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Wednesday, April 28, 1999

An Investment Opinion
by Louis Corrigan

Trading in Prime Time

Move over Mark McGwire. The thrill of watching a home run just can't compare to hitting one. Indeed, it's looking more and more like spectator sports in general will soon just fade away as daytrading moves into the center of American life.

The major television networks will no longer blow billions of dollars to win the broadcast rights to NFL games. Instead, each night they'll vie to carry the official Nasdaq Level II quotes for the next day's projected hot stocks. And "viewers" won't enjoy access merely to split-screen instant replays or zoom shots. With WebTV console in hand, they'll be able to trade the bid and the ask; they'll have the option of options. No more Bob Costas puns. Instead, the bottom of the screen will be filled with trash-talking traders butting heads while the live audio feed carries heckling play-by-play from Conan O'Brien, David Spade, or maybe Whoopi.

Given the recent gains by the online brokers, perhaps this nightmare vision is already being pitched as 21st century programming. (If not, I'm claiming inventor status.) Thanks to an all-round monster March quarter, the leading online brokers have soared ever higher. And that's despite getting whacked the last few days by general I-Net volatility and some post-earnings blues. Talk about home runs. Ameritrade (Nasdaq: AMTD) is up 135%, E*Trade (Nasdaq: EGRP) 101%, and Schwab (NYSE: SCH) 32% since I last discussed this group just five weeks ago. Here's a look at the gains over the past five weeks and for the year so far:

Company 3/24/99 4/28/99 5-Week Range 1999 Gain

Schwab $84.38 $111.50 $80.00-$155.00 98.4%
E*Trade $52.94 $106.19 $51.75-$144.50 354.3%
Ameritrade $52.00 $122.00 $53.25-$188.38 674.6%

Since I discuss number one online broker Schwab in a nearby article, let's look at the others. Number two online broker E*Trade saw its Q2 revenues bolt to $127 million, up 126% from the year-ago period and up 44% from the first quarter. Yet, it still reported a loss of $14.3 million, or $0.12 per share, after backing out a $20 million one-time gain from the sale of shares of Knight/Trimark Group (Nasdaq: NITE). Earnings were down from the $4.5 million, or $0.05 per share, reported a year ago, but they equaled the Q1 per share loss and beat the consensus estimate calling for a loss of $0.17 per share.

On balance, it was another terrific quarter. The revenue gain came mainly from frenetic trading, as transactions increased 55% sequentially (to about 70,000 trades per day) and 168% year-over-year. That boosted revenue from transactions to nearly $91 million, up 50% from Q1. By contrast, net interest income, E*Trade's other major revenue stream, increased 32% to $28 million, though customer assets did jump 39% in the period to $21.1 billion. The company continues to grab market share, accounting for 2.26% of equities traded during the period versus just 1.55% in Q1.

The loss resulted solely from the $60 million E*Trade spent on marketing, which was up 46% from the $41 million shelled out last quarter and five times what it spent in Q2 FY98. The company continues to move aggressively to build its brand name and win new customers. So far, so good. The marketing brought in 233,000 new accounts during the quarter, well ahead of the 133,000 customers added last quarter. That brought the total to 909,000 by the end of March, up 126% from March 1998. (Just this week, it added its one millionth account.) Acquisition costs fell to $257 per customer for the quarter versus $310 in Q1. With average trading revenue per account flying to $123 for the quarter, up 24% from $99 in Q1, it's pretty clear that the huge ad spending is creating significant long-term value. Indeed, customers are actually becoming even more valuable as they become more hooked on trading.

The March quarter was nearly as sweet for Ameritrade, the number six online broker based on daily trading volume. Revenue hit $64 million, up 112% year-over-year and 22% sequentially, despite nine fewer trading days in this fiscal second quarter versus Q1. Transaction revenues leaped to $47 million, up 141% versus the year-ago period and 28% sequentially, as trades per day hit 52,218, up 197% year-over-year and 56% sequentially. The company reported profits of $8.1 million, or $0.14 per share, improving on a breakeven quarter last year and doubling the analysts' expectations. The company earned $0.13 per share in Q1.

Analysts had originally projected a loss for the quarter, but the company was gaining plenty of new accounts without beefing up its ad spending as much as originally planned. The company ended up spending $13.2 million on ads during the quarter, up from $9.6 million both in Q1 and in the year-ago period. It added 74,000 net new accounts for the quarter, putting the adjusted customer acquisition cost at $178. Ameritrade exited the quarter with 428,000 customer accounts, holding $19.5 billion in assets, up 93% from a year ago and 31% from December.

Deloitte & Touche recently calculated that the cost per stock trade for online brokers is as little as $4.25. All the major players have been working overtime to keep their technology infrastructure supple enough to meet increasing demand, and that costs money. But rising trading volume creates incredible leverage for these businesses since the basic operating expenses (excluding advertising) are growing a lot slower than revenues.

The added beauty of the online brokerage business is that there's simply no limit to how much online trading hyperactive investors might do. They can churn their own accounts as much as they like and still not face that consumption-dampening sight of a stack of unread books ordered from (Nasdaq: AMZN). According to Steve Franco, electronic commerce analyst with Piper Jaffray, average trades per online account rose 22% during the quarter to 3.76. The lower-priced firms enjoy even more active traders.

Though the earnings and price-to-sales multiples on these stocks look out-of-sight, there's good reason. The online brokers appear to be the perfect Internet businesses. They've got a highly addictive repeat-purchase business that's already nicely profitable if you discount the discretionary ad spending. While marketing costs will remain high for a while as the hot competition gets even hotter, one could argue that even E*Trade is under-spending in its efforts to gain market share since the long-term value of each customer is much higher than the acquisition costs. And that value is increasing.

Moreover, the full-service brokers with thousands of sales personnel still have no good answer to the value-oriented, direct-selling online firms. As the stumble at PC maker Compaq (NYSE: CPQ) ought to suggest, companies with such channel conflicts are at a huge disadvantage when confronting nimble players that have built their business models on responding to the customer's orders directly.

With Richard Strauss of Goldman Sachs projecting online trading to grow by 40% to 50% per year over the next 3 to 5 years, there's still a lot of opportunity out there. Investors should take a closer look at these companies, especially if their stocks continue to backtrack from their recent highs. Though all could be hurt badly by a bear market, continued website problems, or anything else that cools the recently hyperactive trading, it at least feels like we're still in the early stages of a major cultural shift that should benefit these leading firms. In other words, Conan here will come.

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