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Interactive Reaffirmed at Neutral

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We reiterate our long term ‘Neutral’ recommendation on Interactive Brokers Group Inc. (IBKR - Free Report) , to reflect strong capital base and a liquid balance sheet. The company’s better-than-peer positioning and technological excellence make us optimistic. Despite these positives, we remain concerned about the Market Making segment’s ability to consistently generate sufficient returns to fund dividend payment.

Interactive has positioned itself at the crossroads of globalization, adoption of technology, spreading of equity culture and optimization of resource allocation on global electronic networks. Further, the company has a very low level of compensation expense relative to the net revenues, mainly due to its technological excellence.

Additionally, Interactive continues to explore opportunities in the faster growing markets. Thus, at present, more than 50% of the new customers are from outside the U.S, resulting in a larger diversification of revenues. With the Central Clearing Houses as its counterparties, sole trading with exchange-listed instruments and continuous monitoring of customer positions, the company has been able to restrict its credit risk to a great extent.

Moreover, Interactive’s robust capital base and liquid balance sheet with a low leverage set it apart from its competitors. The company was able to actively manage its excess liquidity and maintain significant borrowing facilities through the securities lending markets and banks. Also, from April 2011, the company started declaring quarterly dividend of 10 cents per share and since then has maintained the same level.

On the flip side, Interactive is exposed to certain risks related to its international operations. Globally, the company faces uncertainty related to political, economic and financial instability; sudden 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.

Further, Interactive’s dependence on IBG LLC remains a cause of concern. The company’s primary asset is its 11.9% equity interest in IBG LLC. Also, its controlling interest and related rights as the only managing member of IBG LLC make it dependent on revenue generation. If IBG LLC is unable to provide sufficient funds to Interactive Brokers to pay taxes or for any other purpose, the latter’s financial condition may suffer significantly.

According to Interactive’s 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. The segment’s failure to generate sufficient return to pay dividend will force the company to deploy its capital through dividend, thereby lowering its financial flexibility.

However, Interactive currently retains a Zacks #4 Rank, which translates into a short-term Sell rating. One of its peers, Knight Capital Group, Inc. retains a Zacks #3 Rank (short-term Hold rating).

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