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Wednesday, March 24, 1999

An Investment Opinion
by Louis Corrigan

Online Brokers Take a Breather

Blame it on the Dow's failure to stay above 10,000 last Friday. Or on continued worries of a tech slowdown. Or on Milosevic's determination to be remembered as a genocidal thug. What's clear is that the market's recent hiccup has given the leading online brokerage firms a minor lashing. It's difficult to say they're now cheap because by conventional metrics they're certainly not. And since these companies all depend heavily on trading volume, especially trading in highflying Internet issues, they're especially susceptible to shifts in market psychology. In part, they represent a frank bet that investing -- not Tae-bo -- will remain America's primary recreational activity for years to come.

Whenever that seems in doubt, they'll get knocked back, as they have in the last week. Schwab (NYSE: SCH) hit a new all-time high of $92 13/16 last Friday but closed today at $84 3/8, down $5/8. E*Trade (Nasdaq: EGRP) topped out near $62 Friday but closed today at $52 15/16, off $3 5/16 on the session. Ameritrade (Nasdaq: AMTD) reached $58 1/4 Friday but sank $1/2 today to close at $52. Before the Nasdaq's late afternoon rally, the carnage was much worse, with Schwab as low as $80 and Ameritrade as low as $48. Despite the recent sell-off, though, these remain some of the best-performing issues of 1999.

Company 12/31/98 1999 Gain 52-week range

Schwab $56 3/16 50.2% $18 1/2 - $92 13/16
E*Trade $23 3/8 126.5% $5 - $66 7/16
Ameritrade $15 3/4 269.8% $5 5/8 - $67 1/2

The online brokers have performed so well this year because average daily online trading volume has spiked. Analysts are looking for sequential volume gains of about 25% this quarter. If that proves true, then volume will have basically doubled in just the last two quarters. Although growth in assets and customer accounts remain important metrics for valuing these businesses, these firms depend hugely in the near-term on revenue from stock transactions (including market-making activities), which account for 58.4% of Schwab's trailing revenue, 66.1% of E*Trade's, and 66% of Ameritrade's.

Higher trading volume translates pretty directly into improved profitability due to greater utilization of the existing technology infrastructure. Yes, scaling the business depends on adding more customer service reps and techies -- not just on buying more mainframes. All of these firms have strained to add capacity fast enough, and well-publicized system breakdowns have resulted. But as with other e-commerce businesses, there's tremendous leverage in the model, so increased trading means that relatively fixed costs get spread over a larger revenue base.

The latest update on these e-trading dynamics came March 15 when Schwab projected that Q1 earnings would crush the consensus estimate of $0.26 per share.

Q1 FY99 (projection) Q1 FY98 % Change

Revenues $910 to $940 $604 50.7% to 55.6%
Net income $130 to $140 $68 91.2% to 105.9%
EPS $0.31 to $0.34 $0.16 93.8% to 112.5%

In January 1998, Schwab began pricing its basic online trade at $29.95 for all its customers. Previously, customers who wanted the option of talking to sales reps had to pay more for Internet trades. So Q1 1998 was a tough one for Schwab, as revenue and income dipped. That makes for an easy comparison this year. Still, these projected numbers are just phenomenal. There just aren't a lot of businesses where a stiff price cut produces 50% revenue growth a year later backed up by sharply rising profit margins.

Even so, Schwab now trades at 63 times even the recently revised high-side FY99 earnings estimate of $1.35 per share. Meanwhile, the far smaller E*Trade and Ameritrade both plan to spend heavily on advertising and marketing this year in order to pull in more customers and build their brands. Analysts think E*Trade will lose about $0.33 a share this year while Ameritrade earns $0.23 per share, though both are really guesstimates. In the December period, E*Trade spent $310 to acquire each net new customer, whereas Ameritrade spent $200. There's no reason for these firms to turn a profit as long as they can continue to acquire customers at such prices, which analysts believe are well below the net present value of these new accounts.

After all, online brokers are in many ways the quintessential e-commerce plays, looking to attract customers as quickly as possible. So far, so good. With investors racing to get online, Schwab's account base soared 33% during calendar 1998 to 5.6 million while E*Trade's account total jumped 109% to 670,000 and Ameritrade's vaulted 141% to 354,000. Yet, the interesting question is what the online brokers will ultimately be able to do with these customers. As with (Nasdaq: AMZN), these firms clearly hope to lure in customers with the inexpensive, repeat-purchase business of trading stocks. From there, they hope to build long-term relationships that eventually open up additional revenue streams.

Indeed, the market has awarded the online brokers with premium valuations partly because they appear extremely well-positioned to become nationwide full-service retail financial services companies. As Deutsche Bank analyst James Marks has noted, the companies best able to seize the possibilities of the Internet for financial services are firms that already have a financial relationship with customers, a consumer brand, technological expertise, call center experience, and capital (or ample cash flow). Yet, an existing sales force of commissioned brokers or an expensive branch network is actually a handicap since it creates the kind of channel conflict that stymies aggressive innovation.

Companies in many industries might fit this bill -- including community banks, cable companies, credit card companies, or even retailers with their own private label cards. Yet, the firms that strike first, that turn current relationships into active online relationships ultimately built around electronic bill payment systems, should claim a disproportionate share of the spoils. And the online brokers have simply been quick out of the gate at recognizing and exploiting some of the Internet's basic potential. For that reason, these companies are worth a closer look.

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