E*TRADE Needs to Move Away From Trading

Financial sector stocks have been posting very good results lately, but there are glaring exceptions. One of the notable ones is E*TRADE (Nasdaq: ETFC  ) . As the "E" prefix of its name implies, E*TRADE is a survivor of the dot-com boom-and-bust of the 1990s and early 2000s. In fact, its 3Q results are a little too reminiscent of one-dimensional Internet companies that habitually lost money before burning out and disappearing entirely.

Not the best time to be a trader
Investment banking hasn't been a power industry so far this year. It is, after all, a business of volume. This is because the traditional core activity of an IB, trading, brings in money by taking a cut of every transaction made by clients, be it buy or sell, hoard or dump. Volume this year has been down notably when compared to years past, so the "purer" an IB is, the more it's prone to suffering from the shortfall.

Such is the case with E*TRADE. Despite some fairly successful attempts at diversification, the company is at heart a discount brokerage. In this most recent quarter, its trading and investing unit was directly responsible for a whopping 63% of total net revenue. That's some mighty big exposure. By contrast, even a storied IB name like Goldman Sachs (NYSE: GS  ) only makes around half of its money directly from trading and related activities.

So if market volume is down, so is E*TRADE. The financials don't lie: Overall net revenue for this past quarter stood at a shade over $490 million, a $17 million-plus drop from 3Q 2011.

Bye-bye, profitability. Not long ago, after years of wallowing in the red, the company seemed as if it was starting to make a habit of turning in positive net numbers. But 3Q might have put the kibosh on that happy trend, with a net loss for the quarter of $28.6 million. This looked particularly bloody when compared to the $39.5 million of the previous quarter, and especially the $70.7 million the company netted in 3Q 2011.

Interestingly, the biggest single contributor to E*TRADE's loss wasn't in the trading sphere. It was the 43% year-over-year hike in loan-loss provisions to $141 million, which came about because of faulty data the company received about bankruptcies. But had it been operating in a bull market or -- better yet -- less exposed to that market in the first place, they would have had a much better shot at making up for that loss with gains in other units.

The profit goes to the other guys
That lack of diversification is biting E*TRADE. In contrast, its discount broking competitors have been much more effective in building complimentary business units. Charles Schwab (NYSE: SCHW  ) , for example, took in nearly half of its 3Q revenue from asset management and administration fees; these grew 12% year over year to total $524 million. Good thing, too, as trading revenue fell off a cliff at an 18% annual clip. Since trading constituted less than one-fifth of overall revenue, the impact from its shortfall was limited. Chuck managed not only to net a profit, but to grow that bottom line (by about 7% year over year to $238 million).

Not quite as successful in terms of growth but still well in the black is TD AMERITRADE (NYSE: AMTD  ) . That company's top and bottom lines were both down on an annual basis in its most recent quarter. Regardless, it still brought home the bacon with $667 million in revenues and a $154 million bottom line, for a nice net margin of 23%. Of that $667 million, less than 40% was derived from what the company terms its "transaction-based revenues."

Finally, a takeover?
Lack of diversification isn't the only issue facing E*TRADE these days. The quarterly loss will almost certainly revive whispers of a takeover -- the company was rumored for years to be the target of a hungry acquirer like TD AMERITRADE. Falling from the rich prices it used to command, the stock now bobs around in the sub-$10 area. After these 3Q results, it's not likely to rise much above that.

This gives the company a market cap of a little under $2.7 billion at the current share price. Although TD AMERITRADE doesn't look like a prime candidate at the moment, with long-term debt exceeding its cash and equivalents, there are numerous big financial services firms and banks coming off good quarters. Some have big stockpiles of cash and might be happy to acquire one of the market's name discounters.

Maybe being folded into a larger company and adding bodies to its client base is what would be best for E*TRADE at this point. As the company is now, it's probably too vulnerable to survive on its own, unless it can start to wean itself off that heavy dependence on trading.

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Eric Volkman owns shares of TD AMERITRADE. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Goldman Sachs and TD AMERITRADE Holding. Try any of our Foolish newsletter services free for 30 days.

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