Discount Brokers Feel the Pinch


By Justin Hibbard Like many individual investors, Gordon Feller has been sitting on the sidelines for four years. Through a bear market and recovery, his modest assets have gathered dust in accounts at Charles Schwab (SCH). This year, though, the San Rafael (Calif.)-based consultant plans to resume trading stocks -- but not necessarily with Schwab. Instead, he's bargain hunting, as price cuts sweep the discount-brokerage industry. He's wants "good pricing on commissions but also the added services I'm looking for," such as wealth management.

Don't call it a price war. Discount brokerages prefer the euphemism "pricing pressure." But whatever it's called, commission fees are tumbling. And brokerages are relying more than ever on income from sources other than trading. That has renewed discussion on Wall Street over whether these firms are properly valued.

SHRINKING COMMISIONS. As brokerages earn an ever greater chunk of their revenues from related businesses such as banking and mutual funds, some analysts believe the companies should be valued more like banks and asset managers, which typically trade at lower multiples than brokerages.

The shift toward nontrading revenues over the past decade has been dramatic. In 1994, Schwab derived 51% of revenues from trading commissions. Then, "we started to migrate more of our business toward asset-management fees and net interest income," says Christopher Dodds, Schwab's CFO.

This year, Schwab will earn just 16% of revenues from commissions, the rest coming from things like mutual-fund sales fees and interest on margin accounts. A similar shift occurred at rival E*Trade (ET), which in 1994 pulled in 88% of revenues from trading commissions and order flow. Since then, it has expanded into banking and asset management, and this year's commissions will make up 22% of revenues.

INCREASED URGENCY. Some discount brokerages are accelerating the change. Ameritrade (AMTD) is throwing resources behind Amerivest, its online portfolio advisory service, to gather more assets and fees. It expects to earn roughly 64% of revenues from trading commissions this year, more than its closest competitors.

Though Ameritrade performs about 70% of its customers' transactions, it manages only about 25% of their assets. "That tells us they have their equity-trading execution money with us, but their serious investment money elsewhere," says Ameritrade CEO Joe Moglia. Now the goal is to attract more long-term investors through Amerivest, which offers fee-based services like investment advice.

The quest for fee revenue has gained urgency as the drumbeat of commission price cuts has quickened. This week, Schwab eliminated service fees on brokerage accounts for customers with $25,000 in assets -- just three months after the firm lowered online-trading commissions from $29.95 to $19.95. On Jan. 1, Scottrade slashed commissions on limit orders from $12 to $7. Last month, Ameritrade began testing IZone, a bare-bones service that offers online trades for $5 apiece. E*Trade says it will lower commissions for its best customers later this year.

CHANGING PERCEPTIONS. The volume of retail trading is increasing as investors return to the markets. But hopes for a spike in commission revenue have been dampened by price competition. This week, Schwab reported that the number of daily average revenue trades in the fourth quarter rose 38.5% from last year. But that's 17% faster than the rise in commission revenues during the same period.

"It's now clear that the price war that Schwab's new strategy set off among the online brokers is constraining the growth of the firm's commission revenues," wrote Brad Hintz, an analyst at Sanford C. Bernstein & Co., in a research note released Jan. 19.

Beyond the dim outlook for trading revenues, perceptions of discount brokerages are changing. On Jan. 3, Friedman, Billings, Ramsey Group analyst Matthew Snowling downgraded Schwab to underperform, declaring its price-earnings ratio of 25 too high. "Through a series of defensive moves, Schwab is slowly changing its business mix to one that may be more stable down the road, but also inhibits its growth potential," Snowling says, referring to Schwab's shift toward asset-management fees.

SPECIAL TALENTS. Discount brokerages have often commanded p-e ratios in the 20s -- a premium awarded because surges in retail trading can suddenly boost their earnings. But because trading levels and commission prices can crash just as fast, brokerages have worked to become less dependent on commissions. That stability comes with a price: Because asset managers' earnings tend to grow more slowly and predictably than those of brokerages, investors typically grant them p-e ratios in the high teens. For example, money-market fund manager Federated Investors currently trades around 17 times earnings.

Some investors may be willing to pay a premium for the special talents of individual firms. Schwab, for instance, has distinguished itself with an uncanny ability to gather assets -- it currently manages over $1 trillion in assets, which compares to roughly $80 billion each at Ameritrade and E*Trade. "Schwab's premium valuation is based on a superior business model," says Kenneth Worthington, an analyst at CIBC. Similarly, E*Trade attributes its premium partly to its use of technology to integrate various financial services such as banking and trading, says Jarrett Lillien, the company's COO.

Yet investors inevitably lump companies into categories and value them according to their peer group. As long as discount brokerages continue to diversify, the valuation question likely will persist. Hibbard is a writer for BusinessWeek in the Silicon Valley bureau


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