Interesting article on potential margin problems for online brokers from Barrons this weekend:
interactive.wsj.com
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Payback Time
If the Nasdaq stays down, brokers who depend on margin loans
could be squeezed
By Andrew Bary
The plunge in the Nasdaq threatens to pinch the profits of many securities
firms by reducing the monstrous trading in technology stocks and by
prompting a decline in margin borrowing, which has become an important
earnings source on Wall Street, especially for online brokers that lack the
diversified revenue stream of full-service firms like Morgan Stanley Dean
Witter and Merrill Lynch.
Sanford Bernstein analyst Steve Galbraith told clients last week that a
"deleveraging of the system" would profoundly affect what he calls "pure-play
retail brokerage" firms -- online brokers.
Margin loans, made to buy stocks, have mushroomed in recent months as
aggressive investors have sought to magnify potential profits from surging
technology shares and other highflying issues. Margin debt stood at a record
$265 billion in February, up 46% from October, and 75% higher than the
$151 billion of February 1999. Data due next week could show another rise
in March.
The sharp increase in margin loans has prompted calls for the Federal
Reserve, which regulates them, to tighten rules that for more than 25 years
have let investors buy stock by paying 50% of the price in cash and
borrowing the rest.
Margin lending is a low-profile and
lucrative business. It's estimated that
securities firms earn interest spreads
of 2.5 to 3 percentage points on
margin loans. Brokerage clients pay
7%-10% for these borrowings,
depending on the size and importance
of their accounts. Online brokers have
correctly bet that their clients will
focus on commissions, which average
just $15 per trade, and not on margin
interest.
Galbraith estimates that margin lending accounts for an average of 20% of the
revenues of the major online brokers, including E*Trade Group, Ameritrade,
DLJdirect, TD Waterhouse and Charles Schwab (see accompanying table).
Some firms don't provide exact figures on the size of their margin loans and
their margin-related revenues. But they do report net interest revenues.
Margin income is a big component of interest revenues.
Margin lending makes up considerably more than 20% of the operating profits
of the online brokers, although reported profits generally are minimal, owing
to heavy marketing expenses. Schwab is the exception; it has substantial
earnings. E*Trade, the No. 2 online broker, reported earnings of less than a
penny a share in the March quarter, while Ameritrade said its profits totaled
two cents a share in the period.
Dick Bove, an analyst at Raymond
James & Associates, says margin
lending is the major source of profits
for many online brokers.
The first-quarter profit reports from
Ameritrade and E*Trade demonstrate
the beneficial impact of surging margin
borrowing. Ameritrade's net interest
income rose to $38.8 million from
$14.4 million in the March 1999
quarter, while E*Trade's tripled, to
$96 million, and made up almost 25% of its net revenues. Ameritrade and
E*Trade customers are particularly heavy users of margin, with Galbraith
estimating that such debt has accounted for more than 10% of customer stock
holdings at the two firms, compared with 1.5% for the overall stock market.
The growth in net interest revenues has been notable at Schwab, but not as
dramatic as at E*Trade and Ameritrade. Schwab's interest income rose 55%,
to $203 million, in the fourth quarter from the level a year earlier, as the
company's margin debt outstanding grew to $16.9 billion, up from $9.6
billion. Schwab has yet to report first-quarter profits.
One of the bullish arguments for the online brokers is their growing margin
revenues, but Galbraith argues that the trend is in danger of reversing. The
stock prices of most major online brokers, as the accompanying charts show,
are well below their peaks in early 1999 despite strong revenue and account
growth. The declines reflect concern about increased competition from
full-service firms, fear that the pool of attractive untapped clients is shrinking
and the prospect of further downward pressure on commissions.
The first-quarter reports from
E*Trade and Ameritrade, however,
offered no signs that these issues were
blunting growth. Trading exploded,
with E*Trade reporting that total
transactions in the quarter jumped
237%. The firm said it added a net
603,000 new accounts in the period,
bringing its total to 2.6 million. That's
a quarterly rise of 30%, a huge
increase in a supposedly saturated
market. Given the sharp increase, the
cost of attracting each new account fell sharply at both E*Trade and
Ameritrade -- a bullish development.
"These companies proved that they could increase their accounts by
mindblowing amounts," Bove says. "The question is whether this represents a
frenzy at the top of a market or a longer-term trend." A skeptical Bove
believes account growth rates and trading could slow markedly in the quarters
ahead. Galbraith predicts that margin lending is apt to drop. "The reversal in
growth in margin-related income that we would expect, given Nasdaq
declines, should highlight the perils of putting long-duration valuations on these
earnings streams," Galbraith wrote last week. By "long-duration" valuations,
he means high price/earnings multiples.
Schwab, which fell 15 1/4 to 39 7/8
last week, trades for 40 times
projected 2000 profits, while E*Trade
is expected to post a slight loss for its
fiscal year ending in September.
Galbraith has an "underperform" rating
on both stocks, and doesn't rate the
other big online brokers.
Galbraith says it's a stretch to assign a
P/E of 40 to a company like Schwab
that still relies heavily on retail trading
and lending, while institutional brokers command far lower multiples. Lehman
Brothers, an institutional firm, has seen its shares fall 11% this year, to 75 5/8,
and trades for seven times estimated 2000 profits. Bear Stearns, another
primarily institutional broker, stands at 39 5/8, having badly trailed its peers in
the past year. It trades for around seven times earnings. Morgan Stanley Dean
Witter and Goldman Sachs, which possess market-leading global
underwriting and investment banking franchises, lately have come under
pressure after large early-year gains. Morgan Stanley, which dropped 16
13/16, to 67 3/4, last week, trades for around 14 times estimated 2000
profits. Goldman, which fell 16 1/4, to 86 1/4, on the week, leaving it way
below its recent high of 128, also has a P/E around 14.
Referring to margin lending, Galbraith said: "Ascribing 40 P/Es to what could
almost be considered subprime-lending operations seems overly optimistic."
He and others believe that Wall Street
is policing margin lending well enough
to avoid outright losses on the loans
despite the recent plunge in large
numbers of highflying stocks. When
stocks drop sharply, individuals who
borrowed to buy them are subject to
margin calls, forcing them to put up
more money or see their holdings
liquidated.
One indication of tightening standards is
that many brokers either don't allow certain stocks to be bought on margin or
require stricter maintenance margins, which means brokers move more
quickly to demand additional collateral when stocks fall.
Galbraith notes that E*Trade has tighter-than-normal margin restrictions on
over 500 stocks and that Ameritrade has such curbs on nearly 700.
DLJdirect says it won't make margin loans against about 400 volatile stocks,
including Exodus Communications, Ariba, Internet Capital Group and Palm. |
