace of client deposits should slow so 4% seems very conservative.

Even annualizing these disappointing MoM numbers gives us 17% account growth or in my view 21% conservative LT client equity growth, which is still 2 pp above my model of LT equity growth at 19%.

Recent additions to the platform Peterffy discussed:

  • Israel markets (next week)
  • New screening functions for IB’s bond platform (direct electronic access)
  • IB features in recent past makes them more & more of a bank:  IB is now considering getting banking license abroad & US. In US, broker-dealers can do almost anything but  limitations abroad are generally more extensive
  • Effective 1st of Jan IB will start paying interest for small clients with total equity lower than 100k (previously 0%). The rate these clients will get will be linearly ramping from 0% to benchmark minus 0.5% with account size from 0 to 100k, e.g. 60k client would get 60%*(bench-0.5%) on his cash

Recent SEC action on the payment for order flow “PFOF” competitor broker’s practice

  • Competitors burdened with more disclosure requirements to clients

Peterffy voiced his concern that brokers who’re accepting PFOF (the vast majority) are routing their orders increasingly to “internalizers” that execute customer orders against their private “parallel” market (e.g.  HFT arm of Citadel, public firm Virtu Financial):

  • This means less and less retail orders are going to the exchanges
    • Because retail orders are the lifeblood of market makers as they are viewed as profitable “noise”, there’s less incentive for market makers to provide liquidity-adding orders limit orders to the exchanges
  • thinks the decreasing real liquidity on exchanges is a “disaster waiting to happen”

I read the Virtu Financial prospectus, and the story is not that simple it seems: exchanges are monopolies and they have been inflating their commissions and data fees over the last years at higher than inflation. IBKR IR themselves complained about that to me when I asked about that cost item. Customers using internalizers save exchange fees that could theoretically be shared amongst client, broker and internalizer. In practice however, this windfall (and slightly worse execution when using an internalizer) goes to internalizer and broker. I still think the internalizer model is a threat to IB’s 100% direct-exchange model as this ongoing exchange trading substitution may continue. This is mitigated by IB’s tiny market share that can grow much bigger in 3 or 4 out of 5 client types (prop shops is saturated &  sophisticated individuals is saturated but only in the US).

Somewhat distressing is Peterffy exaggerating JPMorgan’s new “free trading app” clients being patsies:

Well, obviously, businesses have to make a profit or at least break even. So one day advertise no commissions. They may have to make it up somehow, and so that is partly in selling the orders, partly not paying interest on the deposits, partly charging higher margin rates. I understand that Robinhood does this, and that’s okay. But to the extent JPMorgan is doing this, I think it’s a big mistake. People don’t like to be taken for a patsy, and it’s going to be — they will regret this, I think.

There are huge differences among brokers how much they take as PFOF as they negotiate how good the client execution should be. Fidelity and Schwab have ~10x better price execution than RobinHood and earn less from PFOF. As stated above, theoretically PFOF could be compatible with great execution as exchange fees are saved.  The difference between IB’s price execution and the more established brokers is really a few basis points (insignificant for individuals), while for Robinhood it’s >20bp.

Growth

Interesting point was that not only Asian intro broker clients are growing fast. A lot of European private banks are becoming intro brokers too as they can’t keep up technologically.

TC

Dart Group – Memo post FY17 results

Thomas’s enthusiasm on religiously updating this blog has put me to shame and as such I will share my latest thoughts on Dart post the latest results release last week.

While many investors counsel against sharing investment ideas because it exposes one to commitment bias. Despite the commitment bias risk, I want to document my thoughts ex-ante so that I can remove any hindsight bias should my judgement prove to be wealth destructive. So here we go:

Post the results, DTG share price went on free fall – a whooping 20% drop in 2 days. Just like TC, DTG makes up ~25% of my portfolio. So this was emotionally hard to bear despite all the lessons of rationality that we keep reading about in books.

The market reacted violently because:

  • Operating profit probably did not meet market expectations given the run-up in share price before the results release
  • Huge uncertainty associated with the non-UK ownership issue

I suspect the issue surrounding non-UK ownership was the more important driver is pushing the share price down. As we all know, market hates and punishes uncertainty very punitively.

From an operational perspective, I was very happy with the progress that DTG is making for couple of reasons:

  • The capex numbers confirmed a previous assumption that DTG has ~50% discount on the listing price of the new Boeing 737-800s
  • Revenue growth in winter season continued which is critical as the newer fleet would have to be justified by better utilization rate all year round
  • Advanced revenue jumped 40% YoY which is STRONG indicator of the success of the new bases – Stansted and Birmingham
  • Net debt was very much under control helped by the cash flow generated by negative working capital with growth

The main reason for softer EBIT margin was due to one-off costs and cost ramp up in new airports (Stansted and Birmingham) i.e. the cost was incurred before the revenue came in.

When we decided to invest in DTG in Oct 2016, the biggest risk was that Brexit would lead to a sharp drop in demand for oversea package holidays which would be disastrous for DTG as it was taking on debt to purchase new aircraft. Increasing capacity through debt when demand is about to decline is a recipe for massive value destruction as witnessed in many of the commodity companies.

However the strong advanced sales and the revenue growth in FY17 indicated that the demand for package holiday in the UK has not been affected by the weaker Sterling post Brexit. This corroborates the UK holiday data released by ONS in May 2017. The strong growth in advanced sales is an important signal because it implies that people are booking their summer holidays as usual. In fact the strong demand for FY 2017 summer is particularly encouraging because Britons would have fully digested the impacts of Brexit and still decided to spend on holiday in the subsequent year.

The implication of the above point is that our worst-case scenario is increasingly unlikely to happen and as such the downside risk of an investment in DTG is diminishing. Operationally, the range of outcomes for DTG in the next 2 years is heavily skewed to the base and bull case. (Base case assumed growth associated opening 2 new bases and no growth afterwards and bull case assumes that there is still 5% organic growth in topline after the new bases are up and running at steady state)

Going forward, I think the value of DTG is driven by the following factors:

  1. Normalized run-rate FCF in base case in GBP 120 – 140m which implies an FCF yield of 17% based on the share price today
  2. Pay down of debt will lead to appreciation of equity value
  3. Given a mix of old and new aircraft in the fleet today, DTG can choose to retire old planes more quickly depending on the demand conditions. Full credit to TC for his insight on this point
  4. Multiple expansion as the company proves its success with the new bases and lower leverage in the steady state environment

As such I have added and will continue to add to my DTG position if the price goes down further in the absence of new information.

On the non-UK ownership point, the context is such that both EU and UK requires their airlines to be majority owned by EU or UK nationals. Before Brexit, UK airlines just have to comply with the EU regulations. Post Brexit, UK airlines have to ensure that the company is majority UK owned to maintain its operating license. DTG is proposing to add a new clause to the article of association to force any non-UK shareholders to sell his/her shares. Ryanair and Easyjet already have this clause in their article of association. The worst case is that we are forced to sell when the share price is very low as we are not UK nationals.

Firstly, DTG noted in its announcement that they believe currently non-UK shareholders make up less than 35% of the shareholder base. DTG is 40% owned by its founder, Philip Meeson who is a UK national. Secondly, the company will try its best to avoid activating such clause unless absolutely required. Thirdly, we still dont know how the Brexit negotiation will play out on this issue – maybe it is favorable maybe it is not.

So there is a good chance that this clause is not required. But the important question is if the company decided to trigger this clause how are they going to decide which shareholders to force sell. I.e. if there are 40% non-UK shareholders and DTG wants to bring that down to 35%. How do they choose which 5% of the non-UK shareholder base to force sell?

The company did not comment on this. But we decided to look at Ryanair and Easyjet for inspiration. It turns out that it depends on the chronological order at which non-UK shareholders register their shares with the company. For example, if you are the first non-UK shareholder to register with the company then you are the last one to be forced to sell. And they will first force sell the shareholders who have not registered with the company. So this gave me great comfort that as long as I register my shares with DTG asap, I should be okay.

So I am comfortable with the two issues and continue to hold the DTG shares. Of course I change my mind when the facts change to quote John Maynard Keynes.

MC

Notes on package holidays

We recently took an interest in the business Dart Group plc “DTG”.

My notes on the Package Holiday industry, as the high growing segment of DTG is Jet2holidays:

  • Necessary adjustments – the package holiday industry suffered as new tech competition (e.g. Booking, Expedia and later Airbnb) grew offering customers more choice:
    • Assimilation – One key advantage of online competitors for customers is customization (exact holiday length, start/end date, type of hotel room). The industry adjusted by offering more choice.
    • Consolidation & bankruptcies – TUI and Thomas Cook have increased their market share since the financial crisis. Size has brought some two-sided power on price.
    • Control – Recent strategy has been to increase control over customer experience by expanding assets on the balance sheet (hotels, planes). Large package holiday firms might scoop up a low-cost airline like DTG to increase control. Note: Jet2Holidays is very focused on customer experience (e.g. see news on unique resort check-in).
    • Differentiation – package holidays to remote places where booking websites are not as penetrated yet (First Choice’s strategy as early as 2005). A move away from commoditised package holidays boosts margins. In 2012, 3/4th and 2/3rd of TUI’s Nordic and British customers respectively booked such highly tailored holidays (2/3rd of German customers was “still” buying mass-market packages).
  • Renaissance – In part because of these adjustments, there has been a renaissance since ’08. Mintel forecasts a further 10% rise in demand by 2020. As of 2016 however, total package holiday demand is down 25% since its peak in the early 2000’s.

 

On all-inclusive package holidays:

  • value proposition
    • being spoiled by free lunches
    • peace of mind
      • holiday sorted out
      • no unexpected expenses
      • being looked after if holiday goes wrong (e.g. terrorism)
  • Growth  all-inclusive grew from 8% of worldwide holidays to 12% in the period ’10 – ’13 (PhoCusWright via Economist)

 

One last remark: Booking/Expedia/Airbnb charge quite high commissions (10-20%). This offers leeway for existence to others. It could also be a risk down the road if these commissions fell.

Notes on the European airline industry might follow.

 

 

References

A history of package holidays – Independent

A new package  – Economist

Tour operators are down but not out – Economist

Horrible holidays – Economist

Travelling on the same ticket – Economist

The return of the free lunch – Economist

From satanic mills to sundecks – Economist

Tour operators are down but not out – Economist

Thomson and First Choice to merge – FT.com

Different Towels – FT.com

Travel groups brace for holiday booking decline – FT.com

Tui to sell Hotelbeds Group for €1.2Bn – FT.com

 

SABMiller – AB Inbev deal

This week the Inbev offer for SABMiller shareholders closes.

While SABMiller trades at 45 pounds, i.e. the cash offer consideration, there’s also a partial share offer option that has become more interesting after Brexit currency volatility. By electing the partial share offer, one gets future Brussels listed Inbev shares with a five year lockup, and a small sum of cash upfront. Have a look at this great company presentation for background.

I imagine that the lockup clause is to discourage as many non-family holders of SABMiller as possible of taking this sweeter option and pay less for a successful merger. AB Inbev management is notorious for being frugal. If you are a real long term investor, this is true time arbitrage to take advantage of.

I made a Google Excel sheet with live updated prices to analyze the economics of this offer.

What I found is a pre-tax IRR (as of Oct. 4th) of 2.8% p.a. above the return one gets by just holding AB Inbev (ABI in Brussels) in the same period.

This positive carry is created by

1) paying only 80c on the dollar for ABI restricted stock,

2)  getting the extra dividend on this incremental 20c of ABI stock.

A 25% dividend tax subtracts less than 10 basis points p.a.

I am still hesitant to participate. On the one hand I am a big fan of these large positive carries. On the other hand I have doubts about the valuation of public mega-cap companies today. This brings me to very interesting letters of the hedge fund Horizon Kinetics about the unsustainable index ETF boom (see here here and here)

Because my portfolio is not levered at all (I am about 90% invested, and 10% in cash), there is room to participate and hedge my exposure by shorting AB Inbev as the short borrowing cost is zero. As my restricted stock is unlisted, this can only be done at a small percentage of my portfolio to avoid margin call mayhem in case Inbev stock rallies heavily.

If I participate and hedge my exposure, it will most probably be at a percentage of NAV < 5%.

Best,

TC

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