Executives
Adam DeWitt - Chief Financial Officer
David A. Fisher - Chief Executive Officer
Analysts
William Tanona - Goldman Sachs
Richard Repetto - Sandler O’Neill
Mike Vinciquerra - BMO Capital Markets
Mark Lane - William Blair
Edward Ditmire - Fox-Pitt Kelton
Brian Bedell - Merrill Lynch
Michael Hecht - Banc of America
George Grose - American Capital
Richard Fetyko - MCF & Co.
optionsXpress Holdings (OXPS) Q4 2007 Earnings Call January 29, 2008 9:00 AM ET
Operator
Good day and welcome to the optionsXpress Holdings fourth quarter and full year conference call. At this time, I would like to turn the conference over to Mr. Adam DeWitt, Chief Financial Officer. Please go ahead, sir.
Adam DeWitt
Good morning, everyone and thanks for joining us for our fourth quarter and full year 2007 earnings call. I am Adam DeWitt, the CFO of optionsXpress, and joining me today is our CEO, David Fisher.
By now you should have received a copy of our press release via fax or e-mail. 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 website, 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 in the media in whole or in part without our prior consent.
At this time, I’ll turn the call over to David, who will recap the highlights of the year as well as for the fourth quarter. Following his remarks, I will walk you through the financials and David will wrap up with our outlook before we finish with your questions.
David A. Fisher
Thank you, Adam. Good morning, everyone. Thanks for joining our call today. I’ll apologize if I sound a little hoarse, my kids got me sick over the weekend, but I’ll do my best.
I am very pleased to report another year of strong results for optionsXpress. As you have probably already seen in our release, 2007 was a record year for us. We generated record revenue of $247 million, record net income of $98 million and record earnings per share of $1.55. All three of these metrics eclipse our 2006 results by over 30%. We also ended the year with our fifth consecutive record quarter by generating EPS of $0.44, 42% higher than the fourth quarter of 2006.
We believe that both our fourth quarter and full year results underscore our ability to generate consistent growth by leveraging our highly robust and profitable platform. We’ve also demonstrated our ability to execute on the major initiatives we have laid out for ourselves, while continuing to drive our business forward.
In 2006, it was our conversion to self-clearing. This year, it was the completion and integration of our first acquisition, XpressTrade. In the fourth quarter, we completed what we believe to be the best-of-breed online futures platform. We accomplished this significant achievement in the middle of our busiest quarter ever in terms of transactions. Our futures products are now seamlessly integrated into our award-winning brokerage platform, allowing our customers to trade securities products and futures product side by side.
The futures markets have seen tremendous growth recently, but we believe that the surface has only been scratched when it to comes retail adoption of the product. We see all the right dynamics in place for this to accelerate, and have seen increasing focus on the retail customer by the major futures exchanges.
We also continued the momentum in our new account growth. Our efforts to retool and refine our marketing strategy led to 48,800 new accounts this year, including 14,600 in the fourth quarter. We were able to produce this increase while maintaining the industry’s lowest acquisition costs per net new account.
At this time last year, we clearly expressed our disappointment with a drop-off in our new account totals but at that time we were adamant that the fundamentals of our business were so strong and that the drop was simply a result of not executing as well on our marketing plan as we had historically. By redoubling our efforts in our marketing over the course of the last year, we were able to successfully reconnect with our customers and I think the results speak for themselves.
While growing our customer base is a companywide effort, we have certainly benefited from the leadership of Paul Eppen, who we hired as our Chief Marketing Officer in August. As I mentioned during our last call, Paul has been tasked with expanding in our already sharp marketing strategy, scaling our marketing spend to generate more accounts at an acceptable rate per account and offering innovative and fresh ideas to track new customers. While he is still new to the business, he has already had a tangible impact on our results and we look forward to expanding on our marketing vision.
While our marketing will attract the high value clients we’ve come to expect at optionsXpress, our educational content will continue to be more important to distinguish our platform from our peers and drive customer engagement.
Increasingly, we are using education as a new account generation tool, reaching out to novice investors and showing them the benefits of adding derivative products to their investing portfolios. We also continue to stress ongoing education for all of our customers. Our education is currently going through an evolutionary process as we shift from one-off seminars and single topic based content to curricular-based education where investors have a series of courses that guide them through their investing education.
2007 also marked the inauguration of our Personal Coaching Program. Demand has been much stronger than we expected and we have found the feedback to be overwhelmingly positive.
During the recent period of volatility in the markets, we have seen the benefits of increased education pay off. Customers are using hedging strategies and advanced orders to minimize the impact of the market swings. This also allows them to put on new positions when they see opportunity created by the volatility, instead of being panicked and getting forced out of positions unnecessarily.
So clearly we see a significant portion of our growth coming from our core self-directed retail business. However, we’ve been successful in finding opportunities to generate additional growth by expanding into new areas that leverage our platform. brokersXpress, our wholesale business serving registered reps and RIAs continues to generate solid results. We ended the year with over 13,000 accounts in that business and close to $1 billion in assets. Through a growing and dedicated salesforce, our pipeline continues to develop.
The international market remains strong as well, and as a result we’re able to acquire accounts at a lower cost per account than we are in the U.S. This is an attractive opportunity for us and we’ll continue to pursue it going forward.
Finally, our initial strides on the institutional front are showing some momentum. We brought on the first group of accounts and we believe that we are further refining our value proposition in that market.
Now I would like to take a minute and talk about our award-winning brokerage platform. When I step back and look for the keys to our success over the last eight years, what clearly emerges is our culture of persistent innovation. We built a culture where employees are encouraged, recognized and rewarded for thinking ahead, challenging the status quo, and coming up with new ideas. Innovation is not focused on a small development team or product group; instead it’s instilled in every department at every level.
While our focus on innovation certainly leads to unique tools and products for our customers, it’s also responsible for our highly efficient operations and world-class customer service. It is truly a differentiator.
While a lot of our development efforts recently have been focused on our futures platform and integration of XpressTrade, we’ve also been hard at work on some tremendous new tools that we’ll be rolling out to our customers this quarter. Our strategy with respect to tools and our platform in general can be summed by the phrase, “easy to use, but powerful”. We want the novice investor to feel comfortable, not intimated as they are learning; but we also want to ensure that our platform has the depth to continue to meet the needs of our more experienced customers.
With that, let me turn the call back over to Adam, our Chief Financial Officer. who’ll review the fourth quarter and full year financials with you.
Adam DeWitt
Thanks, David. The fourth quarter was a record quarter, completing another record year for optionsXpress. In our three years as a public company, we’ve now posted record EPS in ten of the 12 quarters. In that time, we’ve experienced some remarkable growth. To put it in perspective, our net income in 2007 was double what we earned just two years ago in 2005 and our revenue in the fourth quarter of 2007 was more than 2.5x our revenue in the first quarter of 2005, our first as a public company.
In addition, we’ve never had pre-tax margins lower than 60% as a public company. By keeping our focus, we’ve been able to build a sustained record of balanced growth and profitability. The fourth quarter of 2007 was no exception. While strong trading activity that coincided with market volatility in the quarter helped drive commissions, we also had a very good quarter in terms of account adds and asset growth, our long-term drivers of growth.
Now for some of the specifics for the quarter. During the fourth quarter, we generated net revenues of $68.8 million, 39% higher than the fourth quarter of 2006. Fourth quarter commission revenues of $44 million were 44% higher than the fourth quarter of 2006. As we discussed earlier, higher commissions are driven by organic account growth and higher-than-average trading activity. Customers traded at an average rate of 41 trades per year in the fourth quarter, up from 34 trades per year in fourth quarter of 2006 and 38 trades per year in the third quarter.
Higher trading activity in the fourth quarter was partially offset by lower average commissions. Average commissions during the quarter were $16.84, which is down from $17.16 in the third quarter.
Last quarter, we talked about the impact from the introduction of our lower rate on option spread trades, which we began offering in August. The decline in average commissions from the third quarter to the fourth is primarily related to the additional month with the lower spread rate.
Fourth quarter 2007 net interest income was $15.2 million, an 8% increase over the third quarter of 2007. The increase was driven by an increase in customer cash balances, margin balances, and company cash balances. Looking forward, the Fed rate cuts in the fourth quarter along with the 75 basis points cut last week will likely have an impact of around $0.015 a quarter on earnings all else equal.
Our conversion to self-clearing has certainly helped to diversify our revenue base. From 2005 to 2007, net interest revenue has gone from 9.9% of net revenues to 22.5% of net revenues. The majority of this increase is related to our self-clearing conversion.
Payment for order flow was $8.8 million in the fourth quarter, representing an increase of 3% over the fourth quarter of 2006 and a 9% decline from the third quarter of 2007. Last quarter we said we expected to see pressure on paying rates following the start of the second phase of the Penny Pilot. The decline we saw in the fourth quarter was in line with our expectations.
Similar to the first phase of the pilot, rates have stabilized following the initial drop and we remain confident that there is significant value in our order flow. We have been talking about ways we are trying to get deeper into the transaction to capture more of the inherent value in that order flow. We began taking more concrete steps in that direction during the fourth quarter. In fact, some of the decline in payment in the fourth quarter is related to a portion of our order flow being directed away from our traditional routing mechanisms and towards some new initiatives we are working on. We are hopeful that these initiatives will help us capture more value from our order flow in the long run.
Moving on to expenses, in the fourth quarter, expenses were $23.3 million, an increase of 30% over the fourth quarter of 2006 and a 2% increase over the third quarter. Brokerage and clearing costs for the fourth quarter were 9% higher than the fourth quarter of 2006, but 5% lower than the third quarter of 2007. A decrease from the third quarter was primarily driven by a decrease in payoffs to brokersXpress brokers.
Overall, brokersXpress commissions were higher in the fourth quarter than the third quarter, but the payoff percent was lower. This percent can fluctuate as different brokers have different payout agreements.
Brokerage and clearing costs for the year were 8% lower than 2006 despite a 30% increase in total trades. This decline reflects the efficiencies gained from converting to self-clearing.
Compensation costs for the quarter were $6.7 million, 3% lower than the third quarter. Costs were lower in the fourth quarter primarily due to year end bonus true-ups. While we remain focused on efficiency, we do expect compensation costs to be higher in the first quarter and going forward as we return to more historically consistent levels and our headcount grows to accommodate account growth.
We increased advertising costs in the fourth quarter. Total spend was $4.2 million, up 19% versus the third quarter. The increased advertising costs were planned and as David talked about earlier, resulted in a corresponding increase in new accounts. Cost per net new account was up only slightly from the third quarter to $290 from $285. Throughout 2007, we opened 48,800 net new accounts excluding the XpressTrade acquisition, a 14% increase over the total net new accounts in 2006. In 2008, we are likely to continue to invest more in advertising and hope to continue to build on the momentum that we’ve developed in 2007.
Our pre-tax margins were 65% for the year and reached 66% for the fourth quarter, both records for optionsXpress. While we take pride in our ability to manage costs as we grow and will continue to operate as efficiently as possible, I should note that the higher pre-tax margins are due in part to the unusually high trading levels and that they are likely at the very high end of our range with future margin levels more likely to come down from here than to go higher.
Total net income for 2007 was a record $97.7 million, which represents a 36% increase over the last year. Net income for the fourth quarter 2007 was $28 million, up 44% over the same period last year. Options as a percentage of total trades for the quarter were 68.3% and 66.5% for the full year 2007. The decline from prior years reflects the growth in our futures business.
We ended the year with total client assets of $5.8 billion, a 24% increase over last year, and 3% increase over the last quarter. The increase versus the last quarter compares to an average decline in the market indices of around 4%, implying good organic growth.
Margin balances ended the year at $221 million, a 74% increase over last year and a 33% increases versus the end of September. A significant portion of the increases related to our portfolio margin customers.
Total company cash and short-term investments at the end of the year was approximately $230 million including our cash on deposit at clearing corporations. Of this $230 million, approximately $60 million is being used to support self-clearing operations.
We continue to have no debt. We remain committed to deploying our cash to create the most value for our shareholders whether it is through acquisitions, new business development, dividends and/or buybacks.
I will now turn the call back over to David for some final comments.
David A. Fisher
Thanks, Adam. I think as you can see 2007 was a fantastic year for optionsXpress. Our solid results reflect the strength of our platform, the dedication of our team, and our unwavering pursuit to drive innovation throughout our company. Market volatility during the second half of the year helped drive record activity. However, we all know that market conditions will ebb and flow and there is no way to know what to expect in 2008. So far, market activity has been brisk and our volumes have certainly benefited from that with both DARTs and accounts above December levels.
No matter what the market has in store for us in 2008, we feel confident about our ability to succeed. We’ve achieved tremendous success over the last eight years. These accomplishments are a result of the established and seasoned team that we have built which has continually shown the ability to execute on our strategy in many different environments.
The market continues to present us with opportunities and we remain ready to take advantage of them. We will continue to focus on driving growth in our core self-directed business as well as pursuing opportunities to leverage our platform to generate additional growth. We believe that our performance to date is evidence that this is the right strategy for optionsXpress.
At this time, I will turn the call back over to the operator and we will take some questions.
Question-and-Answer Session
Operator
Your first question comes from William Tanona - Goldman Sachs.
William Tanona - Goldman Sachs
Could we spend a little bit more time understanding the payment for order flow? If I look at the other brokerage revenues as a percentage of option DARTs, it looks like it declined about 22% quarter over quarter to about 488.
I think you said that this was in line with what your expectations were, but if you go back to when the original pilot was in place, clearly we didn’t see that level of a drop. Is that the new benchmark that we should be using or like we saw during the last pilot there, do you expect to see a bounce in that activity as well?
David A. Fisher
Well, I think in terms of the level of drop, I think it was right at our expectations and there were two reasons why it was a little bit sharper than in the first quarter. First, the second phase of the pilot was larger than the first phase of the pilot. There are more names and more volumes.
Second, as Adam mentioned in his remarks, we took a portion of our order flow and basically invested it into the future trying to find ways of maximizing our flow through other types of relationships other than just sending flow down to the exchanges through our traditional liquidity providers. Certainly, while that investment cost us a little bit in payment in this quarter we certainly think it’s going to benefit us going forward.
So, with respect to the second part of your question in terms of the benchmark going forward, we clearly think this is a floor for now and see a lot of opportunities for that number to come up over the next quarter.
William Tanona - Goldman Sachs
Conversely on the average brokerage and clearing costs, that obviously went down as a percentage of overall DARTs as well despite DARTs being up about 12%. So, again, is that something that was one-time or what’s going on on the clearing and brokerage expense that that was so low this quarter?
Adam DeWitt
As I tried to hint at in the remarks, the reason that brokerage and clearing was down is primarily due to lower brokersXpress payouts as a percentage of brokersXpress commissions. brokersXpress commissions overall were actually a little bit higher than they were in the third quarter. But the way that business works is, each one of the reps has a different deal. So if some of the brokers that have a higher payout percentage are doing more of the business, you will see that line item a little higher.
In other quarters, you will see it a little lower when other brokers who have lower percentage payouts are doing more of the business. This quarter it just happened to be more of the latter than the former. It will move around; it’s likely somewhere in between the two. We’re probably closer to third quarter run rate would be a little bit more normal.
Operator
Your next question comes from Rich Repetto - Sandler O’Neill.
Richard Repetto - Sandler O’Neill
Adam, you made reference that high activity rates in 4Q might be coming down. I guess that would be opposite to what we’re seeing I think in January. Could you give us some color on where trading activity might be in January to-date? We’re almost through with the month.
David A. Fisher
Market activity certainly has been brisk so far in January, and our volumes have benefited from that. Both DARTs and accounts are above December levels. We don’t give specific numbers, but we certainly as a result of that market volatility have seen increases from what were already fairly high levels in December on both DARTs and accounts.
Richard Repetto - Sandler O’Neill
We are seeing unbelievable record volumes in the options industry. I’m not saying you are percent-for-percent, but are we seeing dramatic increases like we are seeing close to 80% year over year or close to 50% sequential in the options industry?
David A. Fisher
I would just highlight there that a lot of that activity is pure market volatility, sharp rises in the bids. Certainly the volatility has been very high as well. Our customers are not pure volatility traders. They invest in stocks when there is a lot of volatility and there is sharp movement in stocks they certainly see more opportunities to get to market, put on new positions and that’s what we’ve seen in January.
But I would just caution that a lot of that volatility that we’ve seen, especially in the early part of January, was very much institutional driven, very much people just trading volatility itself.
Richard Repetto - Sandler O’Neill
Understood. That’s helpful. You alluded to, David and Adam, about a portion of the volume invested that you didn’t get payment for order flow on this past quarter. Can you give more details? My mind is running free here on what this could be?
David A. Fisher
Rich, obviously for competitive reasons we don’t want to give too much. But we think there are ways going forward for us to find other ways of maximizing the value for order flow and providing additional value to our customers in terms of greater liquidity than they can get through the traditional exchange-based mechanism and additional opportunities for price improvement. Those can include opportunities of doing things with their own broker dealer or tighter partnerships with third-party liquidity providers. Those are things that we both took steps forward in the fourth quarter in terms of actually directing flow towards some of those mechanisms.
I don’t want to say we didn’t get any payment on those flow but certainly as we are learning and as we are experimenting to what works and what doesn’t work, we are not getting the same level of payment as we did on the exchange-based payment.
That being said, we are very encouraged by the initial results we’ve seen through some of those mechanisms and that makes us very optimistic for both this quarter and going forward.
Richard Repetto - Sandler O’Neill
I guess my question is that you are saying you gave up something on the payment for order flow, so you might have got something, a little bit, but you gave up some. I am trying to understand what the benefit and when you get that benefit is?
David A. Fisher
We are learning how do it and how to do it right. You make some mistakes, you have some wins, and you continue to refine the methodology of doing it. As we were refining it throughout the quarter, I think we are starting to have more wins than losses and we see the opportunity going forward. So it’s not a static environment where you know day one what the profitability of it’s going to be. It’s something you need to learn and get better at over time. As I mentioned, as we got through the quarter, we became increasingly encouraged that this is something that can make a lot of sense going forward.
Richard Repetto - Sandler O’Neill
Adam, you made some comments about sensitivity to interest rates for optionsXpress in ‘08, $0.06 for the year. What are the assumptions here? I know what the interest is, but I guess, yield curve or is that with flat balances? How do you get to that?
Adam DeWitt
All else equal, assuming balances are steady where they are today, and the steep in the curve doesn’t impact us too much since most of our assets and liabilities are on the short end. So it assumes the drop of a total of 125 basis points and the impact on our different categories of cash it flows through and that’s how you get to $0.015.
Operator
Your next question comes from Mike Vinciquerra - BMO Capital Markets.
Mike Vinciquerra - BMO Capital Markets
I’d like to come back to Bill’s question on the clearing costs. When we look at things, your DARTs are up 12.5% quarter over quarter and your brokerage and clearing are down 5%. Can you actually give us an idea about what percentage of your brokerage and clearing line relates to brokersXpress so we can see what the real volatility is? Because I assume in your core business you didn’t see a whole lot of change in terms of your average cost per trade?
Adam DeWitt
It bounces around obviously as the brokersXpress payout level goes up and down. But I’d say it’s roughly 30% to 40% of that line item and it’s going to move higher from here, we assume, over time.
Mike Vinciquerra - BMO Capital Markets
So we were at the lower end of that range this quarter, maybe at the higher end in the third quarter, something like that?
Adam DeWitt
Right.
Mike Vinciquerra - BMO Capital Markets
The other thing I want to ask on is your new futures platform, I’m looking at the percentage of trading between options, equities and other which I guess is predominantly futures, options was up maybe 1.5 points and then other was down almost 2 points in the quarter. Was there any impact from your transition to the new futures platform or was it simply that you saw a surge in new activity, new spread trading on the options and that’s what drove the mix shift?
David A. Fisher
Mike I think there are a couple of factors. We did see very heavy options trading, volume has been high, so that was part of the impact. But also futures volumes and options volumes don’t always go hand in hand. We see at different times different markets have higher activity going on in them and that’s reflected in our volume. But it is not at all related to the integration. The integrating went very well and in fact, in January we are seeing high futures volumes again, kind of back up to the ranges they were before the end of the quarter.
Mike Vinciquerra - BMO Capital Markets
Am I wrong that you guys actually transitioned from the legacy XpressTrade to a brand new futures platform sometime in the fourth quarter?
David A. Fisher
In December, beginning of December.
Mike Vinciquerra - BMO Capital Markets
You are obviously focusing more on education, you brought it up in your prepared remarks and it sounds like you are very encouraged by the results. I assume that this shows up in other revenue, but are we expecting this to be a potentially meaningful proportion of your revenues or a growing percentage of your revenues going forward? Do you see it as more of a marketing and driver of trading activity than you do actually a revenue source in and of itself?
David A. Fisher
Well, we certainly view education as a driver of new accounts and trading activity. That’s the reason we do it, that’s why all of our educational expenses are included in our marketing and advertising line item, because that’s how we view it. We are certainly happy with the response we’ve had to some of our paid educational offerings, most significantly the Personal Coaching Program where we are glad we can make some revenue off it. But we really look at that as an offset of the millions of dollars a year we spend on the rest of our educational offerings, and really with the sole goal of driving accounts, making sure our customers are educated investors and good long-term customers of optionsXpress.
Operator
Your next question comes from Mark Lane - William Blair.
Mark Lane - William Blair
Could you expand a little bit more about the impact the new Chief Marketing Officer has had and what sort of plans that maybe are different from the past or some of the things that you are thinking about doing for 2008?
David A. Fisher
As I mentioned, no one person is make or break in this company and is responsible for the success or lack of success at optionsXpress. But clearly when we were evaluating our marketing in 2007 we felt there was an opportunity to continue to push it forward by bringing in some senior leadership in that group and Paul has filled that role terrifically so far.
Really what he brings to the table is experience with larger marketing budgets, more complicated marketing organizations, larger spends and really driving through down to the analytics, really understand what’s paying off and what’s not paying off. He has had some initial strong successes with us in that area.
Going forward, we also look to him to bring new ideas to us at optionsXpress. We had essentially the same marketing team for seven to eight years here and it’s always, I think at times, good to bring in new ideas and get some fresh perspective on things. Certainly with Paul’s 20 years of experience in the marketing, he has a lot of good ideas that he can help bring to optionsXpress.
But as I mentioned, it’s not all on one person. It’s one great person, one great part of our team, but it is truly a team effort that leads to our success with our new accounts.
Mark Lane - William Blair
Does that assume that there is really no major changes planned for next year then? I mean it seems like, obviously, things have improved from some of the issues 12 months ago; spending is up, it doesn’t really seem like there really need to be any major changes.
David A. Fisher
I guess it all depends on what you mean by major. I mean in ‘07 we spent a lot more money than we did in ‘06. That was somewhat of a major change. We’re continually changing and we are rolling out new ideas, new ways of marketing, going to new sites, new strategies literally weekly, so we are always going through with respect to our marketing strategy.
But as I mentioned, part of what we challenged Paul to do when he came on board was to bring us new ideas, to find new ways of getting our messages out to our customers and we fully expect to rollout some of those in ‘08, whether these are major or not major, I think time will tell, but I would absolutely expect to see some new things from us in ‘08, like it has been in every other year.
Operator
Your next question comes from Edward Ditmire - Fox-Pitt Kelton.
Edward Ditmire - Fox-Pitt Kelton
We are hearing a lot from exchanges and market makers about momentum for maker-taker models in options. Could you talk about how these trends might impact your business?
David A. Fisher
We’ve said for a long, long time we continue to believe there is value inherent in our flow and no matter what the market structure is out there, we will be able to extract some of the value and that’s the reason we are doing some of these things we are doing today with exploring new mechanisms for extracting that value, because we want to be able to take advantage of multiple market structures.
We talked to exchanges and when we tried to get our view of what’s going to happen going forward, we don’t think it’s an all-out move to maker-taker. We think it’s an all out move to multiple market structures. Everyone is trying to do the same thing at every exchange. All the exchanges are trading commodity product. They need to find ways to differentiate themselves. I think increasingly differentiation of the market structure, it will be one of the ways they do that.
So I think there will be maker-taker models, and I think there will be other models, some that are already in place and some of that we haven’t even thought of yet. So for us, it’s important again to have multiple ways of extracting the value in order flow, making sure our customers are getting world-class execution, the best liquidity out there, and price improvement where available.
Edward Ditmire - Fox-Pitt Kelton
At the end of the first quarter of ‘08, the third tranche of the penny classes is coming onto the Penny Pilot. Is that something that will have a similar effect to what we saw in the fourth quarter as far as the average payment for order flow per options trade?
David A. Fisher
I think a couple of things. One, it’s much, much smaller just in terms of the amount of volume and the amount of industry volume.
Second of all, there is a significant amount of pushback on the Penny Pilot right now. I don’t want to make any predictions with respect to the third phase of the pilot because I think it’s too up in the air, but I don’t think that it’s all a certainty that there is going to be a rush to continue to increase the pennies.
Certainly it’s working with some high-volume names, some of the ETFs, and certainly it’s failing in other names. So I think it’s still very much a debate about where pennies goes from here. But in any event the third phase of pilot, even if it goes as planned, should have a much, much smaller effect just because it’s much less volume.
Edward Ditmire - Fox-Pitt Kelton
It seemed like you had a kind of a renewed enthusiasm for the retail adoption rate of options as a class. Is there anything recently you’re seeing that has you encouraged in that?
David A. Fisher
I think it’s just continued adoption by the mainstream media. We continue to see articles in mainstream publications, and we see a lot of the people that haven’t traded options talking to our folks on customer service lines. It just continues the trend that we’ve seen over the last few years, where increasingly we see more people who haven’t traded options historically interested in trading options.
Operator
We’ll go next to Brian Bedell - Merrill Lynch.
Brian Bedell - Merrill Lynch
Could you talk about your commission pricing outlook in 2008, to the degree that it will be impacted by mix shift in products? Whether we’re sort of seeing more of a flow here, or if there’s any new pricing strategies planned that would bring that down more again in ‘08?
Adam DeWitt
We feel pretty good about where our pricing is right now. We don’t feel a lot of pressure from our customers to change our pricing. We think across the spectrum in terms of futures, equities, options we’re pretty well positioned. We’re competitive, which is what we want to be. We think pricing should stay around where it is. It could bounce around a little bit depending on mix changes or average contracts, but it could go up just as easily as it could go down.
Brian Bedell - Merrill Lynch
If volumes are stronger in options, you would expect that to be a positive for the commission pricing?
Adam DeWitt
Well, options in general have a higher average commission than futures or equities so yes, a higher mix of options would lead to a slightly higher average commission.
Brian Bedell - Merrill Lynch
How do you think about revenue coming to the operating margin, it we do remain in a very volatile environment for a while and trade volumes remain elevated, are you likely to let that most of that fall to the bottom line or at what point do you say now we are running at a much higher level and let’s crank up our investment in the business?
Adam DeWitt
Obviously, if we see activity inflated at the levels that it was in the fourth quarter, we will see higher pre-tax margins. As I indicated earlier and David has indicated, we are making a lot of investments in the business. We are certainly probably investing more in advertising next year, in some our educational efforts. So, I think it’s a combination.
Obviously, if there is a much higher trading activity and a lot of that does fall to the bottom line, you will see our pre-tax margins on the higher side. I don’t expect them to go up from where they are right now and they are lot more likely to go down.
Brian Bedell - Merrill Lynch
When you say going down, is there any quarter that we should be thinking of as a normal volume environment?
Adam DeWitt
I mean, over the last three years, we kind of ranged in the low 60s to mid 60s now. Obviously, if we change businesses or recent acquisitions that could change, but status quo, the low to mid 60s range is probably the right range.
Brian Bedell - Merrill Lynch
In the margin balance, can you talk a little bit about what inflated the margin balances in the fourth quarter and whether you think that can persist into the ‘08?
David A. Fisher
Since we introduced portfolio margining this summer, we’ve seen adoption by a number of customers. Not a large number, but a lot of customers that use a lot of the leverage available in portfolio margining and do use a lot of margin balances. We’ve seen margin balances increase pretty steadily in the third and fourth quarters. We saw a good jump in the fourth quarter. There is no reason to think that that can’t be sustained.
One thing to think about it is that line item or that balance has jumped around a little bit depending on market conditions and it’s a little lumpy. The balances are diversified, but there are some customers with some larger balances that move in and out of position, so that number can bounce around especially since we show the number at the end of the month. But there’s no reason to believe that that can’t be sustained where it is now.
Brian Bedell - Merrill Lynch
Did you say also net new accounts so far in January are running higher than December levels?
David A. Fisher
Yes, absolutely.
Brian Bedell - Merrill Lynch
No major changes to the advertising philosophy in terms of the media that you’re using there for ’08?
David A. Fisher
I think Adam mentioned that we’re going to continue to increase the budget, and as long as we can continue to generate a high level of accounts at an attractive cost per account for us. We are going to look at any means we can to generate strong new account growth. As I mentioned, we certainly taxed Paul with bringing new ideas to us, finding new ways of connecting with our customers, and he’s going to look at all media out there. But whatever we do, we’re going to make sure that it’s targeted, that it’s measurable, and is directly leading to high-quality accounts at an attractive price.
Brian Bedell - Merrill Lynch
On the institutional business, can you just remind us of how much traction you’ve gotten in there so far and what type of strategies you’re going to employ to win over institutional customers in ‘08?
David A. Fisher
We just started this business in the third quarter. We’ve had some early successes. We brought in some accounts. Really what we have to offer is our expertise with options execution. We’re able to show our institutional customers a tremendous amount of liquidity, use our understanding of the markets because of our broad base of our retail customers, be able to see where flow is going and how it’s moving across multiple exchanges and multiple market makers.
That’s the expertise that we found the need for out there in institutional customers. So the business is still very, very new, only several months old but the fact that we’ve already been able to bring customers on that we’ve seen that there is a value offering that we have gives us a lot of optimism going forward.
Operator
Your next question comes from Michael Hecht - Banc of America.
Michael Hecht - Banc of America
I just wanted to follow up on an earlier question. We talked a little bit about the impact of higher volatility seems to be having on cyclical trends. Talk a little bit about the secular growth you are seeing for options in future retail trade. I mean, what inning do you think we’re in in both markets from a penetration perspective? Do you think we are in early innings are more like the fourth or fifth inning?
David A. Fisher
Well on the future side, I think it’s still like spring training. There is very small retail participation in the futures market today. We think that’s changing. We’ve had some great results in our futures platform so far, optionsXpress customers adopting futures, but really through the exchanges starting to focus more and more on the retail investors as they are yearning for additional growth as they become more mature, larger public companies.
The new products they are coming out with continually seem to be retail-oriented. So we are very optimistic about futures going forward. We do not see a reason while going forward, most investors won’t want commodities and other futures products as part of their long-term investing portfolios. I would say very, very early on.
On the option side, I think a little later, but still early innings. You know, all the surveys we see, all the estimates we get, that’s somewhere between 10% and 15% of customers with online brokerage accounts currently use options today, and I don’t know exactly how high that number can go, but I can see a world five or ten years down the road where it could be 75% or 80% of our customers are using options product as part of their portfolios.
Our customers today, their average age is over 50, these are customers who didn’t see computers most likely until they were in the 30s and didn’t have online brokerage accounts until they were in their mid 40s, yet today they are investing their portfolios online, in their 50s, they have been very quick to adopt to online investing and options investing in particular.
The next generation of people who’ve used computers for much more of their lives, whose online investing has been part of their entire investing experience, we think that adoption is just going to get easier.
Michael Hecht - Banc of America
How many brokersXpress accounts did you guys have at year end, and can you talk about the growth there versus the overall accounts? Any metrics you can give in terms of mix of revenues there, maybe ‘07 versus ‘06? Is it just generally higher growth there than the rest of the business?
David A. Fisher
We had about 13,000 accounts at the end of the year and the accounts is a little bit misleading in that business only because the accounts tend to be much more diverse, you get some really big accounts, you get some smaller accounts, it’s more asset driven than account driven, it is worth about a billion dollars of assets at the end of the year. But the growth in that business has been very strong, even though we had tremendous growth in our core business with combined growth around 40% for the year, the growth of the brokersXpress business was much faster and we expect it to continue to be faster throughout ‘08.
Michael Hecht - Banc of America
Could you say where headcount ended the year, and what the adds were in Q4 and for the full year?
Adam DeWitt
We ended the year with 265 employees. That was up from 252 last quarter.
Michael Hecht - Banc of America
Any outlook for ‘08 there and how much leverage do you feel you have around comp expense and how low the comp ratio can go, if you look at it that way?
Adam DeWitt
I think we look at it in terms of people and where we need to add people. David talked at lot about investing. We certainly are investing in areas like brokersXpress, futures, and the platform is very scalable. That said, we do expect to add some folks in 2008 and if I take out the acquisition of XpressTrade, we probably had about a 20% increase in headcount in 2007 and something around there or a tiny bit higher or tiny bit lower wouldn’t be out of the question.
Michael Hecht - Banc of America
What were the cash balances at end of year as a percentage of total client assets? Remind me what’s the mix there of money funds versus free credit balances, customer payables?
Adam DeWitt
Well, customer cash on the balance sheet is an $800 million liability. But there’s also an $850 million liability. There is also some money in the money fund that doesn’t show up on the balance sheet. But in the past we’ve said that the customer cash is roughly a third of total assets. It was about the same at the end of the fourth quarter.
Michael Hecht - Banc of America
I’m just trying to do some rough math and think about that because, I mean, if it’s about a third and that works out to I think about $2 billion in cash, so it implies a significant amount in money funds, which I assume are pretty rate insensitive in terms of the fee you earn on those, right?
Adam DeWitt
That’s correct.
Michael Hecht - Banc of America
I just wanted to make sure I was thinking about that right.
Adam DeWitt
Everything else is directly sensitive, so it balances the two out.
Michael Hecht - Banc of America
Absolutely, including the margin balances, sure. Outlook for consolidation, are you interested in buying accounts or any new product areas? Is forex an area of interest for you guys?
David A. Fisher
Sure. Every day that goes by that there is not more consolidation in our industry surprises me. I think there will be more. I’d be shocked if we don’t see some in 2008. As far as how it relates to us, our focus right now is continuing to grow our business. We see great growth ahead. We did one acquisition in 2007, and it worked out very well for us. We expect to do additional acquisitions in 2008 to leverage our platform.
Our preference would be to find more value-added acquisitions; acquisitions that bring us new product, new technology, not just buying accounts. But there could be opportunities in the market. If 2008 is a tough year, the markets are down, there could be some opportunity to buy some accounts at lower cost than we could right now. We certainly would not be afraid to take advantage of those opportunities.
Operator
Your next question comes from George Grose - American Capital.
George Grose - American Capital
During the quarter, you added about 15,000 new accounts which is a nice sequential improvement over the last four quarters. Can you discuss what’s behind this growth, where the new accounts are coming from, and if the optionsXpo contributed to the new accounts?
David A. Fisher
I think that the fourth quarter new accounts are really the culmination of our efforts throughout the year and a refocusing of our market efforts to make sure we’re connecting with our customers, that our messaging is strong, that we’re spending money in the areas that we should be spending it.
Those efforts really all came together in the fourth quarter and generated the higher level of accounts. We see that trend continuing in 2008. We don’t think we’re done improving on our marketing. We think there’s ability to both get better at what we’re doing today, but also the opportunity to spend more money and get more accounts at a similar cost per account. I think we have great momentum on the marketing front going forward into 2008 and are very excited about potential results.
George Grose - American Capital
optionsXpo, did you get new accounts from there?
David A. Fisher
We got a few. Well, optionsXpo is more an event for our existing customers, build some loyalty amongst them, continue the education that we think is so important. But we obviously get some accounts from it.
George Grose - American Capital
You mentioned that your education costs are in advertising. The sequential jump in advertising, can we see that as being maybe your education?
David A. Fisher
Certainly education. We’re investing more throughout all of our different marketing strategies: keyword search, banner ads, offline, email marketing, and certainly education, we’ve increased spend in all those areas and we continue to expect to do that in 2008 as well.
George Grose - American Capital
Since you’ve brought Paul Eppen onboard, can you discuss some of the changes that have been happening and that have also been your material contributors to accounts here?
David A. Fisher
I think the initial success is more related to his ability to help us ramp up the spend to a little bit higher levels, manage the increased complexity as we’re spending more money across more different channels, and drill down further into the metrics; help us really see what’s paying off for us, what’s not paying off for us, and allocating the money accordingly.
Operator
Your next question comes from Richard Fetyko - MCF & Co.
Richard Fetyko - MCF & Co.
Curious about your international comments about the international markets you said that you are seeing a lot of good growth there. Are you going to increase your focus on those markets? Could you elaborate on that and what percentage of your revenues or accounts are from the international markets right now?
David A. Fisher
International has been a great source for success for us for the last couple of years. It’s a big wide, open playing field, lot of additional eyeballs to market to and it’s really just opening up new territory. As we said before, the way we like to think about international when we are going into a new country, it’s like we were unable to market in California before; now we are. It’s a bunch of additional people who haven’t seen our platform and our offerings before, who haven’t maybe heard about the benefits of using derivative products, that we can go out and market to and show them the benefits of using our platform.
We are going to continue to do that going forward. We don’t exactly break out our international business, but it’s significant. It’s around 10% of our total business. It’s been growing faster than our domestic business and so we are going to continue to spend efforts there going forward.
Richard Fetyko - MCF & Co.
Just a clarification, about the open accounts, when you talked about open accounts, are those funded accounts or how do you define the open accounts?
Adam DeWitt
We define an open account as someone who has completed an application and told us how they are going to fund the account. There is a step after the application process is done, basically all their paperwork has passed identity verification et cetera and they tell us exactly how they are going to fund, whether it’s a check number, wire instructions, ACH instructions, et cetera.
Operator
There are no further questions at this time. I’d like to turn the conference back over to our speakers for additional or closing remarks.
David A. Fisher
Thank you everyone for joining our call today. We look forward to having you on future calls.
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