I was asked by e-mail whether I thought E*Trade would become profitable. Since I'd be interested in other people's views as well, I thought I'd answer here and let others jump in, too.I think any profits in the next few years will be happy accidents. What I mean is that if, as a result of factors such as overwhelming trade volumes or other unanticipated revenues, E*Trade brings in more money than they can possibly spend, they might just make a profit. However, so long as their is a comparable competitor (presently and probably forever Schwab) and the growth rates are in the stratosphere, it would be fiscally irresponsible for E*Trade to make a meaningful profit (a penny or two here or there would not bother me). Moreover, so long as E*Trade is sitting on substantial cash or has significant profits from non-operating activities (e.g., major investment gains as in this most recent quarter) I will be very disappointed if E*Trade does not show a substantial loss.How's that? Why would I want a company that is growing it's business at high double digit (or triple digit) rates to sit on cash that will generate only low single digit returns? In the right circumstances, I might even want E*Trade to issue a modest amount of debt (in the form of bonds) to leverage this growth. That is, pay out 7-10% interest rates to generate growth at much higher rates.Now, that should only be within reason. I don't want E*Trade to burn through funds just because they have (or can get) them. This is where metrics such as the cost of subscriber acquisition kick in. If E*Trade could keep their cost per new account among the lowest in the industry and double their ad spending (ergo, double the number of new accounts they are generating), shouldn't they reasonably be willing to pay a little interest to make this happen? Of course, they must not outgrow their infrastructure, either. It is critical that the web not slow down too much and that they have enough personnel to handle the increased technical and phone support.Balanced, managed, high growth. That is what I what to see. Profitability can wait until the market has stabilized into more moderate and stable growth rates.A couple of historical examples may illustrate my philosophy here. I invested in MovieFone (since bought out by AOL, which I now hold), which was losing money. The lone analyst was projecting a profit. I said, hogwash! MovieFone had won a multimillion dollar judgement against a supplier in a convoluted business transaction related to TicketMaster, a MovieFone competitor. It would have been insane for this rapidly growing, high-margin business (with lots of executive staff from key movie studios and theatre companies, by the way) to sit on the cash from this judgement. Spending this money would mean recurring losses.Contrast this to PetSmart, a company I shorted several years ago. This was a large, low-margin business that was growing too fast. The debt and share dilution was going through the roof while the company kept touting the number of stores they were opening. Clearly, the focus on growth only without balancing the cost of that growth against the potential margins was putting them on course for a day of reckoning. Like MovieFone, this paid off handsomely. I only wish I had seen the same features in Boston Chicken, which would have made an even better short (one of the posters on the PetSmart board alerted me to the situation with Boston Chicken, but I couldn't see the connection with some of the internal business dealings that was the key to this one).It is critical that E*Trade maintain a balance between the costs of growth and maintaining a high growth rate. Losses are fine, so long as they remain in balance with the long-term goal of profitability. We can abstractly view that point in time where "everyone" is already online and the number of servers and communciations throughput has more or less stabilized. That is, at some point, E*Trade will no longer need to advertise so aggressively (word of mouth and brand power will wield bigger influence) and the hardware and communications infrastructure will be more or less complete (primarily in maintenance mode). At that point, E*Trade will be a high-margin business: advertising revenue (essentially zero cost to supply), transaction revenue (very low cost) and relatively low personnel (low recurring costs). If, at that point, E*Trade is among the largest of the virtual financial companies, their profits should also be among the highest because of economy of scale: more revenue per cost of software improvement (upgrades to the web interface) which will be the key expense.
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