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| ET > SEC Filings for ET > Form 10-Q on 5-Aug-2004 | All Recent SEC Filings |
5-Aug-2004
Quarterly Report
The following discussion should be read in conjunction with the unaudited Consolidated Financial Statements and the related notes that appear elsewhere in this document.
FORWARD-LOOKING STATEMENTS
Statements made in this document, other than statements of historical information, are forward-looking statements that are made pursuant to the safe harbor provisions of Section 21E of the Securities Exchange Act of 1934. These forward-looking statements may sometimes be identified by words such as "expect," "may," "looking forward," "we plan," "we believe," "are planned," "could be" and "currently anticipate." Although we believe these statements, as well as other oral and written forward-looking statements made by us or on behalf of E*TRADE Financial Corporation from time to time, to be true and reasonable, we can give no assurance that these plans, intentions or expectations will be achieved. Actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements. Important factors that could cause actual results to differ materially from our forward-looking statements are set forth in our other filings with the SEC and in this document under the heading "Risk Factors." We caution that the risks and factors discussed below and in such filings are not exclusive. We do not undertake to update any forward-looking statements that may be made from time to time by or on behalf of E*TRADE FINANCIAL.
OVERVIEW
We are a global financial services company offering retail, corporate and institutional customers an integrated and complementary array of investing, banking and lending products and services. Since we offer and deliver our products and services primarily through the Internet and other electronic media, our current and potential customer base is geographically dispersed and we have a lower operating cost structure than traditional "brick and mortar" financial services companies. During the past two years, we have focused on broadening our portfolio of products and services to increase our customer base, improving profitability and reducing risk to the Company and our shareholders. The results of this strategy have allowed our Company to perform better during the recent economic downturn and report an increase in net income over the period. In the future, we intend to continue to seek opportunities to diversify and expand, while seamlessly integrating our services to provide greater value to our customers and our shareholders. It must be recognized, however, that we face numerous challenges and risks in responding to the dynamics of the financial services industry, which is characterized by increasingly rapid change, evolving customer demands and intense competition.
Our business results are presented as two segments, Brokerage and Banking, which have different characteristics. The Brokerage Segment produces revenues primarily from commissions and margin lending. The Banking Segment earns interest from its diversified interest-earning assets, generates fee-based income and earns revenues from the sales of loans.
The retail Brokerage business continues to be the primary point of introduction for the majority of our customers and we have added Banking products and services, which complement our Brokerage business. In late 2003, we lowered our cost of funds at the Bank and deepened our core customer relationships by sweeping certain Brokerage customer money market balances into an FDIC-insured Sweep Deposit Account ("SDA") product. In 2004, we have transferred additional funds to the SDA as opportunities became available. In addition, the Bank has added higher-yielding consumer loans to its portfolio of products that we will continue to integrate into our offerings to our customers.
In mid-2004, Brokerage Daily Average Revenue Trades ("DART"s) have slowed from levels seen earlier in the year, while margin balances and assets have grown slightly. We will continue to evaluate market conditions and other opportunities as we determine our level of investment in marketing. Additionally, we continue to focus
on lowering the cost of providing Brokerage and Banking services to our customers through innovative technology and operating efficiencies from additional integration of back office systems and processes.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of our financial results of operations and financial position requires us to make judgments and estimates that may have a significant impact upon the financial results of the Company. We believe that of our significant accounting policies, the following require estimates and assumptions that require complex, subjective judgments by management, which can materially impact reported results: allowance for loan losses and uncollectible margin loans, classification and valuation of certain investments, valuation and accounting for financial derivatives, estimates of effective tax rate, deferred taxes and valuation allowances and valuation of goodwill and other intangibles. These are more fully described in "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2003.
RESULTS OF OPERATIONS
Consolidated E*TRADE FINANCIAL Results
For the three months ended June 30, 2004, our net income was $122.9 million compared to $12.7 million for the three months ended June 30, 2003. For the six months ended June 30, 2004, our net income was $211.4 million compared to $34.2 million for the six months ended June 30, 2003. The following sections describe the changes in key operating factors, and other changes and events that have affected our consolidated revenues, expenses excluding interest and other income (loss).
Net Revenues
Net revenues increased 3% to $380.9 million for the three months ended June 30, 2004 and 15% to $781.3 million for the six months ended June 30, 2004 from the comparable periods in 2003. The increase in brokerage revenues is due to increased DARTs and higher margin loan balances as a result of a resurgence in trading activity. The increase in banking revenues is due to higher interest spreads, reflecting the Bank's access to lower cost funds resulting from the introduction of the SDA product to our brokerage customers. See the section titled "Analysis of Revenues" for a detailed discussion about the changes in revenue.
Expenses Excluding Interest
Commissions, clearance and floor brokerage increased 9% to $41.9 million for the three months ended June 30, 2004 and 25% to $85.9 million for the six months ended June 30, 2004 from the comparable periods in 2003. The increase is due to higher Brokerage trading volumes and a one-time termination fee associated with our conversion to ADP of $4.3 million.
Advertising and market development decreased 22% to $14.8 million for the three months ended June 30, 2004 and increased 10% to $38.8 million for the six months ended June 30, 2004 from the comparable periods in 2003. The decrease for the three months ended June 30, 2004 is due to a reduction of market spend due to the current market conditions. The increase for the six months ended June 30, 2004 is due to increased advertising spend during the three months ended March 31, 2004 for placements during the NCAA Basketball Tournament. If current market conditions prevail we expect that the advertising spend will approximate levels of the second quarter spend for the remainder of 2004.
Depreciation and amortization decreased 11% to $20.5 million for the three months ended June 30, 2004 and 16% to $41.1 million for the six months ended June 30, 2004 from the comparable periods in 2003. The decrease in depreciation and amortization primarily relates to our 2003 Restructuring Plan efforts.
Other decreased 26% to $21.5 million for the three months ended June 30, 2004 and 11% to $46.4 million for the six months ended June 30, 2004 from the comparable periods in 2003. The decrease is primarily due to a $7 million expense in 2003 related to an MJK litigation.
Other Income (Loss)
Gain (loss) on sale and impairment of investments increased 42% to a gain of $31.7 million for the three months ended June 30, 2004 and 178% to a gain of $60.3 million for the six months ended June 30, 2004 from the comparable periods in 2003. For the three and six months ended June 30, 2004, gains were primarily from sales of our shares in SBI. We sold shares of SBI resulting in a gain of $30.4 million and $64.6 million for the three and six months ended June 30, 2004, respectively. In addition, we recorded an other-than-temporary impairment of approximately $4.4 million during the three months ended March 31, 2004.
Income Tax Expense (Benefit)
Income tax expense was $41.2 million for the three months ended June 30, 2004, at a tax rate of 31.0% and $6.1 million at a tax rate of 42.5% for the three months ended June 30, 2003. Income tax expense was $91.0 million for the six months ended June 30, 2004, at a tax rate of 33.3% and $20.9 million for the six months ended June 30, 2003, at a tax rate of 42.3%. The rate for the three and six months ended June 30, 2004 decreased primarily due to a tax benefit of a research and development tax credit for which we received a favorable IRS audit result during the three months ended June 30, 2004 and a tax benefit from our tax basis in a partnership interest that was sold during the three months ended March 31, 2004.
Analysis of Revenues
Brokerage Revenues
Our net brokerage revenues increased 2% to $228.0 million for the three months ended June 30, 2004 and 23% to $490.9 million for the six months ended June 30, 2004 from the comparable periods in 2003. The increase for the three months ended June 30, 2004 is primarily due to an increase in principal transaction revenues as a result of a resurgence in market activity and an increase in net brokerage interest income attributable to higher customer margin balances. The increase for the six months ended June 30, 2004 is due to increased commissions as DART volumes are higher than in 2003 and the aforementioned increases in principal transaction revenues and net brokerage interest income during the three months ended June 30, 2004.
The components of our net brokerage revenues and percentage change information were as follows (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
-------------------------- Percentage -------------------------- Percentage
2004 2003 Change 2004 2003 Change
--------- --------- ---------- --------- --------- ----------
Brokerage revenues:
Commissions $ 79,156 $ 85,780 (8 )% $ 191,386 $ 146,668 30 %
Principal transactions 67,447 58,640 15 % 136,876 100,850 36 %
Other brokerage-related
revenues 41,798 45,269 (8 )% 84,955 87,165 (3 )%
Brokerage interest income 43,707 34,868 25 % 84,960 69,188 23 %
Brokerage interest expense (4,134 ) (1,877 ) 120 % (7,254 ) (4,390 ) 65 %
- ------- - - ------- - - ------- - - ------- -
Net brokerage revenues $ 227,974 $ 222,680 2 % $ 490,923 $ 399,481 23 %
- ------- - - ------- - - ------- - - ------- -
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Other key criteria that we use to measure performance and explain the results of our brokerage operations are presented in the following table:
Three Months Ended Six Months Ended
June 30, June 30,
------------------------------ Percentage -------------------------------- Percentage
2004 2003 Change 2004 2003 Change
----------- ----------- ---------- ------------ ------------ ----------
Total revenue trades 7,900,836 7,349,758 7 % 17,637,033 12,639,438 40 %
Daily average revenue
trades ("DART"s) 127,433 116,663 9 % 142,234 101,931 40 %
Average commission per
revenue trade $ 10.02 $ 11.67 (14 )% $ 10.85 $ 11.60 (6 )%
Average (dollars in
millions):
Customer margin balances $ 2,131 $ 1,030 107 % $ 2,056 $ 1,008 104 %
Customer money market fund $ 7,851 $ 7,395 6 % $ 7,969 $ 7,312 9 %
Stock borrow balances $ 1,289 $ 451 186 % $ 1,047 $ 403 160 %
Stock loan balances $ 1,547 $ 613 152 % $ 1,264 $ 560 126 %
Customer credit balances $ 2,521 $ 1,951 29 % $ 2,585 $ 1,823 42 %
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After four consecutive quarters of growth in trading volumes, customer activity slowed in the three months ended June 30, 2004, consistent with overall industry trends. DARTs and total revenue trades have increased for the three and six months ended June 30, 2004 from the comparable periods in 2003. Average commission per revenue trade decreased due to the full quarter impact of Priority E*TRADE. Introduced in the previous quarter, creating a third tier in our retail pricing structure, Priority E*TRADE offers lower commission rates for qualified customers of $12.99 per trade from $22.99 per trade. Although less significant than the pricing initiative, the change in trade mix within our retail business and between retail and professional also contributed to the lower average commission per trade.
Principal transactions include institutional revenues, market-making revenues and net proprietary trading gains. The increase for the three and six months ended June 30, 2004 from the comparable periods in 2003 is primarily due to a resurgence in institutional and market-making activity.
Other brokerage-related revenues include account maintenance fees, payments for order flow from outside market makers, stock plan administration products and services revenue, professional trading rebate revenues, proprietary fund revenues and fees for brokerage-related services. The decrease for the three and six months ended June 30, 2004 from the comparable periods in 2003, is related to lower account maintenance fees and proprietary fund revenues, partially offset by increases in payments for order flow, stock plan administration products and services revenues and fees for brokerage-related services.
Brokerage interest income includes interest earned on margin loans, regulatory cash and investments and stock borrow balances, as well as fees on customer assets invested in money market accounts. The increase for the three and six months ended June 30, 2004 from the comparable periods in 2003, was primarily due to a rise in average customer margin balances. Average margin debt increased 107% and 104% for the three and six months ended June 30, 2004, respectively, compared to the same periods in 2003.
Brokerage interest expense includes interest paid to customers on certain credit balances and interest paid to banks and interest paid to other broker-dealers through our stock loan program. The increase for the three and six months ended June 30, 2004 from the comparable periods in 2003 was due to an overall increase in average stock loan balances.
Banking Revenues
Our net banking revenues increased $6.4 million, or 4% during the three months ended June 30, 2004 and $8.3 million, or 3% during the six months ended June 30, 2004 compared to the same periods in 2003. As shown in the following table, the increases in both the three-month and six-month periods primarily reflect increases in net banking interest income, offset by declines in gain on sales of loans and investments. Net banking interest income rose during both the three and six months ended June 30, 2004 primarily because of a significant increase in net interest rate spread, driven by a lower overall cost of funding as the Bank continued to realize benefits from the SDA funds and an increase in average interest-earning banking assets. These increases were partially offset by modest decreases in the yield earned on average interest-earning assets. Finally, higher interest rates have reduced the volume of consumer refinancings, which in turn, caused the volume and the associated gains on the sales of loans to decline during the three and six months ended June 30, 2004.
The components of our net banking revenues and percentage change information were as follows (dollars in thousands):
Three Months Ended Six Months Ended
June 30, June 30,
---------------------------- Percentage ---------------------------- Percentage
2004 2003 Change 2004 2003 Change
---------- ---------- ---------- ---------- ---------- ----------
Banking revenues:
Banking interest income $ 230,228 $ 181,891 27 % $ 444,612 $ 369,277 20 %
Banking interest expense (115,904 ) (117,954 ) (2 )% (233,510 ) (239,287 ) (2 )%
Provision for loan losses (7,501 ) (7,828 ) (4 )% (16,556 ) (18,161 ) (9 )%
Gain on sales of originated
loans 21,475 62,025 (65 )% 48,575 118,420 (59 )%
Gain on sale of loans
held-for-sale and securities,
net 14,891 20,940 (29 )% 28,953 36,155 (20 )%
Other banking-related revenues 9,690 7,412 31 % 18,331 15,701 17 %
- -------- - - -------- - - -------- - - -------- -
Net banking revenues $ 152,879 $ 146,486 4 % $ 290,405 $ 282,105 3 %
- -------- - - -------- - - -------- - - -------- -
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Banking interest expense is incurred through interest-bearing banking liabilities that include customer deposits, advances from the FHLB and other borrowings. The introduction of the SDA in mid-2003 is the primary cause of a 30% increase in average interest-bearing liabilities and a 73 basis point reduction in the average cost of those funds during the three months ended June 30, 2004, as well as a 26% increase in average interest-bearing liabilities and a 68 basis point reduction in the cost of those funds during the six months ended June 30, 2004.
Net interest spread increased to 205 basis points for the three months ended June 30, 2004 from 145 basis points for the comparable period in 2003 and increased to 195 basis points for the six months ended June 30, 2004 from 148 basis points for the comparable period in 2003. The increases for both periods in 2004 were primarily driven by a lower overall cost of funding. We continue to see economic benefits from the SDA where we swept additional funds during the three months ended June 30, 2004 and grew our total SDA balance by over $400 million to nearly $4.8 billion at June 30, 2004. We plan to sweep additional brokerage customer funds to the Bank in the three months ended September 30, 2004.
The following tables present average balance, income and expense data, related interest yields and rates, and net interest spread for the three and six months ended June 30, 2004 and 2003 (dollars in thousands):
Three Months Ended Three Months Ended
June 30, 2004 June 30, 2003
----------------------------------------- -----------------------------------------
Interest Average Interest Average
Average Income/ Annualized Average Income/ Annualized
Balance Expense Yield/Cost Balance Expense Yield/Cost
------------ --------- ---------- ------------ --------- ----------
Interest-earning banking assets:
Loans receivable, net (1) $ 9,323,548 $ 111,862 4.80 % $ 7,161,143 $ 92,113 5.14 %
Interest-bearing deposits 114,143 1,021 3.60 % 156,776 1,014 2.59 %
Mortgage-backed and related
available-for-sale securities 8,282,552 83,728 4.04 % 6,610,007 62,053 3.76 %
Available-for-sale investment
securities 2,981,826 27,973 3.75 % 2,119,655 22,907 4.32 %
Investment in FHLB stock 100,460 878 3.52 % 79,401 759 3.83 %
Trading securities 771,775 6,131 3.18 % 385,972 3,611 3.74 %
- ---------- - ------- - ---------- - -------
Total interest-earning banking
assets (2) 21,574,304 $ 231,593 4.29 % 16,512,954 $ 182,457 4.42 %
- ------- - -------
Non-interest-earning banking
assets 571,327 863,412
- ---------- - ----------
Total banking assets $ 22,145,631 $ 17,376,366
- ---------- - ----------
Interest-bearing banking
liabilities:
Retail deposits $ 11,512,007 $ 42,928 1.50 % $ 8,473,951 $ 68,542 3.24 %
Brokered certificates of deposit 359,265 2,287 2.56 % 425,849 2,976 2.80 %
FHLB advances 967,297 10,467 4.28 % 956,300 11,194 4.63 %
Other borrowings 7,906,398 60,222 3.01 % 6,061,342 35,242 2.30 %
- ---------- - ------- - ---------- - -------
Total interest-bearing banking
liabilities 20,744,967 $ 115,904 2.24 % 15,917,442 $ 117,954 2.97 %
- ------- - -------
Non-interest bearing banking
liabilities 346,829 603,413
- ---------- - ----------
Total banking liabilities 21,091,796 16,520,855
Total banking shareholder's
equity 1,053,835 855,511
- ---------- - ----------
Total banking liabilities and
shareholder's equity $ 22,145,631 $ 17,376,366
- ---------- - ----------
Excess of interest-earning
banking assets over
interest-bearing banking
liabilities/net interest income $ 829,337 $ 115,689 $ 595,512 $ 64,503
- ---------- - ------- - ---------- - -------
Net interest spread 2.05 % 1.45 %
---------- - ---------- -
Net interest margin (net yield
on interest-earning banking
. . .
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