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Online brokers turn sour
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April 30, 2001: 5:28 p.m. ET
Parade of bad news forces online brokerages to step out of the spotlight
By Lisa Meyer
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SAN FRANCISCO (www.redherring.com) - Like most dot.coms last year, companies like E*Trade, Ameritrade, TD Waterhouse, and Charles Schwab rode the Internet wave. But faced with falling profits due to decreased revenues from inactive investors, these online brokerages are scrambling to diversify their business models in order to find alternate sources of revenue.
Such a shift in strategy requires a certain level of maturity, points out Richard Repetto, analyst for Putnam Lovell, in a recent report. The brokerages must now increase the revenue yield per client: this transition will be the true test of whether their business models will work.
Parade of bad news
The parade of bad news from the brokerages has been relentless. All have announced staff cuts, either by attrition or through layoffs. Similarly, those that have already released earnings for their most recent quarter have reported big decreases in revenue due to lower trading volumes.
Ameritrade reported a loss of 9 cents per share in its fiscal second quarter (excluding one-time charges), compared to a 2 cents-per-share profit a year ago, as commissions and clearing fees fell 39.4 percent. Meanwhile, E*Trade's daily average transactions fell 42 percent year-over-year to 136,000, and its transaction revenues plunged 48 percent from a year ago to $131 million during its latest quarter. The company reported break-even results in the quarter, identical to a year ago.
TD Waterhouse, which is 89 percent owned by Canadian bank Toronto-Dominion (TD: Research, Estimates), recently reported that its average daily customer trading volume in March was 58 percent lower than a year ago and 14 percent below February's volume. It's expected to announce its fiscal second-quarter earnings on May 16. Even top online brokerage Charles Schwab announced a 51 percent year-over-year drop in its commission and trading revenues during its latest quarter. Earnings fell 65 percent to 8 cents per share, compared to 23 cents per share a year ago.
In an effort to offset these declines, Schwab (SCH: Research, Estimates), Ameritrade (AMTD: Research, Estimates), and E*Trade (ET: Research, Estimates) announced recently that they were cutting their advertising budgets by 10 percent, 25 percent, and 50 percent, respectively.
Many industry analysts wonder if the depressed stock market is the only reason for the slowdown in trading activity. These experts question whether too many self-directed investors who lost too much money last year will continue to trade independently. But at the same time, those who sought advice also got burned, critics argue. "No one won in the past market environment," says Ken Worthington, analyst at CIBC World Markets. "A lot of people will be changing chairs."
Indeed, despite the losses in average daily transactions and trading revenues, some online brokerages have seen an uptick in new accounts. Ameritrade opened 138,000 new accounts during its latest quarter, a 3 percent sequential increase. TD Waterhouse opened 57,000 new accounts in March, down 65 percent from a year ago but up 5 percent from February 2001.
"Self-directed investing is not going away," says Robert Sobhani, analyst at BofA Montgomery. "The migration of investors to online brokerages is happening because the commissions have come down." Indeed, 81 percent of all Schwab trades during its first quarter happened online, up from 79 percent during the same period last year.
Yet to address the needs of the gun-shy investor who lost a lot of money in the past year, many online brokerages are bolstering the amount and variety of data they offer, as well as tools to sort it, so that investors can make more intelligent decisions. Schwab has taken the lead in this area by acquiring U.S. Trust, an investment management company that offers financial planning services to the wealthy, last year. Both Schwab and Ameritrade offer mutual referral services with independent investment advisers. Such a service not only provides advice to clients, but also generates new accounts for the brokerages. In a joint venture with consulting firm Ernst & Young, E*Trade offers advice both online and in person.
Banks are the biggest threat
To be sure, all four of these online brokerages are scrambling for ways to grow. Some, like Schwab, are raising fees. Ameritrade, E*Trade, and TD Waterhouse (TWE: Research, Estimates) charge for accounts with low activity or low balances. "Such fees help to get rid of non-profitable accounts or turn them into profitable ones," says Mr. Worthington.
Schwab and Ameritrade are concentrating on attracting more active customers by acquiring direct access technology players CyBerCorp and TradeCast, respectively. Such trade-executing technology is popular among day traders and hedge fund managers who need to make quick trades. E*Trade, Ameritrade, and Schwab offer mutual fund services. With a program called OptionsLink, E*Trade manages employee stock-option programs, and through its recent acquisition of LoansDirect has penetrated the retail mortgage lending market. Both E*Trade and TD Waterhouse have banks which offer them access to customers who can be sold new services.
But the biggest threat to online brokerages comes not so much from each other as from large financial institutions like Citigroup (C: Research, Estimates) and Wells Fargo (WFC: Research, Estimates) that are beginning to move their businesses online. "A lot of their customers don't trade online yet, and they have larger marketing budgets," points out Mr. Worthington. "But companies like Ameritrade and E*Trade have been in online brokerage from the beginning. They have a formula that works."
But is that formula so difficult to replicate? At the end of the day, what do these online brokerages have to offer? Brand name, technology, and customer base. Large financial institutions like Citigroup already have the technology and a brand name. The only reason a large institution would need to acquire an online brokerage would be to gain customers. But even then big banks could simply wait for some of these pure-plays to fall by the wayside and then pick up their customers. "They can just wait until the weaker players go out of business and those customers will go to one of the dominant players," says Mr. Worthington.
If the economic downturn doesn't slide into a full-fledged recession, online brokerages can just cut their fat advertising budgets to offset any more revenue losses. But for the long term, investors should beware that some of these players might not survive. With $806 billion in assets in client accounts at the end of March, Schwab should no doubt be around. TD Waterhouse also shouldn't disappear, with Toronto-Dominion behind it and $154 billion in total customer assets at the end of January. But Ameritrade had only $23.5 billion in assets in client accounts at the end of last month, compared to E*Trade's brokerage assets of $41 billion. Many analysts believe Schwab is already priced to perfection, trading at 35 times estimated 2002 earnings, while TD Waterhouse is valued at just 24 times fiscal 2002 earnings estimates.
Looking at the two pure-plays, E*Trade trades at a 2002 P/E multiple of 38, while Ameritrade is also expensive, trading at 39 times estimated fiscal 2002 earnings. But E*Trade has successfully diversified its revenue base away from strictly online brokerage transactions, so that makes it a better bet than Ameritrade for a long-term investor. Still, in this environment, none of the stocks look tremendously attractive for the short-term. 
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