Wednesday, July 05, 2006

Traditional Brokers Lose to Online Discount Brokers

Bloomberg, Bradley Keoun, 5 July 2006

Evan Cohen, a 41-year-old software developer in Flushing, New York, knows why the discount brokers are back and, more than ever, are undercutting the traditional retail franchises of Merrill Lynch & Co., Citigroup Inc.'s Smith Barney, UBS AG and Morgan Stanley with cheaper and easier trades.

``They offer virtually every tool that every other trading company provides, but you're basically managing your own money'' and the fees are lower, said Cohen, who bought 1,000 shares of Evergreen Solar Inc. through TD Ameritrade Holding Corp. last week, paying an online commission of about $10. Making the same trade on the telephone through a Merrill representative can cost at least $120, and rival full-service brokers charge higher fees, too. The best New York-based Merrill can offer for an online trade is $29.95.

Four years ago, Ameritrade and competing discount brokers including Charles Schwab Corp. and E*Trade Financial Corp. lost more than 90 percent of their market value after the dot-com bust sent their shares reeling. Now, they control about 10 percent of U.S. households' financial assets, up from 7 percent in 2000, after reducing commissions by as much as half to lure investors as stock markets rebounded. Traditional brokers, including Merrill, Smith Barney, UBS and Morgan Stanley, have a market share of about 15 percent, little changed from six years ago.

``The majors have become more focused on the affluent and are less concerned with the emerging investors,'' said Joseph Grano, 58, former chairman of UBS Financial Services, the U.S. brokerage arm of Zurich-based UBS. ``That's allowed the discount brokers to pick up share because the others have stopped chasing it.''

Reducing Fees

San Francisco-based Schwab, the biggest discount broker by assets, last month cut its highest trading commission to $12.95, seeking to prevent customers from leaving for Omaha, Nebraska- based TD Ameritrade or E*Trade of New York, which offer trades for even less. As recently as 2000, Schwab, led by industry pioneer Charles Schwab, 68, charged $37.38 for the average trade.

Even active traders pay full-service firms such as Morgan Stanley about $50 for a typical stock transaction, said David Hendler, an analyst at CreditSights Inc. in New York.

Merrill spokesman Erik Hendrickson declined to disclose prices for customers of the firm's full-service brokerage or its Financial Advisory Center, the call center for clients with less than $100,000. The $120 trades are for people who trade through Merrill Direct, Merrill's service for self-guided investors, which posts commission rates on its Web site.

Hendrickson said the services that Merrill provides are different from those offered by the discount brokers and prices shouldn't be compared.

Cost Advantage

Discount brokers have a cost advantage because they take stock orders over the Internet and process them electronically. Traditional brokers employ financial advisers to add a personalized touch, taking orders by telephone or in person, offering additional services such as estate planning and monitoring client accounts. They're marketing to millionaires they say are willing to pay a premium for the advice.

E*Trade, the No. 4 discounter by assets, spends only $1.83 of its $12.25 average commission on trade processing, mainly for computers and exchange and clearing fees, Chief Operating Officer Jarrett Lilien, 44, said. TD Ameritrade's processing costs are about the same at 15 cents for every dollar of commission revenue.

The companies kept profit margins up and cut trading fees by acquiring smaller competitors and moving their customers onto a single computer system. Between them, E*Trade and Ameritrade are eliminating more than 1,000 jobs.

`Less Handholding'

``The full-service brokers should be worried,'' said Blake Darcy, 49, former chief executive officer of DLJDirect, the online brokerage started by the investment bank Donaldson Lufkin & Jenrette Inc. and now part of E*Trade. ``They continue to live in a world where they say people really aren't smart enough and disciplined enough to manage their own finances, but people today need much less handholding.''

Shares of E*Trade climbed 66 percent in the past year, the biggest gain in the 12-member Amex Securities Broker/Dealer Index. Schwab advanced 43 percent, outperforming most of the largest firms on Wall Street at a time of record earnings for investment banks. Shares of New York-based Goldman Sachs Group Inc., the biggest U.S. securities firm by market value, rose 48 percent and Merrill gained 29 percent.

TD Ameritrade's stock fell 17 percent in the same period, reflecting the $6-a-share dividend it paid in January as part of the $3.5 billion purchase of TD Waterhouse USA. OptionsXpress Holdings Inc., a Chicago-based discounter that went public in January 2005, rose 54 percent in the past year. Fidelity Investments, the Boston-based owner of the No. 2 discount broker, is closely held.

Schwab's Foray

Charles Schwab was among the first to spot the opportunity for discount brokerage in the mid-1970s as the Securities and Exchange Commission moved to end fixed-trading commissions.

Schwab founded his company in 1971 and headed it through 1998 before he stepped down from running the firm on a day-to-day basis. He returned as CEO two years ago after his successor, David Pottruck, refused to cut fees to match rivals' lower rates.

Under Chief Executive Officer Stanley O'Neal, 54, Merrill salvaged its Global Private Client unit from the wreckage of the Internet bubble by courting millionaires with personalized services. From 2000 to 2003, the firm closed a quarter of its retail branches, relegated clients with less than $100,000 to call centers and shed 6,670 financial advisers.

Merrill also has been moving away from charging clients on a per-trade basis and pushing them into accounts that assess annual fees based on a percentage of the assets.

Merrill Club

Russ Loughry, 70, a retiree in Clearwater, Florida, said he belongs to an investment club that trades through a Merrill broker, paying about $200 for a 300-share order. The broker lets the group hold monthly meetings and make copies at his office, and he occasionally provides investment advice, Loughry said.

``If we went to a discount brokerage, we could operate a lot cheaper, but we would lose some services,'' Loughry said.

While Merrill ranks as Wall Street's top-performing brokerage for individual investors by revenue and assets per adviser, neither the firm's private-client unit nor its full- service rivals can match the profit growth or margins of discount firms.

``The bulge-bracket firms have more in the advisory and investment-banking area, which the Internet brokers don't have,'' said Peter Kovalski, an analyst at Alpine Funds in Purchase, New York. ``But if you just look at the retail brokerage part of it, the growth rates of the Internet brokers will probably remain a little bit better than the traditional full-service brokers.''

Profit Margins

Alpine, which oversees $3 billion of assets, owns about 100,000 shares each of TD Ameritrade and Morgan Stanley, and has smaller stakes in E*Trade, New York-based Citigroup and Merrill.

TD Ameritrade made 41 cents in pretax profit for every dollar of revenue it collected in the first three months of this year, the highest ratio in the industry, while E*Trade and Schwab had margins of 37 percent and 31 percent, respectively. By contrast, Merrill's private-client unit had a pretax profit margin of about 22 percent, best among its peers. All four firms are scheduled to report earnings for the quarter ended June 30 later this month.

The three discounters increased pretax profit by an average of almost 29 percent a year since 2001, compared with 11 percent for the biggest full-service brokers, according to calculations by Merrill analyst Patrick Pinschmidt.

`Wonder and Analysis'

Merrill is reconsidering the opportunity it gave up at the low end of the brokerage market. Robert McCann, head of the private-client unit, is seeking ways to serve clients with less than $250,000 and still meet the firm's profit targets.

``I cannot tell you right now that it's at the top of my list of priorities, but I can tell you there are people in this building who are working on it,'' McCann, 48, said. ``We haven't moved beyond the stage of wonder and analysis.''

Merrill derives 41 percent of pretax profit from its brokerage unit, the most among the biggest Wall Street firms.

To be sure, no one got hurt more than the discount brokers during the bear market from 2000 to 2002. Shares of TD Ameritrade fell 67 percent in 2000, after quadrupling during the day-trading boom of 1999 and doubling in 1998.

E*Trade shares fell 72 percent in 2000. The company was forced to close its 30,000-square-foot trading center on New York's Madison Avenue and reported annual losses in 2001 and 2002, hurt by three years of declines in the Standard & Poor's 500 Index. Christos Cotsakos who led E*Trade during its ascension in the late 1990s, resigned in January 2003.

Price War

Neither Schwab, E*Trade nor Ameritrade has matched the share prices they reached in 1999 during the frenzy for Internet stocks.

The price war that helped revive the discount-brokerage industry cost it revenue. Trading commissions at Schwab, E*Trade and TD Ameritrade will total $2.4 billion this year, down from a record $4 billion in 2000, according to estimates by Matt Snowling, an analyst at Arlington, Virginia-based Friedman, Billings, Ramsey Group Inc.

Schwab chopped rates nine times since May 2004. Its latest reduction, to $12.95 from $19.95, may reduce revenue by $25 million a quarter, estimates Richard Repetto, an analyst at Sandler O'Neill & Partners in New York. Schwab has higher costs than other discounters in part because it owns U.S. Trust, a private bank for clients with more than $10 million to invest.

``The commission cuts are about defending but also about grabbing market share,'' said Seth Dadds, an analyst at Garp Research in Towson, Maryland, who covers E*Trade and TD Ameritrade.

Day Traders

There are pitfalls in relying on computers, too. TD Ameritrade was flooded with complaints last month when a programming error left some former TD Waterhouse USA customers unable to gain access to their online accounts for several days. CEO Joseph Moglia, 57, sent clients an e-mail message apologizing for the delays.

Firms such as E*Trade, which made its name in the late 1990s as a venue for day traders gambling on the next hot technology stock, have reduced their dependence on trading commissions by getting into banking services such as savings, checking and money-market accounts, certificates of deposit and credit cards.

Discount customers apply for and monitor all their accounts and holdings online, dealing with employees only through customer-service call centers. E*Trade, now led by 48-year-old CEO Mitchell Caplan, also profits by reinvesting cash balances from clients' trading accounts into higher-yielding instruments.

``We make the same amount of money off someone with $10,000 of cash in their account as someone who trades 10 times a month,'' said Lilien, E*Trade's chief operating officer. ``If you think about the number of active traders out there, it's an infinitely larger population that has $10,000 to $15,000 in their account.''

Adding Branches

E*Trade got 29 percent of its revenue from trading commissions in the first quarter, down from 36 percent two years ago. In May, the company applied to the U.S. Office of Thrift Supervision for permission to open 13 bank branches stretching from Boston to San Francisco. Last year, it obtained a separate banking charter to make credit-card loans.

Schwab reduced trading commissions to 18 percent of revenue from 25 percent in 2003 and almost 50 percent as recently as 2000.

Buying TD Waterhouse from Toronto-Dominion Bank in January increased TD Ameritrade's brokerage branches to 143 from four, doubled its trading loans to $7.3 billion and tripled its client cash balances to $34.3 billion. The firm got 45 percent of fiscal second-quarter revenue from commissions and clearing fees, down from 55 percent a year earlier.

Courting Millionaires

``The concern would be that we have too much of an emphasis on our transaction revenue,'' Moglia said. ``That's no longer the case.''

For now, traditional brokers say they're content pursuing the wealthiest clients, betting there's more money to be made offering advice for a fee than attracting more trades.

To underscore its strategy, Merrill on June 20 unveiled the 10th annual survey of the world's millionaires at the firm's global headquarters in lower Manhattan. The study found the number of people in North America with at least $1 million in financial assets swelled 6.9 percent in 2005 to 2.9 million. Combined, they had wealth of $10.2 trillion.

``This will be the backdrop against which our 15,000 financial advisers work over the next few years,'' McCann said at the presentation. ``Clearly, it is the client above $250,000 that is our primary area of focus, and where we are driving our energies and our investment.''

`Quantity and Quality'

TD Ameritrade's Moglia, a former Merrill executive, said about 37 million households in the U.S. have $100,000 to $1 million to invest. The market is about $14 trillion, he said.

Cohen, the software developer from Flushing, New York, said he was ``using a live broker and paying astronomical fees'' for every trade until about five years ago.

``The advent of online trading has greatly improved the quantity and quality of my trading and obviously the bottom line,'' he said. ``Why would I want to pay that much more money when I can pay $10 a trade?"