Brokerage Stocks: Trouble on the Horizon?

We all know that the brokers play an integral part in both trading and investing. Everyone who trades needs a brokerage account, and some people have multiple accounts with various brokers. These brokers make their money based upon the commissions that they receive, generally on a per trade basis. This has been a profitable model for these brokers, as the market conditions of years past have been bullish, which encourages people to put their money to work in the financial markets. The more money people put to work in the markets, the more commissions the brokers can earn.

But with thoughts of a recession looming, a recent rash of people pulling money out of play in the markets should mean that the brokers' main source of revenue, their commissions, will fall drastically.

This expectation should lead the stocks of these brokers such as Optionsxpress Holdings (OXPS), The Charles Schwab Corporation (SCHW) and Interactive Brokers Group (IBKR) to fall. In fact, the thought of recession has led to recent declines in the prices of all three of these stocks.

What is the problem then? The issue is with the market expectations that these companies are still going to make windfall profits. Under the conditions of tough credit and a market that has seen capital fleeing over the past quarter, it is baffling as to how the analysts can still claim that all three of these brokers (OXPS, SCHW, IBKR) are going to exceed their earnings from the same period last quarter. The stocks are falling for a reason, right? And a stock price generally shouldn't fall on a company that is making more money every single quarter.

For the quarter ended June 8, 2008, analysts have given OptionXpress a mean earnings estimate of $0.39 a share versus actual earnings of just $0.35 a share for the same period last year. For The Charles Schwab Corporation, that estimate is $0.26 per share, versus an actual of $0.23 for the same period last year, and Interactive Brokers Group has been give a $0.49 a share mean estimate despite just earning $0.33 a share for the same period last year.

It is important to realize that these companies have other sources of income other than just their brokerage commissions. They operate some proprietary trading and collect a significant amount of interest from margin accounts. The margin interest is also likely to suffer from having a lesser amount of capital entry into the markets, and even if these companies were able to keep interest and trading income equal to last year's levels, there is still no possibility that they could have brought in the same amount of brokerage commissions.

The bottom line is that it seems as though these companies are set up to disappoint the market when they report for this most recent quarter. OptionsXpress will report on July 15, The Charles Schwab Corporation on July 14 and Interactive Brokers Group on July 21. If one of them reports lower than expected earnings look for the market to then price in lower earnings for the entire group, but until that happens this can be a great opportunity particularly for you traders out there. These look like prime put option opportunities if you can get in before any fall in expectations takes place

In the long run, though, the market will rebound and that is the time for those of you who are long term investors to swoop in and pick up these companies, which are actually quite well managed companies, at bargain prices.

Disclosure: Author holds a short position in OXPS

Comments

[James Davis:]

You need to do some more work on IBKR, they make more than 'some' money from prop trading. THEY ARE MARKET MAKERS WORLDWIDE.

Lumping them in with the others is poor workmanship.

They may or may not beat, but it has little to do with retail clients.

2008 Jul 07 11:19 AM

[Njord Wind:]

Can't say I agree with your short thesis. I don't know a lot about IBKR and even less about SCHW, but I've spent a fair amount of time on OXPS. I've noticed their revenues (and, because of their very stable margins, net income) correlate very highly with quarterly CBOE volumes. The model could use a little work because I don't break out PFOF and interest income, which will be declining to flat in the current environment. However, 2Q08 CBOE volumes were up 27% versus the prior year period, meaning commissions and other brokerage income should remain strong. We've also seen DARTs, net new accounts and margin balances hang in very well during April and May, although admittedly June was a very bad month, and may have scared some people away. Furthermore, the retail investor has hung in thus far, and of course options can be used in either market direction. Bottom line is I've got several indicators pointing towards upside to the 2Q numbers. Do you have something you can point to besides "The stock and market have gone down and thus I don't think they'll hit numbers"? Not trying to be antagonistic, I'm just looking for a little more detail.

On another note, if you've been short these stocks for awhile,well done, good trade thus far. If you've just initiated the positions recently, however, I think you're in the wrong place. In addition to everything I mentioned above, OXPS is currently trading at all-time lows in P/Forward earnings, P/S, P/EBITDA, pretty much every valuation measure, and they numbers aren't even that high: 12X forward earnings and 7.7X EBITDA. Margins have remained steady. The stock has already fallen 37% this year (after a 49% rise in 2007); still, I think you missed your chance.

2008 Jul 07 11:42 AM

[doug estadt:]

Sorry, but must disagree with you on being negative IBKR, Interactive Brokers are growing rapidly and their slick new ad campaigns on CNBC and Bloomberg emphasizing they are approx 15 x better executing trades than most brokers is surely helping them gain new accounts. And they seem to be geared toward more sophisticated clients who will be shorting and trading in int'l markets which doesn't mean their revenues will be declining.

2008 Jul 07 12:02 PM

[Njord Wind:]

Whoops: Disclose needed - long OXPS.

2008 Jul 07 12:04 PM

[Inglefox In...:]

I will say that IBKR is certainly the strongest of the bunch and I used the term "some" to describe the prop trading because I was lumping the three together. It is indeed true that IBKR relies probably more heavily on prop trading than retail investing. In my article I'm taking the assumption that their prop trading numbers will be equal to their numbers from last year (which may not even be possible) and that their retail numbers are what will be responsible for a miss in earnings.
For Doug Estadt, I see the fact that IBKR is undergoing a "slick new ad camgaign" as a sign of a weakened retail business. They are trying to attract more customers by outadvertising the competition.
And there is no doubt in my mind that while IBKR is the strongest of these three there is also no doubt in my mind that OXPS is the weakest. Mr. NjordWind, you have cited forward looking numbers that are based upon analyst estimates and just because a stock is at its lows does not mean that it cannot sink any further. Under the current conditions it just doesn't seem possible for OXPS to have made more money this year than last and I expect a big miss. I hope for your sake that you're right, but I see all of the evidence pointing to the downside.

2008 Jul 07 02:12 PM

[Njord Wind:]

The only forward looking numbers I cited were earnings - on a trailing basis P/sales and P/ebitda are at all time lows. Furthermore, this company has pretty good earnings visibility, at least into the next quarter. This is because they provide us with monthly updates on DARTs, new accounts, margin balances, etc. This means estimates for the current quarter already have 2 months of information built into them. I've got my own model for estimating earnings, it has performed quite well, and it's currently pointing towards the high side of analyst estimates for this quarter.

Could you please elaborate on the "current conditions" under which OXPS can't make more money? I've already pointed to the high correlation of OXPS revenues to CBOE volumes to show how it's quite easy to see revenues and net income increasing year over year. Your short thesis does go beyond "I've got a feeling", doesn't it?

Here's one thing to think about: How, exactly, does capital flee the market? Hint: It doesn't take the bus.

2008 Jul 07 03:37 PM

[Inglefox In...:]

First of all, capital "flees" the market as people sell equities (evidenced in a falling market) and move into cash.

OXPS more than IBKR or SCHW relies on options trading and yes it is true that people can buy put options in falling markets; however, if you look to the CBOE VIX you'll see that people have been forced to pay some extremely high premiums over the past quarter in order to obtain options. These high premiums eat into the available option capital and thus cut the number of commissions that can be earned by the options brokers.

One of the most important things to remember when talking about the DARTs is that the current released DARTs only represent part of the quarter. Don't get a false sense of security in the DARTs because they cannot tell the entire picture.

Of course you can debate all you like, but the real answer will only come when the company reports and so I think it's best to let the actual earnings solve the debate. If you wish to discuss this further then I encourage you to visit my blog.

2008 Jul 07 04:25 PM

[long ibkr:]

I think most of this discussion is failing to understand IBKR's business. As previously mentioned by one post, they are a MARKET MAKER first and foremost. 75% of their business is market making, most of which is in exchange-listed options. So, their performance is tied most closely to volume of options trading and levels of volatility. Using the OCC daily volume numbers and the VIX as proxies for those two elements, one can clearly see why IBKR is expected to perform ahead of year-ago quarter. Bear in mind analyst consensus last quarter was $0.50 and they delivered $0.66. Simply making the assumption that their brokerage biz will disappoint and their trading biz will perform in line with a year ago is a rather erroneous assumption. We're in a credit crunch/bear market, remember? Active traders, the customers of IBKR's brokerage, are most likely to trade actively around this kind of market. And the market making biz should be licking its chops at the options volume and implied volatility levels. I guess InglefoX is just making the short case to talk his book, but I don't find it very compelling.

2008 Jul 08 10:26 AM

[MoneyDude:]

You forgot to mention that Interactive Brokers has the worst customer service in the industry which drives away all of the good clients. They surely are the weakest of the group. They are also subject to devastating trading losses due to insufficient internal controls.

2008 Jul 10 10:12 AM

[jkort:]

What a terriable article. Why does seekingalpha let stuff like this on their site?

2008 Jul 10 07:19 PM

[ChinaGasGuy:]

I do not know much about schwab and the other broker you mention, but you I am extremely familiar with the insides of IBKR. Your 'analysis' is the typical back of the envelope supposition that gets amateur investors very deep trouble in the stock market. The current environment is actually quite favorable to IBKR as their profitability is substantial driven by volatility, and often hurt by a high level of front running which occurs when there is a high level of M&A activity (which has fallen off a cliff during the past 12 months). The do not take net long or net short positions and close each day with a fully matched position comprised of listed securities. They do not, btw, make a lot of money on cash balances like other brokers who offer only puny interest rates on cash. They are uniquely poised to add market share at this point and have the luxury of cherry picking better quality customers rather than the lowest common denominator of the hedge fund world. As for customer service, if you are looking for Chas. Scwab-like customer service (i.e. someone to tell you how to fill out your deposit slip) you would not be satisfied with IBKR, but if you are a small sophisticated institutional investor, you will enjoy an equally sophisticated counterpart.

I agree with the other commentator who suggested Seeking Alpha should raise the bar... this kind of 30,000 foot 'analysis' is really not helpful and belongs on the yahoo bulletin boards.

2008 Jul 11 09:54 AM

[Ames Tiedeman:]

All brokerage stocks will sink this summer. They are doing so now.

2008 Jul 11 09:49 PM

[Njord Wind:]

Did I say something "this company has pretty good visibility", and therefore the likelihood of them missing badly was poor? Being short OXPS at this price has terrible risk/reward, especially if your short thesis is: "I think they're going to miss".

2008 Jul 22 12:13 PM

[James Davis:]

IBKR, nothing like being right for the wrong reasons.

2008 Jul 25 02:27 PM

[vagabond:]

I use to work for ibkr back in 83-84 best company i ever worked for ,i have an account and couldent help buying today . Next week or so will be back over 30 tom peterfiy is very smart and shorts be warned.

2008 Jul 25 04:25 PM