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On Mar 14, 2013, we downgraded Interactive Brokers Group, Inc. (IBKR - Analyst Report) to Underperform based on the company’s lower-than-expected fourth quarter 2012 results and disappointing performance of the Market Making segment. Moreover, the company has delivered an average negative surprise of 20.4% over the past 4 quarters.

Why the Downgrade?

On Jan 15, Interactive Brokers announced its fourth quarter 2012 earnings of 19 cents per share, which lagged the Zacks Consensus Estimate of 21 cents. Further, Net revenues of $247.1 million were 9.5% lower than the Zacks Consensus Estimate of $273.0 million.

According to Interactive Brokers’ latest dividend strategy, the regular quarterly dividend will be paid from its Market Making segment. As a result, the segment’s capital base could decline over a period of time. This segment’s failure to generate sufficient return for paying dividend will force the company to deploy its capital for the same. Consequently, the company will lose its financial flexibility.  

Causes for Concern

Interactive Brokers’ 11.9% equity interest in IBG LLC is also an area of concern. Also, its controlling interest and related rights as the only managing member of IBG LLC makes it dependent on revenue generation.

The company incurs taxes on its proportionate share of the net taxable income of IBG LLC and incurs expenses related to its own operations. If IBG LLC fails to provide sufficient funds to Interactive Brokers to pay taxes or for any other purpose, the latter’s financial condition may suffer significantly.

Increasing number of high frequency trading firms (HFTs) are resulting in additional competition for the Market Making segment of the company. Unregistered HFTs are not exposed to all the regulatory restrictions which are applicable to the registered market makers. This leads to faster and cheaper trades on some exchanges by these HFTs, which could take a toll on Interactive Brokers’ business in the future.

Stocks That Warrant a Look

While we prefer to avoid Interactive Brokers shares until we see signs of improvement in the company's performance, other financial institutions that are worth considering include Evercore Partners Inc. (EVR - Snapshot Report), Morgan Stanley (MS - Analyst Report) and Piper Jaffray Companies (PJC - Snapshot Report) . Evercore and Piper Jaffray carry a Zacks Rank #1 (Strong Buy), whereas Morgan Stanley holds Zacks Rank #2 (Buy).

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