By Jerry Knight
Monday, May 16, 2005

As chief executive of E-Trade Financial Corp., Mitchell H. Caplan is determined to be a winner in the multibillion-dollar game of musical chairs in the online investing business.

Trouble is, so are Charles Schwab, who still runs the discount brokerage firm he founded; J. Joe Ricketts, who controls rival Ameritrade Holding Corp.; Rodger O. Riney, the founder of Scottrade Inc.; and the Canadian bankers who own TD Waterhouse Group Inc.

But there probably aren't going to be more than three seats available when the music stops.

That is why Caplan, after weeks of discreet courtship, went public last week with a $6 billion offer to buy Ameritrade.

Consolidation is inevitable in the online brokerage business, Caplan argued in an interview recently at E-Trade's offices in Ballston. Although officially based in New York, E-Trade operates out of Arlington, where Caplan and other top executives have their offices.

Caplan has roots in the Washington area. He got into the online financial services business a decade ago by turning a tiny Northern Virginia savings and loan into Telebanc Financial Corp., which grew to become the nation's biggest online bank.

At the height of the Internet boom in 2000, Caplan and his early partners sold Telebanc to E-Trade, another hard-charging Internet pioneer. E-Trade catered to the first generation of online traders, investors who tried to make money by jumping on the latest hot technology stocks.

After the Internet bubble burst and the Nasdaq Stock Market cratered in the spring of 2000, the online trading fad faded rapidly. The number of active traders and the pace of trading plunged. E-Trade lost so much money that its founders were forced out. Telebanc's online banking operation became the tail that wagged the dog, and Caplan began running the company in 2003.

Online trading continues to contract, pushing the industry into survival strategies that look like what the airlines are doing -- cutting costs ruthlessly and cutting prices recklessly. Stock trading commissions, which can be as high as $100 at some full-service brokerage firms, have fallen as low as $7.99 per trade for the most active traders.

As with the airlines, overcapacity is a problem. The online brokerage systems were built when millions of individual investors were playing the frequent-trading game. As those people mature from traders into long-term investors, trading volume falls.

"Financial services by and large are pretty commoditized," said Caplan, who thinks E-Trade's diversified operations give it an advantage over firms like Ameritrade and Scottrade, which get almost all their revenue from trading fees. Caplan figures it is futile to compete on price alone when fewer and fewer people are trading.

But cutting the pie into fewer slices would help, Caplan said. Now, for the second time, he is the leading player in consolidation talks.

Last year E-Trade came close to merging with TD Waterhouse, the U.S. brokerage firm owned by Toronto-Dominion Bank, the second-largest in Canada.

Both sides agreed that putting together E-Trade and TD Waterhouse would have been a marriage made in heaven, a combination of "bricks and clicks" that would have made the combined firm a top player online and on land. Toronto-Dominion has a network of local offices, targeting affluent urban and suburban residents, that would mesh nicely with E-Trade's operation.

The courtship foundered, however, over who would lead the company. Toronto-Dominion wanted control and so did Caplan. A compromise, in which Toronto-Dominion would own a majority of the combined firm and Caplan would run it, just wouldn't work, both sides ultimately decided.

The control issue also appears to be the hang-up in Caplan's bid for Ameritrade, which on Friday reported that its trading volume fell 14 percent in its second quarter ended in March, from the comparable quarter last year. Handling fewer trades and making less money on each one, Ameritrade cut its earnings forecast for the year by roughly 16 percent.

In contrast, E-Trade's trading volume for the first quarter was off only 1 percent, and profit rose to $92 million (24 cents a share) from $89.8 million (23 cents).

Despite its problems, however, Ameritrade stressed that it is "not for sale" -- to E-Trade or anyone else. But founder Ricketts issued a statement saying the company "believes there will likely be further consolidation in the industry," making it clear that he would rather be a buyer than a seller. The company has not commented beyond its written statements.

Ricketts and his family own 30 percent of Ameritrade's stock, which probably gives them enough leverage to block the sale of the company.

Ameritrade also has talked to TD Waterhouse recently, but those negotiations could lead to a similar dispute over control that doomed the Waterhouse-E-Trade deal.

So far Schwab and privately owned Scottrade have not been linked to any of the consolidation talks, but industry analysts say both are potential players.

E-Trade remains the "most eligible" of the online investment firms because it is the least dependent on traders.

E-Trade's bank has $26 billion in assets. That makes it twice as big as Chevy Chase Bank, the largest brick-and-mortar banking institution based in the Washington area, and more than four times the size of the District's best-known bank, Riggs, which was taken over Friday by PNC Financial Corp. of Pittsburgh.

E-Trade bank originally was strictly a wholesale operation, taking deposits and investing them with other financial institutions rather than using them to make loans to its own customers. Now the business is evolving into a full-fledged bank that makes loans, especially home-equity credit lines.

In addition to its bank, E-Trade has its own market-making firm, which buys and sells stocks for customers. Caplan said 50 percent of E-Trade's orders are now handled internally, which lowers the cost of doing those trades.

The market-making arm also does business with other brokerages, and E-Trade recently restructured its own brokerage, creating an institutional division that works with pension funds, college endowments and other high rollers rather than small investors.

On the retail side, Caplan said E-Trade is increasingly successful at marketing other financial services to its banking and brokerage clients. The average client now uses 1.9 "services" from E-Trade, up from an average of 1.7 a year ago. That change of two-tenths of a percentage point translates into tens of thousands of new customers for credit and debit cards, equity loans, mortgages and other services that generate more profit than trading.

Merging with Ameritrade would bring in millions of potential customers for banking services that are not offered by that firm but are part of E-Trade's package.

Caplan makes a strong case for why E-Trade ought to be one of the survivors of the consolidation of the online financial services business. So far the logic of his argument has not persuaded anyone to join him, but as trading volumes dwindle, the pressure for mergers will grow. Sooner or later somebody is going to come along and say, "Mitch, let's make a deal."