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Executives

Paul Helbling – SVP, Chief Administrative Officer and Corporate Secretary

Lee Barba – Chairman and CEO

Ida Kane – SVP and CFO

Tom Sosnoff – President of ThinkorSwim Group

Analysts

Richard Fetyko – Merriman Curhan Ford & Co.

Mike Vinciquerra – BMO Capital Markets

Patrick O'Shaughnessy – Raymond James

Tripti Prasad – Sidoti & Co.

Audrey Snell – Kaufman Brothers

Chris Donat – Sandler O'Neill

Investools, Inc. (SWIM) Q1 2008 Earnings Call Transcript May 1, 2008 4:30 PM ET

Operator

Good afternoon, ladies and gentlemen. Welcome to the Q1 2008 Earnings Call for Investools. At this time, all participants are in a listen-only mode. Following the presentation, we will conduct a question-and-answer session. (Operator instructions) As a reminder, this call is being recorded. I will now turn the conference over to Mr. Paul Helbling. Please go ahead, sir.

Paul Helbling

Thank you, Shelly. Today's conference call and webcast will reference an accompanying first quarter 2008 earnings slide presentation that can be found on our website under Investor Relations, and that will be filed today with the SEC on form 8-K. Participants on this call may wish to reference the slide presentation during this teleconference.

Before hearing from Lee Barba, Investools Chairman and CEO, I have some statements to make. Certain statements in this presentation may be forward-looking statements as defined in the U.S. Private Security Litigation Reform Act of 1995. For example, references to our expectations for the level of demand for our products and services, the growth of our online brokerage, the ability to successfully brand our services and products, and the ability to execute our business plans are forward-looking statements. These forward-looking statements are subject to a number of risk factors and uncertainties which are enumerated in this afternoon's earnings release and the accompanying slide presentation. These risks and uncertainties may cause actual results, performance, or trends to differ materially from those expressed in the forward-looking statements. You are advised to read these cautionary statements in their entirety as any forward-looking statement needs to be evaluated in light of these important factors and uncertainties.

In those instances where non-GAAP measures are used, they are fully reconciled to the nearest GAAP equivalent, which can also be found in the first quarter 2008 earnings presentation on our website.

I now turn the call over to Lee.

Lee Barba

Thank you, Paul. Good afternoon and thank you to everyone for joining Investools Q1 2008 investor conference call. As you'll see from our press release, we had a good first quarter. Our strong operating performance in spite of difficult economic conditions and volatile trading markets confirms the strength of our business model in offering the retail investor differentiated trading technology and education-based content.

This afternoon, I'd like to focus our discussion on two main areas. First, a review of our Q1 results, which benefited from the exceptional performance of thinkorswim, and two, a discussion of several initiatives that we believe will transform our core online brokerage business into an even more powerful engine for profitable growth.

Let me start with a few Q1 financial highlights, where I will be referring to our online slide presentation. For comparative purposes, these financial results include the operations of thinkorswim for the full quarter ended March 31, 2007. The company's public filings reflect Investools merger with thinkorswim as of February 15, 2007. Please review the Investools cautionary statements and Investools non-GAAP financial information on Slides number two and number three.

On Slide number four, record quarterly revenues were $91 million, up 39% versus the same period last year, driven primarily by thinkorswim. This quarter was an important inflection point for us. For the first time, and ahead of schedule, our brokerage revenue surpassed the sales transaction volume of our education segment, and we expect this trend to continue.

Net income after taxes was $12 million, or $0.17 per share, a sharp turnaround from the net loss of $25 million for the first quarter of 2007, the quarter of our merger with thinkorswim. Consolidated adjusted EBITDA for Q1 was $16 million, or 20% versus $15 million, or 19% a year ago in the first quarter. Operating metrics were strong on all fronts, with solid increases in new accounts, funded accounts, retail darts, active trader darts, customer assets, and active subscribers.

On Slide number five, retail darts rose 199% versus Q1 2007, and 8% sequentially.

On Slide number six, new retail accounts grew by 24,800, and new funded accounts rose 30%, or by 10,550 versus Q1 2007. And swim ended the quarter with total opened accounts of 148,975.

On Slide number seven, client assets rose to $2.69 billion, or 89% from Q1 of 2007.

On Slide number eight, total graduates and guests were 13,500 in Q1, and subscribers to Investools Online grew to 106,400. We are seeing a continuation of these trends in April, where thinkorswim is setting new records in each of its operating metric categories with over 48,000 retail darts, over 10,000 new accounts opened and over 4,600 new funded accounts, which is our single largest month in new funded accounts, while client assets have grown to approximately $2.9 billion. These are gratifying results, demonstrating the power of our business model and thinkorswim's consistent ability to attract active trading accounts, even in difficult markets.

We indicated during our last conference call that the Q1 education schedule would be lighter than previous years as we tested and transitioned to new pricing. We have successfully achieved the effective sales rate increases we anticipated with this strategy, and as a result, we have now transitioned all of our domestic events to the new pricing two months ahead of schedule.

During March, we experienced a softening in registrations for preview events, which has continued into April. And we have seen a reduced number of attendees in our events from our forecasts and at our partners' events, which we are taking into account in reducing our attendee forecasts for our Q2 and Q3 schedules. In spite of these softer market conditions, we continue to forecast a larger total volume of graduates during Q2 compared to Q1, and have had more than 3600 graduates in April.

Consolidated adjusted EBITDA margins in Q1 were 20%, primarily due to these reduced schedules and lower attendance in our education division. In addition, the company incurred higher professional and legal fees during the quarter, for which I would like to provide some further detail.

As you will see in our 8-K filed today, and our 10-Q to be filed next week, the company is cooperating with a non-public informal inquiry by the SEC relating to representations by certain presenters in certain portions of their presentations at some of our seminars. The company was already engaged in an internal review of compliance policies prior to the SEC inquiry. We wanted to share the information with you directly rather than let market rumors develop. As the leader in investor education, with the best products and services in this market, we are committed to the highest standards of ethics and compliance in all of our student interactions, and will do whatever it takes to ensure that this is the case.

Separately, we have reached an agreement in principle on the key terms of the consensual resolution, subject to final documentation and court approval, with a locality in California relating to claims that certain language in our sales contracts did not conform to state requirements. Legal fees and settlement costs associated with these matters approximated $1.5 million in Q1.

Along these lines, I am pleased to tell you that Pete Santori will be joining swim as our general counsel. Pete's most recent position was Chief Counsel to the market regulation department of FINRA. He has served with FINRA and its predecessor entity, the NASD, for 14 years. Pete will join swim on or about May 31st.

I'd like to spend the remainder of my time today describing our plans to accelerate the transformation of our business as the leading online broker for the active option trader. Thinkorswim has become the primary driver for the company's revenue growth, profit margins and cash flows, and therefore online brokerage is now clearly the best way to position the company from the standpoint of branding to customers and industry comparisons to investors.

The strong performance by thinkorswim since our merger last year, and especially in the past several quarters in difficult markets, has demonstrated our technology leadership and competitiveness in the online brokerage industry. It is clear to us, and now should be abundantly clear to all of you, that thinkorswim is the platform for our future growth, margin enhancement, and expansion of shareholder value.

As a result, we are taking the following series of actions. One, investing additional marketing resources in thinkorswim to expand direct customer acquisition efforts, including pursuing innovative marketing arrangements that present the thinkorswim brand to active investors. Integrating our education segment more closely with thinkorswim, making it a more cost efficient customer acquisition tool. And strengthening and broadening our management team to drive the integration of our online brokerage and education segments.

Let me briefly comment on each of these initiatives. Given the outstanding top line and bottom line performance and growth of thinkorswim, we believe this is the right time to re-brand the company as thinkorswim Group, Inc. This recognizes the high visibility, credibility, and technology leadership that the thinkorswim brand represents to active, educated traders, particularly in the options markets. We believe this re-branding will properly position the company around our core business, bring clarity to our industry comparisons and enhance investor relations and financial transparency. The formal corporate name change has been approved by the Board, and will be implemented prior to year end.

With regard to expanding marketing, direct to thinkorswim, we are continuing a program that began during Q4 of 2007, investing a greater share of our marketing budget to drive direct account acquisition at thinkorswim. Our first independent thinkorswim marketing campaign was a joint broadcast campaign in Q4, announcing our CNBC Plus launch, and although somewhat difficult to track specific account openings from this campaign, we believe this was a successful introduction of the thinkorswim brand to the broader investing public.

We expanded the thinkorswim marketing budget for Q1, utilizing additional CNBC Plus broadcast spots, as well as display ads and search campaigns, while making the necessary improvements to the thinkorswim website for direct customer acquisition. We anticipate increasing that spend in Q2 and increasing the direct to thinkorswim marketing spend, based on response and conversion rates, as new campaigns are launched during Q2 and Q3. Marketing spend on thinkorswim for the full year is estimated to total approximately $5.5 million to $6.5 million.

In our continuing efforts to partner with highly respected investment brands, we are expanding our relationship with CNBC beyond our innovative introduction of CNBC Plus, streaming commercial-free broadcast video and video on demand news clips, which was introduced to all of our thinkorswim customers last October.

Based on our successful CNBC Plus exclusive product launch relationship, we are announcing an additional sponsorship program with CNBC. Thinkorswim is a co-sponsor of the 2008 CNBC.COM Portfolio Challenge, the second installment of CNBC's highly successful investing contest for retail investors. Portfolio Challenge began registration on April 28th of this week, and trading ends on July 27th of this year. This co-sponsorship will allow thinkorswim to participate in blogs, education-based video tutorials, and other marketing activities that will further present the thinkorswim brand to high quality investors and traders who watch CNBC and actively compete in the Portfolio Challenge.

Another key initiative is to reconfigure our education programs to make them a more cost effective catalyst for generating profitable brokerage accounts. The mission of our education efforts is to produce educated and active traders for the world's best online trading technology platforms. Our existing investor education and thinkorswim education and fulfillment teams will be integrated and we will introduce thinkorswim based options training earlier in the education curriculum.

Consistent with the company's re-branding as thinkorswim Group, Inc., a number of administrative, IT, and graduate conversion functions will be relocated to thinkorswim's Chicago offices from Salt Lake City. This will encourage closer coordination between our brokerage and education operations and eliminate a number of staff redundancies. We are making changes in our organization to ensure that we achieve the initiatives I have outlined, including the following important executive changes.

In addition to Pete Santori, who, as I've already mentioned, will be joining swim from FINRA as our general counsel, I have asked Tom Sosnoff, as President of the broker dealer, to take on the added responsibility of chairing our company-wide new product development committee. Tom will ensure that we place the strongest possible emphasis on new product initiatives that leverage our technology resources to offer an integrated, global, cross-market trading platform which supports active traders with education, and risk-based analytic support and service.

Joe Kinahan, currently Chief Derivative Strategist for thinkorswim and a frequent guest on CNBC and Bloomberg TV and radio, has been appointed Senior Vice President, Education. He will be responsible for integrating the Option Planet and education division presentation teams and operations. Joe will also play a significant role in our product development efforts as a member of our new product development team. Joe began his career on the floor of the CBOE 22 years ago, and is currently managing the thinkorswim Option Planet team, and has been responsible for thinkorswim's relationships with the exchanges.

Woody Ma, currently the Head of Technology Development of thinkorswim, will become the Chief Technology Officer of SWIM. He will focus on bringing together our various IT and development initiatives across the company in support of the dynamic development of new products and technology that are at the core of our franchise value. In his expanded role, Woody will have greater responsibility for working with Tom and Joe to create a unified product release schedule across our multiple trading and education initiatives, including our software, web and mobile-based technology platforms.

In closing, our outlook near-term is that thinkorswim will continue its strong, positive trends as confirmed again with record April results. We have outpaced our peers in the growth of retail and active trader darts, and account openings, and we see that continuing. At the same time, we are transitioning to a model in which education will operate in a more focused manner as a customer acquisition channel for brokerage. This implies a lower level of education revenue and margin, and means that we are focused on driving the highest volume of graduates who can be converted to thinkorswim accounts, rather than operating education as a profitable stand-alone business.

To the extent that the results we saw in March on the education side of the business continue throughout the balance of this year, we now expect education will not generate positive adjusted EBITDA. We do expect consolidated adjusted EBITDA to improve from Q1 levels, and finish the year in the mid 20% range. We are evolving the business model we created out of the two companies and two cultures we merged a year ago to build on our strong position in online brokerage, and more closely align the education division with thinkorswim.

Today, I am pleased to report that this integration has happened faster and smoother than we had expected. We will continue to support the growth in our business with a more cost-effective organizational structure and innovative marketing. And we are confident that the changes we are making are right for our business, our students, and our shareholders. I look forward to reporting the positive impact from these initiatives as we progress through the remainder of the year.

Now, I'll turn the call over to Ida Kane, our CFO.

Ida Kane

Thanks, Lee. As Lee noted, our performance for the 2008 first quarter started off the year on a strong footing, and provides a solid foundation for our continuing efforts to transform and grow the business. Total sales transaction volume for the quarter was $80 million, of which brokerage revenue represented approximately 53%, and education sales transaction volume contributed 47%.

Revenue of $91 million was up 39% from the comparable Q1 2007 figure, adjusted to reflect TOS for the full period. Net income was $12 million, turning around a year ago net loss of $25 million. The key drivers responsible for this turnaround include increase in concentration of brokerage activity and recognition of current and prior period sales from the education segment, based on the passage of time or fulfillment of services for our students.

Consolidated adjusted EBITDA for the business was $16 million, or 20% of sales transaction volume, compared with $15 million, or 19% a year ago. We consider this solid margin improvement in light of our transition to new pricing and a light schedule in the first quarter for the education business. As I mentioned earlier, brokerage revenues exceeded the education division sales transaction volume for the first time this quarter, which is ahead of our internal expectations. And we expect our brokerage segment will continue to be the majority concentration of sales volume in the future.

Thinkorswim continues to reach new levels of growth and account activity. Total revenues for the quarter were $42.5 million, up 109% over a year ago quarter and up 2% over the fourth quarter. The key drivers behind the growth in revenue are increased funded accounts and assets from those accounts, in addition to a high level of trading activity, offset by lower interest rates resulting from the Fed's short-term rate cuts.

Commission revenues were $26.3 million for the first quarter of 2008, which is 104% higher than the year-ago quarter, and 4% sequential increase over the fourth quarter. Commission revenues increases were primarily driven by the 124% increase year-over-year in retail funded accounts and the 199% year-over-year increase in retail darts. Our retail clients traded at an annualized rate of 177 trades per account this quarter, up 25% from the year ago first quarter on increased account growth.

Average retail commissions per trade was $8.55 in Q1 versus $9.01 in the fourth quarter, as we aggressively marketed our technology to more active traders, as well as lowered the cost barrier for new traders to test the derivative market. We think it is also valuable to focus on annualized commission revenue per account, which was $1,500 in the first quarter, compared to the same levels a year ago, proving that thinkorswim customers continue to be among the most active retail clients in the industry.

Please remember that these numbers discussed here exclude active retail accounts that use our institutional third party and black box technology, and that distinction is unique to the way we disclose our metrics.

First quarter interest rebate revenue was $7.7 million, a 91% increase compared to the $4 million in the year-ago period, and only down 4% sequentially from $8 million in the fourth quarter. The increase on a year-over-year basis was driven by the 89% year-over-year increase in customer assets, partially offset by the 200 basis point cut in Fed rates year-over-year.

Our average retail account balance was $39,700 as of the end of this quarter, or $2.69 billion in the aggregate, which is up 89% compared to the year ago period, and up 4% compared to last quarter, which compares favorably to the year-to-date decline in the broad market averages.

The average Fed rate during the first quarter was 3.22%. As you know, we finished the quarter at 2.25%. Our interest rebate run rate at the end of the quarter, based on our customer cash levels at quarter end of approximately $1.5 billion, was approximately $6 million per quarter.

Yesterday's Fed rate cut of another 25 basis points will impact that run rate by approximately 10%. Those metrics assume no increase in customer asset balances. Given our year-over-year increase in customer assets of 89% and our continued growth in new funded accounts, we continue to expect our year-over-year interest revenue, even at these lower Fed rates, will increase 20% on a year-over-year basis.

Other and brokerage related revenue, of which the majority is payment for order flow, was $8.5 million for the first quarter of 2008, which is 148% higher than the year-ago quarter, and 5% increase over the fourth quarter. We continue to experience growth in payment for order flow as our overall trading volume increases.

Because of the growth of our core brokerage business, our commitment to our primary liquidity providers, and the quality of our order flow, we have been able to negotiate better rates with the latest rate increases starting on April 1st. We expect this positive trend to continue. We continue to experience record growth in account openings and funding as we integrate our brokerage and toolbox technology and our company branding at levels we weren't able to do a year ago.

First quarter 2008 education sales transaction volume was $37 million, a 37% decrease compared to the first quarter of 2007, and a 21% sequential decline from the fourth quarter. The primary drivers behind the decrease include a reduction in product pricing that is expected to increase the number of graduates, and fewer events and lower registrations and attendees per event during the first quarter.

Education revenue was $49 million, an increase of 8% compared to the year ago first quarter, and a decrease of 8% compared to the fourth quarter. We acquired 10,430 grads during the quarter, a slight increase from the year-ago period.

From an expense standpoint, it's worth pointing out that we did have a higher level of legal professional and consulting related fees in Q1 related to certain legal matters, year-end audit expenses, and the final deployment of SAP for our sales and marketing floors, which happened in December.

Although I can't predict the legal expense impact on a go-forward basis, I can tell you that the technology costs in the period related to amounts that were expensed, rather than capitalized, associated with the last phase of the SAP rollout, were approximately $1 million, and was impacted EPS by $0.015.

On our year-end conference call, we mentioned that we expected the education division to operate at a mid-single digit adjusted EBITDA margin on an annualized basis. We guided to lower margins in the first quarter as we had a pretty light schedule of events on the calendar, given our passing of the $299 initial price point offering. With the lower number of attendees and resulting registration at events during the quarter, the education division finished the quarter with negative adjusted EBITDA.

As Lee mentioned, we are making adjustments to the business. The adjustments we are making are focused on consolidating functions within the two segments of our business, and are designed to maintain the number of graduates available for conversion into our more profitable brokerage business. To the extent the results that we saw in March on the education side of the business continue throughout the balance of the year, we now expect education will not generate positive adjusted EBITDA. We do expect consolidated adjusted EBITDA to improve from Q1 levels and finish the year in the mid 20% range.

The consolidated first quarter adjusted EBITDA was $16 million, or 20% of sales transaction volume, compared to $15 million or 19% in the year ago period. Despite the lower level of sales transaction volume from the education group, as reflected in the net change in deferred revenue on our P&L, the continued growth in our brokerage business fueled the company's after-tax net income of $12 million in the first quarter, compared to a loss of $25 million in the year-ago period.

With regards to income taxes, the company started the year with approximately $110 million of available net operating loss carry-forwards. Now that the company has a year of history with the combined entities, we determined that the estimated annual effective tax rate should be utilized in calculating the income tax expense for interim periods. This methodology has the effect of spreading the income tax expense over the entire year rather than back-end loading the expense at year end.

For 2008, the overall effective tax rate is now projected to be approximately 16%. For 2009, the overall rate is projected to be approximately 39%. From a cash flow perspective, we still expect to pay minimal amount of cash taxes in 2008, given the utilization of net operating losses. We have book tax expense greater than cash taxes, given the majority of the NOLs were previously recorded through purchase accounting, and the benefit never went through the company's P&L.

The income tax expense recorded during the quarter impacted EPS by approximately $0.035. This combined with the technology expenses mentioned earlier equates to a $0.05 impact. At quarter end, our cash, cash equivalent, marketable securities, and accounts receivable balance was $74 million, down sequentially from our year end balance of $80 million.

During the period, the company made approximately $13 million of debt and interest payments and approximately $9 million in bonus payments, mostly related to the retention bonus program established for brokerage employees at the time of the merger, which is being accounted for over a three year term of the program. We ended the first quarter with debt of $107.5 million on our balance sheet.

That concludes my prepared remarks. I now will turn the call back to Lee.

Lee Barba

Yes, thank you, Ida. Shelly, I think we'll open the floor for questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator instructions) The first question comes from Richard Fetyko at MCF & Company. Please go ahead.

Richard Fetyko – Merriman Curhan Ford & Co.

Good afternoon, guys.

Lee Barba

Hey, Richard.

Ida Kane

Hey, Richard.

Richard Fetyko – Merriman Curhan Ford & Co.

A few questions. First off, I just want to get some housekeeping question out of the way. First, the settlement with SEC, or the inquiry from SEC, sounds like you – I wasn't clear whether you’ve reached an agreement and that ends the inquiry?

Lee Barba

No. Richard, that's – it’s an informal non-public inquiry. It is continuing, and there has not been a settlement reached, nor could we comment on one.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. So the $1.5 million is simply related to the legal expenses associated with it?

Lee Barba

Sorry, Richard. By way of clarifying, there was a separate agreement reached with a political entity in California relating to a completely different, unrelated with regard to specific language in our sales contracts. And we reached a settlement, at this point, subject to final documentation with that entity. That is included, the settlement, in the $1.5 million, which includes larger than normal legal fees related to both matters.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. Got it. And then, there was also $1 million expense related to the SAP implementation that ran through the P&L instead of CapEx? Is that correct?

Lee Barba

Yes. Ida can comment. The difference is, until you launch – it's an accounting policy –until you actually launch the product into utilization, you capitalize the cost, which is what we've done. When the product was launched at the end of last year, now you expense any costs related to that rollout. And Ida, is that correct?

Ida Kane

Well the only thing I'll add to that is that's the last phase. We rolled out to our sales and marketing organizations in December. And so that's the last kind of bubble, if you will, on the expense side related to that SAP project.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. All right. Thanks for clarifying that.

Lee Barba

Sure.

Richard Fetyko – Merriman Curhan Ford & Co.

And then more on to sort of the business related stuff. You mentioned in April you acquired over 6,000 graduates. I missed the exact number. And if so, it sounds like the pricing strategy is working—

Lee Barba

Yes.

Richard Fetyko – Merriman Curhan Ford & Co.

–in terms of lifting the sort of graduate numbers. I was just wondering if you had enough time to observe the trends and the conversion into thinkorswim from these graduates.

Lee Barba

Yes. Okay, Richard. First, let me correct that number. The number we announced in our comments was 3,600 graduates in April, which is continuing growth for the year. And I believe, Ida, improvement over last year. The comments that I made, and I want to emphasize them, is that the pricing strategy had exactly the impacts we desired in terms of increased sales. The difference that we didn't see until March, and is continuing in April, was that fewer attendees in the events, including with our partners, reduced the opportunity to convert.

As to thinkorswim conversions, as you can clearly see from the record we had in April, we – so we are getting the flat to last year in the first quarter in terms of number of graduates, an uptick in April, more graduates, and conversion to thinkorswim in April, a record number of new accounts. We want to be absolutely sure everybody understands that. And so we see all the conversion, the events. Once the students are there everything is performing exactly as it always has. There are fewer front-end attendees, and we ascribe that to the current economic conditions.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. And so – and with that 3,600 in April, you expect total graduates to still be higher in the second quarter than the first?

Lee Barba

Yes. Again, I did make that comment, but it is worth repeating. We are – I think we said at the beginning of the year at our Q4 call, we expect 10% to 20% higher graduates for the year. That is still true. At various points, we had hoped that those numbers would be even higher. Based on current economic conditions and response rates into the previews – everything else after the preview is working well – we think we are back to what we told you, which is the 10% to 20% range. So there are more graduates. The conversion and process with thinkorswim, which Tom can comment on, is very, very strong. And once they are at thinkorswim, which is the profit engine for the company, they are performing better than any of the online brokerage competitors.

Richard Fetyko – Merriman Curhan Ford & Co.

Got you. And then, you mentioned – you commented on the education sales margins, obviously have come down and will not be profitable for the rest of the year. What about the sales trends? Last time you mentioned that you expected the education sales to be modestly up versus '07. What do you think they'll end up being, not with sort of a different outlook for '08?

Lee Barba

Yes. So I want to make sure I understand your question, Richard, and address it directly. We are saying that graduates for '08 will be higher than '07. And a lot of the reason for that is that the $299 pricing in our own events, and the $99 pricing in our partner events does and continues to generate significantly higher ESR, effective sale rate. So once the potential students are at an event, this pricing absolutely increases conversion into our education programs. Absolutely, exactly as we had thought that it would. The issue is fewer opportunities, or attendees, in the previews. Is that, Richard–?

Richard Fetyko – Merriman Curhan Ford & Co.

Yes. I understand, I understand. But I do see that the up sell rate from the initial graduates to advance courses has declined and I am sure some of that was anticipated. But – so that's – I guess my question was with regards to the total education sales transaction volume–

Lee Barba

Yes.

Richard Fetyko – Merriman Curhan Ford & Co.

– in '08 versus '07. What sort of trend do you think?

Lee Barba

Yes. Okay. So in education, we anticipate the sales transaction volume in education to be lower than '07.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay.

Lee Barba

And I believe Ida is commenting that at roughly these levels.

Ida Kane

Yes. I mean, Richard, if the trends that we are seeing in March and April continue, then I would suggest that these levels of sales transaction volumes would continue as well, because we are not – because, as Lee mentioned, we are not seeing a deterioration of sales once the individuals are at the event. But we are seeing less people at events right now.

Lee Barba

And you are – just to clarify, Richard, you can see in the numbers, you are seeing a change in mix, which you would expect at the lower pricing, which continues to give us the opportunity to move those students along to additional education as their career or lifetime value continues with the company. Our focus is now much more on getting that conversion process to thinkorswim, which is the margin driver.

Richard Fetyko – Merriman Curhan Ford & Co.

Right. What are you thinking about – what are your thoughts about the whole education sales funnel, the advanced courses? I mean are you going to keep those intact? Are you going to change those as well, and in terms of the pricing and the content, and the whole up sell process?

Lee Barba

Yes. So, Richard, the message is, and I think then we have to move on to some other questioners, is with Joe Kinnehan, we are clearly sending you the message that we are reorganizing our education efforts. We are very focused on the cost issues on that side of the business. We see a continued expansion of our continuing education product and products that will go to the high end with Option Planet, but now integrated with a renewed foundation course, and additional courses that will offer a student the ability to simply buy an online course without a live experience at reduced pricing. I don't want to get lost in the detail. Of course, we are constantly changing the product mix to meet the student needs. The emphasis here is that it is much more aligned with converting the students earlier in their relationship with the company to thinkorswim brokerage accounts. That's the message.

The only other comment, and I'm trying to keep this simple, is when we saw in March and April, as we've commented, the softening in the registrations for the previews, and at our partner events, we had anticipated a strong second quarter. We still do, see more graduates in Q2. But it isn't as robust as we originally thought, as our partners and our own registrations are lower. It still goes great. We were anticipating the lower pricing to be even more, therefore, the focus on the conversion to thinkorswim more aggressively than in the past, and the alignment of education with Joe Kinnehan as the new Senior Vice President to lead that effort from the perspective of thinkorswim.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. And then the last one, if I may, with regards to the marketing spend on thinkorswim direct sort of marketing spend, the $5.5 million to $6.5 million in '08, is that – would you characterize it as an additional to what you anticipated initially, or is it an allocation from the education bucket to the thinkorswim bucket? I was just sort of–

Lee Barba

Yes. I think you should think of it as from within the original spend. And that's the way we are thinking of it. And it's a reallocation. And if you go on cnbc.com and click on Portfolio Challenge, you will now see a series of new ads for thinkorswim. You will see that continue as we develop additional TV – broadcast TV commercials for thinkorswim. Look at the thinkorswim numbers. We have this phenomenal engine, and all we are doing is saying, you know what, the revenues from thinkorswim are larger than education, and that's where our profit comes from. Let's line up education, restructure it, get the cost right, and lets have this conversion to thinkorswim be a primary focus instead of an equal focus. That's what we are doing at the company.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. Thanks.

Lee Barba

Thanks, Richard.

Operator

(Operator instructions) The next question comes from Mike Vinciquerra at BMO Capital Markets. Please go ahead.

Mike Vinciquerra – BMO Capital Markets

Good afternoon. I apologize guys. I don't have a handset where I'm at. Can you hear me okay?

Lee Barba

We can hear you fine, Mike. Go ahead.

Mike Vinciquerra – BMO Capital Markets

Great, thank you. I wanted to ask I mean I am getting a sense with this transition that you just talked about with education, really just – it sounds to me like it's just going to be a driver for brokerage. Do you expect it to be a profitable and contributing business on its own on a go-forward basis, or over the next 18 to 24 months should we expect that that might be running at a breakeven basis just to drive educated investors to brokerage?

Lee Barba

Yes. Mike, we were very clear to say that we are not expecting it for the balance of '08, and I think therefore into the future, as an independent profitable business. However, its value in generating a large number, and even larger number than ever before, of students that can be converted to thinkorswim is how the business is being restructured.

Mike Vinciquerra – BMO Capital Markets

Okay. All right. And then, I think Ida mentioned this when you mentioned the commission rate at $8.55, you mentioned a lower entry point for new traders. Can I interpret that to mean the same minimum, one contract for your Investools clients coming over as now applying maybe to the broader, direct marketed thinkorswim guys?

Lee Barba

Yes. Tom?

Ida Kane

Tom, do you want to comment on that?

Tom Sosnoff

Yes. Hi, Mike, it's Tom. I'll grab it. Yes. Simply put, yes. We compete very aggressively with our software-based competitors, and that's pretty much how the software online trading world of software brokerage firms is driven. So the answer is yes. We've always actually been that way. We've catered from the first day we launched thinkorswim to customers that wanted to trade one contract or one future or 100 shares of stock. And actually we think it's – we are committed to that throughout our education because we believe that you build active and successful traders through a lot of trading. So it's part of our model all the way from education straight through to brokerage. So it's a trend that we expect to continue. And you know, it's important to us. We thought we set that trend years ago, and we expect the rest of the marketplace to come – to basically to match that or to come in to line with us.

Mike Vinciquerra – BMO Capital Markets

Okay. And you and I have discussed this in the past as far as the progression of those people from being single contract traders and then maturing into 10, 15, 20 like your typical client. Are you seeing the progression of your new clients as you would anticipate kind of the – as they grow moving into larger trades? And therefore, at what point do we expect a stabilization in this commission rate? How low does this go before the new guys come in and do above $1.50 a trade kind of level out with the people doing $10, $20 a trade?

Tom Sosnoff

Well right now, we've seen stabilization in the number of contracts we are trading. It’s kind of – we are – we've kind of stabilized over the last six months as far as number of contracts or size of trades. So it's really a little bit more of being more aggressive on the rate side for us, because customers come to us all the time. We match rates. We are aggressive. No firm really wants to lose a customer over a commission rate, and they've pretty much been commoditized throughout the industry as you can probably model out. So we think we are nearing those levels. But again, if you look at our software-based competitors, they all come in significantly lower than we are. So we continue to believe we are that tweener firm. I am not so sure that we build – that we necessarily get somebody that trades one and twos to trade twenties, but what we do is, the more active our platform is, and the more valuable our order flow is over time, the better our technology becomes. So as we continue to push the front-end technology, we believe that we acquire the best customers in the world. And that's our business model.

Mike Vinciquerra – BMO Capital Markets

Okay. Great. Thank you. And then just one more, and then I'll get out of the way, here. Ida, you mentioned, I think you said, I just want to clarify, you run at about $6 million quarterly run rate for interest income as you exit the first quarter, and that would compare to the $7.7 million for the first quarter. Is that right?

Ida Kane

That's correct. At the 2.25% Fed rate.

Mike Vinciquerra – BMO Capital Markets

Okay. And then the cut that we just had here cuts about another 10% off of that on a run rate basis?

Ida Kane

That's correct, with no additional asset growth, which obviously we would expect, given our history.

Lee Barba

The growth of (inaudible).

Mike Vinciquerra – BMO Capital Markets

Okay, okay. Thank you, guys.

Ida Kane

No problem.

Lee Barba

Thanks, Mike.

Operator

The next question comes from Patrick O'Shaughnessy at Raymond James. Please go ahead.

Patrick O'Shaughnessy – Raymond James

Hey, good afternoon.

Lee Barba

Hi, Patrick.

Ida Kane

Hi, Patrick.

Patrick O'Shaughnessy – Raymond James

I was wondering if you can talk a little bit about the quality of the customers that you are bringing in on the education side with the lower price points. Do these tend to be customers of the same general demographics as you were bringing in previously, and they tend to migrate to thinkorswim at the same rates? Or can you give a little bit more information about how the price cut has maybe impacted the type of people that you are bringing in?

Lee Barba

Yes, Patrick. Not a significant change. At $299, I actually questioned the head of our teams yesterday, they would say, no change in the demographic at $299. At our partner pricing of $99, there are on the margin people in the room who do not have sufficient funding to move along at this time with additional education other than a trading room or perhaps the associate program, which is why we are building in some intermediate steps in our new product ladder. But the volume of the students, I think Tom can comment. We constantly still hear the same thing in terms of the people who come to thinkorswim, and you wouldn't necessarily know the wealth or sophistication they have. But they are in our events on the education side and converting to TOS.

Tom Sosnoff

Patrick, I'll jump in for one second. We have not seen any drop off in kind of what you call the quality of clients moving over to the TOS side. So it's been pretty consistent with what we are used to. You know, we are a unique firm in that we bring customers in from other firms through an acquisition model, and we also create customers. We are one of the few customer creation firms out there. So it's a neat model, and it continues to drive, pretty much the same type of customer that we are bringing on for the last seven or eight years.

Patrick O'Shaughnessy – Raymond James

Okay. Next question I had was, with the marketing spend transferring a little bit more from the education side of the business to the thinkorswim side, is it reasonable to expect that a higher percentage of new customers going forward will not have come in through the education funnel?

Lee Barba

I think it is safe to assume that what we are signaling is the growth in thinkorswim and its presence in its competitive space is now scaled enough that it is and has a greater opportunity to originate in addition to education. That's the way we think about it, and while the initial spends that were in Q4 and Q1 are relatively modest, we are seeing response rates and the quality of the accounts coming in through those ads as consistent with thinkorswim quality. If you look at the banner ads, and you can go see them on cnbc.com Portfolio Challenge right now, they are not your normal brokerage ad. And as you click through to the landing page, we are absolutely seeing it self select into a higher quality, more active account. That's how the campaign was designed.

Patrick O'Shaughnessy – Raymond James

Great. And then the last question I had before I let you guys get on to other people, is you briefly touched on payment for order flow, and how it stabilized or potentially even improved a little bit in the quarter. I was hoping you could talk a little bit more about that. If I am running the calculation on a per-trade basis, payment for order flow looks about flat from the fourth quarter of 2007. So to me it looks like it pretty much stabilized. If you can talk a little bit more about that, I would appreciate it.

Tom Sosnoff

Okay, Patrick. It's Tom. Thanks. Basically the end of the year we talk a little bit about payment order flow, and I think we were kind of alone when we said we expected the trends in payment to increase now. What we meant by that is on an apples-to-apples basis, a certain type of order we expected payment based a little bit on scarcity of order and quality of order, to kind of increase this year, because there's a lot of money chasing very small returns, and liquidity providers are able to make a lot of money off of retail payment – I mean off of retail order flow. So we've seen that trend, just like we thought, continue. The difference is that the market has gone to a wider number of penny options. So what's happened is that we've increased the number of penny options out there, and the payment numbers on penny options are less than they are on, let's say nickel wide options or dime wide options. So the increase in penny options has offset the increases in payment for the wider bid S differential, the wider spreads. It's a trend. At this point, we tend to see the penny expansion, at least we think it will slow down probably through the end of '08. We just had our last round about a month ago. And as we are looking right now at their – like Lee said during the presentation, we've just seen a round of increases on non-penny options. We expect that trend, the current trend in payment, based on the kind of the expected value of internalization, for a lack of a better word there, we expect the payment trends to continue. And probably get a little stronger rather than weaker. There's a lot of competition out there, again, for quality order flow. And that's what we have. We also are very loyal to our liquidity provider partners, and we've built a very strong infrastructure, and kind of routing mechanism to maximize payment. We are pretty comfortable with continuing along this trend.

Patrick O'Shaughnessy – Raymond James

Great. Appreciate it.

Tom Sosnoff

Thanks.

Operator

The next question comes from Tripti Prasad from Sidoti. Please go ahead.

Tripti Prasad – Sidoti & Co.

Hi. Just some quick questions. One, kind of wondering about the rationale to pay the taxes now instead of back-end loading those, and in terms of collecting interest.

Ida Kane

Okay. Hi, Tripti. This is Ida.

Tripti Prasad – Sidoti & Co.

Hi, Ida.

Ida Kane

Well so from a – just to clarify it, I mentioned this a couple of minutes ago, the book tax expense differs pretty significantly from our cash taxes. We started the year with $110 million of net operating loss. And because of the history that we had with thinkorswim as a profitable, a net income profitable entity, we are using an annualized effective tax rate, which would basically smooth the expense. It doesn't change the cash payments. Just to give you an idea, the cash taxes paid in Q1 is approximately $400,000.

Tripti Prasad – Sidoti & Co.

Okay.

Ida Kane

So there'll be book tax expense for each of the quarters, but the cash taxes are substantially lower. And obviously that information will flow through all of our Qs.

Tripti Prasad – Sidoti & Co.

Okay. And in terms of the – I know that Lee had said that you couldn't comment on the lawsuit, but just wanted to kind of get to the amounts that you had in liability insurance. I mean last I think that we heard it said it was about $1 million.

Lee Barba

Tripti, I am not sure we have ever commented–

Ida Kane

I am not sure I'm following.

Tripti Prasad – Sidoti & Co.

I'm sorry?

Ida Kane

I'm not sure I'm following the question.

Lee Barba

If your question is, is there a liability insurance to cover it, not that we are aware of.

Tripti Prasad – Sidoti & Co.

Okay. And then lastly, looking at the effect on the interest payments for the quarter, I am sure that some of this will become apparent [ph] when you file the Q, but how much of that is due to I guess the hedge that you have on top of the payments to JP Morgan? So how much of that is – I'm just a little surprised given the declining rates that the interest payments increased.

Ida Kane

So the details will be in the Q. We have a hedge on 50%, which was obviously locked in when we did the loan a year ago. So the rate on the hedge – we are actually – have a loss on the hedge, which flows through on the P&L. I think it was $1.5 million.

Tripti Prasad – Sidoti & Co.

Okay.

Ida Kane

Or you can see it on the cash flow statement, excuse me, it was $1.4 million during the quarter. But again, that does point to the fact that there is a difference between the cash interest expense that we pay on the debt versus what flows through the P&L because of the hedge currently being negative.

Tripti Prasad – Sidoti & Co.

Okay. That's it. Thanks.

Ida Kane

Thanks, Tripti.

Operator

(Operator instructions) The last question comes from Audrey Snell from Kaufman Brothers. Please go ahead.

Audrey Snell – Kaufman Brothers

Hi.

Lee Barba

Hi, Audrey.

Audrey Snell – Kaufman Brothers

Can you give us some idea of the size or the potential drag on earnings from education this year?

Lee Barba

I don't think we can at this time, Audrey. And again, we would refer back to all of our earlier comments. You had the tax, you had the legal, including settlement, and you had the technology. And so, as Ida went through, we are not suggesting to make adjustments, but there were some of those items in Q1 that affected what still was a 20% adjusted EBITDA. So we are doing – I think again the message, to be very clear with everyone on the line, is we are at an inflection point. Thinkorswim has grown from a small, little known, but very powerful online brokerage to being the driver of our revenue and margin growth. And now we've got to realign the education division to support that growth. That's what we are doing.

Audrey Snell – Kaufman Brothers

Okay. Can you share with us any of the new trading products that you intend to roll out over the year?

Tom Sosnoff

Hi, Audrey. It's Tom. You are talking about essentially retail products?

Audrey Snell – Kaufman Brothers

Yes.

Tom Sosnoff

Well we actually don't put out, for competitive reasons, we don't put out our future set of release notes kind of that early. We do make – we continue to make a software release once a month. We are the most aggressive financial tech software firm on the Street when it comes to online brokerage. We've been making one software release that's feature packed for almost seven straight years now, so we are making twelve releases a year for seven straight years.

Our next release is coming out this weekend as we roll out, for example, options on futures this weekend, extensive new futures platform, options on futures, a new trader's log, so customers can track their trades, and notepads, and things like that. In the hopper, it's just the kind of stuff that we don't like to get our customers too excited, but we are – if you are interested, I'll be happy to send you or post on our website years of release notes.

And you can see how aggressive we are. We usually launch anywhere from major features on the customer side. Remember, we are a resource conscious firm when it comes to software development, which means we are very aggressive driving front end technology to the retail customer, most aggressive firm in the world in that respect. And as such, we push out anywhere between six to ten new major client side features once a month. And then on top of that, different bug fixes, and obviously different pieces of complementary web based and mobile technology.

We are continuing to build eleven platforms simultaneously, software and web. And more so than ever, just kind of to back up what Lee said, is we are now focusing on the integration of our investor education technology with our front-end brokerage technology to increase our conversion rates. You saw some pretty unbelievable numbers in April that we just – that Lee mentioned today, and a lot of that conversion was at a much higher rate than you've seen in recent months. So the plan is working.

Audrey Snell – Kaufman Brothers

Great. On a separate topic, when was the official change in price for education?

Lee Barba

Audrey, the $99 for our partner has been effective throughout the year domestically. In Canada, with our partners, the price has remained $999. For our own brand, we were testing throughout Q1 at $299. It became entirely $299 for the foundation course last weekend, which is approximately, as I commented, two months ahead of schedule, and in reaction to what we saw was the softening in the registrations, which is due to the economy.

Audrey Snell – Kaufman Brothers

Right. The most important factor, in your opinion, with regard to registration strength or weakness, is what? The health of the economy or the health of the stock market?

Lee Barba

It's both. It's a pattern – you read the front page of the paper every day the same as the rest of us. And registrations actually, in terms of the phone response, is not that far off. But what happened in March and April – it can turn around. Last weekend, for example, was more positive. But what we saw was they don't show. So you sometimes can't see it. I don't want to get lost in the detail. They are responding to the marketing, but then we saw, throughout March and April, a softening in their actual – they are telling us they were going to come, and actually coming. Those who came, our effective sale rates were up dramatically, and they flowed through, as you can see, to the continuing ad in the press release numbers that you see, exactly as we expected.

More trading room and associate sales, you can see it on the sheet. Fewer PHD and Masters sales, which we worked through an education counselor on a longer time frame. In the interim, accelerating the presence of thinkorswim personnel into those events so that the conversion process to brokerage starts sooner and has been extremely successful as you'll see in the thinkorswim numbers.

Audrey Snell – Kaufman Brothers

Okay, great. One final question, how is Canada doing?

Lee Barba

Canada is doing great. Tom is chomping to answer this one. We are way ahead of schedule in Canada. Tom?

Tom Sosnoff

Thanks, Audrey. I mentioned to Lee that somebody might bring this up today. Well Canada is our first venture outside of – going for full registration outside of the U.S. We are not actually – we are registered in about half the provinces right now, but we are about 100% ahead of schedule, or ahead of our projections as far as account openings and funded accounts go in the first quarter of '08. So I think Canada, so far, fingers crossed, very good. And we are just – I mean, when I say we are in our infancy in Canada, we are truly in our infancy. But we are running over 100% ahead of projections. And hopefully if that trend continues or the trend that we are seeing so far continues, Canada will be a little bit of a home run for us compared to what we thought it was going to be, which will give us a lot of encouragement for moving further around the globe.

Audrey Snell – Kaufman Brothers

And is the foundation course there also priced at $299, or is it $999?

Lee Barba

Audrey, consistent with the earlier comment, in our own brand, moving to $299. With partners unique to Canada, which is a strong economy, particularly when you are out near Calgary, it's at $999, with our partners.

Audrey Snell – Kaufman Brothers

And is the training behavior similar or the same, Tom?

Tom Sosnoff

The trading behavior is a little bit less. Canada is not quite as – the customers in Canada are not quite as far along. It's mostly a stock based trading mentality. Most of the firms there – now there is very few firms that specialize in derivatives. So we are a little bit unique to that space, but our technology has been endorsed. The difference is, currently I think that you'll see our trading volume jump when we actually start routing to Canada. So right now, we are supporting Canadian customers that are trading U.S. listed products. We are not currently supporting retirement accounts there and we are not currently supporting access to the Canadian marketplace. And we are not supporting trading in Canadian dollars. So we are – it's amazing, kind of our growth so far in Canada, when we are basically forcing customers, especially in this dollar environment right now, we are forcing customers to convert to U.S. dollars and to trade U.S. products, so they get kind of double whacked sometimes with the dollar conversion and everything else. But yet at the same time, they are moving over in droves to use our technology, which is, again, it just continues to kind of validate what we've said all along. You build the best front-end technology, you attract the best customers.

Audrey Snell – Kaufman Brothers

Terrific. Thank you very much.

Tom Sosnoff

Thanks.

Lee Barba

Thanks, Audrey.

Operator

The final question comes from Chris Donat at Sandler O'Neill. Please go ahead.

Chris Donat – Sandler O'Neill

Hi. Thanks for sticking around to take my call.

Lee Barba

Yes, thanks Chris.

Chris Donat – Sandler O'Neill

Lee, I'll keep it simple here. Just periodically people wring their hands about the potential slow growth in customer acquisitions, or that the pool of traders and your potential customers has been saturated or whatever. All the low hanging fruit has been picked. Pick your analogy there. Can you just give us a little color from your experience looking at other economic cycles and other markets why you are so comfortable that the economy is the reason and not that we are at one of these saturation points?

Lee Barba

Yes. Yes. We don't think we are at a saturation point, and we continue to believe that both at thinkorswim, which is how they grew originally, as well as in the new combination with Investools, that education is a process, if you will, almost a factory to create and upscale an average investor into a more sophisticated and active trader, especially, if they are on great technology, which they are at thinkorswim. Again, the show rate metric that I referred to, that's an indicator. If we thought that there were other problems, once they appeared, you would see that the entire process of conversion was jeopardized. We are not seeing that. It is that registration and show process. In fact, the sale rates are way up as we anticipated at $299. You wouldn't see that and the continuing up sells in the mix that they are. That's exactly what we had predicted. And again, you can see these factors change fairly rapidly.

Last weekend was good. I'm actually looking at some screens right now from events that are taking place around the country, and show rates are better this week. I think you've had this horrendous news on the front page, and it discourages some people from showing up at the events. We are restructuring around that, and there are several weapons in our arsenal. We have a huge database. There are other avenues that we are pursuing that would continue to bring in highly qualified leads, both to education, and as we've clearly said, direct to thinkorswim. We're going down both paths.

Realign the cost in education. And we have the perfect price point for those people who are still showing, and now bring direct to TOS, which is an entity we would remind you back to our original comments. We had 15,000 accounts here in September of '06 when we announced the deal. We now have – well if you include April, we are over 70,000. That's just unbelievable growth. And not only is it not slowing, April was the record in the midst of some of these issues in education. As we see that decoupling and the power of the thinkorswim brand, we are going with it. That's where we make our money, and we'll realign as needed, as shareholders would expect, the education division to continue to do what it needs to do, but grow thinkorswim on its own. We are ready. It's there.

Chris Donat – Sandler O'Neill

I got it. Your conviction is coming through there, Lee.

Lee Barba

Thank you, Chris.

Chris Donat – Sandler O'Neill

I'm all set. Thank you.

Lee Barba

Thank you.

Ida Kane

Thank you.

Lee Barba

Thank you. Thanks, Shelly. I think that concludes the call for today. Again, thank you for your time.

Operator

Ladies and gentlemen, this concludes the conference call for today. You may now disconnect your line, and have a great day.

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Source: Investools, Inc. Q1 2008 Earnings Call Transcript
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