Description

I believe that a short position in Tradestation Group Inc (TRAD) will provide investors with a 50% return within the next year to 18 months. TRAD is an internet-based securities brokerage firm for institutional, professional and active traders. TRAD shares have risen to $10 from $1 this year as a result of a rebound in online trading revenues. However, it is my belief that going forward that the company will have significant difficulty growing its account base and volumes because the company’s value proposition focuses on a very small niche of very active traders and institutions that design trading strategies based on technical analysis. Furthermore, the company is facing significant pricing pressure and will have higher fixed costs going forward. TRAD shares are priced for perfection and when the company's growth fails to meet investor expectations they will suffer accordingly.

Growth Hurdles:
TRAD attempts to differentiate itself from other online brokers by offering a sophisticated trading platform that allows investors to design and back-test trading strategies that involve technical analysis. The company currently has 11,000 combined equity and futures accounts. The company has publicly stated that their addressable market is made up of over 500,000 active traders.

TRAD's assumptions regarding the size of its addressable market appear wildly absurd. From conversations with the heads of marketing at ActiveTrader Magazine and Stocks & Commodities Magazine, I have been told that in the US there are only 65,000 individuals that would qualify as very active/professional day-traders. Furthermore, the number of very active/professional day-traders has not grown in the past two years and is significantly off from its highs of 1999/2000. Based on my conversations it would appear that TRAD has already captured 17% of the very active/professional day-trading market. Also, due to TRAD's focus on those traders that employ technical analysis and backtesting the company's market is likely to be significantly smaller than 65,000. I would argue that very active/professional day-traders choose their brokers based on pricing and execution, both of which TRAD does not have a comparative advantage.

For several years management at TRAD has said they are attempting to grow the company's institutional equities business, but so far have had little success. In fact, the company's efforts have been such a failure that management will not disclose how many institutional accounts the company has. In conversations with management they have stated that approximately 20% of revenues come from institutions, but most of the institutional accounts are even less active than the company's individual accounts. I believe this is a testament to the low quality of the company’s current institutional account base. Again, I feel that the company over-estimates it's addressable market and also fails to realize that its product adds very little value to most buy-side firms. The buy-side firms most likely to execute trades through TRAD are those that employ strategies with rigorous technical analysis, which is a very small market. In fact, according to bigdough.com there are only 160 buy-side firms in the US that market themselves as using technical analysis. TRAD adds little to no value to most buy-side firms, except those that use technical analysis, as they do not have a comparative advantage in liquidity and execution nor do they offer soft dollars or research. Why would a firm that does not employ rigorous TA ever trade with TRAD?

Slowing Account Growth:
TRAD has been very successful in growing its account base over the last year and a half with a relatively small marketing budget. Surprisingly, the company’s account base has grown from under 4,000 in the first quarter of 2002 to over 11,000 in the third quarter of 2003. However, while recent growth has been tremendous it is already showing slight signs of a slow down. I believe that without a significant increase in marketing spend the company’s net adds will continue to shrink. When comparing TRAD to other publicly traded peers, like AMTD, they should note its competitors add as much as 5x as many accounts in a given month than TRAD has been able to add over the trailing twelve months.

Sequential Account Growth
% Net Adds
Q1’02 76% 1,610
Q2’02 37% 1,367
Q3’02 32% 1,617
Q4’02 16% 1,104
Q1’03 14% 1,093
Q2’03 13% 1,197
Q3’03 12% 1,161

Equity Pricing Structure:
Unlike most of TRAD’s online brokerage peers the company charges commission on a per share basis rather than a flat fee. Currently TRAD is charging its clientele 1c for the first 500 shares traded and 6/10c for each additional share. Along with commission revenues TRAD also receives $100 per month from licensing its trading platform.

Pricing Pressure:
TRAD appears to be facing more significant pricing pressure than the rest of the industry. Over the last six quarters the company’s revenue per trade has decreased by over 67%. In fact, before the company released its latest earnings, management announced that it was again reducing its commission structure and had to lower its revenue and EPS guidance for the fourth quarter. The latest commission restructuring, that went into effect on October 1st, reduced commission on the first 500 shares traded from 1.2c to 1c, but left pricing on all incremental shares at 6/10c. The affect of this price reduction on the company’s top-line will be significant, as it will represent a 13% decline per trade based on management’s assumptions. Management stated that the reason they reduced pricing was to pass on to its clients the savings they would achieve by moving to self-clearing (a topic I will touch on below). I believe that management had to reduce its pricing to keep its account base growing and limit attrition based on the rapidly declining revenue per trade witnessed over the past two years. Why else would a company that is having “so much success” adding accounts do such a thing? Management would essentially be leaving money on the table.



Trading Assumptions
Old New
1st 500 shares 1.2c 1c
Incremental shares 6/10c 6/10c
Avg. shares/trade 800 800
Commission Avg. $7.80 $6.80

Revenue Per Trade
Q1’02 $22.33
Q2’02 $15.54
Q3’02 $10.83
Q4’02 $8.51
Q1’03 $8.53
Q2’03 $7.28
Q3’03 $6.93

Other announced price reductions
Old New
Futures (Round trip) $5.60 $5.00
Single stock Futures $2.40 $2.00

Futures Pricing
Q1 ’03 $7.80
Q2 ’03 $5.60
Q3 ’03 $5.60
Q4 ’04 $5.00 (new pricing)

Higher Fixed Costs:
The company announced in the second quarter that it would begin self-clearing in January of 2004. In my opinion the move to self-clearing is a double-edged sword because a higher fixed cost base can create a lot of operating leverage in good times and significantly reduce operating income in bad. The company stated that from the transition to self-clearing they would achieve $4mm in pre-tax savings. However, the savings projected could prove to be too aggressive as they were announced before the recent price reduction and assumed that trading volumes would continue to increase.

Lofty Valuation:
As you can see below, TRAD trades at a significant premium to its closet comp and industry leader Ameritrade. I believe an investor should also note that AMTD’s margins are twice that of TRAD’s, AMTD is not facing any significant pricing pressure and is taking market share and accounts from competitors like Schwab, Fidelity and Etrade.

Price $9
FDSO 44.7mm
Mkt Cap $425mm
Net Debt ($28mm)
Enterprise Value $397mm
’03 pe 53x, ev/ebitda 29x (taxed eps using a 35% tax rate)
’04 pe 37x, ev/ebitda 21x (taxed eps using a 35% tax rate)


AMTD
$11.50
FDSO 430mm
Mkt Cap $4,954mm
Net Debt ($148mm)
Enterprise Value $4,806mm
’03 pe 19x, ev/ebitda 10x (Taxed)
’04 pe 16x, ev/ebitda 9x (Taxed)

Conclusion:
TRAD is a terrific short opportunity as the company’s business is under significant pressure and is trading at incredible multiples to EPS and EV/EBITDA.

Catalyst

- continued pricing pressure
- higher costs going forward
- slowing account growth