We have downgraded our recommendation on E*Trade Financial Corporation (ETFC) to Neutral from Outperform due to volatile trading business and the turbulence in the global markets.
In July, E*TRADE reported second-quarter 2011 earnings of 16 cents per share, in line with the Zacks Consensus Estimate as well as the prior quarter. However, the company’s net income compared favorably with 12 cents per share earned in the prior-year quarter owing to higher net operating interest income and decrease in provision for loan losses, partially offset by increase in operating expenses and lower non-interest income.
E*TRADE has been severely hit by the global crisis and has incurred significant losses. Higher competitive pressure has added to the woes. In addition, technological advances and regulatory changes in the marketplace might continue to tighten securities spreads. Tighter spreads could reduce revenue capture per share by its market maker, thus squeezing revenues for this line of business.
E*TRADE is reducing the size of its balance sheet, which signifies a decrease in savings and other bank-related customer deposits and net new customer assets, along with a reduction in total assets, thereby creating a weak liquidity and a rickety scenario for the future. We expect net interest margin to remain pressured as well.
Recent regulatory issues also remain a headwind for the company. It is difficult to predict at this moment the specific impact that the Dodd-Frank Act issued in July 2010 and the yet-to-be-written rules and regulations will have on the company. E*TRADE expects its compliance costs to be up slightly given the legislation materially changes the regulatory environment for the financial services industry in which it operates.
On the flip side, E*TRADE returned to profitability in the prior quarter and continued to record positive earnings in the second quarter 2011, driven by higher net operating interest income, decrease in provision for loan losses and positive trends in loan portfolio. The second-quarter performance demonstrated business strength even as trading activity slowed across the industry. We expect the company’s positive trend to continue in the upcoming quarters owing to utilization of E*TRADE's broad range of trading and investment products and services.
The company’s online brokerage business showed positive trend in July and August after reflecting volatile performance over the past several quarters. The delivery of its products and services, primarily through online and technology-intensive channels, aided in delivering strong organic growth in brokerage accounts and margin receivables. Moreover, E*TRADE continues to streamline its balance sheet risk by reducing credit risk in its loan portfolios. It lowered balance sheet risks as its legacy loan portfolio contracted by $0.9 billion from the prior quarter, including $0.7 billion related to prepayments or scheduled principal reductions.
Initiatives to reduce balance sheet risk look promising, although it will add near-term pressure on the interest margin. Moreover, volatility in global markets and uncertainty in economic recovery remains cause of concern.
E*TRADE currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. E*TRADE’s closest competitor – Charles Schwab Corp. (SCHW) also retains a Zacks #3 Rank.
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