Interactive Brokers Group, Inc. quarterly report, Q3 FY2017

Business context and reporting period

Interactive Brokers Group, Inc. filed this unaudited Form 10-Q for the quarter and nine months ended September 30, 2017. The company operates an automated global electronic brokerage business and a market-making business. IBG, Inc. owned approximately 17.4% of IBG LLC; the remaining 82.6% was held by IBG Holdings LLC, so consolidated results include substantial noncontrolling interests.

Financial results and position

Metric	Q3 2017	Q3 2016	Nine months 2017	Nine months 2016
Total net revenues	$426 million	$345 million	$1,187 million	$1,203 million
Income before taxes	$268 million	$183 million	$685 million	$733 million
Net income	$247 million	$168 million	$629 million	$678 million
Net income available to common stockholders	$31 million	$20 million	$78 million	$80 million
Diluted EPS	$0.43	$0.30	$1.10	$1.20
Pre-tax profit margin	63%	53%	58%	61%

Q3 interest income was $243 million and interest expense $61 million; net interest income was approximately $183 million, up 34% year over year. Net interest margin rose to 1.31% from 1.12%.
Q3 commissions increased 13% to $163 million; trading gains fell 71% to $11 million; other income rose to $70 million from $27 million. For the nine months, commissions rose to $477 million, trading gains fell to $26 million from $124 million, and other income declined to $205 million from $228 million.
Non-interest expenses were $158 million in Q3, down 2%; for the nine months they were $502 million, up 7%. Nine-month general and administrative expense included a $21 million write-down of exchange trading rights.
Nine-month operating cash flow was $373 million, investing cash outflow $14 million, and financing cash outflow $294 million. Cash and cash equivalents ended at $2.056 billion, up $131 million from year-end 2016.
At September 30, total assets were $59.843 billion, liabilities $53.531 billion, and total equity $6.312 billion, including $5.216 billion of noncontrolling interests. Short-term borrowings were $38 million; securities loaned were $4.132 billion. Customer payables of $47.550 billion are largely customer-related balances, not conventional corporate debt.
Management reported that 99.3% of assets were considered liquid and aggregate excess regulatory capital was approximately $5.0 billion. All regulated operating companies were in compliance with their capital requirements.

Material changes versus comparable periods

Q3 net revenues increased 23% and pre-tax income increased 46%, supported by higher net interest income, commissions, and other income. Electronic brokerage pre-tax income increased 39% to $225 million.
Customer accounts increased 24% year over year to 457,000; customer equity rose 40% to $115.7 billion; total daily average revenue trades increased 14% to 695,000.
Nine-month net revenues declined 1% and pre-tax income declined 7%. Electronic brokerage pre-tax income grew 3% to $608 million, while market making reported a $35 million pre-tax loss versus $32 million income in the prior-year period.
Q3 diluted EPS rose despite common-stockholder income remaining a small share of consolidated net income, reflecting the company’s 17.4% ownership of IBG LLC and the allocation of most consolidated income to noncontrolling interests.

Outlook, commentary, risks and unusual items

The company completed the transfer of its U.S. options market-making operations to Two Sigma Securities on September 29, 2017, and planned to phase out substantially all remaining options market making outside the U.S. over the following months. It may receive contingent earn-out income under the sale agreement, but no amount is specified.
Management estimated total one-time restructuring costs of approximately $25 million; $24 million had been recognized through September 30, principally impairment and severance. The quarter included an $11 million recovery of exit costs related to the U.S. sale. Management expected approximately $40 million of annual net expenses to be absorbed by electronic brokerage as resources shifted from market making; about $6 million had shifted during the nine months.
Management said operating cash flows, cash on hand and available borrowings should cover liquidity needs for more than twelve months. This is an expectation, not a guarantee.
Low volatility and a lower actual-to-implied volatility ratio weighed on market-making results. The company also cited competition, market-structure changes, unpredictable retail trading volumes, regulatory scrutiny, interest-rate variability and possible market-center consolidation.
Interest-rate sensitivity estimates indicated that a 0.25 percentage-point increase in U.S. dollar rates could raise annualized net interest income by approximately $12 million, while a 0.25-point decrease could reduce it by approximately $15 million, assuming reinvestment of maturing instruments. Mark-to-market losses on government securities may arise as rates change.
Customer margin loans totaled $25.3 billion. The filing warns that fast market moves, illiquid or concentrated collateral, and customer defaults can create losses that are difficult to quantify; automated liquidation may not work in every circumstance.
The company estimated cumulative net losses of approximately $116 million from the 2015 Swiss-franc event, after hedging and debt-collection efforts; ultimate recovery remained uncertain. Pending litigation includes a patent dispute and an appeal in a customer class-action matter. Management said litigation reserves were not material, but outcomes and possible period-specific effects remain uncertain.
Management stated that adoption of revenue-recognition Topic 606 was expected to leave revenue timing unchanged and planned to use the modified retrospective method.

Important facts for investors to verify

Whether brokerage growth, customer balances and higher interest rates can sustain net interest income as rates and customer activity change.
Whether market-making wind-down costs, the expected transfer of approximately $40 million in annual expenses, and any Two Sigma earn-out develop as management anticipates.
How much of reported earnings depended on currency-diversification results, securities mark-to-market changes and the $11 million sale-related recovery; compare with management’s adjusted results.
Whether customer margin-loan growth and collateral controls remain adequate under stressed or illiquid market conditions.
Developments in collection of the Swiss-franc receivables, the patent litigation and the class-action appeal, together with any resulting financial exposure.
Regulatory capital, liquidity and customer-asset segregation requirements, and the effect of the company’s ownership structure and noncontrolling-interest allocation on common-stockholder earnings.