Bad Timing for Commission Price War for Online Brokers
We expect to decrease our fair value estimate for wide-moat Charles Schwab amid news of its pricing cut.
A commission-pricing war is coming at the worst time in a decade for the online brokerages. Interactive Brokers kicked it off last week by offering free trading on U.S.-listed equities and ETFs. Today, wide-moat Charles Schwab (SCHW) announced that it will reduce per-trade commissions for U.S.- and Canadian-listed stocks, ETFs, and options to $0 on mobile and Internet trades. While there won’t be a per-trade commission for options, there will still be a per options contract fee. Right now, we are arguably at a turning point for profits at the online brokerages. Concerns about the U.S. economy continue to build that can cause a bear market, long-term interest rates have already significantly fallen over the previous year, and many expect short-term interest rates to be cut again in coming quarters. This means that growth in online brokerages’ asset-based fees likely won’t fill in the revenue and earnings gap left by cuts in commissions. We expect to decrease our fair value estimate for wide-moat Charles Schwab by around 5% due to the announcement of its pricing cut and are placing our fair value estimates for narrow-moat TD Ameritrade and narrow-moat E-Trade under review as we weigh the likelihood of them also introducing pricing cuts and any market share shifts among the firms.
The operating income effects of the commission cuts are greater than the revenue effect. Charles Schwab derives approximately 7% of its revenue from commissions and estimates that the new pricing plan will decrease revenue by 3% to 4%. With Schwab having an operating margin around 45%, a 3% to 4% decrease in revenue translates to about a 9% decrease in earnings if we assume company expenses are 100% fixed. TD Ameritrade (AMTD) recently derives about 32% of revenue from trading and E-Trade (ETFC) 17%. They also have operating margins nearing 50%, so if they follow Charles Schwab and Interactive Brokers, their earnings could fall around as much as their exposure to trading commissions.
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Michael Wong does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.