The Crunch Is Coming for Online Brokers
October 18, 1999
The Crunch Is Coming for Online Brokers
By Paul R. La Monica
I HAVE A CONFESSION to make. Writing about investing may be what I get paid to do, but when I'm out of the office, I would rather think about anything but the stock market. Unfortunately, the travails of my job keep intruding on my leisure time. Try as I might to avoid any mention of earnings and interest rates, every time I turn on the tube to watch a game or a movie, there's at least one smug advertisement for an online brokerage during each commercial break. Enough, already!
Is it me, or are there just too many online brokerages out there chasing too few customers? You've got Schwab (SCH), E*Trade (EGRP), Ameritrade (AMTD), National Discount Brokers (NDB), TD Waterhouse (TWE) and DLJdirect (DIR) all preaching about why they're the best place to go on the Net to buy and sell stocks and funds. With a click-click here and a click-click there, here a click, there a click, everywhere a click-click.
Personally, I think the stage is set for a major shakeout in this sector. In fact, I'm going to go make a bold prediction: Within the next 12 months, nearly all of the publicly traded Internet brokerages will either be bought out by banks or will merge with one another. Here's why I think this will happen.
The online brokers are all spending gazillions of dollars on advertising even though it appears that account growth and trading volume are slowing. And despite the proliferation of online-brokerage commercials, it seems that the ads aren't doing a great job of raising brand awareness (see story).
But the biggest problem many of these firms face is that most rely on commissions for a huge share of their revenues. That's not healthy when you consider that increased competition is causing commissions to head lower and lower.
Ameritrade would appear to be in particular trouble in this new environment, since more than 70% of its net revenues come from commissions and clearing fees. E*Trade derives more than 57% of its revenues from commissions and Schwab gets about 43%. Compare that to some of the full-service brokers, many of which have huge investment-banking businesses that generate additional fees. Commissions accounted for 27% of third-quarter revenues at Merrill Lynch (MER) and just 14% at Morgan Stanley Dean Witter (MWD).
Schwab, of course, is much more than an online broker. E*Trade has been broadening its services by starting an investment-banking arm (E*Offering) and setting up its own mutual funds. And in the boldest move of all, E*Trade agreed earlier this year to buy online bank Telebanc Financial (TBFC).
But the online brokers will have to adapt even more quickly, given the pace of change in the business. Just a month ago, Lucent Technologies (LU) CEO Richard McGinn predicted that one of the major brokers would announce free online trading services within the next 12 months. Boy, was he wrong -- by 11 1/2 months.
Two weeks ago, American Express (AXP) said it was re-entering the online-brokerage arena, and that it would offer online trading gratis for its most affluent customers.
So the online brokerages will soon face increased competition from American Express and full-service brokers like Merrill, PaineWebber (PWJ) and Prudential. And Morgan Stanley, which owns its own discount brokerage, Discover, is said to be considering offering online trading to all of its customers in the near future. These financial powerhouses are also starting to clutter the airwaves with ads of their own.
Merrill's new commercials stress that customers will be able to trade online but also receive all the full-service amenities they're used to. And mutual fund giant Fidelity, which has had online trading for some time, recently launched an ad campaign for its Powerstreet online-trading service in conjunction with search engine Lycos (LCOS).
The combination of increased competitive pressures and a rough stock market for the past few months has caused a brutal selloff of the online brokers. Schwab's stock has fallen 48% since May, while E*Trade, National Discount Brokers and Ameritrade are all down more than 55%. TD Waterhouse and DLJdirect, both of which went public this year, have slumped severely since their IPOs. That's why it makes sense for some of the online brokerages to sell out. It doesn't look like things will get much better any time soon.
There is only so much profit to be made from collecting a fee every time someone makes a trade. Big brokerages make a lot of money from helping customers manage their investments. "Assets make the world go around," says Dan Burke, senior analyst with Gomez Advisors, a research firm that tracks e-commerce. The larger firms can afford to offer lower or even free commissions because they're more interested in increasing assets under management than simply boosting account growth.
And since banks are also trying to increase their assets under management, Burke thinks some might want to take a look at the remaining online brokers. Banks could build their own online-brokerage capabilities, but with the stock prices as low as they are now, it might make sense to scoop up the companies that already have a fair number of accounts. Once the brokerage is brought into the fold, a bank can offer online-trading services to its customers as well as hawk its own financial products to the online broker's customers. I think that the smaller firms like Ameritrade and National Discount Brokers would be prime targets for banks since they would be relatively cheap acquisitions. Ameritrade's market cap is $2.7 billion and NDB has a market value of just $380 million.
A less likely, but not completely implausible scenario would be for some of the second-tier brokerages to join forces themselves. Why shouldn't E*Trade buy out Ameritrade, for example? Or how about a merger between E*Trade and TD Waterhouse to form a truly formidable competitor to Schwab and the full-service brokers? Burke thinks that one reason online brokers won't merge with each other is that competing online brokers don't have much to offer strategically other than more accounts. That may be true, but it could make sense for online brokers to link up in order to cut costs, both on the infrastructure side and in terms of advertising and marketing. This could especially help E*Trade.
TD Waterhouse and DLJdirect are wild cards in the consolidation game. TD Waterhouse is a majority-owned subsidiary of Canadian bank Toronto Dominion (TD) and DLJdirect is a tracking stock of investment bank Donaldson, Lufkin & Jenrette (DLJ). They shouldn't be as vulnerable to competitive pressures as E*Trade, since they have big parent companies backing them. But you have to think that one of the reasons Toronto Dominion and DLJ decided to set up separate stocks for these units in the first place is that they would command higher P/E multiples as separate entities and hence would be better currency to use for acquisitions than the parent company's stock.
Regardless of who buys whom, it seems clear that there should be some deal making going on in the sector. If the online brokers want to survive for the long term, they will have to come up with a more sound business strategy than simply throwing away millions of dollars on semiamusing 30-second television commercials. If they're not willing to spend some of that money to increase the quality and quantity of additional services on their sites, they'd be better off selling out to a company that already has those services to offer. |
