E*Trade Earnings Preview: Margins Likely To Improve But Pressure On Net Interest Revenue Could Continue

E*Trade Financial (NASDAQ:ETFC) is scheduled to report its Q3 earnings on October 23. The brokerage has been in the process of cutting costs and deleveraging its balance sheet for some time, and has recently been showing signs of success. As a result, its stock has soared in the past few months and is currently trading almost 100% above its year ago levels.

The company has also been benefitting from an industry-wide improvement in trading activity, and is likely to report a growth in trading commissions, just like last quarter. However, its net interest revenue could continue to face pressure in the near future due to the persistent low interest rate environment and reduced balances in interest earning assets.

Our price estimate for E*Trade’s stock is currently around $14, which is almost 20% below the current market price. 

See our full analysis for E*Trade Financial

Cost cutting, De-Risking and Deleveraging To Increase Profitability

Last year, E*Trade’s management set itself a target of lowering annual expenses by nearly $110 million by the end of 2013. ^[1] It also announced plans of deleveraging 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.

By the end of last quarter, both of these goals had been largely achieved, thereby providing E*Trade a lot of financial flexibility. As a result, regulators recently allowed its banking subsidiary, E*Trade Bank, to issue a capital dividend of $100 million to the parent company in order to pay off corporate debt. E*Trade’s management intends to further reduce its corporate debt by distributing a similar amount of money to the parent company every quarter, subject to regulatory approval.

We believe that E*Trade’s corporate expenses, which include corporate interest expense, are likely to decline significantly in the near future due to its debt reduction initiative. Further, its margins are likely to improve as the benefits of cost cutting start to show (see Here’s Why E*Trade’s Margins Will Continue To Improve).

Trading Volumes Are Increasing Gradually

Trading commissions account for almost 30% of E*Trade’s value, according to our estimates. They have been under pressure over the past few years due to an industry-wide decline in trading activity. However, this year we are seeing some improvement and expect the trend to continue in the future as the economy improves. In Q2, E*Trade’s daily average revenue trades (DARTs) increased by 8% year-on-year. DARTs for the first two months of Q3 were also up by 10% and 21% year-on-year respectively. ^{[2] [3]}

However, Net Interest Revenue To Remain Under Pressure

Net interest revenue accounts for over 50% of the value in E*Trade, according to our estimates. In Q2, it declined 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. We expect this trend to continue in Q3 as E*Trade’s average balances in interest earning assets have declined significantly, a result of its balance sheet de-risking and deleveraging initiatives. The pressure on interest yields is also likely to persist and act as a headwind for net interest revenue as the Fed has decided against tapering its bond purchase program. To understand average balances in interest earning assets and net interest yields in detail see our previous articles: A Deeper Look At E*Trade’s Net Interest Income [Part I], and A Deeper Look At E*Trade’s Net Interest Income [Part II]

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1. Letter to shareholders, E*Trade, 2013 [↩]
2. Monthly Metrics, E*Trade, September 2013 [↩]
3. SEC Filing, E*Trade, June 30, 2013 [↩]