| 23 July 2010

The results are in... and color us shocked! E*TRADE Financial (ETFC) posts a profit! You heard me right. The company that had previously reported eleven consecutive quarters of losses -- the same company that was forced to raise capital at the behest of the Office of Thrift Supervision -- the one that actually lost core brokerage accounts in five out of the last 12 months -- the firm that lost their CEO and had trouble finding a replacement -- the firm that lost $1.3 billion (with a "b") in 2009 and another $48 million in the first quarter of this year -- yes, THAT E*TRADE, recorded a profit in Q2. Breathless is what we are. Breathless.

So how did they do it? What sort of magic wands is the firm waving to get these results? Is it weird that we're this excited to find out? Perhaps you'll get excited, too, when we tell you that their results may surprise you. In fact, here's just a taste: E*TRADE actually lost brokerage accounts last month. So what's going on? Are these results sustainable? Let's dig in.

We're going to walk through the standard operating metrics that we like to focus on and we'll compare the latest results to what we saw last quarter and how we commented on those results. You can see that commentary here. As always, we should note that we tend to be more interested in operating metrics than financial performance, which I know may sound odd to some of you. But we hold on to the dear notion that, ultimately, your ability to effectively manage the core business will yield better financial results.

First up: DARTs. We noted last quarter that E*TRADE's trading activity had fallen significantly from higher levels (in the 230k-240k range just over a year ago) while other brokers were channeling. This quarter we see good performance, and numbers that are on par with what we've seen from other brokers like The Charles Schwab Corporation (SCHW). In fact, all brokers that we've reviewed saw a moderate uptick in trading activity in May followed by a big decrease in June. So it's fair to say that E*TRADE's trading activity doesn't reveal much for us. They simply matched the performance of others, just on a lower relative scale. Next up: accounts.



Reviewing net new accounts we see our first surprise. We should point out that we are focused on brokerage accounts, not banking or retirement accounts. (E*TRADE is shedding banking accounts and slowly growing retirement accounts.) But this is okay because this is also what CEO Steven Freiberg says he's focused on as well. In fact, in his comments today he said, "Our results were supported by strength in our brokerage business, including growth in DARTs [and] new accounts."

But wait a minute -- what's that he said? Strength in DARTs and new accounts? The data shows that DARTs were actually 16% lower than the same period a year ago. TD Ameritrade (AMTD) by comparison saw a 12% increase in DARTs versus the same period a year ago.

And, as you can see by the chart below, the firm actually lost 5,000 brokerage accounts in June. (Note the 'zero' line in the chart below.) Were it not for a whopper of an April, Q2 would have been a tough row for new accounts. Even so, the 17,523 new brokerage accounts they added in the quarter pales in comparison to the 51,598 accounts they added during the same period last year. (That's a 66% drop for the accounting geeks.)

Can you see now why we are scratching our head's over those comments? By any measure, their DARTs and new accounts performance was very weak year-over-year. And only moderate on a sequential basis. Maybe this will make more sense when we see what kind of marketing investment they made to acquire these new accounts.



E*TRADE reported a net addition of 2,000 brokerage accounts in Q1. This quarter they reported a net addition of 17,523 accounts. We admit that's good sequential growth, but let's take a look at how much they're spending to acquire these accounts.

There are several ways to analyze this. First, we can assume a lag on account funding and attribute first quarter's spend to second quarter's accounts. Using that method suggest that E*TRADE is spending an average of $2,176 per new account acquisition. To put this in perspective, consider that TD Ameritrade is spending between $300-400 and Schwab is spending $200-$300. We can also compare their spending to optionsXpress. They actually reports the amount they pay to acquire each new account (thank you). Last quarter they told us they paid $672 per new account, which, by the way, is some of the highest numbers they've seen out of OXPS in recent memory.

But even if we give E*TRADE the benefit of the doubt and apply Q2's (lower) spending against Q2's accounts (removing any possible lag effect) the number is still $1,700. We admit this is a step in the right direction, and heaps better than the $20,092 per new account we saw them spending in Q1 (wasted on Super Bowls and babies). But still, no matter how we fudge the numbers, we can only conclude that E*TRADE is spending through the nose to acquire new accounts. 

(We should also mention that the company says it lost 3,000 accounts in the quarter due to some international restructuring. But again, the difference between 17,000 accounts and 20,000 new accounts only pushes the cost/account figure down to roughly $1,500.)

The point is, for a firm that is hoping to rely on the core brokerage business to push them through the tough times, these are some troubling metrics. Consider that, even at their much-improved rates, they are still spending anywhere from 325% to 750% more than Schwab and TD Ameritrade to acquire accounts. And don't forget -- they actually lost accounts last month.



Finally we turn to assets, in hopes of finding an answer. But here again, we are discouraged. Total assets fell for the firm over the last two months. From their ending point in Q1 at $159 billion, through the end of Q2 at $144 billion, E*TRADE shed 9.4% of their assets. To be fair, they are working hard to get rid of non-productive banking accounts.  The firm shed $1.3 billion in banking-related assets in Q2.

But they also lost 10.5% of asset in their brokerage and stock plan accounts, falling from $134 billion in Q1 to $120 billion at the end of Q2. The S&P 500 lost 12% during the same period, so we would expect their brokerage assets to take a hit. But let's not forget that they spent a lot of money to add over 17,000 new accounts which should have added to the pile (and it did, at a rate of $2.1 billion), but it wasn't enough to stave off an overall, significant (we feel) decline in assets. 



E*TRADE is in a tough spot. They're trying to shift their business away from banking (at least 'bad' banking) and international and focus on their core brokerage business. But they're not able to effectively acquire new accounts, and they have admitted that the broker price war will reduce commissions and cost them $50 million in revenue this year.

We can only think that the company's ability to turn a profit in Q2 is directly related to the decrease in bad loan write-offs. Loan loss provisions decreased 42% versus a year ago. CEO Freiberg also noted, "continued efforts to put back loans to sellers resulted in a $20 million legal settlement of loan claims which contributed $15 million to the reduction in the second quarter provision and net charge-offs." This is great news, to be sure. BUt it calls into question whether these activities create a sustainable business.

We were hoping to turn to their conference call for some answers. Mr. Freiberg helpfully pointed to "three important milestones" that suggest their profitability can be "sustained." First, provisions for loan losses are now below loan charge-offs. (They actually reached that milestone in Q3 of 2009.) Second, they are generating what he called "organic bank regulatory capital." And third, that they marked their first profitable quarter since 2007.

That last one doesn't count, in our opinion. It's like saying that one of the reasons they returned to profitability is that they returned to profitability. But anyway, it is important to note that basically the banking business is no longer the drag it once was one the business, and that seems to be the primary explanation behind the sudden profitability.

Comments from CFO Bruce Nolop helped us understand more about their expense reduction efforts. The 7% quarterly decrease in operating expense is nominal, we think, considering the company also lost about 0.5% in revenue versus Q1. They dropped operating expenses 16% versus 2009, but revenue decreased 14% over the same period.

We think the company is still mired in the banking mess and it's clouding the performance of the core brokerage business. Neither Freiberg nor Nolop gave us any forward-looking statements or guidance on their call. In fact, even most of the questions on the call focused on the banking business and neither Freiberg nor Nolop did anything to shift that focus. This is a signal to us that E*TRADE is a company lost in transition. They are neither a high-performing bank nor a high-performing brokerage. Whether or not they will eventually become a high-performing brokerage operation, well, the jury is still out.

We leave you with this thought: profitability for the firm is not yet a trend. Next quarter looks to be very interesting indeed.