Online Brokers on the Verge of a Needed Breakthrough?
September 2, 1999 7:49 AM EDT
By Cheryl Peress
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Internet stocks, and online brokerages in particular, have been scorched in the summer heat. With autumn just around the corner and expectations that online traders will return from the beach to their computers, it's time for investors to revisit the sector.
Some pressures on the industry remain in place. The field is still getting more crowded, and players will need to keep spending to keep pace. Concerns about rising interest rates and the bad rap generated by the proliferation of day trading and the emergence of after-hours trading, has left the former high-flying sector grounded.
Many of these stocks have not recovered since a selloff sparked a month ago when Credit Suisse First Boston analyst Bill Burnham warned of falling trading volumes.
The share price of E*Trade (quote, chart, profile) fell 17% on his report and has drifted down since then. Similarly, shares of Ameritrade (quote, chart, profile), DLJDirect (quote, chart, profile), TD Waterhouse (quote, chart, profile), and even Charles Schwab (quote, chart, profile), often deemed the cream of crop, have yet to see any renewed signs of life.
But for all their trepidation about the short term prospects of online brokers, analysts seem unified in their optimism for the long haul.
"While this is clearly a short term setback, we remain firm believers in the overall fundamentals of the eBrokerage industry and characterize the present market activity as a seasonal/cyclical breather," said BancBoston Robertson Stephens (BBRS) in a recent report.
"Online brokers have revolutionized the financial service industry," said Rich Repetto, an analyst at Lehman Brothers. "Online trading is here to stay."
A Tough Climate and Tougher Environment
The Internet has transformed the retail brokerage industry. Prices have plummeted, as have waiting times for getting investment news and advice and for executing trades.
Online brokerage accounts have grown from just a few thousand at the end of 1994 to more than seven million today, BBRS notes. The firm expects the industry to grow at a 40% clip compounded annually over the next three to five years.
Households with an online trading account will grow from 4.3 million in 1998 to more than 20.3 million in 2003, according to estimates released Wednesday by Internet consultants Jupiter Communications. The company also expects that 41% of US households holding stocks will have online trading accounts by 2003.
Still, the short term prospects look rather grim. The summer season has slowed the advance of online brokerages and their stock-market levels, notes analyst Jim Marks of DB Alex Brown.
With more people on vacation or just spending more time outdoors, transactions per account have fallen. Falling operating margins due to higher spending on infrastructure has also depressed earnings.
Competition is also an issue. And the more new online brokers pop up - both from online players and traditional brokerages just getting into the Internet act - the stiffer competition gets.
More competition demands higher spending on advertising and marketing to generate new accounts. Repetto estimates that for fiscal year 2000, the eight largest Internet brokers alone have budgeted $1.2 billion on marketing.
He explains that there is a fear the firms are being forced to spend huge sums of money to acquire new customer accounts, which will ultimately eat into profits.
"Either spending will bring (new accounts) on quicker or it cuts into the bottom line," notes Repetto. He says that while the companies do have the ability to lever down, the current sentiment is that if they do they won't grow and gain market share. "There's going to be growth, but will it be economical."
Going for Account Growth
Day trading has recently been the subject of much negative publicity for online brokerages. "The day trading issue isn't shaken out yet," says Repetto. But, he notes that one has to distinguish between day trading and active trading. He explains that day trading does not really fall into the realm of online brokers in that these types of traders utilize completely different services.
Still, online brokers have been quick to add a host of new and better services to both attract active customers and to differentiate themselves.
BBRS points out that this week, E*Trade and Schwab both unveiled programs to reward their most active trading customers. E*Trade's Power program offers reduced rates on monthly trades of between 30 and 74 and a $4.95 blue plate special for the 75th trade and over. Platinum customers also receive preferential treatment with respect to IPOs.
Schwab's program Velocity also caters to its more active customers but is focused on order transfer speed. That directly affects execution.
After-hours trading is another issue that has sparked concern, but one which is ultimately a positive for online brokerages - there is more opportunity to trade.
Lehman's Repetto notes that despite the fact that there is limited liquidity, 20-30% of trading occurs at the market open.
Next Move, Higher?
"The eBrokerage leaders are developing scale, strong brands, distribution, and a keen mastery of the electronic channel," said BBRS in a recent report.
Stock prices, unfortunately, fail to reflect these positive attributes. That's because the online brokerage community has been hit with a double whammy.
"We've had a market downturn in Internet stocks since the end of April. Online brokerages are doubly impacted," notes Repetto.
On a valuation basis, the sector has been pummeled as the entire Internet kingdom has gotten caught in a downdraft. Secondly, online brokerages have been hit from a fundamental standpoint. As people turn bearish, they trade less, a factor that directly affects the revenue stream of online brokers.
"We believe the eBrokers, already beaten down by greater than expected seasonality, are suffering from a multiplier effect with any additional bad news," said BBRS in a report.
But, many analysts expect activity to pick up after the summer season comes to an end. Moreover, while the uptrend in online trading volumes may have temporarily hit a wall, most contend that the industry as a whole remains extremely upbeat.
"Stocks will trade up when activity picks up," says Repetto.
If the beleaguered Internet sector makes a comeback, then when trading activity picks up, online brokerages may actually find themselves doubly blessed.