Gauging the Discount on Brokers

Stock trading volumes have fallen steadily throughout this year. Increased program trading and concerns over Iraq and energy costs are just a few of the contributing factors to the lagging activity, which has in turn beaten down the shares of discount and online brokers. But the carnage in this sector over the past two months has the current valuations of these stocks starting to look tempting on the surface, so we took a closer look at these companies.

First up is Ameritrade ( AMTD). The company has already warned that its fiscal third-quarter results would come in at the low end of its guidance range of 14 cents to 22 cents a share on weaker trading volumes. The stock is down 28% this year on lower trading volumes and concerns over the speculated retirement of CEO Joe Moglia, who was hired in 2001 and has since crafted the company's impressive earnings turnaround.

Ameritrade has been buying back stock during this downturn and picking up new brokerage accounts. On a historical basis, the stock is relatively inexpensive here at $10.13, or 15 times 2005 estimated earnings.

We believe this stock could be range bound, though. Investors have gained a lot of confidence in Moglia, and they will need to see some clarity on the CEO issue and a pickup in trading before bidding this stock higher.

The second stock we took a look at, E*Trade ( ET), is more than just an online broker now. Led by CEO Mitch Caplan, the company has branched into the mortgage and banking business.

While the move to a less trading-dependent revenue model could help soften the blow of sluggish retail trading volumes in the near term, the cyclicality of its mortgage and banking business may also cap its earnings multiple, which is currently 11 on the basis of 2005 estimated earnings.

Like Ameritrade, E*Trade is taking advantage of the gap down in valuation and said it will buy back over $300 million in convertible debt due in 2007 and 2008 this year.

But the Fed has started raising interest rates, and mortgage originations and income from interest-bearing accounts will soon feel the impact. We believe the multiple will have difficulty expanding in the near term, save some merger and acquisition speculation, as was the case when the stock hit its 52-week high of $15.40 a share.

At about three times the size of Ameritrade and E*Trade, Charles Schwab ( SCH) has the presence to influence industry pricing, and it exploited this competitive advantage in May when it said it was cutting commission prices for its online stock trades. Although the move will likely put a kink in the short-term revenue picture, the broker believes it will attract new business and protect margins through a hiring freeze.

And it looks like the company will need all the help it can get after losing 18,000 customers in May. Schwab joined the list of retail-dependent brokers that lowered guidance for the second quarter, and we don't believe the price cuts will have an immediate impact on volumes given the seasonality and weak underlying data of the stock market.

Don't Sell These Brokers Short

With the current data points painting such a bleak outlook for online trading, should you be shorting these stocks? We wouldn't, but we don't want to own them yet, either.

First, all three companies stack up well fundamentally. Cash flows have been improving, and since 2001 margins have hung in there through some rough patches along the way.

All three are led by solid management teams that, with the exception of Ameritrade's CEO, should be in place for years to come. Two of the three, E*Trade's Caplan and Ameritrade's Joe Moglia, have turned their respective companies around, and before the recent swoon they had the stock performance to prove it.

The summer trading slowdown has arrived, and that along with lower margin balances should keep all three stocks range-bound, so we would bide some time before putting any capital to work in this group. While we know the importance of being ahead of the curve when it comes to investing, we think putting money to work at this time would be premature, and we will wait until the trading data and earnings conference calls signal that a turn is coming.

David Peltier is a research associate at TheStreet.com. William Gabrielski is a research associate at TheStreet.com and is accredited with a Series 7 license. In keeping with TSC's editorial policy, Peltier and Gabrielski don't own or short individual stocks. They also don't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. They welcome your feedback and invites you to send your comments to stocksunderten@thestreet.com.

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