67 WALL STREET, New York–January 31, 2005–The Wall Street Transcript has just published its Brokers and Asset Manager Issue, a report offering a timely review of the financial services sector to serious investors and industry executives. This 95-page feature contains a roundtable forum and commentary from 6 research analysts and top management of 12 firms, and provides special analysis of the online brokers. It also includes a special ‘Off the Record” section that asks company leadership which management teams in their sector they most respect for their ability to execute and generate shareholder value. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.
2004 was a volatile year for the brokers with two weak quarters sandwiched between two strong quarters. The market, however, finished up about 9% for the year, which should contribute to improving investor confidence as well as better fundamentals for the group as a whole. The multiples are attractive on a long-term basis for these companies, and given that the economy continues to do better, the earnings outlook is favorable. Topics include: Fixed income outlook, Investment banking issues, Impact of Sarbanes-Oxley, M&A activity, IPO market, Equity capital markets, European markets, Regulatory concerns, Asset managers, Industry consolidation, Online discount brokers, Retail sector volatility, Interest rate environment, Investor concerns, Valuation issues, Stock recommendations, Stocks to avoid.
Companies include: Alliance Capital Management (AC); Ameritrade (AMTD); Bear Stearns (BSC); Benefit Capital Companies; BlackRock (BLK); Charles Schwab (SCH); Eaton Vance (EV); E*TRADE (ET); FirstMerit (FMER); Franklin Resources (BEN); Greenhill (GHL); Goldman Sachs (GS); HSBC Holdings (HBC); Integrated Asset Management Corp. (IAM:TSX.V); J.P. Morgan Chase (JPM) Janus (JNS); Jefferies Group (JEF); Legg Mason (LM); Lehman Brothers (LEH); Life Asset Group, LLC; Merrill Lynch (MER); Morgan Stanley (MWD); Paulson capital Corp. (PLCC); Piper Jaffray (PJC); T. Rowe Price (TROW); Quest Turnaround Advisors, Stifel Financial Corp. (SF), SEI Investments Company (SEIC); SWS Group (SWS); U.S. Global Investors, Inc. (GROW); UTEK Corporation (UTK); Analysts include: Matthew E. Fischer of Independent Research Group, E. Robert Hansen III of Standard & Poor’s Equity Group, Brad Hintz of Sanford C. Bernstein & Co., Inc., Cynthia Mayer of Merrill Lynch Global Securities, Robert Lee of Keefe Bruyette & Woods, Richard A. Herr of Keefe, Bruyette & Woods.
In the following excerpt, Richard Herr discusses the impact on exchanges of increasing competition and declining commission rates.
TWST: How about on the other side, the equity trading side? What’s going on there?
Mr. Herr: The equity-trading environment is undoubtedly better with the pickup in volumes. Really, what we continue to wrestle with from a fundamental perspective is the ever-decreasing decline in profit margins given pressure on commission rates. We continue to see margin pressure, and the companies that are doing well are those that continue to right-size their expense base to offset that.
Something that Instinet Group, Knight Trading, ITG and LaBranche, as well as a host of others such as Archipelago (AX) and NASDAQ (NDAQ), are also wrestling with right now are the SEC’s plans to revise the national market system though its Regulation NMS proposal. The revision of the national market system and how this may affect the New York Stock Exchange as well as the NASDAQ market has far-reaching effects on the entire securities brokerage industry. Currently it appears we are going to have new regulations that favor electronic over floor-based auction markets and best-price protection, also known as the trade-through rule. There are going to be business models that win and those that lose as a result. We had some very positive momentum at the beginning of the year in terms of the regulatory front. The SEC had originally proposed Regulation NMS (National Market System) and, at the time, it appeared we would have a rule change in place by summer. However, the process has taken much longer than the Commission originally thought given the complexity of the matter.
We recently had another hearing. The SEC put out a revised proposal, and we’re expecting to have a vote to implement the proposal into law in early 2005. There are a couple of different things on the table right now. It’s hard to say who’s going to be the “winner” in all this, but it’s clear that the New York Stock Exchange, LaBranche and Van der Moolen (VDM), are going to see their business models change radically. The New York Stock Exchange is implementing a hybrid trading model where you’re going to see more hybrid (electronic and manual) trades, which means that more volume will occur electronically, and we’re going to see the specialists such as LaBranche have to change with that. And you could see business models like that of Instinet or Archipelago capture some incremental market share from the New York Stock Exchange if we see more electronic trading occur.
Where we stand currently in the equity trading sector is trading volumes are rebounding, but there’s continued margin pressure and a clouded regulatory environment. However, the recent reports in the press regarding the possibility that SEC Commissioner William Donaldson may be moved from his spot would throw the progress we have witnessed on the regulatory front into limbo once again.
TWST: As you look at these companies, do they have the capability to change as this environment changes?
Mr. Herr: I think they do. I think the New York Stock Exchange, which is private so they don’t have the scrutiny of investors, has already started the process of changing their business model. I think for the specialists such as LaBranche and Van der Moolen, it’s going to be a bit more painful, because they are public. You are going to see layoffs and some significant technology investment in order for them to interact with the new hybrid model.
But I also am a firm believer that we’re going to see consolidation across the space, whether it be New York Stock Exchange specialists or the other equity trading players like ITG, Knight and Instinet. There’s just not enough commission dollars to go around given the margin pressure. I think we may see specialists get rolled up. I’m not saying it’s going to happen in the next year or two, although we already have three of the seven specialists owned by larger global financial institutions. Spear, Leeds is owned by Goldman Sachs (GS); Fleet is owned by Bank of America (BAC); and Bear Wagner is owned by Bear Stearns (BSC). I wouldn’t be surprised to see Van der Moolen sell to a larger commercial bank or investment bank. And for LaBranche, too, I would not put that out of the question, although CEO Michael LaBranche, I think, feels his stock is worth more than it’s trading for right now.
It’s also been in the news about Instinet being up for sale. I think that’s been the case for a couple of years and there’s definitely value there. It’s a matter of what price its parent company, Reuters Group (RTRSY), will take. But at the right price it makes sense for some consolidation among the ECNs (Electronic Communication Networks) because we only have three major players – NASDAQ, Archipelago and Instinet. Some consolidation there would make sense as well just from the expense account synergies alone.
TWST: What are you telling people about the space? Just sit and watch?
Mr. Herr: I think everything obviously has a price when it gets attractive. Looking at the space, a lot of the stocks have already run up in anticipation of stronger trading volumes, but things seem to have pulled back in the last week or so. I think Instinet, if the share price were to drift lower, as some of the take-out chatter subsides, becomes attractive. Management is going to announce in Q1 2005 a restructuring plan, to right-size the expense base once again, and I believe this could boost profit margins significantly.
Instinet is the largest trader in terms of NASDAQ-listed stocks that has about 25% market share. Instinet also has a growing portion of New York Stock Exchange-listed trading, so it’s one of the names I would consider more attractive at the right price.
For the most part the rest of the group has already appreciated significantly, so it’s not something we’re actively recommending at the moment.
TWST: Is there anything you would like to add?
Mr. Herr: Our favorite names in the space are Ameritrade, which I spoke about before, and E*TRADE. We recently initiated coverage of Investment Technology Group, an equity trading company most well known for its POSIT product, which is basically a block-crossing network. The company’s CEO, Robert Russel, resigned in September and its Board of Directors brought the former CEO, Ray Killian, back for a third time. Killian is working with senior management to strategically reposition the company. They’ve announced a couple of acquisitions and I think we’re going to see some more small acquisitions coming out of there, and I think that’s really a turnaround story in that space. Even though you have declining margins, obviously increasing pressure on market share, I think the management team there is fairly visionary. My feeling is they’re probably going to be diversifying outside of equities as well.
Obviously the hot thing right now is derivatives. It might make sense for them to do something there in terms of options trading, but to diversify outside of equities would be significant for the company.
TWST: When might you begin to see some benefits of this management change?
Mr. Herr: I think we’re starting to see some of them now. In 2005 we’ll probably see more on the way. I don’t think we’re going to see any blockbuster transactions happen, but ITG has already announced that it is in talks with a block-crossing network in Europe, E-CrossNet, and expects that deal to close early in 2005. That should give them some scale in Europe in their international operations. Management has not released any details as to how accretive or dilutive that will be to earnings. It most likely would be neutral to accretive in the near term.
ITG has also announced that it is acquiring the 50% of their POSIT technology that they did not already own. They had originally started POSIT as a joint venture with Barra, which was bought by Morgan Stanley (MWD) in 2004. We estimate that’s going to be at least $0.12 to $0.13 accretive on an annual basis just from buying that interest back. So we’re going to see that in 2005, and I think there are more transactions on the way.
The Wall Street Transcript is a unique service for investors and industry researchers – providing fresh commentary and insight through verbatim interviews with CEOs and research analysts. This 95-page special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.
The Wall Street Transcript does not endorse the views of any interviewees nor does it make stock recommendations.
Source: Yahoo Financial News
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