Here’s the entire text of the prepared remarks from E*Trade’s (ticker: ET) Q3 2005 conference call. The Q&A is here. We recognize that this transcript may contain inaccuracies - if you find any, please post a comment below and we’ll incorporate your corrections. And please note: this conference call transcript is a Seeking Alpha product, so feel free to link to it but reproduction is not permitted without the explicit permission of Seeking Alpha.
Welcome to the ETRADE Financial Corporation's Third Quarter 2005 Earnings Conference Call. At this time all participants have been placed on a listen-only mode. Following the presentation, the floor will be opened for questions. I've been asked to begin this call with the following Safe Harbor statements: 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. ETRADE 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. In this call, ETRADE Financial will discuss some non-GAAP measures in talking about its performance, and you can find the reconciliation of those measures to GAAP in the Company's press release, which can be found on its web site at www.etrade.com.
This call is being recorded. A replay of this call will be available by telephone beginning approximately 7:00 p.m. Eastern time today through 11:00 p.m. Eastern time on Wednesday, November 2. This call is also being webcast at www.etrade.com. No other recordings or copies of this call are authorized or may be relied upon. I'll now turn the call over to Mitchell Caplan, Chief Executive Officer of ETRADE Financial Corporation, who is joined by Jarrett Lilien, President and Chief Operating Officer, and Robert Simmons, Chief Financial Officer. Mr. Caplan, please begin.
[Mitchell Caplan, Chief Executive Officer]
Good afternoon, and thanks, everybody, for joining us today. The third quarter was, as we like to say around here, truly extraordinary. In the last 90 days we delivered superior results. From a financial perspective, we generated record net revenue, record customer assets, and the second-highest operating margin in our history. From an operational perspective, we executed on our core initiatives to deliver these financial results while we evaluated and announced two significant consolidation transactions, closed on one, and successfully raised $450 million in senior notes to finance this acquisition.
More specifically, with respect to how we executed on our core initiatives, we continued to broaden and deepen customer relationships. In doing this, we created growth across each of the key drivers of our model, including assets, cash, borrowings, and transactions. We remain committed to delivering a compelling and differentiated value proposition to our customers. Through this commitment, we expanded the engagement of our existing customer base, leveraged over 200,000 new customer relationships, growing total client assets to $106 billion. These growth trends all point to our connection with the retail customer and the continued adoption of ETRADE Complete. As we continue to create greater value for customers, we strengthen the franchise and generate greater value for shareholders.
In the third quarter, with respect to our superior financial performance, we delivered $0.28 in earnings per share on total net revenue of $423 million. We generated these strong results through a combination of top-line growth, prudent expense management, and further operational efficiencies, all realized through the continued integration within and between our Retail and Institutional segments. Our model is delivering.
Our third-quarter results represent 20% year-over-year growth in revenue to a quarterly record, with 35% growth in segment income. These results were achieved despite our expensing of employee stock options for the first time under FAS123-R. Excluding the impact of option expensing, the model delivered 42% year-over-year growth in segment income and a record-operating margin at 37.4%.
As we continue to deliver strong and consistent results through our integrated model stand-alone, we seek opportunities that can accelerate value creation. We have long said that excess capacity in the industry represents an opportunity to create value through nearly any aggregation of trading volume. However, when we consider various consolidation opportunities, we focus on transactions that offer greater strategic value to us through assets and credit relationships. Both Harris Direct and BrownCo represent ideal fits with our strategic vision. Both companies bring trades, which add scale to our transaction business and carry a high incremental margin, but of even more interest to us, they each bring a high quality customer base with attractive asset and borrowing relationships, characteristics consistent with our best customers today.
So as we step back and look at what we expect to achieve from a growth perspective through these two transactions, it's impressive. On a pro-forma basis, Harris Direct and Brown add over 600,000 new accounts and increase total client assets by 63% with cash balances up 45%. Margin debt balances rise 170%, and retail DART volumes increase 52%. In addition, we expect to unlock approximately $340 million in combined annual pretax synergies. These synergies will be realized with only a modest increase in retail commissions as a percent of revenue, moving to about 25% post closings from 20% in the third quarter.
As we continue to execute on our vision of creating an integrating financial services company, we will ultimately move toward a place where we can assess, evaluate, and manage the Company from an enterprise-wide perspective. Two years ago, we took our first major step toward integration with the launch of the Sweep Deposit Account. This product allowed us to better leverage our bank and brokerage models by realizing the synergies of these previously competitive businesses. We have since built on the success of the Sweep account by realigning the structure of the Company to a more customer-centric perspective around retail and institutional segments. As we begin now to integrate Harris Direct and, eventually, Brown, upon closing of that transaction, we will continue to focus on pulling together our operations, technology, and service around our retail customer relationships.
Through the integration of customer cash in the form of deposits, certificates of deposits, checking, money market funds, and Sweep, and credit in the form of mortgage, key lock, margin, and, to a lesser extent, credit cards, we are moving to a place where we have started to think about assets and liabilities and the spread between them on a total enterprise basis. We believe this holistic view of the Company is the ultimate structure that will help drive the best management decisions and illustrate the value of the franchise.
Utilizing the strengths of our institutional segment to leverage growth in our retail relationships, we can optimize the model and deliver greater value for customers and shareholders. I am extremely pleased with the record results that we have generated in many areas of our business and the continued accomplishments of our team. We delivered these strong operating and financial results while remaining focused on enhancing the strength of the franchise for the long term. I'd like to turn the call over to Jarrett now to talk about more of the specifics of the quarter.
[Jarrett Lilien, President]
Thanks, Mitch. Our continued focus on expanding existing customer relationships while attracting new, high-quality customers resulted in core growth in our business in the third quarter. At the highest level, revenue per customer, segment income per customer, and the number of products per customer continued their upward trajectory on both the quarter-over-quarter and year-over-year basis.
I'd like to spend a few minutes on our segment results to discuss how we are achieving this success. In retail, we continue to benefit from our focus on account quality and efforts to deepen engagement across our customer base. In the third quarter, assets per customer increased 25% over the year-ago period, including a 10% increase in cash per customer. This increase was driven in part by our initiative to market and focus on assets and cash management solutions, and rewarding customers with greater value for holding larger asset balances at ETRADE Financial. As we bring cash in to our retail customers, we are able to further leverage the value of that cash in our institutional segment through our balance sheet integration strategy.
Looking across our entire suite of cash products, total customer cash in the system increased by $800 million in the quarter to a record $19.5 billion. When we talk about total cash in the system, this includes cash at the broker dealer, as well as total bank deposits, including C D's, transaction accounts, and the Sweep account.
In the quarter we saw organic growth across all of these cash products. Specifically, we saw organic growth of over $300 million in Sweep, $200 million in CDs, and $200 million in transaction accounts. We also continue to make progress on moving cash from the broker-dealer into the bank's balance sheet by sweeping 700 million of previously un swept cash from the broker-dealer. This combined with the organic growths in CDs, transaction accounts, and Sweep, increased cash on the bank's balance sheet, where it all carries the greatest value to our model, by $1.4 billion. Overall, we saw growth in customer cash balances, even as our customers participated and invested in a strong equity market.
Our focus on the combination of value pricing, functionality, and service is delivering growth in our retail customer base. In the third quarter, we generated nearly 49,000 net new retail accounts, nearly double the growth we saw in the second quarter, and a significant reversal from the net account attrition we experienced a year ago. This, of course, does not include any impact from Harris Direct, which didn't get closed until after the quarter end.
In addition to the growth in customer assets that I already discussed, we also saw growth in margin consistent with increases we experienced in trading activity. Average margin debt increased 12% year over year and 4% sequentially. Retail DART volumes also increased, rising 50% year-over-year and 16% sequentially, corresponding to the movement out of cash and into investments by some customers during the quarter as previously described.
In Professional, DART volume declined 9% year-over-year and 8% sequentially. This decline is a result of seasonal volatility, exaggerated by our exiting of the prop business last quarter and the effect that had on certain professional customers. As a result of a favorable mixed shift towards Retail volumes versus Professional volumes in the quarter, average commission per trade increased to $10.78 from $10.09.
Moving over to the Institutional segment, we continue to realize the benefits from the connection with our retail customers. Growth in retail customer cash, for example, is a critical component of our balance sheet management process. As we grow customer cash and integrate that cash with the bank's balance sheet, we benefit in two ways. We are able to use this cash to replace wholesale funding sources such as repose and FHLB advances, which reduces our aggregate cost of liabilities and or we can use the additional cash to grow the asset side of the balance sheet as we connect with our customers through lending products such as mortgages and HELOCs. We do this while always adhering to our strict discipline around credit and interest rate risk.
In the third quarter, the benefit of this relationship between our Retail and Institutional segments translated into a further spread widening on the bank's balance sheet to 223 basis points, despite a challenging yield curve environment. In addition to delivering further spread widening, we were also able to grow the bank's balance sheet to $30 billion in assets. Loans, as a percent of total assets, also increased to 59% from 45% a year ago.
Our Institutional segment also stands to benefit as we connect to our retail customers around credit relationships such as margin lending. As we continue to focus on attracting and retaining high-quality customers, we expect to generate growth in margin debt balances. Clearly, the additional of Brown and Harris will accelerate this initiative. In the context of the broker-dealer as it stands today, larger margin debt balances provide an attractive source of collateralized, recurring interest-related income, yet the value of margin debt could be enhanced as we ultimately move towards full balance sheet integration.
Before turning the call over to Rob for more of the financial details for the quarter, I'd like to comment on the integration of Harris Direct and Brown. As you know, we closed on the Harris Direct transaction on October 6th, nearly a full quarter ahead of our original schedule. We are very excited to have started on this integration.
We have a dedicated team overseeing this process from start to finish. This team includes many of the people who were involved with our own back office conversion to ADP last fall, which was a significantly larger undertaking. Given their background and experience, we expect a smooth conversion for our new customers, and our goal is to improve the experience for existing customers by leveraging the best parts of the acquired platforms. The early closing of Harris allows us to complete several of the largest integration steps before year-end. With respect to Brown, we remain on track to close the transaction by year-end as we projected, pending regulatory approval.
The early closing of Harris and the anticipated closing for Brown mean that we will be able to focus on one deal at a time, reducing the overall execution risk of these two projects, and increasing our confidence in a clean and smooth conversion process for both sets of new customers. With that, I'll turn it over to Rob for the financial details.
[Robert Simmons, Chief Financial Officer]
Thanks, Jarrett. As Mitch mentioned earlier, we are very pleased with the performance of the Company in the third quarter. As we continue to execute our strategic plan, including both organic growth initiatives and consolidation opportunities, we successfully delivered top-line growth with increasing profitability.
Total net revenue in the third quarter increased 26% year over year and 8% sequentially. This growth continues to illustrate the benefits of our direct and indirect leverage to retail customer relationships. Through increases in customer cash and borrowings, we were able to further reduce our funding costs at the bank, deepen our credit relationships, and widen our net interest spread. At the same time, retail commission revenue grew by 35% year-over-year, and 16% sequentially, while holding at about 20% of total net revenue.
As we continue to grow the bank balance sheet and create greater leverage with our retail customers through borrowing relationships and cash, we expect net interest income to continue to be a growing contributor of high quality, recurring earning. In the quarter, net interest income after provision grew 32% year over year and 5% sequentially to $204 million or 48% of total revenue.
Turning to operating expenses, we continued to demonstrate cost discipline and realize operational efficiencies. Third-quarter segment expenses totaled $272 million, up $19.8 million in absolute terms, but down as a percentage of revenue compared to both the year ago and prior quarter periods.
Two factors contributed to the $19.8 million sequential increase in total expenses. First, compensation and benefits increased $17 million sequentially to $103 million. Of the $17 million increase, approximately $8 million was related to our adoption of FAS123-R and $9 million was related to volume and performance-based compensation. Second, commission clearance and floor brokerage expenses increased $2.2 million sequentially, directly related to the 16% increase in retail DART volumes. Including the effect of these two factors, we delivered year-over-year and sequential operating margin expansion and the second-highest segment income ever, second only to that of the first quarter earlier this year.
To assess the progress we have made over the past year, it's helpful to evaluate our performance year to date. Total net revenue for the nine months ended September 30, 2005, increased 12% over the year-ago period, consistent with our stated goal of 10% to 15% top-line growth. At the same time, total segment expenses increased just 8%, including the adoption of FAS123-R this past quarter. So as revenue growth outpaced expenses, we widened our operating margin by 250 basis points to 35.7% and delivered 21% growth in segment income.
Particularly interesting is that these results were delivered despite flat commission revenue. We believe these results further demonstrate the enhanced operating leverage of our model while highlighting our reduced dependence on trading related revenues.
In light of the progress we have made and the strength of our year-to-date results, we are raising and tightening our 2005 earnings guidance today to a new EPS range of between $1.04 and $1.09 from our previously expected range of between $0.96 to $1.06. Taking into account the $0.79 in EPS that we have reported year to date, our raised guidance implies a range of between $0.25 to $0.30 for the fourth quarter. This revised guidance considers the impact of higher interest expense, restructuring, and field-related costs associated with the acquisition of Harris Direct, which we will offset with approximately $0.03 of the expected $0.08 gain from the sale of ETRADE Consumer Finance.
To preserve comparability with prior guidance, we are excluding the remaining $0.05 of the expected Q4 gain for purposes of this guidance. When we report our actual results for the fourth quarter in January, the bottom line number will include this additional $0.05, resulting in an expected headline number of $1.09 to $1.14.
Our fourth-quarter guidance also includes an estimated $6 million to $8 million increase in marketing spend in accordance with seasonal opportunities and the integration of Harris Direct and Brown. We are also including an assumed decline in average commission to approximately $10 per trade, down from $10.78 this past quarter, as a result of mixed shift in our DART volumes, as well as our simplified pricing structure.
Turning to the Harris Direct acquisition, we are pleased by the fact that we were able to close a full quarter ahead of schedule. That said, we do not expect this to have any material contribution to operating income in the fourth quarter. The early closing does put us on track to be ahead of our initial integration schedule as we head into 2006, as Jarrett discussed, moving the timing of full synergy realization to approximately mid-year versus the September quarter, as originally estimated.
As for our 2006 outlook, we plan to establish guidance in December as we have in the past. With this, I'd conclude by saying that we remain very pleased with the continued performance of the model and the fact that we are well on track to deliver a third year of record profits. We are also excited about the opportunity to accelerate our cash flow generation as we integrate Harris Direct and Brown, and we will remain disciplined in our approach to deploying that cash flow. Operator, we are now ready for questions.
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