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Executives

Adam J. DeWitt - Chief Financial Officer

David A. Fisher - Chief Executive Officer

Analysts

Mike Vinciquerra - BMO Capital Markets

William Tanona - Goldman Sachs

David Scharf - JMP Securities

Bryan Bedell - Merrill Lynch

Michael Hecht - Banc of America Securities

Ed Ditmire - Fox-Pitt

Rich Repetto - Sandler O'Neill

George Grose - American Capital Partners

Richard Fetyko - Merriman

optionsXpress Holdings, Inc. (OXPS) Q2 2008 Earnings Call July 22, 2008 10:00 AM ET

Operator

Good day and welcome to the optionsXpress Holdings Second Quarter 2008 Financial Results Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Adam DeWitt, chief financial officer. Please go ahead, sir.

Adam J. DeWitt

Thanks, Gwen. Good morning, everyone, and thank you for joining us for our second quarter 2008 earnings call. I’m Adam DeWitt, the CFO of optionsXpress, and with me today is our CEO David Fisher.

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

Before we begin, I would like to note that this call contains forward-looking statements that are made pursuant to the Safe Harbor provisions of the federal securities laws. These statements involve risks, uncertainties and assumptions that may cause actual results to differ materially from those anticipated.

Listeners to the call are advised to review the risk factors contained in our prospectus, most recent annual report on Form 10K and quarterly report on Form 10Q 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 our CEO David Fisher, who will recap the highlights from the second quarter. Following David’s remarks, I will walk through the financials, and David will wrap up with our outlook before we finish with your questions. David?

David A. Fisher

Thanks, Adam. Good morning, everyone, and thanks for joining our call today. We are pleased to announce solid second quarter results.

As we discussed in the first quarter conference call, we saw great resilience from our customers, and this resilience certainly has continued in this very challenging market environment. Through the use of options, our customers have been able to effectively employ strategies that have helped protect them against the volatile market swings we have witnesses.

In addition, through their increasing use of our futures products, our customers have gained exposure to rising commodity markets. As a result, our customers remain engaged and performed well during the quarter.

We also saw encouraging inflows of customer assets. Our educational outreach and its message of the benefits of using derivative products continued to resonate with retail investors. The result was solid asset growth despite the declining market with total customer assets up 5% from Q1.

The sustained engagement of our customers clearly contributed to our solid financial results of $0.39 per share of EPS while maintaining 60% plus pre-tax margins.

It seems that many are surprised by the resilience displayed by retail investors over the last two quarters, but today’s retail investors as a group are much savvier than they were in the past. Leading up to the last bear market in 2001 and 2002, retail investors had limited tools and resources with their approach to investing seemingly based more on word-of-mouth stock tips rather than meaningful analysis.

As a result, these investors, who for many made their first trades online during that time, suffered significant losses when the market sold off. In addition, the only strategy used by the large majority of retail investors at the time was to buy stocks.

The paradigm has clearly changed because today’s retail investors are much more knowledgeable of the markets, have vast amounts of financial information and analytical tools at their disposal and are employing a much greater variety of strategies.

We have found more so than ever that our customers are taking advantage of our educational offerings and properly utilizing the easy-to-understand yet powerful tools and resources that we provide to execute on their investment strategies and drive sustained activity.

To that end, our efforts on the educational front have rapidly expanded as we’ve increasingly used our education efforts, not only as an account retention tool, but as a customer acquisition tool as well. We have accomplished this through increasing the rate and frequency of our webinars as well as increasing the number of live events we are hosting globally.

In fact a revised education center is one of the highlights of the recently launched redesign of our website. The primary focus of this redesign was a pre-login portion that is geared towards prospective customers.

Our educational platform has gone through an evolutionary shift in which we now package our events, webinars and text-based content to a more structured curricula-based offering. Visitors to the site can view a series of video and written content based on their product interests and their level of experience. Much of this is content that was previously only available to customers.

In addition, we’ve created a test drive, which allows prospects to use all of our tools and features for ten days without opening an account. Through the test drive process, we’ve caught contact information on these prospects, which allows us to continually market to them. We believe this will lead to better conversion of prospects over time.

While we again had solid new account growth in the quarter with 14,400 net new accounts, a 25% increase over the second quarter of last year, we think the new site design, including the test drive, as well as our other marketing initiatives we are exploring, will continue to drive meaningful account growth at optionsXpress.

Our new site redesign also touched on the post-login portion of our site. In addition to improving the overall speed of the site, the new design is easier and more intuitive for customers to navigate, which has become increasingly important as the amount of content continues to grow.

We’ve also introduced the concept of hubs. The purpose of a hub is to bring together categorized content in one easy-to-use and yet powerful landing page. A great example of this is our new toolbox hub where we make it easier for users to find trading tools based on a specific product focus or skill level. The post-login design is an iterative process, and you’ll see further improvements over time.

While we continue to see many opportunities within our core options and futures business, we also see further growth in our ancillary businesses. With XpressTrade fully integrated at the end of 2007, we have set our eyes on expanding our futures platform offering.

On July 25th we announced the acquisition of Open E Cry. Through this acquisition, we have secured a position within the institutional futures market. Open E Cry’s proprietary software platform called OEC Trader is specifically designed to meet the standards of high volume futures traders. This unique software platform is very different from the optionsXpress web-based platform.

Accordingly, we definitely view this as an additional product, not just a scale plan or existing futures business. We feel that we’ve placed ourselves in a leading position in the futures market, allowing us to take advantage of the great growth the futures industry is experiencing. While equity options remains our largest product, futures has clearly become an important part of our business.

BrokersXpress, our wholesale business serving registered reps and RIAs, also continues to generate solid results. The recent focus in that business has been on adding tools so we can better serve the RIA market in addition to registered reps, which have been the largest part of the business historically. Also, with the difficult market conditions we think there will be an increased opportunity for acquisitions in this space at reasonable prices.

We are also seeing additional opportunities in international markets. We’ve gained traction in Europe where we’ve been spending some of our efforts since receiving our license there. We’ve also started to look more closely at emerging markets where we believe there may be some intriguing opportunities for use to expand there as well.

With that, let me turn the call over to Adam DeWitt, our chief financial officer, who will review the second quarter financials with you in greater detail. Adam?

Adam J. DeWitt

Thanks, David.

As David already highlighted, we are pleased with our financial performance, given the difficult economic environment and significant headwinds from lower short-term interest rates. Total revenues for the quarter were $61.6 million, a 4% increase over the second quarter 2007 revenues and a 1% increase over the first quarter of this year.

At a high level, the increase in revenues over both comparable periods was driven by an increase in trade volume offset by lower interest revenues as a result of the Fed’s rate cuts. Commission revenues of $41 million for the second quarter of 2008 were up 12% over second quarter of 2007 and 5% from our results last quarter.

The increase in commissions over last year was due to an increase in volume from organic account growth and increased commissions from brokersXpress brokers offset by slightly lower trade activity and lower overall average commissions, which are a result of the options spread rate reduction we implemented last August.

The increase over last quarter is due to higher trade volume and a $0.39 increase in average commissions. The increase in average commissions was the result of increased commissions from brokersXpress brokers, which typically carry a higher average commission than optionsXpress retail customers, a higher percentage of option trades and a higher number of contracts per option trade.

Second quarter 2008 net interest revenues were $11.5 million, which represents a 15% decrease over both last year’s and last quarter’s totals. The decline was in line with our expectations due to the steep rate decreases in the first quarter and the subsequent 25 basis point cut early in the second quarter. At this point, the rate cuts are pretty much baked in, and interest income will grow as customer cash grows.

Other brokerage revenue was $8.2 million for the quarter, which is down 7% from the second quarter 2007 but up 10% from the first quarter of 2008. The increase over the prior quarter was due to an increase in option trades, a small increase in the number of options contracts for option trade and a small increase in rate, primarily the result of some of the initiatives we’ve discussed on previous calls.

Payment per option trade increased to $5.24 per trade from $4.98 cents in the first quarter. As we discussed on the last call, the third phase of the penny pilot had a negligible impact on our payment.

Moving onto expenses, total expenses for the quarter were $24.6 million, 14% higher than the second quarter of last year and 6% higher when compared to the first quarter of 2008. Brokerage and clearing costs for the second quarter were 22% higher than the second quarter of last year and increased by 13% over the first quarter of 2008.

The primary driver in both comparable period increases was higher payouts to brokersXpress brokers due to higher commissions from those brokers. As noted earlier, these payouts are more than offset by higher commissions on the revenue side. The remainder of the increase was due to volume-related charges we incur like confirmations and statement and others we pay on specific types of trades like single-listed index options.

Compensation costs were 4% higher than the second quarter of last year and 6% higher than the first of quarter of this year. The growth for us last year was due to increased staffing levels and annual merit raises partially offset by a lower bonus accrual because of better relative company performance in 2007. The growth for us last quarter was primarily due to merit increases, which we split between April 1st and October 1st.

Advertising costs for the quarter were $5.0 million, $1.6 million or 46% higher than the second quarter of last year and 3% higher than the first quarter of 2008, reflecting our continued investment in new account generation. Despite the challenging market environment, costs per new account was only slightly higher than last quarter at $349 per net new account.

Quotation costs were down 13% this quarter versus last quarter, mostly due to a drop in the cost of some of our quote and other data services from outside vendors. Pre-tax margin was 60% during the second quarter despite the $2 million drop in net interest income versus last quarter. The resulting EPS was $0.39 per share compared to $0.37 a year ago and $0.38 last quarter.

Total client assets were $5.7 billion at the end of the quarter, a 7% increase over last year compared to an average decline in the market indices of roughly 15%. Assets were 5% higher than last quarter compared to an average market decline of 2.5%.

Margin balances were $235 million at the end of the quarter, a 52% increase over last year and a 19% increase versus the first quarter of 2008. The increases over both comparable periods were driven by growth from portfolio margin customers. The increase this quarter came mostly from new portfolio margin customers taking advantage of the product. We still expect this line item to fluctuate month to month.

Also, as we previously announced, during the quarter we agreed to purchase Open E Cry for upfront consideration of $18.35 million, approximately $13 million in cash and $5 million in stock. We closed the transaction July 1st. According, the Open E Cry results are not reflected in our second quarter results, but they will be incorporated in our third quarter results for the full quarter.

In terms of how Open E Cry’s results will impact our financial results, it’s helpful to think about how their business operates. A significant portion of Open E Cry’s business is generated through introducing brokers, who are compensated as a percentage of the commissions they generate.

As a result, similar to our brokersXpress business, the revenue is grossed up to include the portion of the commission that is actually going straight out to the introducing brokers. The resulting pre-tax margins are thus lower than a retail business. That said, it is still an extremely capital-efficient business. Required capital for Open E Cry was less than $1 million in the second quarter.

Going forward, the most significant impacts to our financial statements from Open E Cry will be in the commission line on the revenue side and the brokers and clearing line on the expense side. In commissions run rate for the second quarter 2008 was around $3 million for Open E Cry, so you will likely see a similar increase in the commission line in the third quarter, all other things equal.

Brokers and clearing expense has been between 70 to 75% of total commissions for Open E Cry, reflecting mostly the payoffs to introducing brokers. It varies with commissions based on the relationship I described above.

There will also be small increases in comp, technology and GNA. The impact on the rest of the line items will be diminished.

Because its customers are primarily institutional in nature, the average commission on Open E Cry trades is significantly lower than our retail business, and fluctuations in Open E Cry volume have a correspondingly lower impact on our overall revenues. Therefore, we are going to start breaking out institutional trades on our monthly metric reports beginning with our July monthly report.

One last note: We remain committed to deploying our cash to create the most value for our shareholders. We repurchased approximately 350,000 shares for $7.8 million during the quarter for an average price of $22.15. We have now bought back a total of 3.3 million shares at an average price of $21.68 or a total of $71 million.

We continue to look for potential acquisitions like Open E Cry and XpressTrade that can create immediate value by leveraging our platform and/or give us new platforms for growth. We also continue to evaluate opportunities to use our buyback authorization in a context of those acquisition opportunities.

I will now turn the call back over to David Fisher for some final comments.

David A. Fisher

Thanks, Adam.

Our second quarter results reflect our continued execution and our leading position within the growing derivatives market. While we are not inflated from macroeconomic pressures, our customers and our business have proven resilient in an increasingly uncertain environment, and we expect continued strength going forward.

I think optionsXpress specifically and the online brokers more generally have shown the ability to succeed in varied markets. These are not the same businesses that suffered during the marked downturn of 2001 and 2002. Retail customers are better educated about investing and have better tools at their disposal. In addition, online brokers are all highly automated, technology-based firms that don’t have the high overhead of years past.

While I think we’d all rather the markets and the economy were stronger, we feel confident in our ability to succeed in these difficult times as well.

At this time, we’ll turn the call back over to the operator, and we’ll take some of your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We’ll go first to Mike Vinciquerra with BMO Capital Markets.

Mike Vinciquerra - BMO Capital Markets

Good morning, David and Adam.

David A. Fisher

Good morning, Mike.

Adam J. DeWitt

Morning, Mike.

Mike Vinciquerra - BMO Capital Markets

Can I follow up on Open E Cry. I just -- Adam, you gave some statistics which were certainly helpful in terms of revenues. Trying to get a sense for, though, when we look at the various metrics, DARTs for instance. You’ve given some detail in the release for the purchase, but it’s kind of tough to gauge where it stands at this point of the year because then you said that they were up 100% on a year-over-year basis. Can you give us any sense for DARTs and then if there’s any impact at the interest income line or anything like that?

Adam J. DeWitt

Right so on the first point, the DARTs, they’re -- the 100% increase is roughly the same on the DART side, but it really fluctuates a lot. We said that last year they did about 5,000 trades per year, so 100% increase is kind of around where it’s been. But like I said, it does fluctuate quite a bit. We will be breaking those out on our July report so you can kind of see what the institutional trade impact or what the OEC trade impact is.

In terms of the interest, there is a small amount of interest, but the overall, the assets compared to our overall cash assets are so small that it won’t make a big impact on the interest line. You know, you’re talking about $100,000 or so a quarter.

Mike Vinciquerra - BMO Capital Markets

OK, I didn’t know it was that small. Thank you for that. And then when I look at your futures business now, I know you said it wasn’t, David, you said it wasn’t about kind of synergies between the two necessarily, but you’re doing maybe 15,000 trades a day now. Is that enough where you guys might consider becoming a full clearing member of any of the exchanges or is that something that’s just not on the table?

David A. Fisher

No, I don’t think we have a lot of desire to become a full clearing member right now. What that really is a big capital commitment, which really just entails connectivity to the firms. Unlike on the securities side, there’s very little value add in the clearing end of the business. It’s really just kind of just the connectivity to the exchanges and transferring the money back and forth.

There will be some synergies over time, though, in terms of kind of the backend operation, you know, the maintenance of the accounts, what we pay for data and those types of things. They’re just not huge numbers, given the relative size of the deal and, you know, certainly not the primary focus. The primary focus is to grow, you know, to grow that business and grow our institutional presence in the futures market.

Mike Vinciquerra - BMO Capital Markets

Great, OK. Thank you. And then just you’d also mentioned I gues the international contribution or that you’d see some good traction in Europe. Can you give us any sense for what contribution in terms of either maybe your trading activity, your total accounts as actually from folks outside the U.S.?

David A. Fisher

You know, the business continues to grow. You know, it’s probably -- it’s over, say, 20-ish% today, and we’re getting solid, solid growth from that business. Europe was a bright spot during the quarter where we had, you know, previously kind of really struggled to gain some good traction. We kind of hit our stride a little bit there. And as I mentioned in my prepared remarks, we’re starting to see some opportunities in emerging markets where we haven’t really done much of anything historically.

So those international markets are one of the many bright spots for us. Those customers tend to be relatively sophisticated, like the option products, which typically aren’t available in their local market, and usually are much more savvy when it comes to our futures offering.

Mike Vinciquerra - BMO Capital Markets

Very good. Thanks, guys. Appreciate it.

Operator

And we’ll go next to William Tanona with Goldman Sachs.

William Tanona - Goldman Sachs

Hey, good morning, guys.

David A. Fisher

Morning.

William Tanona - Goldman Sachs

Just on the pricing side of it, you gave some good color in terms of why the average commission rate had increased, but could you just spend a little bit more time in terms of the payment for order flow and just kind of break it down in terms of what ultimately drove that and give us some degree of, you know, what percentage each of those components drove the payment for order flow higher?

David A. Fisher

Yes, sure. So we saw a number of items driving the payment higher. The first, which you guys can see pretty easily is the number of option trades just increased relative to total trades. We also saw a slight increase in contracts per trade, and then we saw a slight increase in rate per trade. And I’d say those two latter impacts are probably split if you want a rough estimate.

You know, in terms of overall payment where we are, we feel good about the number in the second quarter as a base. We still think that there may be some opportunity down the road for us to expand on some of these initiatives that we’ve taken on internally. We’ve gotten some good traction, and now it’s up to us to figure out how to expand them.

William Tanona - Goldman Sachs

I guess that’s what I was trying to see, you know, how much of the increase was actually driven by the new initiative and could you kind of expand a little bit further in terms of what you’re actually doing on that front?

David A. Fisher

As Adam mentioned about, you know, the portion that wasn’t just number of trades driven. It was kind of split equally between rate and number of contracts per trade. In terms of, you know, what we’re doing, you know, as we mentioned before, we’re not going to give a ton of detail, obviously, for competitive reasons, but clearly it’s ways of working closer with the liquidity providers to increase their interaction rates with our order flow in order to get better payment rates.

They want to interact with the order flow, and if they can be assured that they’re going to interact with our order flow and not run into some intelligent institution order flow along the way, we’re able to get higher rates, and that’s really where the efforts are focused around.

William Tanona - Goldman Sachs

OK and then I guess just wanted to get your thoughts on the new account side of the business, obviously, 4,000 accounts a little bit lower than what we’ve been seeing from you guys in recent months. Just wanted to get your sense as to what was driving that. Is that seasonality or just seeing a slowdown in terms of retail appetite for new accounts in this environment?

David A. Fisher

Well, certainly this summer is a slower time for new accounts historically, and while the 4,000 is down from where it was last month, it’s certainly up from where it was in June of last year. You know, that’s something we typically have seen, slower accounts in the summer, you know, June, July, August.

That being said, we saw solid account growth and solid engagement from our -- solid asset growth and solid engagement from our juicing customers, which leads us to be very positive about the future and about account growth going forward. You know, many of the initiatives that we’re putting in place now we hope will bear results as we enter the end of the summer and the fall, whether it’s the test drive I mentioned, our educational efforts expanding to new account generation, some of the emerging markets internationally. You know, we think we’ll start seeing some tractions from some of those in August and then more importantly, as we enter into the fall where the kind of new account season improves.

William Tanona - Goldman Sachs

OK and then just lastly looking at your margin balances, you know, the volatility of those balances seem to be far greater for you guys than they are for a lot of your peers. Just trying to get an understanding as to why your balances jump around so frequently, you know, between quarters and between months and certainly intra-quarter as well.

David A. Fisher

Yes, I mean most of it had to do just with really the law of small numbers. I mean for us margin balances are a smaller percentage of our overall client/customer assets. And the reason in that our options -- our customers are primarily options investors, and using options, they get leverage the same way that you could on the margin side.

So in general we see, you know, less overall margin balances relative to our customer balances, and we could have a few large positions swing that number quite a bit on a percentage basis. But, you know, as a whole, $10 or $20 million on a customer asset base of $5 or $6 billion is a pretty small number.

William Tanona - Goldman Sachs

I guess, though, when I look at you guys in terms of margin balances as a percentage of total client assets, you guys are actually one of the higher in terms of that percentage relative to your peers, so I just guess I would have expected that to be a little bit more stable, given the high percentage.

David A. Fisher

Yes, I actually thought it was on the lower side, but like I said, it bounces around quite a bit depending on whether customers are using margin for leverage or they’re using options for leverage. And so we do see them move quite a bit.

William Tanona - Goldman Sachs

OK, thanks.

Operator

We’ll go next to David Scharf with JMP Securities.

David Scharf - JMP Securities

Hi, good morning. Quick question on advertising. I believe last quarter too you talked about remaining comfortable with that $250 to $350 range for marketing expense per new account. We’re at the high end this quarter. I know online advertising’s obviously the bulk of that expense, and it looks like Google had a 19% to 20% year-over-year increase in their costs per click.

Are you seeing anything on the horizon or on the online ad space that would alter that range or should we still feel pretty comfortable being, you know, within that high end of $350 like we saw this quarter?

Adam J. DeWitt

We’re still targeting that range, and obviously, in the slower months for new accounts, the summer months, you’re going to be, you know, more often than not toward the higher end of that range because you’re spending some dollars no matter kind of what’s going on with new account growth.

So we feel comfortable with that range as some online advertising is becoming more expensive, but again, we’re expanding and, you know, looking at multiple marketing initiatives. We always think we’ll get a lot of accounts online, but we’re finding other ways to get new accounts as well that, you know, we think we can keep right in, you know, keep right in that $250 to $350 range going forward.

David Scharf - JMP Securities

Got you . And just secondly on the E Cry acquisition, obviously, you know the institutional business here I would suspect you have plans beyond just a $3 million commission run rate business, can you talk a little bit about the investment plans in this.

I mean, this looks like a nice platform acquisition. Is this a very fragmented business in terms of quite a number of platforms like E Cry that are out there to acquire, should we see any type of step functions perhaps in the marketing spend or investment in this business in the next few quarters?

Just trying to get a sense for how to view this initial step into the institutional side beyond brokers express over the next few quarters.

David A. Fisher

Sure. It is pretty fragmented with there being a lot of platforms out there today and not owned by the strongest players in the industry. In addition, you have seen some of the dominant futures firms historically struggle as of late in the market, and so we think there is a great opportunity to grow that business.

The Open E Cry platform itself we think is terrific and the platform itself does not require a lot of investment. We certainly want to ramp up their business development, add to their team to go out and grow that business, but those are very, very small dollars in the grand scheme of things.

And really the biggest benefit to their marketing and their business development is being hooked up with a larger player like us that can bring a strong balance sheet to the table and show stability to some of the larger institutional customers they are going out and targeting.

So it's really a great win-win scenario and we want that business to be much, much larger and we think just the combination of combining it with us and our balance sheet and just investing a little bit of dollars in business development really should signal for great growth ahead in that space for us.

David Scharf - JMP Securities

Great, David. And how many introducing brokers does that platform serve and is there a fair amount of concentration just among a handful of brokers in terms of where the revenue's coming from or is it pretty diverse?

Adam J. Dewitt

No, it's pretty diverse. I think we said in our press release that they had roughly 20, 2,000, 2,100 accounts at the end of last year and I would say roughly half of the business is coming from introducing brokers. So half of those accounts are coming from introducing brokers and it's a diverse group, it's not concentrated in two or three.

David Scharf - JMP Securities

Great. Great. Thanks a lot guys.

Adam J. Dewitt

Thanks Ari.

Operator

And we'll go next to Brian Bedell with Merrill Lynch.

Bryan Bedell - Merrill Lynch

Great. Good morning guys.

David A. Fisher

Good morning Brian.

Adam J. Dewitt

Good morning Brian.

Bryan Bedell - Merrill Lynch

Just along the lines of Open E Cry questioning. How should we think about sort of your pre-tax margin goals post this acquisition? We know that you obviously -- this will delete your margin somewhat and you have been sort of comfortable in that 60% plus. Any kind of outlook for how this will impact that in the third quarter?

Adam J. Dewitt

Yes, Brian to answer your question, first of all, the base business is going to continue to be 60% plus so the non-OEC business will continue. But you're right, the OEC business will take our pre-tax margins down and if the interest rate environment stays the way it is, it will be sub 60.

Now, as I mentioned earlier, the Open E Cry business, while it doesn't have great margin, it has a very high return on capital. Just to give you some idea, I mentioned the required capital level in June was less than $1 million and we talked about last year they generated a $1 million pre-tax, so this year it's obviously going to go up from that and so the return on equity is very high and we're comfortable with the diluting of margins.

In terms of a goal, I think that if you run the numbers that I gave you through the model in terms of commissions and expenses and kind of where it's coming out, you'll kind of get to an adjusted pre-tax margin for us.

Bryan Bedell - Merrill Lynch

Right, right. And that would be something in the high 50's I would presume?

Adam J. Dewitt

Yes, that's about right.

Bryan Bedell - Merrill Lynch

Basically, yes. It looks about 2% or so diluted to the margin.

Adam J. Dewitt

Right.

Bryan Bedell - Merrill Lynch

Okay. Switching gears a little bit back to the new account growth, you talked about it slows down in the summer with the -- due to seasonal factors. But are you seeing more competition from Ameritrade and Schwab and their options business and is that making it tougher to get down?

David A. Fisher

You know, we're really not. It's a very competitive business. We never would say that it's not, but we've actually seen and I think we mentioned this a little bit a little bit in the Q1 call and I think it's definitely continued through the second quarter.

Competition waned a little bit. Ameritrade and Schwab seem very, very focused on their asset gathering strategies and seem to be distancing themselves from the type of business we're going after.

Some of our direct competitors, more options focused firms that struggle a little bit as of late. So we have actually seen competition wane. And again, the account slow down in the summer. I mean that's nothing new.

I mean, you can look back at last summer in June, we're up from there. And so it's nothing surprising where we are right now. We feel good about the account growth going forward.

Yes, it's a competitive business, but we've always done very, very well at competing in this space and continuing to grow the business so we don't see that changing going forward.

Bryan Bedell - Merrill Lynch

Okay. And then the answer you gave before about the range, the 250 to 350 range, I guess clearly in the summer you could potentially creep above that a little bit as you continue to make investments.

Are there any substantial investments that might really trigger that way above the 350 range that we would theoretically be alarmed about?

Adam J. Dewitt

Not at all. Not at all. I mean, we look at that as more of an annual range and it doesn't mean the smaller the period you look at, the more it can be likely to spike above it. I mean, if you're looking at a day or a week, you can certainly spike above that.

We look at that as more an annual range. We feel very comfortable with it and certainly don't see any major investments that are going to put us way above that range during any period of time.

Bryan Bedell - Merrill Lynch

Okay. Great. And then just lastly, if you can comment a little bit about July. We're into almost the third week here. I know you typically don't like to talk too much about the early month because it's so volatile, but any sense of direction of sort of where we are from June in terms of client engagement?

David A. Fisher

You know, you've seen overall market activities that remain strong and we typically do fairly well earnings month like we are now. But, beyond that, we're not going to comment about specific levels.

Bryan Bedell - Merrill Lynch

Okay. Okay, great. Thanks very much.

David A. Fisher

Thanks.

Operator

We'll go next to Michael Hecht with Banc of America Securities

Michael Hecht - Banc of America Securities

Hi guys, how are you doing? Hello?

David A. Fisher

Hi Mike.

Michael Hecht - Banc of America Securities

Oh, hey sorry. So, let us see. I just want to follow up on the margin balance question. I mean, just kind generally, I mean June growth you kind of saw there was pretty strong so I am just trying, given the market declines we say, any color on what you think is kind of driving the strength there?

Adam J. Dewitt

Yes, the June growth specifically was really coming from additional customers in the portfolio margin program. So in the past, we have seen fluctuations driven by existing customers who just increase their balances. This increase was new customers using portfolio margin that hadn't before.

Michael Hecht - Banc of America Securities

Okay. That's helpful. And then can you give me a sense on where total cash balances ended the second quarter including money fund demand? I am just trying to get a sense if you are seeing any mixture towards higher mix of cash within your kind of overall total assets.

I mean, certainly you guys saw a nice sequential uptake in cash and seg and customer payables on the balance sheet, but looking for more color on the kind of total cash position.

Adam J. Dewitt

Yes, sure. I think it is a similar story as last quarter where we had a little bit of a -- where we have a mix shift. But overall cash balances are still kind of in that 30 to 35% of total assets range. And so you can back into what the money fund balances are.

Michael Hecht - Banc of America Securities

Okay.

Adam J. Dewitt

From the end of the year is actually pretty flat in terms of the credit balances so to speak. If you just add the -- if you look at a payables line 840 compared to 850, so it's pretty close there. I think if you compare the total overall assets were pretty close as well and so therefore the money fund balances were pretty stable as well.

Michael Hecht - Banc of America Securities

Okay. And then I'm sorry if I missed this, did you give where headcount ended the quarter?

Adam J. Dewitt

No, we did not. But headcount ended the quarter at 279.

Michael Hecht - Banc of America Securities

And that to compared to what a quarter ago?

Adam J. Dewitt

273. So we added six net people, mostly in areas where we like to think that investment is still paying off like development. And David talked about a lot of the initiatives on the website and the content and the re-design. So most of those adds are in that. We're not adding a lot of staff volumes have been kind of flatish.

Michael Hecht - Banc of America Securities

Okay. And Open E Cry adds how many people?

Adam J. Dewitt

They had 18. They have 18 I should say.

Michael Hecht - Banc of America Securities

Got you. And then just kind of a broader question on that Open E Cry deal. I mean, it seems to be a pretty nice deal, but I mean shifts, you are focused on more institutional, I mean should we read this as an indication that suggests you think your kind of core retail market is slowing in terms of the growth outlook or rather than just the two business are complimentary?

Adam J. Dewitt

Now, it doesn't at indicate anything about our retail business. We think the growth in the retail business is still very, very strong, both short term and long term. We think all of the dynamics are in place and the retail side should see continued growth for many, many years to come.

We just really see great opportunity in the future space. There is a lot more institutional business there than retail business and while we see the retail business growing, we saw this acquisition as a great chance to gain some exposure to the institutional space.

A lot of what we hear have already today at optionsXpress and really not take our eye off the ball too much in that they are very much a self contained group with a great platform leveraging our balance sheet and now just going out and running and growing that business.

Michael Hecht - Banc of America Securities

Okay, that's helpful. And then just the last question. I mean, nice decline in fully diluted shares this quarter. I mean, just in terms outlook for capital management, maybe you can help us prioritize a little more about how you are thinking about investing in the business organically versus acquisitions versus capital management share repurchase?

Adam J. Dewitt

Like I mentioned in the script, we looked at all of those opportunities kind of in terms of what is going to return the most value to shareholders in the long run. And I think we have send in the past that to do acquisitions where we can leverage our platform and/or give us a platform for future growth, really do more for the shareholders in terms of creating value than a pure buy-back.

And so we did a little bit less on the buy-back in the second quarter but as you see we also completed the acquisition with Open E Cry. So we will continue to look at both of those option and if there is no acquisition opportunities and opportunities present themselves, then we will continue or we will resume kind of being a little bit more aggressive on the buy-back side.

Michael Hecht - Banc of America Securities

Okay. Fair enough. Thanks guys.

Adam J. Dewitt

Thanks.

Operator

And we'll go next to Ed Ditmire with Fox-Pitt.

Ed Ditmire - Fox-Pitt

Good morning guys.

Adam J. Dewitt

Good morning, Ed.

Ed Ditmire - Fox-Pitt

Just adding on to that last question just to be specific, were you guys precluded from buying back more shares because of the acquisition just because it was such a fast pace in the last month of the first quarter, I was a little surprised that the authorization was not exhausted given were prices were?

David A. Fisher

We were not precluded but very early in the quarter we saw the Open E Cry deal materializing and we also have -- there is a number of other acquisition opportunities that we are working on that could use reasonable amounts of cash.

And with these opportunities out there, we actually want to preserve some of our cash balances to be able to go out and be aggressive when we saw opportunities. I think we mentioned last quarter, with the more difficult market environment we are seeing valuations become more realistic and we certainly want to be able to take advantage using our strong cash balances of those acquisitions.

So we were definitely more conservative with the buy-back as we evaluate those opportunities. And that in mention, if those do not come to light, if we don't get to the finish line and we have no trouble resuming the buy-back and being aggressive. And with it again, we were very aggressive kind of through April with it and if we don't have other opportunities to utilize our cash, we have no problem resuming that.

Ed Ditmire - Fox-Pitt

Okay. And just to follow up on that same theme. First of all, you said that you were seeing opportunities in the developing world and I wasn't sure exactly if you meant that you were seeing higher engagement there or you were looking at acquisition?

And then one more follow up. With the Open E Cry acquisition moving into the professional space, it almost seems conspicuous that you guys do not have something more on the institutional options space. Are these areas that might be of interest?

Adam J. Dewitt

The institutional office is definitely an area of interest. We have a small institutional business that we started about a year ago. It's been growing, it's still small. And Open E Cry platform may give us, over time, an ability to expand that business.

There was a less, I think, natural acquisition opportunities in that space where most of the institutional options business is done by the Wirehouse's today. But these are still expanding our own business through leverage in the Open E Cry platform; I definitely think there is opportunity there.

And remind me of your first question Ed?

Ed Ditmire - Fox-Pitt

Just talking about the developing world, you said you were seeing opportunities. I wasn't sure if that was in organic or acquisition?

Adam J. Dewitt

You know, I think it is more organic/joint venture with existing players down there in financial services space, not so much through outright acquisition. We are seeing some acquisition opportunities internationally. Those tend to be more in Europe.

Ed Ditmire - Fox-Pitt

Okay.

Adam J. Dewitt

Thanks Ed.

Operator

And we'll go next to Rich Repetto with Sandler O'Neill.

Rich Repetto - Sandler O'Neill

Good morning guys.

David A. Fisher

Good morning.

Adam J. Dewitt

Good morning Rich, how are you doing?

Rich Repetto - Sandler O'Neill

Good, good, good. I guess my question follows on to the last one, that you look at option volumes in the industry up 15% June versus May, year-over-year in the high 30's. And I guess, I am just wondering, there isn't a better way to leverage your platform.

It looks like it would be up to these opportunities right in the space itself. And I heard what you said from the last question, but I guess that is what strikes me, any comment there?

Adam J. Dewitt

Yes. I mean, what I think there is a lot of opportunity in the institutional space with regards to equity options. Again, I think it is a little harder not to crack because it is so dominated today by the Wirehouse's.

That being said, we see opportunity for ourselves there, that is how we started our institutional business about a year ago and it definitely gained great traction, it is making money albeit very small.

And while -- since there is not kind of smaller players out there who are easy to go acquire, it is more something that we are going to have to build organically over time either through kind of leveraging or trade (inaudible) or leveraging a platform that is not options focused today like the Open E Cry platform.

There is certainly opportunity over time to maybe expand that to equity and equity options and use that as a possible basis for growth in the options institutional space.

Rich Repetto - Sandler O'Neill

And I guess staying on the same theme in trying to look where the puck is going, I guess with the NASDAQ's option platform, the rebate type platform as well as ARCA and pennies it would appear that there is a potential -- there might be a growing market, I am not -- I do not have solid numbers, but a more active trading in options, I guess are you doing anything to position yourselves there or do you agree with that outlook?

Adam J. Dewitt

Well, I thought you were going to go somewhere else with that questions, and I am glad you came back to where you are because I think you are right. I think those platforms provide a nice place for active day traders to trade.

I don't think they are going to be a significant part of the overall options business as people maybe thought a quarter ago, and you have certainly seen them struggle over the last few months in terms of gaining market share and actually slipping back.

But I do they'll provide a nice place for active traders, day traders to go and bank away. And it is an interesting business. It is a business that is hard to grow, there is not a lot of day traders out there in the word. It is a reason why we haven't spent a ton of time and a ton of effort focusing on that limited segment of the market when we historically have been much more focused going after the bulk of the business, the ma and pa customers out there, the 30 million to 40 million online investors and showing them how to use Option and showing them how to use the optionsXpress platform.

That being said, now that we have this Open E Cry platform, which is certainly a terrific platform for active traders, day traders on the futures side, we are absolutely going to look at the feasibility of expanding that to the equity and equity options space.

Rich Repetto - Sandler O'Neill

Okay. And then I guess my last question is and this is being very nit-picky because you have the tops in pre-tax margins in the industry, but I did see, and I heard Adam talk about it would be 60% at least the core business, but you were at 60 and I guess this was the lowest margin in over a year and I understand you got higher marketing, you got lower net interest, but even pre-marketing it is a low.

And I guess the question is, is there more -- is there core investment going on or is it just those metrics that are driving the margin down and again, I acknowledge you have got great -- I would be happy with a 60% pre-tax margin if I ran a business.

Adam J. Dewitt

Right. Rich, I mean the primary factor driving the margins down to 60 this quarter is really interest revenue. I mean, if you just look at interest in the prior environment a year ago, it would several points higher.

That said, there is also growth in BX, which we have talked about, has a lower margin but at the end of the day, does not return any less profits to us, it is just from an Op-ex standpoint has lower pre-tax margin because the commissions are higher, but then you have to gross them up for the payouts and the payouts increase your expenses.

So, you end up with a lower margin, although the business on a capital return basis and just an overall dollar basis is still returning just as much as the retail business.

Rich Repetto - Sandler O'Neill

Okay. And I guess the question is, in the summer, well it could go below 60 on the core if trading activity was to pull back in the summer. Would you offset that with a decline in marketing or so forth?

Adam J. Dewitt

Well, I think we look at them separately. In marketing, you bring another good point, if you look at our expenses, if you exclude advertising; I think this is our lowest year-over-year expense increase since we have been public.

But we are comfortable spending more money on advertising because the return on it is so high. In turns of expenses, we watch them very carefully. Headcounts only up 6% year-over-year even though our account base is up 24%.

But in terms of whether -- I do not know if we make adjustments on the advertising expense. I mean, we really look at that as a long-term investment and it is almost cutting off your nose to spite your face a little bit if volumes are down a little bit.

So, I mean, theoretically, you could dip below, but we have everything, you are talking about a scenario where everything is working against us and nothing is working with us. If interest rates turn around a little bit and then all of the sudden we are over 60 in the non Open E Cry business, so it really depends on the business environment.

Rich Repetto - Sandler O'Neill

Understood. Thanks guys.

Adam J. Dewitt

Thanks Rich.

David A. Fisher

Thanks Rich.

Operator

And we will go next to George Grose with American Capital Partners.

George Grose - American Capital Partners

Hey, good morning. Can you talk a little bit about the growth at brokersXpress year-over-year, Q-over-Q basis?

Adam J. Dewitt

You know, their assets have continued to grow nicely. They are about 1.1 billion now. The business is something you can continue to see growing going forward. The growth that we saw that Brokers and Clearing line item is a little bit more driven by mix shift in terms of which of their brokers are doing the most business and that just fluctuates from quarter to quarter and not as much driven by the overall business.

Not that that business is not growing, it is just not the biggest change in that line item. That is just more the brokers who charge higher commissions; we get a higher split doing a lot of business in the quarter.

George Grose - American Capital Partners

And but I guess the impact on your pricing, I guess you mentioned that the -- because the commission rates went up was partly helped by the brokersXpress, I am just wondering if that can maybe offset what you might have lower rates with Open E Cry going forward and might have kind of stable pricing here.

Adam J. Dewitt

Well I was just thinking about them different. I mean, the brokersXpress, like David said, it had -- this quarter had a lot to do with the mix shift not just the Brokers that are doing more business, but the types of securities that they are buying might have a higher price point.

And that, what you are seeing there is the commissions are higher to offset brokerage and clearing expense that is higher. I think that the Open E Cry, for example, you have to think about it differently, that is not really going to be an offset.

I mean, overall, our average commissions are going to decline because of the Open E Cry. But like I said earlier, we are comfortable with them declining and we are comfortable with the pre-tax declining because the return on capital is strong.

George Grose - American Capital Partners

Okay. Maybe lastly here, then with all of the initiatives that you have going on, the options futures and how do you plan on meshing all of that with the education and I guess can you comment, are you generating any revenues from the education here?

Adam J. Dewitt

Directly we do not generate any revenues from education. Our education is free. And something we always prided ourselves in. We think it is well worth the investment of better educated investors can be a better customer for us.

In fact, as we mentioned in our prepared remarks today, we actually push that education more out to the forefront with making it available to just any visitor to our site now, you do not even need to be a customer anymore.

In terms of how we mesh that all together, if you go see our new education on our new redesigned site, you will see that it is now much more curricula based and it is divided both by product type and by levels of investors.

So you can say, I want to focus on futures and I am an intermediate level investor and we have a curricula set forth for you right there. So it is very easy for our customers now to focus in on the education that is important to us as we have added -- that is important to them as we have added these new products.

George Grose - American Capital Partners

Okay. Thank you.

Adam J. Dewitt

You are welcome.

Operator

And we will go next to Richard Fetyko with Merriman.

Richard Fetyko - Merriman

Yes, hi gentlemen. You have added a healthy number of new accounts in the first quarter and the second quarter, but the DARTs continue to decline. They declined 2% sequentially in the second quarter and also that follows an 8% sequential decline in the first quarter, so that implies the trading per account has declined again and really questions the quality of incremental accounts, particularly since your closest competitors DARTs have increased 16% sequentially in the second quarter.

So, just I was wondering if you care to explain how you are adding more accounts but the DARTs have declined two quarters in a row? Thanks.

Adam J. Dewitt

Sure. It is 100% market environment. I mean our trades per account are rounded to 34 both this quarter and last quarter. We track quarters in the past where the trades per account on an annual add basis were below 34 and we have had quarters in the past where our trade per account on an annualized basis were below 34.

I mean, we really see a range from the kind of low 30s to kind of around 40. It is very typical for a business in terms of fluctuation. I know you are somewhat new to following our company, we discussed a lot in the past, not so much in the last couple of quarters, how we look at our accounts on a vintage basis.

We break them down into the quarter that they have joined optionsXpress, we look at the quality of those accounts across a number of different metrics. And once again, we looked at that, as we do every quarter, and we have seen absolutely no degradation at all in terms of the quality of your new accounts.

Whether you look at asset size, activity rates, average commission, you name the metric, we look at it and we continue to add the same quality accounts that we always have. And it is not really surprising for us.

I mean, when you look at the market space, 30 million to 40 million online accounts and that number is growing at about 5% year. Only 10 to 15% of those accounts are using options say, that is still a 3 million to 4 million number of 300,000 accounts which single digit market share, I mean we do not at all think that we have cherry picked the cream of the crop.

We are going after the ma and pa retail investor, the bulk of that 30 million to 40 million accounts and we think that can provide great solid growth going forward.

Richard Fetyko - Merriman

All right. Thanks a lot.

Adam J. Dewitt

You are welcome.

Operator

And that concludes our question-and-answer session. That also concludes our conference. Thank you everyone for joining, you may now disconnect.

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Source: optionsXpress Holdings, Q2 2008 Earnings Call Transcript
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