The on-line trading industry grew so quickly that it could barely accommodate record volumes at the last week of October. Stock of companies with significant exposure to on-line trading appreciated an average of almost 50 percent from July to October. Charles Schwab kept its top position, but E*Trade squeezed Fidelity out of the second spot. Takeover activity heated up; Quick & Reilly sold to Fleet Financial. Yet price wars slashed the average commission in the top 10 firms by 45 percent in the same period. Piper Jaffray examines the tumultuous industry and offers an outlook for the near term, with acquisitions taking center stage. Excerpts follow.

As commission prices continue to fall dramatically, there has been speculation in the industry that commissions could eventually be eliminated and rebates established for some trades, unnerving investors with visions of profit margins evaporating along with commission rates. While rates could decline and even be eliminated, this will only occur if firms can generate sufficient revenues from assets under management and margin balances to offset lost commissions. The Internet may be magic, but it is not immune from the basic laws of economics.

"Free trades" are nothing new. For example, Fidelity and Schwab offer "free" mutual fund trades, generating revenues via 12b1 fees from mutual fund companies and interest income from uninvested funds. In addition, full-service brokers have been pushing "wrap accounts" which eliminate or limit transaction fees in favor of a single asset management fee.

discounts on the horizon

On-line trading firms could offer the same pricing structures and use income from payments for order flow, uninvested funds, and margin balances to offset transaction costs. However this scenario is greatly complicated by two main factors. Payments are decreasing dramatically. Also, on-line trading customers tend to carry lower balances than full-service brokerage counterparts.

On-line trading firms would eliminate commissions only for customers who generated revenues to cover transaction costs. The pricing structure would be similar to that used by banks for checking accounts and other demand deposits.

This is unlikely to happen soon. If it did, it would be more a publicity stunt than a serious business strategy. Similar stunts were attempted when payments for order flow reached their apex at the end of 1996 and firms advertised "free trades" or fixed rate account payments. With the fall in payments for order flow, these firms retreated from these offers.

The next few months should prove interesting. The recent commission price cuts theme should become less pronounced due to three factors. First, the rapid decrease in payments for order flow is raising the floor on pricing by removing the hidden subsidy that made past price cuts palatable. At under $20/trade, the difference in commissions has become miniscule relative to the value of the trade for all but the most active traders. Price is likely to take a back seat to considerations such as speed of execution, quality of content, and customer service. Finally, with major players instituting major price reductions in recent months, it is unlikely that significant resolve exists for more cuts soon.

That said, we believe that Schwab, the industry leader, will reduce prices to hold onto its most active traders. Rather than cutting prices across the board, Schwab (and others) will provide discounts to their most frequent traders, (as) Fidelity has done.

The key economic issue facing on-line trading firms will be customer acquisition costs. During the past two months, numerous on-line trading firms, including E*Trade, Ameritrade, DLJ Direct, and Discover Direct, have announced $20 million-plus advertising campaigns. The industry plans to spend a quarter of a billion dollars on advertising over the next 12 months.

What's more, this spending (will) be heavily "front-end loaded" as firms seek to establish brand identity and gain share ahead of the market's maturation.

As acquisition costs expand, on-line trading firms will have to be careful not to destroy value by overpaying for new customers. How much a firm can spend on customer acquisition depends on a number of factors, including trades per customer, net revenue per trade, net margins, and current P/E. Given current trends, any firm paying north of $250/customer is running the risk of destroying value.

A number of firms may follow in the footsteps of Tradewell and American Express and waste a tremendous amount of money if they don't stick to a disciplined marketing regimen. We will be watching fourth quarter acquisition expenses to determine how successful firms are in avoiding the pitfalls.

With so many firms spending so much on marketing, the pressure to find cheap sources of high-quality customer growth will be intense. In the past, firms focused on recruiting customers from full-service brokers and traditional discount firms; now firms will increasingly recruit from each other.

old customers in demand

Why would firms shift from acquiring new users to stealing existing users? The old customers are the most profitable. Any retail traders worth their keyboards switched to on-line trading a long time ago. The most profitable customers are already on-line and entrenched with existing players. New users are more mainstream investors, much less active traders and therefore less profitable.

The stage is set for a substantial increase in "churn" rates akin to those among on-line services (AOL, Compuserve, Prodigy, etc.) in early 1996. With easy pickings gone and new customers less lucrative than existing customers, firms will offer free trades and limited-time discounts to lure the most profitable customers.

It will be important for firms to increase customer "switching costs." To date, switching costs have been largely limited to the hassle of closing and opening an account. As this process gets easier, the only costs remaining are check fees on account withdrawals. If firms fail to increase switching costs, account churn will accelerate dramatically. To prevent this, firms will have to focus on creating economic incentives for customers. The most obvious way to do this is to create "frequent trader" accounts similar to "frequent flyer" accounts.

In the midst of all this, a number of banks and insurers will launch on- line trading services by the end of 1998. They are one year too late to market, but that will not stop them from spending a lot of money to promote services and muddying up the waters.

This leads us to our final point: The stars are falling into alignment for a significant increase in acquisition activity in mid- to late-1998.

William Burnham is senior research analyst, electronic commerce, at Piper Jaffray. For information on obtaining a copy of the report, call 612- 342-5540.

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