TD Ameritrade Is A Bet On Successful M&A, Rather Than Organic Business Growth

Long/short equity, special situations, event-driven, momentum

The rise of discount/free online brokerages has wholly disrupted traditional brokerages like AMTD.

As a result, AMTD has focused on growing its asset-based revenues through M&A.

This is why AMTD is a solid bet in the retail brokerage industry during a rising rate environment.

However, if the Fed indeed starts cutting rates, then this can leave AMTD exposed to massive headwinds.

My valuation of AMTD suggests that its probably fairly valued as it is. Hence, I think theres little potential upside at these levels.

TD Ameritrade (NASDAQ:AMTD) has historically been a reliable retail broker for its clients. However, I think that the rise of discount/free electronic brokerages has completely disrupted AMTDs industry. Unfortunately, AMTD seems to be stuck in its ways and is now resorting to growing its accounts through M&A rather than a better value proposition. In my view, this will probably translate into sluggish growth going forward. Hence, I think theres little potential upside in AMTD at these levels.

AMTD is a retail broker. Its revenues can be broken down into asset-based and transaction-based. AMTD offers financial products like stocks, exchange-traded funds, options, futures, forex, mutual funds, fixed income, margin lending, cash management services, and annuities. Its worth pointing out that AMTDs asset-based revenues represent roughly 62% of total sales, while the remaining 38% come from transactions (and other revenues). Moreover, AMTD typically benefits from higher 1) trade volumes, 2) volatility, 3) account balances, and 4) interest rates. In my view, these are the four critical variables for AMTD. This is why, during Q4 2018, AMTDs revenues increased due to higher trade volumes and a spike in the VIX (volatility).

Naturally, brokers like AMTD can be considered good plays on market volatility. Often, investors flock to these types of stocks during periods of market uncertainty. However, the problem with this rationale for AMTD is that it doesnt seem to be an uncorrelated asset. Thus, if the market drops, AMTD will likely follow suit as well. This is unlike pure plays on market uncertainty like the Nasdaq (NDAQ) or the CME Group (CME). In fact, I think even Interactive Brokers (IBKR) can be an uncorrelated bet on market volatility.

Source:Portfolio Visualizer. AMTD has the strongest correlation with the broader market among its peer group

As you can see, AMTDs correlation matrix shows that its collated with the rest of the market (as measured by the SPY). AMTDs correlation factor is 0.65, while IBKR and CME have correlation factors of 0.48 and 0.47, respectively. Uncorrelated stocks are typically attractive because theyre not as exposed to systemic risks as other securities.

The fact that AMTD trades alongside the rest of the market is very telling. After all, as previously mentioned, 62% of its total revenues are asset-based. This means that, while trading volume is essential, what really moves the needle for AMTD is interest rates. Since interest rates tend to correlate very tightly with equities, then its evident why AMTD is also 65% correlated with the SPY.

However, the problem with this is that AMTD, at this point, appears to be more like a bank than a broker. You see, AMTDs main competitors are E-Trade (ETFC), Charles Schwab (SCHW), and Interactive Brokers. In my view, AMTD does well when compared to ETFC or SCHW. However, if you analyze AMTDs value proposition against IBKRs, youll quickly realize that the latter is superior in a few aspects. For example, AMTD has a competitive trading platform, but its execution, margin rates, and commissions are inferior to IBKRs.

In my view, this is AMTDs biggest problem: it lacks a sustainable competitive advantage against discount/free online brokerages (like IBKR or Robinhood). Thus, AMTD will face difficulties when competing against them for new accounts. Unfortunately, I believe that AMTD is outclassed in some key areas, and I fear that this could translate into sluggish growth.

Source:Investopedia. Discount brokerages like IBKR are significantly cheaper than AMTD

Nevertheless, its worth pointing out that AMTD is already starting to offer somecommission-free ETFs. So, its possible that this will strengthen AMTDs value proposition for customers. Still, realize that AMTD does profit byselling its clients order flow. So, its not technically free because high-frequency traders make clients pay through unfavorable order execution. This is why I dont think that AMTDs commission-free ETFs are going to enhance its value proposition significantly either. After all, sophisticated investors probably understand the tradeoffs.

Ultimately, AMTDs growth strategy seems to hinge on M&A. You see, AMTD itself acknowledged in itsannual reportthat part of its business strategy is to capitalize on theongoing consolidationof the US retail brokerage industry. It remains to be seen whether or not this will create a sustainable business moat for AMTD. However, I remain skeptical because simply acquiring similar competitors wont change the fact that AMTD is an expensive retail broker with an OK trading platform. AMTD can grow its accounts through M&A, but over the long term, I believe that only its value proposition will be able to sustain it.

In any case, recently, an analyst from Deutsche Bank (DB) noted that theres amodest possibilityof a merger between AMTD and ETFC. I think that this makes complete sense, given AMTDs position within its industry. After all, the resulting broker would be among the biggest in the industry and would benefit from a more significant number of accounts. Also, AMTD and ETFC have very similar brokerage operations, so I do think theyd be an excellent fit.

Source: AMTDs2018 10-K. The company appears to be focusing on growing its clients account balances through M&A.

However, this wont change the fact that AMTD seems to be doubling down on increasing accounts (to benefit from rates) while theFed is signalingitll cut rates in July (and maybe even September). Instead of doing this, I think AMTD should pivot towards becoming competitive on price.

The reality is that AMTDs organic growth appears to be sluggish. After all, its difficult for AMTD to grow its trading-based revenues if its more expensive than its competition. For example, if you exclude the recent Scottrade acquisition, then AMTDs growth would have been closer to 6%. This is because before AMTD acquired Scottrade, it had a revenue CAGR of 5.58%. So, its no surprise to see that AMTD is now resorting to M&A to fuel future growth. Thus, if AMTDs organic growth remains in the single digits going forward, then its going to be challenging to justify a higher valuation. Hence, I think AMTD has limited potential upside at this point.

First of all, AMTD has approximately $1.68 billion in FCF and contractual obligations of roughly $710 million. Also, AMTDs interest payments are approximately $120 million, while its debt-to-equity ratio is 0.42. So overall, Id say that AMTDs liquidity is sound for the time being. In fact, AMTD has almost enough cash on hand to repay all of its debt if it needed to do so.

Source:Seeking Alpha. AMTDs dividend yield is close to its 2016 highs

Furthermore, AMTDs dividend yield of 2.39% is decent. The companys 4-year average dividend yield is 1.83%, so you could say that its an attractive dividend yield in historical terms. In my view, AMTDs higher-than-average dividend yield is typically a good indicator of value. Still, the absolute dividend yield of 2.39% isnt going to attract dividend investors anytime soon.

Now, lets look at AMTDs earnings power. For this, I decided to run a simple valuation model for AMTD as well. As you can see, my model suggests that AMTDs fair value is $55.28 per share. This valuation would suggest a very modest potential upside of 7.3%. Since every valuation model has a margin of error, Id say that this approach also indicates that AMTD is reasonably valued.

Thus, after looking at the company through different angles, Id say that theres nothing that jumps out as a screaming buy. In my view, AMTD seems reasonably valued.

Finally, Id like to mention a few key risks that can play out for AMTD.

Interest rate risks. AMTD traditionally benefits from higher interest rates, so its revenues will probably suffer if rates decline. The fact that AMTD seems to be doubling down on this type of revenue at this time is worrying, in my opinion.

Credit risks. AMTD makes most of its revenues through margin lending, which exposes it is to third-party risks.

AMTD faces intense competition and suffers from a severe lack of competitive advantages. Currently, the brokerage industry is facing massive shifts. The rise of commission-free trading and electronic brokerages has commoditized many financial services. This lack of differentiation is why AMTD heavily relies on marketing and M&A to grow its revenues. However, I believe that competitors like IBKR have a better value proposition as a whole, which could continue to hamper AMTDs growth.

Growth through M&A exposes AMTD to execution risks. If management fails to realize the anticipated synergies, then M&A can cause unforeseen losses. Also, M&A wont necessarily strengthen AMTDs value proposition, so the rise in accounts could be short-lived as a result.

The fact that AMTD is much more expensive than discount/free electronic brokerages is concerning. Ill concede that ATMDs commission-free ETF trading is a great incentive that could bring in new customers. Nevertheless, I still believe that AMTD needs to focus on improving its value proposition as a whole (i.e., becoming the best trading platform with better execution and lower fees), instead of focusing on M&A. The reality is that I dont see AMTD trying to go in that direction, so M&A is their next best alternative. I do agree that AMTD could benefit significantly from a merger with E-Trade. After all, the resulting company would enjoy the benefits of size and would be in a strong position to adapt to the industrys changing trends.

Ultimately, I think that AMTDs M&A will probably work out over the short term. However, over the long run, I remain skeptical of AMTDs prospects due to its lack of pricing disadvantages. Hence, I think that any potential upside in AMTD will probably come from multiple expansion, rather than intrinsic business growth (unless interest rates suddenly shoot up).

I prefer avoiding these types of investments because betting on multiple expansion when the market is at all-time highs seems risky. Still, I do believe that AMTD could be a solid investment in a rising interest rate environment. However, since rates are likely going to trend lower due to the Fed, I think theyll actually become a headwind in the near term. Thus, for all these reasons, AMTD is a pass for me.

Disclosure:I am/we are long IBKR.I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.