Interactive Brokers Group, Inc. quarterly report, Q2 FY2019

Interactive Brokers Group, Inc. — Q2 2019 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2019. The company is a global electronic broker and a smaller, winding-down market-making business. IBG, Inc. owns approximately 18.5% of IBG LLC; the remaining 81.5% is reported as noncontrolling interests.

Financial performance and position

Metric	Q2 2019	Q2 2018	Six months 2019	Six months 2018
Total net revenues	$413 million	$445 million	$971 million	$972 million
Income before tax	$225 million	$271 million	$564 million	$611 million
Net income	$210 million	$258 million	$534 million	$577 million
Net income available to common stockholders	$32 million	$41 million	$81 million	$87 million
Diluted EPS	$0.43	$0.57	$1.07	$1.20
Pre-tax margin	54%	61%	58%	63%

Q2 interest income rose to $432 million from $333 million, while interest expense rose to $173 million from $108 million. Net interest income increased 15% to $259 million. For the six-month period, net interest income rose 14% to $505 million.
Commissions fell 4% in Q2 to $178 million and 13% for the six-month period to $351 million. Trading gains fell 50% in Q2 to $6 million and 48% for the six-month period to $13 million.
Other income was a $30 million loss in Q2 versus $23 million of income a year earlier, principally reflecting a $74 million mark-to-market loss on the Tiger Brokers investment. For six months, other income was $102 million, including a net $29 million Tiger Brokers gain.
Non-interest expenses were $188 million in Q2, up 8%; six-month expenses were $407 million, up 13%. The six-month increase was driven chiefly by $47 million of customer bad-debt expense, versus $3 million a year earlier.
At June 30, total assets were $66.0 billion, liabilities $58.4 billion and total equity $7.6 billion. Cash and cash equivalents were $3.2 billion; cash segregated for regulatory purposes was $8.8 billion. Customer receivables were $25.9 billion and customer payables $53.1 billion. These large balances primarily reflect brokerage and customer-related activity.
Short-term borrowings were $15 million. Management reported no variable-rate debt outstanding. Operating lease liabilities were $129 million.
Six-month operating cash flow was $2.045 billion, investing cash outflow $62 million and financing cash outflow $116 million. Cash, cash equivalents and restricted cash increased $1.881 billion to $12.0 billion; operating cash flow is materially affected by customer balances and other brokerage activity.
Aggregate excess regulatory capital was $6.285 billion, and all regulated operating companies were reported in compliance with their requirements. Management stated that available cash, operating cash flow and borrowing capacity should cover liquidity needs for more than 12 months.

Material changes and operating trends

Q2 consolidated net revenues declined 7% and pre-tax income declined 17% year over year. The main offsets to lower other income, commissions and trading gains were higher net interest income.
Electronic brokerage Q2 net revenues increased 7% to $473 million and pre-tax income increased 7% to $302 million; six-month pre-tax income declined 4% to $552 million. Six-month commissions were pressured by lower trading volumes and smaller average trade sizes.
Customer accounts increased 19% year over year to 645,000 and customer equity increased 14% to $153.1 billion. Q2 total customer DARTs rose 4% to 828,000, while six-month DARTs declined 3% to 838,000.
Management cited lower market volatility and a flat-to-inverted forward yield curve as relevant conditions. Higher benchmark rates and customer credit balances supported net interest income; the company noted that much of the additional interest earned on customer cash is passed through to customers.
The market-making business continues to wind down following the transfer of U.S. options market-making operations and exit from most non-U.S. options activity. It produced Q2 pre-tax income of $11 million and six-month pre-tax income of $17 million.

Outlook, risks and unusual items

The filing provides no specific earnings or revenue guidance. Management said customer growth, market activity, volatility, interest rates, competition and regulatory developments may affect results; trading volumes and market conditions are not predictable.
A small number of customers’ concentrated positions in one security generated a net aggregate loss of approximately $42 million in the first half of 2019. The stated maximum loss was approximately $51 million if the security became worthless and no customer debt was collected; collection efforts and the ultimate outcome remain uncertain.
The Tiger Brokers investment produced a $74 million Q2 mark-to-market loss after a $103 million Q1 gain. The company reported a 7.6% beneficial ownership interest and was subject to a 180-day lockup following Tiger Brokers’ IPO.
The company was providing information to FINRA, the SEC, the CFTC and the U.S. Department of Justice in inquiries focused on anti-money-laundering and Bank Secrecy Act practices. Management said outcomes could not be predicted and did not believe the inquiries were likely to have a materially adverse effect.
Patent litigation includes a scheduled February 2020 trial concerning four patents for which prior invalidity determinations were vacated; other patent invalidity determinations were affirmed on appeal. A separate customer class-action matter had remaining negligence claims after earlier claims were dismissed or affirmed as dismissed. Management said litigation reserves were not material, while acknowledging outcomes are uncertain.
Key stated risks include margin-credit losses during rapid market moves or concentrated collateral, market and currency fluctuations, interest-rate spread compression, trading-volume variability, regulatory changes and off-balance-sheet settlement exposure. The company also disclosed that clearing-house guarantees could exceed posted collateral, though management considered payment under those guarantees remote.

Important facts for investors to verify

Whether the $42 million customer margin loss is recoverable and whether exposure could approach the disclosed $51 million maximum.
How much of reported earnings depends on net interest income, customer balances, market conditions and mark-to-market items, including Tiger Brokers and U.S. government securities.
Whether account and customer-equity growth can offset weaker commissions, lower trading activity and reduced average trade sizes.
Developments in the regulatory inquiries and litigation, including the patent trial and remaining class-action claims.
The distinction between consolidated net income and income available to IBG, Inc. common stockholders, given the 81.5% noncontrolling interest in IBG LLC.
Liquidity and regulatory-capital trends, recognizing that much of the balance sheet consists of customer-related assets and liabilities and that regulatory capital is subject to operating-company restrictions.