Interactive Brokers Group, Inc. quarterly report, Q3 FY2012

Business context and reporting period

Interactive Brokers Group, Inc. filed this unaudited Form 10-Q for the quarter ended September 30, 2012. The company operates electronic brokerage and market-making businesses through IBG LLC, which it consolidates; IBG, Inc. itself owned approximately 11.9% of LLC at quarter-end. The 2011 comparative results were restated.

Financial performance and position

Amounts below are in millions of dollars except per-share data, percentages, and where stated otherwise.

For the first nine months of 2012, net revenues were $883.4 million versus $1,050.4 million; pre-tax income was $430.8 million versus $588.9 million; and net income attributable to common stockholders was $31.6 million versus $48.3 million. Diluted EPS was $0.70 versus $1.09. Comprehensive diluted EPS, which includes currency translation in other comprehensive income, was $0.71 versus $1.06.

• Revenue drivers: Q3 trading gains fell 23% to $149.7 million and commissions and execution fees fell 23% to $100.6 million. Interest income was $65.4 million and other income was $17.1 million. For the nine months, trading gains declined 28% and commissions and execution fees declined 11%.
• Expenses and margins: Q3 non-interest expenses fell 13% to $146.0 million, mainly because of lower execution and clearing costs; employee compensation rose 3% to $57.7 million. Nine-month non-interest expenses declined 2% to $452.6 million, while compensation increased 12% to $180.2 million. Nine-month pre-tax margin was 49%, down from 56%.
• Segments: Q3 electronic brokerage pre-tax income declined 23% to $80.8 million, with a 48% margin; market-making pre-tax income declined 30% to $90.2 million, with a 59% margin. Nine-month segment pre-tax income was $254.4 million for brokerage and $180.2 million for market making.
• Cash flow: Nine-month operating cash flow was $211.7 million, investing cash outflow was $46.4 million, and financing cash outflow was $210.7 million. Cash and cash equivalents decreased $36.0 million to $1.660 billion.
• Balance sheet and liquidity: Total assets were $33.862 billion at September 30, versus $30.404 billion at December 31, 2011. Cash and securities segregated for regulatory purposes were $12.326 billion. Customer receivables were $9.391 billion and customer payables were $21.281 billion. Management characterized 98.7% of assets as liquid, primarily marketable securities, customer cash, and collateralized receivables.
• Debt and capital: The $101.4 million of senior notes outstanding at year-end 2011 was fully redeemed by June 30, 2012; the program was discontinued. A new $100 million, three-year secured revolving facility was undrawn at quarter-end. Operating companies had $2.85 billion in excess regulatory capital and were in compliance with requirements.

Changes, outlook, risks, and unusual items

• Management attributed weaker results chiefly to lower trading volumes, subdued market-making conditions, lower volatility, narrower options spreads, and comparison with the unusually active third quarter of 2011. Q3 total customer DARTs fell 21%; customer accounts rose 11% to approximately 205,000 and customer equity increased 35% to $31.5 billion.
• Currency translation boosted Q3 trading gains by $41.5 million, compared with a $22.7 million loss in Q3 2011. For the first nine months, translation effects swung adversely by $25.3 million year over year. Approximately 63% of company equity was denominated in currencies other than U.S. dollars.
• No earnings guidance was provided. Management said operating cash flows, cash on hand, and available revolving credit should meet liquidity needs for more than 12 months. 2012 gross capital expenditures were expected to be broadly level with prior years; future technology infrastructure spending may rise. A quarterly dividend of $0.10 per share was declared for payment December 14, 2012.
• Restatement and control weakness: The company corrected its accounting for Holdings’ redeemable noncontrolling interests before the June 6, 2012 Exchange Agreement amendment. The error affected equity classification and EPS, but not reported net income attributable to common stockholders or cash flows. The amendment eliminated the cash-redemption alternative; Holdings’ interests were subsequently classified as permanent equity. Management identified a material weakness involving review and interpretation of complex accounting issues, including noncontrolling interests and stock-based compensation. A remediation plan began in September 2012, but the weakness remained as of quarter-end.
• Risks and contingencies: Results remain sensitive to trading activity, volatility, bid/offer spreads, market structure and competition, foreign exchange, interest rates, and customer margin credit. The filing describes unquantifiable potential exposure from margin lending and customer transactions, as well as off-balance-sheet risk in futures. A patent-infringement case brought by Trading Technologies remained in early stages; reserves for litigation were not material, but the outcome was uncertain. The company also noted regulatory inquiries that could result in sanctions, though management did not expect a material financial effect.

Important facts for investors to verify

1. Review the restatement disclosures and subsequent filings for the material weakness, remediation progress, and any additional accounting corrections.
2. Track trading volumes, market-making conditions, brokerage DARTs, customer account growth, and customer equity to assess whether revenue declines persist.
3. Assess how translation effects and the company’s GLOBAL currency strategy affect reported trading gains, comprehensive income, and equity.
4. Distinguish consolidated LLC results from earnings attributable to IBG, Inc. common stockholders, given the parent’s approximately 11.9% LLC ownership.
5. Monitor liquidity, regulatory capital, customer margin exposure, credit-facility covenant compliance, and developments in litigation and regulatory inquiries.