Will Online Brokers Join the M&A Rush?

Two hedge funds are pushing TD Ameritrade to merge with a rival; S&P thinks industry consolidation could be positive for shareholders

Shareholders with a significant stake in TD Ameritrade (AMTD; $21) are pushing for it to merge with other online brokerages, and it's a positive development for the company's shares, which were 4.2% higher in afternoon NASDAQ trading June 6.

Fewer discount brokers would also be a positive development for the industry, S&P Equity Research believes. The overall investment banking and brokerage industry has lagged the market thus far in 2007, with the S&P investment banking and brokerage index up 6.2% through June 1, vs. an 8.9% improvement for the S&P 1,500.

As a result of the news about the activist shareholders, S&P equity analyst Matt Albrecht upgraded his opinion of TD Ameritrade to buy from hold on June 6. Securities & Exchange Commission filings show two hedge funds, JANA Partners and S.A.C. Capital, have built up a position in Ameritrade shares representing about 8.4% and are agitating for a business combination with a peer.

Operations Overlap

Which peers would the funds prefer? Named in the filing are E*Trade Financial (ETFC; $25), whose shares were trading higher by about 7% in the afternoon on June 6, and Charles Schwab (SCHW; $22), whose shares were trading lower by nearly 1%. E*Trade carries a strong buy opinion from S&P, while Schwab is ranked hold.

"We believe the converging business plans of entities in the industry make this a real possibility, and we think it would add to shareholder value," Albrecht says. S&P has a positive fundamental outlook on the investment banking and brokerage industry.

Albrecht was not surprised to hear there might be some consolidation among the top three, "considering that AMTD's management had said in their last conference call they are always open to consolidation within the industry and they are in constant contact with competitors." Where the surprise came, he said, was among the large hedge funds. "They seem to be agitating for changes sooner than I had anticipated the consolidation might happen," Albrecht says, explaining that the top three online brokerages' business plans are all converging, and there are obvious cost-saving possibilities with their technology overlaps and back-office operations.

Consolidation Now

To Albrecht, consolidation benefits make a combo a no-brainer. But time may be of the essence, with borrowing rates likely headed higher.

Albrecht thinks the funds have moved in now to speed up the process, but doesn't see activist hedge funds being the catalyst behind the consolidation trend among brokerages or even asset management firms.

There are a number of other companies that are of a reasonable size and could have attractive businesses for a potential acquirer that a fund could take a stance on, Albrecht believes. Yet he doesn't think any other combo is as "obvious as this one potentially with AMTD and one of its rivals." The online brokers have seen typical seasonal volatility, but their focus shift toward asset gathering has led some measure of predictability to results. Albrecht sees increased price competition among brokerage firms if they stand alone, and he expects online discount brokers to continue to expand operations to attract more long-term investors.

As a result of the June 6 news, Albrecht is raising his 12-month target price on Ameritrade by $5 to $25—which is 23.4 times his fiscal 2007 (ending in September) profit estimate of $1.07, a valuation that is in line with the company's historical average—on his view of favorable industry trends and the increased likelihood of a strategic move by management.

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