| 29 July 2010

OptionsXpress (OXPS) hit some headwinds this quarter. You wouldn't know it reading the headlines, all of which gush about the fact that the firm beat Wall Street analyst expectations. While it's commendable that the firm performed better financially than most had expected, we thought we'd take a look at how they're doing operationally, by focusing on the core metrics in their brokerage business.

Financially, let us recall, the firm saw a 20% dip in net income in the first quarter, compared to the fourth. CEO David Fisher suggested at the time that they were making investments in the business that have "strengthened the core franchise." All in all we were impressed with the growth in assets, but starting to worry about increased account acquisition expenses.

Net income of $15.6 million was 20% higher in the second quarter for the firm as compared to the first quarter, which is a testament to the firm's operating efficiency. If we have concerns, they center around the firms ability to attract new customers, not make money off of current customers. We watched monthly metrics roll in throughout the quarter and we saw that trading activity was trending up (as it was for all brokers) but we noticed that by May, optionsXpress started to see a decrease in new account activity and actually lost assets in May. But we were cautious about raising any red flags until we had a chance to see what was going on with spending in the quarter. Well, now we know. But first, we take a look at DARTs through the quarter.

DARTs for the firm, while strong in the beginning of the quarter, fell off in June. But all in all the activity was still averaging above historic levels. This matches the trading activity we've seen from other brokers. By comparison, we earlier reported that E*TRADE (ETFC) was seeing trading activity lower than historic averages. Trading activity matters more to optionsXpress than most other firms because they're able to achieve higher effective margin rates thanks to active traders placing more complicated (and expensive) trades.

Adam DeWitt, Chief Financial Officer of optionsXpress, explains: "The higher level of trading also demonstrates the operating leverage in our business as earnings were up 20% sequentially while revenues were only up 11% (both figures before CBOE-related gains)."



But when welook at new accounts, this is where we start to see signs of possible trouble. We say 'possible' trouble because we know it's not unusual for brokers to pull back on their marketing spends heading into the summer -- historically a slow season for brokers, at least in terms of new account activity. OptionsXpress saw a nice uptick in new account activity toward the tail end of Q1, but faded back to historic low levels by the end of Q2.

But perhaps we're jumping the gun and being too harsh on OXPS. Their overall new account growth was good -- it's just that most of it came in April and the month-over-month downtrend is a little concerning. CEOs are usually good at putting a good spin on things, so we'll let Mr. Fisher explain:  “Our powerful, innovative platform and exceptional customer experience continue to attract new customers despite the challenging economic backdrop and declining market indices weighing on the average retail investor," he said in a statement. "As evidence, we opened our highest number of net new accounts since the second quarter of last year and our customer asset growth exceeded broader market index performance in both the quarter and year to-date.”

It has been suggested that we also look at gross accounts -- and this is something we'd like to do and will add going forward. As a firm grows it requires more and more net new account activity just to stave of attrition. This, we think, will paint a clearer picture of the overall account health of each of the brokers.



We also think it's important to understand how much a broke is paying to acquire new accounts. This metric is a direct reflection of their ability to efficiently acquire new account. It's a metric that also represents product quality, customer service performance and other characteristics. In addition to smart marketing, better product and customer service yields a lower cost of acquisition.

In the case of optionsXpress, however, they've seen their cost per net new account climb at a time when total accounts are falling. Now that they're paying north of $700 to acquire each new account, we wonder 1) is this a short-term phenomenon and 2) is it sustainable long term? E*TRADE, by comparison, saw a decrease in new account activity, but they also decreased their marketing spending. Charles Schwab (SCHW) saw the same thing.

Is optionsXpress just slow to realize that they should be spending less? Or has their marketing just become less efficient? If the decline in new account activity thatbegan in May continues to be a trend, we'll know the answer.



Finally, we also noticed a decline in assets. While it's not unusual for the firm to see a one-month dip in assets this is the first time we've seen the firm shed assets two months in succession. Again, this is something we'll keep an eye on as we receive the next set of monthly updates. Keep in mind that the S&P 500 lost 12% during the same period, so we would expect assets to take a hit and OXPS only lost about 10%. Other brokers experiences similar declines, which is why we're not too concerned at this point.
 


Let us know what you think about their performance. And as always, if you have ideas for new charts or figures to track, we're all ears.