Ameritrade founder Joe Ricketts has stubbornly refused to follow the path most travelled by his competition. Instead of adding diversified revenue streams, he has stuck with the original discount brokerage model -- trading commissions and interest on margin loans. With an economic downturn looming on the horizon, we may find out soon if this has been a wise choice.
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Joe Ricketts, founder of discount broker Ameritrade (Nasdaq: AMTD), is either a clever new economy visionary or a onetime business pioneer who has lost his way in a new, uncharted territory. We may soon know which. One thing is for sure -- this holiday season has been a bumpy sleigh ride for Mr. Ricketts. On the down side, the steep stock market decline has led to an unexpected reduction in online trading. Not only are Ameritrade customers trading less frequently, according to company data released early this month, but their account balances are shrinking too, reducing their ability to trade on margin. As trading commissions and margin loans are Ameritrade's only revenue streams, the holiday news couldn't be worse. A pre-epiphany Ebenezer Scrooge would be delighted. On the up side, Mr. Ricketts didn't get a black stick in his holiday stocking. In fact, he got something very nice indeed: a Lifetime Achievement Award from the Chicago Stock Exchange. The award recognizes Ricketts' 25-year effort to provide low-cost brokerage services to self-directed investors, a Foolish quest that began on phone lines when the Internet was nothing more than a concept. Today's story isn't about holidays past, though, or even holidays present. It's about the future -- specifically, Ameritrade's fitness to weather the gathering storm on the economic horizon. Dancin' with the girl he brung For the most part, early online brokers, including Ameritrade, focused on items one and two, leaving the balance to banks and old-school brokerages. True to the industry's "new economy" roots and in opposition to most of his competition, Ricketts has steadfastly maintained this two-pronged focus, "outscoring" the other services via partnerships -- with MBNA America (NYSE: KRB) for credit cards; with NetBank (Nasdaq: NTBK) for online banking; with electronic trading exchanges for market making; with outside asset managers for mutual funds; and with Epoch partners -- jointly created by Ameritrade with competitors Schwab (NYSE: SCH) and TD Waterhouse (NYSE: TWE) -- for investment banking. Ricketts' simple model stands in increasingly stark contrast to one adopted by his major competitors. (You can compare discount brokers in our Discount Broker Center.) Nowadays, conventional wisdom says that online brokers must diversify revenue streams beyond online trading in order to sustain their impressive growth and to insulate themselves against economic downturns. Oh yeah, one more thing: the new economy gurus have changed their minds and are now saying that every online business must develop a trusted Main Street presence, the kind that Schwab has built with its local branch offices. In terms of revenue, Schwab has long been diversified through its proprietary mutual funds and market making business. TD Waterhouse has been a leader in integrating bank and brokerage services. Working to catch these rivals, E*Trade (Nasdaq: EGRP) has been frantically busy -- acquiring an online bank and a network of ATM machines, starting a few proprietary mutual funds, and partnering with Target to sell E*Trade services in its stores. Even old-school brokerage Morgan Stanley Dean Witter (NYSE: MWD), already a global power in five of the six listed (above) revenue sources, long ago filled out its consumer offerings by adding the Discover credit card business. So what does Joe know? Can this model be successfully applied in the brokerage business? Joe Ricketts appears to be trying. Let's break it down into three pieces: High margin customer relationship High rate of customer asset turnover Ability to guide business through changing markets On the flip side, can Ameritrade sustain -- let alone grow -- its business in a down market? Will traders hibernate? Will Ameritrade have the scale for cost-effective advertising to maintain account growth? Given that the discount brokerage industry has yet to see an extended bear market, we have no experience to fall back on. The way things are going, though, the facts may emerge sooner rather than later. Indeed, we may soon have the verdict on Joe Ricketts' contrarian business plan.
There are essentially six ways that today's brokers, online and off, are bringing in revenues:
SCH TWE EGRP AMTD MWD
Total Revenue 5.7 1.6 1.3 0.6 27.8
Breakdown
Customer Trading* 41% 64% 54% 69% 13%
Interest Spread 20% 22% 26% 27% 10%
Other 39% 14% 20% 4% 77%
*Includes Commissions and Payment for order flow
For year ending:
08/31/00 MWD
09/30/00 SCH, EGRP, AMTD
10/31/00 TWE
Contrary to popular opinion, the "new economy" isn't defined by dot-coms or even by the Internet. Fundamentally, it's about "light" business models, and its seminal example is networking equipment giant Cisco Systems (Nasdaq: CSCO). By outsourcing manufacturing as well as research and development, Cisco sheds asset bulk, focusing on the high-margin customer relationship. This strategy drives maximum return on shareholder equity and, perhaps most importantly, enables Cisco to move nimbly in a rapidly changing technology market, leaving partner businesses to deal with any heavy assets that may, suddenly, have little economic value.
On the surface, with trade commissions rapidly closing in on commodity pricing and payment for order flows (kickbacks from market makers) under government investigation, it looks like this criteria eludes Ameritrade. But, this top-level perspective ignores the level of Ameritrade customer trading and margin borrowing. In fact, when we look carefully at the bottom-line numbers, the margin picture looks pretty good. If advertising, development and non-cash expenses are added back, Ameritrade leads its peers in terms of operating margin before taxes: SCH TWE EGRP AMTD MWD
Operating Margin* 35% 34% 37% 44% 45%
*Advertising, development, and non-cash expenses added back to pre-tax operating profit
Here, the numbers appear to favor arch-rival E*Trade. Either E*Trade brokerage customers are more lucrative or its mix of bank and brokerage accounts generates a greater return on customer assets: SCH TWE EGRP AMTD MWD
Trading Customer Revenues (billions)
Customer Trading 2.4 1.0 0.7 0.4 3.6
Interest Spread 1.2 0.4 0.4 0.2 2.8
Total 3.5 1.4 1.1 0.5 6.4
Individual customer acct assets (billions)
9/30/00* 960 165 66 36 778
9/30/99 699 118 31 23 536
Growth 37% 40% 113% 57% 45%
Revenues per $1000 in average customer assets
Rev per $1000 ($) 4.2 9.5 22.6 18.4 9.7
*8/31/00 for MWD and 10/31/00 for TWE
Unlike the Cisco example, where the changing market is technology-based, brokerage "lightness" can be defined as "the ability to negotiate changing economic conditions." Here we can only speculate: Will the high costs of big-name fund managers and sell-side analysts as well as glitzy offices in the world's major capitals drag down the big name brokers in hard times, when investment-banking revenues are paltry? Will the lack of demand for consumer loans and the high cost of capital drag down brokerage banking and credit operations?
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