Friday, October 13, 2006

Calls of Note Part 5

Friedman, Billings, Ramsey is out with an interesting piece on online brokers in light of Bank of America's move to "$0 Commission", which has once again ignited fears over a price war among online brokers--fears they believe are misplaced. In fact, history suggests that the online brokerage industry move to lower commissions rates has been calculated and has created shareholder value each step of the way. A review of average commission rates shows a decline of 31% since 2000--a trend that would be worse if not for the increase in higher fee option trading. With such a backdrop, many believe this will ultimately result in zero fees. Despite the intense pricing pressure on commission rates, the successful online brokers have actually
thrived as a result of diversifying their business models and being able to drive down incremental costs. As a result, revenues and profitability are at all-time highs--contradicting the fears of those focused simply on commission pricing pressure. With such scale and efficiency advantages over potential rivals--in trading, cash management, and lending products- firm believes that TD Ameritrade (NASDAQ:AMTD), E*TRADE (NYSE:ET), and Schwab (NASDAQ:SCHW) are well positioned going forward, even if the industry moves to zero commissions.

To isolate the more recent price-cutting period beginning in 2004, the all-in average commission rate of online brokers under coverage has fallen 18%. When adjusting for E*TRADE's sale of its professional trading segment in 4Q05, which increased its average commission rate after the divestiture, the average rate drop of the group has fallen even more at 23%. While many assume this is a reflection of the eroding economics of the business,
the opposite is true. Much of the decline in commission rates was a function the brokers passing on the efficiency gains realized to customers, while the rest is a reflection of the change in the business model that has increased the profitability of accounts while at the
same time being able to offer lower trading costs to customers.

Despite the drop in commission rates, revenue per account is up 46% and, more importantly, profit per account is up 87% since 2003. This trend underscores the move across the industry to diversify revenues into cash management, lending, and asset management sources. So, while brokers are often willing to lower commission rates drive account and asset growth, the trade-off is in higher fee and spread income, which more than offsets the loss of transaction revenues. All together, earnings growth on average is up 87%.

Notablecalls: Traders are happy with lower commissions, brokers are also happy.. one big happy family!

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