TSC 21: E*Trade President Says Business Is Starting to Click - TheStreet

TSC 21: E*Trade President Says Business Is Starting to Click

The online broker isn't feeling any summer slowdown yet, Jarrett Lilien says.
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E*Trade

(ET) - Get Report

survived the dot-comeuppance and morphed from the one-sided brokerage brainchild of a mercurial leader into an online financial services company with a new chief executive and a full suite of banking and trading products. In

its most recent quarter, the company reaped benefits from both its brokerage business and its new banking business and raised earnings guidance for the rest of 2003.

But in Wall Street's eyes, E*Trade still has some maturing to do -- the company's stock trades at a discount to its peers. To get the inside story on E*Trade's quarter, its new executive leadership and a recently announced initiative to share mutual fund fees with its customers,

TheStreet.com

talked with Jarrett Lilien, E*Trade's president and chief operating officer.

TSC:

In the second quarter, the company showed significant growth in its banking business, and trading volumes were up more than 40% sequentially. What in Wednesday's release was the biggest surprise?

Lilien:

Well none of it was a big surprise because I'd been working on it all quarter. (Laughs.) I wasn't too surprised by anything but -- not to be a joker -- I think the best thing about the quarter was retail investors being back in the marketplace. I read about

Merrill Lynch's

(MER)

quarter and

they talked about how the retail business was flat. That the retail investor wasn't back in the market.

That is really interesting to me because the retail investor

was

back in the market in a big way -- just not with wire houses. They were back with the online players and that's a really significant part of the quarter. What was also significant within that was it wasn't just active traders -- it was traders and everybody else. Main Street was in there as well. And that has not been the case for the last couple years. This was an across-the-board comeback of retail just not to the traditional houses.

TSC:

A rising market certainly generated investor interest over the last quarter, but analysts are starting to warn about a summer slowdown in trading volumes. What are the company's forecasts going forward and how will E*Trade manage around a drop in trading?

Lilien:

We don't externally forecast where we think the markets are going to go. That's not within our control. My opinion is that when you look at a summer slowdown, you've got to put that into context. The summer slows down in a normal type of trading year, but could you call January, February, March normal times? So a slowdown from what is the question. And if you look at our numbers so far over the first 15 days of July, our average daily trading volume was still 18% above what we experienced in the second quarter. If there is going to be a slowdown, it hasn't happened yet.

TSC:

Late Wednesday night, E*Trade announced a plan to refund some mutual fund fees to customers. How is this going to work? And what is E*Trade trying to accomplish?

Lilien:

As a broker, when you raise money for mutual fund companies, they will pay you 12b-1 and SSA fees and other fees. We find that we can do this more efficiently and so we can return some of those fees to the customer.

How it works is that every dollar in mutual funds that a customer has with us we will share the fees that we get, we will partner with our customers 50-50. The goal for E*Trade is to increase the number of people who come to E*Trade to buy and hold their mutual funds and to increase the amount of funds they hold with us. The only way we know to do that is to come up with some kind of innovation. Our strength is using technology, finding some inefficiency in the market, and returning that to our customers. If you talk surprises for the quarter, our Mortgage on the Move innovation was a way to return benefit to the customer and now there's this mutual fund idea as well. We're really excited about it.

TSC:

I'd imagine that the mutual fund industry would be a bit cautious about that kind of move. What was the reaction from the mutual fund companies?

Lilien:

Well, we're still working on the details with them, and it's really important that they're partners with us on this. All we're doing here is increasing the benefit to the customer. I don't expect that we're going to find a lot of resistance. Where there could be people unhappy is at other brokers, who are receiving these fees, introducing competition on that side of the business that's never been there before.

TSC:

Net interest margin continues to be an issue, falling to 142 basis points in the last quarter. In the past, the company had a stated goal of 200 basis points. Considering that the Fed's cuts to rates make this process more difficult, have you changed your targets and how do you plan to boost margins down the road?

Lilien:

The goal is still 200. That's always been a little bit more of a battle cry. We have a couple of battle cries within the company. One is 200 basis points. Another one is a buck in earnings. Those are aspiration-type goals that we're working towards. And so 200 is the goal until we get to 200.

At the moment, though, you're right. We're in an environment where with the mortgage market so hot, you're getting a large number of prepayments, and that is hurting our spreads. That said, though, the volume that is going to the mortgage business has more than offset that decline. The decline in net interest margin cost us $3 million in this last quarter and we had about a $4 million increase from the increased volumes out of the mortgage company. At the moment, that's the value of the diversified model. It's paying off. Going forward, net interest is going to take care of itself. Right now, if it's declining we're getting an offset from the mortgage business. When interest rates start going up, it's going to take care of itself and be much easier to widen spreads.

TSC:

The Mortgage Bankers Association of America predicts that the refinance boom will taper off in 2004. What's your plan with the mortgage business?

Lilien:

We've always been expecting that the refinance boom will at some point slow down. It really hasn't yet. We ended the quarter with a pipeline of $1.7 billion in locked loans. When we started the previous quarter we were at $1.2 billion in locked loans, so we're starting the quarter in a better position. Nonetheless, we're preparing for when interest rates do go up and refinance business cools off. There are two major things we're working on to prepare. One is to increase our exposure to the purchase money side of the business rather than the refinance side of the business. Mortgage on the Move speaks right to that -- it's a great purchase money option. And also we're doing a lot of work on the HELOC (home equity line of credit) side. As interest rates rise, you'll see less on the refinance side, but you'll see a pickup on the HELOC side. We're preparing for that inevitable day when refinancing slows down.

TSC:

You mention your diversified model, which may have hurt your valuation on Wall Street.

Ameritrade

(AMTD) - Get Report

, which is just an online broker, is valued at three times E*Trade's price-to-earnings multiple, while

Charles Schwab

(SCH)

is more than double. Why is this? And how are you changing it?

Lilien:

One of my personal goals is to erase that differential in our valuation. It shouldn't be that way. I think the reason it is this way is the past. We had some leadership issues in the past, but those are gone. Another problem that was out there that we've taken big steps to correct was that we didn't have a lot of transparency with our numbers. It was very difficult for people to see inside the business and see what was going on. For you to buy our stock, you had to have faith in what leadership was saying. And if you didn't have faith in leadership, you just didn't want the stock. Leadership has changed, so that's a big positive. And we've started segment reporting and just this last quarter, added three pages of metrics that give more clarity into our business. We feel that if anyone sits down and does an apples-to-apples comparison

with our rivals, they'll see we should have a premium to the competition and not this ridiculous discount that we have.

TSC:

Talk a bit about the management change. How is working with

new CEO Mitch Caplan different than working with Christos Cotsakos, the company founder?

Lilien:

It's very different. Mitch -- he's a very intense guy. He knows the business inside and out. He gets into a super level of detail and he's the kind of guy that when you've got an issue, you've got something you want to talk about, he'll jump right in and get into all that detail. At the same time, he's a good delegator. When he sees that you've got it, he'll sit back and let teams go get their stuff done.

What I also really like about working with Mitch -- although sometimes it can drive you crazy -- is that when the stock price ever goes down, he takes it personally. It's a nice thing. He takes the business personally and he sees the success of the business as his success. And he's a competitive guy and he wants us to win. It's a very different environment and the morale inside the company is great.

The company has come together in ways that it had never been together before and this shows up in the ease that we're getting our integration projects done. Bank and broker are working together as one company. The restructuring we announced last quarter is well ahead of schedule and that's because people are working together and are excited and it's really all a reflection of his leadership.

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