Description

Tradestation is an online broker targeting highly active traders - their average account trades nearly 2x per day. This is a business with razor thin margins. However, in the past, the company was able to differentiate itself itself with its backtesting technology. However, this product is quickly becoming commoditized. Rather than being the only backtesting platform as in the past, Tradestation is now only the second best platform behind Wealthlab (a subsidiary of Fidelity) and Schwab's Cybertrader product is competitive as well. This is erroding the company's pricing power and it appears from the company's own actions that they will no longer be able to charge clients "platform fees", a 100% margin fee just to have an account open at the firm. Details of the short are listed below:

1. Increasing Competition Which is Commoditizing a Former Proprietary Product

Just over one year ago, Fidelity acquired a small company WealthLab. WealthLab was a software company that offered back testing technology and competed against Tradestation, however, unlike Tradestation, Wealthlab did not have a brokerage business and thus could not offer an integrated offering of back testing and trade execution (TRAD make this leap in 2001). However, when Fidelity acquired the platform (for approximately $50m), the first upgrade they made was to integrate trade execution into the platform. Since that time, Fidelity has constantly upgraded the platform and is now generally considered a better platform than Tradestation. For example, Wealthlab offers back testing on fundamental data, on baskets of stocks (i.e. test my strategy on all retail stock or define your own list of stocks), and allows a user to “drag and drop” trade instructions into a testing methodology rather than having to know all the details of a computer programming code. Tradestation offers none of these things (company claims fundamental data will be added by the Spring). See the most recent Barron’s “Electronic Investor” that describes some of the Wealthlab advantages. Schwab has also built back testing technology into their Streetsmart Pro trading platform.

2. Pricing Pressure is Resulting From the Competition

Tradstation has continually been forced to reduce their trade commissions and most recently has began waiving their platform fees at lower and lower minimal levels of activity. These recent price cuts (and platform fees are 100% margin) are not yet fully reflected in the numbers as the first reduction went into effect as of Sept 1 (so only 1 month reflected in latest quarter) and will cost the company $0.05 annually, and a second reduction went into effect on Dec 1 costing another $0.05 annually. So these two price cuts collectively will impact 2006 EPS by $0.10 and I expect more platform fee reductions because Wealthlab charges ZERO for platform fees. This has not been fully appreciated by the sell-side because the company quit disclosing platform fees at the beginning of this year (but I can still make pretty accurate estimates based on past disclosures).

On top of the reduction to platform fees, the company has been reducing its base commission rates (many of these rates are negotiated over the phone by high volume traders that know they have bargaining power so even if commission reductions are not announced, they continue to drop).

Base Commissions / Trade

2002: $13.27 2003: $7.14 2004: $5.32 1Q05: $4.98 2Q05: $5.00 3Q05: $4.74

On the pure execution side, Interactive Brokers is advertising stock trades for $0.005 or less, option trades for $0.50 to $0.75, and future trades for $0.25 to $1.20 per contract. Tradestation is priced higher for equities and options (same price for futures). Full fees can be compared at:

http://www.interactivebrokers.com/en/main.php

http://www.tradestation.com/fees/All_Asset_Types.shtm

http://www.cybertrader.com/MarginAndFees/Overview.aspx

http://personal.fidelity.com/products/atp/content/wealthlab.shtml.cvsr

Note that while Fidelity does not publish per share pricing, they will negotiate per share pricing over the phone for active traders.

Additionally, the straight commissions do not tell the whole story, Tradestation’s margin rates are much higher than the above mentioned firms, cash credit rates are much lower, and stock borrow is much worse because Tradestation self clears and is a relatively small firm.

3. Risk to 2006 Estimates and Guidance

My 2006 estimate is $0.50 vs the street at $0.59. The main items that I believe the sell-side is missing is 1) the reduction/elimination of platform fees, 2) declining activity of incremental accounts (see discussion below on questionable account adds), 3) continued decline in base commission rates, and 4) almost all of the company’s revenue growth in 2005 was from increased interest income compliments of the Fed increases. Without the fed increases, interests income will experience little to no growth.

4. Minimal Takeout Risk

The co-CEOs (and founders) each filed 10b-1 plans to sell 17.5% of their respective holdings – just under 10% of the entire company. Not the type of move an executive would make if the company were being dressed up for a sale. Additionally, E*Trade recently shuttered their “professional segment” and explained that despite its size (DARTs were approximately 40k per day) the business was only marginally profitable. In a follow-up conversation I had with the company, E*Trade explained that the business is no longer about gaining the most DARTs, its about gaining the most clients assets and thus these high volume, low margin business are just not attractive. Ameritrade several years back also shuttered their foray into the simi-professional segment when they acquired and then approximately a year later shut down Tradecast. So with E*Trade and Ameritrade already out of that business and Fidelity and Schwab already offering inhouse developed products, there are few left with interest to acquire (especially at a current market cap of $700m, over a 60% premium to what Schwab paid for Cybertrader in April 2000! – the peak of the tech bubble)

5. Low Margin Business Without Platform Fees

The main difference between Tradestation and other simi-professional trading platforms was their ability to charge platform fees. Without these additional fees (which are being eroded due to competition), the business becomes very low margin.

6. Overall Size of Market is Not Growing

The overall size of the day trader market peaked in 2000 and since then shrank and became stagnant. It has become a game of stealing customers because the overall size of the market is not increasing.

7. Questionable Quality of Recent Account Adds

The average account asset balance and trades per account have been steadily declining for several years which indicates that either 1) their existing accounts are trading less and shrinking in size or 2) the new accounts that are being added are of a lesser quality. Whichever it is, the result is the same – the quality of their account base is declining

Declining Quality of Accounts

2003 2004 1Q05 2Q05 3Q05
Trades / Account / Day 2.27 2.20 2.13 2.02 1.90
Avg Account Equity $119k $66k $60k $59k $58k

8. Losing Proposition for Clients = Unsustainable Business Model

Brokerage revenue (commission, platform fees, and net interest charged to clients) represented nearly 7% of client assets in 3Q05! How many investors can show profitable returns when they are weighed down by 7% transaction costs? Not many, which indicates to me that over time, the majority of their clients will not make money or they will lose money. Thus account attrition should be high (currently its not disclosed) over time and makes the sustainability of this business model very questionable.

9. Valuation

Price / Earnings Multiples

2006E 2007E
TRAD (consensus) 27x 22x
TRAD (my est.) 32x 26x

ET 17x 14x
AMTD* 20x 15x
SCH 23x 18x
OXPS 28x 22x

*Excludes $6.00 special dividend
Note: ET and AMTD earnings power is understated for 2006 because they will not realize full synergies from their respective deals until 2007

Catalyst

1) 2006 estimates are too high and likey to come down 2)Core product, backtesting, WAS differentiated and WAS proprietary and allowed the company to charge premium pricing IN THE PAST. This is no longer the case, their platform is now second best to Fidelity, thus the premium price will go away. Competitors are offering lower prices and company has been forced to reduce rates and/or eliminate fees