Saturday, September 18, 2010

Barron's on TD Ameritrade

  
Barron's, Sandra Ward, 18 September 2010

Hard to believe amid all the hand-wringing about the direction of the economy and the markets, but day trading is alive and well.

A healthy number of individuals continue to indulge a passion for buying and selling stocks, and options and futures on those stocks, on a daily basis, in spite of the continued exodus from actively managed stock mutual funds and intensified interest in bond investments. For proof of these animal spirits, look no further than TD Ameritrade. A leader in online brokerage services based in Omaha, Nebraska, its clients placed a record 413,000 trades a day in the firm's fiscal third quarter, ended June.

Daily trading volume dropped during the summer months, as is typical for the season. But the seasonal drop was exacerbated this year amid renewed fears of a global slowdown brought into sharp relief by continued high unemployment, European debt troubles and looming financial reforms in the U.S. Nonetheless, the impact was softened by strong net inflows of new assets. TD Ameritrade continued to rake in new assets at a pace exceeding the firm's yearly target range of 7% to 11%. Indeed, the firm collected net new assets of $28 billion in the year through June 30, a 12% annualized rate of growth and up 32% from the first nine months of 2009. It now has a total of $324 billion in client assets.

TD Ameritrade appears to be benefiting as investors migrate from the big investment firms to a more self-directed approach to their portfolios, trading for their own account or enlisting the aid of a financial advisor, many of whom use TD Ameritrade as a platform for client accounts. The firm is also gaining from the "breakaway broker" phenomenon, as more and more brokers are choosing to operate independently as registered investment advisors and using TD Ameritrade for their "back office" needs. A sales force whose compensation is linked to bringing in new assets also has made a big difference.

The company's strong relationship with its 45% stakeholder and triple-A-rated Toronto Dominion Bank has also bolstered its asset-gathering efforts. And its 2009 acquisition of thinkorswim Group, the leader in the profitable and fast-growing options-trading arena (Barron's has named thinkorswim the No. 1 online broker two years in a row, and in four of the past five years), puts more capabilities into the hands of its big base of active traders and provides other customers with important tools for better managing their money. And thinkorswim is just the latest in a long line of acquisitions that TD Ameritrade has successfully integrated into its operations.

TD Ameritrade has taken itself beyond its role as simply a discount broker by offering an expanded line of wealth-management services that appeals to a wider audience, as suggested by the improvement in its ability to boost assets under management.

Reflecting this growth in assets, the company is on track to deliver earnings gains of 19% in fiscal 2011 and nearly 30% in fiscal 2012 based on consensus earnings estimates of $1.21 a share for next year and $1.56 the next. Yet, the company isn't getting a lot of credit for this increase, and that's resulted in a wide gap between its expected growth and its stock price: TD Ameritrade shares sport a P/E multiple of just 12.8 times fiscal 2011 estimates and 9.9 times 2012. Charles Schwab, in contrast, trades at 25 times this year's expected earnings and 15.3 times 2011 consensus estimates.

Asset managers typically trade at a 20% to 40% premium to the market multiple. TD Ameritrade wouldn't command the full premium because of its discount brokerage, but its fans argue a higher multiple is warranted.

Its valuation also overlooks a clean balance sheet, a recently authorized 30-million-share stock buyback program (it expects to purchase 12 million shares between now and the middle of November), the possibility of a dividend payout and the potential for a big earnings impact once interest rates begin to rise. Indeed, a 25-basis-point increase in the fed-funds rate would be the equivalent of a seven-cent rise in annual earnings.

"They have extraordinary leverage to interest rates," says Mac Sykes, a brokerage analyst at Gabelli & Co. He considers the stock attractively priced at current levels based on its normalized earnings growth, operating leverage from economies of scale and positive impact from increases in interest rates—widely seen as occurring by the end of next year. Sykes puts a private market value of $24 on the shares, based on a multiple of nine times his enterprise value to Ebitda estimate of $1.4 billion in 2011. It currently trades at 6.2 times EV/Ebitda.

Morgan Stanley's Celeste Mellet Brown recently reiterated an Overweight rating on TD Ameritrade shares after hosting a dinner meeting with management Sept. 7. She cited outsized growth in net new assets, upside potential from a rise in interest rates, the likelihood of return of capital to shareholders and a stock price at bargain levels. Brown attaches a price target of $25 to the shares, which would represent a 61% gain from the current $15.50.

TD Ameritrade has $63 billion in interest-sensitive assets, of which $42 billion is in higher-yielding insured deposit accounts with Canada's Toronto Dominion Bank. Low interest rates have been a problem for all financial institutions and there's no question they are hurting TD Ameritrade's net interest margin and, in turn, operating margins.

But the firm is less interest-rate-sensitive than most, including the granddaddy of all discount brokers, Charles Schwab. About 52% of TD Ameritrade's revenues came from trading in 2009, compared with 24% for Schwab, which has more customers in interest-bearing accounts. The near zero fed-funds rate has led Schwab to waive fees associated with its money-market funds to keep the funds' yield from slipping into negative territory. Schwab also said last week it will take a charge of $130 million in the third quarter to cover losses in its money-market funds related to a defaulted investment.

Another potential catalyst to move TD Ameritrade shares higher is the option Toronto Dominion Bank has to buy the rest of the shares it doesn't already own under a shareholder agreement inked in 2006, when Toronto Dominion's U.S. brokerage business, TD Waterhouse, merged with Ameritrade. Under the agreement, which runs through January 2016, its ownership is capped at 45% between now and 2016 but allows for the bank to make a tender or merger offer for the remaining shares prior to the agreement's end.

TD Bank hasn't commented on its intentions except to say it is happy with its ownership of TD Ameritrade. But it is instructive to note that it bought a stake in the former BankNorth in 2004 and integrated some operations before eventually buying the rest of the bank in 2007. Yet, TD Bank is important to TD Ameritrade's future in other ways. TD Ameritrade plans to tap into the 1,300 branches the bank operates on the East Coast, making its brokerage services—trading, investing and advising—available to the bank's customers.

A precursor of this plan has been in place on Sixth Avenue in Manhattan, where a TD Bank branch and a TD Ameritrade branch sit cater-cornered to each other and refer clients to each other's products.

Did somebody say animal spirits?
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A long string of acquisitions from September 2001 through June 2009 has helped TD Ameritrade bulk up.
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