Summary

TD Ameritrade (AMTD) operates as an online discount retail brokerage with $324B in client assets.  AMTD and peers Charles Schwab, E*Trade, and Fidelity have benefited from a secular trend of client accounts departing the traditional wirehouses (Merrill Lynch/BofA, Smith Barney/MS, etc) to the lower fees and commissions of the online brokers.  AMTD has a reputation for drawing active traders due to a best in class retail platform for equities and derivatives, leading to higher commissions per account than competitors. Macro factors have disguised the progress made by AMTD over the past two years, and the latest equity sell-off, interest rate decline, and trading volume slump have given investors an intriguing entry point.  Sentiment is poor; TD Ameritrade recently hit 52-week lows.  Valuations for the group have historically ranged above 20x, yet AMTD is available at 12x 2011 EPS. 

Revenue              

2009A   2.4B     (-5.1%)

2010E:   2.6B    (+8.3%)

2011E:   2.9B  (+10.3%)

EBITDA

2009A:      1.21B   (7.7x)

2010E:      1.16B   (8.0x)

2011E:      1.35B   (6.9x)

EPS

2009A:    1.10  (13.5x)

2010E:    1.05  (14.1x)

2011E:    1.25  (11.8x)

The value proposition of online brokerages to the consumer is compelling, with $8-10 trades versus up to $50 at a wirehouse.  Profitability to Morgan Stanley or Merrill Lynch from a sub $1MM account is minimal and often negative due to the costs involved with full service.  Higher annual fees have been implemented at several wirehouses as a result, creating acceleration in client departures to cheaper substitutes such as AMTD.  

The size of the opportunity is compelling.  Morgan Stanley/Smith Barney boasts approximately $450B in client assets from accounts below $1MM.  At Merrill Lynch/Bank of America this number is even higher.  UBS, CS, and RJ also have hundreds of billions of small accounts that we expect will continue to move towards online discounters.  AMTD has $324B total in client assets - we expect asset growth of +10% at TD Ameritrade over the next several years driven by this secular trend.

We have communicated with brokers who have left the wirehouse framework and have either chosen to go independent or join an existing Registered Investment Advisor (RIA) group.  Our contacts have shared with us the strong ties keeping clients at major houses has begun to fade following the losses realized across '08 and '09.  The big brand did not save them from losing money.  One broker with a $70MM business at Wells Fargo left to join an RIA using TD Ameritrade as the principal custodian.  He stated that Wells Fargo pushed him to trade his clients' portfolio more actively than he thought was necessary.  He shared that he has access to top management at AMTD and that customer service is excellent.  Another RIA contact who has assets spread across Schwab, AMTD, and Fidelity is allocating all new client assets to AMTD, given how pleased she is with the service and feedback.  When asked for a reason, she said that "TD wants to actively improve our experience, the team makes more effort [than the other custodians] at helping us with solutions for our clients."

Business Drivers

TD Ameritrade recognizes revenue from two sources: commission fees (48%) and asset-based revenues (52%). 

Commissions:

Commission fees are influenced by changes in competitive pricing, market trading volumes, and mix of products traded.  Checks with competitors indicate fees have stabilized with each major industry participant at rates between $8 and $10.  Trading volumes have been sluggish, even for the summer, with daily trades down 12% year over year in July at AMTD (down 20% at E*Trade).  Historically, trading volumes have moved steadily upwards, and we would bet that eventually continues. 

Trading mix is a positive company-specific theme at AMTD.  In 2009, TD Ameritrade purchased Thinkorswim Group at 12x fwd EPS - and competitors agree that the acquisition gives AMTD the best retail options trading platform on the market.   AMTD is educating their active investor base on covered calls, writing puts, and trading in fixed income and futures.  Options carry 2x the revenue as an equity trade, futures and fixed income trades approximately 2.5x.  Options trades as a percentage of total trades has climbed to 20%, with futures and fixed income composing another 5%.  The advertised equity trade is $9, but average commission at AMTD is closer to $13.  The increasing mix of non-equity trades leads to our preference for AMTD over peers.

Asset-based Revenues:

Asset-based revenues were negatively impacted by the deflation in equity prices in 2009, and then by low interest rates in 2010.  While commission revenues rose 23% in '09, asset revenues fell 26%.  The drivers: the S&P down 22% on average from '08, and lower net interest margin on client cash balances.  While average equity asset prices have recovered by 15% from '09, interest rates have fallen further leading to asset revenue growth of only 12% for 2010.

Sensitivity to interest rates is explained as follows.  Net interest revenue and spreads on client cash are tied to the current Fed Funds/overnight LIBOR rate.  Insured deposits (client money market accounts) have longer durations:  24-30 months.  The split between the two is roughly half and half, but the majority of money market accounts have rolled onto a lower rate.  As older insured deposit accounts roll into new rates, at the current yield curve this will be a slight headwind to AMTD if rates do not increase.

While we cannot predict the direction of macro events, with short term interest rates near zero, the next significant move would seemingly have to be up.  At a minimum, short term rates cannot move significant lower.  A 100 bps upward move across the yield curve would increase EPS by 7 cents a quarter, 28 cents for the year.  TD Ameritrade offers investors tremendous optionality to an inflationary environment at a time when the market consensus is focused on deflation.  Just as hurricane insurance is cheapest when the waters are calm, so is the option value on inflation when deflation concerns persist.  Our estimates do not factor in a change in the yield curve.

Share Buyback:

TD Ameritrade has stockpiled $720MM in cash for what many analysts expected to be part of a possible acquisition of E*Trade.  However, with ETFC's $18B loan book full of consumer credits and mortgages, and negotiation of fair value for the portfolio would appear difficult.  Management has taken another direction, deciding to return a portion of the cash to stock holders.  On Aug 9^th the company established a new buyback program to repurchase 30MM of the 594M outstanding shares, with CEO Fred Tomczyk citing "At current prices we see further repurchases of our stock to be an attractive use of capital, providing additional value for our shareholders."

Valuation:

TD Ameritrade trades at 12.0x 2011 EPS.  Interest rates sit at low levels and trading volumes have been soft.  With optionality on a low multiple relative to a 20x average, we see tremendous upside in AMTD shares.

We expect 10% revenue growth in 2011, driven primarily by a 10% increase in client assets and an improved commission mix offsetting persistent low interest rates.  EBITDA margins have fallen from +57% in '07 to 45% in '10, and asset growth should allow margins to move back to 50% within the next two years if interest rates and equity prices stabilize.  Earnings should grow 19% in 2011, from $1.05 to $1.25.

We value AMTD at 15x 2011 EPS of $1.25, or $18.75.  Current prices offer 27% upside over the next 12 months.  A macro environment conducive to higher interest rates could drive '11 EPS though $1.50, and a mid/high teens multiple could provide bull case upside to $25.