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INNOVATION
& DESIGN Home Page Architecture Brand Equity Auto Design Game Room SMALLBIZ Smart Answers Success Stories Today's Tip INVESTING Investing: Europe Annual Reports BW 50 S&P Picks & Pans Stock Screeners Free S&P Stock Report SCOREBOARDS Hot Growth 100 Mutual Funds Info Tech 100 S&P 500 B-SCHOOLS Undergrad Programs MBA Blogs MBA Profiles MBA Rankings Who's Hiring Grads | | JANUARY 18, 2001 STREET WISE By Amey Stone Online Brokers: Is Not Bad Good Enough? Enduring the bear market and dot-com shakeout shows this business' promise. But only a few e-brokers will prove to be good investments
Although the downturn proves that online brokers have business models that work and are viable long-term, at some point there will be a shakeout. Nearly 150 online brokers entered the business in recent years. No way can they all survive and still make money (see BusinessWeek, 1/22/01, "Why E-Brokers are Broker and Broker"). Yes, in the near-term, results for the quarter ended in December, while weaker, are far from disastrous. But these firms may need to do some drastic belt-tightening to keep investors happy during a bear market. And their business won't be booming again until the bear market is more memory than reality. Ameritrade Holding Corp. (AMTD ) reported on Jan. 17 that in its latest quarter, it had widened its losses to $23 million, or 13 cents a share, from $21.7 million, or 12 cents a share a year ago. On a positive note, revenues were up 14%, to $131 million, vs. a year ago, and perhaps most important, operating margins grew 15%. And in part because it announced plans to lay off 350 employees, or 14% of its workforce, investors didn't punish the company for the bigger losses. ON THE REBOUND. Results for E*Trade Group (EGRP ) are due Jan. 24. Wall Street's consensus is for earnings of 1 cent a share, up significantly from a 12-cents-a-share loss a year ago. Knight Trading Group (NITE ), a market-maker that gets the bulk of its business from retail investors, on Jan. 17 reported earnings of 28 cents a share, down from 47 cents a year ago, but far better than the 22 cents Wall Street expected. All these stocks, including market leader Charles Schwab (SCH ) and TD Waterhouse (TWE ), posted gains on Jan. 17. Even before this encouraging sign on the earnings front, the stocks had rebounded off recent lows. At about 12.56, E*Trade is up nearly 70% year-to-date, and Ameritrade, now at 9.75, is up 40% this year. Like other members of the finance sector, they owe this bounce mainly to the Federal Reserve's surprise half-percentage point rate cut on Jan. 3. The move made the cost of money cheaper, and the consensus view in the market is that the Fed will cut rates again when policymakers meet in Washington at the end of January. That's not to say that the economic slowdown that prompted the cut doesn't count. Consumer confidence has plunged, and consumer spending has declined, suggesting "transaction levels aren't going to come back any time soon," says Erick Maronack, research director at investment management firm NewBridge Partners. TRADING RANGES. "We are seeing a rebound from some overly pessimistic views on these stocks," says Richard Repetto, an analyst at Putnam Lovell Securities. But the recovery will be relatively short-term, he says, given his expectation that stock performance will be less than stellar the next few years. Repetto predicts an 8% to 10% rise in stocks, at a time when investors had become accustomed to annual returns of 20% or better. Given that most individual investors trade when market momentum is positive, a weaker performance in equities will likely temper their enthusiasm for trading. He says of online brokers: "I think we'll see these stocks settle into trading ranges that aren't a whole lot higher from where we are right now." To be sure, while analysts see some positive trends for discount brokers -- such as growth in assets under management and diversifying revenue streams -- stocks in this industry move up when the overall market is strong. "You really need a sustained bullish market" for these stocks to outperform, says Scott Appleby, an analyst with Robertson Stephens. "You don't need a bull, but it can't be a bear." CUTTABLE COSTS. At the end of 2000, Appleby lowered his projection for transaction growth in online brokerages from 40% annually for the next three years to 20% to 25% a year. His favorite is E*Trade. He likes its recently announced acquisition of mortgage lender LoansDirect, and he notes that E*Trade Bank has more than $11 billion in assets. Appleby also likes E*Trade's operating flexibility, especially compared to its offline rivals, and he thinks it could easily increase earnings 100% if it dramatically cut costs. In other words, when online brokers cut staff, quality of service may suffer but customers probably won't bolt. However, traditional brokerages don't have that flexibility. Usually, when they cut the size of the workforce, they're laying off salespeople who often take clients and their assets with them. One of the biggest costs online brokerages face is marketing. "You strip out [those costs] and these guys have decent margins," says Repetto, whose top pick is TD Waterhouse. He says the company has a similar business model to Schwab, but at half the valuation, he thinks it's a better buy. Schwab is trading at about 40 times his estimate for 2001 earnings, while TD Waterhouse is at 20. Given its high stock price relative to other industry players, Wall Street is increasingly negative on Schwab, and many firms have lowered the stock's rating to a hold. Analysts say it's subject to the same pressures in a slowing economy as the other online brokers but the stock price hasn't adjusted. HEAVY METTLE. While E*Trade and Ameritrade are down 50%, Schwab's stock price is even with where it was a year ago. Still, in a wobbly market, it seems counterintuitive to criticize a stock for failing to drop like the rest. "The fact that it hasn't sold off is a good thing," says Maronak. He likes Schwab because its customer assets dwarf the competition. "Schwab looks like it still has the right recipe to compete with Merrill on one hand and contend with up-and-comers like E*Trade and Ameritrade," he says. Still, despite weaker financial results, online brokers are proving their mettle amid a bear market and the dot-com shakeout. If you think the market is headed higher this year, this might not be a bad time to buy for the long-term. But much of the recent optimism has been priced into these stocks, while there's still room for Wall Street to react negatively if surprised by disappointing fourth-quarter results in coming weeks. The bottom line in this bottom-line business: Publicly traded online brokers are here to stay. But if you want to invest in their future, choose your entry point carefully.  Stone is an associate editor for Business Week Online  | | |
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