Category Archives: Research

A quick potential idea for my Dutch readers

I don’t think a lot of people in the Netherlands will have missed the fact that ABN Amro is going to relist on the Amsterdam stock exchange this month. It’s big news in the mainstream media because ABN Amro was nationalized in 2008 at a cost of €21.7 billion for the Dutch tax payer. The bank has currently a book value of €17 billion, and the Dutch state appears to be willing to take a small loss on the bailout. They intend to IPO certificates for a price between €16 and €20 which implies a valuation between €15.0 and €18.8 billion.

I’m not particularly interested in owning ABN Amro, but what is interesting is that Dutch private investors get a preferential treatment in the allocation of shares. Individual investors will get a full allocation for the first 250 shares unless more than 10% of the shares that are sold in the IPO are necessary to do this. To hit that number more than 75 thousand investors have to request the full 250 share allocation, and I think that that is unlikely to happen.

Participating in an IPO is on average profitable, but the problem for retail investors is that you run the risk that you only get an allocation when there is not a lot of interest in the deal. Because of how this deal is structured that’s not going to happen here. At the same time, we know in advance that this is not some hot web 2.0 stock that could make a huge jump on the first trading day. It’s just a boring bank. But I do think that it is highly likely that the IPO will be priced at a point where it is more likely than not that the stock will make a small jump on the first trading day. So I’m going to subscribe to some shares, and we’ll see what will happen :).

Random ABN Amro picture


No position in ABN Amro at this moment

Interactive Brokers as a GARP investment?

Interactive Brokers isn’t your typical value stock: it’s trading near an all-time high with a P/E ratio of 44x and a P/B ratio of 2.6x. But despite that the company managed to get a spot on my research list. It’s one part curiosity simply because I’m a customer at the firm and one part because I strongly believe that Interactive Brokers is awesome. I have experience with a large number of different brokerages and not a single one comes even close to Interactive Brokers. I’m clearly not the only investor who shares that opinion since the number of customers has grown at an almost 17% CAGR since 2008:

Account growth at Interactive BrokersWhen you look at a graph like that I think it’s pretty easy to justify a lofty multiple, but before we do that we should try to understand the business and the competitive landscape a bit better.

Business model

The first thing to realize is that Interactive Brokers is, despite their awesomeness, not a broker for everybody. They target sophisticated investors who already have significant experience, are more active than average and have more money than average. What they offer are, among other things, lower fees and better trade execution. For the past twelve months, IB reported that their customers average total trading cost was 1.2 basis points of trade value compared to daily VWAP (I’m sure you know this, but it’s worth emphasizing: one basis point is one one-hundredth of one percentage point!). Other brokers don’t disclose this statistic, and presumably for good reasons since they not only charge higher fees but also execute trades at worse prices.

IB all-in trading costs

IB can offer lower costs because of their superior technology that allows them to automate many aspects of their business. Technology is also part of the reason why they are able to execute trades at better prices: their order routing is better, and they don’t sell their customers order flow to internalizers. They also pass-through exchange rebates to customers which reduces the incentive to route customer orders to exchanges with a high rebate – that the broker can pocket – at the expense of price and/or fill rate.

Another good thing about their business model is that IB attracts the most valuable customers. Most electronic brokers have to spend a significant amount of money on advertising to attract customers, and most customers that they attract are small accounts from inexperienced investors. These accounts are not very profitable (if at all) because they usually don’t generate a lot of trading commissions and they do place a heavy load on the customer support department. I couldn’t find the source, but I do remember hearing that Binck – the biggest online broker in the Netherlands – is generating more than 80% of its revenues from just 0.1% of its customers. I think that’s bad news for Binck because exactly those large and active accounts can presumably gain a lot by switching to Interactive Brokers.

The latest annual report of Binck is in my opinion worth reading because they explain their business model very well. They write the following about their weaknesses:

  • Heavy dependency on volatile transaction income and a relatively small group of very active customers for online brokerage
  • High fixed cost base (infrastructure)
  • Still not enough volume to make optimal use of economies of scale

While IB’s fixed cost base is without a doubt higher than Binck’s their strengths are basically Binck weaknesses. They do have economies of scale and because of the rapid growth in customer accounts this competitive edge is only getting bigger. At the same time, they have an offering that is especially well tailored to the most valuable customers of other brokers. Binck’s risk is Interactive Brokers opportunity.

I think that looking at revenue/employee is a useful exercise that shows the combined impact of higher automation and having active customers at IB. They are generating by far the highest revenue/employee while – based on revenues – they are just a small brokerage. The fact that Binck is lacking economies of scale also shows nicely in this table:

Broker revenue per employee comparison

While Binck ($600M market cap) is of course very small compared to TD Ameritrade ($20B), Schwab ($39B) and E-Trade ($8.0B) I actually think that they probably don’t differ that much with regards to the type of customers that they have and attract. I bet they are also making the most money from a relative small number of active accounts: accounts that can gain a lot by switching. The latest presentation of IB has a nice slide that shows that many customers are indeed price sensitive and switching from the big US brokers to IB:

Effect of IB's low margin rates

What we see here is that IB has rapidly taken a large part of the pie, and for a good reason because IB offers margin loans at rates that are a magnitude lower than the competition. Customers that use margin are presumably predominantly the more sophisticated active traders. At the same time, this data point is not good news with regards to IB’s growth prospects since it seems that they have already managed to grab decent market share in the US. Tripple IB’s size and they have 100% of this market: that’s never going to happen.

Growth prospects

Luckily for IB the market is bigger than the US. Interactive Brokers already gets ~50% of revenue from outside the US, but I suspect that that number has a lot of room to grow. A large part of the readers of this blog are from the US, and I think that they probably don’t realize how good they have it with regards to broker options. Brokers like TD Ameritrade and Fidelity might not be cheap, but at least they are somewhat reasonable and not total crap. In many European and Asian countries, there are really no solid options. You get crap trading possibilities combined with sky-high fees for everything. I think that this is driving IB’s impressive growth in Asia:

Geographic shift IB customers

How far they can continue to grow is a tough question. IB’s CEO, Thomas Peterffy, is very bullish, expecting accelerating growth in the near term and a long runway. From the Q4 results conference call, when asked about account growth:

Thomas Peterffy – Chairman and CEO
All I can tell you is that I am surprised that it’s not ramping up faster. So I think that next year will be over 20%. That’s what I think.

And from the Q3 results conference call:

Thomas Peterffy – Chairman and CEO
Well, if you really want to know my honest opinion, I think that in 10 years we could be the biggest broker in the world, and I am not kidding, because our technology is way out ahead.

One thing to realize is that a growing number of customer accounts doesn’t directly translate into profits. The first graph that I posted in this article looked pretty sweet, but when we look at the number of trades that customers make we see that growth is lower and less consistent:

IBs growth in DARTsIt makes sense that the average number of daily trades is way more volatile than the number of accounts since it depends heavily on market volatility: clients don’t trade if nothing is happening in the market. But I do think it is telling that DARTs have grown at a CAGR of 8.8% since 2008 versus an account growth rate of 16.8%. I think that many of the most active traders have already made the switch to IB years ago: a lot of the low-hanging fruit has been picked.

The second major component of IB’s income is interest income and this source of revenue is better correlated to the number of accounts since IB’s customers use roughly 30% margin as percentage of their equity. Thanks to rising markets IB’s customers have steadily increased their average equity per account. Of course, there is a risk that a new crisis can undo all these gains. In 2014 approximately 56% of brokerage revenue consisted of commissions, 36% interest income and 8% other.


When valuing a growth stock I think it is often most useful to reverse engineer what kind of assumptions are required to justify the current market price, and see if you think those assumptions are (at the minimum) reasonable and something you can be comfortable with. Before we start with that we first need to understand IB’s corporate structure:

Corporate structure Interactive Brokers

The publicly traded stock is just a small part of the whole company, the remainder is still owned by Thomas Peterffy. The current market cap of the whole company is $13.6 billion, but this also included a market making unit with a book value of $1,036 million that consists of liquid securities. The market making unit is still generating a solid profit, but is at the same time struggling a bit in recent years because of competition from high-frequency traders. Simply valuing the market making business at book value is reasonable I think.

So that leaves us with a $12.6 billion value for the brokerage business, a segment that managed to generate $588.5 million in pretax earnings last year. IB is currently paying a tax rate of less than 10%, but as far as I understand that is caused by the fact that the company doesn’t recognize the tax payable by the IBG LLC partnership. Accounting for the fact that IB does a lot of business in foreign countries with a low tax rate, I think that using a 25% rate is reasonable.

A simplistic valuation can be made with the H-model that assumes that the initial high growth rate linearly declines in a certain number of years to a long-term growth rate. When we make the simplifying assumption that earnings are roughly equal to free cash flow we can use the following set of assumptions to arrive at a $12.6 billion valuation:

H-model valuation IB

It’s a very simple model, but I think these growth assumptions aren’t very aggressive nor is an 8% discount rate very low in today’s interest rate environment. The model also doesn’t account for operating leverage that is presumably present in IB’s business model.


IBKR is probably an interesting stock for people who specialize in buying growth at a reasonable price. The stock is not cheap, but you also don’t have to envision some extreme sky-is-the-limit story to justify the current price. One interesting question to ask yourself when you consider investing in IBKR: what’s your edge versus fellow investors? There are going to be a lot of smart investors who use the broker, understand their business model and know firsthand how they compare to the competition. IBKR isn’t some obscure stock that no-one knows about.


No position in IBKR

Senvest: invest in a great hedge fund at a big discount?

I know, I know, you are expecting a follow-up post on my Italian REIFs thesis, but a friend pressured me into looking at Senvest in the meantime. So blame him if this isn’t what you wanted to see ;). Anyway, the investment case for Senvest appears to be compelling. The company has a big investment in its own funds and a reported book value/share of CA$221 at the date of the latest quarterly report while the stock is currently trading for CA$166. This already represents a 25% discount, but the picture is probably a lot better because the main fund of the company has performed great in the subsequent five months.

NAV/share of the Senvest Partners fund increased 23.3% between 30 September 2014 and 28 February 2015. We can use this return as a crude measure to approximate the current book value per share of Senvest. Doing this gives us a book value of ~CA$272/share which implies a 40% discount. But it gets even better: those returns are measured in US$ while the company reports in CA$. With the US$ appreciating approximately 12% versus the CA$, we could be looking at a book value of ~CA$305/share and a discount of ~45%. That sounds pretty great for a hedge fund that has generated a >20% return since inception in 1997.

Figuring out if the company is a good deal at that discount should be a relative straightforward exercise. The value of their investments can be approximated by taking the current value, add a premium for estimated future alpha while applying a discount for operating costs and tax inefficiencies. The value of the business itself can be based on the amount of fees they generate. It’s a simple business model to understand, in theory…

Understanding Senvest

Unfortunately, the reported financials of Senvest are one major clusterfuck because they are required to consolidate their funds with the operating company. One of the results of the consolidation is that the management fee that flows from the funds to Senvest disappears since it is now an intra-company transaction. At the same time costs that were payable by outside investors appear on the income statement of Senvest. Economically it is of course not changing the situation: it just makes it harder to understand.

I think that the fees earned and the costs shared with outside investors are now reflected in “change in redemption amount of redeemable units”. But since the value of these units also change based on the returns of the fund it just becomes a gigantic mess. I don’t think it is possible to extract from the current financial statements the effective amount of the management fees that flow from outside investors to Senvest, nor is it possible to calculate what percentage of the incurred costs are paid by outside investors. But perhaps it’s my limited accounting knowledge that is the problem here, so if I have a reader that knows how to figure this out I’m all ears! Because what I want to know is basic: what kind of TER are you paying if you buy assets through Senvest?

Luckily the consolidation of the funds into Senvest is a new development, so we can just look at the income statement of Senvest for the year 2012 to get an idea of the costs of running Senvest. The funds lost money in 2011 and ended near the high watermark at the end of 2012, so it’s a good year to evaluate since it should represent, to some extent, fixed annual costs:

Income statement 2012

You can see the effects of the consolidation in the income statement. Total costs for running the company and the funds were CA$21,7 million and CA$3.3 million of those costs were borne by outside investors while the company also earned $2.7 million in management fees. Unfortunately (for us) those fees don’t all accrue to shareholders since the CEO of Senvest, Richard Mashaal, receives 40% of the annual fee through his ownership of the entity that acts as an advisor to the Senvest Master Fund and Senvest Israel Partners fund. This is however not visible in the above statement since it is accounted for as income attributable to non-controlling interests. So shareholders effectively only got CA$1.6 million in management fees.

If we add this all up we get effective annual expenses of CA$16.8 million of which $CA6.1 million are operating costs for the funds (interest, transaction costs and other expenses) while the remainder are the net costs of the employees running the fund. With an starting equity of CA$285 million and an ending equity of CA$359 million in 2012 that turns out to an total expense ratio of ~5.2%. You need to generate some serious alpha to overcome this hurdle!

And remember: this is in a year where the company didn’t earn, but also didn’t pay a lot of performance bonuses. When we look at 2013 there are almost CA$60 million in costs. If we adjust these costs based on the same split as in 2012 we get the following picture:

Senvest operating costs 2013

The high costs are mainly the result of the fantastic performance of their funds in 2013. The good news is that Senvest also generated CA$18 million in management fees for net yearly operating costs of approximately CA$34.8 million. During 2013 equity increased from CA$359 million to CA$630 million, which gives us an implied TER of 7.0%. A bit higher than in 2012, but it seems that the majority of the bonus payments can be netted out against the 1.5% + 20% fees that are payable by outside capital. Note that these numbers are without accounting for taxes. In 2012 and 2013 taxes accounted for respectively 1.0% and 2.5% of average equity.


Given Senvest’s track record it appears that they are worth their money since they have generated an annualized return of more than 20% since 1997. Unfortunately, the possibility that some manager is capable of generating alpha is not something I want to pay for since the base rate of this being true is extremely low. And while Senvests results sound great their strategy appears to be leveraged long, so risk-adjusted it’s probably less impressive.

When we see Senvest as an investment fund with a TER that varies between 5% and 10% the current discount suddenly looks a lot less attractive. It’s really unfortunate that they don’t have enough outside capital to generate a decent management fee that can offset their operating costs. I love buying assets at a discount, but not with this cost structure.

If you think that Senvest is capable of generating enough alpha to offset their expenses (or better) the company is probably a great investment at the current price point. Certainly could be the case! I’m not going to bet on it though.


No position in Senvest

Amaya: is PokerStars a high-quality, high-growth business?

A recent write-up on VIC describes Amaya – the new owner of PokerStars – as a high-quality and high-growth business. As a former professional poker player I have literally played millions of hands at PokerStars and I know firsthand how awesome they are compared to the competition. They have the best software, the best customer support and perhaps most important: they are reliable. Because of that (and being “flexible” in interpreting US laws) they have grown to be the biggest site, and I think it is unlikely that they will lose this position since running an online poker site is a business with strong networking effects and economies of scale.

As a poker player you want to play on the site where you can find the widest variety of games running at any time of the day. At the same time attracting new recreational players is one of the biggest expenses that new (and existing) sites incur, but as the biggest site you can spread your advertising costs over a larger number of customers. So I’m agreeing with a large part of the thesis that the author of the write-up summarizes as follows:

In what amounted to a back-door IPO for the dominant global player in online poker, The Rational Group—owner of PokerStars and FullTilt Poker—was acquired (closed August 1st, 2014) by Amaya, a B2B gaming solutions provider one-tenth its size. While the headline EBITDA multiple appears reasonable given online gaming comps, the true proforma profitability of the business is not widely understood: minimal taxes and CapEx means that virtually all of the EBITDA not consumed by interest becomes free cash flow. Given this, Amaya’s current $28 share price implies a 13x multiple on our estimates of 2015E FCF, which we view as very cheap for a company that dominates its global market (>60% of online cash poker games) and has been growing rapidly (PF 20% 3-yr revenue CAGR & PF 42% 3-year EBITDA CAGR). Moreover, we expect strong FCF growth to continue over the next several years through: (1) the addition of online casino games and sports betting to its poker brands; (2) organic growth of their existing offerings in this rapidly growing market; (3) balance-sheet deleveraging; and (4) expansion of their online poker brands into the US.

At the same time I also think that this thesis is horribly flawed, and the reason is simple: I don’t think online poker is a market with healthy long-term growth prospects. The question that the author fails to address is: what will happen to the business when the most popular poker variants are solved by the computer? This is not a question of if, but a question of when and there is a reason that people don’t play chess or backgammon online for money.

Earlier this year scientist announced that they have solved heads-up limit hold ’em. The most played poker variants are a lot more complex than that game, but years ago it was reasonable popular. While it wasn’t officially solved until this year no-one was playing it for significant amounts of money anymore because you would risk getting your ass kicked by someone who would be getting strategy advice from the computer. While no-limit – the most popular poker variant – is a lot harder than limit the computer is learning fast. PokerSnowie is a commercially available program that is already pretty capable and better than most humans.

I think there is a reasonable high probability that within five or ten years computer-assisted players will be too good and too widespread and that as a result PokerStars’ main business will collapse. Because of that risk I think it is foolish to pay a high multiple for the company.

Online poker illustration


No position in Amaya

Atlas Energy merger arb/spin off opportunity?

Someone on Twitter posted a slide from the latest investor presentation from Atlas Energy that piqued my interest. The majority of the company is being acquired by Targa Resources, but before the transaction is closed a small part of the company is being spun off to existing shareholders. Management seems to believe that the implied price of the new Atlas Energy Group is substantially below intrinsic value:

Atlast Energy Group implied valuation

The merger perspective

While this sounds great we have to realize that at least a part of the possible undervaluation represents a merger risk premium. The size of the risk premium should however be small since:

  1. Both stocks showed a muted market reaction when the deal was announced (so the downside should be limited as well)
  2. The deal is for a large part in stock so the price is automatically adjusted (to some extent) based on changing conditions in the oil and gas market
  3. Regulatory concerns should be zero given that we are talking about two relative small players in a commodity business (and the companies indicate in the merger agreement that no approval from any government authority is required)
  4. The merger agreement seems to be airtight since neither changes in market conditions nor extreme events such as disasters or the outbreak of war are valid events for termination.

The only negative is perhaps the fact that the termination fee is ‘just’ $53.4 million, or approximately 3.6% of the current deal value. If Targa Resources would really want to get out from the agreement they could do so. Since both stocks have moved in aggregate a limited about since the deal was announced in October, and with a very high correlation, I doubt that anything has changed so far that would lead to the acquiring party wanting to cancel the deal.

Since we are receiving one security with an uncertain value it is impossible to calculate what the potential return of the merger arbitrage is, but this might exactly be the reason why there is an opportunity here. People who ordinarily would play the merger arbitrage game might not enter because they don’t want a large exposure to the new Atlas Energy Group that cannot be hedged. At the same time the people who would want to buy just the new Atlas Energy might not be interested in the merger arbitrage game since you need a lot of gross exposure to ATLS and TRGP to buy a small new Atlas Energy position.


What the potential return is of the combined merger arbitrage/spin off depends of course critically on the intrinsic value of the new Atlast Energy. The management team seems to think that the disconnect between price and value is pretty huge:

Managements estimate of the new Atlas Energy GroupSome of these numbers are already outdated and a bit lower while other are potentially too optimistic, but if it’s roughly right you still get a great deal. The stub is currently trading for $4.21, so if it’s worth $13 you would be looking at more than 200% upside! That should give you some wiggle room to adjust certain items downwards.

Almost all value is related to Atlas Resource Partners. The company owns 100% of the General Partner (GP) Interest, 100% of the Incentive Distribution Rights (IDRs) and a 27.7% Limited Partner (LP) Interest. The limited partnership units are easy to value since they are traded on the NYSE under the ARP ticker. The general partnership units are also relative straightforward since they are entitled to 2% of ARP’s cash distributions. With ARP currently trading at a >19% yield I think we have to conclude that the current distributions are not sustainable, and that makes sense since oil prices have dropped a lot. Perhaps a bit crude, but if the current price is right a fair yield is probably roughly half the current yield. This would mean that the company would distribute approximately $100 million per year to LPs, and as a result the GP would be entitled to ~$2 million/year. This would also imply that the IDRs would be far out the money since they only start to generate cash flow at distributions of more than $0.47/quarter. This represent a yield of more than 15% at the current market price.

So I have a huge discrepancy between the fair value estimate from management and my own estimate. A $17 million revenue stream at a 20x multiple (pretty high) is worth $6.50/share. A $2 million revenue stream at a 15x multiple is worth just $0.60/share and would eliminate almost all upside even if we take all other estimates at face value (I think some need to be adjusted downwards, but not by a whole lot).

So I’m I being too pessimistic here? Is the market too pessimistic about ARP? The management team seems to think so if we believe the Q&A from the latest conference call (emphasis mine):

Thanks Lee. Well of course I think our latest acquisition demonstrated how we can actually grow, we expect profitably without issuing additional equity at these ridiculously low prices. Although one should note that the entire sector wrongly in my opinion is creating yields that are in double-digits. So that part is really foolish, but you will know more about the market than I do. But I do know that with the imagination as we’ve demonstrated one can do deals even where common wisdom would say you can’t do great deals. And I think our counter cyclical approach has proven to be very useful in the past and we’re just watching as the panic in the oil patch increases, we’re in a position now to diversify nicely.

Or are they perhaps right and is there here indeed a great opportunity? And if they are right wouldn’t it make more sense to buy ARP directly? What do you think?


No position in ATLS, TRGP or ARP at the time of writing.