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E*Trade Financial (NASDAQ:ETFC) reported its earnings for Q3 2013 on October 23. As expected, the brokerage’s margins have improved significantly over the same period last year due to its focus on reducing costs. Its net interest revenue has also declined in line with our expectations due to continued yield depression and lower balances in interest earning assets, while trading commissions have increased on the back of higher trading volumes (read: E*Trade Earnings Preview: Margins Likely To Improve But Pressure On Net Interest Revenue Could Continue).
E*Trade also announced that it has sold its market making business – G1X Execution Services – to an affiliate of Susquehanna International Group, LLP for $75 million, a price that is at the lower end of our estimate for the business (read: How Much Can E*Trade Fetch From Selling Its Market-Making Unit?).
We have a revised price estimate of about $16 for the company, which is slightly below the current market price. Below we explain how the Q3 data has impacted our model.
G1X Sale To Impact Fees And Service Charges
Once the sale of G1X is completed, the principal transaction revenue generated by E*Trade is expected to fall to zero. At the same time, its revenue from Fees and Service Charges is expected to increase rapidly as more customer trades are routed to third parties in exchange for a volume-based fee. In Q3, the revenue generated in this fashion increased 29% as E*Trade started sending more trades outside the firm. We have updated our model to reflect these changes.
The Impact Could Also Be Felt On Interest Earnings Assets
The $75 million received in exchange for G1X is likely to increase the cash balance on E*Trade’s balance sheet. In anticipation of this event, we have increased our near-term forecast for E*Trade’s interest earnings assets slightly. The brokerage’s interest earnings assets have dropped significantly during the past year due to its de-risking and deleveraging initiative, in which it reduced its wholesale borrowings, transferred sweep deposits off its balance sheet to third parties, and directed customer payables and new customer cash to money funds. Now that the deleveraging activity is complete, we expect the balance sheet to start growing again. In addition to the $75 million jump, interest-earning assets are also likely to increase as E*Trade continues to attract new customers.
However, Net Interest Revenue Is Likely To Remain Depressed
Higher asset levels should ideally lift E*Trade’s net interest revenue. However, we may not witness that happening anytime soon as the yield on these assets continues to fall. In Q2, E*Trade’s net interest revenue declined 8% as the spread on these assets dropped almost 5 basis points to 2.3%. We expect the weakness in this business to continue until the low interest rate environment in the U.S. starts improving.
Meanwhile, Trading Business Is Doing Well…
On the trading business front, however, things seem to have improved. Trading commission revenue increased 13% y-o-y in Q3 as daily average revenue trades (DARTs) jumped 13% over the same period. The growth in trading volumes was driven by a 3% growth in brokerage accounts as well as an improvement in the average number of trades executed by a typical client. We expect trading activity to continue improving gradually in the next few years as the macroeconomic environment and retail investor sentiment improves.
…And So Are Margins
Another big positive for E*Trade this year has been the improvement in its EBITDA margins. The brokerage set out to cut almost $110 million in costs last year and its efforts seem to have started paying off. Excluding one-time expenses, E*Trade’s EBITDA margin for the first nine months of this year was above 40%, up from 26% last year and significantly above our earlier forecasts. Given the improvement, we are increasing our projections and now expect E*Trade’s margins to touch 45% by the end of this decade. The forecast is still within the 40%-45% range in which E*Trade’s margins hovered before the financial crisis (read: Here’s Why E*Trade’s Margins Will Continue To Improve).
Given the changes made to our model in relation to the sale of G1X and the increased forecast for E*Trade’s margins, our new price estimate for E*Trade’s stock has increased almost 15% to above $16. Margins remain the biggest driver of this change.