Recovering equity markets and increasingly optimistic expectations for economic recovery have helped push shares of TD Ameritrade (AMTD) higher as the online site attracts record high assets from retail and institutional investors. Total client assets recently reached an all time high of $395 billion last quarter, a 2% monthly increase from December, helped by estimated inflows of $2-$3 billion. Retail trading activity was strong, although at least partially helped by seasonal trends, reporting an increase of 25% in January from December. Also, as client confidence continues to grow stronger, margin balances increased 7% last quarter.
Surprisingly, trading activity only paints part of the picture for AMTD considering less than half, 45%, of revenue is derived from commissions and transactions fees. This form of revenue is expected to continue to represent a declining percentage of total revenue going forward. Insured deposit account fees are the second largest revenue driver at 27% of the total, while net interest revenues are 18%, investment product fees represent 6%, and the remaining 4% are from other various business activities.
Increased volatility in the equity markets and a period of sustained optimism have been a positive catalyst for AMTD shares over the last six months. However, near zero interest rates have been a serious headwind to profitability. The steepening of the yield curve has been helpful, but until the Fed starts to raise rates again, AMTD will not realize its full earnings potential. A Credit Suisse report indicated that for every 25 bps rise in the Fed Funds Rate, AMTD is likely to gain an incremental $0.07 of EPS. (EPS for the last fiscal year were reported at $1.05 per share.)
While the Credit Suisse report indicated the helpful impact of future rate increases, they are not expecting an event to occur until the 2013 calendar year. This is where I believe expectations are too modest. Given the recent inflationary backdrop in the worldwide financial media, I believe that rate increases will take place sooner than 2013 to combat inflation in the United States. The sooner the increases take place, the more likely the upside surprise will be for EPS. However, this scenario could occur, and still not provide a positive outcome. Should inflation come too fast unexpectedly, corporate profitability could be negatively affected resulting in a relapse of fear for the investment community, causing investors to withdraw assets.
Although the short and intermediate term outlook and subsequent consequences for AMTD are uncertain, the long term outlook remains attractive. With a mostly fixed cost structure, AMTD is poised to increase profitability margins as the company continues to grow. The balance sheet has $1.4 billion in cash compared to $1.3 billion of long term debt and is a strong cash flow producer. The company recently repurchased 3.2 million shares last quarter and has approximately 27 million shares left in their current repurchasing program. Also, AMTD paid its first dividend, $0.05 per share, to shareholders two quarters prior.
Overall, the AMTD business model is very attractive; however, there are two noteworthy risks. First of all, price competition in the online investment brokerage world will always be a risk. Should a competitor choose to offer significantly lower fees for trades than AMTD or offer competitive rates for insured deposits, revenue would be negatively affected in a severe way. Another slightly worrisome characteristic of AMTD is that 40% of shares are owned by Toronto Dominion Bank, while another 15% are owned by the Ricketts family. This automatically puts all other shareholders in the minority, which leaves them subject to the interests of these two parties.
Shares of AMTD have rallied over 44% since the end of August 2010, outperforming the S&P 500 by over 17%.
The rallying equity market has brought excitement back into the shares of AMTD, but the consensus estimates for EPS for the upcoming calendar years of 2011 and 2012 have actually been pressured lower as the stock has climbed higher. The stock now trades at 18x forward EPS, which is at the high range of where the stock has traded over the last four years.
The intrinsic value of AMTD is $24.50 based off internal valuation models, which is 14.5% higher than the closing price on 2.15.2011 of $21.38. The one year target price is $29. These values were found after assuming an average annual revenue growth of 9.5% over the next five years and operating margins expanding to 47% from the 2010 levels of 37%. (Operating margins were 48.5% in 2009 and 52% in 2008.) The terminal value five years out was derived by using a 16x trailing EPS multiple. This multiple was chosen because of the long term EPS growth expectations of 10-%11% and strong cash flow generation which will be used for share repurchases and also an increased dividend payout.
While the most opportune moment to buy shares of AMTD may have passed, there still appears to be some upside from the current price. Perhaps a better window of opportunity will present itself in the near future, but AMTD’s sound business model and profitability outlook make it a solid name to own for the long term even at current valuations.