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Executives

Adam DeWitt − CFO

David Fisher − CEO

Analysts

Rich Repetto – Sandler O’Neill

Mike Vinciquerra − BMO Capital Markets

Brian Bedell − Merrill Lynch

Mark Lane − William Blair

Betsy Miller − Goldman Sachs

Edward Ditmire − Fox-Pitt Kelton

Patrick O'Shaughnessy − Raymond James

David Scharf − JMP Securities

Richard Fetyko − Merriman Curhan Ford

optionsXpress Holdings, Inc. (OXPS) Q3 2008 Earnings Call Transcript October 21, 2008 9:00 AM ET

Operator

Good day, everyone. Welcome to the optionsXpress Holdings’ third quarter 2008 financial results conference call. Today’s call is being recorded. At this time, I’d like to turn the conference over to Mr. Adam DeWitt, Chief Financial Officer. Please go ahead, sir.

Adam DeWitt

Thanks, Melissa. Good morning, everyone, and thanks for joining us for our third quarter 2008 earnings call. I’m Adam DeWitt, the CFO of optionsXpress. And with me today is our CEO, David Fisher.

By now, you should have received a copy of our press release that was faxed or e-mailed to you. If you haven’t, please call Victoria Paris at 312-553-6715 and we’ll make sure you get one. Alternatively, you can view a copy of our release, listen to the call, and submit any questions to us via our Web site at optionsxpress.com.

Before we begin, I would like to note that this call contains forward-looking statements that are made pursuant to the Safe Harbor provisions of the Federal Securities laws. These statements involve risks, uncertainties, and assumptions that may cause actual results to differ materially from those anticipated. Listeners to the call are advised to review the risk factors contained in our prospectus, most recent annual report on Form 10-K, and quarterly report on Form 10-Q for descriptions of risks, uncertainties, and assumptions related to forward-looking statements. Please note that this call is intended for investors and analysts, and may not be reproduced into media in whole or in part without our prior consent.

At this time, I’ll turn the call over to our CEO, David Fisher, who will recap the highlights for the third quarter. Following David’s remarks, I will walk through the financials, and David will wrap up with our outlook before we finish with questions. David?

David Fisher

Good morning, everyone. Thanks for joining our call today. We are pleased to announce solid third quarter results. We generated revenues of $66.9 million, our second highest total revenue ever and net income of $24 million, resulting in earnings per share of $0.40.

We believe our ability to achieve the results in an extremely challenging operating environment is a testament to three main factors, first, the cost market [ph], and particularly, the resiliency of the retail investor; second, the market, namely the growth and stability of the derivative markets in the US; and third, optionsXpress, particularly our still scalable technology, efficient operating model, and our strong financial position.

While these factors have long been at the center of optionsXpress’ success, they were certainly highlighted this quarter by the tremendous volatility and uncertainty in the markets.

I’d like to spend a couple of minutes touching on each one of these in a little more detail. Throughout this year, we’ve highlighted the resilience we’ve seen from our customers. And this resilience has continued despite the tremendous market volatility witnessed in the latter part of the third quarter. Through the use of options and futures, our customers have effectively employed strategies that have helped protect them against the market swings we’ve witnessed. Again, it cannot be overstated how different today’s self-directed retail investors are from those investing online during the last creative [ph] market turmoil following the dot-com bubble.

Today, optionsXpress customers are taking advantage of our tremendous educational offering to become knowledgeable of investing and properly utilizing the easy to understand, yet powerful tools we provide to execute under investment strategies. Having these resources available to them has given our customers a confidence to remain engaged in the market. In fact, we saw customer activity rates increased throughout the quarter as market conditions worsened.

September DARTs reached 39,400, which was a 28% increase over August, and 11% increase over September last year. Importantly, volumes have continued to be robust through the first three weeks of October.

Our proven scalable platform continued to perform extremely well, allowing our customers to execute their trades in this volatile, high volume environment without disruption. We believe our experience and expertise with derivative products has clearly been a differentiator in these volatile markets. We are able to quickly and clearly communicate to our customers about changes in the marketplace like the short-sale ban, which was announced just hours before the market opened on an expiration day.

We have been successful in emphasizing to our customers the safety of their assets at optionsXpress. We have effectively worked with our customers to manage their leverage in their accounts, while keeping risks at an acceptable level.

Near the end of the quarter, we saw a spike in customer inflows in particular, large accounts from other firms, who in one way or another had struggled during the quarter. This trend has continued since October. Specifically for the third quarter, we reported net new accounts of 10,900. July and August new accounts were impacted by the seasonally slower summer months. However, as we moved into September, we saw increased momentum, with 3,000 net new accounts, which was 18% more than August, and in line with September last year.

During the quarter, we continued to implement new and interesting marketing initiatives to increase our presence and new account generation, while maintaining our spend at a level similar to that in the first half of the year. Much of our marketing in late has been focused on two dominant themes, successful investing and challenging market environments, and the safety and stability of optionsXpress.

For example, we are running a special webinar series on investing in volatile markets. Sessions include understanding option volatility, using spreads to minimize risk, and using ETF option strategies to more efficiently hedge a portfolio. We have advertised this series through our homepage, banner ads, and limited print advertisements. The turnout at these events have been very good.

Even with all the activity during the quarter, we were able to continue to focus on growing our − to continue to focus on our growth initiatives for optionsXpress. As you may have seen in our press release, we have signed an agreement to acquire Horwitz & Associates, an independent broker-dealer and investment advisor. The purchase price for this transaction is $4 million in cash, plus an earn-out based on futures performance. With approximately 28 reps and advisors, over 4,000 accounts and $1 billion in customer assets at the end of September, this acquisition will add significant scale to our brokersXpress business. We hope to close this transaction around the end of the year.

We also continued to pursue opportunities in international markets. For example, in September, we announced a strategic alliance with India’s top brokerage firm, Reliance Money. We’ve seen good growth in international business so far this year. We continue to see opportunity both in other emerging markets as well as developed countries.

I will touch on our strong financial position at the end of our remarks. But before that, let me turn the call over to Adam DeWitt, our Chief Financial Officer, who will review the third quarter financials with you in greater detail. Adam?

Adam DeWitt

Thanks, David. As David already noted, we’re very pleased with our financial results given the market backdrop. It speaks to the resiliency of our business model as well as our customers for us to generate robust earnings in good markets and bad without the risk many financial services firms have faced over the last 15 months. In fact, September, arguably one of the most difficult months in capital markets in years, was our strongest month for the quarter, both in terms of trades and even more importantly as an indicator of long-term growth, new accounts.

Total net revenues for the quarter were $66.9 million, a 4% increase over third quarter of 2007, and an 8% increase over last quarter. Commission revenues were $45.1 million for the third quarter of 2008 or up 14% over the third quarter of 2007 and up 10% from our results last quarter. A portion of the increase in both comparable periods was due to the Open E Cry commissions beginning July 1. Open E Cry generated a little over $3 million in commissions during the quarter. The initial increases in commissions were due primarily to a higher average retail commission rate, which is partially offset by lower overall retail trading activity. While total overall average commission was $14.87 during the quarter compared to $17.16 a year ago and $17.20 last quarter, this decrease is driven by Open E Cry's lower average commission rate.

Retail average commissions were actually up approximately $1.00, driven by higher average option contracts during the quarter. Third quarter 2008 net interest income was $12.3 million, which represents a 13% decrease over last year's income of $14.2 million and 7% increase over last quarter. The decrease for us last year was related to the decrease in the Fed funds rate while the increase over last quarter is related to a number of small items, including the addition of open E Cry, higher average margin balances and a one-time credit due to the re-negotiation of our futures clearing relationship.

Overall cash balances during the quarter were relatively flat despite the volatility in asset balances from market declines. When the Fed cut to 2%, we discussed the impact of an incremental 25 basis points Fed funds cut as a $0.005 per quarter. This latest 50 basis points cut, therefore, would translate into about $0.01 impact per quarter. This is roughly correct provided balances and mix remain flat. The next 50 basis points impact will likely have a greater impact of approximately $0.02 per quarter, all other things equal, since we start eating into money market management fees at this low of an interest rate level.

To put the impact of all the Fed cuts to date in perspective, if we had had earned the same rates on our customer cash this quarter as we did last year's third quarter, our interest income would have been approximately $4 million higher and total revenue growth for the quarter would have been over 10%. Payment for order flow for the quarter was $8.7 million which is down 9% from last year but up 6% from the second quarter. The decrease from last year was related to lower rates on a blended order flow as a result of the Penny Pilot while the increase over last quarter was due to both an increase in our payments for order flow rates and an increase in total contracts resulting from higher average option contracts per trade.

We continue to see strong demand for our order flow and feel that our payment rate should remain stable or increase for the near future. On the expense side, total expenses were $29.1 million, up 28% from last year and 18% from last quarter. Much of the increases in both periods are related to the addition of Open E Cry. Brokerage and clearing costs for the quarter were 68% higher than the third quarter last year and 57% higher than last quarter. The primary driver in both comparable periods was the addition of Open E Cry, most of whose expense flows through this line item in the form of payouts to introducing brokers much like our BX business.

Payouts to brokers during the quarter were approximately $2.2 million for Open E Cry and $2.1 million for BX brokers. I remind listeners that these payouts have been recognized both in the commission line and in the brokerage expense line have the impact of grossing up our revenue and lowering our margins even though the economic value of the underlying trade remains high. To put the impact in perspective, our pre-tax margins would have been over 60% without this gross up.

Non-payout brokerage and clearing costs were also higher during this quarter, primarily due to the extreme market conditions. But going forward, these costs should decline as the market stabilizes and returns to more historical levels. Compensation costs were $8.0 million during the quarter, 16% higher than the third quarter of 2007 and 13% higher than the second quarter of this year. The increases were due mostly to the addition of Open E Cry and a higher bonus accrual. Overall compensation costs per employee were roughly flat with the third quarter of 2007.

Advertising costs for the quarter were $4.9 million, a 39% increase over the third quarter of last year and 2% decrease when compared to the second quarter. For the fourth quarter, we currently expect somewhat higher advertising spend as we head towards a traditionally stronger first quarter for opening new accounts. Technology costs for the quarter were $1.2 million, 24% higher than last year and 26% higher than last quarter. Most of the increase was due to the added technology cost from Open E Cry. Pre-tax margin was 56.4% during the third quarter which is down from 64.5% for the third quarter of 2007 and down from 60.0% last quarter. Most of the decline is due to the incorporation of Open of E Cry into our financial results.

As we’ve discussed before, despite the lower pre-tax margins in the Open E Cry business, it still generates high returns on capital and as I noted earlier, our pre-tax margin would have been over 60% without the gross up impact from the growing introducing broker payouts.

Resulting third quarter 2008 net income was $24.0 million, representing a 5% decrease over the third quarter last year and a 3% increase over last quarter. EPS was $0.40 for the quarter, flat with last year and $0.01 higher than the last quarter. We believe our customer accounts have performed well given the market conditions. Total client assets ended at $5.3 billion, an 8% decline versus last quarter which is consistent with market declines and a 6% decrease over last year which is much better than a 20-plus percent in the market averages over that time.

Margin balances were $200 million at the end of the quarter, a 21% increase over last year and an 18% decrease versus the second quarter. The decline during this quarter occurred mainly in September as our customers deleveraged in the face of the extreme volatility and lower overall asset levels. Our margin balances remain above historical levels, at comparable asset levels in part due to portfolio margining. I'll now turn the call back to David Fisher for some final thoughts.

David Fisher

Thank you, Adam. Though the turmoil in the financial markets has weighed heavily on investors minds, we have continued to deliver strong performance at optionsXpress. Our business is healthy and we have continued to grow our customer base by reinforcing our leadership position in derivative products. Supported by our stable technology, our strong team of employees did a terrific job of assisting our customers navigate these difficult markets.

Looking forward to 2009, it's difficult to predict whether the activity rates we are currently seeing will continue or whether the worsening economy will lead to a more stagnant market. While no business is fully insulated from macroeconomic pressures, we believe we are well positioned given our efficient operating model with the highest margins in the industry, and we believe we have the flexibility and nimbleness to react quickly to unpredictable market conditions. Clearly we have demonstrated our ability to succeed in varied markets. We also have the strong balance sheet with no debt. We do not rely on credit to fund our business as our broker's operations are completely self funded.

With our strong cash flow, we have completed two acquisitions. We have $70 million in stock repurchases and we have paid growing dividend. We've been able to grow our company cash to over $200 million, all without borrowing. For all these reasons, we believe to believe our efficient business model and cash flow provide us with significant capital flexibility which will give us the ability to not only sustain a − weather a sustained market dislocation but also to create additional shareholder value by taking advantage of opportunities that result there from.

Longer term, we still see strong growth ahead in retail adoption of derivative products. New products that appeal to retail investors are being rolled out on a regular basis and investors are becoming increasingly educated to the benefits of using these products. OptionsXpress' expertise makes us well positioned to further capitalize on this enduring trend. At this time, we would like to turn the call back over to the operator. We will take some of your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And we'll go first to Rich Repetto with Sandler O’Neill.

Rich Repetto – Sandler O’Neill

Yes, good morning guys. Congrats on a strong quarter.

David Fisher

Thanks, Rich.

Rich Repetto – Sandler O’Neill

I guess the first question just to verify or validate some of the numbers. When you say Open E Cry was 3.0 and the retail commission was $1 higher, we are not like rounding − it was 3.0 or 3.1? Like how much different could it be other than what you gave? I guess that’s the question.

Adam DeWitt

It’s around $3 million. So if it was significantly higher or significantly lower, I would have given you a different number. So probably $1 million is a good way to think about it.

Rich Repetto – Sandler O’Neill

Okay. And then, you did mention in these prepared remarks, you said you picked up accounts from people who had struggled. I was wondering it wasn't anybody to me that in particular struggle in the quarter. I was trying to see who you might be referring to and quantify that impact because -- as well how much was organic growth -- how much can you attribute to this?

David Fisher

I think there was a few factors. First, we definitely saw some inflows of accounts from more full service brokers who obviously did have some difficulties during the quarter. There were some outages − site outages during the quarter which we believe we benefited from and we believe some brokers had trouble managing the risk and the margin and leveraging customer accounts and drove some more sophisticated higher balance accounts to us.

Rich Repetto – Sandler O’Neill

May I ask -- a good point. I wasn't looking broad enough here. You also said that customers started -- the market loan [ph] balances that went down about 14% in September. Did some of your customers deleverage? I was wondering with the markets down, I’m looking at my screen 15% in October whether that deleverage has continued in October. What the margin balances look like more realtime?

David Fisher

We definitely saw some continued deleveraging in October but, as Adam mentioned in his comments, if you kind of look at asset levels and we look at day to day asset level and we compare them to where -- kind of similar levels historically when we were at similar asset levels, margin balances as percentage of assets are still above those historic trends because of portfolio margin, because of the advent of portfolio margin. We haven't gone below what we normally see as margin balances as a percentage of total assets.

Rich Repetto – Sandler O’Neill

Got you. And the very last question David is, you said you could react quickly if, let's say, the retail investor pulled back materially. Could you just be a little bit more specific when you say, “react quickly about market”? How would you offset a material slowdown in trading if that ever occurred?

David Fisher

Sure. Good question. We kind of look at it from two perspectives. One is we think we have a very efficient operating model, so we don't have a lot of overhead dragging us down. We continue to generate a lot of cash flow even in a slower market. But secondly, we have a significant amount of cash on our balance sheet.

We are showing our ability to execute on acquisitions, and whether it's acquiring brokers who are struggling, whether it's picking up talent from firms that go under, we think we can act very, very quickly, use our significant resources behind us to take advantage of the opportunities that we certainly expect to see in 2009.

Rich Repetto – Sandler O’Neill

Okay. Thanks guys and congrats again.

David Fisher

Thanks, Rich.

Operator

We'll take our next question from Mike Vinciquerra with BMO Capital Markets.

Mike Vinciquerra – BMO Capital Markets

Thank you. Good morning guys.

David Fisher

Good morning.

Mike Vinciquerra – BMO Capital Markets

I wanted to drill down a little bit on the activity during the quarter. If we strip out the institutional trades, it looks like trading was more like 30, 31 trades annualized versus the 38 you guys quoted last year. Number one, am I looking at the numbers right? And secondly, what might explain the significant drop because obviously we saw pretty good trading in July, pretty good trading in September, maybe a little weakness in August but overall, I mean, people were actively trading on the retail side.

Adam DeWitt

Mike, I think your numbers are correct. Really what we saw was a stronger September, but a really weak August trades per account per year were down in the 20s and then July wasn't nearly as strong as July traditionally is. We usually have a good first month of the quarter as it's earnings season but July was definitely weaker. So balancing out that with those two months, with September, and we end up at a lower overall activity rate.

Mike Vinciquerra – BMO Capital Markets

And when you look at your customers, Adam, is there a difference between the active traders, maybe the highland traders, versus I'll call them the main street guys in terms of who is still engaged with the main street folks pulling back more so than your guys that are more engaged in market everyday?

Adam DeWitt

No difference among the different groups. I guess there was a pull back generally across the board and I think it's important to note that even though 31 is certainly on the low side, it's definitely within the range of 30 to 40 that we've talked about in the past and given the market backdrop, we feel pretty good about it.

Mike Vinciquerra − BMO Capital Markets

Okay, fair enough. Thank you. And then the Horwitz transaction, I'm not sure I quite understand the operating structure there. Did you actually buy a firm that does the same thing as brokersXpress and therefore you don't actually own the advisors, you are just outsourcing or providing outsourcing services or what is the structure?

Adam DeWitt

(inaudible) we do own the broker relationship and we own the economics from those transactions. So it's not just an outsourcing function. We're in charge of supervision and recruiting new reps just like we are in the BX side, and it's just a great thing. David talked about it in terms of scale. We're almost doubling the amount of assets in the BX and it gives us a fuller spectrum of the different types or reps, the average account size is closer to $200,000 at Horwitz and we think it could be a good way to get the BX business growing.

Mike Vinciquerra − BMO Capital Markets

Okay. Just to clarify. You do not – these are not employees of yours? Now, this is just a firm that you purchased the brokers, the reps are actually independent?

Adam DeWitt

Yes.

Mike Vinciquerra − BMO Capital Markets

Okay and could you share with us at all any economics on this revenue acquired because $4 million seems like a rather small sum. I assume the biggest portion is going to come in the year now but can you give us any economics?

Adam DeWitt

Yes, actually the earn-outs are not that much greater but in terms of the economics, we'll give you more detail. It's not going to have any impact during 2008. As David mentioned, we're looking to close around the end of the year. So, if we close in December or January, it's not going to have an impact on our fourth quarter. Last year, just to give you some sense of size, they did about $10 million in revenue, a little bit over $10 million in revenue, and on that about $0.5 million in pre-tax but we think that there is probably some synergies on the clearing side that we can leverage our platform.

Mike Vinciquerra − BMO Capital Markets

Excellent. Okay, thank you.

Operator

We'll take our next question from Brian Bedell with Merrill Lynch.

Brian Bedell − Merrill Lynch

All right. Good morning guys. Congrats on a good quarter.

Adam DeWitt

Thanks, Brian.

Brian Bedell − Merrill Lynch

Just while we are on the subject of the Horwitz acquisition, that was in 2007 you're recording the $10 million revenue and $500,000 pre-tax?

Adam DeWitt

It's actually in 2008 but they have a year-end June 30. So it's a pretty recent number.

Brian Bedell − Merrill Lynch

Okay. And any sense of what you might be able to take the operating margins in that business up to say over the next 12 months or so?

Adam DeWitt

I think it's a little early. I mean, I think we should − we'll give you guys a little bit more color on the next call. It's certainly higher than where it is today, than that $.5 million, but we'll give you guys a little bit better sense as we get (inaudible) through the close process.

Brian Bedell − Merrill Lynch

And how do you expect this to jump start your RIA strategy a little bit more? Maybe if you want to talk more strategically about what your game plan and progress has been so far in that as to what your outlook is over the next 12 to 18 months particularly given this environment where we're seeing a lot of turbulence?

Adam DeWitt

I think it really does two things for us. One is, it gives us more expertise on the RIA side of business a little more, the high end asset management side, where they've got a good team of people there, some good products which we're going to utilize and they have more experience recruiting in that space. I think the second piece is, in that we found in the BX business scale really matters. The more brokers you have, the easier it is to recruit. They help you recruit; they recruit for you. They tell their friends; they tell guys they used to work with and certainly this brings us a new type of broker that we haven't worked with as much in the past that's going to have more of those relationships which we think will help generate additional growth as well. Other than that, it's a really nice acquisition and they're toughing [ph] very, very well. While the brokers are a little bit higher end and a little bit more asset management focused, that almost the entire difference. Everything else they do is right in line with brokersXpress and the integration should be fairly simple for us.

Brian Bedell − Merrill Lynch

Great. How many reps do you have now with this? How many reps do you have overall in the RIA folks?

Adam DeWitt

Before the acquisition, we had about 300 reps in our RIAs at brokersXpress, so this adds another 30 or so.

Brian Bedell − Merrill Lynch

Great. Okay. And then David, you were talking a little bit about the (inaudible) being very strong. If that relative to September or relative to the third quarter in terms of size?

David Fisher

That's relative to September. Now again, you know these markets, they are extremely difficult to predict what is going to happen tomorrow let alone for the rest of the month or the rest of the quarter, but the volatility has certainly continued through the first three weeks of October. Our customers have state engaged that resilience continues. As we mentioned new account growth and inflows of assets did increase at the end of September and the beginning of October. We are getting the benefit from those new customers, so we've seen a healthy start to the month, but I'd loathe to predict what happens from here. I mean we could stay busy throughout the end of the year or things should come to a crashing halt; there's just no way to predict.

Brian Bedell − Merrill Lynch

Right. The new account flow in October so far, is that building on momentum from say the second half of September?

David Fisher

Yes, it has.

Brian Bedell − Merrill Lynch

It has, okay. Great. And just one last question just on the payment for order flow. You have mentioned in prior calls, there were a number of strategies to improve the value or actually get the value of your order flow recognized by working with different market makers. Is that what's primarily driving the increase in the order flow payments this quarter, or is it just general market factors?

David Fisher

We've been extremely pleased with how some of those initiatives have gone. It's a little difficult to tell because it's been a very good market environment for market making. Spreads have been wide. Volatility has been high. Market makers have done well, so we don't want to become overly optimistic necessarily about those results over the past say 60 days, but they have been very good and we are very encouraged about those initiatives.

Brian Bedell − Merrill Lynch

Okay. Great. Thanks very much.

Adam DeWitt

Thanks, Brian.

Operator

We'll take our next question from Mark Lane with William Blair.

Mark Lane − William Blair

Good morning.

David Fisher

Hey, Mark.

Mark Lane − William Blair

So, we don't want to become overly optimistic necessarily about those results over the past say 60 days, but they have been very good and we are very encouraged about those initiatives.

Brian Bedell − Merrill Lynch

Great. Thanks very much.

Adam DeWitt

Thanks.

David Fisher

Thanks Brian.

Operator

We’ll take our next question from Mark Lane with William Blair.

Mark Lane − William Blair

Good morning.

David Fisher

Hi, Mark.

Adam DeWitt

Good morning, Mark.

Mark Lane − William Blair

So the average commission on the retail side, you said it was up $1 and you implied that was driven by larger order sizes. Is that a market phenomenon that's helping it?

David Fisher

Yes, we see bounce arounds – we have seen it bounce around historically. We saw a lot of index rates this quarter which typically people, we do see higher contracts per trade, and people are using the indexes a little bit more than individual stocks. So, that probably contributes a little bit, but we do think that it was more related to market conditions than a permanent shift.

Mark Lane − William Blair

So are you, given some of the dynamics with the account flows between firms or some things that you saw during the quarter, is your marketing spend going to be higher than in the fourth quarter than it would have been otherwise? Or why wouldn't you spend even more to take advantage of that?

David Fisher

Those kinds of accounts I think are very difficult to target through marketing. We are spending more. We are spending differently. We are trying to be more visible, spending more on banner ads and print, less on some of e-mail and search so we can be more visible with our messages about stability and taking advantage of and trading successfully in this volatile markets, but we really think it's our reputation and kind of how stable we've been over the last eight years and our expertise in the space and at difficult times, I think (inaudible) rises to the top and I think that's definitely what we have seen over the last four to six weeks.

Adam DeWitt

So in terms of fourth quarter, we almost always spend more in the fourth quarter than we do in the third quarter and we intend to spend more in the fourth quarter than we do in the third quarter, but we aren't necessarily going to ramp to a unreasonably high level to chase after this one opportunity.

Mark Lane − William Blair

Okay. The RIA business, so how much scale is enough to make that business more attractive to you? $2 billion isn't really a whole lot of assets either. So, is this just an opportunistic transaction that helps the organic growth or could you continue to do more deals in this area to build out?

Adam DeWitt

I think both. We've been extremely pleased with the growth of our brokersXpress business. The business is only 3.5 years old, something like that. It's going into 300 brokers in RIAs, $1 billion, now we are doubling that. We are really leveraging that platform while gaining ourselves some expertise.

So it's a great way to add scale. I think it’s going to help the organic growth of that business, but to the extent we see other opportunities, I think we'd love to pick up more accounts and more assets in that space as well. One thing to note, while a lot of that business − some of that business is asset based, it is still largely both on the brokersXpress side and the Horwitz side transactional based. So, it ends up looking more like our retail business than say, a high end, high net worth asset management business.

Mark Lane − William Blair

And on the cash side, then, so you said there is over $200 million of company cash and the vast majority of that is excess right?

Adam DeWitt

Right. That is correct.

Mark Lane − William Blair

So, I can understand maintaining some level of cushion given the market environment, but that's a pretty significant level relative to the size of the company. Is it fair to say that share repurchase would pick back up, now that the quarter has been disclosed and you should be out of the blackout period and those sorts of things?

Adam DeWitt

Yes, I think that is right. We have been in the blackout period for the last few weeks, certainly during most of this market turmoil. We have $30 million left on our existing buyback authorization and then from there, we want to be very strategic with our cash. If we think our stock is one of the best uses for it, then we have shown our ability to buy back stock.

And we plan to continue to pay a dividend and we have a very deep pipeline of acquisitions that we think will only continue if market conditions deteriorate through 2009. That being said, in the very short-term, we do want to be a little bit conservative with our cash just given what is going on in the marketplace.

As you know the credit is extremely tight. Everyone is talking about loosening in the last couple of days and there might be some high signs of loosening kind of bank to bank, but in general you can't borrow much and in that environment, having a little cushion on the balance sheet definitely helps us and should help our investors sleep a little better at night.

Mark Lane − William Blair

Okay. Thank you.

Operator

We'll take our next question from Betsy Miller with Goldman Sachs.

Betsy Miller − Goldman Sachs

Good morning guys.

David Fisher

Hi there, Betsy.

Betsy Miller − Goldman Sachs

First, on the net interest income, that actually went up sequentially even though you had Fed funds flat and most of your balances down, margin loans were down. So can you kind of explain what drove that?

Adam DeWitt

Sure. It was a number of small items alone, one was the addition of Open E Cry. We didn’t have Open E Cry interest in the second quarter and then we also had higher average margin balances which contributed to it and then finally, we had a one-time credit due to the renegotiation of our futures clearing relationship. The first two are more sustainable. The third is obviously a one-time pickup. So the three of those together constituted almost all of that increase.

Betsy Miller − Goldman Sachs

Okay. Can you quantify what that one-time credit was?

Adam DeWitt

They were all about a third of the increase.

Betsy Miller − Goldman Sachs

Okay. And then on the infos that you referenced, did we see most of that benefit in the September metrics? Can you kind of compare what the benefit in terms of net new accounts and customer assets might look like in October versus November versus September, has it picked up?

David Fisher

Actually we saw very little of it in September and more of it happened right at the end of the month, really more into the beginning of October.

Betsy Miller − Goldman Sachs

Okay, great. Thanks, guys.

Operator

We'll take our next question from Edward Ditmire with Fox-Pitt Kelton.

Edward Ditmire − Fox-Pitt Kelton

Good morning, guys. Can you talk at all about any interesting trends that might be happening and bad customer debt expense with the high volatility, are there certain customers that are turning into − having problems with the extreme levels of volatility?

Adam DeWitt

Yes, sure, Ed. Actually, we were very pleased with our − David talked a lot about our performance in a lot of areas that we were pleased with during the third quarter, and customer risk was one of those areas where we performed extremely well.

Believe it or not, I think our customer losses in September were lower than they are on average, almost a de minimis amount on the P&L, and it's due in large part to just our approach to managing risk. As you probably know, we don't extend unsecured credit to our customers to trade and so we are very diligent about that, and then when the market gets volatile, we adjust margin requirements accordingly.

So overall, our risk management did an excellent job throughout the third quarter and continues to do a great job in October.

Edward Ditmire − Fox-Pitt Kelton

And just – apologies if you've said this before, but is there any way that you could tell us, as a percentage of revenue, what is normal for bad debt expense at optionsXpress?

David Fisher

It's tiny, tiny. I mean it's −

Adam DeWitt

Less than 0.5% of revenue.

Edward Ditmire − Fox-Pitt Kelton

Great. Thank you.

Operator

We'll go next to Patrick O'Shaughnessy with Raymond James.

Patrick O'Shaughnessy − Raymond James

Good morning, guys.

Adam DeWitt

Good morning.

Patrick O'Shaughnessy − Raymond James

First question I had was, can you talk about if you've seen any different trends in your customer's trade and behavior? Are you seeing more sells in this environment? Are you seeing more use of puts, are you seeing more things that would indicate that people are using your options functionality to basically play the stock market in different ways than they would have played in the past?

David Fisher

A couple of things. We've seen, as Adam mentioned, definitely a higher use of index products and we tend to see that in volatile markets and also in down markets where things are moving quickly, customers don't necessarily have a lot of time to do a lot of research in individual company, it's hard to guess which ones are going to have the bigger impact, so people look to broader-based indexes. So that was definitely a trend that has continued into October.

We've seen a little bit more short-term trading. I wouldn't call it day trading. It doesn't mean people are highly active. It just means their trades have shorter duration. They are not necessarily holding everything to expiration; they're looking for swings in the markets for opportunities to get out.

We've seen our customers continue to be successful in using our advanced order functionality, so they don't need to be watching over the positions all the time. They have contingent orders and stop orders and trigger orders placed against their positions, so that they are protected from any violent swings in the markets.

So those are really all around the edges, I think the bulk of the business is similar. But yes, customers are using the technology. They are using our education; they are using our tools to slightly modify their approaches as we've seen changes in the market environment.

Patrick O'Shaughnessy − Raymond James

Got you. My next question was on the Open E Cry economics, going over my notes from earlier when you were speaking, you mentioned that you had $2.2 million of expenses from Open E Cry. Was that overall or was that just what impacted the brokerage and clearing line?

Adam DeWitt

That was actually just the payments to brokers.

Patrick O'Shaughnessy − Raymond James

Okay.

Adam DeWitt

So we've been asked that in the past about BX, about the impact of the BX payouts to brokers and Open E Cry has as well, so we thought we would give a little bit more color. So that is just payments to brokers.

Patrick O'Shaughnessy − Raymond James

Got it and then kind of a longer term question, if I look at your business model now, 55%, 60% operating margins, where do you guys see yourselves in two to three years if you continue going down the path of buying (inaudible) or buying companies like Open E Cry? Does that take you into an environment where you could realistically see operative margins fall below 50% or further, or are you going to have a target in mind that you want to, no matter what you're doing with acquisitions, you want to keep your margins above a certain level?

David Fisher

We are looking at acquisitions like I would say, like Horwitz and even more importantly Open E Cry. Operating margins are a very, very small factor for us because it's completely misleading.

We've gone through this analysis with a lot of people before without these broker payouts where you can have two different brokers in Open E Cry's case, two different IDs who have the exact same deal. Maybe they have a deal with Open E Cry where they pay a $15 ticket charge to Open E Cry. One broker could charge a $20 commission to his customers, you pay $15 of that to Open E Cry, keep the $5 for himself for the total of $20.

So Open E Cry has a net revenue of 75%. You can have a broker across the hall from that guy who charges $100 to his customers, pays $15 to Open E Cry for ticket charge, and keep the $85 for himself and that makes Open E Cry's margins look like 15%. It's the exact same economic transaction. In each case, we are likely to have over 60% pretax margins once -- when you look at total revenue.

When you look at total revenue, one looks on the surface like a terrible business, one looks like a great business when they are the exact same business. And the return on equity for the business, it's the exact same business. So we have to kind of put operating margins aside a little bit and focus on the other economics of the deal. And specifically, what we internally is kind of ignore those broker payouts and compare it to self-directed retail business and say another way of bringing customers in, you don't care what the broker is charging. You care what you are netting and so we kind of ignore them a little bit internally and look at it that way. If you ignore those broker payouts, we see our margins staying at or around 60%. If you include those broker payouts, it could drop based on the percentage of that type of business versus self-directed retail business.

Patrick O'Shaughnessy − Raymond James

Got it. Thank you guys very much.

David Fisher

Thanks, Patrick.

Operator

We'll take our next question from David Scharf with JMP Securities.

David Scharf − JMP Securities

Hi. Good morning.

David Fisher

Good morning.

David Scharf − JMP Securities

I apologize, guys. I missed the first few comments, popped on a little late. You probably addressed this. But can you give a little bit of a color on once again, in terms of the source of a lot of the new accounts. It's nice to see it picked up nicely, close to 4,000 in September. Any sense for both profiles in terms of age, average balance as well any sense for the source in terms of competitive takeaways where they may be coming from if there was any difference there, is the profiles changing all.

David Fisher

I don't think the profile changed a whole lot. I think around the edges, we got a few more accounts from some of the things we were doing with search. We changed our messaging a little bit again to focus on chance of stability and security. We also got I think a little bit higher percentage of a larger accounts right at the end of the quarter and then into October. That is not so much reflected need the numbers you are seeing, but as a trend we saw increase at the end of the quarter starting to get some larger accounts. Again, seeing optionsXpress value our expertise, our stability, the strength of our balance sheet. I think that benefited us as the quarter came to the end and as we moved into October.

David Scharf − JMP Securities

Got you. And lastly just as we think about commissions as it relates to the mix, obviously with Open E Cry all future options are now below 50% of the total trades. When we start layering in the Horwitz acquisition and perhaps more like that, just trying to get a picture of what the business mix is going to look like perhaps 12, 18 months from now, in terms of how much of this is going to be options related. We are still looking at 50% to 60% of trades being options related longer term and that should help drive our commission thinking.

Adam DeWitt

I think the first thing to think about is that really we have transformed a little bit with the XpressTrade acquisition back in early 2007, really more derivatives focused than just options focused. And so, I think we'll continue to see vast majority of our trades being derivatives focused, for the time being options and futures. An interesting note aside, Horwitz, one of the reasons that deal made a lot of sense was for an independent broker shop, they do a lot of options volume. They use derivatives quite a bit. It's almost 30% to 40% of their trade, so it's a good thing with us, but I think you'll continue to see our business mix being skewed towards options and futures and to the extent that options increase or futures increase relative to the other, it's still part of the same derivatives pool.

David Scharf − JMP Securities

Got you. And this is lastly just more of a technical question. Index options, there's no payment for order flow on that, correct?

David Fisher

There is only one that is not, is the SPX.

David Scharf − JMP Securities

Okay, got you. Thanks a lot guys.

David Fisher

Thanks, David.

Operator

We'll take our next question from Richard Fetyko with Merriman Curhan Ford.

Richard Fetyko − Merriman Curhan Ford

Good morning guys. In the last 12 months, you had added 55,000 new accounts. It's up 22% year-over-year. Yet your retail DARTs have declined by 3% year-over-year. That is a disaster, isn't it? The annualized trades per account has declined from 38 in third quarter of '07 to 31. That is the lowest level in four years. How can you pretend like the customer is resilient?

David Fisher

You are comparing one period to one period. It was a very, very slow July and August and we saw activity rates pick up in September and we have continued to see that into October. So I think you are focusing on just that one time period as opposed to looking at more globally how the business has changed.

Richard Fetyko − Merriman Curhan Ford

I'm not looking at just one period. It's been down year-over-year. The retail DARTs were down 8 % in the first quarter, 2% in the second and 3% in the third but…

David Fisher

In the fourth quarter of last year, they were up substantially over the fourth quarter of the year before. So if your thesis is from December to January, the business completely changed and fell apart, you run with that thesis. What we've been saying throughout the year is the market goes in cycles and we know our business. We know our customer base and we know that we didn't go from December 31st to January 1st and have the business completely change. So again you can't look at our business in any brokerage business just in any one period. The business definitely goes through cycles and you will see those activity rates fluctuate significantly in different market cycles.

Richard Fetyko − Merriman Curhan Ford

When you say resilient, you mean resilient throughout the market condition is I guess what you mean. It's clearly not being resilient. Their activity is down dramatically, so they're being impacted. I think the fair statement would be, they're being impacted dramatically and hopefully they'll come back in the upcycle.

What about the advertising expense per new customer?

David Fisher

I would disagree with that. We have continued to trade. We have added new accounts. Our customers have outperformed the market in their accounts. Our asset levels have grown. I would say they've performed very well and remain very resilient.

Richard Fetyko − Merriman Curhan Ford

Your asset levels are down year-over-year, Dave.

David Fisher

And the market is down a lot more.

Richard Fetyko − Merriman Curhan Ford

Okay. All right. So relative to the market, okay. What about the customer acquisition expense. It's up 60% year-over-year. What do you expect going forward in terms of customer acquisition expenses?

David Fisher

It would really depend on the market environment. I think in a stable market environment like we saw in 2008 or the first half of this year, we think $300 per account is a very attainable level still. If we have an extremely slow or stagnant market in 2009, it's more difficult to predict. But if we have an extremely active turnaround in 2009, I think it could be lower.

Richard Fetyko − Merriman Curhan Ford

Okay. All right. I guess we'll agree to disagree. Thanks guys.

David Fisher

All right. Thanks.

Operator

We'll take a follow-up question from Rich Repetto with Sandler O'Neill

Rich Repetto − Sandler O'Neill

Hi guys. My questions has been asked and answered. Thanks and congrats on a good quarter.

David Fisher

All right.

Operator

It appears we have no further questions at this time. This concludes today's call. We do appreciate your participation. You may disconnect at this time.

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Source: optionsXpress Holdings, Inc. Q3 2008 Earnings Call Transcript
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