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E*Trade (NYSE: ETFC) is a leading online brokerage firm, which also offers retail banking services, such as checking and savings accounts and CD accounts. That diversification may have come at the wrong time, with the 2008 Financial Crisis affecting on the financial stability of the firm. It exited its mortgage lending services in 2008, and for the 2009 fiscal year, E*Trade reported a $1.3 billion loss.^[1]

The online brokerage firms have been facing increased competition and downward price pressure as traditional retail banks, such as Bank of America (BAC) and Wells Fargo (WFC), have entered the industry. This pressure prompted E*Trade to find another retail outlet: retail banking. However, since E*Trade’s banking division invests customers' deposits to earn money on the interest rate spread, fluctuations in the values of its holdings has impacted earnings significantly since it has reported negative profits since 2007.^[2]. With the collapse of the subprime mortgage boom, many of the company's holdings have seen their values decline significantly. To help lower its debt from mortgage-related losses, it made a public offering 435 million shares in June 2009.^[3]

This shift in E*Trade’s business model towards retail banking has changed the way the company makes money. However, since its exit from loan origination, E*Trade has shifted its focus back to growing its online brokerage. Its number of brokerage accounts increased by 8% from 2,520,102 accounts in the third quarter of 2008 to 2,729,137 in the third quarter of 2009. Brokerage related cash, which is the company's most profitable source of funding increased by $2.6 billion by the third quarter of 2009 compared to the third quarter of 2008. However, trading and investing net operating interest income decreased 11% to $577.3 million in the first nine months of 2009.^[4] In addition, its net new customer assets, an indicator of the amount of usage by existing and new users, increased more than 200% from $2 billion in the first nine months of 2008 to $4.2 billion in the corresponding period in 2009.^[4] However, since online brokerage revenues are commission-based, revenues could fluctuate significantly with conditions and activity in the equity markets.

Business Overview

E*Trade has consolidated its business into two main segments to better assess the objectives of each segment, as well as allocate resources more efficiently.^[4] Its primary sources of revenue include net operating interest income, commission, fees and service charges, principal transactions, loss on loans and securities, and other revenues.^[4]

• The Trading and Investing segment is E*Trade's main service sector. It provides an online investing and trading platform that allows clients to trade market and limit equity, options, futures, exchange-traded funds, and bond orders. In addition, 25% of its revenue is generated by its retail banking arm which includes checking, savings, sweep, and money market accounts, along with certificates of deposit (CDs), as well as mortgage, home equity, margin, and credit card products.
• The Balance Sheet Management generates additional net operating interest income by leveraging loans (previously originated or purchased from third parties) and customer cash.^[4] Net interest income is generated by taking customers' deposits and loans, and reinvesting them where they hope to earn a high return. Although this can be a risky practice, it can keep the difference, also known as the spread) between the two interest rates. The more money E*Trade has in its clients’ accounts, the more its can earn on the interest rate spread.

Customers

E*Trade's clients include both individuals and corporations which account for approximately 2.7 million active brokerage accounts, 1.0 million stock plan accounts and 0.8 million active banking accounts.^[4] E*Trade earns revenue by charging commission fees on its clients' trades. The amount of the commission varies from client to client, depending on the size of a client’s account and how often she execute trades. Rising competition has driven down commission fees in the industry, leading E*Trade to focus on mass affluent investors, asset accumulation, and interest income.

• Mass Affluent investors are investors who execute fewer than 30 trades per quarter and hold over $50,000 in assets in combined retail accounts. This group is particularly sought after because of the high cash accumulation of each investor.
• Main Street investors are investors who execute fewer than 30 trades per quarter and hold less than $50,000 in assets in combined retail accounts. These investors pay a higher commission for stock trades than the Mass Affluent group.
• Active Traders are clients who execute more than 30 trades per quarter. These clients pay lower commissions on their trades, regardless of their total assets.
• Corporate Clients: E*Trade manages the employee stock plans for over 2,500 firms in more than 100 countries, which cumulatively cover over 1.3 million employees. While the corporate services sector is not E*Trade's main focus, it is a significant source of revenue and provides nearly 33% of total profit.

Key Operating Metrics

• Daily Average Revenue Trades: DARTs are the average number of trades clients make in a day. Each of these trades provides revenue for the broker-dealer through their commissions.
• Net Interest Spread: The net difference between the interest rate the broker-dealer makes on its investments and the interest rate it pays its clients. The larger the net interest spread is, the more money the broker-dealer makes on its clients assets.
• Total Client Assets: The total amount of money that the broker-dealer is holding for its clients. The higher their total client assets the more they can exploit the net interest spread and create revenue. This makes building up client assets a main focus for broker-dealers.

Trends and Forces

Differentiation through product and service enhancements

E*Trade has faced increased competition for its online brokerage, which has effectively dropped trading prices and commissions. To grow revenues, E*Trade expanded into the retail banking industry business in an attempt to attract new customers and offer its existing customers a broader range of products and services. To further differentiate itself, it has introduced enhancements to its product and service offerings. For example, it has increased its customer services by launching 24/7 phone and online chat services for potential customers, as well as current customers who may have investment related questions. It has introduced personal finance planning tools to aid its customers with retirement, tax, and trading activities.^[7] In addition, it has even extended its trading capabilities to Blackberries and iPhones. MobilePro, its free trading app, was the most downloaded finance app for iPhones and had more than 2 million Blackberry log-ins in less than one year.^[8] E*Trade is considered to have the leading mobile platform among its online brokerage competitors TD Ameritrade Holding (AMTD) and Fidelity Brokerage Services.

Account and Asset Growth

As cash accumulation takes over as the main source of revenue for broker-dealers, asset and account growth is becoming more important. ETFC can increase assets and account growth by:

• Increasing the total number of accounts: In 2009, ETFC added 115,000 net new brokerage accounts. ETFC has a total of 4.5 million customer accounts, and of these, 2.7 million are brokerage accounts.^[1] Brokerage accounts are especially important to ETFC's business model because they generate additional revenues through commissions, fees, and service charges. In 2009, ETFC raised ts average commission per trade to $11.41, a 6.7% increase over 2009. The number of Daily Average Revenue Trades, or DARTs decreased from 215,949 in 2008 to 173,778 in 2009. The combination of increased accounts and fees, raised the company's total net revenue by 15% from $1.9 billion in 2008 to $2.2 billion in 2009.^[1]
• Specifically targeting mass affluent accounts: By targeting wealthier investors, E*Trade can increase its total available assets more quickly than by acquiring more lower-income customers
• Gaining a larger "wallet share", which refers to the percentage of a client's total assets that are held in E*Trade accounts. For example, a customer that uses E*Trade has a larger wallet share of a customer that uses both ETFC's banking services and brokerage services versus a customer that only uses its brokerage services.

Market Swings & Fed Interest Rates

Revenues based on commissions are susceptible to swings in the stock market, which are linked to general economic conditions. In a bearish market, the trading volume is relatively low and this in turn decreases revenue from commissions. On the flip side, an upturn in the market will increase trading volumes and hence commission revenue for E*Trade. In periods of economic uncertainty, trading volumes can spike significantly, reflecting investors' apprehension about the future of the economy.

Furthermore, the Fed's interest rates directly affect broker-dealer's net interest revenues. The U.S. Federal Reserve's recent decisions to lower the target federal funds rate to 3% could hurt E*Trade's net interest margins and put pressure on revenues. E*Trade is particularly leveraged to interest rates since interest income makes up a larger percentage of its total revenues than any of its main competitors.

Competition

E*Trade Financial faces strong competition, most importantly from Charles Schwab (SCHW),TD Ameritrade (AMTD), Fidelity, and Scottrade. E*Trade and TD Ameritrade are very similar in structure: they both run a no-frills investing platform geared towards self-guided investors. Asset accumulation can be difficult for E*Trade and other no-frills online brokers as they're competing against firms that offer more advanced guidance for investors. As a result, E*Trade is far behind their "high-touch" counterparts when it comes to wallet share because they don't offer investment advising products and services. Charles Schwab--which has more comprehensive offerings--has been more successful in attaining a greater share of its clients' total assets.

By stepping up its retail banking offerings, E*Trade has decreased its dependence on commissions, but it has become increasingly reliant on interest income as a principal source of revenue. Changes in interest rates can, therefore, have a significant impact on earnings. This is especially true for E*Trade, which derives a larger percentage of its revenue from interest income than its main competitors, Charles Schwab (SCHW) and TD Ameritrade (AMTD).

• Market Share Comparisons: Market share can be measured in a few different ways: accounts held; total assets; or number of trades made. As of 2006, E*Trade held 15% of the market share measured by number of accounts, 8% when measured by total assets and 18% of total trade volume. These data show that E*Trade's customers fund their accounts with about half the funds on average compared to the overall market and implies a relatively smaller wallet-share. Schwab, on the other hand, holds twice the market share in assets that it does in accounts on average.

• New Accounts Acquired: An important metric for comparing competitors is new client acquisition rates. Price wars among the online broker-dealers have driven down commission fees in an effort to attract new clients.

The chart below shows the percentage of new accounts that E*Trade, TD Ameritrade and Charles Schwab have acquired each quarter and illustrates how competitive the market for new accounts is. E*Trade has a relatively more volatile new account acquisition rate:

• In Q4 2005, E*Trade accounted for nearly 80% of new accounts
• E*Trade under-performed against Schwab and Ameritrade in the last 2 quarters of 2006
• In the first quarter of 2007 (not represented on the chart), E*Trade's 13% annualized growth rate is outpacing both Schwab (3%) and Ameritrade (7%)

Changes in new account acquisition are often driven by marketing and advertising spend as well as efforts to cross-sell products to their existing customer base.

• Revenue Composition Comparison: The sources of revenue are different between the competing online broker-dealers. In particular, Charles Schwab is quite different because their main source of revenue is from asset management fees, a source of revenue that E*Trade and TD Ameritrade do not have. Below are the revenue compositions for TD Ameritrade, E*Trade and Charles Schwab. Notice the extent to which E*Trade has moved towards asset-based revenue streams: 58% Net Interest Income vs. 41% and 34% at TD Ameritrade and Charles Schwab, respectively. This shows E*Trade's aggressive move towards a new business model that is less reliant upon trading based revenue streams. By increasing its dependence on interest-based revenue streams, however, E*Trade has increased its exposure to market fluctuations; its investments are linked to market conditions and can be volatile. Schwab and TD Ameritrade are relatively less exposed to this risk.

• Commissions on Trades: The fees that clients pay to make trades can be a significant factor when choosing a broker-dealer. Brokerages have been competing vigorously to offer lower trading fees, often giving a number of free trades to new clients or to customers who refer new clients. In 2007, E*Trade made $11.73 per trade on average, Charles Schwab (SCHW) charged $14.01 on average, and TD Ameritrade Holding (AMTD) pulled in $12.90 per trade on average.

Recently,Wells Fargo (WFC) and Bank of America (BAC), who are new in the brokerage industry, have offered fee-free online trading to a number of their customers. Offers like this will apply great pressure on the well established broker-dealers to cut their fees even further. To make up for lost commission revenues it will be necessary to increase revenues in other areas such as net-interest revenue. If the current trend continues it is likely that trading fees will continue to fall in the years to come.

References

1. ↑ ^{1.0 1.1 1.2 1.3} Business Wire, "E*TRADE FINANCIAL Corporation Announces Fourth Quarter and Full-Year 2009 Results"
2. ↑ Google Finance: ETFC
3. ↑ Top News, "E-Trade Financial prices public stock offering at $1.10 a share," Dominic Haber, 06/20/2009
4. ↑ ^{4.0 4.1 4.2 4.3 4.4 4.5} E*Trade 10-Q 3rd Quarter Report, 11/04/2009
5. ↑ ^{5.0 5.1} E*Trade 10-k 2006 Annual Report, 12/31/2006
6. ↑ ^{6.0 6.1} E*Trade 10-k 2008 Annual Report, 2/26/2009
7. ↑ Investment News, "E-Trade unveils personal finance planning tool on website," Sue Asci, 05/13/2009
8. ↑ Mobile Banker, "Web Brokerages Push Smart Phones' Trading Capabilities," Michael Sisk, 07/09/2009
9. ↑ AMTD, SCHW, ETFC FY2007 10-K Annual Reports on http://www.sec.gov