The Starting Line: E*Trade diversity helps in downturn

The online broker arose during the dot-com boom, when it seemed as though everyone was trading tech stocks like baseball cards, and now is showing that its expansion strategy can reap rewards in a downturn.

E*Trade surprised investors Wednesday by reporting a 29 percent jump in operating profit for the third quarter, and raising estimates for its fourth quarter. E*Trade reported net income from ongoing operations of $9.3 million, or 3 cents a share, up from $7.2 million, or 2 cents a share, in the year-ago quarter. But sales fell from $340 million to $292 million during that same period.

For some time now, the company has been expanding from its role as an Internet-only broker in order to diversify its sources of cash, which primarily came from stock trading activity. The company has gone into mortgage banking, credit cards and 401(k) management, among other areas.

"E*Trade's multiple revenue streams sheltered it relative to its peers," said J.P. Morgan analyst Gregory Smith. The company takes in money from various enterprises, such as brokerage services, mortgage banking and credit cards.

But the company still faces some risks, which happen to revolve around a slowing economy and sea change from the heady day-trading days in 1999. For starters, E*Trade, which largely caters to consumers, doesn't have the track record of the Charles Schwab and Fidelity, but it's trying to move its brand to online banking and mortgages, and other areas that are unchartered for the company.

That expansion could cause E*Trade to lose focus. Online rivals such as Ameritrade, which recently bought National Discount Brokers, have stuck to their original missions for the most part.

And while E*Trade's new revenue streams did help offset the brokerage-based losses, much of the savings came from new cost-control measures; the company said that, for instance, consolidating facilities will boost the bottom line by 10 to 12 cents per share in 2002. While it's good to keep a tight lid on expenses, it's not as if it can keep shutting down offices each year.

Nevertheless, E*Trade has been busy expanding of late:

• On Tuesday, it announced plans to open up "E*Trade Zones" at 22 Target stores around the country later this year, allowing customers to have a physical contact with the company. The new stores are opening up in areas with somewhat lower average-income levels than the typical brokerage accounts; President Jerry Gramaglia said the idea is to surround its existing E*Trade Centers in cities like Boston, New York and Beverly Hills with the Target locations in the suburbs.

• On Wednesday, it signed exclusive agreements with Visa USA and Visa DPS to issue a single card that customers can use at automatic teller machines to access bank and brokerage accounts. The cards will allow customers using selected E*Trade ATMs to make withdrawals, request balances from and transfer funds between E*Trade Bank and E*Trade Securities accounts.

• And Thursday, it launched E*Trade Pro, a direct-access trading platform aimed at "hyperactive traders." The new platform includes streaming intraday charts, streaming watch lists, and live order status and account positions. It also allows customers to chose how they want orders routed, either through direct access to Island ECN, Instinet and Archipelago, or through E*Trade's proprietary auto-routing to market centers.

Tough times
So far, E*Trade's diversification moves have worked out, but E*Trade has maintained its bottom line by cutting back on expenses. Instead of growing its way into Wall Street's good graces, it has been cutting back to hit estimates.

The problem facing E*Trade is the same one facing the other online brokerages, and some offline ones as well: The economy is slowing down, and so is the amount of trading people are doing.

According to Internet research company Gomez, online brokerage accounts grew a meager 1.96 percent from the first quarter of this year to the second quarter. That compares to 15 percent growth over the same period last year.

And people who are opening accounts aren't doing as much trading. J.P. Morgan analyst Gregory W. Smith estimates that--even considering the spike in overall volumes following the reopening of the stock markets after the terrorist attacks last month--daily trades at online brokerage firms dropped 20 percent to 25 percent sequentially during the third quarter from the second quarter.

The drops have already had an impact on brokerage firms; in August, Schwab announced that it would reduce its work force by about 9 percent this year. And Ameritrade in September said it expects to report a net loss for the fourth quarter and plans to take a $30 million restructuring charge.

Not everyone has been able to make it through alone; Toronto-Dominion Bank on Wednesday said it would buy back discount brokerage TD Waterhouse Group for $9 a share, just two years after it sold the minority stake for more than twice that price.

"The challenge for the firms is that (they built) their infrastructures (based) on the compound annual growth they were seeing in 1999 and 2000," said Dan Burke, director of brokerage services at Gomez. "It is a challenge for firms that don't have long history. Schwab, Fidelity, they're hurting, but not as much as the E*Trades of the world."

While there is a core of investors who will trade day in and day out, even as markets tank, investors who were taking a more casual attitude may back out entirely, choosing to put their savings in more staid investments.

Can E*Trade do everything?
To adapt to the new economic reality, E*Trade's solution has been to diversify.

E*Trade has been working hard at that approach, and according to Gramaglia, that's what's helped it succeed in tough times.

Transaction revenue represented less than one quarter of all revenue, he said. Of course, that number has dropped not so much because of the rise in other divisions, but because of the drop in trading. In fact, transaction revenues fell 30 percent from the previous quarter.

But the company was able to offset that loss with contributions from other divisions, including an additional $30 million in mortgage-related fee income, and $13 million from other services.

And divisions like E*Trade Mortgage are also bringing in new customers. Only about one quarter of all mortgage customers already had brokerage accounts with E*Trade, he said.

The company recently acquired market maker Dempsey for $173.5 million. (Market makers, or specialists, are traders that are prepared to buy or sell shares of a particular stock at any time for their own accounts; they usually look to profit from quick turnover rather than from gradual price movements.) That deal allows E*Trade to handle execution of its customers' trades internally, instead of working with an outside firm. It is expected to begin contributing to the bottom line in the fourth quarter, potentially adding $100 million in revenue and 5 to 7 cents in earnings per share.

"E*Trade's ability to achieve profitability continues to validate other parts of the business model," said Robertson Stephens analyst Justin Hughes. "The company was profitable in a bear market while digesting the impact of lower trading volumes by capitalizing on the current refinancing boom with their mortgage business producing $30 million of revenue."

Gramaglia said the company plans to continue expanding its services, and plans to launch a new site next year "that pulls all these products together," along with a new marketing and ad campaign.

Boosting the E*Trade brand is "critical," Gramaglia said. "It's part of deepening the relationship and adding new products and services. Whether it's the bank or E*Trade mortgage, all products serve to broaden that relationship."