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AMTD AT A GLANCE

P/E ► 19.2 AVG EV/EBITDA ► 12.8 AVG ROA ► 3.8% AVG ROE ► 19.9% HIGH Debt to Equity ► 4.17 AVG Interest Coverage Ratio ► 70.9 HIGH

 

 

 

 

 

 

TD Ameritrade (NYSE: AMTD) is an online stock brokerage, and it executes more than 253,000 transactions on an average day.^[1] Both individuals and institutional investors use TD Ameritrade's service, trading stock, bonds, and options.^[2]

TD Ameritrade's traditional revenue base comes from the transaction-based fees it charges to clients for brokerage and clearing services. This business model has been successful for online brokers because operating costs are so low in this industry. In fiscal 2007, TD Ameritrade made $1.02 billion in operating income, recording an operating margin of 39.08%.^[3]

TD Ameritrade also makes money on the cash in its clients' accounts, by lending out this money to other clients through margin accounts, and to third-party borrowers through affiliate banks. 2006 was the first year in which this revenue was greater than TD's earnings from transaction fees.

Background

Toronto-Dominion Ameritrade, or more simply TD Ameritrade, grew out of the union of two discount brokers. In 1971, Ameritrade was originally created as a local investment bank in the state of Delaware. ^[4] However, Ameritrade took its first steps to become one of the leading brokers in 1974 by initiating its brokerage services. In 1994, Ameritrade took its first steps towards addressing the rapidly expanding Internet market by purchasing Aufhauser and Company, a company with a platform for the first Internet security trading service. ^[5] Most recently in 2005, Ameritrade bought TD Waterhouse, another online brokerage firm and network of Registered Investment Advisors, for 192 million shares of Ameritrade and $20,000 dollars in cash. ^[6]

Company Overview

Cost Structure

Part of what keeps TD Ameritrade so competitive within the online brokerage services industry is its uniquely constructed cost structure. Operating for the most part as an online brokerage, maintaining only around 100 brokerage firm locations throughout the United States, TD Ameritrade’s fixed cost infrastructure has allowed for greater financial flexibility and has resulted in one of the lowest operating expense per trade figure out of all the publicly traded brokerage firms. ^[7] For FY 2007, TD Ameritrade spent $79.7 million in clearing and execution costs and $83.4 million in occupancy and equipment costs. ^[8]TD Ameritrade’s highest fixed cost for FY 2007 was $413 million in employee compensation and benefits. ^[9]  

Revenue Sources

There are two different ways in which TD Ameritrade makes its money. The first is directly through the transaction fees that it charges to its clients. The second is asset-based revenues.

Over the past five years, TD Ameritrade’s growth in asset-based revenue has outpaced its growth in transaction-based revenue. For FY 2007, transaction fees earned $813 million in revenue whereas asset-based revenues were $1.32 billion; this was the second year in which TD Ameritrade earned more from asset-based revenues than from transactions.^[10] For the most part, the amount of revenue brought in via transaction fees is directly tied to the performance of the overall economic environment. For this reason, many brokerages have turned to revenue sources that don't directly depend on trading volumes in order to diversify and protect themselves against downside risk.

Asset-Based Revenue

The first way in which TD Ameritrade earns asset-based revenue is through loans to clients who elect to purchase securities on margin. In margin loans, TD Ameritrade facilitates a loan to the client and charges an interest rate based on the type and terms of the loan to the client. The client pays down the interest and the capital within the period specified. The second way in which TD Ameritrade earns asset-based revenue is through opt-in money management services that it provides to its clients and account holders. Money from these accounts is loaned out to banks (in this case, TD Bank USA). The bank, in turn, makes long term loans on the cash and pays short term rates to the account holder, making a profit on the interest rate spread.

Transaction-Based Revenue

TD Ameritrade offers and facilitates the transaction of corporate stock, fixed income securities, exchange traded funds, options trades, mutual funds, cash management services, and margin accounts. For most of the transaction-based services that TD Ameritrade provides, it charges a fee. Transaction revenue is dictated by the trading volume and the total fees that are collected based on those volumes. From 2006 to 2007, TD Ameritrade saw a 16% increase in the volume of trades executed on its platform, exhibiting a relatively small change in average commissions and transactions fees per trade of about -5%. ^[12]

Trends and Forces

Trends and Forces Affecting Transaction-Based Revenue

• Competition for mass market investors is high – TD Ameritrade, along with its competition Charles Schwab and Etrade, is competing primarily for mass market investors (investors with portfolio value under $100,000). Each company employs a slightly different strategy when approaching the market.
  • TD Ameritrade is relatively new in the market and is still digesting its acquisition of TD Waterhouse, but is working to build a business platform out of low fees per transaction and an extensive RIA network. ^[14]
  • Charles Schwab has the incumbency in the market and focuses on garnishing funds from high end mass market investors and mass affluent investors (investors with portfolio value between $100,000 and $1 million). In achieving this, Charles Schwab has placed heavy emphasis on building new client accounts in addition to encouraging current Charles Schwab investors to increase positions.^[15]
  • Etrade has a deposit growth rate 4 to 5 times higher than an average bank, allowing them to offer higher yield deposit earnings to its clients in addition to the ability to take larger positions in margin lending. ^[16]
  • Comprising more than half ($1.7 trillion) of US investible assets within the online brokerage industry, these three companies are prone to pricing wars as a result of the commoditization of brokerage transactions, so even the slightest edge in mass market appeal will expand balance sheets.^[17]

• Low variable costs for online brokerage mean low barriers to entry - TD faces plenty of competition from existing brokerages like Charles Schwab and E*Trade, but it also must continually contend with new entrants to its industry. The low cost of online trading means that competitors with lower price points constantly threaten AMTD's market share, while some major banks offer trades for free as loss leaders. AMTD must maintain customer loyalty and attract new users through the strength of its brand name and website, because it cannot compete with the lowest-priced competition. The firm is betting that online investors are looking for quality and an established name as well as trade price when they choose an online broker.

• TD's revenue growth depends on the health of the US/global economy - The most significant economic factor affecting transaction-based revenue is the overall health of the US and global economy. In times of prosperity, companies exhibit higher growth rates and promises of high returns for investment capital. As a result, investors have more confidence in the ability of corporations to achieve these, and the volume of investment transactions increases. In addition, investors have more disposable capital to spend on stock transactions in bullish times. However, in times of economic recession, the future of corporate earnings hangs in the balance of uncertainty; questions about the ability of retail and institutional investors to sustain capital investments creates an overall lack of confidence in the market, pushing stock prices down cyclically in addition to lowering trading volume. With the current questions circulating within the media of an impending economic recession, TD Ameritrade’s transaction based revenue will suffer if volume trading decreases in the long term.

• When the Fed cuts interest rates, TD's profits increase - Over the six months from Sept. 2007 to March 2008, the Federal Reserve has lowered interest rates to 3% through five rate cuts. September 18th, 2007 was the first time the Fed cut rates in four years. In general, rate cuts are positive for corporations because they allow companies to expand projects, since cost of capital for the firm is lower. Additionally, since debt products provide lower rates of return on investment, investors are more inclined to invest in corporate stock when interest rates are low. This increases AMTD's daily trade volume, and, subsequently, its profits.

Trends and Forces Affecting Asset-Based Revenue

• TD Ameritrade depends on the Yield Curve for a large part of its revenues - Money market sweep accounts and margin loans are the two ways that TD Ameritrade earns asset-based revenue. In both cases, the firm's profits are tied to the yield curve, which is determined by the market's current interest rate spread. The yield curve describes the difference between short-term and long-term interest rates. When the yield curve is positive, meaning long term interest rates are higher than short term rates, TD makes higher profits on the loans it makes with the liquid cash in its clients' accounts - it pays out lower short term interest rates on this cash, but loans it out at the higher long-term rate to make a profit.

• Recession conditions reduce revenues from margin buying – Besides the revenue lost from falling trade volume, in a recession fewer people will buy stock on margin, which will result in additional loss of revenue for AMTD. Even though the cost of margin calls might have fallen with interest rates, investors during a recession tend to pull money away from equity and invest in less risky assets such as corporate and Treasury bonds. So AMTD suffers from lower revenues in a recession both because transaction volume is lower, and margin buying is less frequent as well.

Competition

TD Ameritrade faces strong competition, most importantly from Charles Schwab (SCHW),E*TRADE Financial (ETFC) , Fidelity, and Scottrade. E*Trade and TD Ameritrade are very similar in structure: they both run a no-frills investing platform geared towards self-guided investors. Asset accumulation can be difficult for E*Trade and other no-frills online brokers as they're competing against firms that offer more advanced guidance for investors. However, ETrade and TD Ameritrade are divergent with respect to their platform development. TD Ameritrade is still digesting the acquisition of TD Waterhouse and is in the midst of fully integrating the newly acquired RIA network and brokerage locations with TD Ameritrade's technological platform. Further competition is provided by Charles Schwab--which has more comprehensive offerings-- which has been more successful in attaining a greater share of its clients' total assets through a larger, more cohesive network of associated RIAs.

Revenue Composition Comparison: The sources of revenue are different between the competing online broker-dealers. In particular, Charles Schwab is quite different because their main source of revenue is from asset management fees, a source of revenue that E*Trade and TD Ameritrade do not have. Below are the revenue compositions for TD Ameritrade, E*Trade and Charles Schwab. Notice the extent to which E*Trade has moved towards asset-based revenue streams: 58% Net Interest Income vs. 41% and 34% at TD Ameritrade and Charles Schwab, respectively. This shows E*Trade's aggressive move towards a new business model that is less reliant upon trading based revenue streams. By increasing its dependence on interest-based revenue streams, however, E*Trade has increased its exposure to market fluctuations; its investments are linked to market conditions and can be volatile. Schwab and TD Ameritrade are relatively less exposed to this risk.

Notice the difference in revenue composition. E*TRADE Financial (ETFC) generates more than half of its revenue from interest income, which would make it the most exposed to any collateralized debt obligations and/or mortgage backed securities that the brokerage would be responsible for fulfilling as a result of their sweep account operations. Relative to E*TRADE Financial (ETFC) , Charles Schwab (SCHW) generates a greater proportion of its revenue through asset management fees, which would make its balance sheet the most exposed to any reduction mass market brokerage transactions.

• Daily Average Revenue Trades: DARTs are the average number of trades clients make in a day. Each of these trades provides revenue for the broker-dealer through their commissions.
• Net Interest Spread: The net difference between the interest rate the broker-dealer makes on its investments and the interest rate it pays its clients. The larger the net interest spread is, the more money the broker-dealer makes on its clients assets.
• Total Client Assets: The total amount of money that the broker-dealer is holding for its clients. The higher their total client assets the more they can exploit the net interest spread and create revenue. This makes building up client assets a main focus for broker-dealers.

References

1. ↑ [http://www.sec.gov/Archives/edgar/data/1173431/000095013707017708/c21738e10vk.htm AMTD FY2007 10-K Annual Financial Report, “Business Overview,” p. 8.]
2. ↑ [http://www.sec.gov/Archives/edgar/data/1173431/000095013707017708/c21738e10vk.htm AMTD FY2007 10-K Annual Financial Report, “Business Overview,” p. 3. ]
3. ↑ AMTD FY2007 10-K Annual Financial Report, “Selected Financial Data,” p. 21.
4. ↑ AMTD FY2007 10-K Annual Financial Report, “Aquisition of TD Waterhouse,” p. 5.
5. ↑ AMTD FY2007 10-K Annual Financial Report, “Aquisition of TD Waterhouse,” p. 5.
6. ↑ AMTD FY2007 10-K Annual Financial Report, “Aquisition of TD Waterhouse,” p. 5.
7. ↑ AMTD FY2007 10-K Annual Financial Report, "Strategy,” p. 4.
8. ↑ AMTD FY2007 10-K Annual Financial Report, “Consolidated Statements of Income Data,” p. 33.
9. ↑ AMTD FY2007 10-K Annual Financial Report, “Consolidated Statements of Income Data,” p. 33.
10. ↑ AMTD FY2007 10-K Annual Financial Report, “Selected Financial Data,” p. 21.
11. ↑ AMTD FY2007 10-K Annual Financial Report, “Consolidated Statements of Income Data,” p. 33.
12. ↑ AMTD FY2007 10-K Annual Financial Report, “Trading Activity Metrics,” p. 31.
13. ↑ AMTD FY2007 10-K Annual Financial Report, “Trading Activity Metrics,” p. 31.
14. ↑ Hennessy, Tom. “Financial Brokers & Asset Managers: Online Brokers.” Deutsche Bank Global Markets Research, page 7. April 11th, 2007.
15. ↑ Hennessy, Tom. “Financial Brokers & Asset Managers: Online Brokers.” Deutsche Bank Global Markets Research, page 7. April 11th, 2007.
16. ↑ Hennessy, Tom. “Financial Brokers & Asset Managers: Online Brokers.” Deutsche Bank Global Markets Research, page 6. April 11th, 2007.
17. ↑ Hennessy, Tom. “Financial Brokers & Asset Managers: Online Brokers.” Deutsche Bank Global Markets Research, page 5. April 11th, 2007.
18. ↑ AMTD, SCHW, ETFC FY2007 10-K Annual Reports on http://www.sec.gov