optionsXpress Holdings Inc. (OXPS)

[expat7]

8 Jan 07 - Morningstar: Online Brokerage Review
by Patrick O'Shaughnessy | 8 Jan 07 |

With 2006 in the books, now seems like an appropriate time to review the online brokerage sector. We cover five online brokerages here at Morningstar: Charles Schwab SCHW, E*Trade ETFC, TD Ameritrade AMTD, TradeStation TRAD, and optionsXpress OXPS. On the whole, we believe this group is currently expensive, but we are impressed with a couple of the business models and would look to pick up shares at the right price.

Industrywide, we view the near-term impact of price competition as low due to the overall value proposition that large, established brokerages offer. Nevertheless, with competitors offering cheaper and even free stock trades, it seems likely that pricing pressure will ultimately mount. Arguably the most vulnerable of the bunch is TD Ameritrade, where the merger between TD Waterhouse and Ameritrade offered significant scale benefits but little in the way of diversification and long-term growth. The firm still boasts great returns on invested capital, but it is much more dependent on trading demand than its competitors.

Going different routes, E*Trade and Charles Schwab have been more effective at minimizing pricing risk and creating superior long-term growth possibilities. E*Trade has chosen to emphasize its banking capabilities to capture a higher share of its customers' wallets. By offering easy access to savings accounts, mortgages, and home equity loans, E*Trade has created a successful online banking operation that enjoys significant cost advantages. Schwab, on the other hand, has focused on becoming the premier online financial advisor. With a very popular "Talk to Chuck" advertising campaign, the firm has enjoyed great success in attracting customer assets away from expensive and often-conflicted full-service brokerages.

We also follow two niche players in the brokerage industry. Both TradeStation and optionsXpress have grown rapidly over the last several years by offering innovative trading capabilities in profitable niches. They will be hard-pressed to sustain their growth, however, as larger brokerages look to protect their turf and other start-ups emerge in this low-barrier-to-entry business.

As we often say at Morningstar, a great business does not make for a great stock. While we like the direction that E*Trade and Schwab are heading, the market has largely priced in much of their earnings potential. However, investors tend to overestimate the impact a weakening stock market would have on these firms, and if these stocks were ever to reach a reasonable price, we think it would make sense to pick up shares. We view TD Ameritrade, on the other hand, as a less attractive investment. Until management lessens its reliance on trading-generated revenue, the firm will have limited growth opportunities and continue to be overly dependent upon the trading climate. Finally, we believe TradeStation and optionsXpress remain risky bets, and we'd advise a large discount to our fair value before purchasing shares of these firms.
http://www.morningstar.ca/globalhome/industry/news.asp?articleid=MStarUS182891_2007-01-08_12-34-00