E*TRADE Financial (ETFC)

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See all 5 Bulls Reasons Bulls: Reasons To Buy Had more success with retail banking - a key profit center - than any other online brokerage 100% agree Had more success with retail banking - a key profit center - than any other online brokerage Their Retail sector is quite strong and managed well. Recently, the supervisor of investment banking and retail, Donald Layton, was named the CEO. Layton seems like the perfect fix to improve the investment banking side, which seems to be in need of some fix. Moreover,... read more View or Edit Reason 2 votes 100% agree Relying on interest revenues is smart 100% agree Relying on interest revenues is smart E*Trade's shift towards asset-based revenue streams will remove some of the volatility associated with the commissions-based revenues that arise through general market swings. View or Edit Reason 1 votes 100% agree One of the strongest brands in online stock trading 100% agree One of the strongest brands in online stock trading E*Trade has one of the (if not the) strongest brands in the online discount broker space. On top of their strong brand is one of the best trading platforms available online. Behind the brand and the platform, is an extremely profitable retail business model, where... read more View or Edit Reason 1 votes 100% agree See all 4 Bears Reasons Bears: Reasons To Sell The Current Book Value Is Not Completely Accurate. 100% agree The Current Book Value Is Not Completely Accurate. The MBS papers owned by ETFC have not been completely priced. Until these securities are priced the actual book value cannot be fully determined and is just an estimate. View or Edit Reason 2 votes 100% agree The online broker-dealer industry is very competitive 50% agree The online broker-dealer industry is very competitive The online broker-dealer industry is very competitive. Falling prices and an increasing number of strong competitors are making more difficult for well-established firms to remain profitable. View or Edit Reason 2 votes 50% agree More reliant on interest revenues 0% agree More reliant on interest revenues E*Trade has a significantly higher mix of net interest revenues than its competitors. This could lead to less growth if the Fed stops tightening interest rates. View or Edit Reason 0 votes 0% agree Send the authors a comment or suggestion Be the first to make a suggestion See All Suggestions

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E*Trade is a leading online brokerage firm. As online trading has become more competitive and trade prices have dropped, E*Trade has expanded into the retail banking industry in an attempt to attract new customers and offer existing customers a broader range of products and services. In addition to its original online trading services, E*Trade now offers checking and savings accounts, CDs, and mortgage services.

This shift in E*Trade’s business model has changed the way the company makes money. As an online brokerage, E*Trade’s revenue was mostly commission-based; as such, revenues could fluctuate significantly with conditions and activity in the equity markets. 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).

E*Trade’s brokerage business has been facing increasing competition, especially after traditional retail banks Bank of America (BAC) and Wells Fargo (WFC) made a splashy entrance into the retail brokerage industry in late 2006. Also, since E*Trade’s banking division invests customers' deposits to earn money on the interest rate spread, fluctuations in the values of its holdings can impact earnings significantly. With the recent collapse of the subprime mortgage boom, many of the company's holdings (particularly in the forms of CDOs and asset-backed securities) have seen their values decline significantly, pressuring earnings. The extent of E*Trade’s exposure to the credit crunch is unknown, but there has been speculation that the company may either seek an outside investment or be sold to another firm outright.

[edit] Business Overview

E*Trade Financial's main focus has historically been its online trading and investing arm. Recently, however, E*Trade has been expanding its focus to include more standard retail banking features. Its goal is to become more than just an online broker-dealer and eventually be a fully functional online bank that can provide its clients with nearly all of their financial needs.

• Investing and Trading: E*Trade provides an online investing and trading platform that allows clients to trade market and limit equity, options, futures, exchange-traded funds, and bond-orders. This is E*Trade's main service sector.
  • Commissions: 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 shift its focus to asset accumulation and interest income.
    
• Banking and Lending: E*Trade also provides retail banking options including checking, savings, sweep, and money market accounts, along with certificates of deposit (CDs). Additionally, E*Trade offers mortgage, home equity, margin, and credit card products.
  • Net Interest Income: E*Trade generates revenue by taking customers' deposits and reinvesting them where they'll (hopefully) earn a high return; by doing this, it can pocket the difference (called 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, as the chart to the right illustrates. Note: bps stands for basis points, where 1 basis point is 1/100th of 1%.

[edit] Customers

• Individual Clients
  • Mass Affluent investors are investors who execute fewer than 30 trades per quarter and hold over $50,000 in assets in combined retail accounts. Because E*Trade and similar broker-dealers rely so heavily on cash accumulation for revenue, Mass Affluent investors are particularly sought after.
  • 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 around one third of total profit.

[edit] Business Driving Factors

[edit] Account/Asset Growth

As cash accumulation takes over as the main source of revenue for broker-dealers, asset and account growth is becoming more important. An effective way to grow assets is through increasing the number of mass affluent accounts; by targeting wealthier investors, E*Trade can increase its total available assets more quickly than by acquiring lower-income customers. Another key factor for asset growth is gaining a larger "wallet share", which refers to the percentage of a client's total assets that are held in E*Trade accounts.

[edit] 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.

[edit] Credit Crunch

In 2007, fallout from the subprime lending collapse and the resulting contraction in the credit market had a materially negative impact on E*Trade's performance. Despite record revenues and income in the company's retail segment, large write-offs on securities and a substantially increased provision for loan losses in its institutional segment led to a net loss of $1.4 billion for the year. Many of the securities E*Trade was forced to write off were backed by mortgages, whose values have decreased in the wake of the subprime fiasco. The tightening credit market and general uncertainty about the direction of the economy have made it more likely that loan customers will default, which prompted the company to set aside more money to cover these losses.

In addition to the nearly $200 million in write-offs announced in its earnings release on October 17, E*Trade announced on November 9, 2007, that further write-offs were likely in the fourth quarter. According to the company, collateralized debt obligations (CDOs) and second-lien securities account for around $450 million of its $3 billion portfolio of asset-backed securities, which could significantly impact the overall value of E*Trade's holdings. E*Trade said that it couldn't predict the exact amount of the write-downs, but it did say they would likely be "significant". It also mentioned that the Securities and Exchange Commission had launched an informal inquiry into the company's mortgage holdings, though an E*Trade spokeswoman said that this was "part of an industrywide review of the mortgage industry".^[1]

On November 12, 2007, Fitch Ratings downgraded E*Trade's CDO asset manager (CAM) rating to CAM4, the next-to-lowest rating on its 1-5 scale, citing poor performance relative to other firms and the low quality of the CDOs in its portfolio.^[2] Additionally, a Citibank analyst lowered his rating for E*Trade to sell and went so far as to mention the possibility of the company's filing bankruptcy if customers continue to withdraw assets.^[3] E*Trade's stock plummeted over 58% in response to these reports and concerns about how the company will fare if mortgage values continue to decline.

E*Trade finally received some much needed relief from the credit crunch during the fourth quarter 2007 after if announced that it will be selling its entire $3 billion portfolio of asset-backed securities to Citadel for approximately $800 million.^[4]

[edit] 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.

[edit] 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.

In addition, E*Trade has established a low reputation for customer service compared to the competition. If this trend continues, E*Trade could be faced with high levels of customer attrition in a competitive buyers' market.

• 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.

[edit] References

1. ↑ http://money.cnn.com/2007/11/09/news/companies/etrade_writedown/?postversion=2007110920
2. ↑ http://money.cnn.com/news/newsfeeds/articles/apwire/3d61bec6f8fa8f65db0594b62d100358.htm
3. ↑ http://online.wsj.com/article/SB119488109085890062.html?mod=hps_us_whats_news
4. ↑ http://online.wsj.com/article/SB119630834657507587.html?mod=rss_whats_news_us_business
5. ↑ AMTD, SCHW, ETFC FY2007 10-K Annual Reports on http://www.sec.gov