You don’t need to be Carnac to know that the investment banking industry will never be the same as a result of the incredible losses of the past 18 months.  Whether this is the inevitable ebb and flow of an industry that rewards risk taking and leaves the strongest combatants to survive or the unintended institutional result of that very profit-taking mentality, we are seeing the restructuring of one of our largest industries first-hand.  And these changes are irrevocable.

For those that are interested in these seismic alterations, Roger Ehrenberg begins to lay out the beginnings of a vision for what the new landscape might look like.  He starts by asking these questions:

What does a functional Wall Street of tomorrow look like? What businesses does it choose to be in? Where and how can it bring value to clients, both issuers and investors, in ways that are logical, straightforward, transparent, and consistent with its objective to increase its own shareholder value?

Roger comes to the conclusion that “dissaggregation” and “specialization” will mark Wall Street 3.0, or whatever it is called.  That all of the consolidation that occurred over the past decade will be undone and we will return to the world we used to know, where bankers, traders, issuers are segmented- at least that’s his take on the commercial side.

However, with last week’s announcement that online broker and investor education site, ThinkorSwim, was being acquired by TD Ameritrade, I believe we are seeing the exact opposite occurring in retail brokerage.  Rather than specialization, retail brokerage will be defined by further consolidation in the next few years.  Here are a few reasons why:

1. Infrastructure Overcapacity:   The industry has been slowly rationalizing their infrastructure build-out from the initial wave of launching online trading.  Don’t forget that it is has only been 10 years since E*Trade, TDAmeritrade, and Schwab cannibalized the brokerage commission cash cow.  What seems standard today was so new not too long ago that it was a huge deal when Schwab’s market cap briefly passed that of Merrill Lynch.  When the markets contract, trading revenues decline and there is too much capacity supporting too few trades.  The only way to create a more efficient network is to consolidate trading on a single platform to reduce the effective cost per trade.
2. Commoditized Services:   In the past 10 years, trading, for the most part, is as reliable and efficient as flicking a light switch.  The online brokerage firms have done a fantastic job creating a scalable, low-cost platform that allows us all to make trades in our underwear.  Having said that, is there really a noticeable difference between buying 1,000 share of Google at Schwab, E*Trade, TDAmeritrade, etc.?  Thanks to their hard work and investment, other than a dollar here or there, a trade is a trade is a trade for most retail investors.  Other than giving out lollipops when you make a transaction, there is little differentiation across the firms.  And you can expect that trading, someday soon, will be going to zero or near zero, especially since the average investor makes about 5 trades per year.
3. Cost Per New Account:   If you have ever watched a golf or tennis tournament, you can see their is no shortage of commercials out there trying to convince you you should be walking on the beach with a golden retriever by the time you are 50.  With solid profit margins and commoditized services, marketing has become one of, if not, the highest expense line item as these firms try to build “brand.”  By establishing “trust” with individual investors, these brokerage firms hope to convince you to open an account with them and then charge you those small fees you love so much.  The reality is that the cost per new account for brokerage is exceedingly high (upwards of $1,000 per new account opened) because the switching costs are so high.  Once you are in, it is very difficult for you to want to close that account in the future.  If you have ever done it, you know it is a pain.  So, M&A is a customer acquisition strategy in a competitive environment that adds more trades on their systems.
4. Assets are King:   As brokers move away from a per transaction model, assets under management are the industry obsession.  Fee-based services are more predictable and are not reliant on trading, which decline when the markets move down or sideways.  Schwab and Fidelity have done a great job of addressing system overcapacity by selling their services to third-party advisor firms and institutions.  Just like Amazon has done with AWS, the brokerage firms are leveraging their expertise in building and hosting secure, high-volume trading systems and are selling it to anyone with a few million to manage.  In order to get to scale on the retail side, acquisitions make a lot of sense, rather than convincing one person at a time to open an IRA.
5. Active Traders and Options Trading Leverages Market Voltility:  There are two groups of retail investors that are extremely valuable in markets like these: active traders (those making more than 20 trades a month) and options traders (those investing in market volatility).  With trading revenue under pressure for a commoditized service, these traders generate 80% of a firm’s profits in this area.  Options trading represents an underinvested area for most brokerage firms as they require a different set of functionality and a different client base.  They will need a full suite of services to be able to cater to any kind of individual investor.  You have seen each of the online brokerage firms segment their active trader segment to more effectively cater to their needs.  Look for even more of this as they search for incremental revenue.

Now, let’s look at the numbers to see how TDAmeritrade valued ThinkorSwim. Then we can see who might be next on the trading block.  TDA paid $606MM for a firm with 90,000 accounts, over $300MM in revenues, $50MM in Net Margin, and 50MM trades per year.  The combined company now places TDA/SWIM as the highest volume retail trader.  As far as muliples go, this deal values SWIM at $6,800 per account.  On the face of it, this seems extraordinarily high, but then you see that the average revenue per account is about $3,500.  This is a very strategic deal for TDA as they have a stated goal of targeting active traders and option traders.

So, who else is a potential acquisition target for the large online brokers?

E*Trade: With a market cap of $700MM, 3MM accounts, and the third largest in terms of trades, E*Trade would be the bell of the ball if it weren’t for its ugly balance sheet after dipping into the sub-prime waters.  The damage caused by the former CEO has been staggering and now the firm finds itself with a strong brokerage business and customer focus, but concerns abound about when the other shoe will drop.  That said, at $250 per account, any of the big firms will be salivating to swoop in at take E*Trade out once the risks associated with these investments have been worked through.

OptionsXpress: With a focus on options trading and similar volumes as ThinkorSwim, OXPS is a perfect consolidation play.  The firm has 315K accounts and a market cap of $760MM, valuing each account at around $2,500.

Tradestation: With 42K accounts and a market cap of $250MM, this puts the implied value of $6K per account.

Revenue and margin multiple analysis will also be a factor but all three of these companies make strategic sense for the big firms.  It will be interesting to watch.