Ya want more "choice words?" Hitting the Wall As online-trading growth slows, does a shakeout loom?
By Michael Santoli
Wall Street's mouse-clicking brigade of online stock jockeys is having a
harder time luring new enlistees than it has at any point since the
dream-peddling ads of Internet brokerage firms began swarming the
prime-time airwaves a couple of years ago. After chalking up skyrocketing
sequential increases in trading volume of 47% in the first quarter and 34% in
the fourth quarter of 1998, the number of keyboard-driven trades in the
second quarter is estimated to have risen by a decidedly more terrestrial 15%,
according to Credit Suisse First Boston analyst Bill Burnham. Helping to bear
out Burnham's forecast, Charles Schwab Friday said the number of trades it
handled last quarter was merely "comparable" with the prior three month's
volume. And Ameritrade, one of the faster-growing publicly traded Internet
brokers, last week issued a quarterly earnings report that, while showing net
income solidly ahead of expectations, noted that its average daily trade tally
was up 14% from the previous quarter's.
Now, that rate still represents brisk
growth and ensures that the online medium
will continue to win market share from
more traditional modes of investing. But,
side by side with numerous other
challenges now faced by the online
brokerage business, the swift deceleration
in volume growth could portend a tougher
climb for cyber brokers, particularly those
that haven't yet built dominant market
positions.
Internet-focused discount brokers have
aggressively lured investors away from full-service brokers and the earlier
generation of branch-based discounters, while picking up the business of the
novice investor dazzled by the bull market. But there are signs that the
low-hanging fruit has mostly been plucked, especially when it comes to the
most attractive and potentially lucrative customers.
A recent survey by J.D. Power & Associates
conducted for Dow Jones Newswires (which,
like Barron's, is published by Dow Jones & Co.) found that, of the investors
who don't already invest online, 70% say they aren't likely to do so. And the
survey, which queried investors with portfolios worth more than $100,000,
was conducted in April -- which was far and away the busiest month ever for
online brokers. In sum, the study determined that 66% of investors operate
entirely offline, 17% trade only online and the other 17% maintain an offline
account while also using the 'Net for some transactions.
That third group, however, is going to be harder for the pure online brokers
such as E*Trade and Ameritrade to make much hay in. That's because Merrill
Lynch last week wheeled out a new all-inclusive, single-fee account featuring
advice plus online trades, and virtually every other full-service firm is poised to
follow with some sort of bundled 'Net trading option. The old-line brokers
have just taken away one significant source of new-account growth from the
cyber firms.
Another concern for the electronic crowd stems from the basics of supply and
demand for new technologies. Because the earliest adopters of online services
will quite naturally tend to be those likeliest to trade the most actively, the
growth rate of revenue-generating trades will begin to lag the number of new
customers.
Consider this from Ameritrade's recent earnings report: In the latest quarter,
the Omaha firm saw the number of customer accounts grow by 18%, while
the assets in all accounts rose by 16% and its average number of trades per
day advanced by 14%. So, each account added is smaller and, on average,
less active.
That's the immutable law of diminishing returns at work. But its dangers are
exacerbated by the intensely competitive market-share war in the segment,
which has caused the top online brokers to shovel piles of money into
brand-building ads in the quest for new customers. Predictably, the publicly
traded players have fashioned an "earnings before advertising expenses" line
item in their financial reports, as if the hard cash spent in flooding the media
with their names isn't worth dwelling on.
E*Trade, which is on a stated mission to spend itself into the red (just
temporarily, it hopes) to make its brand ubiquitous, laid out $257 for every
new account added in the first quarter, according to CSFB's Burnham,
erasing whatever profit it would have made on the new customer, along with
existing ones. That compares with $135 for industry leader Schwab, $185 for
DLJdirect and $84 for TD Waterhouse. Ameritrade, cognizant of the
long-term hazard of this profligacy, has curtailed some ad spending to stay in
the black.
Another trend weighing on the industry's profitability is the steady slide in
"payment for order flow," essentially kickbacks to the online brokers from
wholesale trading firms paid in exchange for channeling their customers'
orders to them.
According to an SEC filing by Ameritrade for a planned sale of 10 million
shares, the average size of a payment received has crashed from $5.51 in
fiscal 1997 to $2.35 in fiscal 1998 and $1.96 in the six months ended March
26. The erosion in this significant revenue stream has been anticipated for
some time, but that scarcely eases the sting to the bottom line.
A month ago, when Schwab's closely tracked monthly trading data showed a
steep drop from April to May, the notion dawned on investors that the
online-trading game is a somewhat cyclical one, lashed firmly to the
moment-to-moment vagaries of Internet stocks themselves. The online-broker
stocks quickly gave back some of their massive earlier gains, and the shares
of the major firms now sit 30%-45% below their peaks. Yet their still-stout
valuations could come under further doubt if the recent volume patterns prove
to be the normalized growth path of the business.
Schwab -- to take the industry's top innovator, best franchise and the
market-share king with more than a quarter of all online trades -- still has a
stock priced as if the company is bullet-proof, at 75 times forecast 1999
earnings. This valuation persists even as Merrill Lynch saunters into the
online-trading saloon to sit at the card game with the same $29.95 flat
commission structure in its holster. E*Trade and Ameritrade, it hardly requires
mention, have P/Es well north of Schwab's, solidly in triple digits.
At a minimum, a shakeout may be on the way for the online brokers, one that
will see the dozens of marginal players scurry for crumbs, sell themselves or
simply leave the game. Meanwhile, the established giants -- Schwab,
E*Trade, Fidelity, Waterhouse -- will likely consolidate their market positions
and gravitate toward niches or try to become omnibus gateways for all
financial services. DLJdirect, for instance, is staking out the high end, targeting
more affluent investors. Schwab, of course, is continuing to bundle together a
world of research, mutual-fund offerings and other services to enrich its menu
and fashion a virtual full-service firm with third-party providers.
Brassy E*Trade already has pulled aboard mortgage lending, IPO sources, its
own mutual-fund catalogue and sundry other goodies with an eye toward
becoming an out-and-out Web portal for finance. Then last week, it acquired
TIR Holdings, an international firm that executes securities trades for
institutions. One reason for the deal? To offer "a broader base of products
that customers are expected to find attractive, based on varying market
conditions." It appears the writing on the wall is being read. |
