Hesitate to Invest in This Brokerage Firm

Anh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

In order to become traders/investors in the stock market, investors need intermediaries to help to buy/sell stocks. These intermediaries are brokerage firms. So one might think if it is a necessity for investors, brokerage investment services would be a business which can grow over time and offers shareholders a good return in the long run, especially if these companies are underpriced. However, in some cases, one might be a customer but should not be an investor in a certain business. Personally, I think it is the case for this discount brokerage firm.

E*Trade (NASDAQ: ETFC) recently announced its third quarter earnings results. The revenue for the third quarter was $490 million, and the net loss was $29 million, or $0.10 loss per share. It was a disappointing result when prior quarter, it booked $40 million profit, or $0.14 EPS, and in the same quarter 2011, it had net income of $71 million, or $0.24 EPS.

After the earnings announcement, its share price dropped from $9.42 to $8.75, a loss of 7.1%. Year-to-date, E*Trade’s price has been quite volatile. Its stock’s beta is 2.34. It theoretically means that E*Trade’s stock is 2.34x more volatile than the general market.

<img src="/media/images/user_14219/screen-shot-2012-10-23-at-33254-pm_large.png" />

Disappointing third quarter results

In third quarter 2012, E*Trade recorded a much larger gain on loans and securities, nearly $79 million, 3.25 times higher than last year figure of $24.3 million. However, it had to factor in the much larger provision for loan losses, of $141 million, whereas the provision was only $98.3 million the same quarter last year. In addition, the company had to book more than $50 million losses on early extinguishment of debt, which was the main reason bringing its $59.9 million operating income into net losses. The company said that it resulted from the fact that it terminated $520 million of its fixed-rate wholesale borrowing, which were expiring in 2014.

Industry peers

As of September 2012, it had $5 million in shareholders’ equity, $29.13 billion deposits, $14.9 billion available-for-sale securities, and $10.6 billion loan receivables. The company had 4.4 million customer accounts, including 2.9 million brokerage accounts. The number of brokerage accounts was much less than 5.7 million accounts of TD Ameritrade (NYSE: AMTD) and 8.7 million accounts of Charles Schwab (NYSE: SCHW)

Currently, it is trading at $8.44 per share. Compared to its other two peers, E*Trade is the smallest firm with only $2.41 billion market capitalization, whereas Charles Schwab’s market cap is $17 billion and TD Ameritrade’s is $8.61 billion. Psychologically, customers would feel safer when they park their money with the largest brokerage firms. That explains why Charles Schwab has the most brokerage accounts, which are three times higher than E*Trade's. In addition, Charles Schwab and TD Ameritrade seem to plan more actively for their expansions. Charles Schwab is following the franchise model by partnering with independent advisors, and it hopes to have 80 branches by 2013. TD Ameritrade would grow by having more and more salesperson (100 more annually) without opening up many branches. How about their operating metrics compared to E*Trade's?

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p><strong>EFTC</strong></p> </td> <td> <p><strong>AMTD</strong></p> </td> <td> <p><strong>SCHW</strong></p> </td> </tr> <tr> <td> <p><strong>Operating margin (%)</strong></p> </td> <td> <p>22.24</p> </td> <td> <p>38</p> </td> <td> <p>33.42</p> </td> </tr> <tr> <td> <p><strong>D/E (%)</strong></p> </td> <td> <p>86</p> </td> <td> <p>33</p> </td> <td> <p>26</p> </td> </tr> <tr> <td> <p><strong>ROE (%)</strong></p> </td> <td> <p>2.75</p> </td> <td> <p>14.4</p> </td> <td> <p>10.81</p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>29.6</p> </td> <td> <p>14.5</p> </td> <td> <p>20.5</p> </td> </tr> </tbody> </table>

We can see that among the three, E*Trade has the lowest operating margin, highest leverage level, and the lowest return on equity. In addition, it doesn’t pay any dividend, whereas the dividend yield of TD Ameritrade and Charles Schwab are 2% and 2.1% respectively. Now E*Trade has the most expensive valuation, of 29.6x, much higher than TD Ameritrade’s, of 14.5x and Charles Schwab’s, of 20.5x. Furthermore, E*Trade's DART (daily average revenue trades) experienced the most significant downfall in the third quarter. Its DART was 129,000, 22% down year-over-year, whereas Charles Schwab's was 261,500, 19% lower than Q3 2011. And TD Ameritrade had the highest DART among the three, of nearly 355,450 in its second quarter, down only 4% compared to the same period last year.  

My Foolish Take

We can see that among the three dominant brokerage firms, E*Trade is the smallest of the three and seems to have the least operating performance. It recently experienced a disappointing third quarter results with the most significant decline in year-over-year DART figure. In addition, the firm paid no dividend, had a high beta for its stock price and a high valuation. That is why I personally do not think E*Trade could be suitable for long term investors to buy at the moment. 

hoangquocanh has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend TD AMERITRADE Holding and Charles Schwab. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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