E*TRADE Financial (NASDAQ:ETFC) has had a tough financial year in 2012 with low investor confidence and weak trading volumes weighing on income. During the last earnings announcement the company reported a net loss of $29 million, triggering a 10% slide in the stock price. But E*TRADE is not an isolated case, online brokerage firms Ameritrade (NYSE:AMTD), Charles Schwab (NYSE:SCHW) have also been suffering from tepid trading volume that comes with uncertainty in the economic environment. Ameritrade reported a 11% decline in transaction based revenues for the fiscal year ending September while Schwab also observed a decline in the same during the period.
We believe that the brokerage business will gradually recover as global macro-economic conditions improve. With only 20% of its revenues derived from trading commissions, E*TRADE seems better suited than its competitors (Ameritrade earns about 40% of its revenues from commissions) to ride through the trough. Our price estimate for E*TRADE is $8, in line with the current market price for the stock.
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Where Is E*TRADE Making Its Money ?
E*TRADE’s biggest revenue stream is income from interest earning assets like one- to four-family home equity, consumer and other loans, customer assets as well as margin loans given to clients for trading. Interest income accounts for 60% of the brokerages’ revenues, the rest are earned through fees and service charges on offerings like mutual fund services and advisor management.
One-third of E*TRADE’s interest income is derived from loans acquired by third party originators. Margin receivables is the category closely related to trading activity and accounts for 15% of the total operating interest income. These are basically loans extended to customers to allow them to purchase securities against assets owned by the customers as collateral.
Trading activity measured in terms of DARTs (Daily Average Revenue Trades) has been subdued this year. For the first nine months of the year DARTs were down 13% from the same period last year, and fell by a further 10% in October. Despite this decline, margin receivables increased by 8% in the nine months ending September, although the yield on the same declined from 4.08% to 3.94%. We believe that improving market conditions will lead to higher growth in margin receivables and the yield that the company receives on them.
Customer assets including client’s security holdings, cash and deposits and vested options increased by 28% in the first three quarters of 2012, reflecting the company’s focus on consolidating assets to wade through the prevalent economic conditions. As a result, E*TRADE reported a 5% increase in interest earning assets in the first three quarters of 2012. We expect this trend to continue in the coming years.
So How Does The Trading Slump Effect The Stock Price?
E*TRADE’s brokerage accounts at the end of September were up 4% from the prior year with a further 23,365 gross new brokerage accounts added in October. This growth rate is close to the to 4% that the company has maintained in the last three years.
More brokerage accounts means that trading volume can increase even if the number of trades per account remain low. This number dropped significantly in the last three years, from 19 in 2008 and 2009 to around 14 in 2011, and further to around 13 in the current year.
Although we currently forecast an increase based on improving global economic conditions, our model shows that even if trading activity declines to 10 per account, the stock price will not move much. This is of course taking into consideration that other metrics such as number of brokerage accounts and interest earning assets grow as expected. You can modify the interactive chart below to gauge the effect a change in forecast would have on our price estimate.
Trading activity will also be influenced by the Federal Reserve measures to stimulate the U.S. economy, but the effect might only be visible in the coming years. Notes:
- Fed Links Rates to Joblessness, Expands Bond Purchases, Bloomberg, 13th December, 2012 [↩]