Options Xpress (OXPS) provides an online brokerage service to retail investors and specializes in equity options and futures trading.  The company began doing business in December 2000 and has quickly grown to over 200,000 accounts.  They are known for their excellent trading platform and have been selected by Barron’s as “Best Online Broker” in the annual surveys from 2003-2006, by Kiplinger’s as “The Best Online Broker” in 2006, by Forbes as “Best of the Web, Favorite Options Site” in 2004, and by SmartMoney as “Best Discount Broker” in 2004.

Investment Thesis 

Options Xpress is an extremely high quality and fast growing business that trades at a significant discount to its intrinsic value.  It’s ROE is well in excess of 100% when adjusting for excess cash, and the company has organically grown revenue and EPS at 58% annually over the last 3 years.  Despite these metrics, the company has a forward PE of 16x and even lower than that when you adjust for excess cash. I believe the reason stems from the fact OXPS is unfairly compared and valued against Charles Schwab (SCH), Ameritrade (AMTD), and E*Trade (ETFC) despite having superior operating metrics, returns on capital, and margins.  In addition, the street is worried about slowing account growth and reductions of payment for order flow, two concerns I will address and believe to be overblown.  There are several upcoming catalysts for the stock, and I believe over the next 2 years it offers the potential for at least 20% annualized returns with very little downside risk.

Competitor Comparison

While Options Xpress operates in the online brokerage space it has a superior business model relative to some of the other operators.  The company focuses exclusively on attracting active options traders.  Compared to the average brokerage customer their customers have larger account balances, are more likely to use margin, trade more frequently, trade in up markets and down, and are more sensitive to service/execution than price.  In addition the company has developed a great reputation with traders (evidenced by awards listed above) and an effective “grassroots” marketing strategy involving channel partnerships, relationships with securities exchanges, options educators, investment publishers, software vendors and financial portals, that allows them acquire new customer accounts at a significantly lower cost than competitors. Here is a comparison on some key metrics vs. their competitors.

Operating Metrics

Advertising Expense Per New Account: OXPS $130, while SCHW, AMTD, and ETFC all spend over $1,000 per account

Annual Trades Per Account – OXPS 39, AMTD 11, ETFC 11, SCH 10

Average Commission per Trade – OXPS $21 while SCHW, AMTD, and ETFC are all around $15

Cumulative Account Growth last 3 years – OXPS 180%, AMTD 15%, ETFC 6%, SCHW -5% 

Financial Metrics

Pre-Tax Margins – OXPS 62.5%, AMTD 51.7%, ETFC 40.5%, SCHW 34.5%

Annual Pre-Tax Income per Account – OXPS $623, AMTD $154, ETFC $252, SCHW $247

Return on Equity – OXPS 49%, SCHW 18.8%, AMTD 34.7%, ETFC 16.5%

Annual Revenue Per Employee – OXPS $1.05 mil, AMTD $481k, ETFC $537, SCHW $366

Street Concerns

1) Slowing Account Growth

In October of 2006 OXPS account growth began to slow.  Over the last 3 months of 2006 average monthly account growth was 2,733 compared to an average of 5,111 accounts in the first 9 months of the year. The slowing account growth was attributed by some on the street to Investools acquiring an online brokerage firm known as Think or Swim in September 2006.  Prior to the acquisition, Investools (a provider of investor education) had served as a channel partner and referred potential account to OXPS. Investools stated that 84% of their 20,000 annual referrals were directed to OXPS.  This equates to 16,800 accounts annually or 1,400 accounts per month, compared to the commentary by OXPS management that the amount was insignificant, and reports by sell-side analysts that the numbers were closer to 500 monthly.

Whatever the correct number of referrals from Investools is I remain unconcerned about account growth for 3 reasons.  OXPS ended 2006 with 204,600 accounts.  Even if new accounts stays at the depressed levels of 2,700 monthly the company will report 2007 y/y account growth of 16% which is still really strong organic growth.  Secondly, management is very aware of the issue and spent a considerable amount of time addressing it on their 4Q conference call.  In order to stimulate growth they are developing new educational initiatives and partnerships including a partnership with CNBC for the million dollar portfolio challenge in which the OXPS brand will be integrated into the virtual trading contest.  Management has stated that the early results from the new initiatives appear positive and February new accounts rebounded to 3,200 and that run-rate would allow them to grow accounts 19% y/y in 2007.  Lastly, OXPS advertising is much more productive than that of their peers and generates high incremental ROI’s.  At a current expense of just $130 per new account compared to $1,000 plus for their peers the company has significant room to increase spending and management has indicated it’s willingness to do so. 

2) Payment for Order Flow - Payment for order flow occurs when exchanges, options specialists, market makers, and other market centers make payments to broker-dealers in return for receiving customer orders. In 2006, payment for order flow accounted for approximately 18% of OXPS revenue. In January 2007, the six option exchanges, at the direction of the SEC, instituted a 6 month pilot program to allow the options of 13 stocks to be quoted and traded in $0.01 increments in lieu of the $0.05 increments previously used.  The change to $0.01 increments however, is expected to translate into tighter spreads, which benefits investors, and leads to more liquid markets with higher volumes.  To be clear, this is a pilot program that will not have a material effect on OXPS earnings in the near-term, and is merely a six month test after which the SEC might even decide to discontinue the program.  The key issue on deciding if the program is permanently implemented is one of capacity.  The exchanges are already struggling to keep up with the rapid increases of options volume over the past decade and the move to penny increments with the associated higher volumes will only increase those strains. 

Despite the risks, OXPS seems well positioned to weather any potential adverse effect.  Even if payment for order flow begins to decline, OXPS with 3% of total options volume annually is likely in a good position to command some economic value for their order flow.  Also, the increases in liquidity and volume will provide positive benefits to counteract the reduction.  I don’t have any special insight into the probability of the test pilot program being permanently enacted, but I believe the risk is already more than reflected in valuation which I will address later on.                  

Other Positives

1) Market Opportunity – The options markets that OXPS currently serves has very favorable growth dynamics.  Over the last 25 years the total U.S. listed options market volume has grown by 25% per year. In addition, there are approximately 30 million online brokerage accounts today and this number is expected to grow to 37 mil by the end of 2008. However of these 30 mil accounts, it is estimated that only 10% of online accounts are authorized to trade options.  Since Options Xpress only has 200,000 account there is plenty of room for them to grow in this growing market.

2) Insider Ownership – According to their most recent proxy, directors and executive officers own 66.7% of the company. 

Catalysts

1) Conversion to self clearing – On December 2006, OXPS completed their conversion to self-clearing.  Prior to the conversion, OXPS used Goldman Sachs as their clearing agent meaning they had to split net interest profits on customer cash balances and margin debit balances while also paying a higher variable expense on trading volumes. On their 2Q06 call OXPS stated that self clearing will impact finanicals in 3 ways.

a.       An increased yield on customer assets of 15 – 25 basis points. Based on customer assets of approx $5 bil and a higher yield I estimate this will provide an increase in interest revenue of $10 mil.

b.      An approximate 35% reduction in brokerage and clearing expenses.  Based on 2006 expenses of $36 mil and a reduction of 35%, I estimate a decrease of approx $12.6 mil in expenses. 

c.       An increase of 15-20 employees in order to support self clearing operations. Assuming 18 employees at an annual cost of 100k yields an increase in expenses of $1.8 mil. 

So overall I estimate the move to self clearing will increase pre-tax earnings by $20.8 mil in 2007 and increase EPS by $0.18 (20.8 times 40% tax rate divided by 63 mil shares outstanding).  Also the increase of 15-20 employees is largely a one-time expense which the company will be able to leverage in to greater EPS increases over time as customer assets and trading volumes increase.

2) Capital Redeployment - As of December 31 2006, OXPS had $194 mil of cash and no debt on their balance sheet.  Adjusting for the $24 mil spent on Xpress Trade (discussed below) the company now has $168 mil.  In 2007 the company generated FCF of $103 mil (including some WC benefits) on $186 mil in rev, meaning they converted 55% of sales into free cash.  If I project 15% revenue increases with 50% FCF conversion (to be conservative on WC) in 2007/2008 they will generate $107 mil and $125 mil in those years respectively.  This would mean at the end of 2008 (assuming no share repurchases) the company will have cash of $400 mil compared to the current market cap of $1.5 bil.  Management has also stated willingness to return free cash to shareholders.  Last year the company paid a nominal dividend of $0.20 per share, but recently raised it 25% to $0.25 per share.  Also given its undervalued stock price, strong cash balances, and FCF the company will likely initiate a share repurchase program in the near future.  Assuming a 6.5% forward earnings yield and 4.5% return on cash, every $100 mil in share repurchases adds $0.03 to earnings.           

3) Xpress Trade Acquisition – In January 2007, OXPS announced the acquisition of Xpress trade for $37 mil (2/3 cash 1/3 stock).  XpressTrade is a leading Internet-based futures and foreign exchange broker based in Chicago and their management team has agreed to join OXPS.  The acquisition brings the company 2,600 customer accounts and assets of $126 mil at a very cheap price.  According to the press release, Xpress Trade had 2006 pre-tax income of $7.8 mil so utilizing a 40% tax rate they only paid 8x earnings.  This for a company which grew revenue and earnings 58 and 68% in 2006.  In addition, the acquisition makes great strategic sense as it significantly expands OXPS capabilities in futures and foreign currency trading.  Conservatively assuming 30% growth in 2007 for Xpress Trade and low cost saves the earnings accretion is at least $0.05.

4) International Expansion – International expansion basically represents a free call option and I haven’t really factored it in my numbers.  In the past 2 years, Options Xpress has just begun taking steps to expand internationally including:

 - in 2004, they purchased a minority interest in an Australian registered broker;

-  in 2005, they obtained a license to provide brokerage services in Canada

-  in early 2006, they obtained a license to provide brokerage services in Singapore

- in late 2006, they received approval to provide brokerage services in the European Union.

5) Company getting Acquired – Discussed in valuation section below. 

Valuation

I will look at OXPS valuation from 3 perspectives 1) Comparable PE Multiples 2) Acquisition Multiples or Private Market Values 3) FCF Yields 

1) OXPS currently trades at 20x trailing earnings, 16x 2007 consensus earnings, and 13.5x 2008 consensus earnings making no adjustments for excess cash.  Here are the comparable multiples for other online brokers:   

SCHW: 19.29x, 20x, and 19.8x

AMTD: 16.3x, 14x, 11x

ETFC:  15.7x, 13.3x, 11.1x

Average: 17.1x, 15.7x, 13.9x      

So OXPS basically trades in-line with the other online brokers on a P/E basis despite having superior growth, returns on capital, margins, and operating statistics as discussed above. 

2) On September 19, 2006 InvestTools acquired the online options broker Think or Swim for 30.4x trailing pre-tax income.  Also although it was awhile ago, but in September 2005 ETrade acquired Brown and Co (a company similar to OXPS) from JPMorgan for 20x pre-tax earnings.  In 2006 OXPS had pre-tax income of $117 mil.  Placing a 25x multiple on this yields a price $2.94 bil or $46 per share which is double the current stock price of $23.

3) Lastly OXPS has a trailing FCF yield of 6.8% and according to my estimates 2007 and 2008 FCF yields of 6.9% and 8.3% respectively. These are very high FCF yields on absolute terms and relative to the market.  

Target Prices and Scenarios

Worst Case:  My worst case scenario for OXPS which I view as very unlikely (maybe 10% probability) would include:

-         Payment for order flow going to 0 in 2008 with no positive offset from tighter spreads and increased volumes.  I estimate this would lower revenues by 18% and have a higher effect on earning due to margin so let’s say 25%.

-         Account growth slows to 0% in 2007 and 2008 compared to current pace 16%

-         FCF remains flat at $100 mil in 2007 and 2008

-         Accretion from self-clearing of $0.18 in 2007 and $0.20 in 2008

-         Accretion of $0.05 from Xpress Trade

-         No share repurchases or acquisitions

The company reported 2006 EPS of $1.15 and we won’t grow it.  Take 25% off that from payment for order flow, and you get $0.86.  Then add the accretion from self clearing and acquisition gives you 2008 EPS of $1.11.  Placing a 15 multiple on this gives you $16.65.  Then add back the company’s cash balance of $164 mil plus approx $100 mil in FCF in 2007 and 2008 and this yields $364 mil or $5.70 per share.  This gives you a stock price of $22.35 compared to the current price of $23.84.

Base Case:  

-         Payment for order flow declines 20% when including positive offset from tighter spreads and increased volumes. 

-         Account growth of 15% in 2007 and 2008 

-         FCF goes to $107 mil in 2007 and $125 mil in 2008 as discussed above

-         Accretion from self-clearing of $0.18 in 2007 and $0.20 in 2008

-         Accretion of $0.05 from Xpress Trade

-    The company repurchases $50 mil in 2007 and 2008 adding $.03 to earnings

The company reported 2006 EPS of $1.15 and we grow it 15% per year to get 2008 EPS of $1.52.  Take 5% off for payment for order flow (25% of earnings times 20% reduction) gets you $1.45.  Then add the accretion from self clearing, the acquisition, and share repurchases gives you 2008 EPS of $1.73 (note this compares to consensus of $1.75).  Placing a 18 multiple on this (which I don’t think is unreasonable given the quality of the business) gives you $31.15.  Then add back the company’s cash balance of $164 mil plus approx $57 mil ($107 -50 repurchase) in 2007 and $75 mil ($125 mil – 50 repurchase) in 2008 yields $296 mil or $4.70 per share.  This gives you a stock price of $35.85 or 50% above the current price of $23.84.

Best Case:  The company gets acquired at 25x 2006 pre-tax earnings (as discussed above) which yields a price of $46 or approx double the current price of $23.84.   

Catalyst