Tuesday, June 27, 2006

TD Ameritrade Technical Glitch

  
TheStreet.com, Marc Lichtenfeld, 27 June 2006

TD Ameritrade encountered a serious technology glitch last week: Legacy TD Waterhouse customers had difficulty obtaining online access to their accounts for three days. I should know: I'm one of those TD Waterhouse customers.

After growing frustrated with the inability to access my account and long waits to reach a customer service rep, I realized the outage could put the company in jeopardy of missing their numbers or seeing a wave of defections from their newly acquired Waterhouse clients.

Spokesperson Kim Hillyer said that although the problem would naturally affect trading revenue, the company is "still within guidance." On April 24 , the company raised EPS guidance by 3 cents for fiscal 2006, which ends Sept. 30, to 94 cents. Wall Street has taken a more conservative view with a consensus estimate of 91 cents. Nevertheless, the sell side is bullish, with 10 analysts rating the stock a buy and only two holds.

Although analysts remain enamored with TD Ameritrade and potential investors may be wooed by a roughly 30% drop in share price over the past month, it's best to wait before getting involved with the stock, which was recently down 3.5% at $14.78. TD Ameritrade operates in a fiercely competitive business that is increasingly commoditized. Customers won't tolerate technical problems, and last week's glitch only further complicates the company's efforts to transition itself from its historic reliance on active traders.

In order to facilitate its goal of being a more diverse wealth manager, the company acquired TD Waterhouse in January, inheriting over 2.2 million accounts in the process and raising the firm's total to over 6 million accounts. One of the plums of the deal was the fact that Waterhouse was the third-largest player in the Registered Investment Advisor segment.

Brokers and financial planners who are not employees of a brokerage can choose where they want to house clients' accounts. These types of accounts are desirable, as the advisors tend to bring in large amounts of assets at once, and TD Ameritrade hopes to increase that part of its business.

But "everyone is courting money managers," says Lauren Bender, analyst with research and consulting firm Celent. "While [TD Ameritrade] should be, too, they need to differentiate themselves. Otherwise, what's their angle?"

The new company also has a focus on what it calls the "mass affluent"-- customers with less than $1 million in investable assets -- offering financial planning products and guidance for do-it-yourself investors who are focused on the long term.

But herein lies the problem. How does the company go about building up these new segments while maintaining the resources necessary to feed the beast that is its active-trader business? TD Ameritrade has 25% of the marketshare for online trades, according to the company. That's an impressive figure, certainly, but one that becomes worrisome in the face of falling commission rates and the commoditization of trading.

While the company undergoes its transition, trading volumes will be critical to meeting the Street's expectations. Average client trades per day have picked up in fiscal 2006. Trades have averaged over 220,000 per day during the current fiscal year, far exceeding last year's average of 156,000 and averages from the past four years.

Those figures were aided considerably by the Waterhouse acquisition, but it's important to remember that in this high fixed-cost business, additional trades are highly profitable. That also means the inverse is true. If traders and investors become discouraged with the market, trading volume could fall, hurting revenue and profitability. While TD Ameritrade is taking steps to remedy the situation, the company's performance still depends largely on active trading and the direction of the stock market.

In the wake of last week's technical problems, CEO Joe Moglia apologized to customers and the company said it is making amends on a case-by-case basis, but generally is offering free trades to investors who were affected by the outage.

The problems were unusual, because Ameritrade has a history of successful integration of acquisitions, including Datek in 2002 and JB Oxford in 2004. Celent's Bender was surprised at the technology issues. "In meetings with analysts, they boast about how good their integration of acquisitions is, so they have some explaining to do," she says.

Bender believes that if the company handles the situation well, it will be a nonevent. Both Wall and Main Streets will be watching closely for signs of any future integration problems. If any arise, don't be shocked to see investors head for the exits even before the customers.

TD Ameritrade is a solid company with very capable leadership. But good companies don't always go hand in hand with good stocks. Ameritrade is in that position. While slightly undervalued on a price-to-earnings basis compared to its peers, it is significantly overvalued based on P-E-to growth, price to book and price to sales bases, as the chart below illustrates.

Of the four companies in the above table, TD Ameritrade has the highest long-term debt-to-equity ratio, at 138.6%, followed by E*TRADE with 137.4%, Schwab at 11.1% and OptionsXpress, which is free of debt.

If the stock were cheap, I'd consider taking a shot, because Moglia and his team have a good track record. But with valuation concerns and an uncertain future, investors may be better off trading with TD Ameritrade rather than owning it.

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