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Interactive Upgraded to Outperform

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We are upgrading our recommendation on Interactive Brokers Group Inc. (IBKR - Free Report) to Outperform based on substantially better-than-expected first quarter results with the rebound of Market Making and continuous growth in Electronic Brokerage. The initiation of quarterly dividend was also an impressive move.

Interactive Brokers’ first quarter 2011 operating earnings per share came in at 41 cents, far better than the Zacks Consensus Estimate of 27 cents. This also compares favorably with the prior-year quarter’s earnings of 6 cents. Results for the reported quarter include the effects of currency translation.

Results benefited mainly from improved top line, which was dampened by higher-than-expected interest and non-interest expenses.

Despite declining market volumes, Interactive Brokers’ Market Making segment is positioned to improve on better revenue capture. The company is ready to withdraw certain less profitable products from this business to avoid risks.

We expect the company’s strategy with respect to structural changes in the business to bode well. On the other hand, larger average trade sizes continue to improve its Electronic Brokeragesegment results.

Starting second quarter of 2011, the company will continue paying quarterly dividend of 10 cents per share. This reflects management’s confidence on its capital strength for the long run. Management’s expectation to increase this dividend amount over time further gives us confidence on its capital efficiency.

Interactive Brokers’ position with respect to the interface of four broad historical trends is very impressive. The company has positioned itself at the crossroads of globalization, adoption of technology, spreading of equity culture and optimization of resource allocation on global electronic networks.

As part of its globalization, the company processes trades in stocks, futures, options and forex on more than 90 exchanges across 19 countries and in 15 currencies. Adoption of technology has resulted in increased profit margins for the company. Unlike many of its peers, the company has a very low level of compensation expense relative to net revenues, mainly due to its technological excellence.

On the flip side, according to Interactive Brokers’ latest dividend strategy, the regular quarterly dividend will be shelled out of its Market Making segment. As a result, the segment’s capital base could reduce over a period of time.

This segment’s failure to generate sufficient return to pay dividend will force the company to deploy its capital through dividend. This will, in turn, reduce its financial flexibility.

Also, Interactive Brokers’ revenue and profitability significantly depend on trading volume on the bourses. During 2010, total trading volume decreased 3.0% year over year. Though the scenario in the equity market has greatly improved since the financial crisis, a low volume in the U.S. or foreign securities and derivatives could have a materially adverse impact on the company’s business and financial conditions.

Moreover, Interactive Brokers is exposed to certain risks related to its international operations. During 2010, the company generated approximately 19% of its net revenue from outside the United States. Also, its operations are geographically diversified. The company generated 17%, 41% and 53% of its trading gains in 2010, 2009 and 2008, respectively, from operations conducted internationally.

Globally, the company faces uncertainty related to political, economic and financial instability; unexpected changes in regulatory requirements; some trade barriers; exchange rate fluctuations; and applicable currency controls. Volatility of the U.S. dollar against other currencies could be a near-term resistance to earnings improvement.

There are concerns related to the company’s dependence on IBG LLC and wide international exposure. However, its fundamentals remain strong with a liquid balance sheet, sturdy capital base and high barriers to entry.

Interactive Brokers currently retains a Zacks #1 Rank, which translates into a short-term Strong Buy rating. However, BGC Partners Inc. , one of Interactive Brokers’closest competitors, retains a Zacks #3 Rank (a short-term Hold’ rating).

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