If you’ve been investing for a while, you’re probably familiar with options.
Maybe you’ve even traded them. But what can you honestly say you know about the
few companies that provide options contracts or the industry itself?
Did you know that for the past 34 years the options market has been growing at a
24% annual clip, 22.5% in the past 10 years, and finally 27% in 2005? And did
you know that despite this torrid growth, fewer than 10% of all domestic online
brokerage accounts are authorized to trade options? In the United States alone,
analysts estimate that there will be approximately 26 million online brokerage
accounts by 2008, and with just 9% of those accounts servicing a fast growing
niche, we Fools sense a great opportunity.
Enter the company that has been voted the best online brokerage by Barron’s
for the past four years running: optionsXpress (NASDAQ: OXPS). In 2004,
SmartMoney even dubbed the options dealer “nearly flawless.” It is
beloved by investors who want to execute complex options strategies, but it
offers simple, straightforward trading, too — all with fast execution times and
staff who can answer difficult questions. It has won plaudits for its website
design, which integrates the “Three Es” of its business strategy: customer
education, tools for evaluating options strategies, and top-notch execution of
orders.
Clearly, this is a well-regarded company with a lot of customer loyalty. But
just how does it fit into the crowded and competitive brokerage industry?
The first online brokerages were disruptive innovators, pulling the rug out from
under traditional full-service brokerage firms that didn’t serve the needs of
increasingly sophisticated clients who wanted to execute their own trades as
quickly and cheaply as possible. Now, optionsXpress is disrupting the
disruptors.
Stealing share from former rebels Etrade (NASDAQ: ETFC), Ameritrade (NASDAQ:
AMTD) and others, optionsXpress has forced industry-wide improvements in options
offerings. But OXPS hasn’t eaten up enough of the bigger guys’ bread and
butter—standard equity trades—to cause a stir. Rather than sacrifice margins and
pursue a costly war for options dominance, the bigger players have left well
enough alone. Meanwhile, optionsXpress can continue to perfect its business and
then steal another sliver. And another, just like its recent entry into the
24-hour futures market bolstered by its $37 million acquisition of XpressTrade.
With a market cap of $1.5 billion, the company is a little fish compared to
ETrade’s $10.4 billion or TD Ameritrade’s $10.6 billion. It attracts mostly
options traders, of course, but even within that niche it has plenty of room to
grow –with about 3% share of the options market –and plenty of profits to make.
Options traders represent an excellent business opportunity. They tend to trade
more often than other investors, creating more commissions, and they often have
a higher net worth. But they are less attractive to mainstream brokers because
their trades require more specialized service.
And, importantly, optionsXpress’s numbers reflect this kind of superior
profitability. For the year ended 2006, profit margins were a breathtaking 38.4%
on a top line increase of 45% to $186.9 million. Operating margins have stayed
impressively high since IPO, generally in the low 30% range. And returns on
equity and assets, which decreased in 2006, still blow AMTD and ETFC completely
out of the water. On top of this, customer assets increased an astounding 37% to
$4.7 billion, reflecting customers’ faith in the company itself. And, for a
little icing on the cake, the company offers a modest but symbolic .8% dividend
yield.
So where are the dark clouds here? The obvious one would be a major event that
causes trading volumes to drop, hampering revenues. However, I believe that
options traders are on the craftier side of the individual trader spectrum, and
would be more willing to step into a market that is troubled. The other issue is
the relatively thin moat between optionsXpress and its competitors. At some
point farther down the road, optionsXpress might not just be a nuisance and may
become a demonstrable threat to the bigger guys. Should that happen, I believe
the company might just be a great buyout candidate.
All in all, I believe optionsXpress is positioned to deliver outstanding
performance over the next several years. Whether it continues to simply create
great profits serving options traders, expand its niche and challenge the
dominant online brokers at their own game, or even attract a buyout from a
larger company, we stand to gain from here on out.
