Don't Read Too Much Into Schwab's Acquisition

By James Brumley | March 20, 2011 AAA

In what some consider to be an omen of more consolidation to come within the brokerage industry, Charles Schwab (Nasdaq:SCHW) has paid $1 billion in stock to bring in smaller rival optionsXpress Holdings (Nasdaq:OXPS). The bid translated into an immediate 15% gain for optionsXpress shares, pulling them up to a price of $17.71.

The decision prompted two immediate questions. The first one was, did Schwab overpay? The second - what does Schwab hope to gain with optionsXpress? In the bigger picture, it also leaves investors wondering which, if any, brokerages are acquisition targets. Here's a quick look at all three questions.

TUTORIAL: Options Basics

Did Schwab Overpay?
In some regards, yes, Schwab did overpay. The offer ended up being 12.4-times the trailing earnings level for optionsXpress, versus the long-term average price of only 11-times earnings for deals of this size. In other regards though, it was a smart purchase at a palatable price.

Assuming nothing changes between now and the third quarter when the deal is expected to go through, Schwab's $21.2 billion market cap will increase by another $1.0 billion to reflect the new shares being issued to facilitate the deal. Schwab's $1.127 billion in 2010 revenue will combine with OptionsXpress' $231 million in 2010 revenue, while Schwab's 2010 profits of $454 million will be combined with the $51.9 million OptionXpress earned last year.

That said, 2010 was an off year for Schwab, which normally earns well above $1 billion. And, the union of the companies is expected to reduce annual expenses by $20 million, and improve revenue by $60 million.

Why optionsXpress?
In simplest terms, rather than organically grow a bigger options business, Schwab chose to buy a firm that was already neck-deep in the business. And, it may well be the wiser choice. Options trading activity has grown every year since 2002, and option traders make about six times as many trades as the average stock investor. For perspective, Charles Schwab is the largest independent broker-dealer in terms of assets, playing custodian to $1.6 trillion in client assets.

One would think that being the biggest online broker would also mean it generated the most revenue-bearish trades, but this isn't the case. Even when combining the revenue-bearing trades of optionsXpress and Schwab for Q4 of 2010, TD Ameritrade (Nasdaq:AMTD) still generated more revenue-bearing activity, even though Ameritrade only holds $394 billion in assets - about 25% of what Schwab is holding.

The disconnect between the large asset base and the low revenue-bearing trade volume may be a throwback to Schwab's beginnings, when it encouraged buying and holding mutual funds instead of active trading. In retrospect, those buy-and-hold customers may be reliable, but not all that profitable. optionsXpress customers could help bridge that gap, as the client base Schwab just garnered is a much more active - and therefore much more profitable - brokerage customer. (To learn more about mutual funds, see Mutual Funds: Introduction.)

Who's Next?
From some perspectives, optionsXpress was the last of the great brokerage firms that had (1) an attractive customer base, and (2) had some really cool trading tools. TD Ameritrade already purchased ThinkOrSwim and its proprietary trading platform in 2009. With optionsXpress now off the table, the only remaining potential targets are either too big, or too specialized, for their own good.

Take E*Trade (Nasdaq:ETFC), for instance. It's been suggested that Wells Fargo (NYSE:WFC) could be (and should be) interested, but with a market cap of $3.4 billion and spotty earnings, Wells Fargo may not care for what E*Trade can or can't bring to the table. From here, only two broker-dealers are worthy buyout contenders, and both of them are long shots.

The first one is TradeStation Group (Nasdaq:TRAD), with what could arguably one of the most advanced trading platforms available today. Its challenge is that these tools come with monthly fees or trading requirements that would make most retail investors do a double-take. If a larger firm saw a way to take the technology and reduce its cost, that would be one well-armed brokerage firm.

The other possible acquisition target is Interactive Brokers (Nasdaq:IBKR) - a diametrical opposite to TradeStation, in that it's focus is on low-priced trades at the expense of bells and whistles. Still, its customer base is self-identified as active traders.

The Bottom Line
Though Schwab pulled the trigger on optionsXpress, don't necessarily look for more M&A in the brokerage industry anytime soon. It was a good purchase, but it was also the last clearly good purchase to be had at this point in time. Any others may be misfit, or quite costly. (To learn more, see What Makes An M&A Deal Work?)

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