December 18, 2006
Research Associate: Ankita Mitra , MBA
Editor: Nachiket Moghe, CFA
Sr. Ed.: Ian Madsen, CFA: ; 1-800-767-3771 x417
www.zackspro.com 155 North Wacker Drive l Chicago, IL 60606
E*Trade Financial (ET - NYSE)
/$22.98
Note: All new or revised material since the last report is highlighted.
Reason for Report: Revised Estimates Previous Edition: October 24, 2006
Overview
Based in New York City, E*TRADE Financial Corporation (ET) provides financial solutions to retail and institutional customers globally. It offers retail investing and trading products and services, including automated order placement and execution of market and limit equity, futures, options, exchange-traded funds, and bond orders; real-time streaming quotes, commentary, and news; advanced trading platforms for traders; personalized portfolio tracking; and access to approximately 7,000 nonproprietary and proprietary mutual funds. The company’s products and services also include Federal Deposit Insurance Corporation-insured sweep deposit account; mortgage, home equity lines of credit and second mortgage loans secured by real estate; vehicle, marine, automobile, and credit card loans; and online bill payment services. In addition, it provides advisory and asset management services to retail clients; and token-based security solution, which offers security at the point of access to the Internet to safeguard personal financial information. The company serves retail, institutional, and corporate customers through the Internet and other electronic media. As of September 30, 2006, the company had $51.5 billion in assets, $4 billion in stockholders’ equity, and about 4,180 employees. ET operates on a calendar year basis. For more information about the company, please visit its website at www.etrade.com.
Analysts have identified the following issues in evaluating the investment merits of ET:
Key Positive Arguments / Key Negative Arguments· ET’s strong business model has helped it maintain its growth rate despite the difficult yield environment.
· The balance sheet is expected to remain strong, which, moving forward will be a key driver of earnings.
· ET has a strong operating leverage position.
· Growth of net interest income expected through either widening of spread and/or expansion of the enterprise balance sheet.
· With increased trading, pre-tax margins will continue to rise toward ET's target of 50%. / · The company faces stiff competition from larger financial services companies.
· Downturn in domestic equity markets is likely to pressure the company’s trading revenue.
· The company’s results are highly correlated to the performance of the US share market.
· It may experience credit losses based on its loans outstanding, principal transaction losses and reduced net interest spreads.
Despite the volatile equity market and flat yield curve, ET once again demonstrated its ability to deliver strong results as it migrates away from the old transaction-based model to a more consistent and stable asset gathering model, according to analysts.
Recent Events
Effective December 1, 2006, the Board of Directors elected Stephen H. Willard, a current member of the Board, as Vice Chairman.
Effective November 7, 2006, the Board of Directors expanded the number of members of the Board to ten and elected R. Jarrett Lilien, the company's President and Chief Operating Officer, as a Director. He will be a Class II member of the Board and will stand for election at the next annual shareholders meeting in May of 2007. He will not serve on any Committee of the Board.
On October 18, 2006, E-Trade Financial Corp. reported a 43% rise in quarterly net profit as retail clients' assets increased and the number of new deposit and lending accounts grew. E-Trade reported a third-quarter net profit of $153 million, or $0.35 per share. Excluding an acquisition-related charge, the company earned $0.36 per share. Revenue for the period rose 39% to $582 million. E*Trade reported an in-line quarter, defined by solid balance sheet growth, strong client cash balances, and good expense management and tempered by soft retail engagement and modest spread pressure.
On August 8, 2006, ET announced that it has increased its ownership stake in IL&FS Investsmart Limited (Investsmart).
Revenue
The tables are current as of 12/18/06.
E*TRADE Retail consists primarily of retail brokerage operations, but also includes consumer loan originations, and revenue obtained from providing the Institutional segment with broker sweep deposits. E*TRADE’s corporate business, serving corporations with employee stock option services, also falls under the Retail umbrella. E*TRADE Institutional comprises the institutional securities businesses (market making as well as stock loan operations) as well as the balance sheet-sourced spread income of the prior banking segment.
Total net revenue for 3Q06 increased 39% year over year to $582 million. Net operating interest income after provision for loan losses increased 68% year over year to a record $343 million - representing 59% of total net revenue. The company's record net operating interest income was the combined result of a 42% increase in enterprise interest-earning assets and a 34 basis point increase in enterprise net interest spread compared to the year ago period. Non-interest revenue increased 11% year over year to $239 million with higher commission-related revenue and lower gain on sales of loans and securities, net.
Prior to the 3Q06 earnings release, the consensus projected 41.9% and 7.8% growth in total revenues in 2006 and 2007, respectively. Following the release, the forecast for 2006 total revenues decreased to 40.1% while that for 2007 increased to 10.0%. In the recent update, the forecast for 2006 total revenues decreased to 39.3%, while that for 2007 increased to 15.9%.
($ in millions) / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 1Q07E / 2007ENet Interest Income / $324.8 / $344.6 / $355.1 / $376.4 / $1,399.9↓ / $393.0 / $1,674.3↑
Provision for credit losses / 10.2 / 10.2 / 12.6 / 14.8 / 46.9 / 59.3↑
Commissions / 175.9 / 167.2 / 133.7 / 158.5↑ / 635.7↑ / 160.7 / 690.1↑
Principal Transactions / 30.7 / 31.7 / 22.8 / 27.3↑ / 112.8↑ / 128.8↓
Gain on sale of loans & securities / 11.6 / 11.1 / 16.0 / 15.0 / 53.8 / 55.0↑
Service charges & Fees / 32.0 / 33.7 / 33.9 / 34.5 / 133.9↓ / 143.3↑
Other Revenues / 33.6 / 33.3 / 33.2 / 32.7↑ / 132.9↑ / 138.9↑
Total Non-Interest Income / 283.8 / 277.0 / 239.6 / 264.1 / 1,044.7↓ / 1155.4↑
Total Revenue (before provision) / 608.6 / 621.7 / 594.6 / 640.1↑ / 2,448.4↓ / 2,838.0↑
Total Revenue (after provision) / 598.4 / 611.4 / 582.0 / 630.3↑ / 2,405.8↓ / 649.3 / 2,744.5↑
The growth in average interest earning assets was very strong at 5.3% q/q ($46.4 billion), which helped to drive net interest income 3.1% higher than 2Q06. Enterprise net interest spread was 286 basis points, down from 291 basis points in 2Q06 and compares to 252 basis points in 3Q05. According to one brokerage firm (B. of America), with continued mix shift (to higher yielding cash products), heavy reliance on wholesale funding sources, and flat yield curve, it is hard pressed to see NIM expansion occur going forward. Another analyst (Sandler) believes ET has done a good job of increasing NIM despite a difficult environment and is ahead of peer Schwab in this respect.
Management indicated seeing an opportunity to deepen customer engagement around cash via higher rate offerings, leading to $1.5 billion in total cash growth during the quarter. Continued growth in client cash is expected to replace wholesale funding sources over time, resulting in higher margins.
Linked-quarter net revenue growth for the retail segment decreased 8.4% to $392.3 million (but up 46.2% from the prior-year quarter). Retail revenues accounted for 67% of total revenues compared to 70% in 2Q06 and 64% in 3Q05. Institutional-related revenues were $190.2 million in 3Q06, compared to $186.7 million in 2Q06 and $159.5 million in 3Q06. The institutional segment accounted for 33% of firm-wide revenues, up from 30% in the previous quarter and 36% a year-ago.
Commission revenues were $133.6 million, decreasing 20.1% q/q and increasing 16.9% y/y mainly due to a lower than expected average rate per contract at $11.95 as compared to $12.23 in the prior quarter and $14.42 in the year-ago period. The average commission rate declined 2.3% sequentially. The reason was mix related, as the company saw a higher proportion of active trader volume in 3Q06 due to a pullback in trading by less active customers. One brokerage firm (Lehman) believes that a decline in options trading, which it estimates carries a per transaction commission nearly twice that of a typical equity trade, also impacted the blended commission rate. It expects the blended rate to improve again in 4Q06 from a more normal volume mix. Management expects commissions to be around $12.00 in 4Q06.The Zacks Digest Average for commission revenues is $133.7 million.
Gain on sale revenues of $16 million were up 44.1% q/q and down 26.8% y/y. The declining trend in the gain on sale revenues year-over-year is consistent with management's focus on net interest income by retaining higher yielding loans on the balance sheet. Service charges and fee revenues of $33.9 million increased almost 1% q/q and 3.1% y/y. Principal transaction revenues of $22.7 million were lower by 28.2% q/q and 4.6% y/y.
Other Metrics / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 1Q07E / 2007E /Retail Trading/Investing Accounts ($ in millions) / 3.63 / 3.63 / 3.65 / 3.66 / 3.66 / -- / 3.77 /
Daily Average Revenue Trades ($ in thousands) / 181.70 / 165.60 / 145.24 / 165.66↑ / 161.07↑ / 164.13 / 172.15↑
Retail Commissions Per Retail Trade ($ in millions) / 12.10 / 12.23 / 12.00 / 12.05 / 12.15↑ / 12.15 / 11.41↑
Average Interest Earnings Assets ($ in billions) / 41.34 / 44.07 / 46.36 / 48.45↑ / 45.05 / 50.70 / 53.35↑
Net Interest Spread ( in percentage) / 2.86% / 2.91% / 2.86% / 2.85% / 2.87% / 2.91% / 2.80%↓
Return on Average Equity (in percentage) / 16.40% / 16.60% / 15.40% / 16.05%↑ / 15.67% / -- / 16.47%↑
EOP Margin Debts ($ in billions) / 6.81 / 7.51 / 6.44 / 6.84↑ / 6.84↑ / -- / 7.22↓
Daily average revenue trades (DARTs) were 135,130 per day in 3Q06, down 18% from 2Q06, but up 44% from a year ago. While gross new retail trading/investing accounts added in 3Q06 were 151,344 (down from 169,595 in 3Q06), attrition was lower at 151k lost accounts in 3Q06 vs. 177k accounts lost in 2Q06. Total retail investing/trading accounts at E*Trade ended the quarter at 3.627 million, roughly unchanged versus the prior quarter and marginally below the growth seen out of peers. Retail activity seems to be gathering momentum up 10% in September and 7% in October.
Average margin debit balances were down 5% versus the prior quarter at $6.66 billion and ended 3Q06 at $6.42 billion. Assets in client accounts ended the period at $155.0 billion (excluding unexercised options (vested, as peers exclude these balances in their total client asset metrics) vs. $152.3 billion last quarter (a 2% increase).
Total client assets rose a somewhat disappointing 1.9% during September to $184.8 billion, with trading/investing assets of $163.0 billion, representing a 1.7% increase, and total deposits of $21.8 billion increasing 2.7% sequentially. The growth in trading/investing assets lagged the 2.5% S&P 500 index increase and the 3.4% NASDAQ Composite index increase.
Total DARTs for September increased 9.6% sequentially to 140,229, with U.S. DARTs of 119,865 increasing 8.8% over August and international DARTs posting a strong 14.6% increase to 20,364. International DARTs recovered from their steady decline since their May all-time high of 25,829, highlighting the potential of the channel from both a commission revenue standpoint as well as net interest income from cash and lending products. Both E*TRADE's domestic and international trading segments outpaced the 5.3% sequential gain in DARTs posted by Schwab for September.
End-of-period margin debt fell $60 million to $6.424 billion during September, which failed to correlate with the improvement in trading volumes during the month. However, the company expects margin activity to catch back up in the near term, along with improved market environments and trading activity. Gross trading account adds of 45,311 during the month, combined with 41,879 accounts lost, brought in 3,432 net new trading accounts and nudged total trading accounts up 0.1% to 3.627 million. On a quarterly basis, total customer assets increased 2.6%, with total sweep deposits of $10.4 billion falling $100 million over the June quarter-end, while CDs of $6.8 billion increased $700 million. Transaction accounts of $4.6 billion also grew by $500 million. Along with $9.8 billion in brokerage cash and money market funds, which saw a $300 million increase, total cash grew $1.5 billion during the September quarter. Management also indicated options trading comprised 13% of domestic DARTs during the quarter.
Please refer to the separately published spreadsheet of ET for additional details and updated forecasts.
Margins
The consolidated operating margin fell to 38% from 43% sequentially, reflecting the seasonally soft retail operating margin, which fell to 37% from 44%. The institutional operating margin actually increased to 41% from 38% and was at its highest in two years. The company's consolidated pre-tax margin was approximately 37.2%, decreasing from 39.5% in the prior quarter and 39.7% in the year-ago period. The Digest average pre-tax margin for 3Q06 is 36.4%.
Prior to the 3Q06 earnings release, the consensus was calling for a 41.9% and 39.1% pre-tax margin for 4Q06 and 2006, respectively. Following the release, the pre-tax margin expectations for 4Q06 and 2006, both, decreased to 40.5% and 38.0%, respectively. In the recent update, pre-tax margin expectations for 4Q06 decreased to 40.4% and increased to 38.4% for 2006.
Margins / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 1Q07 / 2007EPre-tax operating margin / 36.4% / 38.4% / 36.4% / 40.4%↓ / 38.4%↑ / -- / 42.1%↑
After-tax net margin / 23.4% / 25.2% / 25.7% / 26.2%↓ / 25.4%↑ / -- / 26.7%↓
Efficiency ratio / 58.3% / 56.8% / 60.4% / 54.7%↓ / 58.1%↑ / -- / 52.3%↓
Total operating expenses (excluding advertising and charges) were $334.7 million in 3Q06, increasing 4.5% q/q and 48.6% y/y. Excluding $17 million in restructuring expenses and $18 million in fraud expenses, total operating expense was $299.7 million. Management commented that it would likely see an additional $10 million in restructuring charges in 4Q06. Compensation expense of $110.7 million decreased 11.9% relative to 2Q06 and increased 7.4% from year-ago levels. Compensation as a percent of net revenues was 19%, compared to 20.6% in the prior quarter and 24.6% in the year-ago period. Compensation as a percent of net revenues was lower as a result of synergies in headcount from the acquisitions. Management commented that it would likely see the compensation to net revenues ratio within the approximate range of 19% to 20% on an annual basis. Advertising and marketing expenses decreased 21.4% q/q to $23.9 million from $30.4 million in 2Q06 while higher by 12.9% from $21.2 million in 3Q05.