Online Brokers See the Darkness, Await the Dawn

If 2002 is the year online brokerages finally dig themselves out, their hole only got deeper in the year's first quarter.

First-quarter earnings reports are due from

Charles Schwab

(SCH)

,

E*Trade

(ET) - Get Report

and

Ameritrade

(AMTD) - Get Report

over the next two weeks, and while both Ameritrade and E*Trade will show year-over-year earnings improvement thanks to cost-cutting, none of the three is expected to beat its December quarter numbers.

Deep cost cuts by all three, and diversification into new sources of revenue at Schwab and E*Trade, have bolstered profits. But the companies remain highly dependent on a fickle stock market, and retail trading and margin lending have yet to pick up.

After an earnings warning last month, analysts are betting that Schwab will pull in 8 cents a share, on par with its year-ago and fourth-quarter earnings numbers. Ameritrade, which lowered its own guidance on April 5, citing online trading activity levels, is now seen earning 2 cents a share. That's up from a 9-cent loss in the year-ago period but down from 4 cents a share in profit the December quarter. E*Trade is expected meet its target of 7 cents a share, which is up from break-even in the year-ago quarter and on par with the fourth quarter.

"The first quarter is going to reflect what continues to be a generally weak stock market," said Kenneth Worthington of CIBC World Markets. "The retail environment still stinks. There's not a lot that's changed. Going into the beginning of this year, there was a lot of optimism about a rebound in the stock market, but given the change in market sentiment, retail investors probably won't really come back until the fourth quarter," he said. After online retail trading activity surged 25% in the fourth quarter of last year from the third, some hoped that retail investors were ready to jump back into the market with both feet, he said.

E*Trade reports its first-quarter earnings on April 17, Ameritrade is scheduled to release its fiscal second-quarter earnings on April 23, and Charles Schwab is expected to report earnings between April 15 and April 19.

Different Strokes

Unlike its peers, E*Trade is unlikely to warn this quarter or miss its numbers, analysts said. After an aggressive move into banking over the past year, E*Trade now gets around 29% of revenues from mortgage lending and 13% from other banking products. "E*Trade

retail trading volumes should be lighter than expected, but they can make that up with better-than-expected results in the mortgage and banking business," said J.P. Morgan analyst Adam Townsend.

Interest rates rose in the first quarter, driving a mad rush to refinance mortgages, while weak stock market conditions kept investors in CDs and money market accounts, he said. E*Trade doesn't provide monthly updates on trading activity like its peers do, but data from other online brokerages suggest that overall trading activity flattened out vs. the fourth quarter.

Charles Schwab averaged 148,000 daily revenue trades in the first two months of this year, on par with the fourth quarter, while Ameritrade saw average daily revenue trades edge up to 91,000 in the first three months of this year, from 86,000 in the fourth quarter. Datek, which recently agreed to be acquired by Ameritrade, saw daily average revenue trades slip to 76,000 trades in the first quarter, from 78,000 in the fourth quarter. And TD Waterhouse, controlled by Canada's Toronto Dominion Bank, handled around 109,000 revenue trades daily in the first quarter, up from 105,000 in the fourth quarter.

Margin lending, meanwhile, has declined to $147 billion at the end of February, from $150.5 billion at the end of December. March data are not yet available. "We had a nice move up after Sept. 11 but started to roll over in February," said Worthington.

Stock Market Blues

Higher compensation costs are the biggest reason for Schwab's lowered first-quarter guidance, analysts say. The company announced plans to

reinstate bonuses this quarter in March.

But Charles Schwab is also less insulated from the stock market than E*Trade. Close to half of its revenue came from its asset management business in the fourth quarter, and while that was one of the stronger performing areas of Schwab's business, with revenue up 6% to $436 million, this may have reflected a temporary asset shift toward higher-margin money market funds, according to Salomon Smith Barney analyst Guy Moszkowski.

Ultimately, Ameritrade is by far the most dependent on the stock market, with 62% of its revenue coming from brokerage transactions and 23% from net interest income on margin loans.