smartmoney.com
May 27, 1999
Time to Trade In E*Trade?
By Stephanie AuWerter
LOOKING AT the earnings reports of E*Trade Group (EGRP) these days is a little like peering at that picture of your 15-year-old nephew on the annual Christmas card photo. If you squint a little, you can see the good-looking guy who's struggling to emerge. But right now it's braces and acne. Call it an awkward phase.
Of course, like most hot Internet companies, E*Trade's stock price reflects future potential, not its status as a gangly adolescent. Profits? Chances are that was the last thing on investors' minds as they bid the stock up well over 1,000% from November till mid-April. But the stocks of online brokers have taken a hit recently. E*Trade's stock has plunged 28% since its April high. This could bring the issue of profitability back into the picture.
Is it time to step up and buy E*Trade? Not yet. Following the popular Internet business model, the company's vow to put marketing before profits ensures that it will remain in that teenage phase a bit longer. And it's too soon to say whether it will be that prince you were hoping for, once it emerges.
E*Trade's investment in technology and marketing has made it a darling of Wall Street and Main Street alike. Its highly lauded Web site, Destination E*Trade, has the basics -- real-time quotes; stock, fund and option trading; and some research. It also has extras like screening tools for bond trading and, for active customers, Nasdaq Level II quotes and securities data from Bridge Information Systems.
At the same time, E*Trade is expanding its breadth of services. Earlier this year the company bought a 25% stake in Archipelago, a so-called electronic communication network (ECN) for securities trading. The company is also building an investment bank that will enable it to bring more IPOs to its customers. Attracted by those services, customers are signing up in droves. Over the three months ended March 31, the number of E*Trade accounts grew by 35% compared with 17% for the overall online brokerage industry, according to research issued by e-commerce analyst Stephen Franco at U.S. Bancorp Piper Jaffray.
But there is something else attracting those customers, too. It's E*Trade's elephantine marketing campaign. This fiscal year the company is expected to spend approximately $250 million on marketing and advertising sponsorships in an effort to bring in customers and build the value of its brand. These days you see the E*Trade logo on a whole lot more than just CNBC. It's on AOL, Ally McBeal, the X-Files, you name it. And you probably see it in your mailbox, too. One of the broker's latest mailers offers investors $75 for any new non-IRA account that remains open for six months.
1999 Costs & Profits of Brokerage Accounts*
BROKER AVG. ACQUISITION
COST*** PROFITS BEFORE ADVERTISING**** PROFITS AFTER ADVERTISING****
Schwab $136 $183 $157
Ameritrade** 160 223 87
E*Trade** 288 138 -103
* Figures are estimated
** Based on fiscal year starting September 1998
*** Per customer, per account
**** Pretax profits, per average account
Source: Goldman Sachs
This type of massive spending wiped out profits during the last two quarters of 1998 and is expected to do so again this year. "As [CEO] Christos Cotksakos would say, 'There's a moratorium on profits,'" says Lisa Nash, a company spokeswoman. "It will never be cheaper than it is right now to obtain customers." That's because of an explosion in online trading demand and an inchoate provider marketplace. Ameritrade (AMTD) employed a similar strategy during part of fiscal year 1998, but returned to profitability last summer.
Does it really make sense for E*Trade to be spending so much? Clearly any relative newcomer has to spend more than the established players in order to obtain new customers. But E*Trade is spending more than most of its competitors to achieve this. On top of that, the profitability of these accounts is comparatively low. E*Trade's accounts are figures that investors should watch, as E*Trade continues to expand.
This year Goldman Sachs analysts expect E*Trade to spend $288 to acquire each new account. Meanwhile, Ameritrade will spend $160 and Charles Schwab (SCH) will spend $136. But E*Trade's customers may not be worth the extra money. Here's why. The value of an online brokerage account depends upon the commissions and management fees it generates during its lifetime. And that depends upon things like account size, trading volume, commission prices and retention. Add those things up, and E*Trade comes out behind Schwab and Ameritrade.
Great Expectations
E*TRADE SCHWAB AMERITRADE
Customer Assets $21 billion $542 billion $20 billion
Market Capitalization $10.3 billion $44 billion $3 billion
Market Capitalization per $1 in Customer Assets $0.49 $0.08 $0.12
Average Customer Account Size $23,100 $91,900 $45,700
Lowest Commission Available $14.95 $29.95 $8.00
Average Cost to Acquire One Customer $288 $136 $160
Number of Accounts 909,000 5,900,000 428,000
FY 1999 Est. Advertising & Marketing Spending $252 million $218 million $16 million
Long-Term Earnings Growth Estimate 38.20% 22% 33%
Year-2000 P/E 246 68 137
Data based on Q1.
Source: ABN AMRO, Goldman Sachs, U.S. Bancorp Piper Jaffray, PC Quote and company reports
For starters, E*Trade's accounts are smaller than those at Schwab -- an average $23,100 vs. $91,900. And even smaller than those at Ameritrade, where accounts average $45,700. Rob Sterling, an industry analyst at Jupiter Communications, says that E*Trade's challenge will ultimately be to pull customers from Schwab and other full-service brokers. "That's tough," he says. "You need to give them more than just information."
And, while E*Trade's customers transact more often than Schwab customers, the broker's average commission is lower -- $19 vs. approximately $40 at Schwab (for online trades). Of course, Ameritrade's average commission is even lower at approximately $11. Although, its customers are more active than either E*Trade's or Schwab's. Bottom line: Goldman Sachs estimates that E*Trade's profit per account before advertising expenses is just $138, compared with $183 at Schwab and $223 at Ameritrade.
Moreover, E*Trade needs to prove that it can retain its customers during bear markets. So far the company's reported 95% retention rate per quarter is in line with the industry average. But a bear market may reduce profit margins on existing accounts and lead investors to focus more on service than commissions. And in the service area, E*Trade ranks dead last according to our most recent discount broker survey. In response, an E*Trade spokeswoman said that since the survey E*Trade has begun offering online customer service "chats" and has also beefed up its customer service staff.
Given the challenges ahead for E*Trade, investors should ask themselves whether the company deserves its stock price. By several measures, it is trading at many times the multiples accorded Charles Schwab and Ameritrade. Consider the market capitalization of each company relative to its customer asset base. At Schwab, investors pay just eight cents for $1 in customer assets. At E*Trade, the number is 49 cents -- six times as much. And at online broker Ameritrade, investors only pay 12 cents.
Now, you might be willing to pay six times as much for a dollar at E*Trade if you expected that E*Trade could earn six times as much money off each dollar it takes in. But that doesn't seem likely right now.
Now look at P/E multiples. Schwab sells at 68 times year-2000 earnings estimates. Ameritrade sells at 137 times. And E*Trade goes for 246 times. Over the next few years analysts expect E*Trade to log 38% annual profit growth, only slightly more than the 33% they expect for Ameritrade. Schwab is expected to grow 22%. Given E*Trade's P/E estimate, you'd expect its growth figure to be about 50% higher than Schwab rather than four times as much.
Finally, let's consider the price investors are paying for expected revenue. That's the way the Internet analysts like to do it. At Schwab, investors are paying 11 times 1999's expected revenue. At Ameritrade, it's also 11 times. And at E*Trade, it is 19 times.
For the past 18 months or so, looking at the fundamentals of the online broker set wasn't of much interest to many investors. But as the last few days have shown, these stocks can fall just as rapidly as they can rise. Who knows, if the current trend continues, maybe these numbers will start to matter. |
