(IBKR) Interactive Downgraded to Neutral

We are downgrading our recommendation on Interactive Brokers Group, Inc. (IBKR) to Neutral based on weak brokerage metrics for May. Primarily, a year-over-year decline in Daily Average Revenue Trades (DARTs) was disappointing.

Interactive Brokers’ first quarter 2011 operating earnings per share came in at 41 cents, far better than the Zacks Consensus Estimate of 27 cents. This also compares favorably with the prior-year quarter’s earnings of 6 cents.

Results benefited mainly from improved top line, which was partially offset by higher-than-expected interest and non-interest expenses. The company’s brokerage business continued to perform well during the quarter and results of the Market Making segment improved on better revenue capture. Also, the balance sheet remained highly liquid with a relatively low leverage.

Despite declining market volumes, Interactive Brokers’ Market Making segment is positioned to improve on better revenue capture. The company is ready to withdraw certain less profitable products from this business to avoid risks.

We expect the company’s strategy with respect to structural changes in the business to bode well. On the other hand, larger average trade sizes continue to improve its Electronic Brokerage segment results.

Starting second quarter of 2011, the company will pay a quarterly dividend of 10 cents per share. This reflects management’s confidence on its capital strength for the long run. Management’s expectation to increase this dividend amount over time gives us more confidence on its capital efficiency.

On the flip side, Interactive Brokers’ brokerage metrics for May were mixed with a negative bias. Most importantly, total customer DARTs declined 17% from the prior-year month to 420,000. Also, the Electronic Brokerage segment reported customer margin loan balance of $9.5 billion, reflecting a 10% decrease from $10.5 billion recorded in the prior month.

Also, according to Interactive Brokers’ latest dividend strategy, the regular quarterly dividend will be shelled out of its Market Making segment. As a result, the segment’s capital base could reduce over a period of time. This segment’s failure to generate sufficient return to pay dividend will force the company to deploy its capital through dividend. This will, in turn, reduce its financial flexibility.

Though the company’s fundamentals remain strong with a liquid balance sheet, sturdy capital base and high barriers to entry, we remain concerned about its Market Making segment’s ability to consistently generate sufficient return to fund dividend payment. Also, there are concerns related to Interactive’s dependence on IBG LLC and its wide international exposure.

Interactive Brokers currently retains a Zacks #3 Rank, which translates into a short-term ‘Hold’ rating. Similarly, Knight Capital Group Inc. (KCG), one of Interactive Brokers’ competitors, retains a Zacks #3 Rank.

INTERACTIVE BRK (IBKR): Free Stock Analysis Report

KNIGHT CAP GP (KCG): Free Stock Analysis Report

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