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Friday, July 9, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Learn from Merrill Lynch!

I'm watching with keen interest the changes wrought on businesses by the Internet. Having never lived through a technological revolution, I really don't know what outcome to expect. Who will emerge as the ultimate dominant force in the Internet field? Will today's young leaders remain on top of the heap or will new upstarts come in with even better solutions than those offered today? Could it be possible that some of the old-line companies will find a way to combat the upstarts?

The Internet has influenced few industries more significantly than the stock brokerage business. Due to the tremendous and rapid changes the new communication medium has created, we are seeing old-line firms move fairly aggressively to incorporate the Internet into their business plans. As this happens and competition intensifies over the next 12-18 months, we will gain a clearer picture of whether slower-moving firms with tremendous marketing and financial strength have a chance to compete against firms that quickly embraced the Internet.

Just a few years ago, trading stocks over the Internet was a novelty offered by only a few firms. Seeing the potential to reduce costs and increase efficiencies (not to mention the fear of competitive threats from other deep-discount brokerages), Charles Schwab & Co. (NYSE: SCH) and TD Waterhouse (NYSE: TWE) embraced the new technology and began offering lower-priced online trading. Although the commission reduction from these services risked reducing revenue if the move didn't result in increased volume, these firms recognized the important of price to their offerings. One of the primary reasons customers had selected a discount broker was, not surprisingly, the fact that they offered low-priced trades. Customer loyalty would likely be weakened significantly if cheaper options were available elsewhere.

As discount brokers embraced the Internet, full service brokerage firms pretty much ignored what was happening. They didn't feel they were really competing on price. Instead, they felt their differentiating factors were research recommendations and a relationship with a broker. They didn't believe their customers were very concerned about price. In addition, it was tough for them to figure out how to incorporate low-priced Internet services into their business models. Most full service brokers are paid commissions out of the fat transaction fees charged to customers. If they were to provide low-cost trading, how could they provide their brokers with hefty compensation? (Discounters didn't have this conflict since their brokers were usually paid a salary.)

Not surprisingly, investors have been running from full service brokers into the hands of firms offering cheap Internet trades. After denying or ignoring this influence for a long time, the full service firms have finally started to prepare to fight. (Do you think it had anything to do with the fact that the market capitalization of Schwab surpassed that of Merrill Lynch?) Prudential Securities, a large full service firm, has already introduced a product that charges a flat $24.95 per trade, in addition to an annual account service fee based on account assets.

A bigger threat may come from Merrill Lynch (NYSE: MER), the nation's largest full service brokerage firm, which announced plans for two different options that might appeal to investors. The first is a "wrap account," which provides all services to clients for a flat annual fee based on assets. Investors will incur no charges for individual trades. The second is an account that doesn't have an annual fee but charges $29.95 per trade. This later option, which is expected to be available in December, is a direct threat to Schwab, which also charges $29.95 per trade, but doesn't offer advice or proprietary research. As far as I can recall, this will really be one of the first instances where an old-line company competes head-to-head against a profitable Internet competitor.

The market seems to have concluded that Merrill Lynch and the other traditional brokerage firms have lost the race. Schwab is valued at $44 billion, yet Merrill Lynch, which in addition to its brokerage operations has a very profitable worldwide investment banking group, is valued at only $29 billion. E*Group (Nasdaq: EGRP) and TD Waterhouse each trade for more than big old-line firms like Lehman Brothers Holdings (NYSE: LEH), Donaldson, Lufkin, & Jenrette (NYSE: DLJ), and Paine Webber Group (NYSE: PWJ). Ameritrade Holding Corp. (Nasdaq: AMTD) is worth more than A.G. Edwards (NYSE: AGE), Legg Mason (NYSE: LM), and Raymond James Financial (NYSE: RJF) combined.

Given their slow response over the past few years, it is understandable that many people foresee traditional firms not adapting to Internet competition. Now, as these companies finally wake up to this competitive threat, it will be interesting to see how well they fare. Can Merrill Lynch's strong brand and army of over 14,000 brokers compete in the online world against Schwab? What about the other companies in the industry? Will they let their customers continue migrating to Internet firms or will they find strategies that allow them to maintain, or even gain market share?

Results from the impending broker battle might help investors determine what will happen in other industries being hit by E*competition. We will finally see if a company like Merrill Lynch can use its resources to effectively fight a firm like Schwab, which embraced the Internet early on. Billions of investment dollars are at stake in answering that question. For the first time in a long time, we might actually learn something from the actions of Merrill Lynch.

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