E*TRADE Financial Corporation (ETFC) reported first-quarter 2012 net income of 13 cents per share, beating the Zacks Consensus Estimate by 4 cents. More importantly, the company returned to profit after reporting a loss of 2 cents per share in the prior quarter.

The upbeat performance was driven by upturn in brokerage business, which aided improved total daily average revenue trades (DARTs). In addition, higher revenue due to improved non-interest income was positive for the quarter. Yet, increase in operating expenses acted as headwind.

Including an income tax benefit associated with certain losses on 2009 Debt Exchange of $26 million or 9 cents per share, E*TRADE reported first-quarter net earnings of $63 million or 22 cents per share compared with the net loss of $6 million or 2 cents per share in the prior quarter.

Performance in Detail

Total revenue climbed 3% sequentially to $489.4 million in the quarter. The rise was attributed to overall higher non-interest income, partially offset by lower operating interest income. Moreover, the reported revenues topped the Zacks Consensus Estimate of $472.0 million.

The DARTs for the reported quarter increased 12% sequentially to 157,000. Net new brokerage assets reported were $4.0 billion, significantly up from $1.7 billion in the prior quarter.

At the end of the quarter, E*TRADE reported 4.4 million customer accounts, including a record of 2.8 million brokerage accounts. Net new brokerage accounts scaled up to 46,000 from 10,000 in the prior quarter.

Net operating interest income plummeted 1.5% sequentially to $284.9 million in the quarter. The sequential decline was due to the 17 basis points (bps) fall in the net interest spread. In the quarter, net interest spread was 2.49%, down from 2.66% in the prior quarter.

Non-interest income was $204.5 million, up 10% sequentially. The climb was driven by net gains on loans and securities, high fees and service charges and increased commissions.

Total operating expense moved up 0.6% sequentially to $306.2 million. The sequential rise was attributable to higher FDIC insurance premiums, advertising and market development and compensation expenses. However, lower professional services and reduced other operating expenses were positives.

Credit Quality

Overall credit quality was mixed during the quarter. E*TRADE’s provision for loan losses dropped 42% sequentially to $71.9 million. Net charge-offs more than doubled to $315.6 from $120.3 million reported in the prior quarter, while allowance for loan losses also decreased 29.6% sequentially to $579.2 million.

For E*TRADE’s entire loan portfolio, special mention delinquencies dipped 20% sequentially, and total at-risk delinquencies slumped 19% sequentially.

Balance Sheet

E*TRADE reduced its balance sheet risk further. The company’s loan portfolio was $12.4 billion at the end of the reported quarter, down by $780 million from the prior quarter, mainly related to $464 million of paydowns.

The company maintained bank capital ratios well above the regulatory well-capitalized threshold. As of March 31, 2012, E*TRADE reported Tier 1 common ratio of 9.4%, in line with the prior quarter. The risk-based capital ratio was 17.0%, compared with 17.3% in the prior quarter. Further, Tier 1 leverage ratio was 7.3%, down from 7.8% in the prior quarter.

Performance by Peer

Among E*TRADE’s peers, Charles Schwab Corporation (SCHW) reported first quarter 2012 earnings of 15 cents per share, in line with the Zacks Consensus Estimate. However, this compares unfavorably with the year-ago quarter’s earnings of 20 cents.

Improved trading revenue and no provision for loan losses were among the positives for the quarter. However, higher operating expenses and lower net interest revenue as well as asset management and administration fees were the headwinds.

Our Take

The competitive position in the market for brokerage business depends on trading customers, predominantly active traders. As the long-term investing customer group is less developed, compared with the trading customers, there is an opportunity for future growth as and when the long-term customers expand.

Development of innovative online trading and long-term investing products and services, delivery of advanced customer service, creative and cost-effective marketing and sales, and expense discipline can be considered as the key factors in executing E*TRADE’s strategy to profitably expand trading and investing business.

Further, E*TRADE’s initiatives to reduce balance sheet risk look promising, although, it will put near-term pressure on the net interest margin. Though the company’s capital position and improving delinquency trends are impressive, regulatory issues in the current uncertain environment remains a concern. However, improvement in new brokerage accounts and DARTs improvement suggests that management is focusing more on the company’s core business.

E*TRADE currently retains a Zacks #3 Rank, which translates to a short-term ‘Hold’ rating. Considering the fundamentals, we also maintain our long-term ‘Neutral’ recommendation on the stock.

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