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No. of Recommendations: 13
My time horizon for holding E*Trade will extend as long as the company continues to demonstrate that it is growing its account base and assets at a rate faster than the OLB industry average and its current leaders. Both E*Trade and Ameritrade have shown the OLB industry is one of the few truly profitable Internet businesses (see quarterly reports dating back to '97 thru mid-98). I think I remember seeing that the average cost to execute a trade was somewhere in the neighborhood of $4.50. Their servers are already a sunk fixed cost, but even as upgrade to serve their growing customer bases the technology behind the scenes continues to progress and computer prices drop, thus lowering the cost per transaction over time.

Think about the general business for a second. First, financial service products are already highly profitable endeavors ... just witness the large number of traditional banks, brokerages, and insurance companies there are and the staggering amounts that they rake in profits every year. Second, they are one of the few products that are ideally suited for selling over the internet because there is usually no physical product which is being bought and sold. That means no shipping or inventory costs. Transactions are just data being moved around. Brokers have a very enviable position in this industry because they get a cut from every trade, where the customer gains or loses. Furthermore, they can make out handsomely by loaning out cash held in money market accounts to people who want to buy on margin. They get to keep the difference between the margin interest collected and the money market interest paid out.

The advantage that the broker has over the market maker (in this case, NITE) is that he owns the customer relationship. The customer in most cases doesn't care where the trade gets executed, just so long as it gets done. That's why I think NITE will eventually get squeezed out of its sweet position by the ECNs, like Instinet and Island. It's cheaper to execute trades on them, and the bid-ask spreads are much narrower than the market makers would like to keep them. However, the brokers will lose a valuable revenue stream in the payment-for-order-flow that they currently receive by directing trades to a particular market maker.

E*Trade and the other OLBs are spending gobs and gobs of money on advertising to build a brand name, and they are sacrificing current profitability for long term success. I think that this land grab for the customer right now is a good strategy. The shift from traditional broker to online broker invites a window of opportunity to grab new clients who are looking for a faster, cheaper way to trade. Financial accounts are inherently "sticky". Ask yourself how often do people like to switch their banks or brokers? Not very often, unless they're masochists who like dealing with all the paperwork. People are creatures of habit and generally won't move their wallets, so to speak, unless their current institution does something totally brain-dead that really pisses them off (ala Morgan Stanley raising rates for its old Discover brokerage customers) or there is a real big financial incentive for doing so (say cutting the cost of a trade from $100+ to ~$20, or shaving a 1 1/2 points by refinancing your mortgage).

I personally see E*Trade as having the momentum and the brand name to build critical mass. They've overtaken Schwab in terms of number of net new accounts added per quarter, and pulled in over 5x the number of new customers than Ameritrade during Q3. One way I like to gauge the mindshare the company is garnering is based on which brokers are consistently mentioned in the financial press. Almost always without a doubt, the two brokers mentioned are Schwab and E*Trade. Ameritrade and TD Waterhouse do get their fair share of coverage, too, but I don't think it's as prevalent.

Lastly, a word about the stock. The stock has been in the toilet for well over 6 months. Concerns about competition, rising ad costs, stagnant trading volume during the seasonal slow summer months, and rising interest rates have spooked many investors away from this sector. However, when you focus on the business itself, it's still growing like gangbusters. I don't think this trend is likely to end soon. I see E*Trade becoming the AOL of the online financial industry. Just over five years ago, it was a neck and neck horse race between AOL, CompuServe, and Prodigy for pole position in the internet access space. AOL continued its massive carpet bombing marketing campaign to gain mindshare, and lo-and-behold it worked! They didn't necessarily have the cheapest access plans or the best user interface, but people came nonetheless. E*Trade is working hard to become your one-stop financial services shop, and I think that they have as good a shot as any in reaching that goal. The snowball is just starting to roll downhill.

Build the brand and they will come.

Paul (XCon)
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