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How Zero Commissions Will Affect E*Trade's Growth

By Jon Quast - Nov 23, 2019 at 10:16AM

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It's willing to forge a contrarian path to deliver for its investors.

Online broker pioneer E*Trade ( ETFC ) is joining the ranks of Robinhood and other brokers by offering zero commissions on all stock trades. This move was inevitable, as other large brokers like Charles Schwab had already waved the white flag in the zero commission broker wars. The move allows E*Trade to offer something consumers have come to expect.

E*Trade is a hot growth story, being named to Fortune's 2019 list of Fastest-Growing Companies. Furthermore, the company had guided for $7 in earnings per share for 2023 -- a sharp increase of 69% from current trailing-12-month EPS of $4.13. But that was prior to cutting commissions on trades. Now investors wonder whether E*Trade has much of a future at all.

standard stock trading chart

Image source: Getty Images.

Why the change?

When E*Trade announced  that it was eliminating base commissions on all trades, it was reluctantly giving in to the new industry standard. New CEO Mike Pizzi said in the third-quarter earnings call, "While we did not favor this shift, we believe it enhances our competitive position in our core retail franchise." 

E*Trade's full-year 2018 revenue was $2.9 billion. The move to eliminate base commissions will cost it $300 million annually in lost revenue -- or about 10% of total revenue. But Pizzi mentioned that the company has lost customers to lower-priced competitors, and the move to cut fees is an effort to win them back. In the first month of zero fees, the company noted increased growth in new accounts -- a promising sign.

When asked about further price cuts, management stated that it doesn't anticipate any. It thinks that option traders willingly pay for a superior platform, which E*Trade believes it has. The company also manages over 2 million corporate stock plan accounts, which it believes will also continue to be paying customers.

What's the plan?

While losing 10% of revenue isn't ideal, it's crucial to remember that 65% of E*Trade's revenue comes from interest made from undeployed customer cash just sitting there. This cash currently totals $65 billion, which is up 5% quarter over quarter. Federal interest rates directly impact this revenue, and the rates were lowered three times in 2019. E*Trade's interest income would benefit from a hike, but there's no telling when that will happen.

As might be expected, however, in light of $300 million in lost annual revenue, E*Trade won't reach its $7 EPS goal by 2023. But the EPS goal always assumed zero growth in commissions. So losing this revenue does not kill the plan entirely -- It merely pushes the goal back to 2024. The goal for 2023 is now $6 EPS, still up a healthy 45% from today. Of course, that's if it can hit its EPS goals.

For now, the plan isn't very complicated and can be broken down into three main components. The first is to increase revenue by growing the cash deposited in its system. Zero commissions plays into that since a big part of growing deposits is growing its user base.

The second step is to increase its operating margin. It intends to do so by cutting costs and increasing its net interest margin (the difference between what the company pays in interest and what it earns in interest).

Step three is to continue to buy back shares. Over the last seven quarters, the company has bought back over $2 billion of its own stock. This increases earnings per share without increasing earnings, since there are fewer shares. Currently, the company is authorized to repurchase another $1 billion in stock, which it anticipates doing by next year's third quarter.Considering that E*Trade has a $9 billion market cap, repurchasing shares at a rate of $1 billion annually is a very aggressive plan.

The contrarian path forward

When an analyst begins a question by saying "With all due respect," it's apparent that there's frustration with E*Trade's current plan. Indeed, many pundits believe the company would benefit by merging with a bigger finance player. Shares dropped sharply on news that Charles Schwab was acquiring TD Ameritrade, as it took a potential E*Trade suitor off the table.

In closing, it's worth noting that during Pizzi's days as CFO, E*Trade made concrete 18-to-24-month business goals starting in October 2016. Two years later, the company had hit three out of four. As a result, revenue had increased almost 50%, and EPS had nearly doubled. The stock also beat the S&P 500 during that time.

I believe this recent track record gives Pizzi credibility, and he deserves a chance to execute his contrarian plan to reach that $7 EPS goal as an independent company.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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