Sector Spotlight: Online Brokers Stumble

While Schwab has surged ahead, other online brokerage stocks have suffered thanks to a trading slowdown.
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Enough of the guesswork.

Online brokerages will soon tell investors exactly how the bottom line fared during the last three months when retail investors pulled back from the frenetic trading pace that marked the early months of the year. Despite signs that volume picked up late in the quarter and may be recovering, results from the most recent quarter aren't going to be pretty.

Under the weight of scaled-back but still massive advertising spending, both

E*Trade

(EGRP)

and

Ameritrade

(AMTD) - Get Report

are expected to post slight losses for the June quarter. Among the major online brokers, only

Charles Schwab

(SCH)

is expected to come in with a positive number for the quarter.

Further up the food chain,

Nasdaq market maker

Knight Trading Group

(NITE)

-- whose largest customers are brokers like E*Trade and Ameritrade -- will fare better. But weak overall trading volumes did cause analysts to lower their earnings expectations for this trading house last month, after already having reduced estimates.

Falling Volumes

Investors began trading less in the most recent quarter after being spooked by the market's radical swings. The Nasdaq, for instance, closed at 5048.6 on March 10. By the March 15 close, it was at 4582.61, and on April 14, it closed at 3321.2, its recent low. Those swings led to margin calls. (When investors borrow money to buy stocks and the stocks fall below a certain level, they must either sell the stocks or put more money into their account.) Those margin calls made investors reluctant to trade at the earlier brisk pace or to borrow more money to trade with. For online brokers, that cut into margin interest revenue and trading commissions. In addition, the overall market downturn likely kept some potential customers from opening accounts.

Given all this, one thing analysts will look for is any sign that investors were coming back into the market in June. "It seems like in the middle of May the sentiment was, the market had dried up and people were picking up their bags and going home. When the smoke cleared, it wasn't great, but it wasn't catastrophic," Matt Vetto, a

Salomon Smith Barney

analyst says.

These stocks could use some good news. E*Trade is off about 39% this year, Ameritrade is down 47% and Knight has given up 39%. Only the more diversified Schwab -- which is moving into products like trusts with its recent purchase of

US Trust

-- has gained, up 29% so far.

Given the changes in market climate, there's also a focus on how much more brokers paid to acquire each new account through advertising during the recent quarter compared to earlier this year. Even though advertising spending overall declined radically during the quarter, fewer investors signed up for new accounts, meaning the per account cost still increased.

For instance, E*Trade added more than 600,000 new bank and brokerage accounts during the March quarter to put its total at 2.5 million accounts. This quarter, Salomon Smith Barney's Vetto is looking for only 300,000 new accounts. (His firm hasn't performed underwriting for E*Trade.) Slower customer account growth and resulting rising acquisition costs are the story across the board. Greg Smith of

Chase H&Q

estimates that Ameritrade's per account costs will rise about 17%, E*Trade's by 5% and Schwab's by 38%. (Chase H&Q has done banking for E*Trade but not for Ameritrade or Schwab.)

Emphasis on Spending

The reason so much focus is being put on accounts is that much of the trading information is out there already. Both Schwab and privately held

Datek Online

announce figures monthly. Smith, for instance, uses that information, as well as a 12% decline in Nasdaq trading volume, to come up with his industry-wide estimate for a decline in online brokerage average daily trades of 25% during the quarter.

According to

I/B/E/S

, analysts expect a loss of one cent a share at E*Trade and Ameritrade, compared with E*Trade's loss of 10 cents a share one year ago and Ameritrade's loss of 5 cents a share in income a year earlier. For Schwab, consensus estimates put earnings at 15 cents for the quarter, up from 12 cents a year ago. Knight is due to earn 51 cents, up from 43 cents a year ago.

If all this sounds rote, it's not. After all, the last three months were some of the most volatile for the financial markets in years. And it isn't known yet how well the online brokerages managed their risk during this tumultuous period, says Russell Keene, an analyst at

Keefe Bruyette & Woods

. In the past year, many brokers have increased the number of stocks that they will not allow to be purchased on margin or raised the margin maintenance requirements on them.

DLJdirect

(DIR)

, for instance, actually publishes a list on its Web site of every stock with extra margin requirements.

"There could be loan-loss problems or excessive loan provisioning. There could be problems with the balance sheets," explains Keene. "I don't think any of that is going to happen, but ... "