Online brokers E-Trade (NASDAQ: ETFC) and Charles Schwab (NYSE: SCHW) will both be reporting quarterly results this week. Over the past five years, E-Trade has been a strong performer for investors, returning around 120% vs Schwab and the S&P 500’s which have both returned around 60%. This is despite E-Trade losing a third of its market value in the last 12 months. So which of the two online brokerages offers the better opportunity going forward?

 

Lower Interest Rates Will Hurt Etrade More

Both companies have seen their share prices under pressure since June last year, and both have fallen roughly 33%. E-Trade is now trading on a slightly lower forward multiple due to concerns that lower interest rates will put pressure on its earnings.

E-Trade, with a market cap of $11.3 billion is just over a fifth of the size of Schwab. It trades on a trailing multiple of 11.2 and a forward multiple of 10.5. Charles Schwab trades on a trailing multiple of 15.5 and a forward multiple of 14.5. Schwab also has a slightly higher dividend yield – though that could change quickly.

The major difference between the stocks is the amount of revenue earned from the interest spread on client cash accounts. E-Trade generates a substantially higher percentage of its revenue from the interest rate spread it earns on client deposits.

 

Schwab’s Revenue Streams Are More Diversified

Charles Schwab is better placed to benefit from economies of scale and it has deeper pockets to fund growth and make acquisitions.

By contrast, Schwab earns a significantly higher percentage of its revenues from its various asset management products, whereas E-Trade earns just 4% of its revenues. This revenue is more likely to be annuity-like income

Both companies are well placed to benefit from the robo-advisor revolution. In the event of consolidation in this industry both would probably benefit. However, Schwab is better placed to benefit from economies of scale and it has deeper pockets to fund growth and make acquisitions.

E-Trade’s management has done a fantastic job growing the company and improving profitability over the last few years. Almost every measure of margin and return has steadily improved. The question here is whether the company is well-positioned for the future.

 

Schwab’s Two-sided Platform

This is where Charles Schwab may be better positioned despite trading at a premium. Schwab has all but established itself as the platform business within the online investing and money management industry. Clients have a wide array of products to choose from, including ETFs, mutual funds and other products provided by third parties.

It is now becoming increasingly attractive for third parties to have their products available on the platform. This creates a type of network effect as more products makes the platform more attractive to clients and more clients make the platform more attractive to providers. As the platform becomes more attractive to providers it gains pricing power on the fees they charge. In addition, the entire business benefits from economies of scale which justify further investment in the user experience.

E-Trade is trading at a discount due to expectations of lower rates, but that discount might persist as investors take note of Schwab’s potential. There is a very real possibility that Charles Schwab could take E-Trade’s position as sector leader over the next few months. That could become a self-reinforcing trend if investors start switching their sector exposure from the latter to the former. Investors should pay attention to the relative performance of the two stocks as the market digests their results over the next week.