E*Trade Financial (NASDAQ:ETFC) is one of the three largest publicly traded retail brokerages in the U.S. Its stock has jumped almost 90% since the start of 2013. One of the reasons why the markets have been so bullish about the brokerage is the fact that it has made significant progress in cleaning up its balance sheet and reducing its expenses. The brokerage’s adjusted EBITDA margin increased from 13% in 2010 to 26% last year, according to our estimates.
We project that E*Trade’s adjusted EBITDA margin will continue to increase over the next few years and stabilize at just under 40% by the end of our forecast period. The margin improvement is likely to be driven equally by an increase in revenue off a fixed cost base and a decline in E*Trade’s loan losses. The 40% margin forecast is also close to E*Trade’s pre-crisis EBITDA margins, which hovered between 40%-45% in 2005 and 2006.
Aggressive Cost Cutting And Expense Discipline
Last year, E*Trade’s management announced plans to reduce its annual expenses by $110 million by the end of 2013. Within this $110 million, $30 million was to come from reducing marketing expenditure while the remaining $80 million was supposed to come mainly by cutting expenses related to compensation and professional services. 
Impressively, the brokerage has been able to execute this plan very quickly and has already made some decisions to ensure that the target is achieved in time.  Its advertising and marketing expenses declined by almost $24 million from the first half of 2012 to the first half of 2013, while its professional services expenses declined by nearly $5 million over the same period. Clearing and servicing expenses have also reduced by $5 million over this period.
As more of E*Trade’s cost-cutting initiatives start to have an impact, we expect its expenses to remain below their year-ago levels in the coming quarters and years. This is likely to be a strong tailwind for the company’s overall margins.
High Operating Leverage
Brokerages usually operate off a fairly fixed cost base. That is, a large portion of their expenses are fixed in nature and do not change much even if revenue increases or decreases.
Due to this, we believe that any future increase in E*Trade’s revenue is likely to directly impact its bottom line and help improve margins. We expect this to happen as trading volumes and bond yields gradually improve in the coming years.
- Trading volumes are an important driver for E*Trade’s trading commissions, which account for almost 20% of its total revenue. Unfortunately, this driver has remained under pressure since the financial crisis due to weaker investor confidence. E*Trade’s trading commissions declined from $547 million in 2009 to just $377 million last year as its daily average revenue trade (DARTs) dropped from almost 170,000 to just 138,000 over the same period. However, volumes have been showing signs of revival this year and are likely to improve in the coming years as retail investors gain more faith in the sustainability of the economic recovery. For the first six months of this year, E*Trade’s DARTs improved by 1% year over year.
- Bond yields directly impact the yield earned by E*Trade on its interest earning assets. Unfortunately, this driver has also remained under pressure in the past few years due to the Federal Reserve’s expansionary monetary policy (see chart below). However, the situation seems to be changing gradually, and yields are likely to improve in the coming years as the Fed rolls back of its bond purchase program. (See our previous article to understand this driver in detail: A Deeper Look At E*Trade’s Net Interest Income [Part II])
Lower Provisions For Loan Losses
E*Trade invested heavily in risky mortgages before the financial crisis and its margins have taken a hit in the last few years due the heavy losses reported on this portfolio since 2008. However, the company is in the process of rapidly shedding these loans and aims to reduce this portfolio by almost $400 million every quarter. 
As the portfolio runs off, we expect E*Trade’s provisions for loan losses to decline and its margins to improve. Its provisions for loan losses declined from $1.6 billion in 2008 to just $355 million last year as its net loans portfolio shrank from around $19 billion to nearly $10 billion over the same period. The company ended Q2 2013 with net loans receivables of around $9.1 billion.Notes:
- E*Trade Fired 40 Employees This Week Amid Cost Cuts – Sources, WSJ, February 7, 2013 [↩]
- E TRADE Financial Corporation (ETFC) Management Discusses Q2 2013 Results – Earnings Call Transcript, SeekingAlpha, July 24, 2013 [↩] [↩]