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Executives

Paul Helbling – SVP, Chief Administrative Officer and Corporate Secretary

Lee Barba – Chairman and CEO

Tom Sosnoff – President, thinkorswim Holdings Inc.

Ida Kane – SVP and CFO

Analysts

Mike Vinciquerra – BMO Capital Markets

Patrick O'Shaughnessy – Raymond James

Richard Fetyko – Merriman Curhan Ford & Co.

Chris Donat – Sandler O'Neill

thinkorswim Group, Inc. (SWIM) Q2 2008 Earnings Call Transcript July 31, 2008 4:30 PM ET

Operator

Good day, everyone, and welcome to the thinkorswim Group Inc. second quarter financial conference call. Today's program is being recorded. At this time for opening remarks, I'd like to turn things over to Mr. Paul Helbling. Please go ahead, sir.

Paul Helbling

Thank you, Kelly, and thank you for joining us today to review thinkorswim Group Inc.'s second quarter 2008 results. Today's conference call and webcast will reference an accompanying slide presentation that can be found in the ‘Investor Relations’ area of our website at www.thinkorswim.com/investors. For those of you that have dialed in to today's call, you may want to have access to these slides as you follow along with today's discussions. And for those of you that have connected to our webcast, the slides will automatically be presented and synchronized with today's call. The slide presentation will also be filed with the SEC on Form 8-K and will be available in a timely manner.

Before I turn this call over to Lee Barba, our Chairman and CEO, I have to make a few brief statements. First, certain statements in today's conference call and accompanying slide presentation may be forward-looking statements as defined by the US Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to a number of risk factors and uncertainties, which may cause actual results, performance, or trends to differ materially from those expressed in today's press release. You are advised to read the cautionary statements that accompany today's press release and the Company's other periodic filings with the Securities and Exchange Commission, including the most recent Annual Report of Form 10-K.

Second, there are certain non-GAAP financial measures which the Company believes to be valuable in representing its operating performance such as Sales Transaction Volume, or STV, and adjusted EBITDA. The Company has prepared separate tables in the second quarter earnings release that reconcile these non-GAAP financial measures to the nearest GAAP equivalent. STV is not a substitute for GAAP revenue and adjusted EBITDA is not a substitute for GAAP measures of earnings or cash flow.

And third, the financial numbers reported for both the three-month and six-month periods ended June 30, 2007 and 2008 represent unaudited financial results. In the opinion of management, this information reflects all adjustments necessary to make a fair presentation of the Company's financial position and operating results for each of the periods presented.

As a reminder, the six-month period last year reflects the Company's combined results following the completion of the merger between Investools and thinkorswim on February 15, 2007.

With that, I now turn the call over to Lee Barba, our Chairman and CEO. Lee?

Lee Barba

Thank you, Paul, and good afternoon. Thank you, everyone, for joining thinkorswim's Q2 investor conference call. I'm joined on the call by Ida Kane, thinkorswim Group's CFO, Tom Sosnoff, the President of our broker dealer, thinkorswim, and as you heard, Paul Helbling, thinkorswim Group's Chief Administrative Officer.

I'm going to start and the slides should synch up. They'll go fairly quickly here with Slide number four. Record revenues of $97 million, net income of $18.6 million, EPS of $0.27, and adjusted EBITDA returns of 27% are strong results for a quarter marked by discontinuous volatile markets, a deepening credit crisis, and a quarter when the consumer confidence index hit the lowest level since May of 1980.

We're in the retail consumer business, so we believe that our record results prove the strength of our business model, which, in conjunction with the proactive intra-quarter adjustments management put in place, particularly to marketing and acquisition strategies, led to adjusted EBITDA returns that were well above our earlier forecasts.

Before we review the detailed operating and financial highlights of the second quarter, I'd like to emphasize that the core strength of our thinkorswim brokerage business and trading platforms continues to produce industry-leading results in every operating metric for online brokerage, irrespective of market conditions and consumer sentiment, and has done so for 22 months since our merger announcement.

Funded accounts opened in the second quarter were approximately two times the number of new funded accounts opened by our two primary software competitors, Trade Station and Interactive Brokers. And market share gains in retail option contracts traded in the past year, as reported by the OCC, have doubled to 2.2% of traded contract volumes, a sector of the market that everyone is fighting over and in which we continue to gain share and exceed the volumes of web-based brokers with substantially larger account bases. When active trader option trades are added to retail, thinkorswim now represents just over 3% of daily option contracts traded.

It is the consistency of this growth that leads us to raise our forecast from our prior conference call for the rest of 2008 and led to management's decisions during Q2 to accelerate the amortization of our outstanding term loan by $5.6 million, and reinitiate our stock buyback program with an authorization to purchase up to 5 million shares over the next two years.

On the following slide, you'll see that new accounts opened and funded continue their 22-month string of record-setting growth as we added another 26,825 new accounts and 12,350 new funded accounts during the second quarter.

Next slide, more importantly, we are sharing with you our high level metrics for cost per account acquired, which was approximately $490.00 per new funded account during Q2, a substantial decline from acquisition costs in Q1. Well educated, wealthy, active, loyal, and derivative-trading oriented customers are what everyone in the online brokerage industry is seeking, but which SWIM has always attracted with its sophisticated technology, professional trade-level support, and education services. Quarter-after-quarter, we attract the best accounts in the industry and quarter-after-quarter we scale the account base with record new account growth without experiencing an increase in turnover.

So when we counterpoint the $490 acquisition cost per funded account against annualized revenue per account of $2,300, we believe that our marketing and acquisition strategies are well worth the cost to acquire accounts of this quality. In addition, we believe, based on consistently low turnover rates that have not experienced a trend change that the average life of a thinkorswim brokerage account is longer than one year.

One further comment on account acquisition. We have worked hard to diversify the acquisition channels that support the growth of thinkorswim. While our Education division remains the largest source for high quality, educated accounts at thinkorswim, we continue to see growth in four other significant channels. One, additional education partners who work with thinkorswim on unique education and/or derivative trading strategy niches. Two, growing referrals from loyal thinkorswim account holders. Three, the growing success of independent thinkorswim branding campaigns such as the CNBC Plus and CNBC Portfolio Challenge sponsorships as well as growing online and anticipated TV ad spends. And four, stronger-than-anticipated account growth from our Canadian operations where we are now approved in six of ten provinces as well as other offshore account referrals and ForEx accounts that now consistently generate approximately 10% plus of monthly new account openings.

The following slide shows you retail account growth that continued to outpace competitors, increasing 16% from the first quarter from 45,400 to 52,500 in Q2, while continuing prior trends of consisting of over 80% derivative-based trades.

Slide eight, more importantly, shows that thinkorswim continues to gain market share in the rapidly-growing options trading sector, having doubled market share, as I said earlier, over the past year from 1.1% to 2.2% while outpacing growth rates for OCC-reported option contract trading volumes.

Slide nine, thinkorswim continues to significantly outperform all of our other online brokerage peers in DART growth.

Slide ten demonstrates that our account base remains of the highest quality and is characterized by consistently high trading volumes in derivative securities, which reached 82% of total trades during Q2. Annualized trades per funded account remained high at 185 per year, an increase versus Q1 trading levels.

Slide 11 shows average commission revenues per account increasing to $1,650 during the quarter from $1,500 in Q1 and these activity levels were achieved with an increase in average retail commissions per trade during the quarter from $8.55 in Q1 to $8.88 in Q2. Average contracts per trade increased marginally from 6.5 in Q1 to 6.7 in Q1, while the composition of the trades did not change from the normal high volume of multi-leg spread trades and index options.

Slide 12, in spite of market indices that have declined approximately 14% for the year and 3% during the quarter, customer assets of thinkorswim grew from $2.69 billion in Q1 to $3.1 billion at the end of Q2, or 16%. And while client accounts, activity levels, and assets grew, we did not see any decline in the quality of the accounts in terms of average funded account balances, which remain constant at approximately 40,000.

On the following slide, finally, in spite of dramatic inter-quarter shifts in partner schedules and declining trends in registration and show rates, our Education division produced a healthy number of second quarter graduates of 11,510, up approximately 10% over Q2 of 2007 and 5% over Q1 of this year. These results are a testament to the hard work and dynamic operating environment we maintain in the division and the product pricing strategies we put in place earlier in the year.

We continue to see significant differences in the demographic and trading activity of customers who open thinkorswim brokerage accounts between students who are willing to pay for education versus those who believe they can learn how to be successful investors by watching free webinars.

We invite every investor on this call to take a free two-day workshop and download our online course in order to demonstrate the power of our foundation force and the live training which supports the course versus the investor education products of other online brokers.

Commencing with our Las Vegas Investor Conference on August 10 through 12, the foundation course will include introductions to options, futures, and ForEx for the current pricing of $299, in addition to the seven steps to get started as an investor by searching for, analyzing, and paper trading equities. Decide for yourself whether a free webinar downloaded from one of our online brokerage peers is comparable to two days of live and online training and six months of support on the world's most comprehensive investor education content, the Investor Toolbox.

On Slide 14, let me start into a summary of the second quarter. Before I start the summary of those results, let me provide an outlook as well for the balance of 2008 and update you regarding the SEC inquiry. During the second quarter, the Company was informed by the SEC that its previously initiated informal inquiry had been made formal. The Company has been cooperating fully with the SEC since the beginning of this inquiry and intends to continue to cooperate. This inquiry is focused on the Education segment of the Company and not its Broker Dealer segment. Because it is ongoing, the Company cannot predict the outcome of this inquiry at this time, and as a result, no conclusion can be reached as to what impact, if any, this inquiry may have on the Company or its operations. We will continue to provide updates on this matter during our quarterly conference calls, as appropriate.

As we progress through 2008, we can see the emergence of the future of our Company as one of the major firms in the online brokerage segment, a segment that has performed well throughout the market and economic downturn. The unique growth and potential of thinkorswim is that it has been scaled over the past 22 months on the two most important growth segments of the online brokerage industry – education and derivatives trading, particularly options. These aren't segments we need to build or add to. They are the very foundation of thinkorswim's business model, which we continue to leverage for continued growth and improved margins.

It is because of this positioning that we are optimistic about the future. We continue to have our challenges, but the core strength of our business model is not in question given the consistent outperformance of thinkorswim's operating metrics against strong competitors. We have learned to harness the Education segment of the business to thinkorswim and redirect the efforts of this segment to become an efficient marketing and acquisition engine for our broker dealer and we will continue to do so.

Investing approximately $500 for an active, educated, funded account that returns this investment mid-way through the first year by generating an expected $2,300 of annualized revenue is a good business. While we don't intend to guide investors to this specific cost per account in future quarters, we do intend to spend in this range, plus or minus, as long as the quality of new accounts, trading activity levels, and composition of trades continues as it has for 22 consecutive months. It just makes business sense.

And it's worth adding that the loyalty or turnover rate of these accounts has not increased or changed trend in spite of scaling the funded account base by five times in 22 months, from approximately 15,000 accounts to over 78,000 funded accounts at the end of Q2 2008. As a result, we remain focused on the efficiency of acquisition through a growing and diversified number of channels to drive high quality account growth to generate improved margins for our shareholders.

To conclude this section of the presentation on Slide 15, and as we look forward, we see the substantial improvements we achieved in the first half of 2008 continuing. Of note, we remind shareholders that in Q3 we expect normal, seasonally slower student and account growth and we will have approximately $2 million of incremental expenses related to our Las Vegas Investor Conference at the Bellagio where we will be hosting 1,600 of our students and customers August 10 through 12.

July has been another strong month for trading, only slowing in the past week or so as we head into the middle of the summer. We expect to report July account openings of approximately 8,000 new accounts and 3,500 new funded accounts with DARTs of approximately $58,000, so we are off to a good start in the seasonally-slow third quarter.

As we look out through the end of the year, we are bullish about the continued growth of our sector, derivatives trading, in the online brokerage market, bullish about the sustained high activity levels of our customer base, and bullish about the increasing diversified number of channels and marketing mix that we are putting in place to sustain long-term growth and improve margins through efficient account acquisition at thinkorswim.

As we said in our press release, we exceeded our forecast in Q2 as the result of aggressive intra-quarter adjustments to marketing acquisition and scheduling opportunities and the continued growth of our brokerage unit. We believe that we will exceed our earlier indications of a flat performance to Q1 through Q3 with an improving Q4.

Based on these revised forecasts, we have reactivated our stock buyback program, which is currently authorized for a share purchase of up to 5 million shares over the next two years.

We feel very positive about our Q2 results, particularly in light of the economic and market backdrop, optimistic about the balance of 2008, and bullish about our longer term prospects as we grow free cash flow, pay down our debt where we made an additional amortization of $5.6 million during Q2, and amortize our merger-related obligations, including retention bonuses to further improve margins in the future.

I've asked Tom to provide more detail with regard to our brokerage operations, the online trading environment, and our relentless technology and product upgrades to assist active traders. Tom?

Tom Sosnoff

Thanks, Lee. Thanks, everybody for coming on board today. I get the fun job today. I get to add some color to our business and I get to answer some of the most commonly asked industry questions that come to me. I thought I'd start off with interest rates.

We believe – and this is obviously is a little bit subjective – but we believe that short-term rates are heading higher. And the good news is that thinkorswim has no exotic spread risk or no yield curve risk. Many of our competitors have already tweaked some of their short-term models and their near-term results have the built-in advantage is already being displayed of longer-term, higher rates. We've taken the very conservative approach. We currently have no rate curve risk whatsoever. And any movement to the upside will benefit us with the majority of every basis points move in Fed funds dropping down. Since the futures market anticipates higher rates into '09, we are confident that those benefits have not yet been realized and that they are sustainable in our model.

Next, I'm going to jump into payment for order flow. On every earnings call for the past year, we have projected steady to higher payments for stock-and-option order flow on an apples-to-apples basis. We continue to believe that payment for order flow will increase, at least marginally, and we will see payment going higher throughout '09. Some of our reasoning is the following – scarcity of independent, non-conflicted order flow aggregators like TOS; more competitors and plenty of available capital on the liquidity provider side; much improved exchange technology, integrated matching engines at the exchange level are making directed flow more attractive; the premium on the TOS retail business, because of our enormous growth potential and because of our track record of delivering consistent account growth, DART growth, and a high percentage of options and derivatives business. We are a proven loyal partner to most of our liquidity providers and we believe that there are creative internal opportunities that we have because of our industry experience coming from a market maker background and our own backend technology. The bottom line is we feel that our order flow is worth more than we're currently getting paid for and we will work to modify that opportunity and we think the added value is also sustainable.

On the clearing side, we get a lot of questions about clearing and we thought it would be best to talk about it. We are very happy with our current relationship with Penson Financial. They're an excellent clearing firm. They've been a very strong business partner of TOS since our inception. We look forward to continuing and expanding on that relationship with Penson, but we're not limited to nor are we comfortable with not exploring and seeking clearing opportunities that potentially could accelerate our growth strategies. Since we're in a contract year with Penson, our expectations are that we reach a mutually agreeable partnership and we believe that given the growth of our retail and active trader business our new clearing deal will have a positive and ,again, sustainable impact on our future results.

Next, I thought we'd just discuss our technology a little bit. Institutional first. We have committed a ton of resources the past few years to our institutional platform called thinkpipes and now we're starting to get paid. The thinkpipes platform currently has distributional relationships with industry leaders such as Citi, Credit Suisse, UBS, and in July alone, just to give you an indication, we averaged over 182,000 option contracts per day and about half of that is CMTA-ed away. Our institutional technology is fast, it's clear and agnostic, it's broker neutral, it's architecturally strong, and we believe it's poised to take a large percentage of the institutional space away from older, legacy platforms.

Our retail platform, thinkorswim, continues to deliver one major release per month and we have added thousands of new features in the last year alone. Sometimes our competitors tend to brag when they release features and functionality that we've had for years. TOS challenges our dev team to produce intellectually-driven, powerful trading tools. Upcoming releases include the industry's first AI interface based on machine learning. We are rolling out an automated, robotic thick client in the next month, which will allow clients to trade on defined signals. We have new portfolio of management tools that will allow for single-click position dissection and we're rolling out an active trader interface that caters to retail futures traders and active day traders.

The front-to-back integration of our stock options, futures, and FX platform will make TOS unlike any other platform in the world. Although there are lots of other one-stop shops, there are no other platforms that will analyze data weight [ph] chart, configure, and trade all from the same page, all with single-click technology.

On the brokerage side, we believe the industry will remain strong for years to come. This is our business and we love it. Of course, we don't think it will be a one-way train and we do anticipate some pull-backs, especially in the recent volume spikes and in the recent retail trading activity. However, most of this consolidation should be short-lived and contained in the traditionally slow months of August and September. We probably would have guessed that July would have been slow as well, but as you can see, we had another strong month. Regardless, we expect Q4 and Q1 to ramp right back up.

The reasons for our industry bullishness are simple – efficient markets, better technology, and an educated customer. We believe that the US derivatives market is still in its infancy and infancy as defined by a new era of efficient markets. We generally believe that we’ll see a reasonable but small increase in futures business as a percent of our customer retail DARTs. We believe that global access is more of a marketing tool right now and not a real customer opportunity, but we do think the global expansion to reach new customers is critical and it is part of our model going forward. We feel mobile applications, including iPhone technology will increase product demand and we feel that our customer base is going to get younger with new product mix and the nature of the new business. We're not your parents' brokerage firm anymore.

To recap, payments should remain strong. Technology will determine winners and losers. Interest rates will be positive for us and we're just looking forward to a pretty positive – yes, we have a pretty positive outlook on the industry in general. I'm now going to turn the call over to Ida Kane, our CFO.

Ida Kane

Thanks, Tom. As Lee mentioned, we had record second quarter results, which demonstrates both the growing scale of our brokerage business and our improved efficiency in executing our customer acquisition model. Second quarter revenues of $97 million reflects a 22% increase our prior year and 7% increase over the first quarter. For the first time, over 50% of the revenue generated in the quarter originated in the brokerage segment of the business, which grew 82% over the prior year second quarter and 15% over the first quarter.

Commission revenues increased to $33.1 million and reflect a 98% increase over prior year and a 26% increase over the first quarter. The increase in commission revenues primarily reflects an increase in the number of funded accounts, up 100% year-over-year, and 17% on a sequential quarter basis, increased trading activity per funded account, up 21% year-over-year, and 4% sequentially. Retail commission rates per trade declined 13% year-over-year, but increased 4% sequentially and an increase in the number of contracts per trade up 3% from 6.5 to 6.7 on a sequential basis. Our continued growth in customers and activity speaks to the value of our trading technology and educated base of accounts.

Interest income totaled $6.2 million in the second quarter. This was an increase of 24% on a year-over-year basis and a decrease of 19% on a sequential quarter basis. As expected, we continued to experience interest spread compression during the quarter with the Fed funds rate averaging just over 2% during the second quarter compared to just over 3.2% during the first quarter. This was partially offset by the increase in our customer assets held in cash and money market accounts, which grew 17% sequentially and 113% year-over-year to $1.75 billion at the end of the second quarter.

Going forward, a 25% basis point increase in Fed funds rate would result in an additional $3.2 million of annual interest revenues based on June customer asset and cash balances.

We broke out payments for order flows separately for you this quarter to provide more visibility to this revenue stream given the growth. Payments for order flow revenue increased to $7.9 million during the quarter, up 98% year-over-year and 20% on a sequential quarter basis. The increase in payment relates to increased volume from our growing customer base as trading activity is mostly options oriented.

We have provided for the first time cost per funded account, which includes Education net margin or adjusted EBITDA and direct brokerage acquisition spend. Annualized revenue per funded account is brokerage related, the majority of which is commission revenue. Education sales volumes were approximately $34 million during the quarter for 11,510 paid graduates and continuing education sales to our base of over 100,000 active subscribers as of June 30. Education Sales Transaction Volumes and corresponding costs are key components of customer acquisition costs that we have provided to you today.

Compared to last quarter, this reflects an increase in efficiency per customer acquired via Education with lower Sales Transaction Volume in part due to changed pricing strategies announced earlier in the year.

Second quarter net income of $18.6 million reflects a 206% increase over prior year and 62% increase over the first quarter. The increase in net income can be attributed to the highly profitable brokerage segment that continues to grow at record pace. In addition, given the nature of deferred revenue and the timing difference between cash in-flows from sales and recognition of revenue in the Education segment, we feel adjusted EBITDA as a percent of Sales Transaction Volume is a useful non-GAAP measure of operating performance within a specific period.

Second quarter adjusted EBITDA of $22 million or 27% of total Sales Transaction Volume reflects an 11% decline year-over-year, but a 38% increase on a sequential quarter basis.

For purposes of this discussion, I wanted to expand on the quarterly results by breaking them into three buckets instead of two. We may continue to do this in the future and I wanted to give you a better view to the improvements that we have made during the quarter as well as discuss a few things that will impact these results in the upcoming third quarter. Using our definition of adjusted EBITDA, brokerage operated at a record 58% adjusted EBITDA margin or $28 million during the quarter, up from approximately 56% during the first quarter. We spent an approximate $2.6 million at the adjusted EBITDA level for Education customer acquisition during the second quarter, an efficiency gain of almost $2 million from the $4.5 million spent in the first quarter at the adjusted EBITDA level. In addition, corporate overhead adjusted EBITDA was approximately $4 million of cost during the quarter, up from $3.5 million in the first quarter, mostly related to professional fees.

So we generated approximately $28.5 million in adjusted EBITDA from brokerage, spent $2.5 million in Education acquisition, and had $4 million of corporate overhead. That reconciles us to the $22 million of reported consolidated adjusted EBITDA in our earnings release. We feel good about the progress we've made to improve the efficiency of customer acquisition strategies and expect to finish the balance of the year above our first quarter results on an adjusted EBITDA margin basis.

Having said that, as we mentioned earlier, we will host our annual Investor Conference in Las Vegas in early August. This will be our second largest ever, with approximately 1,600 students attending. We expect about $2 million of incremental cost in Q3, mostly coming through the cost of revenues line on the P&L. This obviously will impact adjusted EBITDA margins, assuming all else equal.

Although July is off to a good start, we do expect lower graduate and account volumes during the third quarter, which is seasonally a low quarter and to pick back up in Q4.

With regards to taxes, the increase in effective tax rate during the quarter relates entirely to our increased estimates around our results. Given our current expectations, we should have about a 27% effective tax rate for the year. You'll notice it's higher than that during the second quarter as we apply the effective tax rate against the year-to-date results to determine the current period expense, so we had a little bit of a pickup in Q2 related to prior quarter.

We started the year with approximately $110 million of available net operating loss carry-forward and we do expect to utilize over $60 million of this amount for 2008 results and then the balance will carry forward to 2009 and beyond. We do continue to expect our effective tax rate for '09 and beyond to be 39%. I just want to remind you that from a cash flow perspective, of the $11 million in tax expense during the year-to-date period, we still only expect to pay about $5 million in cash taxes due to these net operating losses.

During the second quarter, we generated $14.3 million in free cash flow. This has increased from $5.5 million in the first quarter, which was burdened by $6.7 million in retention bonus payments made to the employees of thinkorswim as part of the 2007 merger agreement. This was the first of three annual payments that aggregated to $20 million that also flows through our P&L. Without this merger-related obligation, we would have generated approximately $27 million in free cash flow over the first six months of 2008. We believe the Company will continue to generate strong free cash flow as we continue to acquire active, educated customers at an efficient cost.

Furthermore, we see other opportunities for improved margins over time, including, but not limited to, additional cost savings, continued growth on the brokerage account base, wider interest margins as the interest rates are raised, and growing payments for thinkorswim's high value, option-based order flow. Any or all of these opportunities would add to our overall free cash flow, which could be used for additional stock repurchases, debt retirement, or acquisitions.

With that, I'll turn the call back to the conference operator and we'll take some Q&A.

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

Thank you and good afternoon, guys.

Lee Barba

Hey, Mike.

Mike Vinciquerra – BMO Capital Markets

I must say, I hand it to all three of you, I had trouble keeping up with each of you with all the good data you were spitting out there, so I appreciate that. But I want to follow-up on a couple of things. One, the cash from your customers surged in the quarter, as you mentioned, Ida, and it's pretty astonishing. I've got it at 56% of your client assets, much higher than it was last year. Is this something that you expect to continue? Is this market conditions, Tom? What's really going on with that position?

Tom Sosnoff

Say that again, Mike, just the –

Mike Vinciquerra – BMO Capital Markets

Sure. The client assets that were in cash, I measured – based on the statistics you're not sharing with us – at 56% of your clients' assets; last year it was about 45%, 46%. What's driving the increase? Even at 45% or 46%, it's incredibly high for the industry.

Tom Sosnoff

Well, I mean you are comparing us to the rest of the industry, Mike, and really were one of the few firms that 80 some odd percent of our business is in the derivatives space. Most people keep their cash as cash. So whereas – we are a very different animal. If you look at our $40,000 average account size, that would be – if you compare it apples-to-apples, for example, with a firm that controls more of let's call it share of the wallet, you'd be looking at their actual cash portions of their account that they use for trading, probably smaller than what we have. So if you look at our business a little bit different than most of the other businesses, we've always maintained a high percentage in cash. It makes sense, number one, for the business we're in and it also makes sense for the way the market's been relative to volatility the last couple of months. You've seen people just pull back a little bit on their allocations to new positions. So they've pulled back, they've left it in cash, and they're ready to play. It's basically just a sidelines effect.

Mike Vinciquerra – BMO Capital Markets

Okay. So realistically when we look forward in terms of projecting interest income earned off a client balances, something around the 50% mark would be reasonable expectation on our part?

Ida Kane

Yes. That would be about right, Mike.

Tom Sosnoff

That's the way it's been since – almost since our inception. That's why we brought up the topic of interest rates because we clearly have a lot of upside that we haven't locked ourselves in at all. We basically haven't hedged ourselves and haven't mortgaged our future on the interest rate side. So any uptick in interest rates drops right down to us.

Mike Vinciquerra – BMO Capital Markets

Okay, very good. Thank you for that. And then, Ida, just to clarify, you said $3.2 million annualized for every 25 basis points. Did I hear that correctly?

Ida Kane

That's right.

Mike Vinciquerra – BMO Capital Markets

Okay. And Lee, I know you mentioned the SEC issue and you said there's limited things you can say. Is there anything at all you can tell us, though, in addition regarding what it relates to? I mean is it – do you have to change your business practices on the Education side? Is there anything that may keep you from operating as you have for the last ten years?

Lee Barba

Yes, Mike. As I'm sure you'll appreciate, we really can't add to the comments that we made. We're fully cooperating and we are working very hard to get through this process as quickly as we can, but that's all we can say.

Mike Vinciquerra – BMO Capital Markets

Okay, very good. I'll jump back in queue, guys. Thank you.

Ida Kane

Thanks, Mike.

Tom Sosnoff

Thanks, Mike.

Operator

We'll hear next from Patrick O'Shaughnessy with Raymond James.

Patrick O'Shaughnessy – Raymond James

Hey, good afternoon, guys.

Ida Kane

Hey, Patrick.

Lee Barba

Hi, Patrick.

Patrick O'Shaughnessy – Raymond James

First question I had was about some of your expenses. Given the growth that you had in the brokerage business during the quarter, I would have expected some of those expenses to come in perhaps a little bit higher. So I was wondering if you could maybe detail some of the steps that you took during the quarter that led to expenses actually come in a little bit lower than myself and perhaps some of my peers might have expected.

Lee Barba

Yes. Patrick, for people who have known us for a long time, we tend to move pretty quick. Just to recap a little bit what we said at the beginning – at the end of Q1 we were expecting a very heavy schedule through that particular channel. When we saw adjustments to it based on changes in reg, changes in show, and partner schedule, we very quickly adjusted the selling expense line, as Ida can expand, and we very opportunistically looked at the rest of the schedule for the quarter. Without interrupting a standard level of graduate growth – 11,000 is a good number for Q2 – we felt that that was the right way to manage the quarter and we're continuing to manage it that way going forward. That's why we gave you the CPA or Cost Per Acquisition and we're trying to direct all of the analysts and investors to understand how we now are focused on that metric by, one, diversifying the channels of acquisition for thinkorswim and managing the largest channel, which is the Education division, more efficiently. So you can see the CPA, Cost Per Account, coming down pretty dramatically between Q1 and Q2. And while we're not giving you a specific CPA to put in your models, we think that the improvements we found during Q2 we can stay closer to this range than the Q1 level because we were caught out on the change in schedule. That's where you saw very quick adjustments in cost throughout that segment without decaying in any material way the number of graduates. And obviously, that speaks to – since you didn't see any change in the quality of the accounts of thinkorswim – there's your next question. We're able to have managed that without in any way impairing the quality or activity levels of the student base that converts over to thinkorswim.

Patrick O'Shaughnessy – Raymond James

Very good. The next question I had was the commissions per trade, obviously, I think Tom spoke about this a little bit. They jumped up a little bit in the second quarter versus the first quarter. Did I hear correctly that that was essentially just kind of a trade mix shift function where customers were perhaps sending through larger orders and that was responsible for bringing that average commission per trade amount up?

Tom Sosnoff

You heard that right. Usually when there's a little bit of a stabilization in the market customers get a little more comfortable and they may increase their size or when – we're an investor education Company as well and as our customers get better and better and they get more confident they may bump up their size. But there was a small, marginal shift in the amount of contracts traded by our customers and that – we've said all along that we thought at some point as customers get better and as markets get more efficient they trade more and they trade a little bit bigger. And that's what we're looking at here.

Patrick O'Shaughnessy – Raymond James

Very good. I will jump back in the queue. Thanks.

Tom Sosnoff

Thanks, Patrick.

Ida Kane

Thank you, Patrick.

Operator

(Operator instructions) We'll move next to Richard Fetyko with Merriman Curhan.

Richard Fetyko – Merriman Curhan Ford & Co.

Question on the thinkorswim side in terms of the independent marketing dollars that you have allocated to that channel. Just curious, what kind of customer acquisition trends you're seeing, how happy you, are you going to allocate more to that channel or expand that?

Lee Barba

The simple answer is yes. It's all of those subtext questions. We continue to be pleased with the independent marketing. I think we've given an earlier number, Richard, Ida, can correct me, of $5 million to $6 million over the course of the year. It continues to ramp. At our current ramp, we're a little bit lighter because of economic and market conditions. But you'll see that ramp up late in Q3 and into Q4. But we might be closer to the $4.5 million, $5.5 million than $5.5 million, $6.5 million, but that's a minor adjustment. We are, as I indicated, changing the mix. So we started off with some banner and very minor search programs independent through the thinkorswim brand. You're going to see a lot more new creative on the thinkorswim banner ads and you will see a series of campaign – TV campaigns that we're hoping to start late in Q3, early in Q4. So we're pleased with the results of the independent marketing campaigns. We see that potentially long-term as one of the most significant new diversified channels of acquisition for thinkorswim.

Richard Fetyko – Merriman Curhan Ford & Co.

Got you. And then, Tom, on the payment for order flow, you mentioned a number of reasons why the rates could actually go up. Could you just kind of quantify for us what the potential upside is, not necessarily what timeframe, but do you think that the rates could have another 25%, 50%, 100% upside over time?

Tom Sosnoff

That's a tough one, Richard, because it's loaded and I don't want to disappoint so I'm going to be very careful here. Like I (inaudible) in my little speech, I think our payment for order flow is worth a lot of money and how we define that –. I basically think of it as an arbitrage – what we're getting paid versus what it's worth versus the risk that's involved in somebody else internalizing it or directing it to somebody else. I think at the very least it's a nice little bump maybe that's a small number. But, I'm not comfortable yet putting a number on that, again, only because I don't want to disappoint. But I'm comfortable saying that I think that number's going to be higher than what it currently is.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. So on the timing, then, when do you think you might see some of those improvements? Is it this year, next couple of quarters, or '09?

Tom Sosnoff

This has been our focus this year. We had to do a lot of data mining. We had to do a lot of research. We spent a lot of time basically just figuring out exactly what we have. We're in pretty good shape right now. We're comfortable, so we intend to start the process immediately. I don't know when that actually hits, but we're talking probably fourth quarter would be fair. Incremental changes maybe until the fourth quarter, then really looking – we're looking out into 2009 because we want to give our liquidity partners time to ramp up, too.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. All right. And then, Ida, lastly on the education profitability, you've improved quite nicely sequentially, but I imagine that some of the cost saving initiatives were implemented intra-quarter, so I was just wondering if some of those cost saving initiatives will have a bigger impact on the following quarters. Obviously, third quarter is seasonally the weakest, but perhaps – do you think you can bring that Education business to EBITDA break even point? Is that something you're seeking to do or are you comfortable with the EBITDA loss that you had in the second quarter in that segment?

Lee Barba

Richard, let me take a shot first and then Ida can give you the detail. Again, we want investors to understand our shift in thinking that it's really a marketing and acquisition engine for brokerage, one of a diversified number of channels that we keep growing. That's point number one, we want to keep reemphasizing that. Number two, it is true, as you suggest, that the cost savings were largely gained in the back half of Q2 and therefore, you would see – I want to separate out selling expense or marketing expense, which we're very opportunistic about, from core staffing expense, for example, and you will see the staffing expense roll into Q3 and Q4 more. We continue to restructure and we have seen a decline in staff consistent with revenues, that's in excess of the 15% level and we're going to continue to look at that. We don't intend to stop. We're not done. And that is what you will see more in Q3 and fully in Q4. So, Ida can add to that.

Ida Kane

Yeah, and just to add to that, Richard, but I also wanted to make sure that everybody remembered, we have the Las Vegas Investor Conference in Q3 and that our schedule as well as some of our education partners’ schedules are seasonally light in Q3. So I would say if you're comparing it on a run rate basis I wouldn't over-expect for Q3 on the improvement because of these additional items that we're going to have in the quarter. That obviously wouldn't repeat in Q4, so then in Q4 I do expect that we would be able to not only realize the full quarterly benefit of cost initiatives that we have in place, but also not having larger kind of items in the quarter like Las Vegas conference.

Richard Fetyko – Merriman Curhan Ford & Co.

Got you. All right, thanks.

Lee Barba

Richard, I want to take the opportunity since that came up to just – so that it's not a surprise going out. The Q3 schedule is more than in the past weighted much heavier towards the very end of August and September, more than it has been historically just so that everybody understands that. And number two, there are these other items in Q4. So we've seen, as I commented, on the thinkorswim side, very strong growth in brokerage accounts. So we've adjusted schedules to be more present with the education workshops in Canada as well to take advantage of now being almost 100% regulatorily approved. And I think Tom can tell you, we will be by October. So in Q4 and even a little bit at the end of Q3, we're in Canada more than we ever have been. When we go to Canada, we tend to in some cases with our partners stick at the higher price point. So again, these are little things that affect, but we want to make sure we're giving more information to everybody so there are no surprises. That may get you fewer graduates, but the quality is extremely high, and our success with thinkorswim in Canada. So, we are making those – that's another example of the kinds of adjustments we're making in running that acquisition channel to optimize it and keep CPAs at very cost-effective and efficient levels. Tom–?

Tom Sosnoff

Just a little follow-up, Richard. As far as from Lee's Canadian push, we are going to be supporting the educational side with being able to take registered accounts in Canada. We're also going to be able to route trades to Canada from US customers and Canadian customers. We currently only route from Canada to the US and we're going to actually drive Canadian data through our platform. So, we're essentially opening up the border, so to speak, and – for trades for data and for registered accounts.

Richard Fetyko – Merriman Curhan Ford & Co.

Okay. Thanks for the clarification.

Operator

We'll move now to Chris Donat with Sandler O'Neill.

Chris Donat – Sandler O'Neill

Thanks. Congratulations, everyone, on a very strong quarter there.

Lee Barba

Thanks, Chris.

Ida Kane

Thanks, Chris.

Chris Donat – Sandler O'Neill

Just digging a little deeper on the selling expense, I want to make sure I understand what's going on. I'm showing basically a $5 million decrease quarter-on-quarter–

Ida Kane

That's right.

Chris Donat – Sandler O'Neill

And I'm trying – it sounds like you're using maybe four and – or more aggressively using four channels for building your customer base. I guess what incremental expense came from what was new and then what came out from the traditional Education channel as far as expenses go?

Lee Barba

I want to make sure we understand and respond to your question, Chris. There wasn't a material change in the number of thinkorswim accounts that came from the Education segment. However, we can see incrementally the way we spend our marketing dollar and the returns, which is back to Richard's question, that there's room to grow. For example, the separately branded marketing spend and we did increase that in Q2 versus Q1 and it was very minimal last year in Q4, and are planning to step it up towards the end of Q3 and Q4, as we said earlier. Referrals is a bigger – and we say this every single conference call, it's very hard to track. Tom can tell you – I'm a friend of a friend of a friend who started in Investools but they opened an account with thinkorswim and they just tell me they had the best experience. So referrals we think is very large channel. Partner relationships – Tom can comment – seems strange. Other online brokers comment on it and so we want to make sure you understand in addition to Investools, thinkorswim has many of the leading other niche derivative-based education companies. And we see an increasing number of accounts coming from that source as well. And of course, the 10% – I think, actually, last in June it was closer to 11% or 12% – from Canada, other offshore, and ForEx accounts. We like this mix. That's why we're emphasizing it to investors and over time we are putting more and more energy into growing all channels, but focusing on the diversity.

Chris Donat – Sandler O'Neill

Okay. So, let me restate what I guess what I think I'm hearing. So the $14 million of selling expense in the second quarter kicks up by a couple of million in the third quarter because of Las Vegas, and then probably comes back down to $14 million, $15 million?

Ida Kane

Well, actually, the Las Vegas conference is going to flow through the cost of revenue line–

Chris Donat – Sandler O'Neill

Right, right, yes.

Ida Kane

So that wouldn't be the case.

Chris Donat – Sandler O'Neill

Okay.

Lee Barba

And Chris, I think what you saw in Q2 is how quick we can move. If we see consumer sentiment changing, if we see online brokerage accounts, if we see the quality of accounts we're continuing to get even through the end of July, we'll take that spend up and we'll do it very quickly.

Chris Donat – Sandler O'Neill

Okay.

Lee Barba

I think what you're seeing us do is manage the efficiency much tighter than we ever have in a difficult period and still get great results with that improved margins. It can go up quickly if we see that the market is turning. And we would do that, given the quality of accounts we've proven over 22 months we can continue to get.

Chris Donat – Sandler O'Neill

You mean the efficiency would go up or the spending would go up or you'd see more accounts come in also if you increase the spending?

Lee Barba

I was commenting on the spending, but the efficiency – and again, I'm taking the opportunity to repeat – at $500 – roughly $490 in Q2, if that number were $600 or $400, as long as we saw the annualized revenue at the levels we've got – and you have to plot out in a spread sheet versus what that number is for other online brokers – you'd be crazy not to spend that money to get the quality of account that we're giving to thinkorswim. The return on that investment is anywhere from five to seven months and that's on a one-year annualized revenue and margin analysis. You'd want to do that all day long. So yes, the spend can go up very quickly. We've pulled it in. We're managing to the efficiency. But efficiency is not to a specific number. It's – loyalty is there. Derivative trading activity is there. The wealth and size of the accounts is staying the same. You'd spend into it and that's what we're going to do. We just tightened it up in Q2.

Chris Donat – Sandler O'Neill

Okay. One quick question for Tom on the thinkpipes. Is there a point where we'll start to see more metrics coming out besides – you mentioned what was going on in July with 182,000. Anything from the outside we will be able to see or this is something we'll hear more and more about?

Tom Sosnoff

I think, Chris, it's something that you're going to hear more and more about fourth quarter and probably we may even throw out some stuff – kind of projecting out – next year. I mean we've really – we consider ourselves a financial technology firm more so than anything else. And we've been building this particular piece of institutional technology very lean for the last five and a half years. This is not a new platform. It's mature. It's stable. It has a very deep, powerful architecture. Like I said briefly before, it's agnostic, it's broker neutral. It goes to multiple clearing firms. It's distributed by some major partners on the Street. It's becoming a player. It's just turned the corner with respect to volume and we – we'll do – I'm not sure how many shares of stock a day through the platform right now, but the option volume was right for July. But just as far as number of orders – a couple of hundred thousand orders a day through the platform, not fills, orders. And it's become like a little favorite – a cult favorite on the institutional space right now. I'm hoping that by the first quarter of next year we can push something out there to you guys so you can model a little bit better.

Chris Donat – Sandler O'Neill

Okay, thanks. And then just one last one for Ida there. I missed the tax rate for the remainder of the year you expect?

Ida Kane

27%.

Chris Donat – Sandler O'Neill

27%, thank you.

Ida Kane

No problem. Thanks, Chris.

Operator

And we do have time for one more question. That will come – a follow-up from Mike.

Mike Vinciquerra – BMO Capital Markets

Thank you, guys. Actually, I've got three questions, but I'll make them short if I can. First, Tom, you'd be disappointed if I didn't bring up the commission rate one time on the call. The rate, obviously, higher in the quarter, but the longer term based on the aggressive pricing you're offering to certain clients of some of your competitors, should we still anticipate that would drift slowly lower over time?

Tom Sosnoff

It's tough, Mike. I'm not sure. I think I personally –we've said that one of the nice things about SWIM right now is that there's a lot of firms out there that have a much higher basically ticket (inaudible) so we're pretty comfortable. We live –and we've mentioned this many times on these calls – we live right in between the average of other software-based brokers and the average of most of the web-based brokers. We're that one tweener firm in that $8.50 to $9.00 range. I'm one of those that believe that it's much more a function of the efficiency of the market. So if we're able to maintain really cool products going forward, meaning if the exchange is cooperative, they continue to build technology, if there continues to be lots of liquidity, I think that number is –. I don't see much change. It'll vary a little bit, but we're not modeling it much higher. We're not modeling it much lower. This is right where we see it.

Mike Vinciquerra – BMO Capital Markets

Okay. Very good. Thank you. And Ida, in the G&A category, can you break that down between payroll and bonuses and kind of the other component of that, just to give use a sense? I assume that bonus accruals were pretty high given the performance this quarter?

Ida Kane

Yes, I could if I had it in front of me.

Mike Vinciquerra – BMO Capital Markets

It's not that critical, so we can discuss it later if that's easier. But while you're digging that up, one other question on the repurchase plan. What resources do you currently have available to put to use in your repurchase program? How much money do you have available on the balance sheet and then you said you've generated another $27 million in free cash during the first half?

Lee Barba

Yes. So, I don't think it's a limitation of cash and Ida can comment on the end of quarter cash position and if she wants, the current cash position. That isn't the limitation, Mike. It will be under our loan agreement. There are some limitations initially. We're going to live within those at this – for this timeframe and then if we needed to change it we'd have to go back to the banks. So, it's not a cash constraint. We've got a lot of cash. In fact, I don't mind saying – Ida's going to kick me under the table – at the end of July, the numbers that I've seen, we are very fast approaching – we're not quite there – where we were before the merger. And so I mean we took all our – we basically took our cash down as part of the acquisition. You remember it was funded with the JPMorgan loan. Tom, Scott and other shareholders took back 50%, and then the third element was a substantial cash infusion from off of our balance sheet at Investools at the time. We're getting back to those levels, which gives you some idea how fast cash has re-accumulated. So the limitation is really the loan docs and our desire to purchase stock back at attractive levels. I do want to use this opportunity – it's a little bit out of order, but just by way of full disclosure, I think some of you have asked and know, so let's put it on the record. As the CEO, I have some options maturing later in the month of August. They're 550,000 options. I'm obviously going to exercise them and I will need in order to fund the exercise to sell some stock – not a material amount, but I will need to do that – and I want to put that on the record so nobody is surprised when it happens.

Ida Kane

And Mike, to answer your question, let me just give you a couple of numbers and I'm going to break it out by category just so you can tell and then if you have other questions let me know. But payroll costs in cost of revenue were $10.0 million this quarter compared to I think it was $10.1 last quarter. Payroll and selling was $2.47 million in Q2 compared to $2.6 in Q1. And then in payroll, it was $8.7 million in Q2 compared to $8.8 in Q1. So you can see the decreases across the board in payroll.

Mike Vinciquerra – BMO Capital Markets

Okay, great. Thank you very much.

Ida Kane

No problem.

Operator

And everyone, I'll turn the conference back to you for closing remarks.

Lee Barba

No, thank you, Kelly. I think we'll conclude based on the Q&A. Thank you, everyone, for attending the conference call.

Operator

That concludes today's conference. Have a pleasant rest of your day.

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Source: thinkorswim Group, Inc. Q2 2008 Earnings Call Transcript
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