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Interactive Brokers Group, Inc. (IBKR) reported earnings in late April and beat analysts estimates hands down.  The company earned 66 cents a share compared to 31 cents for the first quarter last year which is good for an impressive 112.9% increase.  Net revenues were $528.4 million which compares to $330.8 million last year.  Despite the fact that the company is a brokerage by name, the majority of the income came through market making activities where traders make the firm money by offering liquidity to the market and taking advantage of the spread (difference between the bid and the ask price for financial instruments.)  The term “traders” is used lightly as more often than not, the trades are executed electronically with little or no human intervention.  Software is created to keep a tight grip on risk parameters so that there are very few unpleasant surprises that might be associated with a human trader taking too large of a position.

The market environment in the first quarter was extremely beneficial to IBKR as disconnects in the financial area led to increased volume traded and at the same time, the spread on many contracts widened significantly due to the volatility.  Interactive Brokers took advantage of this situation and this is accounted for in their attractive earnings numbers.  While the positive surprise is certainly encouraging, investors should be cautious not to extrapolate this type of growth out into the next several quarters.  While markets still continue to trade with more volatility than was seen over the past year, the second quarter has so far been more sanguine which will likely keep the company from reporting further significant surprises.

In one of the more unique offerings we have seen this year, management formally issued a tender offer for 50 million shares at a minimum of $33.50 per share.  On the surface, this does not seem like such an abnormal offer unless you note that at the time, the stock was trading below $28.00 per share.  But Interactive Brokers has been consistent in offering their stock in atypical formats.  Their decision to come public by using niche underwriters instead of the larger established Wall Street firms has likely played a part in the low amount of coverage received from analysts which in turn may have a negative effect on the stock price.  A careful reading of the IPO documents will uncover a plan to offer 12.5% of the company’s float each year for 7 years.  Management recently commented that the offering would hopefully increase the float to a level where more institutions would be able to participate in the stock.

Since the report, the stock has climbed into the low 30’s but still failed to cross the stated minimum price for the tender offer.  As such, the company has withdrawn its offer and has stated that it will not register another public offering until April 15, 2009.  While this likely increases stockholders confidence that their interest will not be further diluted, the thought of twice the number of shares hitting the market next year could still hang over the price and serve as resistance.

Still, the fundamentals are in place for this firm to grow rapidly over the next several years.  Diversification efforts have transformed the firm from one that trades primarily options, to an organization hat now only receives 40% of its trading gains from US options.  As its presence continues to grow in its 3 active continents, (North America, Europe and Asia/Pacific), the geographic diversification should continue to help groom a stable revenue base.  Risks appear to be well under control with the debt to equity ratio at a healthy 7.8%, and management noted that its only counterparty risk is with established clearinghouses instead of individual clients.

The stock trades just under 17 times this years expected earnings which is an attractive multiple given the strong profit margins and the expected future growth.  Volatility should remain in the market for at least the next several months giving the company a chance to capitalize on the next few quarters earnings announcements.  Since the immediate pressure from the stock offering is now off the table, it appears that this is an attractive time to pick up shares of this well run, growing company.

IBKR Notes

FD: Author does not have a position in IBKR

Additional Reading:

Andrew Horowitz with a great early call on IBKR

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Morningstar, Inc. (MORN) reported earnings late last week which were met with enthusiasm by investors. The company reported that although the first quarter had challenges relating to a volatile and declining market, the company still managed to grow revenues to $125.4 million which is 31.4% higher than last year. Their profitability was equally impressive with net income coming in at 47 cents per share compared to 33 the year before. Management noted that the results were driven by strength in investment consulting as well as the licensed data it sells to subscribers.

Although the 30% plus revenue growth looks very impressive on the surface, but after accounting for acquisitions over the last year, organic growth was only 17.4%. Currency translation also benefited the headline revenue number as the company has grown international sources of revenue. In fact, overseas revenue now accounts for about 25% of total revenue which is a testament to the diversification efforts of management.

While acquired revenue growth may not carry the same weight as organic revenue growth, management should be commended for their disciplined approach to acquisitions. At this point, the balance sheet is still very strong with $215 million in cash and investments. On the liability side there is no long-term debt which will give them flexibility to not only ride out a weak economic period, but enables them to take advantage of the situation by making long-term investments in new acquisition targets at a time when prices for these companies are very low.

The most recent major acquisition was a purchase of Hemscott and although this new company may not have as much in the way of additional revenue, Morningstar is getting a very attractive India data center which it should be able to leverage by storing more of its company-wide information in this centralized location. Hopefully this will lead to cost cutting measures which will improve the efficiency of the entire operation.

In reading a research report by WR Hambrecht, I became aware of a disturbing cloud on the horizon. Currently, Morningstar receives a good bit of business from major wall street firms who purchase research. The agreements are a result of lawsuits back in 2004 and as part of the settlement, companies such as Merrill Lynch and SmithBarney are required to offer their clients independent third party research for five years. Up to this point, the Hambrecht analyst believed that wall street would continue with the arrangement in order to stave off additional lawsuits in the future. But now that the firms are in more financial distress and are in cost cutting mode, there is more likelihood that the individual contracts will not be renewed. While this is an issue that will not actually occur until July of 2009, it is worth keeping on the radar as the stock price will adjust in accordance with future expected events.

While Morningstar is a very healthy company and has traded up very nicely in the past few days, the valuation is at a place where there appears to be a good deal of risk in the position. For those holding a long position with profits, it may make sense to take some gains off the table or to hedge the position by selling out at the money calls. For example, at the time of writing, one could sell the June 75 calls for $3.30 which helps to cut back a bit on exposure and gives additional premium to add to current gains. In conclusion, this is a strong company that should survive a weak global economic cycle, but the stock is pricey at this point and should be treated with caution.

MORN Notes

FD: Author does not have a position in MORN

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On Friday, investors in Dolby Laboratories, Inc. (DLB) were treated with a 10% gain as the stock rose in response to the firms earnings announcement.  The company reported numbers for its fiscal second quarter (ending March 31) and the results were quite impressive.  Revenue came in at $172.6 million which was up 34% compared to last year.  Net income was 56.8 million or 49 cents per share, good for a 44% gain over the same quarter last year.  Management cited broad strength across many global markets including PC, gaming and its broadcast business.

Listening to management’s commentary, its easy to see why revenues were so strong.  The company has its hands in a broad assortment of digital media which attractively diversifies the company’s offerings.  In fact, it is nearly impossible to buy a consumer electronic device that does not feature at least one license held by Dolby.  Of particular note, the company receives royalties for every version of Vista home premium or ultimate edition.  Also, blue ray has been dubbed the standard of choice for high definition home film medium and Dolby receives royalties from each of these players as well.  The company notes that notepads are just now beginning to be shipped with blue ray players and as this trend picks up, it will likely have a strong impact on 2009 revenues.   The company received the vast majority of its revenue from the license segment instead of products and service.  Since the license business carries higher margins, the profitability of the firm is very strong.

Some of the weakness on the product and service side stems from the company’s digital cinema business.  Currently there is $20 million worth of deferred revenue that was originally expected to be realized in the second half.  (Deferred revenue usually occurs when a company receives payment up front for a service or a product that has not yet been delivered.  Once the product is completed - or gradually as it is in the process of being completed - the company is able to book the revenue on the books as it has now been “earned.”)  It now appears that the revenue will not be able to be booked until the first half of fiscal 2009 as the equipment has yet to be completed and then must be certified by a third party in order to be deemed complete.  Management appears to be explaining the change as an issue with the timing regarding the third party.  While it should be any investors nature to be skeptical, management appears to be very conservative on other metrics which helps them hold credibility in this metric that is difficult to verify.

One such example of a conservative approach involves the company’s handling of a cash alternative held on the books.  A position of roughly $80 million in auction rate securities came to the forefront during the conference call.  The auction rate debt market has essentially “locked up” in recent months as liquidity has dried up and trading has come to a virtual halt.  While very little has changed as to the creditworthiness of underlying issuers, there is basically no way to get out of some of these securities.  Management took the prudent step of 1) disclosing the issue, 2) writing down the value by $3.5 million, and 3) reclassifying the position as a long-term investment from a short-term security.  While this particular instance should not be a major concern to investors, it is important to understand how connected different markets are, and how disconnects in one are of the financial world can bleed over into seemingly unrelated securities.

On the call, management was asked to comment on the current state of the consumer.  It was surprising to hear how upbeat their perspective was as literally no mention was made of any softness.  While management committed to governing conservatively and keeping close tabs on future changes, they were optimistic that notebook shipments would grow 10% over the next year and the guidance issued was relatively strong.  While this optimism doesn’t quite match what has been seen in other consumer discretionary sectors, technology is one of the stronger areas of the market and that may reflect similar underlying views by a broad cut of equity investors.

While there are considerable concerns regarding the state of the overall economy, Dolby appears to operate as one of the “best of breed” in the consumer discretionary category.  The stock is not immune from rises in the unemployment rate, or declines in consumer confidence, but at the same time they may receive more than their share of revenue from the economic stimulus package.  Since the company has revenue coming in from all corners of the world, they are less likely to get severely hurt by US weakness.  A global recession would certainly cause more of a struggle, but at this point there still appears to be solid if not a bit slower growth.

DLB Notes

FD: Author does not have a position in DLB

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Baidu.com, Inc (ADR) (BIDU) is the Chinese equivalent of Google Inc. (GOOG).  The company not only offers a search engine for users to find relevant internet content, but also hosts a suite of products similar to Google’s offering of productivity, entertainment, communication, and information products.  Most recently, Baidu has launched an instant message service and is currently in the testing stage.  In China, instant messaging is a reasonably professional way of communication and it is likely that this medium will be adopted by a large segment of the population.  While the service does not produce any revenue, it will go far towards expanding Baidu’s brand name and locking in users.

Late last month, the company issued its earnings report for the first quarter.  The results beat expectations with revenue up 108.4% over the past year to $81.9m (using a fixed currency translation), and earnings per ADR were 0.67 which compares very favorably to the 36 cents earned during the same quarter last year.  More importantly, the company issued forward guidance for the second quarter with expectations of $111 to $114 million.  This is above the consensus expectations and was enough to send the stock higher for the day.

Yet even with the positive numbers, there appear to be a few concerning issues arising.  For starters, management noted that there were 161,000 active online marketing customers which is only up 3.9% sequentially.  This hardly shows the kind of robust growth in new customers that one would expect from such a dynamic growth company.  While the quarter was not expected to be seasonally strong, this figure still stands out as less than impressive.  But the more pressing concern was the increase in Traffic Acquisition Costs (TAC).  This is the commission or portion of revenue that Baidu shares with its affiliates who drive traffic to the site.

Not only did TAC costs increase in nominal terms, the figure came in significantly higher as a portion of revenue.  Last year during the first quarter, traffic acquisition costs accounted for 10.3% of revenue.  In the same quarter this year the numbers were much higher at 13.3%.  That’s a nearly 30% increase in a major cost of good sold.  If this were a car manufacturer and the cost of steel rose by 30%, it would make the front page of every financial journal.  At this point, it appears investors are looking past this issue as the incremental revenue is garnering more attention and offering optimistic investors hope.

Another reason for investor’s optimism is the fact that the Olympics are just around the corner.  Expectations are high as the games have boosted the country’s economic status as well as its information flow.  Investors are right in believing that this period will offer the company excessive opportunities to rake in advertising revenue, but one has to begin to wonder if the good news is already baked into the price of the stock.  We may currently be in a period where investors “buy the rumor” only to “sell the news” once the higher revenue is realized.  In this business, it pays to look at each exciting story with a skeptical eye, especially when a stock is trading at an excessive multiple and running higher into a resistance area.

Finally, there are beginning to be some concerns about the possibility of competition stealing away incremental pieces of market share.  While BIDU certainly has the first mover advantage over competition, it is unreasonable to think that in this period of open technology and a dynamically creative workforce, new competitors could not begin to put together a product that rivals Baidu’s offering.  As Alibaba and Yahoo invest in their Chinese presence, and Google partners with China Mobile, it remains to be seen whether either of these competitors can begin to cut in on Baidu’s dominant presence.  It would appear unlikely that either would be able to eclipse Baidu’s solid lead, but even taking a few percentage points away could cause investors to hold a more cautious view and knock the ethereal multiple down a couple of notches.  I think it is time to exercise caution on Baidu and may possibly even consider shorting the name should the pattern begin to break down.

BIDU Notes

FD: Author does not have a position in BIDU, GOOG, or YHOO

Additional Reading:

Barrons on the Baidu earnings report

Bloomberg details Baidu’s numbers

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