Riding the Up Market

It was a banner first quarter for online brokerage firms. Omaha-based Ameritrade, for one, broke several of its own records in the first quarter of fiscal 2004, including net income of $72 million, or 17 cents a share, and an operating margin of 63 percent, or $143 million. Add to that another personal best: “We made more in the last three quarters than in our cumulative 28-year history,” says CEO Joe Moglia.

But the question is, is the upward trend for real? Already skeptical pundits are worrying over potential “mini-bubbles” in the market and about what could happen if investors still suffering from post-recession trauma get spooked and pull out in a hurry. But Moglia, who has good reason to be realistic about the sustainability of the market given that his firm’s revenue depends on equities trading, believes that after nearly four positive quarters, it might be time to exhale. “The recovery has legitimately begun,” says the 54-year-old native New Yorker.

As further proof, Moglia points to Ameritrade’s monthly client survey results, which show an attitudinal change on the part of investors. In September only 40 percent thought equities were a good long-term investment. In January, that number rose to 70 percent. “And retail is a lagging indicator,” says Moglia. “[Retail investors] don’t come in ahead of the market, but rather as it’s moving.”

Average client trades per day at Ameritrade were up to 254,000 in January from 175,000 in December and 116,000 last March. Those numbers-the highest of any online brokerage firm-put Ameritrade in a solid position vis-à-vis its three nearest competitors: E-Trade, TD Waterhouse and Charles Schwab. While the downturn forced E-Trade to focus on other financial services businesses, such as mortgages, and TD Waterhouse has been shopping itself to rivals, the little online brokerage firm from the heartland emerged from the fray with a firm grip on the industry’s most lucrative client: the high-volume trader. “Everyone covets Ameritrade’s customers,” says Tim Carpenter, senior analyst with Gomez, a Waltham, Mass., firm that does benchmarking of online companies. Despite charging $1 more per trade than its rivals, Ameritrade has managed to steal market share, says Moglia. “For every account we lose to those three firms, we get 3.7 back,” he says.

Not bad for a company that was in a spiral in 2001. Moglia joined as CEO in March of that year, in the thick of a market deep freeze that laid siege to the financial services sector. Moglia had to employ all his motivational skills-some of which he acquired as a college football coach in the ’70s and early ’80s-to inspire management to make the necessary cuts in expenses. Any manager who couldn’t redeploy resources had to eliminate them, which resulted in a nearly 50-percent reduction in the work force. Moglia then had to rally remaining embattled employees to deliver on his promise to the Street that the firm would be profitable, come bear or bull market. And it worked. For fiscal year 2002, Ameritrade managed a comeback from a 22-cent operating loss the year before to a 12-cent gain. Last year, that gain jumped to 32 cents.

“One of the things we have going for us is that anything we’ve ever said we’d do, we’ve delivered on,” says Moglia. “If I were an analyst, I’d like to cover us. We’re an open kimono.”

The transparency and consistency have provided a strong card for Ameritrade with analysts and investors. It also helps that Moglia spends about a third of his time on the road talking about the company. He estimates that about a hundred new institutional investors have bought in over the past year. And Ameritrade’s stock, which sank to as low as $3 during the bust, is trading at around $16, with analysts giving it room to grow, to about $21 in the near future. Moglia also increased the firm’s full year earnings forecast to between 49 cents and 79 cents.

Yet, despite all the good news, perception battles remain. “People still think online brokerage means day trading, some of what went on in ’98, ’99, 2000, but that’s not the case,” says Moglia. He says Ameritrade’s average client does only 15 trades a year, compared with the day-trader’s average of 200 per day.

Still, some have wondered whether Ameritrade is too focused on just one type of trader, or even just one area of the business, particularly when that one area is as volatile as equities trading. After all, it was E-Trade’s diversification, particularly into mortgages, that offset the damage done by the plunging market. But Moglia says sometimes diversifying can hurt as much as it helps. It was precisely the simplicity of Ameritrade’s pure-play model, he argues, that helped it stay lean and able to steal market share away from larger competitors. “With our model, you have less risk on your balance sheet, a lower cost structure, fewer regulatory issues because you’re in fewer businesses,” he says. “That usually means your management team can respond very quickly.”

It can, for example, quickly shift gears in a downturn and become an aggressive consolidator just when the weak usually get eaten. “Since July ’01, there have only been 13 M&A deals in online brokerage in the United States,” boasts Moglia. “We’ve done five of them.”

The $1.3-billion acquisition of rival brokerage Datek in 2002 was the largest of the 13 deals, and has been a big coup for Ameritrade. Moglia says he is “constantly looking” at other potential buys. But he’s not going to buy just to get size, even if rivals begin merging. “There’s two reasons why you don’t want to do an M&A deal: one, because you get intimidated and two, because your ego gets in the way,” says Moglia, noting that 75 percent of mergers fail. “We won’t do a deal because we’re intimidated.”

What he will do is try to make some noise with a print ad campaign taking a big swipe at mutual funds. “The typical individual doesn’t necessarily recognize that they’re paying 144 basis points and getting crappy performance to boot,” says Moglia of mutual fund customers. Ameritrade plans to promote, as an alternative, exchange-traded funds and is setting up an education center for investors to learn more about them.

Investor education is the one area Ameritrade has been consistently criticized, given that it doesn’t offer a lot of in-depth analysis or advice on its site. With at least one new offering now in pilot stage, the firm will go after the longer-term investor, offering help with portfolio allocation. But Moglia insists his relatively sophisticated customers don’t want a lot of proprietary research. “They say they can get that anywhere,” he says. What they do want is fast, easy trading and excellent technology, and they’ve demonstrated they’re willing to pay more to get it. Gomez’s Carpenter notes that as the cost of technology comes down, price may become more of an issue.

In the meantime, Moglia is enjoying Ameritrade’s position, though he says he will be even more cautious in a bull market. “The better the market, the easier it is to be a little lazier and undisciplined. It’s easier to throw money at things,” he says. The key is making sure that every business decision leads back to one of two things: “To enhance the client experience and make money for shareholders,” says Moglia. “Those are the only two reasons we exist.”