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Wednesday, May 26, 1999

An Investment Opinion
by Louis Corrigan

DLJdirect Goes Online

The tracking stock for online broker DLJdirect (NYSE: DIR), part of Wall Street securities firm Donaldson, Lufkin & Jenrette (NYSE: DLJ), enjoyed a jazzy first day of trading today, helped along by an Internet sector that rallied off some punishing early morning lows to rebound from yesterday's sell-off. Initially priced to go public at $13 to $15, DLJdirect was bumped to a target range of $18 to $20 last week, with the 16 million share offering done today at $20. The stock opened at $26 5/8 and closed at $30 1/8, up $10 1/8, just off the high of $30 3/8. With 101 million DLJdirect shares now outstanding (excluding 10 million reserved for employee stock options), DLJdirect now sports a market cap of $3.04 billion.

The action on Wall Street didn't bode well for a Net IPO, with the queen of the Internet stocks, Morgan Stanley's (NYSE: MWD) Mary Meeker, reportedly saying the sector could see an additional 20% correction. But DLJdirect is a promising prospect. The firm claims about 4% of online trading -- only a seventh of the market share held by online leader Schwab (NYSE: SCH) and less than a third of the share enjoyed by fast-growing #2 online broker E*Trade (Nasdaq: EGRP). Nonetheless, it is the seventh largest online broker.

Despite a $20 limit order price that's middle-of-the-pack, DLJdirect has consistently rated among the best online brokers for quality and range of services. It pulled down the number one spot in Barron's recent survey, and Gomez Advisors has ranked it tops in five of the last seven quarters, including last quarter. Institutional investors like its connections to an old line Wall Street firm. They also think the cash raised in the offering should allow DLJdirect to ratchet up its marketing so it can fortify its brand and grab new customers before they've committed to competitors. With E*Trade shelling out an astonishing $60 million during the March quarter on advertising but seeing its cost of customer acquisition actually fall, it's clearly time for potential players in this industry to ante up or risk being forced out of the hand by more aggressive marketers.

Here's a quick overview of DLJdirect's financials. The company's revenues increased 75% last year, to $117.9 million from $67.2 million. Net income rose to $1.5 million, or $0.01 per share on a pro forma basis, reversing the FY97 loss of $3.6 million. Commissions accounted for the bulk of revenues (66.8%) while various fees (21.4%) and interest on margin and other loans (11.6%) made up the rest. The fee income includes payment for order flow, distribution fees from money market funds, and revenues from DLJ for developing certain technology products and services.

First quarter results looked like this. Revenues jumped 96% year-over-year to $47.2 million from $24.1 million. Net income soared to $7.2 million, or $0.07 per share on a pro forma basis, reversing last year's loss of $2.3 million. Outside of a slight boost in commission revenues, the mix was pretty similar to the first quarter of FY98, with commissions contributing the most (67.9%) and fees (20.3%) and interest (11.8%) filling out the picture.

As with other online brokers, DLJdirect enjoys attractive operating leverage as the basic fixed costs get spread out over increased revenues. In other words, basic operating expenses should grow a lot slower than revenue. And that's what happened, as operating expenses minus ad spending increased by just 58.1% last quarter. However, net income did benefit a lot from the fact that advertising spending dropped to just $6.1 million last quarter from over $9 million in the first quarter of FY98. Although the Q1 FY98 number was something of an anomaly, representing 36% of FY98 ad spending, DLJdirect still spent less last quarter than it did on a quarterly basis last year, when ad spending totaled $25.1 million overall.

DLJdirect tracks both total accounts and active accounts. The latter is defined as "those accounts at the end of the related period with at least one trade in the last twelve months or with a balance at period end." Total accounts grew 35.6% last year, from 390,000 to 529,000, and by 11.5% last quarter, to 590,000. Meanwhile, the number of active accounts increased by 45.8% last year, from 144,000 to 210,000, and by 15.7% in the first quarter to 243,000. Total customer assets increased by 93.5% last year, from $4.6 billion to $8.9 billion, and by 25.8% last quarter, to $11.2 billion.

By contrast, Schwab added 388,000 new customers in the March period, ending with 5.9 million active accounts holding $542 billion in customer assets. About 2.5 million of those were considered active online accounts, and they held $219 billion in assets. Also, E*Trade attracted 233,000 new accounts in the March quarter, bringing its total to 909,000 as of March 31. Its customer assets jumped 39% in the period to $21.1 billion.

However, DLJdirect took in $141.5 in commissions per average active account during the first quarter, up 34% from the $105.8 in the year-ago period. That compares favorably to E*Trade, which saw average trading revenue per account rise 24% year-over-year to $123 in the March quarter. However, a good chunk of E*Trade's accounts are less active employee retirement accounts. So the comparison isn't apples to apples. Still, it does suggest per account commission revenues is increasing nicely at DLJdirect.

What this all suggests is that DLJdirect has a relatively attractive customer base; it just needs to increase that base. For the twelve months ending in March, the company spent just over $23 million on advertising, putting the average acquisition cost per customer at $281. For the March period, the cost per new customer dropped to $185. That's in the ballpark with E*Trade, where customer acquisition costs fell to $257 last quarter from $310 in the December period. Similarly, number six online broker Ameritrade (Nasdaq: AMTD) spent $178 on advertising per net new customer last quarter after spending $200 per customer in the December period. Depending upon what kind assumptions you make about the lifetime value of a customer, all of these firms could afford to spend more and still generate positive economic returns. Some analysts put the threshold point at $500. I think it may be much higher.

DLJdirect will receive the net proceeds from the sale of 11 million shares, with the money raised from the other 5 million shares going to the parent DLJ. So the online broker will get about $203.5 million, according to the prospectus. It plans to spend a total of $65 million on ads this year, with most of that paid for by the offering. Yet, part of the money raised will go to pay a note issued to an affiliate while another portion will be used to pay down its revolving credit facility. The prospectus puts the balance at $93.8 million, or $124.6 million if the underwriters opt for the over-allotment.

How many new customers can DLJdirect attract based on a $200 per account acquisition cost? Based on the current planned ad expenditures, the company could more than double its active account base by adding perhaps 295,000 new accounts. Though DLJdirect will be spending to build up its facilities, hire new staff, and expand into Europe, some additional portion of the offering could be used to fund customer acquisition. So the cash infusion should boost DLJDirect's standing significantly, assuming its marketing can compete with the slick ads from E*Trade and Ameritrade.

However, competition for customers will only heat up as number three online broker, Toronto-Dominion Bank's (NYSE: TD) Waterhouse Securities, plans to raise $1 billion in an offering next month and number ten player National Discount Broker (NYSE: NDB) looks to raise more cash. Also, DLJdirect is a tracking stock, which means that parent DLJ has the right to exchange its stock for shares of DLJdirect at just a 10% to 15% premium. Also, DLJ can offer online trading to its full-service brokerage customers or even open a competing online brokerage unit. These things may not be much to worry about, but they point to restrictions that have perhaps kept other tracking stocks, like ZDNet (Nasdaq: ZDZ), from lifting off as much as genuine Net spin-offs.

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