Welcome to E*TRADE Financial Corporation's First Quarter 2006 Earnings Conference Call. At this time, all participants have been placed on a listen-only mode. Following the presentation, the floor will be open for questions. I have been asked to begin this call with the following Safe Harbor statement.
During this conference call, the company will be sharing with you certain projections or other forward-looking statements regarding future events or its future performance. E*TRADE Financial cautions you that certain factors including risks and uncertainties referred to in the 10-Ks, 10-Qs and other reports it periodically files with the Securities and Exchange Commission could cause the company's actual results to differ materially from those indicated by its projections or forward-looking statements. In this call E*TRADE Financial will discuss some non-GAAP measures in talking about its performance, and you can find the reconciliation of those measures to GAAP in the company's press release, which can be found on its website at www.etrade.com. This call is being recorded. The replay of this call will be available beginning at approximately 7 O' clock P.M. Eastern Time today through 11 O' clock P.M. Eastern Time on Wednesday, May 3rd. This call is also being webcast at www.etrade.com. No other recordings or copies of this call are authorized or may be relied upon.
I will now turn the call over to Mitchell Caplan, Chief Executive Officer of E*TRADE Financial Corporation, who is joined by Jarrett Lilien, President and Chief Operating Officer; and Robert Simmons, Chief Financial Officer. Mr. Caplan, please begin.
Mitchell Caplan, Chief Executive Officer
Thanks everybody for joining us today. Just over a year ago, we launched a new marketing campaign designed to build on the strength of our existing brand while broadening what it means to global consumers. We created a new slogan that asks customers to challenge the ordinary and be extraordinary. At the same time, we ask our management team to do the same. We brought new ideas together to challenge the traditional value proposition and enhance the customer experience. We broadened the ways in which we create value for customers to include comprehensive, industry-leading cash management, credit, investing and trading solutions. By deepening our customer relationships and leveraging our infrastructure to drive efficiency and growth across our global operations, we have and continue to create value for our shareholders.
As we look at how the franchise has done, particularly in the past year, it’s truly extraordinary. Through the combination of organic growth initiatives and strategic acquisitions, the franchise has never been stronger. We have grown total client assets to nearly $200 billion on a base of over 4 million accounts. Across this increasing customer base, we are now generating meaningful product engagement beyond trading. We are seeing significant organic growth in cash, assets and credit as we have created industry-leading functionality for these products. Through our integrated model, we are benefiting from these dynamics in both our retail and institutional segments.
As an example, consider the growth in cash alone we have experienced. Our base increased over 65% in the past year to a record in excess of $30 billion. While the benefits to our retail segment are apparent, our institutional segment continues to drive greater economics by leveraging this growth to significantly reduce our balance sheet funding costs. This link between retail and institutional has translated directly into spread expansion and record net interest income for the company on a consolidated basis.
Similarly, our growth in retail customer assets and trading activity continues to better benefit our institutional equities business by providing greater order flow and deeper liquidity for our institutional clients. In the last three years, we have worked diligently to position the business to deliver growth and superior financial performance through various market environments. The result of this past quarter demonstrates the success of our model. We generated strong growth in our core business, while accelerating that growth through the integration of additional assets, cash, credit and trading from our two recent acquisitions. As we drive further customer engagement from our existing and new customers, we continue to unlock the full value and opportunity of our integrated model.
I'm pleased to announce that in the first quarter the company produced a record $598 million in total net revenues and record earnings of $0.36 per share. This excludes $0.03 in acquisition-related integration expenses as we guided to in December. Including these expenses, we generated GAAP EPS of $0.33, also a record. We delivered growth in all the key drivers of our business.
As we had executed on our vision of creating an integrated financial services company, we are just beginning to realize the power of our centralized technology, operations and service platform on a global basis. We are now in a place to leverage our success around customer assets, cash and credit in the U.S. and extend these solutions to our international clients in Canada, Europe and Asia. We continue to see a tremendous opportunity to capitalize on the growing mass affluent population in the U.S. where 44 million households remain relatively under served. As we move outside of the U.S., we believe the opportunity is immense, particularly as we look to regions such as India and China.
We have already seen some success internationally with regard to customer cash, and this is even before we have begun to market these solutions. Moreover, credit relationships in these regions remain largely untapped for us. As we strive toward achieving global integration, our international operations not only differentiate us within the industry but more importantly, they represent a natural extension of our model and a significant source of long-term growth.
In sum, we are extremely pleased with our model has and continues to deliver. As we seek to create value for customers and shareholders, we remain committed as a franchise and as a management team to challenge the ordinary and be extraordinary. With that, I would like now to turn the call over to Jarrett.
Jarrett Lilien, President and Chief Operating Officer
Thanks, Mitch. Our results for the first quarter proved the power of our model and truly demonstrate our unique ability to leverage our retail performance through our institutional business to generate superior results. We have long said that at the center of our model is the global retail customer. Through an integrated technology, operations and service platform, we are best positioned to leverage customer engagement across cash, credit, investing and trading solutions.
Around this time last year, we rolled out our first iteration of E*TRADE Complete focused on driving broader customer engagement. An important part of Complete was our Intelligent Cash Optimizer. Since this launch, we have experienced tremendous organic growth in customer cash. By organic growth, we mean inflows from customers above and beyond acquisitions. These balances grew $800 million in the third quarter of last year, followed by $1 billion in the fourth quarter of last year and $1.6 billion last quarter. The first-quarter results represent a 22% annualized growth rate on our enterprise customer cash, which now represents 65% of our enterprise liabilities.
Combined with the trends we are seeing through our Quick Transfer functionality, this organic growth is extremely encouraging. During the quarter, we processed over 750,000 customer initiated Quick Transfer with almost $3.0 being transferred in for every $2.0 out. Interestingly, the largest cash inflows came from the bulge bracket firms and national brick and mortar financial institutions. This continued trend of E*TRADE as a destination for cash solidifies our view that our value propositions are resonating well in the marketplace.
Turning to credit. In mid-February, we further enhanced Complete with the launch of our Intelligent Lending Optimizer. This Optimizer allows customers to realize value by demonstrating the most efficient ways to borrow. For the quarter, 8% of traffic to the Intelligent Lending Optimizer resulted in credit applications inquiries. While we are early in its deployment, we hope this Optimizer will create deeper credit relationships with our customers, especially as they respond to the changing interest rate environment.
In investing, continuing our leadership and commitment to innovation, we launched the Intelligent Investing Optimizer, allowing customers to maximize their investment portfolio based upon their own goals and risk preferences. In addition, we rolled out a series of enhancements for our retail investors, answering the growing need for more sophisticated research and product functionality. As we continue to enhance the customer experience, we seek to attract and retain higher quality wealth building customers.
In the first quarter, total client assets increased 8%. Adjusting for market appreciation, we saw sequential asset growth of 3.5%, representing an annualized growth rate of 14%. In trading, we had a very strong quarter as well. Within our 181,000 total retail DARTs, U.S. volumes were up 41% from the prior quarter and 115% from year ago. Even more impressive was the further growth in our international and options trades. Continuing to outpace domestic growth, international trading increased 43% versus Q4. Option-related DARTs grew 53% sequentially and now represent 12% of aggregate DART volume, up from 11% in the fourth quarter.
We view the growth in the international and options businesses not only as proof that our value proposition is resonating but also that the model is expanding. We are pleased by the performance of our trading products as they benefit from an 85% incremental operating margin and allow for additional upside in stronger equity market environments. Our average commission in the first quarter was $12.10. This is lower than our guided range of 12.25 to 12.40 for the year. The disparity resulted from two factors. First was the free trade offer extended to Harrisdirect customers upon conversion. The costs associated with this offer was $0.13 to our average commission rate and was a part of the overall $0.03 of acquisition integration expenses in the quarter. Excluding the impact of this offer, our average commission rate would have been $12.23. The second factor was our success in retaining more BrownCo customers and models, coupled with a higher level of engagement. Given our outlook for the remainder of the year, we continue to view our initial guidance range as a fair estimate.
Turning to our institutional results. We are pleased with the record performance which directly correlated to our heightened levels of retail customer engagements. You will recall that our retail customer cash and credit relationships each play an integral part in balance sheet management. Leveraging these retail customers’ flows, we generated record net interest income after provision of $315 million. This was driven by an enterprise net interest spread of 286 basis points and average interest earning assets in excess of $41 billion.
With respect to moving clearing under the bank, we are confident that we will be receiving the economic benefit associated with this by midsummer as originally forecasted. We continue to guide to a spread of approximately 286 basis points for the balance of the year as a result of several factors. While acknowledging the expected benefit for moving, clearing under the bank, as well as the potential upside from continued growth in customer cash and credit, uncertainties related to the current rate environment and the shape of the yield curve persist. In addition, as we grow the balance sheet for the remainder of the year, the majority of the assets will be comprised of our traditional mix of mortgages, HELOC and margin.
Further looking at institutional, our equities business also continues to benefit from its link to our retail segment. This business benefited from the increase in retail trading activity that we experienced in the quarter, driving an increase in institutional principal transaction revenue and institutional commissions. I would now like to spend a few minutes on the status of our deal integrations.
In January, we completed the Harrisdirect conversion. The Brown conversion is now scheduled for early May, and it will be operationally less complicated as the platforms are substantially similar. With respect to attrition, the economic drivers for both transactions, assets, cash, credit and DARTs all remain above plan.
Specifically as of the quarter-end, Harrisdirect economic attrition with its 6.6% and Brown with its 2%, both against our 15% modeled level. As evidenced in our Q1 results, the economic attrition we have experienced is being more than offset by deep end engagement from our new Harrisdirect and Brown customers.
Given the increased engagement trends across all accounts and products, we will continue to invest in our service platform. When we announced each of these acquisitions, we discussed we would retain the entire service platforms from both companies to help strengthen our overall service offering. Our view of the costs associated with achieving this was predicated on the volumes and engagement levels forecasted at that time. Since then, we have seen a greater level of engagement across our entire customer base. As a result, we see a need to make an additional investment in service to support the higher customer activity levels. To that end, we have begun to higher additional service representatives. This investment will ensure that all E*TRADE financial customers new and old enjoy improved service as they continue further engagement with us.
The first quarter was a great one for the company. We made significant progress in expanding customer relationships, driving growth in our operating metrics both domestically and internationally, while delivering solid financial performance. With that, I will turn the call over to Rob for the financial details.
Robert Simmons, Chief Financial Officer
Thanks, Jarrett. Our first quarter financial results built on a record year-end 2005 and delivered another quarter of record performance. During the quarter, we remained focused and disciplined in executing on our core strategic plan, while accelerating that plan through the integration of our recent acquisitions. This combination not only produced record revenue and earnings but also record results across many of the key drivers of our business.
First, quarter total net revenue increased 43% year-over-year and 25% sequentially to a record $598 million. Net interest income after provision increased 79% year-over-year and 30% sequentially to a record $315 million. As we have achieved greater balance sheet integration over the past year, we have more effectively monetized the growth in customer cash and credit balances. As a result, net interest income has become a larger portion of a growing revenue base and now represents 53% of revenue, up from 42% just a year ago.
Non-interest income, which includes retail and institutional commissions, fees and other revenue also continue to grow, increasing 17% year-over-year and 20% sequentially. The year-over-year growth in reported non-interest income is the result of a 60% increase in commissions and a 43% increase in other revenue, offset by a 74% decrease in gain on sale of loans and securities. Rather than originating and selling loans, we have improved the customer experience by putting more origination volume on balance sheet. This allows us to retain the customer relationship while driving growth in spread-related revenue. The shift away from gain on sale has favorably impacted the overall quality of our earnings. Our model is designed to generate a growing base of recurring revenue as customers engage in assets, cash and credit solutions. As witnessed in the first quarter, our model also maintains strong leverage to growth in trading activity.
Turning now to expenses. In the first quarter, we continued to deliver prudent control and operational efficiency within our core operation while integrating our acquisitions of Harrisdirect and BrownCo. Total expenses excluding corporate interest were $355 million. Our first quarter results included acquisition-related integration expenses that we outlined in December. Most of these expenses appeared in professional services and compensation and impacted our earnings by $0.03 per share. We have carved out these items for discussion purposes, as well as for our guidance as they are not truly reflective of the full integration of the operations and the synergies of the acquisitions. Evaluating our results with this in mind, we can see that the model continued to deliver great operating leverage. In fact, each of our operating expense line items including compensation, clearing of servicing costs, communications, marketing, professional services all declined as a percentage of revenue in the quarter.
Compensation and benefits is now at 19% of revenue, down from 21% in the fourth quarter and over 22% a year ago. Given the combination of our controls and the increased scale in the model, we generated a record 44% operating margin in the quarter, excluding the acquisition integration-related expenses. We achieved operating margin improvement even as we increased our marketing spend by $3 million sequentially. Illustrating the leverage in the model, 74% of the sequential growth in revenue in the quarter fell directly to our segment income. The model is working and delivering impressive earnings generation for every new dollar of revenue.
Before concluding, I would like to spend a minute on our earnings outlook for the remainder of the year. As stated in our press release, we increased the high and low end of our earnings guidance for 2006 by $0.05. This increase is predicated on a number of factors. First, it reflects the strength of our first quarter results. Second, it considers the fact that we are only three months post-conversion on Harrisdirect and still pre-conversion on BrownCo. While current indications around the combined attrition levels are encouraging, we believe it is prudent to maintain our current assumption until we have greater clarity after converting BrownCo.
Third, we remain hesitant to extrapolate Q1 market volume trends, and we will update our expected DART range at the midyear point when we have a better view of activity through the spring and summer. Fourth, our revised guidance reflects a higher than originally forecasted share count as a result of the performance of the stock. At the current stock price, we're experiencing a higher diluted share count as a result of employee stock options in the mandatory convertible notes issued last year. The impact of this increased share count was not contemplated in the initial guidance we provided in December.
Fifth and finally, we remained committed to investing in service as an integral component of our asset gathering and franchise building initiatives as Jarrett outlined earlier. The net result of these factors is our $0.05 increase in guidance. Within these factors, there are sources of upside, as well as offsets to our earnings production in 2006. On the positive side of this equation is approximately $0.15 of higher earnings expected in 2006 from the out performance of the first quarter, plus the impact of cash, margin, debt, balance sheet size, spread and DARTs all at the high end of our guidance range. Against this, we have head wins of approximately $0.04 associated with the higher share count and $0.06 related to our investment in service. The net of all this is the $0.05 increase in guidance. As we continue to monitor guild-related attrition, the interest rate environment, customer cash and credit growth, as well as the equity market environment we planned to provide an earnings update in July where as appropriate. And with that, I would like to open the call for questions. Operator?
Operator Instructions. Your first question comes from Rich Repetto with Sandler O'Neill.
Q - Richard Repetto
Hi guys, can you hear me?
A - Mitchell Caplan
Yeah Rich, perfectly.
Q - Richard Repetto
Congratulations. Excellent quarter.
A - Mitchell Caplan
Thanks a lot.
Q - Richard Repetto
The first thing is the cash inflows. You know, that is a number that just jumps out at you. And I guess, Jarrett, you talked about the bulge bracket and traditional brick and click -- brick and mortar clients bringing more to. Is there any more color to this granularity? More specifics to say, is it coming from Harrisdirect higher balance accounts or BrownCo higher balance accounts more than the rest of your customer base, or is it spread out? And how consistent do you think this inflow of cash will be throughout the year?
A - Jarrett Lilien
Yes, Rich, it is very much across the board. We're seeing it, and that's what is really encouraging about it. With Harrison Brown, we are finding as these customers see the product mix that we have, that they are engaging more with us. And that engagement is really offsetting what we are losing from the accounts that are leaving us. So that is very encouraging. But then on top of it is it continues to be a strong trend that is a value proposition that is just ringing home with our customers, our existing customers, and they continue to bring more cash, and they continue to engage more with us across the board.
A - Mitchell Caplan
Yeah, and I guess the only thing I would add Rich, is that we are seeing a billion 6. We were actually quite pleased by the given that 100% of that was organic growth in the quarter. I think you're beginning to see more and more of the effect of the Cash Optimizer, which is embedded in the E*TRADE Complete product. As Jarrett said, you are definitely seeing additional engagement from both Harrisdirect and Brown. We had not modeled any of that when we announced the deals, as you know because it was just too hard to try to model what could be perspective cross-sell. But we're succeeding and certainly hope to given the kinds of accounts that we acquired, their average balances. But we are also seeing it in the new accounts that we are bringing in, three or four times the value of those that are leaving, as well as with our current base. And we're seeing them across the board from a lot of the bulge bracket firms whether it is places like Morgan Stanley, Merrill Lynch, Citigroup, UBS, really pretty much all of the bulge bracket firms. I mean I think that is sort of the new battleground for us given our business model and what we're trying to achieve in terms of growth.
A - Jarrett Lilien
I guess just kicking this dead horse to death, the other place where we're seeing some nice inflows are from the, as we were saying, the sort of bricks and mortar banks. So not only is the value proposition really ringing home with investing in customers and the traditional brokerage firms, but we're also seeing assets and trading and cash coming directly from some of the more traditional big banks as well.
A - Mitchell Caplan
Yeah, I think at very decent size balances. So, the goal here is to try to again engage with that investing based customer recognizing that they have got savings of cash, 10 to 15% of their total assets somewhere, and our obviously call to action is bring it to E*TRADE Financial. Do we think it is sustainable? We certainly are hoping for that, and that's how we intend to execute.
Operator Instructions. At this time, we have no questions.
Mitchell Caplan, Chief Executive Officer
Okay. Thanks everybody for joining us, and we will keep you updated.
This concludes today's E*TRADE Q1 2006 Earnings Conference Call. You may now disconnect.
Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.
THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.
If you have any additional questions about our online transcripts, please contact us at: firstname.lastname@example.org. Thank you!