Of E-Trade’s Leading Suitors, TD Ameritrade Is the Best Buy

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Business is getting better at E-Trade Financial (NASDAQ:ETFC), and that has investors wondering who — if anyone — will buy the once-troubled online broker. Charles Schwab (NASDAQ:SCHW) and TD Ameritrade (NASDAQ:AMTD) are the leading candidates, although both will have a hard time pulling the trigger given E-Trade’s risky mortgage portfolio.

Forget mergers and acquisitions for a second, though, and instead let’s focus on the two potential suitors. The way I see it, investors should sell Schwab and buy TD Ameritrade. Here’s why:

Insider Ownership

Both firms have a decent amount. TD Ameritrade’s insiders include founder Joe Ricketts, who recently retired from the board to dedicate more time to his other ventures, the Chicago Cubs and the American Film Company. All told, its executive officers and directors as a group own 13.6% of its stock. Charles Schwab’s insider ownership is 17.5%, with most held by its founder, Charles R. Schwab.

What breaks the stalemate in terms of ownership is Toronto-Dominion Bank (NYSE:TD), TD Ameritrade’s largest shareholder at 45%. TD sold its former discount broker in 2005 to Ameritrade and stayed on for the ride. Electing five of the 12 members of the board, it should be reassuring to TD Ameritrade investors that a bank as capably run as TD continues to value its investment in the discount broker. It certainly gives TD Ameritrade an edge when it comes to financing growth. Risk-averse investors might even consider owning TD Bank stock instead, which gives you indirect ownership in TD Ameritrade as well as direct ownership in one of the world’s best-run banks.

Quarterly Results

We’re comparing apples and oranges in this instance because TD Ameritrade’s most recent quarter is its third, but it is Charles Schwab’s second. Nonetheless, we still can look at some of the key numbers from both their quarterly reports.

In terms of pre-tax profit margin, TD Ameritrade’s is 460 basis points higher at 37%. TD Ameritrade also had a higher annualized return on shareholder equity at 15.1% — 110 basis points higher than Charles Schwab. TD Ameritrade’s total client assets increased 28% to $414 billion, while Charles Schwab’s client assets were $1.7 trillion — an increase of 22%.

However, it wasn’t all TD Ameritrade in the three months ended June 30. Charles Schwab excelled in net new assets, where it added $15.4 billion in client funds for an annualized increase of 10%, which is 200 basis points higher than TD Ameritrade’s increase. In addition, its fee- and spread-based revenues experienced higher growth in the quarter, while its trading revenues experienced a slower decline.

Where TD Ameritrade gets a huge advantage is employee compensation. Charles Schwab’s compensation and benefits in the quarter came to $430 million, or 36% of its revenue, while TD Ameritrade’s compensation was $169 million, or 25% of revenue. It’s possible Charles Schwab is a much better place to work. It’s equally possible that TD Ameritrade saves a bundle being based in Omaha as opposed to San Francisco. Unless Charles Schwab moves to Omaha, I doubt it can close the gap in operating margins. All things being equal, Charles Schwab can outsell TD Ameritrade until the cows come home, and it still won’t be more profitable.

Valuation

Citigroup analyst William Katz upgraded TD Ameritrade in mid-September from “hold” to “buy,” suggesting its stock price is so low that the possibility of interest rates rising — which previously had been factored into the stock price — is no longer the case. Furthermore, Citi believes that TD Ameritrade will buy E-Trade Financial despite CEO Fred Tomczyk indicating it wasn’t interested in the assets and TD Bank, its largest shareholder, probably wouldn’t be either.

Nonetheless, Katz sees the potential deal providing an 18% to 26% increase in its earnings, which translates to about a $3 gain on its stock price. Regardless of whether the deal happens, TD Ameritrade’s current price-to-earnings ratio is 25% lower than Charles Schwab’s. There’s no doubt about it: AMTD is the cheaper stock right now.

Bottom Line

Charles Schwab is going into the franchise business. Its future expansion is through the recruiting of independent registered investment advisors to open new branches across the country. It hopes to have 80 operating by 2013. Think of this as the Edward Jones approach, only giving away ownership of the offices through franchising.

TD Ameritrade, on the other hand, will grow its business by adding 100 salespersons annually, placing them in existing branches. Where it sees opportunities to open new offices, it will, but sparingly. Frankly, this is a more sensible approach to gathering assets. So much can go wrong in the franchise model, including quality control, that I have to wonder if the $50,000 franchise fee Charles Schwab receives is worth it. I already think TD Ameritrade’s stock is the better buy. The franchise idea only confirms it.

As of this writing, Will Ashworth did not own a position in any of the aforementioned stocks.

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia.


Article printed from InvestorPlace Media, https://investorplace.com/2011/10/e-trade-td-ameritrade-charles-schwab-toronto-dominion-bank/.

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