(4,146 words) [IBKR]

Partly due to an exceptionally low volatility trading environment, which has made it difficult to earn profits and which Petterfy says may continue “indefinitely,” the company is winding down its options market making operations.

While the company will use the excess capital from market making to further support its brokerage operations, the latter was already heavily over-capitalized, so now there’s another $1.5bn in total capital from market making being heaped on top of the $3.1bn excess capital at brokerage?  While some investors have pointed to the possible distribution of this capital as a value unlocking opportunity, management has made it clear that a return of capital is not in the cards.  Furthermore, the discontinuation of market making means $39mn in recurring annual expenses related to personnel and technology (~3% of brokerage revenue vs. 60%+ existing brokerage EBIT margins) will be spilling over to the brokerage side, which mostly neutralizes the $49mn of incremental investment income from a 25bps rate hike (which benefit only attenuates as rates move higher).  If we back out excess capital, include ~$30mn in corporate overhead, and account for the market making expense spillover and the rate hike benefit, it looks like the stock trades at just under 15x brokerage segment EBIT (and 20x if we don’t back out excess capital), which would be quite cheap if high-teens account growth trickled down to comparable earnings growth….but, I have serious doubts about this.

The time series below shows that the 17% 10-year CAGR in brokerage accounts has resulted in a 14% CAGR in daily average revenue trades, with the growth disparity persistently widening over the last year or so.  Since 2014, brokerage accounts have grown by 44% while DARTs have grown by just 8%.

While most of this is due to unusually low volatility (the average VIX during 1q17 of 11.72 was -43% y/y and the lowest quarterly average in the last decade, against which DARTs were -12% and cleared DARTs / account -25%), I suspect that part of this can also be tied to a mix shift towards sleepier introducing broker accounts, whose trading activity also generates far lower revenue and dollar profit per trade.  As I wrote a few months ago:

The way the introducing broker arrangement works is that IBKR takes all the broker’s client trades and runs them through a volume tier that gives the broker very low rates, and those brokers in turn charge their clients what IBKR would have charged had those clients come to IBKR directly (the introducing broker keeps 2/3 of what the client pays, IBKR gets only 1/3).  My understanding is that although these accounts generate far lower revenue per trade, they are still quite profitable because they are unencumbered with recurring sales expenses (the introducing broker, not IBKR, interfaces with the end customer).  Still, even if these commissions came on at a 100% contribution margin, we can impute based on IBKR’s brokerage margins that they would still generate far less profit per DART than the average IBKR customer.  Furthermore, the ultimate customer being sourced from these introducing brokers is relatively less active in his trading.  This quarter IBKR’s average customer account transacted 400 times this year vs. 450 times the prior year and the average introducing broker customer spent $463 in annual commissions compared to $1,437 for the average direct individual customer.

There’s been a lot of focus on the deleterious impact of low volatility and price competition from other online brokers, but in my opinion, 1) volatility is cyclical and all else equal, today’s account growth sows the seeds for DART growth recovery when volatility normalizes and 2) the company’s cost advantage remains intact.  Even with various online brokers cutting their commissions in recent months, the margin loan and commission rates assessed by IBKR are still much lower.  And besides, IBKR isn’t even going after the same customer base as Schwab, Fidelity, Ameritrade.  The mix shift dynamic that I referenced above, however, is a problematic long-term issue since clearly these introducing broker accounts are not incremental to account growth (as evidenced by the consistent mid/high-teens y/y growth), trade far less frequently, and come at way, way lower dollar profits per trade.


This might be the only investable stock related to apparel-related brick & mortar retail that I know of.  Read my prior post ([ADS] Form vs. Function) to brush up on the business if you’re not familiar with it.  The Citron short report from August 2016 is sensationalized and click-baity….though, that’s not to say this company doesn’t have hair on it.

[Here is how the ADS’ revenue and adj. EBITDA is apportioned]
% total
Revenue Adj. EBITDA*
LoyaltyOne 18% 15%
Epsilon 30% 23%
Card Services 52% 62%
* less stock comp

On the surface, the stock trades at 15x 2017 EPS (after subtracting stock comp), with putative 20%+ growth in 2018 and beyond.  What gives?

Well, over 60% of the company’s profits derive from its private label credit cards business, which is considerably exposed to secularly challenged offline specialty retail (~30% of revenue comes from Ascena and L Brands) and has experienced elevated provisions over the last few years to boot.  Epsilon, a rather mediocre adtech/marketing business, has lost a few big customers, experienced pricing pressure and intensifying competition from SaaS competitors, and all around disappointed expectations quarter after quarter.  AirMiles (part of the LoyaltyOne segment) recently revised breakage assumptions [loyalty programs like AIR MILES make an estimate about the percentage of points issued that won’t be redeemed; the higher this number, the better – it’s pure profit] lower, resulting in significant margin compression.

I talked about the “delinquency wedge” in a prior post….

where I noted:

…if 2017 delinquency rates converge to 2016 delinquency rates as 2017 progresses, the y/y growth in credit losses should be flat, translating into a resumption of 20%+ earnings growth. But, why should we suddenly expect the wedge to close when the near-term wedge expectation – 1q17 – is so wide?  Well, apparently, if you look at the Trust data, the 2015 vintage went to loss pretty quickly and the co. says that at the 2-year maturity mark [so, 2017 for the 2015 vintage], the loss rates attenuate.

So the big idea here is that we shouldn’t freak out over the 50bps y/y increase in delinquency rates (from 4.3% in 1q16 to 4.8% in 1q17).  Per the above series, which management published in 3q16, this deterioration was exactly according to expectations, and as the “wedge” narrows (i.e. 2q17’s delinquency rate should only be +40bps above 2q16) throughout the year, provisioning expense growth should grind to flat in the catastatic act, which should allow a greater proportion of Card Services revenue growth to trickle down to EBITDA.

But private label revenue growth seems less likely to be what it was.  In halcyon days, a +3% comp from retail private label card customers would have translated into 8%-10% growth in ADS’ Card Services from tender share gains [that is, increasing penetration of private label sales within existing merchant customers], but negative retail comps all around now deliver something closer to +3% Card Services growth from tender share, pressuring the company to sign more new retail clients (2-3 more names/year than before) to compensate.  Even if ADS is successful in doing so (management believes it has only penetrated half its potential TAM), I suspect that on-boarding new clients requires higher sales and support costs than improving engagement at existing ones, so the contribution margins won’t be as strong and the mid/high teens EBITDA growth that the segment has experienced over the last few years will likely soften.

After a few tough years, Epsilon looks like it started to regain its footing this quarter.  The agency business fell off a cliff (-28%), but this is now an insignificant ~1.5% of ADS total revenue and the negatively comping adtech business (~1/4 of Epsilon segment revenue) should be flat by year-end as the company is seeing success with its CRM offering, which saw +47% growth this quarter on new client wins and a laddering up of sales to existing clients.

And finally, LoyaltyOne.  The company will try to pressure its rewards suppliers to make up for the lost profit from lower breakage assumptions, but I think it’s fair to say that margins here will be structurally lower relative to the past (it’s hard to compensate for revenue that carries 100% margins).

So I dunno.  On the one hand, 15x earnings is certainly attractive in this market given stabilizing trends in 2h17 and double-digit earnings growth beyond.  On the other hand, there’s a whole slew of negatives that cast doubt on management’s sanguine expectations of a 20%+ earnings “slingshot” (management’s words, not mine).  First, secular challenges in offline retail partially offset the share shift from mass marketing to targeted marketing and from general purpose cards to private label, not to mention cyclical concerns attending possibly peak credit cycle.  Is it realistic to expect flat delinquency growth over the next few years when money center banks have admonished higher credit card losses?  Second, the company has no discernable edge in the highly competitive adtech space, where it also apparently has outsized exposure to the auto vertical.  And finally, on LoyaltyOne, we’ll just have to see if the company’s margin recapture efforts at Air Miles materialize.


While the company pat itself on the back for adding 2.6mn cards on a gross basis this quarter even while cutting back on marketing and promotion expenses, recall that the company spent a massive amount on marketing (+35% y/y) the prior quarter.  And in any case, it’s the net adds that really matter and on that basis, it’s hard to argue that the company is getting a good return on its investment thus far.  On its earnings call, management remarked that attrition has been “remarkably stable,” but of course member rewards spending must be taken into account for this to mean anything.  From 2q16 to 1q17 (post Costco card loss), the company spent $2.8bn on marketing and promotion while its worldwide card membership base increased by 3mn.  Over the same period a year ago, AXP spent $2.5bn in M&P while card membership increased by 4.8mn.  So, more spending for fewer net subs.

On the plus side, the average card member spend increased by 11% y/y….but, I guess that’s expected given the 20% increase in rewards spending.

When we strip out Costco, it appears the company has been spending well ahead of billings and revenue:

(% y/y growth, ex. Costco, other)
3Q16 4Q16 1Q17
Gross billings 7% 7% 8%
Proprietary billings N/A 5% 6%
Revenue 5% 6% 7%
Marketing and promotion 10% 35% -4%
Card Member rewards N/A 13% 20%
Card Member services and other 3% 19% 14%

It’s quite possible I’m making something out of nothing (I do that sometimes).  After all, it’s only been a few quarters.  But, for now, I stand by what I wrote in my last AXP blurb:
The company points to its reduction non-marketing/rewards costs over the last year, but it has more than recycled those savings into higher marketing spend and more generous rewards and card member services.  Some of the elevated marketing costs probably represent 1-time marketing splurges, but given the competitive card environment (not to mention the larger, longer-term threat of PayPal and other payments facilitators taking share on- and off-line), my expectation is that these promotional costs continue to grow – perhaps not by mid to high-teens, but by enough to mostly offset incremental opex saves.  It seems that “brand” is not the competitive differentiator it once was in the payments space and that the industry will have to increasingly compete on the basis of rewards and user experience.

Speaking of which, there was a widely-circulated New York Times article discussing the waning appeal of the Amex brand to millennials that is well worth the read.  Here are some excerpts:

Millennials, however, don’t really need travel agents or concierges: They have Priceline and Yelp. Nor are they traditionally fans of opera, ballet, Dom Pérignon tastings, or the other high-culture events Amex can get cardholders into.

This is the real reason Amex’s executives became so worried when they heard about the dinner, one of multiple held by Chase, when a cardholder said his Sapphire card made him more interesting. American Express, for decades, has essentially sold snob appeal. But for millennials, snobbery isn’t quite as appealing as it once was. Or, more precisely, snobbery has to be hidden and camouflaged as something else, like an Instagram post from your Iceland spelunking adventure or a lament about how hard it is to find a charging station near Burning Man for your electric sports car.

The Chase Sapphire Reserve — which in the seven months since it was released has signed up more than a million cardholders, half of whom are under 35 — is all about emphasizing what cardholders can do, rather than what they can buy.

“The message we send is, this isn’t your father’s credit card,” said Pam Codispoti, who created the Chase Sapphire Reserve after 18 years at Amex. “For millennials, travel might mean taking an Uber to a hole-in-the-wall restaurant in Chinatown, and then riding the subway to karaoke, and then catching a taxi home. So we’re going to give you accelerated travel points on all that. This is a card for accumulating experiences.”

…it’s an uphill battle for Amex, in part because the company is fighting an image of conspicuous consumption it has cultivated for decades.

…many people who work at American Express aren’t all that millennially minded themselves. If you visit Amex’s headquarters in Lower Manhattan, you’ll find squared-jawed men in bespoke suits and fashion model-glamorous women, but not a lot of young people in the uppermost ranks. The company’s chief executive, Kenneth I. Chenault, has led Amex for almost 16 years, an eternity in corporate America. In one Amex brainstorming session, according to an executive I spoke with, participants spent 10 minutes trying to figure out what FOMO meant before turning to Google.


Despite its 50%+ run-up over the last year, the stock still looks reasonably priced at 0.9x TBV / 1.3x BV and 14x LTM earnings given the company’s solid and improving fundamentals.  Return on tangible equity (10.3%) and return on avg assets (0.9%) continues to gradually but steadily accrete towards a 12% and 1% target, respectively, on strong core loan and deposit growth, cost rationalization, and higher short rates.  Compared to the retail banking segments of money center peers, BAC’s has witnessed faster annual and sequential loan growth and together with JPM, has taken deposit market share.  Importantly, these are high quality deposits – half are checking accounts and nearly 90% of those checking accounts are primary (i.e. operational accounts used to pay the bills and less likely experience outflows in the face of rising rates).  BAC, like its peers, has seen very little change in rates paid on consumer and small business banking deposits (avg. deposit costs +7bps y/y and +5bps q/q), so the substantial majority of rate hikes have flowed through to earnings.  Most of the 7.4% q/q increase in net interest income was due to higher rates.

Avg. Deposits Avg. Loans
Consumer banking
BAC 10% 3% 8% 2%
C (North America) 3% 0% 5% 1%
JPM 11% 3% 5% 0%
WFC 5% 1% 0% -1%
[Aside: In JP Morgan’s 2016 annual letter, Jamie Dimon noted the industry-wide disparity between deposit growth and loan growth….

….placing much of the blame for ineffective monetary policy transmission (of which the divergent lines are a symptom) on a slew of sloppily conceived and restrictive capital and liquidity rules, which, to cite just one consequence, have supposedly curtailed $1tn of mortgage lending (of 3mn loans, ex. subprime and Alt-A) over the last 5 years, which JPM thinks could have otherwise contributed 50bps to GDP growth in each of those years.]

Despite concerns around a slowing auto market, BAC’s auto lending was +12% y/y as its loans continue to be focused squarely on prime/super-prime and carry lower charge-off rates than peers.  In contrast, WFC’s auto loan originations were -29% y/y as it has tightened credit underwriting standards in response to rising delinquencies.  Note that KMX (below) has seen a bifurcation in the auto lending market for a few quarters now, with a pronounced contraction in subprime offset by growth in prime.

As mentioned in a prior post, BAC trades at a discount on TBV relative to JPM and WFC because of its relatively low current returns on equity, but between greater than industry average loan growth and exposure to rate hikes (a +100bps hike in short rates could translate into a hsd boost to after-tax earnings over a year), and opportunities to further rationalize the cost structure, returns seem likely to continue trending the right way, which could contribute to a re-rating.

P/TBV 1.3x 0.9x 1.6x 1.8x
Efficiency ratio 67.0% 58.0% 61.0% 62.7%
CET1 Ratio 11.0% 12.8% 12.5% 11.2%
ROTE 10.3% 8.5% 13.0% 13.9%
ROA 0.88% 0.79% 1.03% 1.15%


With all the amplifying noise surrounding used car surplus and attendant price weakness, there are two points worth making.  First, this is a spread based business.  What matters is not the price at which KMX sells the car to the customer but rather the gross profit dollars that the company pulls out of each car it sells – which is a function of both the price KMX sells the car to the consumer and the cost of the car to KMX – and how quickly it sells those cars.

You can see below that gross profit/used vehicle sold has been remarkably stable for years:

FY10 $2,072
FY11 $2,156
FY12 $2,177
FY13 $2,170
FY14 $2,171
FY15 $2,179
FY16 $2,159
FY17 $2,163

$GP/unit during the most recent quarter of $2,134 represented the 24th straight quarter where $GP/unit remained between $2,100 and $2,200.  Even during the GFC, when KMX’s average unit selling price declined by ~20%, the company still maintained its GPUs at pre-recession levels.

Given the unsavory and anachronistic reputation typically assigned to used car dealers, you might be surprised to know that CarMax actually has a very sophisticated buying and pricing operation.  Everything from inventory turns on vehicle types, reconditioning costs for each vehicle, the length of time each vehicle sits on the lot (tracked through RFID tags), the time of day that test drives occur, customer feedback, current auction data, and historical data on how quickly each car sells and at what margin, are fed into proprietary algorithms that allow the company to adjust retail pricing daily according to local market conditions and its buyers to bid prices on models appropriate to what the company is seeing across its 173 stores.  Relative to less sophisticated peers, KMX can even pay up for inventory and still generate better returns because it turns inventory so much faster.

The second point is that used car prices do influence recovery assumptions and thus impact the financing side of the business, which funds nearly half of the company’s used car sales.

During the most recent quarter, used unit comps accelerated from 0.7% last quarter to 8.7% on strong conversion (better online experiences, including new online finance pre-qualifications, search engine optimization, and more recently, an online appraisal pilot) and a modest boost in store traffic, driving market share gains of 0-10 year old vehicles by ~2% in its comp markets (KMX’s share in comp markets is only 4%-5%, so still plenty of room for penetration).  The strong comp was again driven by strength in non-Tier 3 customer comp of +15.3% (the best in many years and vs. +9.8% last quarter) offset by headwinds in Tier 3 [Tier 3 is essentially sub-prime, < 550 which typically has 10x the losses vs. the rst of CAF (KMX’s internal financing arm).  Most of this lending is outsourced to third-parties.  Beginning January 2014, the company started originating its own Tier 3 loans, but at only 1% total used units sold and 5% of total Tier 3 loan volume, CAF’s participation in this segment is small.  CAF makes up about half of all used vehicle sales, with 25%-30% financed by third parties to whom KMX pays a fee and the remaining 20%-25% from customers who pay cash or arrange their own financing.  CAF gets first dibs on lending to a customer; if that customer doesn’t meet CAF’s criteria, it gets chucked to Tier 2 and 3 lenders].  As has been the case for the last year, increases in credit applications from higher-end credit customers have been partially offset by contracting volumes at the lower tiers, with Tier 3 particularly impacted by tax refund delays (according to IRS data, down 10% y/y in late Feb).

Financing income declined 10% y/y with average managed receivables growth of +11.5% offset by higher provisions (loan loss allowances tick up to 1.16% from 1.1% last quarter) and slightly lower net interest margins.

So, there are really 2 concerns to consider here: 1) lower recovery values translating into higher provisions, which directly impacts CAF earnings and 2) a broader slowdown in credit applications (beyond Tier 3) or tighter underwriting, which leads to decelerating unit comps.  This is exactly what happened at CONN, a furniture and electronics retailer that internally financed its sales (albeit, to a subprime customer base; CAF’s loans are predominantly prime).

Wholesale vehicle unit sales (older vehicles sold into auction and which represent ~14% of car revenue and ~37% of units, continued to be challenged by a shortage in 7-9 year old cars (an aftershock of the decline in new vehicle sales during the GFC), which also tend to carry the highest unit $GP and so dragged down gross profit/wholesale vehicle from $1,005 last year’s 4q to $938 this quarter.  But, this supply issue should naturally correct as it reflects the recovery in new car sales post-2008/2009.

The company continues to expand the store base by ~7%-8%/year, though a good chunk of these new stores are in lower population MSAs (so, expect fewer units sold / store).

Stock is down 10% ytd; trades ~18x trailing earnings.


On 4/10, SVU announced that it would be acquiring Unified Grocers, a grocery wholesaler co-op (customers who make > $3mn in purchases are required to be members) on the west coast that distributes a variety of goods (frozen, ethnic, gourmet; 2/3 perishables, 1/3 non-perishables) and provides various support services to supermarkets, convenience and specialty stores, and restaurants.  SVU is paying $114mn in cash, assuming Unified’s $261mn in debt, and incurring $60mn in one-time charges on the path to realizing $60mn in year 3 run-rate synergies.  So, after tacking the one-time charges onto the purchase price, SVU is paying 11x Unified’s pre-synergy and 4.4x post-synergy LTM EBITDA and bringing consolidated leverage up half a turn (to ~3.5x).

Unified’s operating results look pretty spotty, with the number of Members (who constitute 70% of sales) declining every year since fy08 at a ~5% clip.  There was also an independent audit investigation conducted by the Board in 2014 relating to the setting of reserves at the company’s former insurance subsidiaries.  Unified sold its insurance subsidiaries to Amtrust in 2015, but based on my read of the footnotes, it looks like Unified may be on the hook for certain reserve deficiencies for a 5-year period after the sale.  I don’t know where this agreement stands post-SVU acquisition and management didn’t address it on the call.

As you well know, the grocery industry has recently faced intense pressures on multiple fronts: specialty stores and small-format chains are devoting more floor space to the grocery category, Wal-Mart is pricing more aggressively, online ordering and direct delivery is becoming increasingly viable, and consumer shopping patterns are getting more fragmented.  This has spurred consolidation among traditional grocers, with independent retailers being gobbled up by larger peers who can leverage their own in-house distribution capabilities, pressuring wholesalers in turn.  SVU’s wholesale segment EBITDA margins, about flat over the last 2 years, have held up pretty well through all this, but there’s little doubt that the competitive landscape is only getting tougher, and grocery wholesalers will need to consolidate further to remain competitive and meet the needs/offset the bargaining power of their fewer but larger retail customers.

SVU also has a retail grocer division (40% of SVU’s segment EBITDA), about which I previously wrote on 1/13/17:

Retail has been more of a train wreck, with persistently negative msd comp sales and customer traffic declines.  I have written about the havoc that the deflationary environment, escalating competition, and SNAP benefit cuts have had on the grocery sector here, here, here, and here.  Its banners continue to feel the impact of lsd cost deflation and new competitor store openings in markets enclosing 2/3 of SVU’s store base (with increasing price competition from both mass retailers and traditional grocers), and if these challenging trends continue, it will have a spillover effect on the wholesale side.  EBITDA margins have compressed from 5.9% in fy14 to 3.9% LTM, and EBIT turned somewhat negative over the last 2 quarters (though still EBITDA profitable), and the segment is barely generating cash on an EBITDA – capex basis.  If store refreshes fail to reverse comp declines, we should probably expect the dual pressures of top-line weakness and capex intensity to result in cash burn at some point soon

And competitive landscape for grocers is only getting more competitive.  According to this PYMNTs article, Walmart – who wants its prices to be “15% lower than its competitors 80% of the time” – is testing price cuts on grocery goods int he Midwest and Southeast, with the aim of setting prices at a mid/high single digit discount to peers.  Retail food prices fell y/y in March for the 16th straight month.

Here’s what the wholesale divisions of the combined company looks like:

SVU Unified
(Wholesale) Grocers Combined
Sales          7,652.0          3,748.6        11,400.6
EBIT              224.0                   9.6              233.6
% margin 2.9% 0.3% 2.0%
EBITDA              267.0                39.6              306.6
% margin 3.5% 1.1% 2.7%

If we value the challenged grocery segment at $900mn (~0.2x sales / 5x EBITDA), the implied valuation on the remaining wholesale business is 6x synergized EBITDA / 7x EBITDA – MCX.  “Cheap” in this market….likely for good reason.