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Wells Fargo downgrades 3 online brokers after fee-free trading launches

Wells Fargo Securities analyst Christopher Harris has downgraded TD Ameritrade Holding Corp., Charles Schwab Corp. and E*TRADE Financial Corp. following the brokers' cuts to zero-dollar commission fees.

The analyst downgraded TD Ameritrade to "underperform" from "outperform," while downgrading Schwab and E*TRADE to "market perform" from "outperform." Harris also reduced his brokerage coverage sector rating to "market weight" from "overweight." His "underperform" rating on Interactive Brokers Group Inc. remains unchanged.

"We believe that identifying a bull case for this group now has become very difficult," Harris said in an Oct. 3 note.

All four online brokers cut commission fees on certain online trades to zero dollars within the last week. The online brokers are expected to take a significant hit to revenues by introducing free trading.

Schwab indicated that it expects a revenue hit of $100 million per quarter, or 3.5% of total revenue, while TD Ameritrade anticipates a $220 million to $240 million decline per quarter, or 15% of total revenue. E*TRADE estimated that the revenue impact on its second-quarter results would have been about $75 million, or 10% of its revenue.

TD Ameritrade's lower rating "reflects its current worst-in-class EPS growth profile, corporate governance missteps (uncertainty in the CEO role) and fewer idiosyncratic drivers of upside relative to peers," Harris wrote.

The industry expected online broker commission rates to move to zero, as it has been facing pressure from Silicon Valley-based startup Robinhood Markets Inc., which rose to prominence by offering free trading, and from big banks, such as JPMorgan Chase & Co. and Bank of America Corp.'s Merrill Edge platform. But the timing of these cuts was surprising, Harris said. Previous commission fee pricing cuts have been offset by a rising interest rate environment, a rising stock market and increasing asset prices.

Today, the market faces "a very uncertain macro backdrop," with a potentially shaky economy and falling interest rates, Harris said. Trading revenue has acted to stabilize during declining interest rates and falling equity markets. Now, the online broker business model looks "even more like interest rate proxies," which does not have a good risk-to-reward at this point in the rate cycle, he added.

The "only positives," according to Harris, are likely expense cuts and stock buybacks. But even the possible earnings benefits from those actions "don't deserve a very high multiple," he said.

The analyst was also surprised at how fast TD Ameritrade and E*TRADE responded to Schwab's cut, both announcing in-line plans less than a day later. Commission fee revenue makes up a much larger piece of total revenue at TD Ameritrade and E*TRADE than it does at Schwab.

"We were surprised at how fast these companies responded to [Schwab's] move, which must mean they view [Schwab] at zero as a significant threat to their near- and long-term prospects," Harris said. "More broadly, the fact that customers at e-brokers seem unwilling to pay a few dollars in commissions implies they don't assign a lot of value to the additional services and products these companies offer."

Harris lowered certain EPS estimates for TD Ameritrade and E*TRADE by a "remarkable" percentage. He now expects TD Ameritrade to report EPS of $4.05 in fiscal year 2019, up 1% from $3.99 expected previously. However, the analyst anticipates EPS at TD Ameritrade of $2.70 in fiscal year 2020 and $2.85 in fiscal year 2021, down from prior estimates by 33% and 34%, respectively. Harris now expects E*TRADE to post EPS of $3.72 in fiscal year 2019, down 7% from previous expectations of $4.00. He also expects E*TRADE to report EPS of $3.05 in fiscal year 2020 and $3.30 in fiscal year 2021, down 32% and 33%, respectively, from former estimates.

The analyst also reduced his expectations for Schwab and Interactive Brokers. He expects Schwab to report EPS of $2.50 in fiscal year 2019, down 6% from $2.65 expected previously. The analyst anticipates Schwab's EPS at $2.30 in fiscal year 2020 and $2.60 in fiscal year 2021, down from prior estimates by 18% and 16%, respectively. Harris expects Interactive Brokers to report EPS of $2.12 in fiscal year 2019, down 6% from $2.25 expected previously. He anticipates the broker to post EPS of $2.35 in fiscal year 2020 and $2.55 in fiscal year 2021, each down 4% from previous expectations.

The analyst also updated his price targets. Harris has set a price target of $39 for Schwab, down 22% from the previous $50 target. He has dropped TD Ameritrade's price target 48% to $30 from $58 and E*TRADE's price target 33% to $37 from $55. Harris also reduced his price target for Interactive Brokers by 7% to $40 from $43.