E*Trade Financial (NASDAQ:ETFC) posted a net loss of $54 million for Q3 2013 on July 24. While the figure looks bad at the first glance, much of this loss can be attributed to a one-time goodwill impairment charge of $142 million, related to the company’s decision of exiting its market-making business.
After adjusting for this one-time charge, the brokerage’s performance looks almost in line with the forecasts we had made in our pre-earnings article. E*Trade’s net interest revenue was lower by 13% year-on-year due to a $4.6 billion decline in average interest-earning assets and a 9 basis point reduction in net interest spread from Q2 2012 to Q2 2013. Meanwhile, trading commissions were up 14% year-on-year on the back of an 8% increase in daily average revenue trades (DARTs). Since net interest income is the largest contributor to the company’s top line, its impact on total net revenue was higher than that of trading commissions. E*Trade’s total net revenue declined by 2.7%, from $452 million in Q2 2012, to almost $440 million in the most recent quarter.
Overall, we feel that the company’s current performance is justified given that it has lately been focused on de-risking its balance sheet by reducing its size, instead of boosting revenues. We are noticing some positive takeaways from this earnings report that are likely to improve E*Trade’s performance over the long term.
Cost-Cutting Is Complete
Last year, E*Trade’s management set out on a drive to improve efficiency and had set itself a target of lowering annual expenses by $110 million by the end of 2013.  That target seems to have been substantially achieved as of Q2, well ahead of schedule. This is a very positive sign for the company because reduced expenses will help drive profit margins higher, especially when the macro-economic conditions improve. Brokerage firms usually work from a relatively fixed cost base,and increasing asset and trading volumes often result in higher margins due to this reason.
With Deleveraging Complete, We Can Expect Growth In Balance Sheet Again
Over the past few quarters E*Trade has been trying to deleverage almost $8.5 billion from its balance sheet by primarily reducing its wholesale borrowings, transferring sweep deposits off its balance sheet to third parties, and directing customer payables and new customer cash to money funds. This was done because the company wanted to improve its Tier-1 leverage ratio so that regulators allow it to deploy bank capital to its parent company in order to pay off its high cost debt.
In Q2 2013, the company completed almost $800 million of deleveraging, which brings the total deleveraging done till date to $8.7 billion – higher than its stated goal of $8.5 billion. With deleveraging complete, we believe that the company will again start focusing on growth and its cash deposits will gradually start growing as it continues to attract client assets. This should positively impact net interest revenue going forward.
Trading Volumes And Average Revenue Per Trade Seem To Be Recovering
This quarter we have seen a year-on-year increase in trading volumes of almost all brokerages. The DARTs for E*Trade were 8% higher while those of Charles Schwab (NYSE:SCHW) and TD Ameritrade (NYSE:AMTD) grew by 6% and 12%, respectively. Additionally, we are also noticing an industry-wide improvement in average commissions per trade due to changes in trade mix, which is a result of the growing popularity of options trading among retail investors. Year-on-year, the average revenue per trade for E*Trade, Schwab and Ameritrade expanded by $0.42, $0.04 and $0.70, respectively. (Related article: New baby boomer hobby: trading options)
This is a positive sign for the industry and especially for E*Trade because trading commissions account for 25% of the value in its stock according to our estimates, the highest ratio among the three brokerage firms. Should this trend continue in the coming quarters, there could be a 3%-5% upside in our price estimate depending on the quantum of increase in trading volumes and average commission rates.
Our Model Will Be Updated Soon
As noted above, E*Trade’s management has decided to sell the company’s market-making business, which accounts for almost 20% of the value in the company along with some other revenue sources. The sale is anticipated to occur within the next three to six months, and is likely to impact our model significantly. Therefore, we will upload an updated model and provide new price estimate only after the company files its 10-Q form.Notes: