E*Trade, Lean and Mean for Round Two

Leaner and meaner
A poster child of the dot-com boom, E*Trade (NYSE:ET) saw its stock price sink to a low of $2.50 in 2001 on a revenue plunge of 18% and a massive net loss of $241 million. That was then.

But lately, Mitchell Caplan, elevated from chief banking officer to CEO in 2003, has steered a once-reckless ship known for its profligate ways into safer waters, ruthlessly cutting expenses and restoring gross and operating margins to 60% and 35% last year, from an abysmal 53% and 5% in 2001. Head count has been reduced to 3,500 from 5,000, the $2 million Super Bowl commercials have been relegated to the dust bin, and every new venture is being vetted for profitability.

Toward more consistent revenues
Much of the renewed optimism about E*Trade has also been due to its success as a banker; E*Trade has laid a strong foundation toward more consistent earnings and insulated itself from the vagaries of the stock market by becoming the eighth-largest thrift in the business. In 2004, net interest income (interest income net of interest expense) contributed 30% of total revenue, up from a paltry 13% in 2001 -- offsetting the decline in brokerage revenues, which dropped from 40% of total revenue in 2001 to 33% in 2004. It also made up for the declining gains on the sale of loans and securities, which fell from 12.4% of revenues in 2001 to 6% in 2004. Brokerage proprietary trading operations also dipped a bit, from 18.5% of revenues in 2001 to 16.5% in 2004. In 2004, E*Trade got 74% of its revenues from brokerage commissions and net interest income, compared to 63% in 2001.

Unfortunately, the brokerage business, with its price wars, still outweighs banking revenues by one-and-a-half times. The brokerage industry has two clear segments:

The full service segment, dominated by the likes of Merrill Lynch, offering research, advice, and telephone order execution by brokers (the old fashioned way!) at $35 and above a trade.

The no-frills, discount segment, which targets the Internet trader, who neither expects nor receives services for his $5 to $11 per trade.

In the latter segment it's a scrappy dogfight. If Scottrade's value proposition centers around its $7-per-trade offer, archrival Ameritrade counters with a test product of $5 per trade. JPMorgan's (NYSE:JPM) Brownco teases the trader with $5 for market orders and even the venerable Fidelity recently raised arms with $11 per trade for select clients.

Banking segment a big competitive advantage
E*Trade's banking interest income grew 29% in 2004, relative to 2003 numbers, largely fueled by its mortgage and loans portfolios, which grew 27% and 42%, respectively. E*Trade has targeted larger families with dual incomes to keep default rates low. As an online bank it has lower operating costs and the cost of acquiring customers is spread over both brokerage and banking offerings. Having a bank and access to a pool of deposits also allows it to give better interest rates to its brokerage customers. The big negative of online banking is that it restricts growth, and the fastest growth is coming from the pockets of ethnic immigrants, such as Hispanics, who don't have the same online density.

Imitation being the best form of flattery, Ameritrade (NASDAQ:AMTD) is looking to emulate E*Trade's success in banking by starting banking operations in late 2005.

While banking has been the stronger suit this year, largely due to mortgage revenues, it remains a highly cyclical business. In a rising interest rate scenario, with lower spreads between short-term and long-term rates, profitability may decline notably. After all, E*Trade derives interest income on mortgages issued at long-term rates (20 or 30 years), while customers are paid on deposits/CDs pegged to short-term rates; there is a distinct possibility that short-term rates will exceed long-term rates in uncertain interest rate environments. E*Trade's best bet is to continue to leverage its economies of scale across both businesses and stay ahead as the lowest cost operator.

A solid long-term buy?
In 2004, E*Trade earned $389 million or $0.99 a share on revenues of $1.52 billion, compared to $203 million in 2003. However, it took a $134 million facility restructuring charge in 2003, and $31 million of 2004 earnings was also earned from discontinued operations. Strictly comparing operating income from continuing/core operations (net of one-time gains and charges) reduces the comparative net income gain to 13% over last year, as outlined below:

Significantly, most of these gains came from lower operational costs. Not bad for a 3% growth in revenues, and a small 1% growth in active accounts.

Revenue growth in the brokering segment is likely to remain low, given the price dynamics of this cutthroat, cyclical, commodity business.

However, I feel this is an engine that can churn out consistent increases of 12% to 15% in net income over the next three to five years in an intensely competitive environment, given its strong foothold in both banking and brokering, focused management, and ability to spread operating costs over both segments.

At 12 times trailing earnings, it stacks up well against Ameritrade's P/E of 15, and Schwab's (NYSE:SCH) P/E of 34. Ameritrade though, had net margins of 30%, compared to 25% for E*Trade, while Schwab, with a higher cost structure, eked out only 10% of revenues (net of charges related to discontinued operations). E*Trade faces less downside in a price war, given the strength in its banking business. In fact, the price war is comforting because it represents a serious barrier to entry.

A solid long-term buy? I think so.

• No More Free Trades
• The $5 Stock Trade
• Second Chance for Schwab?

Fool contributor Bobby Shethia doesn't own shares of any of the companies mentioned in this article. He did own a propeller beanie once. The Motley Fool is investors writing for investors.