Online Brokers May Face Another Round of Consolidation

The Wall Street rally that pushed the Dow Jones industrials to 13,000 has been a boon for investors, but not the nation's online brokerages, and that could force another round of industry consolidation.

Individual investors have been notably absent from this year's stock runup--the professionals have been the ones doing the buying. The resulting lack of retail trades has been evident in quarterly earnings reports from brokers like E-Trade Financial and TD Ameritrade Holding.

Tough market conditions might be enough to bring executives at online brokerages to the negotiating table, analysts said. Not only can they combine with each other, but bigger financial institutions might consider a deal to boost their retail brokerage capabilities.

"Things are much more volatile, and this has made it harder to predict trading levels," said Jarrett Lilien, president and chief operating officer of E-Trade, after the company reported earnings last month. "The markets are almost back to levels they've been before, but retail hasn't really been the driver of this market. It's mostly institutional."

He would not comment about the potential for future deals, but said--like any good company-- E-Trade would weigh any proposal that would build shareholder value.

First-quarter earnings results showed that trading revenue accounted for about one-third of online brokerage revenue--down from about two-thirds before, according to a report from Deutsche Bank.

This caused both E-Trade and Ameritrade to cut their outlooks for 2007 because of reduced trading activity amid choppy market conditions. Charles Schwab Corp. did not adjust its full-year forecast.

Richard Repetto, an analyst with Sandler O'Neill, said a combination between E-Trade and Ameritrade could cause enough overlap to cut 15% in expenses. Both companies, which already held talks about a deal two years ago, would be a more fierce rival to industry leader Schwab.

"Consolidation should be more likely given the compatible and complementary strategies of Ameritrade and E-Trade," Repetto said.

Any deal would come just a few years after the industry's first wave of consolidation. A field of dozens of online brokers--with names like Datek, J.B. Oxford, and National Discount Brokers-- began to shrink.

Big deals formed, with Ameritrade striking a deal with Canada's Toronto-Dominion Bank to buy its brokerage house. E-Trade, unable to secure a deal with Schwab or Ameritrade, bought Harrisdirect from BMO Financial Group and BrownCo from JPMorgan Chase.

Seth Dadds, an analyst with GARP Research, said "prospects for industry consolidation seem to provide fodder for debate around earnings times." However, he said profit warnings don't mean times are so tough online brokers need to consider a sale.

"Simply one quarter of lowered expectations should not be viewed as the impetus for consolidation, in our view," he said in a report. "We think that the fundamentals of the online brokerage business would have to deteriorate over several quarters before the major online players would begin to consider serious merger discussions."

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