Business Breakdowns
· Freddie Lait, Jacopo Di Nardo
Whatever happens with markets becoming more digital and outsourcing within the B2B channel will probably continue for the next 5, 10 and 20 years. Big question is, can someone compete with this? Can someone come away to stop them organically growing share? Given the counter positioning and that first comment about acquisitions and the competitors to reinvest, to try to build the direct market access and to invest in prices and cost and automation like this business has, everyone's folding and using this business instead of trying to compete with it. [00:00:00] S2: To your comment of more participation into financial markets by all sorts of individuals, especially after Covid, we believe that to be a pretty good tailwind too because as we said at the beginning, someone who is inexperienced and might have a smaller account balance, he might start a Robinhood account or eToro or whatever else he can get his hands off depending on the jurisdiction. But after a certain period of time, after becoming more accustomed to trading and honestly after having increased his own disposable income, we do believe the proposition of joining Interactive, especially as an active trader, is so much better than anything that's around there. But we do see a lot of his customers eventually dropping to Interactive over time as soon as the account balances reach $100,000 or $200,000.
· Freddie Lait, Zack Fuss
[00:00:00] S1: And if I can just add one more thing you mentioned earlier, some people are upset with the customer service. We see a lot of analogies between this business and other low-cost businesses that we look at. One would be sort of Ryanair. And I think it's really compelling to see that business, another business we like, where Michael O'Leary said, "I didn't realize looking after customers would make me so much profit." And he started making the customer experience more pleasant. I think they're doing that at Interactive too. They've had this obsessive focus on costs and automation for 50 years, including in their prime brokerage business. But they've just rolled out what they call the sort of white-glove service, which is a very manual, independent director looking after your account as a hedge fund. And I expect a bit more of that over time coming back into the business on the customer service too, which slightly opens up their market. One final thing they're doing as well is really relaunching their app, which will come in and help that customer acquisition that Jacopo said of those who are out there learning the ropes in apps like eToro and Robinhood, but may want to grow up into Interactive later. [00:00:00] S0: And so we touched upon it in relation to M&A. But clearly a business that's generating as much excess free cash flow as this one, capital allocation becomes increasingly important. What is their demonstrated strategy as it relates to redeploying the cash that they're generating on an ongoing basis if M&A is not available to them?
· Jacopo Di Nardo
[00:00:00] S2: This is a very important question, especially as the business will eventually mature. And in fact, at the moment the only capital return we are receiving is a dividend yield that's usually targeted to be about 0.5 to 1% of the total market capitalization. And there's a couple of things though to keep in mind. I think the company wants to keep a balance sheet that's as strong as it can be, mostly to develop the prime brokerage and hedge funds business. And one of the reasons being that the companies they do compete against, behemoths like Goldman, Morgan Stanley, UBS and Bank of America, are materially larger financial institutions. So to win over customers and hedge funds that manage 1 to 5 billion dollars of assets, they do need potentially stronger balance sheet than what we actually could imagine ourselves. The second point comes actually with the company structure. It is a publicly listed company, but still today, insiders own roughly 80% of the stock, of which most of it, 75%, is still Thomas. But the CEO and CFO also have a significant stake in the business. And therefore launching extremely big special dividends or share repurchase programs is not necessarily doable until the float of a business is increased. So we, like many other external investors, we are looking at the topic. We do believe over time, as Thomas, as he rightly says, is not immortal and he's approaching or above 80 years of age, we will see how that evolves. But it is something that we do like to an extent, because if you think about ways of maturing as a business, the final phase when growth slows down and is not what it used to be 20 years ago. Any business has a choice to make which can be growing again through M&A whenever it is possible, or returning excess cash to shareholders. And we are not even close to there. As Freddie has discussed, there's a potential over time to probably 20x the number of customers on the platform. But once that is done, having excess capital to return to shareholders, as the structure has probably changed by then is an option. But as investors, we do like to have—there's other businesses that are in that situation, I guess Berkshire Hathaway being an enormous one, which is in a similar position with an incredible amount of cash and Treasuries sitting on the balance sheet.
· Zack Fuss
[00:00:00] S0: And so when you're evaluating financial businesses, there's always a debate about how to properly value them. And without asking you guys to opine upon the valuation itself, what do you think are the most important metrics here in IT being return on equity, price to book, PE? How do you go about valuing a business like this?
· Jacopo Di Nardo
[00:00:00] S2: It's really a combination of everything you've mentioned. I think to an extent today the ROE of a business, we can look at it in two ways. One is obviously including the excess capital and one is excluding it. One thing you realize quite quickly is actually how capital-light it is compared to normal financials, especially when you back out the excess capital. So it might make 15 to 20% ROE, including the 19 billions of excess capital, but it might make 10, 15 times as much excluding that. Earnings and price to earnings, normalized earnings are also another way we look at it. So sticking in our own assumptions obviously of accounts growth and trades per account and commissions, and then looking at what a normalized and average net interest income could be given the prevailing rates of interest around the world. But as you say, it is not one of the simplest businesses to value on either of the two metrics. So we do focus really on both and see how both interact with each other at the same time. We do not feel yet confident enough to assume a significant capital return of the excess capital. So we let it build in our model with our mind going 5, 10, 15, 20 years from now, what will that capital eventually earn? But so far I think they've proven to be fairly good stewards of it.
· Freddie Lait
[00:00:00] S1: One other way to think about it is to invert it. Given the competitive advantages, given the demonstrable success across these verticals, which are all very nascent, given the arguments we've made around the sort of the limited reduction in revenue per account, either from NIM Sensitivity, which will bobble around or from the commissions and trading per account, you're making roughly $1,500 an account in revenues at the moment. What's the probability they can get to 10 or they can get to 20, thus making 15 or 30 billion dollars in revenues? And they make a 75% operating margin. I think they make a 75% net margin. It'll probably be around there. It could go up a little higher. But that's with their generous offering back. You're talking about a very profitable, rapidly growing business. And the question one really needs to ask is: who's going to stop that happening? Is there a competitor in the marketplace that will stop that? If not, how fast or how slow will it happen is the bigger question. And something Thomas has said is we can grow at 30% with no advertising. We can probably grow at 40, 50% if we do more targeted advertising. But they're not looking to do that right now. But I do think they could accelerate the account growth if they wanted to because there's a lever they haven't pulled yet.