In most normal industries, the numbers would shock. E*Trade is paying $1.6bn for BrownCo, a brokerage business which would probably be worth $800m-$900m by itself. What are the synergies to offset a premium this big?
In E*Trade’s case, it is not as far-fetched as it sounds. The company has two big advantages. The first relates to E*Trade’s mix of banking and broking. Brokers typically have a mismatch between margin debt balances, the money brokers lend to clients trading on margin, and customer cash piles. But being brokers, their options for redressing this imbalance are limited. Excess cash, for instance, can only be invested in low-yielding securities. E*Trade, however, gets a cheaper source of funds and more profitable places to put extra cash. This advantage contributes about $60m of the deal’s $154m of annual synergies.
The other synergy is common to all online brokers. Pushing more trading volumes over the same platform is extremely profitable, yielding an incremental margin of 85 per cent. E*Trade gets BrownCo’s $80m of operating profits, but with very few of its costs. Even on conservative assumptions that E*Trade loses some of BrownCo’s customers and does not benefit from cross-selling the synergies should more than cover the whopping premium.
Of course, there are risks. E*Trade is increasing its exposure to trading, where competition is tough, especially with a revived Charles Schwab. But this deal helps to strengthen E*Trade ahead of any further consolidation.
