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E*TRADE Financial Corporation (ET)

Q2 2006 Earnings Conference Call

July 19, 2006 5:00 pm ET

Executives

Mitch Caplan - CEO

Jarrett Lilien - President, COO

Rob Simmons - CFO

Analysts

Rich Repetto - Sandler O'Neill & Partners

Matt Snowling - Friedman, Billings, Ramsey

Mike Vinciquerra - Raymond James & Associates

Richard Herr - KBW

Prashant Bhatia - Citigroup

William Tanona - Goldman Sachs

Patrick Pinschmidt - Merrill Lynch

Campbell Chaney - Sanders Morris Harris

Michael Hecht - Banc of America Securities

Presentation

Operator

Welcome to E*TRADE Financial Corporation's second quarter 2006 earnings conference call. (Operator Instructions) I have been asked to begin this call with the following Safe Harbor statement.

During this conference call the Company will be sharing with you certain projections or other forward-looking statements regarding future events or its future performance. E*TRADE Financial cautions you that certain factors, including risks and uncertainties referred to in the 10-Ks, 10-Qs and other reports it periodically files with the Securities and Exchange Commission could cause the Company's actual results to differ materially from those indicated by its projections or forward-looking statements.

This call will present information as of July 19, 2006. Please note that E*TRADE Financial disclaims any duty to update any forward-looking statement made in the presentation.

In this call E*TRADE Financial may also discuss some non-GAAP measures in talking about its performance. You can find a reconciliation of these measures to GAAP in the Company's press release, which can be found on its website at www.etrade.com.

This call is being recorded. Replays of this call will be available via phone, webcast and by podcast beginning at approximately 7 pm ET today through 11 pm ET on Wednesday, August 2. The call is being webcast live at www.etrade.com. No other recordings or copies of this call are authorized or may be relied upon.

I will now turn the call over to Mitchell Caplan, Chief Executive Officer of E*TRADE Financial Corporation, who is joined by Jarrett Lilien, President and Chief Operating Officer; and Robert Simmons, Chief Financial Officer.

Mitch Caplan

Thank everyone for joining us today. Just over three years ago we set out to redefine our target market and measure the corresponding opportunity ahead of us. While many questioned us at the time, we strongly believed that running monoline brokerage or bank businesses was not the best approach to truly connect with the retail customer and deliver long-term shareholder value.

We believe that the right model was to create complete integration between brokerage and bank, and then to run the entire company off of an integrated technology operations and service platform globally.

By doing so, we believe that we would eventually create a franchise that would generate a high return on each incremental dollar of revenue, irrespective of whether it was from trading, assets, cash or credit. We have spent the last three years executing on this strategy and today we're there.

The model has clearly reached an inflection point, generating superior returns for shareholders by delivering value to customers through relevant, value-based financial solutions in any given macroeconomic and geopolitical environment.

Getting to this point required hard work and some tough decisions. We evaluated our model and the strength of our value proposition to ensure that we were well-positioned within the global financial services marketplace. With respect to the model, we realigned our operations and management structure around customer segments. Further, we divested or exited non-core businesses, improving consolidated profit margins and allowing us to focus on building our core franchise.

We took the improved profits of the Company and delivered enhancements to the financial solutions for our customers, and value to shareholders through earnings growth and additional share repurchases, translating into improved return on tangible equity.

With respect to enhancing our value proposition, we took a multi-step, multi-year approach. We first focused on price to get back in line with the competition and to begin to differentiate based on our customer segmentation strategy. Over the past few years we have adjusted pricing across cash, credit, investing and trading products. We did so in a way that ensures we deliver compelling value on a product by product basis, and in the aggregate through bundled offerings.

The changes we have made more effectively align value with client engagement, rewarding customers for increasing asset levels, transactional activity, and overall revenue contribution to the Company. We continue to feel very good about how we are positioned on price.

We then turned to functionality and made significant enhancements across our entire suite of products. These enhancements culminated in the launched of E*TRADE Complete, which now includes a set of industry-leading tools designed to help customers optimize their investing, trading, banking and lending relationships.

Having significantly strengthened our value proposition around price and functionality, we most recently increased our focus on the third component of the value proposition: service. As we stated just last quarter, we are investing an additional $42 million this year to enhance our service organization and to significantly increase quality levels. This investment is integral to a series of initiatives we have launched to lower attrition levels, increase overall account quality, and ultimately build a stronger franchise.

We also recognized that to deliver consistent and superior performance we must maintain an operating structure that is flexible in the short term, without sacrificing our long-term growth opportunities. The flexibility of our operating structure and the relevance of the suite of products it supports proved itself during a highly volatile second quarter.

During this past quarter, broad macroeconomic and geopolitical concerns, such as inflation, rising interest rates, oil prices, and continuing conflict in the Middle East caused instability throughout the world's markets. The Dow Jones Industrial average hit a six-year high only to give back all of its gains for the year. Emerging market indices, which had significantly outpaced the U.S. for some time, fell precipitously.

Investors quickly looked to reduce risk in their portfolios and eventually stepped away from the market, resulting in a sharp industry-wide decline in June trading activity.

At the same time, we saw high volatility in the fixed income market with the yield curve steepening in early in the quarter and then inverting by mid-quarter. We saw customers begin to look at cash as an offensive investment option, and deployed excess liquidity into deposit products in search of a safe haven with an attractive return.

While our model enjoy all the leverage and operating benefits during a strong economic environment, it is precisely in these volatile macroeconomic conditions that we outperform and stand out within the industry.

While many in the financial services sector struggled in the second quarter, we generated top line growth while reducing total operating expenses. This combination translated into another quarter of record earnings and operating margins.

Total revenue increased to a record $611 million, driven by continued growth in cash and credit relationships, as an offset to declining trading volumes. Through greater scale and efficiencies, core operating margin, excluding acquisition-related integration expenses, was steady at 44%. Including these expenses, increased to 43%, well on its way to our goal of 50%.

Pre-tax income increased to a record $242 million, including approximately $8 million, or $0.01 per share, of deal integrated related expenses as we have previously guided.

On the bottom line, we delivered record earnings of $0.37 per share, excluding these integration expenses, or $0.36 per share on a GAAP basis. Our model was tested once again, and it differentiated itself once again; this time, by performing in highly challenging global economic conditions. We remain extremely pleased with the performance of the business and its ability to deliver these superior results.

As we continue building our franchise globally, we will focus on strengthening the banking, lending and investing components of our value proposition. Delivering relevant and timely financial solutions to the tens of millions of global wealth-building customers will drive organic growth in accounts, deeper customer engagement, and increased total profitability of the model.

We will also continue to seek consolidations and partnerships within the global financial services marketplace when we see an opportunity to turbo charge these growth initiatives.

Now, to provide further details on the success of our operations and the specifics of the quarter, I would like to turn the call over to our President and Chief Operating Officer, Jarrett Lilien.

Jarrett Lilien

Thanks, Mitch. As we always we say, at the center of our business is the global retail customer. Through our integrated model, each action that we take in executing on our plan is designed to enhance the customer experience, drive further customer engagement, and then propel retail results that can be leveraged through our institutional segment to fully maximize shareholder value.

So, how did we execute in the second quarter? In a volatile market filled with uncertainty, as Mitch described, we generated superior results, while at the same time successfully completing the account conversion of BrownCo in early May.

Net new account additions increased 58% versus the year ago period to 41,000. This increase was driven through a combination of new customers and broadened engagements with existing customers. We are pleased with the continued growth in our Mass Affluent and Active Trader segments. In fact, the account growth within these segments is trending at a 30% annualized rate. More importantly, we drove this net new account growth despite the heightened pace of attrition to be expected as we move through the final phases of the Harrisdirect and BrownCo integrations.

We also saw the highest level in three years for new deposit and lending account openings, precisely what we would have expected to see in an environment with increasing focus and attention on cash and lending products. One of the clear benefits to us of the changing market dynamics is the interest in cash as a deposit product. Balances in our deposit products increased by $1.7 billion this quarter, as customers begin taking advantage of the higher returns in a rising rate environment. Sweep was up $400 million. Transaction accounts were also up $400 million. Certificates of Deposit were up $900 million.

As the market turned lower, we saw customers proactively deploying excess liquidity into deposit as an offensive portfolio move. Customers also continued cash accumulation across our deposit products. On a gross basis, enterprise customer cash increased by approximately $1 billion in the second quarter.

Against this gross increase were two anticipated offsets. The first was seasonal outflows of approximately $250 million related to taxes. The second was approximately $400 million of outflows related to model deal attrition from the Harrisdirect and BrownCo transactions.

Considering the impact of these two factors, our $1.7 billion in new deposits and our $300 million of net new enterprise cash growth demonstrates that we continue to be a destination for our customers' cash.

Having developed an integrated, cost-effective model that anticipates and delivers timely and relevant solutions to our customers' needs, we stand uniquely positioned to benefit from customers' increased focus on cash products. Just as we believed several years ago that cash products would become of greater interest as a form of asset allocation, we are now entering a period where we believe compelling lending solutions will gain greater attention.

In discussing our credit solutions, we delivered another quarter of solid balance sheet growth, with average interest-earning assets increasing by $2.7 billion, or about 7% sequentially. We accomplished this while continuing to adhere to the same strict discipline the bank has employed for the last 17 years with respect to both interest rate and credit risk management.

As a result of our ability to grow the balance sheet in the current rate environment, we were able to take advantage of rising rates on credit products, funded by growth in customer cash balances. While many of our competitors saw compressing interest rate spreads, the average yield on our assets increased by 31 basis points sequentially, while the cost of our liabilities increased by only 26 basis points. The result: a 5 basis point increase in our net interest spread.

By leveraging technology and our integrated balance sheet, we see a unique opportunity to create and deliver interesting, value-oriented credit products to retail customers. The launch of our Intelligent Lending Optimizer earlier this year is a perfect example. We will use technology solutions like the Optimizer to drive greater awareness of the credit products we offer, thereby helping customers to more effectively manage their borrowings.

By having the vision to stay ahead of the curve, we will continue to offer the most relevant value proposition.

In our investing solutions we continue to execute on our strategy on multiple fronts. We furthered our Regional Advisor initiative with the announced acquisition of Retirement Advisors of America, an investment advisor with over $1 billion in assets under management. This transaction enforces our commitment to providing a full continuum of services to our customers as they build wealth.

We also continued to deliver on our promise of being a customer advocate. In the second quarter, we made our largest rebate of 12b1 fees, putting nearly $2 million in the pockets of our mutual fund investors.

In trading, volatility in the equity markets resulted in a general slowdown across the industry. Although total DART volumes declined 9% sequentially in the second quarter, they doubled over the year ago period through the benefits of continued growth in accounts, both organically and through acquisitions.

International trading activity continued to outpace domestic volumes, actually increasing 5% sequentially. Our international operations continue to be a strong growth contributor within our retail trading business, and over time will become a significant contributor across our entire model.

Through the success we are experiencing internationally, we are now looking to extend our banking and lending solutions into many of those markets. An additional positive trend embedded in our trading results was the out-performance of option volumes relative to equities. Option-related DART further increased as a percentage of our total U.S. DART volumes to represent 12.4% of volumes versus 12.2% last quarter, and 10% a year ago.

Continuing our leadership in trading functionality, we announced this morning a set of enhancements to our retail platform for both equities and options. Within these enhancements we have added a series of conditional order types, such as trailing stops for options.

These new features will allow customers to employ hedging strategies or simply allocate their investing dollars among the most attractive investments, given evolving market conditions.

Features such as these and our order execution quality, which was recognized earlier this year by an independent research firm as one of the best in the industry, are reflective of our view that the battle continues to be less over price, and more over functionality and service.

Finally, I would like to provide a quick update on deal attrition. Given that we have fully completed the conversion and integration of both Harrisdirect and BrownCo, we believe that we have passed the peak attrition period for both transactions. This will be our final update to these attrition statistics, as both customer bases are now fully integrated into our core.

As of June 30, economic driver attrition had flattened out at 10% for Harrisdirect and 5% for BrownCo. We're very pleased with both outcomes, given that our modeled accretion for each transaction assumed 15% economic driver attrition.

Further, we were pleased to announce that we have now achieved over 98% of the expense synergies related to these transactions. This is ahead of the original timeline, and coupled with a lower attrition level, a key contributor to the strength of our customer metrics and our economic out-performance through the first half of the year.

With that, I will turn the call over to Rob for the financial details of our results.

Rob Simmons

Thanks, Jarrett. Our continued run of record results builds on our first quarter momentum, our execution within our core model, and on the integration of our acquisition. During the quarter, we remained focused on execution, driving top line growth while managing expenses.

Proving that flexibility and benefit of multiple revenue touch points with customers, second quarter total net revenue increased 2%, or $13 million sequentially, to a record $611 million. We delivered this increase despite an $8 million decline in retail commission from weaker trading volumes, consistent with the industry.

Retail commissions represented 21% of total net revenue, down sequentially from 23% in the first quarter. Net interest income after provision increased 6% sequentially to a record $334 million. The increase in net interest income was the result of both a larger balance sheet and further net interest spread improvement as we benefited from higher asset yields, continued growth in customer cash, and strong credit metrics.

Net charge-offs declined to 15 basis points from 18 basis points in the prior quarter, a proof point of the high credit quality and conservative product mix of our portfolio. Mortgage and home equity products receivables increased, as did margin debt balances, while the consumer loan portfolio continued to roll off as planned.

Looking at expenses, we continued to exercise prudent control and deliver efficiency across our operations. Total operating expenses, excluding corporate interest, were down 1.1% sequentially to $351 million. Included in the expense base was approximately $8 million of acquisition integration-related expenses as previously outlined. We continue to expect these deal-related expenses to remain about $0.01 in the third quarter before dropping to zero in the fourth quarter, for a annual total of $0.05.

Through efficiency and cost control, each of our operating expense line items were flat to down as a percentage of revenue in the quarter, demonstrating the leverage in the model.

Compensation and benefits increased $9.7 million, but still held at our target of approximately 20% of revenue. This increase was primarily the result of the additional salaries from our planned service investment of approximately $8 million in the quarter.

Marketing spend was down just over $4 million quarter-over-quarter to $30.4 million, remaining consistent with the range set forth in our original guidance. We will continue to prudently allocate the marketing spend among our suite of products in relation to current market dynamics.

In this past quarter we continued to invest in marketing areas such as cash and credit solutions to wealth-building customers and in international markets, while reducing our spend for domestic trading solutions.

With revenue up 2% and total operating expenses, excluding corporate interest, down 1%, operating margin expanded to 43% from 41% in the prior quarter and 36% a year ago. In addition, we achieved a new milestone this quarter, generating over $300 million in EBITDA for the first time in the Company's history.

Also, during the quarter, we were pleased to learn that our improved profitability and demonstrated stability of the model has been recognized by Moody's Investors Services, a leading credit rating agency. Moody's upgraded our bank credit rating by two notches to investment grade, and also upped our corporate rating by two notches. This marks an important acknowledgment of the progress we have made as a Company.

The broad-based market volatility in the second quarter provided a window for us to opportunistically continue with our share repurchase program. During the quarter, we purchased in the open market approximately $48 million of stock, or about 2 million shares, at an average price of $23.79 per share. After this purchase activity we have $131 million still available on our Board-approved share and debt repurchase program. We will continue to balance leverage targets and growth opportunities against the value created by buying back our debt and equity securities.

Finally, as we typically do at this point in the year, we have gone back and revisited the key driver assumptions and bottom line earnings forecasts that we established previously. Given the strong performance we have delivered year-to-date, and taking into consideration the current trends we are seeing, including the final deal attrition levels, we are comfortable raising and narrowing our guidance range at this time.

We are raising the low end of the previous range by $0.07 and the high end of that range by $0.02, thus tightening the overall range to our new EPS outlook of $1.42 per share to $1.52 per share. This range excludes the expected $0.05 in deal-related integration expenses that we previously outlined. Including these expenses, we now expect to earn between $1.37 and $1.47 in GAAP EPS. A table containing the revised range for each of the key earnings drivers is included in today's press release.

In conclusion, we are pleased with the Company's performance and our model's flexibility through volatile market conditions. We remained focused on building an integrated, global franchise to deliver superior shareholder value over the long term.

With that, operator, I would like to open the call to questions.

Question-and-Answer Session

Operator

Our first question comes from Rich Repetto - Sandler O'Neill.

Rich Repetto - Sandler O’Neill & Partners

Congrats on a nice quarter. Mitch, the first question is on the cash side. I can see the benefit of the $1.7 billion increase in the deposits. On the cash it says including money market funds, that is the side where it looks like it decreased. I'm just trying to see, where would we see the impact there of a cash decrease? In fees or where? I'm trying to just understand how the cash here drives the income statement.

Mitch Caplan

You're right. As you see it move over onto the balance sheet as a deposit product, it shows up in net interest income, and it is part of spread. Then to the extent that it is just fees that we are receiving on third-party cash that is going out or otherwise, that may show up in fees. Then there's also a part that gets consolidated on our overall consolidated balance sheet separate from the bank, which would show up in net interest income as well.

Let me bridge you through the quarter, because I think it will help.

One of the things that we were able to do was bring over $1.7 billion onto the consolidated balance sheet. That was meaningful in helping drive the 5 basis point increase in spread in the quarter. By and large what you saw was about 31 basis points up on asset yields and about 26 basis point up on cost of funds, which resulted in the 5 basis point spread.

Part of the reason why you were only up 26 basis points is because you were able to grow that cash on the balance sheet, which is very cost-effective for us, not only from a rate perspective, but also obviously from duration characteristics, as we have talked about.

When you think about enterprise cash, that is the overall cash balance that came in. We brought in I believe about $800 million about three or four quarters ago. Then it was $1 billion, $1.6 billion. This past quarter it was about $1 billion when you look at the organic number. Then we lost about $250 million, which we typically lose in a quarter related to tax and tax payments. Then we had excess attrition in the quarter related to Harrison Brown, which accounted for another $400 million of outflow that you wouldn't otherwise expect to see.

So as you look at our earnings guidance that we just gave you for the year at $1.42 to $1.52 and you look at the enterprise cash, what you will see is embedded in those numbers is that we presume in the second half of this year on the low end we will bring in somewhere about $1.7 billion in new enterprise cash; and on the high end, about $3.8 billion.

Given what we have historically seen over these last four or five quarters, given what we're currently seeing in the marketplace in terms of levels of interest in cash as a product, I think we feel very comfortable with those ranges.

To the extent the opportunity is greater, and we exceed them, then we will come back and revisit again at the end of next quarter. But given what we are seeing now, I think we put a prudent range around the enterprise cash for the rest of the year.

Rich Repetto - Sandler O’Neill & Partners

Your fees increased in every category as well.

Mitch Caplan

Yes, absolutely.

Rich Repetto - Sandler O’Neill & Partners

The next question is, and I think I know the answer from Jarrett's prepared remarks. On the expense side, if you look at all of the expenses for marketing, professional services, communications and the other expenses, you were down $18 million in aggregate quarter-to-quarter. That is the indication of the faster integration?

Mitch Caplan

That is right.

Rich Repetto - Sandler O’Neill & Partners

Now we do see an offset with comp going up. Is that the increase of headcount on the service side?

Mitch Caplan

It is. It absolutely is. So there are two numbers, if I remember correctly, that went up in the absolute, quarter-over-quarter. One was comp and benefits, and the other was the servicing expense. Obviously, in the clearing and servicing as the size of the balance sheet grows, you have more servicing expenses because your absolute dollars are growing on balance sheet, so that is an increasing number. Although I think we're continuing to gain efficiency with that number, both around the percentage of revenue, as well as the actual costs associated with servicing.

On comp and benefits, when we guided at the end of Q1 to our numbers, we said we were going to make an additional $42 million investment in service this year. $8 million of that is showing up this quarter, and it is showing up really in the comp and benefits related to service.

The other $1.7 million, for the total of $9.7 million, is really frankly related to bonus accrual. We're doing quite well as a Company and we are continuing to accrue bonuses accordingly.

Rich Repetto - Sandler O’Neill & Partners

You mean you're not pulling back bonus accruals this quarter? That's a joke.

Mitch Caplan

No, we are accruing based on performance.

Rich Repetto - Sandler O’Neill & Partners

There is all this attention right now on people shopping, with the interest rates where, on higher cash rates, moving deposits around. It seems like you were focused on cash awhile back. I'm just trying to see the positioning of E*TRADE as an enterprise, integrated financial service as people do get more cognizant of cash and the rates. How do you think the end results will be for you?

Mitch Caplan

I hear you completely. I think you're right. Hopefully we were ahead of the curve. We started talking about cash a couple of years ago. I believe that the next real interesting opportunity is not only with cash going forward, but also on the credit side. I think you're going to be able to see us, over the long term, continue to be in a place where we benefit from not only engagement with customers around cash and what that cost of funds is for us, but as well engaging with customers in the growth around credit products. We're starting to see it already. You see it in the size of the balance sheet, the growth this quarter in margin, the growth this quarter in whole loan products.

But independent of that, I would say our view has always been that this value proposition you create has lots of different components. One of them is price. One of them is functionality. One of them is service.

In a rising rate environment we have typically -- in the old days as a bank and now as a consolidated enterprise -- do better, because customers begin to focus on cash as a more interesting and unique product. What you will find is people have different behavior for different parts of their cash.

There's a part of the cash which is invested at all times, and there's a part of the cash that is uninvested. Uninvested typically fits in types of accounts like Sweep or Free Credit. Interest rates matter; they matter less when it is their invested cash and they are growing a bigger part of their overall allocation in cash because of the uncertainty of the market, at that point value and rate matters more. So you see more growth in things like certificates of deposit and money market accounts.

But as you look across all of our products I think we have done a very good job of being able to -- again, it is a rising rate environment. We did see cost of funds go up, but they went up 26 basis points against an increase on the asset side of 31 basis points.

You'll notice that in the guidance for the second half of the year, we said spread could be anywhere I think from about 285 basis points to about 300 basis points. I believe that was the range that we gave. So we said, given that we're currently at 291 and we see opportunity going as high as 300, so you could be up another 9 basis points. But we also said there's some chance that if we want to take advantage of a tremendous opportunity in the marketplace to grow cash, and we see that in products like money markets and/or CDs, as long as they are products that we're selling to our current customers.

This past quarter, one of the things that we saw was the growth in all of our deposit accounts. 75% or 80% of them were related to cross-sell. It was growing cash products by engaging with our existing customers and adding to the balances as well.

Again. it is people who are interested in having that holistic relationship, an entire relationship with us as opposed to somebody who simply is just putting cash in for the rate at this moment in time.

Rich Repetto - Sandler O’Neill & Partners

Great. If you could just tell Rob, we're ready for the second half of his guidance, which has a net revenue, the income and everything else that was in the previous guidance, if you remember. I am just joking. Thanks. That is all I have.

Mitch Caplan

Touche.

Operator

Our next question comes from Matt Snowling - Friedman Billings.

Matt Snowling - Friedman, Billings, Ramsey

Great quarter, guys. I just wanted to follow-up on the question on cash, and you may have answered it. Given the conditions of the market I'm surprised that you only had about $4 million of cash sweeping into the bank. Does that mean that the customer is actually going out and searching for higher rates?

Mitch Caplan

Actually, what happened is, what you're seeing is the net result of all the activity in the quarter, so you're absolutely right. What you would have traditionally seen as a couple of billion dollars -- I think it was as high as $1.7 billion or $1.8 billion -- that initially went into Sweep. Then, from Sweep some of it stayed there, and some of it moves into other areas like the transactional accounts like money market, CDs and otherwise.

The idea as you saw I think $1.7 billion in growth in overall deposits. And you're right, a portion of it was in Sweep. I think it was $400 million that was in Sweep. It may have been a bigger number, and then you may have seen some of it reallocate.

Matt Snowling - Friedman, Billings, Ramsey

Is this really driven through the Cash Optimizer product that you have?

Mitch Caplan

100%.

Matt Snowling - Friedman, Billings, Ramsey

Okay, great. You guys mentioned some opportunities on the international front. I was just wondering if you could go into a little bit more detail about particular markets or maybe products that may be interesting at this point?

Mitch Caplan

I think there are two things that we're trying to attack in tandem. The first is our core businesses in both Europe and Asia. So we really operate out of the UK. We passport into most of the other European countries out of a central location from our UK operation in London. Then the second is Asia, where we pretty much do the same thing from our Hong Kong base.

In each of those, I think we have talked in the past, we're surprised quite frankly; not only were you seeing growth in daily average revenue trades -- and I think Jarrett touched on that in his comments, where you saw in the quarter a 5% increase in daily average revenue trades internationally, while you saw a decline on the U.S. side.

I think we're up in daily average revenue trades about 80% or 82% year-over-year and that is obviously not impacted at all by the acquisition, since there are no revenue trades coming from the international locations as a result of either Harris or Brown. So that is just the pure growth there.

Independent of that, we discovered that we had $1 billion and growing of cash. One of the first things that we have begun to do is market U.S. dollar-denominated cash as a product in both our core European and Asian locations. You are beginning to see growth; as it gets to be a bigger and bigger number, we will start to break it out separately for you.

At the same time, we believe that the right way to run the overall business -- and that is what I think Jarrett was talking about in his comments -- is you'll see us in both Europe and Asia, by way of example, having a balance sheet. So you're not only engaging in just cash, but you're engaging in cash and credit. You're putting it on a balance sheet. Each of those balance sheets in Europe and Asia will consolidate into one global balance sheet.

We believe that there is interesting opportunity for growth there. I suspect you'll hear more about that as the we give guidance for 2007 later this year.

Similarly, we are approaching sort of a different tact around the emerging markets. We think that there is an interesting opportunity for us in our business model in places like India and China and the Middle East. It is a situation where we would do it a little differently, likely with a partner. And again, I think we will talk more about that as we give more specific guidance for 2007 later in the year. But it is an avenue that is interesting to us.

On top of all that, I guess it wouldn't be shocking if the opportunity presented itself to look for consolidation or partnership opportunities, whether it is in the emerging markets or Europe or Asia.

Matt Snowling - Friedman, Billings, Ramsey

Great, thanks.

Mitch Caplan

Absolutely.

Operator

Our next question comes from Mike Vinciquerra - Raymond James.

Mike Vinciquerra - Raymond James

Good afternoon. I want to just clarify back on the cash growth question, you did $1 billion this quarter net of the two what we think are one-time items. You're looking for $1.7 billion to $3.8 billion. Am I looking at that correctly? The right comparison there is net of any loss of money market mutual funds that we saw this quarter?

Mitch Caplan

That's right.

Mike Vinciquerra - Raymond James

Fair enough.

Mitch Caplan

That's exactly right. I guess on the low end it would be whatever it is, $1.7 billion $1.8 billion for the second half of the year; $850 million a quarter. On the high end at $3.8 billion you would see us back at the $1.7 billion or something that you saw us at in the prior quarter.

Mike Vinciquerra - Raymond James

Thank you. Two questions on the bank balance sheet, I guess. When I look at CD balances rising so sharply in the quarter, what is the strategy there? Are those brokered CDs? Are those coming in through your own retail channels? What was the driver?

Mitch Caplan

Yes, they are pure retail. They have nothing to do with broker. They are coming in entirely through our own channels. Rob is showing me the number, so that I get it right. About 77% of the CDs, as well as the other deposit products, came as a cross-sell from our current customers.

Mike Vinciquerra - Raymond James

Fair enough. One question I did have on the balance sheet, when I look at your interest, repurchase agreements are the second-largest funding source you have in there. Also, according to the stats that you guys released, your most expensive funding source. I'm just curious why are they such a big percentage? Is there a way to reduce those? Is it really that you're going to drive the customer cash so that you can then slow the utilization of repos and bring your average cost of funds down?

Mitch Caplan

First of all, I know this frustrates you and I understand it, and it frustrates me. But when you look at the face of the numbers it is hard to understand what is the most or least expensive cost. Because you may, for example, have disproportionately attached some of your hedges to your reverse repurchase agreements, making them look more expensive than, for example, a federal home loan bank advance or borrowing.

So you can't automatically assume that your reverse repurchase agreement is in fact more expensive than your FHLB. I think it is a practical matter, Mike Leschak who runs our Treasury Group, is constantly managing what is most effective way for us to borrow. Is it a federal home loan bank advance, or is it a reverse repurchase agreement with The Street?

The more important question that you asked is, can we continue to grow cash and can we continue to take down what we view as wholesale borrowings, which would include reverse repurchase agreements and FHLB advances? The answer is yes. A year ago, I think it was about 50% that our deposits were bore to the percentage of our total interest-bearing liabilities. Now we are at about 63%. Our stated goal is to move to 70% and then go beyond that.

Mike Vinciquerra - Raymond James

Thank you. Just for modeling purposes, on the tax rate, around 35% the last couple of quarters. Is that a good rate to use, Rob, going forward?

Rob Simmons

Yes, I would say it is going to be there, or maybe a little higher. Again, it depends on the mix of where the incomes is derived. Again, we benefit a little bit as income is derived internationally. You saw that on a relative basis international was strong in the second quarter.

Mike Vinciquerra - Raymond James

Thanks very much, guys.

Operator

Our next question comes from Richard Herr - KBW.

Richard Herr - KBW

Good afternoon. Just a quick follow-up on Mike's question on the tax rate. Does the new guidance assume a 35% or does it assume a 37% as we had in the prior guidance?

Rob Simmons

We didn't specifically comment on rate, but you've got the right range there. It is going to be in the 35% to 37% range.

Richard Herr - KBW

Maybe we can get an update on the consolidation of the bank and broker balance sheet. I think it either was the last call, or maybe it was the Investor Day, we had spoken about it sometime during the summer.

Mitch Caplan

Yes, happy to do it. Nobody asked and we didn't give an update. Again, we said sometime during the summer. We continue to remain very comfortable with that. I think a couple of points I can probably give you that will perhaps give some guidance in how we're looking at it.

Number one, again, we are through the process and the discussions with all the regulators. At this point we feel very comfortable with the guidance that we gave around the summer. More importantly, as we just upped our guidance for the rest of this year, tightened it and upped our guidance, I think a part of that is just we are seeing a lot of engagement from our core customer base.

Again, Jarrett talked a little bit about this. We are seeing improved growth rates in the Mass Affluent customer. It is growing at about a 30% rate, and so you are seeing a lot of that translate through into the actual performance around revenue per customer and earnings and all of those metrics. So we felt good about that.

We felt pretty good, obviously, about the attrition level. We beat both of them with respect to both Harrisdirect and Brown. Included in our guidance is an assumption, obviously, that we are going to get clearing under the bank. Should we not for any reason, we have a plan B, and that plan B gives us the economics that again makes us completely comfortable with the guidance that we're just given you. So we don't see any risks to that. But embedded in our guidance that we just gave you is the assumption that we will be fine with respect to this goal.

Richard Herr - KBW

That's great. Thank you for the update there. One topic that hasn't come up in a bit is consolidation. It seems like everybody is focusing on the summer slowdown and has stopped talking about it. Mitch, what do see as the opportunities on the horizon? Has there been anymore discussions since the last round last year or two years ago about people looking to pair up?

Mitch Caplan

I think it is fair to say that in general it would be unrealistic for any of us to not recognize the value that has been created through consolidation. Clearly, I suspect Ameritrade sees it in connection with some of their numbers, and what they're looking at with respect to TD Waterhouse.

Clearly you are seeing the benefit for us both in the current out performance in the first half of the year and now what we have guided to in the last half of the year. That is a piece of it, as you look at both Harrisdirect and Brown. With Swab, anybody in the marketplace, there's no way to avoid that there is economic value associated with consolidation.

So my guess is that when you look both here and abroad that there will be continued consolidation in the future. I really believe it. I'm not going to put a timeline on it, but I do believe that the opportunity exists and I think it probably will occur.

Independent of that for us is also what are the other avenues that are interesting? What are the other pieces of our model where we believe we can turbo charge that growth and continue to deliver the kind of outpaced performance that we're delivering this year as a result of really strong core economics, as well as any other smaller consolidations that we may do.

Richard Herr - KBW

Thanks for taking my questions, and congratulations on a good quarter.

Mitch Caplan

Thanks a lot, I appreciate it.

Operator

Our next question comes from Prashant Bhatia - Citigroup.

Prashant Bhatia - Citigroup

Just a quick question on expenses. You mentioned you are done with merger-related synergies on the expense side?

Mitch Caplan

We are at about 98%. I think one way to think about being fully done is, Rob just guided to $0.01 next quarter of integration-related expenses or deal-related expenses. I think once we get through that quarter you would be done, and you would have seen the full value.

Prashant Bhatia - Citigroup

So when we look at it, we take the expense base we have right here, the $351 million, back out the merger-related charges, you have some restructuring charges in there as well -- $340 million or so is the run rate we should assume going forward?

Mitch Caplan

Yes. The only thing that would obviously change that is you have some variable expenses based on the overall performance of the business. Secondly, it does not presume that we continue to look for cost efficiencies in the business, which I think we will always do.

Prashant Bhatia - Citigroup

Great. And then in terms of growing the balance sheet, I guess your guidance now shows period end assets getting to about $50 billion?

Mitch Caplan

Yes, I actually think it may be average.

Prashant Bhatia - Citigroup

Okay, you're getting the average. So the period end could be even higher.

Mitch Caplan

Yes.

Prashant Bhatia - Citigroup

When you think about the deposit growth numbers that you have put out, should we be assuming you get to a 30% wholesale fund rate by the end of the year, or is that too early?

Mitch Caplan

Directionally you are correct. It may be a little more than 30%, a little less than 70%, but you're continuing to move in the right direction, absolutely. It is a great way to think about it. That is how I think about the model.

Prashant Bhatia - Citigroup

Just finally, I think you purchased a couple of RA firms, you have one more pending. How much success are you seeing in getting some of the E*TRADE customers to use these RAs?

Jarrett Lilien

We are seeing a lot of success. Measuring it right now with a few advisor firms, the percentages look unbelievably great, but we're starting from a small base. But it is directionally exactly what we want. It is proving out the whole model that we're looking to build out this regional network.

What we are seeing is that we're getting leads from both directions. We're getting leads from the E*TRADE customer base that we are being able to hand over to our advisors. And likewise, the advisor customers that we required are starting to engage and utilizes E*TRADE product that we're producing. So far it is very, very encouraging. But as you said, still early days and still something that we're building on.

Mitch Caplan

The other thing I might point you to, just in terms of the absolute dollars, is if you look at the P&L, and you look at some of the other revenue, you can begin to see it growing. Typically in the other revenue category part of the growth you'll see is from the fees related to the service charge and fees line; you can see the growth from quarter over quarter. Part of that growth is due to the fees that are coming out of the advisor business.

That would be on top of the run rate that was already embedded in there when we acquired them in the prior quarter. So you are beginning to see more growth in fees. A lot of those these are coming from the referrals that Jarrett is talking about, that we begun to make from our customer base in those regions to those advisors.

Prashant Bhatia - Citigroup

The RA business, the revenues are booked in service charges and fees, and we should look for that to grow as the business grows?

Mitch Caplan

That's correct.

Prashant Bhatia - Citigroup

Thank you.

Operator

Our next question comes from William Tanona - Goldman Sachs.

William Tanona - Goldman Sachs

Good evening, guys. On the net new broker banking accounts, obviously they have been pretty strong in the last two quarters. You touched upon this a little bit in terms of talking about the CDs. But can you give us sense as to what percentage of those net new accounts or new openings are coming from outside investors or new investors? What percentage is coming from previously or heritage E*TRADE, and then what percentage is coming from either Brown or Harris?

Mitch Caplan

That is the mix. About 77% of them are coming from our current customer base. About 23% are coming from outside as new customers entering into the system on a stand-alone, pure banking and lending. Of the 77%, I can't give you the exact percentages, but I looked at the numbers the other day. There is a disproportionate growth in these last two quarters.

In both this past quarter and the prior quarter coming from both Harrisdirect and BrownCo customers engaging around, not only their core investing account and trading, but also beginning to open the bank accounts which they are using for their cash management product.

William Tanona - Goldman Sachs

That is helpful. You also mentioned that you are 98% of the way through on the expense synergy side. Can you give us sense as to where you stand in total overall synergies for both Brown and Harris?

In terms of thinking about prioritization, consolidation obviously is one, but what other are your key growth areas that you're focused on? How would you prioritize consolidation, international growth versus domestic growth?

Mitch Caplan

First of all, let me answer your question about the two deals. The synergies that we guided to were obviously both expense synergies and revenue synergies. On the revenue side, they were driven by things like balance sheet consolidation, both margin as a product as well as cash as a product, and then trading.

Independently, on the expense synergies side it was across the board in almost every category: comp and benefits, professional services, literally across every one of the categories. We indicated that we were about 98% of the way, as you just pointed out, on the expense side. On the revenue side we're there and actually ahead of plan.

The reason that you know that we're ahead of plan is because we didn't assume that there would be any additional engagement when we initially gave guidance around each of these deals. We just assumed that whatever was on balance sheet from those customers around cash and credit would be moved onto our balance sheet, and we would optimize it.

You have actually seen not only that get moved over and optimized, you've also seen additional engagement, which has driven more revenue synergies than we obviously would have guided to at the time at which we did the deal.

The last piece would have been around our market-making operations and bringing over order flow. In this past quarter, actually one of the things that was surprisingly strong for us was our institutional business. If you look at our numbers, I think our commissions were down overall by about 5%. Retail commissions, which really are disproportionately the largest part of it, were down 6%, but institutional was only down 1%.

When you look at principal transactions it is up, because our market-making business was stronger, (a) as a result of some international operations that we're beginning to realize there and the value around that, as well as around the full internalization of BrownCo this past quarter.

I don't know if that helps you think about where we are, but we believe that we're complete with the conversions and the integration of Harrisdirect and BrownCo. As Jarrett said in his comments, they are a part of our Company now, and we just think about continuing to grow the business organically. We think there's a lot of opportunity, both domestically as we have repositioned ourselves to be more of a focused player with those customers who are building wealth; 44 million households in the U.S. alone. So we're attacking that first and foremost.

But we also think that over the long term -- meaning over the next two to five years -- there's a huge amount of opportunity on the international front. It is competitively in a very different place than where the U.S. is. Most of our direct U.S. competitors have withdrawn from their international operations. We stayed firm. We have turned the business into one that has actually become quite profitable. The top margins have improved pretty dramatically. It is something that we would look to use as a very strong growth vehicle in the next two to five years.

William Tanona - Goldman Sachs

That is very helpful. Thanks. And then lastly, in terms of opening of new offices, new centers, how should we think about you guys growing those going forward over the next 12 months? How should we think about the profitability? How long does it take for those to become profitable, on average?

Mitch Caplan

I think as we entered the quarter we were at about 16, if I remember correctly, 16 or 17. We opened three. Then we went from 17 to 20, so we now have about 20. Typically, it runs us anywhere from $300,000 to $500,000 on an annual basis to run one of these. $300,000 would be a branch in a city where the square footage is a little smaller. $500,000 would be a branch in a city where the square footage is a little bit larger. What we are demanding and what we are seeing is payback in under 18 months.

William Tanona - Goldman Sachs

Great, thank you.

Operator

Our next question comes from Patrick Pinschmidt - Merrill Lynch.

Patrick Pinschmidt - Merrill Lynch

A quick question on total client asset growth. Last quarter you mentioned that ex the market appreciation, total client assets grew 14%. Can you give a similar metric for this quarter, ex the market depreciation?

Mitch Caplan

You know what, we have been working on trying to create, which we want to add to the metrics, just a flow number because we think it is the right thing to do. You will see it next quarter. By next quarter you will see an absolute flow report which shows you exactly that.

Part of the problem with assets and the movement in the value of the assets; Jarrett and I both are convinced that there is a huge value to our Corporate Services Group. The reason that is a case is that when you look at the sheer volume of both number of customers and the value of both the vested, in the money options and the unvested, in the money options, it is a huge number.

We have been extremely successful in these last five quarters at growing cash from those customers, and then retaining that cash, and then ultimately using that as a point of entry for our customers to do other things with us across the business. That is the good news.

The bad news is, as you well know, it is a very volatile number based on what is happening in the underlying equities market. In this particular quarter, 15% of our overall assets are coming from the vested and unexercised options, and those were down 17% in value. It disproportionately drops the overall value of where we are, or can do the same thing to the upside on the assets.

So we sort of look at it just as a feeder and an opportunity out there. But we recognize that what we really need to get this report to everybody publicly around flows. You will see it next quarter.

Patrick Pinschmidt - Merrill Lynch

Great. Then in terms of employee headcount, full-time employees were up 8% during the quarter. Does this relate primarily to the compensation expense investments you have been making?

Mitch Caplan

Yes. It is almost exclusively related to service. My recollection is if you look year-to-year we were up 1,200 or 1,300. Literally like 1,100 of that was entirely related to service. Exactly the same thing would be true on a quarter-to-quarter trend.

Patrick Pinschmidt - Merrill Lynch

Final question on commission rate guidance. I know this is real small, but you took down the commission rate guidance.

Mitch Caplan

It has nothing to do with pricing, and everything to do with mix.

Patrick Pinschmidt - Merrill Lynch

Got you. Thanks guys.

Mitch Caplan

We are extremely comfortable with where we are currently pricing.

Patrick Pinschmidt - Merrill Lynch

Great, thank you.

Operator

Our next question comes from Campbell Chaney - Sanders Morris Harris.

Campbell Chaney - Sanders Morris Harris

Good afternoon, everybody. I'm looking at your schedule for average enterprise balance sheet data. I'm looking at the yield on the margin receivables, it went up about 52 basis points for the quarter. Can you give us an idea of what your interest rate outlook is for the remainder of the year, and how influential this number is going to be for your margin outlook?

Mitch Caplan

Let me step back and do it a little more broadly, if I can, because I know some of our competitors talk specifically about margin and what happens in a Fed hike with respect to their margin balances. We believe that the right way for us to manage our business is to run a consolidated balance sheet, and then look at total assets and total liabilities, margin being a part of the overall asset mix.

One of the things that we have tried to do consistently over these last 17 years -- and we talked a little bit about on the call -- is obviously be conservative with respect to credit, and the same is true with respect to interest rate risk.

By and large, our position has always been modeled to a flat yield curve, and put ourselves in a position where we are relatively neutral with respect to interest rate risk. So there is no way you are absolutely neutral, but if you think about our business, it is an interesting statistic. If you thought about the bank balance sheet stand-alone, like many bank balance sheets, you would be liability sensitive. When you consolidate and run an enterprise balance sheet, we suddenly become asset sensitive.

Clearly what that means is in a rising rate environment it will help us. You are basically pretty neutral. Our duration mismatch at this point is about three months. I suspect what you would see is in up 100 you might see an increase of about $40 million in earnings, and up 50 you might see an increase of about half that. That is sort of the range that you might be willing to think about.

Campbell Chaney - Sanders Morris Harris

Got it. I'm sorry, you said your duration mismatch is three months?

Mitch Caplan

About three or four months, right in that range right now.

Campbell Chaney - Sanders Morris Harris

You manage it into that range?

Mitch Caplan

Yes, we do. I mean typically it is the range that I'm pretty comfortable with, Jarrett is pretty comfortable with. Dennis is sitting here saying that he is comfortable with. We have often found ourselves in under two months, but typically that was because we were in a situation where from an interest rate perspective, interest rates were either still flat to down, prepayments came in higher. Your overall balance sheet was smaller than you thought it would be.

Now in a rising rate environment, you're not as susceptible to prepayments, and it is a little easier to manage where we are. We are coming in just about that three, four month rate for duration mismatch that we feel comfortable with.

Campbell Chaney - Sanders Morris Harris

Looking at your average home loans quarter-to-quarter, did that come from your Loan Optimizer or how did you get that growth?

Mitch Caplan

Yes, so we're able to continue to grow our loan portfolio both on mortgages, home equity lines of credit and margin. You saw margin growth. I think margin was up about $500 million quarter-over-quarter on balance sheet, and about $400 million or $500 million as well in our home loans. A lot of this is really is we're beginning to engage more and more with our customers.

Campbell Chaney - Sanders Morris Harris

It would be safe to say this was all organic from your existing customers?

Mitch Caplan

Some of it is organic. Some of it is purchase. But we have made a huge transformation away from being in the traditional sort of mortgage business where you originate and sell, or whether you're purchasing or whatever, and really pushed hard toward the growth of our balance sheet coming from our core retail customers.

Campbell Chaney - Sanders Morris Harris

Thank you.

Operator

Our final question comes from Michael Hecht - Banc of America Securities.

Michael Hecht - Banc of America Securities

Hi guys, good afternoon. I think we have pretty much gone through everything here now. But just a couple of quick follow-ups. You guys talked about the economic attrition, 10% at Harris, 5% at BrownCo. I'm just curious about account attrition that you are seeing, as it relates to Brown specifically. I know the conversion is mostly behind you. I'm just curious. So you converted their pricing schedule to your own, or are those accounts still grandfathered at the $5 and $10 level for trade?

Mitch Caplan

They are grandfathered, but it really doesn't matter because they look from a behavior perspective very much like our more active customers who are effectively paying the same rates.

Michael Hecht - Banc of America Securities

And account attrition?

Mitch Caplan

Account attrition. We didn't give it, but it is not meaningfully different.

Jarrett Lilien

Where you've got an account attrition is the account attrition has been slightly more than the economic attrition. What that is telling you that the accounts that we're losing are less than the average quality customer. We're keeping the high-quality, the active traders, the high asset customers. The ones we're losing tend to be the lower activity, lower asset customers.

Michael Hecht - Banc of America Securities

That is fair. I just want to come back to this question on the balance sheet of the decline in cash in the quarter, the 11.5 to 10.1, because when I look at your overall balance sheet you free credits only fell about $300 million, which are probably the lowest yielding form of balance for a retail customer, which implies that you had over $1 billion decline in money fund balances, which are probably the most competitive. How does that happen?

Mitch Caplan

They got moved onto the bank's balance sheet. You're looking at two different things. You have to look at it in the aggregate. The overall deposit growth on the balance sheet was $1.7 billion. So you had $1.7 billion in growth in customer deposits in the quarter. That was comprised of CDs, money market, other forms of transactional accounts and Sweep. Independently you had the cash balances, or free credits, which are outside of that, and that's where you saw the decline.

Michael Hecht - Banc of America Securities

On the money fund side, some of the stuff you talked about, the attrition from Harris, some of that may some of the tax selling?

Mitch Caplan

That's right. Exactly what it was.

Michael Hecht - Banc of America Securities

I'm guessing you guys don't want to comment on trends you're seeing for the July DARTs. But most of your competitors have said they are only down slightly. Is it fair to say you guys are tracking the industry there?

Mitch Caplan

We're always going to track the industry, as Jarrett likes to say, plus or minus. I refuse to comment about something that is so insignificant to our overall business model over the last however many days.

Michael Hecht - Banc of America Securities

I agree. I'm just wondering if you can maybe comment on whether the activity you're seeing out there broadly on the retail trading side, while may be insignificant, is still probably substantial to you.

Mitch Caplan

Not substantial anymore. It is about 20% of revenue.

Jarrett Lilien

Another way to look at it is if you look at our guidance, we have said for the second half of the year we expect to range between 140 and 160. In the first half of the year we were at 173. So we are expecting, and we have built into our up guidance, lower activity in the second half.

Michael Hecht - Banc of America Securities

Just broadly, the activity that you're seeing out there on the trading side, do you think it is more typical seasonality or are you seeing evidence of retail folks just heading for the hills? How are you feeling about the environment?

Mitch Caplan

It is normal seasonality.

Michael Hecht - Banc of America Securities

Great. Thanks, guys.

Operator

Now I would like to turn the floor back to Mr. Caplan for his closing remarks. Please go ahead, sir.

Mitch Caplan

Thanks very much everybody for joining us. We will speak to you on the earnings call for Q3.

Operator

Thank you. This does conclude today's E*TRADE conference call. You may disconnect your lines at this time and have a wonderful evening.

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Source: E*TRADE Financial Corporation Q2 2006 Earnings Conference Call Transcript (ET)
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