June 15, 1999
The 'Net Puts Banks and Brokers to the Test
By Vito J. Racanelli
Editor's Note: Today's special Internet Week Weekday Trader focuses on the 'Net's impact on financial services.
It's a truism that technological revolutions create new industries almost overnight. But the most important changes often can't be predicted at all.
Just as the internal combustion engine eventually led to the U.S. interstate highway system, drive-in banking windows and airbag safety systems, the rise of the Internet will transform businesses in ways that we can't imagine now.
The financial services industry is at ground zero for these changes. Banks, brokerages and insurance companies could be unrecognizable in five to ten years.
The impact of the Internet was hammered home on Wall Street recently, when Merrill Lynch, once an outspoken opponent of online trading, announced that it, too, would offer its own Web-based system at commissions far below its traditional full service fees. Since that bombshell dropped, brokerage stocks have fallen sharply from their highs; banking and most other financial service stocks haven't performed well all year.
Merrill's surprise move, however, marks only beginning of the next phase for online financial services: a competitive free-for-all to get into every home in America. For those that get with the program early enough, the Internet will provide a great opportunity. Everyone else will be toast.
Why financial services? Because it's expected to be a boom industry of the next decade, thanks to the rapid accumulation of private wealth and increased interest by the public in investing, says Arnold Danielson of Danielson Associates, an independent industry consultant.
For banks and insurance companies, in particular, the Internet effectively "commoditizes" many conventional sources of revenue, says Danielson. With the click of a mouse, consumers will be able to compare interest rates on savings accounts and mortgages and premiums on auto and home insurance. Nasty price wars and a squeeze on profit margins is inevitable, he adds.
And it's happening quickly. A recent report by CIBC World Markets said Web-based mortgage origination revenue will explode to 25%-30% of this $1.4-trillion market by 2005, from less than 1% last year. Meanwhile, the average loan margin -- the revenue an originator receives as a percentage of the total loan -- will plummet to 0.75% from 1.25%, the report predicts.
On the plus side, the Internet should help cut the costs of maintaining bank accounts, says Invesco Strategic Financial Services Fund manager Jeff Morris. Indeed, a recent report by consulting firm Booz, Allen & Hamilton estimated that the average cost per transaction over the Internet was less than 1% of the average cost of a branch transaction and only about 4% of the average cost of using an ATM.
More importantly, there will be sources of revenue for banks that use the Internet effectively, asserts Morris. Banks that lead the Internet charge will take market share, he predicts. Credit card operations, for instance, can do more customized marketing of products and get better and faster feedback, he says.
Yet size will still matter, says Danielson. "The major players -- a small group after the recent wave of mergers -- will dominate the game," he predicts. Danielson picks Citigroup, Wells Fargo and Bank One as the banks best positioned to exploit the Web.
At Monday's close of 39 11/16, shares of Wells Fargo trade at 18 times First Call's consensus estimates of $2.22 per share in 1999, a discount to the 27% earnings growth expected this year. They also change hands at about 15x 2000 estimates of $2.57 per share, which is a projected 16% rise from 1999. Meanwhile, Citigroup shares trade at 16x consensus profit estimates of $2.63 per share this year and at 14x next year's estimates of $2.98, roughly in line with the company's long-term expected earnings growth of 14%.
Of the major banks, Danielson singles out Bank America and First Union, "with their large branch networks and a lot of deposits," as the most vulnerable to Internet banking. But the biggest losers of all may be small and mid-sized banks in the U.S. "This is a scale business, and smaller institutions won't be able to compete, " Bank One president and CEO John McCoy predicted at a recent banking conference. That should step up pressures toward even further consolidation in banking.
In the brokerage industry, online trading, whose commissions can be as little as ten percent of what full-service brokers charge, will squeeze the traditional brokers, says Invesco's Morris. And CIBC estimates that online brokerage accounts will more than triple to 25 million by 2001-2002, from fewer than seven million last year.
Full-service brokers that remain complacent risk losing many potential new clients, and may have to pay even more to woo them later. Firms like PaineWebber and A.G. Edwards have been slow to offer online trading. Even Merrill -- despite being hailed for suddenly "embracing the 'Net" -- will go through some pain making the transition over the next year or two, Morris says.
The difference in market valuations is telling. Charles Schwab shares change hands at 61x consensus estimates of $1.33 per share this year, a 57% increase in earnings from 1998, and at 50x 2000 estimates of $1.62 (a 22% gain from 1999). Meanwhile, Merrill stock trades at only about 13x 1999 estimates of $5.21 per share in 1999 at 12.5x estimates of $5.33 per share next year. Schwab's 22% projected long-term growth is nearly twice that of Merrill.
Even online brokers aren't immune to the competitive pressures they've helped create. Merrill's move is certainly a shot across their bow, and any serious market correction could discourage many new investors who have flocked to online trading. (On Monday, shares of Schwab, E*Trade Group and Ameritrade fell sharply on news of lower online trading volume in May by Schwab customers.)
Ironically, the Internet may push online and traditional brokers closer together in some ways. While full-service firms slash their fees for online trades, online brokers are now moving up market with products and services like research and advice in an effort to snare wealthier -- and more profitable -- clients.
For traditional brokers that can leverage the technology properly, there are "huge opportunities," says Jim Folwell, a consultant at Cerulli Associates, a Boston-based research firm that specializes in brokerages. He likens the situation to what movie-theater operators went through with the advent of the VCR 20 years ago. Theaters survived by adding more screens and seats, improved the sound and increased admission and concession prices, he says. (It's arguable whether the movies have gotten better, though.)
The full-service firms will have to provide a menu of services and prices for different customers, he says. Folwell singles out Prudential as one of the leaders among traditional brokers with a "wide range" of account offerings and pricing. In the long run, he says, the Internet will take over a broker's more mundane responsibilities -- like giving out stock quotes and news -- thereby freeing up time for more profitable activities. That should make individual brokers more productive, he says.
Because of the Internet, everything is up for grabs in the once-staid financial services industry. But by the time every home in America is wired to the Internet, only the companies that make the best use of new technologies -- and do it early enough -- will still be around to profit from it.
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Wednesday: Weekday Trader looks at the impact of the Internet on health care.
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