E TRADE Financial Corporation (ETFC) news: Short E-Trade Due …

ByNicholas Pardini ameritrade, company, ETFC, facebook, financial, interactive, major, private, short Comments Off

Summary

Silicon Valley Start-Up Robinhood will offer completely free trading for cash stock positions.

This is an existential threat to E-Trade whose business is competing mainly on price.

E-Trade’s valuation and competitive position make it a better short than other discount brokers.

Technology has continued to be a disruptive force in the financial services industry. In the late 1990’s online brokerage platforms built by companies such as E-Trade (ETFC), TD Ameritrade, and Scottrade reduced the costs of trading for retail investors to a fraction of previous levels. They also caused the extinction of the stockbroker, and took down many full service stock brokerages with it. However, with the innovations of tech upstart Robinhood, Inc., online brokerages such as E-Trade may become dinosaurs themselves.

Robinhood, Inc. is displacing online brokerages by offering 100% free trades for cash stock and ETF trades. In fact the company has found a way to turn a profit, and will be charging commissions for margin-based trades, and derivatives trades (futures, FX, and options). Not having to pay brokerage fees will open trading up to millions of traders and likely increase volumes, but will cause failures of the business models existent within current online brokerage houses. Robinhood is a serious threat due to receiving venture backing from both Google and Andresson Horowitz along with already having 154,000 subscribers before launch. When the expected app launch occurs in Q2 2014, expect the subscriber base to be much higher. Skeptics argue that the lack of a marketing budget would prevent Robinhood from challenging the big brokers. The case of apps such as Skype, Dropbox, Evernote, Whatsapp, and Facebook disproves this notion. Translating a normally paid service to a free app is strong enough of selling point that awareness of the company will spread from user referrals and social media.

Since Robinhood is private and likely faces a bubble-like valuation in venture capital circles, the best bet to capture on this trend is to short online brokerages. Scottrade is privately held, Interactive Brokers (IBKR) is the leader in cost and in terms of popularity amongst professional clients, and Ameritrade has a strong balance sheet (AMTD), so shorting E-Trade is the best way to profit off of the creative destruction as it is the weakest major company in the sector.

E-Trade is already on weak footing, and the threat of obsolescence from Robinhood may worsen its outlook. Even after massive equity inflows from retail investors and a recovery in brokerage trading activity, E-Trade only squeezes out a 7.3% profit margin and a 0.6% return on invested capital. With Robinhood offering zero trading commissions for cash accounts, and lower commissions than E-Trade for margin accounts and options, E-Trade will struggle to compete. With a bloated expense budget that includes brick and mortar locations, 3000 full time employees, and high marketing budgets (such as Super bowl ads), E-Trade may not be able cut costs low enough to turn a profit.

The outcome is that E-Trade will lose its client base to Robinhood or similar competitors. To slow down the loss rate, E-Trade will either have to increase its marketing budget or cut prices that will erode the company’s profitability. Institutional investors and professional traders use either Interactive Brokers or prime brokers from big banks for brokerage services, so E-Trade is reliant on the more fickle retail investor for its customer base. Retail investors are far less likely to trade options, futures, or equities on margin, so they would be content with Robinhood’s free platform to conduct trades. Any speed advantage E-Trade may have will not compensate the cost savings going with a broker providing free trades as well.

Based on the degree of optimism revolving around E-Trade it has a lot of room to go down. Analysts are expecting 30% earnings growth per year over the next five years and have very bullish sentiment towards the stock. The company has also benefited from momentum investors who only trade on price acceleration. E-Trade’s stock has doubled in the past twelve months and now trades with an inflated P/E ratio of 43. E-Trade only has a brokerage business, so they have no diverse assets to protect themselves. With a debt/equity ratio of 5.72 at current prices, debt servicing will also become an issue as revenues fall.

Once the market realizes that the prospect of free stock trading will destroy E-Trade’s business, the company can easily fall 40-50% within twelve months of Robinhood’s release to the general public (only limited release currently). E-Trade could also buy Robinhood itself, but will hurt its financial position by overpaying for the acquisition in the process.

Source:

Short E-Trade Due To Creative Destruction From Robinhood App

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in ETFC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More…)

Author

Nicholas Pardini