We have initiated coverage on E*Trade with a Buy (2) rating. E*Trade is a leading franchise
in the intensely competitive and rapidly growing online brokerage industry. E*Trade
boasts a predictable business model that allows the flexibility to deliver financial
performance at or above expectations. The principal revenue drivers, such as account
growth and transactions per account, are quite visible, and operating expenses and cost of
goods are relatively discretionary. In spite of a highly competitive market, we believe that
E*Trade has developed an enduring franchise. Our Buy (2) rating reflects both the
opportunity and the intensely competitive nature of the online brokerage industry. Our 6-
12 month price target of $33 (+50%) suggests a fiscal 1999 earnings multiple in line with
E*Trade's 35-40% growth rate.
A Leading Franchise In A Huge Market
Strong December Quarter
E*Trade reported December quarter (fiscal Q1) EPS on January 5, delivering $0.16, a penny
above Street expectations, on $51.1 million in revenues, up 104% y/y. Accounts grew to
325,000, up from 225,000 in September. 65,000 of the new accounts were converted from
OptsionLink, an online/telephone trading service for corporate employee stock option plans
that E*Trade recently acquired (and took a $2.7 million charge for in the quarter).
Additionally, there was strong growth in interest revenue (+30% q/q), which accounted for 24%
of total revenue. We believe that this stable, high-margin revenue stream will become
increasingly important, as E*Trade transitions its business model from a mere discount
brokerage trading operation to an online financial services company.
The Online Brokerage Market Is A Monster Category
Forrester Research believes that the number of online brokerage accounts will grow from 3
million in 1997 to over 14 million in 2002. A second measure, which may well be more
important than number of total accounts, is total value of the assets held in online accounts.
Forrester believes that this will grow almost 500% over the next five years, from $120 billion
under management in 1997 to almost $700 billion in 2002, due to the concurrent growth of the
discount brokerage industry and number of online users.
BUY E*Trade's Franchise Rises Above The Online Price Wars
In the midst of an online price war, E*Trade has delivered a string of consecutive quarters of
25%+ account growth and sequential earnings and revenue growth. During the quarter, online
brokers such as Ameritrade and Quick & Reilly's SureTrade launched $7.95 per trade (for
trades less than 5000 shares) marketing campaigns. These aggressive moves, combined with
larger players such as Fidelity matching E*Trade's $14.95 per trade, caused E*Trade's stock to
fall from a high of $48 in September to its current price of $23. E*Trade's robust account and
revenue growth suggests that customers base their online broker choice on more than simply
price. As online brokerage customers and public market investors grow to understand these
differentiating factors, E*Trade's prospects and valuation should expand to reflect the sizable
opportunity the company is successfully pursuing.
E*Trade's Accounts Are Growing Rapidly, While Retention Is 95%
Annualized
The result of E*Trade's brand and marketing efforts can be readily seen in the tremendous
account growth the company has experienced over the past year. In 1997, E*Trade's accounts,
including those converted from the OptionsLink acquisition, have grown to 325,000, up from
145,000 one year ago (+124%). Meanwhile, E*Trade has consistently managed to retain 95% of
its customers on an annualized basis.
Charles Schwab Is The Largest, Ameritrade The Most Aggressive Of
E*Trade's 30+ Competitors
Charles Schwab (SCH-$40) boasts approximately 1.1 million online accounts, of which an
estimated 250,000 are active. Our belief is that Charles Schwab sees the online brokerage
market as an extension of the fragmented discount brokerage market and thus positions its
eSchwab product within its overall product portfolio to bolster its leadership in its core
business. Ameritrade (AMTD-$26) clearly believes that the online brokerage market is a
unique and emerging market and is pursuing a market share strategy at the cost of bottom line
performance, with its launch of the $7.95 per trade pricing this fall. We believe that
Ameritrade has roughly 125,000 active online accounts.
The Business Model: Revenues, Accounts And Assets Should Continue To
Grow And Margins Should Improve
E*Trade boasts a classic category-leading Internet business model: marketing, R&D and G&A
costs are relatively fixed, and management has the flexibility to let upside surprises flow to the
bottom line or to be reinvested in the business. Revenue is a function of the number of
customer accounts and the transaction frequency and revenue-per-trade added to the high
margin interest revenues. Management has suggested that cost of services should be around
50% for fiscal 1998, yet demonstrated in the December quarter that those margins are within its
control and can be dialed downward should the quarter warrant it. Furthermore, E*Trade has
flexibility within each of its operating expense lines, and, combined with the highly visible
nature of its consumer transaction revenue stream, can effectively manage to a target 20%
operating margin. |
