TD Ameritrade (AMTD) is a leading discount brokerage in the US, and competes for a slice of the $25 trillion US retail investing market. Brokerages make their money from two major sources, transaction-based revenue and asset-based revenue. Transaction-based revenue refers to commissions from trades, and asset-based revenue refers to interest from clients’ margin and cash balances, commissions from sales of mutual funds and other financial products, as well as income from securities lending. The relevant metrics in this industry include DARTs (daily average revenue trades, or the number of trades clients make in a day), revenue per trade, net interest spread (difference between the interest rate the brokerage makes on its investments vs the interest rate paid to clients), and total client assets. TD Ameritrade leads the brokerage industry in DARTs, with its clients making 357k trades a day in the last quarter, with an average commission of $12.76 per trade. It has $234 billion in client assets. In FY2008, TD Ameritrade had total revenues of $2.48 billion, with about 40% of that being transaction-based revenue, and 60% being asset-based revenue.
TD Ameritrade excels in an industry that is fiercely competitive. Due to the low fixed costs of running a brokerage (the majority of the cost involved is trade clearing cost which is a variable cost), even a brokerage with a small client base can turn a profit. With low barriers to competition, the industry is filled with small players offering heavily discounted prices, with some banks even offering free trades as a loss leader to gather assets. At least one discount brokerage (Zecco) has offered free trades with the intention of surviving only on asset-based revenues. There are also niche players catering to specialized pools of retail investors, notably Interactive Brokers, which caters to active and commodity traders, and thinkorswim and optionsXpress, which cater to options traders. However, these small companies have negligible client assets, and compete mostly on the basis of price and on the attractiveness of their trading platforms. The market leaders in terms of client assets are the banks which cater to the affluent market (clients with net worth above $1 million). Examples include Merrill Lynch ($1.5 trillion in client assets) and Citigroup ($1.1 trillion). These banks ply their trade with relationship bankers and private client services, offering their clients access to hedge funds and other exotic financial products deigned too risky by the SEC for the common investor. Charles Schwab (SCHW), the incumbent in the mass affluent market (clients with net worth of $100k to $1 million) with $1.2 trillion of client assets, is Ameritrade’s fiercest competitor. Facing direct competition from discount brokers, it has sharply cut its trading commissions, and distinguishes itself from discount brokers by offering full service financial consulting and proprietary mutual fund products. Schwab derives 85% of its total revenue from asset-based revenue, and has mainly focused on up-selling more lucrative proprietary mutual funds to its clients to offset losses from dropping trading commissions. E*Trade (ETFC) was previously also a strong contender in the industry, but has recently imploded in spectacular fashion after it posted massive losses due to its subprime mortgage holdings, and is now flirting with bankruptcy.
Both Charles Schwab and Ameritrade primarily target the mass affluent market, using very different strategies. Charles Schwab targets investors who prefer more hand-holding and human contact, with its “Talk to Chuck” advertisements and its large network of independent investment advisers (IIAs). TD Ameritrade focuses on the self-directed investor who wants a trustworthy brokerage where he feels comfortable leaving a large portion of his net worth. TD Ameritrade serves this niche by offering reasonably priced commissions with excellent execution times and good customer support, combined with a reputation for doing right by customers. For example, after some of its customers incurred losses due to illegitimate logins by hackers, TD Ameritrade offered to reimburse the customers for their losses despite having no contractual obligation to do so, and started an Asset Protection Guarantee program to cover all customers from losses due to illegitimate logins, as long as basic precautions to safeguard passwords are taken. When the Reserve Primary Fund and International Fund broke the buck, Ameritrade provided up to $55 million to bring their customers up to par value (Ameritrade was not contractually obligated but felt that it should do so because some of their customers had their cash balances automatically swept into the Reserve Primary Fund). More recently, when the yields of many money market mutual funds dropped to the low single digits, TD Ameritrade waived the sales commissions to prevent customers from getting negative yields on these products.
What is TD Ameritrade’s overall strategy? Historically, TD Ameritrade has focused on the mass affluent market, as this is the most efficient market to target in terms of asset gather. It has refused to drop commissions below $10, as doing so just attracts smaller value accounts that cost more to service. More recently, however, Ameritrade has started going after other segments of the investing market. A few years ago, it made its first foray into the sub-affluent market by setting up a separate Izone brand offering $5 commissions, at the price of not having any phone support (support is through email only). Ameritrade is also acquiring thinkorswim mainly for two of its assets: its widely-praised trading platform, and its Investools investor education business. With Investools comes content and educators which can be offered to Ameritrade clients, perhaps at no charge, and is especially valuable to a company which is primarily targeting self-directed investors. The CEO has also suggested during a recent conference call that he would like to set up a separate brand for active investors using the trading platform acquired from thinkorswim. Moving into these markets will not increase client asset base much, but will increase trading commissions, and transaction-based revenue tends to be more resilient during an economic downturn compared to asset-based revenues. Active traders tend to trade even more during periods of high volatility, while margin borrowing and sales of mutual funds tend to decrease during a bear market. I believe that if TD Ameritrade achieves a 50-50 mix of transaction- and asset-based revenue, it will be better positioned for future downturns.
In this particular downturn, TD Ameritrade also has many structural advantages. Firstly, it has a strong cash position and almost no liquidity concerns. AMTD ended its last quarter with a cash balance of $1.3 billion and long term debt of $1.4 billion. The debt is fully floating rate debt indexed to 1-month LIBOR plus 1.5% (currently at around 2% net), and is not due till December 2012. Secondly, its ownership is in strong and stable hands. The Ricketts family holds about 22% of outstanding stock, while the TD Bank holds about 40%, and is increasing its stake to about 45%, the maximum allowed under a stockholder’s agreement. Thus more than two-thirds of the stock is in the hands of long-term shareholders. In addition, TD Bank is in the relatively stable Canadian banking sector, receives the majority of Ameritrade’s MMDA balances, and is in a position to loan funds to Ameritrade in the extremely unlikely event that it is necessary. Thirdly, AMTD is actually increasing its market share in the current downturn. In the last quarter, client assets was down 22% to $234 billion, but this was in the face of a 40% drop in the S&P, and is largely due to net new assets of just under $8 billion, about $2.3 billion of which was due to the dislocation experienced by E*trade. There are also reasons to expect that the pool of self-directed investors will increase in the future. Following the financial crisis and Madoff scandal, more people are realizing that their own finances are too important to be left in the hands of other so-called experts. In addition, a number of new ETFs has allowed the retail investor to invest in basically any asset class. Therefore, in the current climate of increased awareness of counterparty risk and greater financial self-sufficiency, I expect TD Ameritrade to make at least modest market share gains. This is above and beyond gains derived from Ameritrade’s new push into the sub-affluent and active investor markets, which would take several years to fully develop.
There are also several low probability risks that are associated with AMTD. The first is lawsuit risk deriving from its Investools acquisition. Investools is in the investor education business, an industry where sleazy operators abound. Reviews on the internet suggest that complaints about Investools can be mainly divided into two types : complaints that the education offered is worthless, and complaints that high pressure sales tactics were used. In a large group of Investools students, surely some would go on to lose money and become disgruntled. From a legal point of view, these students probably do not have a case as it does appear that Investools has provided the services that it was contracted for. The cases involving high pressure sales tactics may have legs, but appear to be largely isolated incidents. In any event, Investools have standardized and dramatically reduced the rates it charges students, which should lead to less complaints in the future. A second risk is the matter of the $700 million worth of auction rate securities which have been bought by Ameritrade clients. Auction rate securities are a class of bonds which has recently become illiquid as the auctions which were used to price them have failed. While regulators have demanded that investment banks such as Goldman Sachs and Morgan Stanley redeem the auction rate securities that they have sold, alleging that the banks have misrepresented the products as suitable for conservative investors, they have not demanded the same of the mid-tier brokers which have sold these products. One reason is that many of these brokers, including Ameritrade, did not actively push the sales of the auction rate securities, mainly referring clients to prospectuses when asked to. Another reason is that forcing the brokers to redeem the securities would immediately put many brokers into a liquidity crisis. As a result, negotiations are ongoing between the brokers and the Financial Industry Regulatory Authority, led by Mary Schapiro. In the worst case scenario, AMTD would have to put $700 million of auction rate securities onto its own books, which would eat up a lot of cash but probably would not mean instant insolvency, as the securities are mostly backed by high quality assets with a good cash flow, but are just illiquid in this environment. The most likely outcome is that some part of the TARP money would be used to redeem the auction rate securities. Thirdly, management compensation is on the lavish side, with the 7 named executives alone taking up $42 million in compensation. Especially egregious is the non-executive chairman, who alone takes up $20 million in compensation. Lastly, the biggest argument against investing in AMTD is probably that it’s earnings are positively correlated with the market, and hence it is likely to amplify the gains and losses in the rest of your portfolio, and therefore has minimal diversification value.
In 2008, AMTD had a revenue of $2.5 billion, of which about 60% is from asset-based revenues and 40% is from transaction-based revenues. On the asset-based side, $527 million is from margin interest (from an $8.13 billion margin balance, or 6.48% rate), $22 million is from securities lending and other financial instruments, $628.7 million is interest from the $15.64 billion in MMDA balances (4% rate, most of which are invested with TD Bank in Canadian mortgages yielding about 4.5%), and $309.4 million is from selling $70.8 billion worth of mutual funds and other instruments (0.43% sales commissions), for a total of about $1.487 billion. On the transaction-based side, a total of 78.43 million trades were made in 2008, or about 311k trades per trading day (average 11.3 trades per client per year), at an average commission of $12.97, for a total of $1.017 billion in revenue. Net expenditure was $1.274 billion, the largest of which was compensation expense at $503 million, followed by advertising expense at $173 million and professional costs at $108 million. Occupancy costs, depreciation and amortization, and communications and clearing costs each take slightly more than $100 million, for a total of $310 million. Interest expense was $78M. This leaves another $102M for other miscellaneous expenses. Income before tax was $1.226 billion, and about $804 million after tax, or about $1.35 per share.
In the latest conference call, management has reduced expected earnings for 2009 to $0.90 – $1.10 per share, which is a PE of 10 at AMTD’s current trading price of around $11. In the first quarter of 2009, margin balance has dropped dramatically to about $4.2 billion, and margin interest revenue was $84 million (8% rate). MMDA revenue came in at $163 million, actually an increase from previous and year before quarters mainly due to the effective interest rate clients receive basically going down to zero. Investment product fees unsurprisingly took at hit and came in at $69 million. Transaction-based revenues actually went up, to about $287 million. This works out to a net revenue of about $600 million for the quarter, or $2.4 billion for the year (based on business not deteriorating further). Expenses for 2009 is likely to come down from several factors. Firstly, management has announced $60 million in expense reductions, of which $40 million will occur in 2009. Secondly, interest expense will come down from $78 million in 2008 to about $25 million in 2009 due to the lower LIBOR. Thirdly, based on my read of the proxy, the lower EPS will result in $10 million being shaved from executive compensation. This adds up to about $100 million in expense reductions, which offsets the $100 million in revenue reduction, giving us the same $1.35 EPS for 2009 with optimistic projections. In a more bearish scenario, with margin balance dropping to $3 billion, giving only $240 million interest income annually, and MMDA revenue decreasing by another 20% to $520 million annually, revenue would come in at $2.2 billion. With expenses at $1.15 billion and 592 million shares, EPS will come in at $1.15. Note that this analysis excludes the impact of the thinkorswim acquisition, which will likely add another 3-5% to earnings. Therefore, I estimate that AMTD will come in near the upper side that range, with a decent chance for a surprise pop above that range if the market recovers even slightly.
Ordinarily, with low interest rates coupled with high volatility, AMTD would make a killing from both its asset-based and transaction-based revenues. However, we live in unusual times, and the fear is that the recent market slide will prompt investors to pull funds from stocks on a large scale back into cash accounts at banks (which is currently yielding near zero), thereby continuing to depress AMTD’s revenue. I think that this is unlikely to happen, and with AMTD trading at a PE of 10, this is a rare opportunity to invest in a quality company at a reasonable price.
(Disclaimer : I am both a client of and an investor in TD Ameritrade.)
{ 9 comments… read them below or add one }
You say the TDA did not “actively push Auction Rate Securities” in your article above. Just to clarify, TDA DID actively sell ARS to their clients. They screened which clients had cash on hand, called those clients and very actively solicited the sales of auction rate securities in order to earn TDA revenue from Nuveen Investments. TDA has denied any wrongdoing, but they either intentionally or unintentionally misrepresented ARS as highly liquid and safe…essentially as a money market fund. TDA has done nothing to help those clients they bilked and defrauded.
If TDA is so innocent in the ARS, why are they in settlement talks with the SEC???? I would take my business elsewhere.
DISCLAIMER: I AM A CLIENT OF TDA…BUT NEVER AGAIN!
I wouldn’t trust TDA further then I could throw them. As highlighted above they targeted their clients to see garbage like auction rates and have resisted making it right with the clients. If they treat clients like this how much concern do you think they will have for investors?
It’s interesting that you say TDAmeritrade didn’t push these Auction Rate Securities. How come they “cold-called” me pushing Nuveen Closed End Funds…which I’m still stuck with a year later?
When they called me about my $100K plus money market fund with “ideas” to improve my yield I said I wanted two things: Safety and Liquidity. I got neither. I would have never moved my money had TDAmeritrade not called me to solicit this move.
I trusted TDAmeritrade once…never again.
Hey Everyone: Learn from my mistake.
It has been a full year since TDA clients lost access to their ARS money.
You give your money to a broker.
You expect it back.
TDA’s clients don’t have their money back.
So why would you do business with TDA?
TD Ameritrade is a great company provided your interests are in-line with theirs. If not, I promise you, you will be screwed!
My interests fell out of line with their interests when they decided to cash in on lucrative commissions related to dumping auction rate securities onto its clients holding cash reserves. They said they were same as cash and they were a highly liquid, safe, money market alternative. Shortly after allowing them to purchase auction rate securites with my cash reserves, the market imploded and I’ve been unable to access my money for one year now.
TD Ameritrade completely turned their backs on their customers and have been absolutely horrible. I will NEVER do business with TD Ameritrade or any comany affiliated with them. DO BUSINESS WITH THEM AT YOUR OWN RISK!
I wouldn’t touch their stock with a ten foot pole.
Not only did TDA actively push auction rate securities, their primary money fund also froze up. This is the type of junk TDA peddles. Their clients cannot even depend on the money fund. I am not sure what finally happened to the hapless money fund investors, but the ARS money is still stuck.
Screwing customers is a bad business practice, and – short term random price fluctuations aside – bad companies make bad investments.
About their cash position: In a recent (2/6/9) article AMTD chairman mentioned that one of the potential uses of the cash is to pay for ARS settlements. The chairman also mentions that he thinks that they are close to the settlement. So, there goes the cash – already set aside for a purpose.
Another time bomb is that a lot of (wealthier) TDA clients are waiting for their ARS redemptions before they flee TDA. A sign of desperation on TDA part is that they are begging for money by giving away iPods and GPS navigators for new deposits. The questions, of course are, why do they need to beg, how long will this money stay, and will the money generate enough income to offset the cost of acquiring it.
Finally, look at their trainings. TDA trainings are targeting investors who have a day trader like mentality. This is in Ameritrade’s genes as this is a company that grew up with the day traders during the tech bubble. The new bust will likely do the opposite of what the boom did – that is, they will shrink the number of day traders. That will shrink the niche AMTD is targeting.
I used to have a large account with TD Ameritrade. All I have with them now is an auction rate security which was sold to be under false pretenses. It is stated above,
“Ameritrade did not actively push the sales of the auction rate securities, mainly referring clients to prospectuses when asked to.” This is a lie. Think about the illogic of that statement. How many people even knew about auction rate securities and would inquire about them? Do you? A TD Ameritrade broker called me and actively solicited me to buy this and misrepresented it as akin to a money market fund. I was never given a prospectus. In fact when I found I could not sell what was supposed to be a liquid investment, I asked TD Ameritrade for a prospectus and was told there wasn’t a prospectus and to contact Nuveen. I finally got the 182 page prospectus from a securities lawyer. One of their brokers also pitched the Reserve Fund to me. This is the one which “broke the buck” and became illiquid. Thankfully I passed on that. TD Ameritrade misrepresents their commissions, claiming you only pay $9.99 per trade. See what happens when you write a covered call, and your stock is called. Assuming I get my money back from their auction rate securities scam, I will never do business with them again! They are dishonest and dishonorable people.
Your recommendation of TDA is a joke. They directly pushed ARS on clients. At least TDA is in settlement talks. Oppenheimer, which actively pushed auction rates on their clients and lied repeatedly about the investment and even disguised the fact that auctions were involved, is in no such settlement talks.
Oppenheimer appears to be in real trouble from a capital standpoint. I’d avoid all the mid tiers, starting with Oppenheimer. If an investment goes south, regulators have little interest in helping mid tier clients. Stick with the big firms. If anything goes wrong, the big firms have the capital to make it right. Oppenheimer, tDA, E trade, to invest with these firms is a form of gambling.
I say never do business with any of these firms that sold auction rate securites. These firms have burned, ruined and shattered peoples lives beyond repair.
You kow who you are, you are nothing better than a murderer and someday your dishonestly and disloyalty to mankind is going to bite you in the rear. You will eventually pay for your evil ways and the man up above will see to it.