Online Brokers' Blasè Response To BOA May Come Back To Haunt Them

by: Marc Gerstein

E*Trade Financial Corp. (NYSE:ET) must be feeling pretty comfortable with its on-line trading perch. It took until yesterday for the company to finally announce that it would not follow along with a Bank of America Corp. (NYSE:BAC) initiative, announced on Oct. 11, to let customers trade stock for free. By now, E*Trade stock has fully recovered from the 11 percent drop it sustained in response to the free-trading announcement. There's a fine line between confidence and complacency, and Wall Street seems to have edged too far toward the latter.

Only one of the analysts who covers E*Trade, Campbell Chaney of Sanders Morris Harris, addressed the Bank of America issue. In an Oct. 12 report, he dismissed concern saying that:

"[t]ypical of marketing campaigns, the fine print on this promotion reveals many hidden fees and interest inefficacies that will not likely prove to be the punch in the stomach that yesterday's price action in ET shares suggested."

He may be right in suggesting a cool response on the part of the average E*Trade customer, who makes 10-11 trades per year with an average per-trade cost of $12, to Bank of America's two-account requirement [a self-directed brokerage account and a deposit], its $25,000 minimum deposit, and its lower CD rates.

Along those same lines, analysts who cover TD Ameritrade Holding Corp. (NASDAQ:AMTD) and Charles Schwab Corp. (NYSE:SCHW) may have been right to completely refrain from addressing the topic, and rival banks such as Wachovia Corp. (NASDAQ:WB) may be right in not going along, at least so far.

But will such comfort still be justified, say, six months or a year from now?

One consideration is Bank of America's size. In terms of market capitalization, it just passed Citigroup Inc. (NYSE:C) to become the world's largest bank. Therefore, it's at least arguable that anything Bank of America does becomes important, simply because Bank of America is the one that does it.

The other, and potentially more substantive, concern is business evolution. Even if it's true that Bank of America's free-trading setup is not the be-all and end-all of on-line trading, it is a start. In a world where asset gathering, rather than commissions, is the key to investment-services prosperity, it seems hard to ignore the fact that Bank of America has broken ground on a marketing infrastructure to go along with the trading infrastructure it, and other banks, already have. Who is to say revisions to the program won't later add considerably to its appeal?

On the other hand, who is to say any revisions at all will materialize? Perhaps the free-trading effort will turn out to be little more than a testing of the waters that goes nowhere.

While we cannot know the future, we can use what we do know to determine the extent, if any, to which on-line broker stock valuations leave room for competitive threats that, although visible, don't presently seem formidable but may become so down the road.

Table A shows our estimates of the minimum five-year EPS annual growth rates needed to enable those who buy shares of E*Trade, TD Ameritrade or Charles Schwab to achieve reasonable returns over that time frame. The table also compares those break-even growth rates with consensus Wall Street long-term growth rate expectations.

Table A gerstein 30.11

The results seem OK at first glance, although less so for E*trade which, unlike the others, seems to lack any margin for error. On closer consideration, though, all of the valuations raise concerns.

First, note that our break-even growth-rate projections use currently-published fiscal 2007 EPS estimates as a starting point. If any estimates are reduced in the year ahead, something that happens a lot and could be especially noteworthy in an industry where so much depends on hard-to-predict short-term stock-market developments, the growth-rate hurdles we compute would have to be revised upward.

And as hard as it is to predict year-ahead earnings in this business, it's much more difficult to predict longer-term results. Tables B and C show that most analysts who cover the stocks don't even bother to try, and that among those who do, there's a wide range of opinion.

Tables B and C Gerstein 30.11

Consider, too, the inherent volatility in the business. Admittedly, it's very hard to assess even the past, given that trends are often distorted by unusual factors such as acquisitions or changes in business models such as E*Trade's efforts in on-line banking. Subject to that proviso, and focusing on revenues rather than the much-more-volatile EPS line, Table D shows what we have for the companies, along with trends in the Russell 2000 and NASDAQ 100, indexes that may serve as a reasonable proxies for market conditions as viewed through the eyes of customers of the firms.

Table D Gerstein 30.11

It's not clear that any strong conclusion can be drawn from Tables A through D. Actually, though, that's the point. Expectations for double-digit EPS growth rates are priced into the shares of the on-line brokerage firms. But the data yields little to help us solidify convictions around whether such earnings progress is do-able.

Compare that with the situation for Bank of America. Here, we estimate a break-even EPS growth rate of only 5.3 percent. Table E provides do-ability context for Bank of America alongside comparable figures for the on-line brokers.

Table E Gerstein 30.11
Table E Gerstein 30.11 cont.

Bank of America is not by any means a slam dunk. It's sales-growth history, too, has been erratic. And it's likewise hard to lock in confidently on the long-term earnings growth-rate forecast.

But compared to the on-line brokers, there are some noteworthy differences:

* Bank of America's break-even growth rate is low, in an absolute sense.

* Bank of America's break-even growth rate is near the low end of the range of expectations, as with TD Ameritrade but in contrast to the situation with E*Trade and Schwab.

* Discomfort on Wall Street with long-term growth-rate projections is a fact of life, but with Bank of America, the degree of discomfort is less, as evidenced by the fact that more than half the analysts covering the company took the trouble to publish an estimate.

* On a percent [from low to high] basis, the range of long-term expectations for Bank of America is wide, but we could arguably be more tolerant of that since the break-even growth rate is so close to the low end of the range.

Still, this is not to suggest that Bank of America shares are necessarily better than those of the on-line brokers, especially given that one Wall Street analyst, Matthew Fischer of Prudential Equity Group, suggested, in a Nov. 20 research report, that E*Trade might be a takeover target.

But the data does provide food for thought for industry observers who are so casually brushing aside the Bank of America free-commission initiative. It's there. It has the potential to be improved. And the on-line broker stocks seem to have little margin for error to accommodate future surprises on this front.

At the time of publication, Marc H. Gerstein did own not shares of any of the aforementioned companies. He may be an owner, albeit indirectly, as an investor in a mutual fund or an Exchange Traded Fund.

Note: This is independent investment and analysis from the investment channel, and is not connected with Reuters News. The opinions and views expressed herein are those of the author and are not endorsed by