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?)

Use the Investopedia Stock Simulator to trade the stocks mentioned in this stock analysis, risk free!

Related Articles
  1. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  2. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  3. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  5. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  6. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  7. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  8. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  9. Mutual Funds & ETFs

    3 Vanguard Equity Fund Underperformers

    Discover three funds from Vanguard Group that consistently underperform their indexes. Learn how consistent most Vanguard low-fee funds are at matching their indexes.
  10. Investing News

    Alphabet Earnings Beat Expectations (GOOGL, AAPL)

    Alphabet's earnings crush analysts' expectations; now bigger than Apple?
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
Trading Center