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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
for the quarterly period ended December 31, 1999
Commission file number 1-11921
E*TRADE Group, Inc.
(Exact name of registrant as specified in its charter)
Delaware 94-2844166
(State or other jurisdiction (I.R.S. Employer Identification Number)
of incorporation or
organization)
4500 Bohannon Drive, Menlo Park, CA 94025
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (650) 331-6000
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
As of February 7, 2000, the number of shares outstanding of the registrant's
common stock was 289,095,417.
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E*TRADE Group, Inc.
Form 10-Q Quarterly Report
For the Quarter Ended December 31, 1999
Table of Contents
Page
----
Part I--Financial Information
Item 1. Financial Statements
Consolidated Statements of Operations.......................... 3
Consolidated Balance Sheets.................................... 4
Consolidated Statements of Cash Flows.......................... 5
Notes to Consolidated Financial Statements..................... 6
Management's Discussion and Analysis of Financial Condition and
Item 2. Results of Operations.......................................... 14
Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 34
Part II--Other Information
Item 1. Legal and Administrative Proceedings........................... 35
Item 2. Changes in Securities and Use of Proceeds...................... 36
Item 3. Defaults Upon Senior Securities................................ 37
Item 4. Submission of Matters to a Vote of Security Holders............ 37
Item 5. Other Information.............................................. 37
Item 6. Exhibits and Reports on Form 8-K............................... 37
Signatures.............................................................. 38
----------------
UNLESS OTHERWISE INDICATED, REFERENCES TO "COMPANY" MEAN E*TRADE GROUP, INC.
AND ITS SUBSIDIARIES.
----------------
E*TRADE(R) and the E*TRADE logo are registered trademarks of E*TRADE
Securities, Inc. All other products, trademarks or service marks mentioned in
this document or any document incorporated by reference herein are trademarks
or service marks of E*TRADE Group, Inc., its subsidiaries, or other companies
with which they are associated or with which they have a business
relationship.
----------------
FORWARD-LOOKING STATEMENTS
Certain statements in this discussion and analysis, including statements
regarding the Company's strategy, financial performance and revenue sources,
are forward-looking statements based on current expectations and entail
various risks and uncertainties. The Company's actual results may differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including, but not limited to, those set forth
under "Risk Factors" and elsewhere in this report. Readers are urged to
carefully review and consider the various disclosures made by the Company in
this report and in the Company's other reports filed with the SEC, including
the Company's Annual Report on Form 10-K as filed with the SEC, that attempt
to advise interested parties of certain risks and factors that may affect the
Company's business. Readers are cautioned not to place undue reliance on these
forward-looking statements to reflect events or circumstances occurring after
the date hereof. The following should be read in conjunction with the
Company's financial statements and notes thereto.
2
PART I. Financial Information
Item 1. Financial Statements
E*TRADE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
(in thousands, except per share amounts)
(Unaudited)
Three Months
Ended
December 31,
------------------
1999 1998
-------- --------
Revenue:
Transaction revenues..................................... $152,312 $ 60,320
Global and institutional................................. 33,699 28,106
Interest--net of interest expense (A).................... 43,341 21,809
Other.................................................... 16,656 5,685
-------- --------
Net revenues........................................... 246,008 115,920
-------- --------
Cost of services........................................... 107,058 49,399
-------- --------
Operating expenses:
Selling and marketing.................................... 119,492 55,001
Technology development................................... 36,294 14,566
General and administrative............................... 38,441 17,719
Amortization of goodwill................................. 1,654 --
Merger-related expenses.................................. 3,297 --
-------- --------
Total operating expenses............................... 199,178 87,286
-------- --------
Total cost of services and operating expenses.......... 306,236 136,685
-------- --------
Operating loss............................................. (60,228) (20,765)
-------- --------
Non-operating income (expense):
Gain on sale of investments.............................. 31,316 --
Unrealized gain on venture funds......................... 25,453 --
Equity in losses of investments.......................... (3,843) (103)
Other.................................................... 60 66
-------- --------
Total non-operating income (expense)................... 52,986 (37)
-------- --------
Pre-tax loss............................................... (7,242) (20,802)
Income tax benefit......................................... 2,028 9,215
-------- --------
Net loss................................................... (5,214) (11,587)
Preferred stock dividends.................................. -- 60
-------- --------
Loss applicable to common stock............................ $ (5,214) $(11,647)
======== ========
Loss per share (Note 5):
Basic.................................................... $ (0.02) $ (0.05)
======== ========
Diluted.................................................. $ (0.02) $ (0.05)
======== ========
Shares used in computation of loss per share (Note 5):
Basic.................................................... 247,163 231,883
Diluted.................................................. 247,163 231,883
- --------
(A) Interest is presented net of interest expense. Interest expense for the
three months ended December 31, 1999 and 1998 was $33,628 and $9,446,
respectively.
See notes to consolidated financial statements.
3
E*TRADE GROUP, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(in thousands, except share amounts)
December 31, September 30,
1999 1999
------------ -------------
(Unaudited)
ASSETS
------
Current assets:
Cash and equivalents.............................. $ 98,650 $ 85,734
Cash and investments required to be segregated
under Federal or other regulations............... 808,953 103,500
Investment securities............................. 103,921 189,145
Brokerage receivables--net........................ 4,243,618 2,912,581
Other assets...................................... 65,012 41,987
---------- ----------
Total current assets............................ 5,320,154 3,332,947
Property and equipment--net......................... 168,617 155,785
Investments......................................... 781,013 424,293
Goodwill--net....................................... 356,167 --
Other assets........................................ 68,316 13,955
---------- ----------
Total assets.................................... $6,694,267 $3,926,980
========== ==========
LIABILITIES AND SHAREOWNERS' EQUITY
-----------------------------------
Liabilities:
Brokerage payables................................ $4,758,423 $2,824,212
Bank loans payable................................ 107,785 3,000
Deferred income taxes............................. 144,501 23,256
Capital lease obligations......................... 31,698 --
Accounts payable, accrued and other liabilities... 207,452 162,845
---------- ----------
Total liabilities............................... 5,249,859 3,013,313
---------- ----------
Commitments and contingencies (Note 8)
Shareowners' equity:
Common stock, $.01 par value; shares authorized,
600,000,000; shares
issued and outstanding: December 1999,
252,896,567; September 1999, 239,822,663......... 2,529 2,398
Additional paid-in capital........................ 1,105,496 763,958
Accumulated deficit............................... (26,088) (20,874)
Accumulated other comprehensive income............ 362,471 168,185
---------- ----------
Total shareowners' equity....................... 1,444,408 913,667
---------- ----------
Total liabilities and shareowners' equity....... $6,694,267 $3,926,980
========== ==========
See notes to consolidated financial statements.
4
E*TRADE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(in thousands)
(Unaudited)
Three Months Ended
December 31,
------------------------
1999 1998
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss............................................ $ (5,214) $ (11,587)
Reconciliation to net cash provided by (used in)
operating activities:
Deferred income taxes.............................. (2,552) --
Depreciation and amortization...................... 19,343 5,537
Equity in losses of investments.................... 3,843 103
Stock compensation expense......................... 2,638 2,200
Gain on sale of investments........................ (31,316) --
Unrealized gain on venture funds................... (25,453) --
Other.............................................. (200) (200)
Net effect of changes in brokerage-related assets
and liabilities:
Cash and investments required to be segregated
under Federal or other regulations................ (705,453) (16,500)
Brokerage receivables.............................. (1,331,037) (176,127)
Brokerage payables................................. 1,934,211 212,366
Other changes, net:
Other assets....................................... (17,635) (11,290)
Accounts payable, accrued and other liabilities.... 68,207 (2,055)
----------- -----------
Net cash provided by (used in) operating
activities....................................... (90,618) 2,447
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment, net of capital
lease.............................................. (30,521) (3,383)
Purchase of investment securities................... (358,686) (1,862,406)
Purchase of investments............................. (23,865) (777)
Sale/maturity of investment securities.............. 443,910 1,878,366
Proceeds from sale of investments................... 39,393 --
Restricted deposits................................. (49,759) --
Cash used in acquisitions........................... (26,707) --
----------- -----------
Net cash provided by (used in) investing
activities....................................... (6,235) 11,800
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from bank loans, net of transaction costs.. 102,535 --
Proceeds from employee stock transactions........... 7,214 1,696
Other............................................... 20 (54)
----------- -----------
Net cash provided by financing activities......... 109,769 1,642
----------- -----------
INCREASE IN CASH AND EQUIVALENTS..................... 12,916 15,889
CASH AND EQUIVALENTS--Beginning of period............ 85,734 47,776
----------- -----------
CASH AND EQUIVALENTS--End of period.................. $ 98,650 $ 63,665
=========== ===========
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest.............................. $ 24,991 $ 10,141
=========== ===========
Cash paid for income taxes.......................... $ 503 $ 47
=========== ===========
Non-cash activities:
Unrealized gain on available-for-sale securities... $ 327,909 $ 44,236
=========== ===========
Assets acquired under capital lease obligations.... $ 31,698 --
=========== ===========
Acquisitions, net of cash acquired:
Common stock issued and stock options assumed...... $ 323,967 --
Cash paid, less acquired........................... 26,707 --
Liabilities assumed................................ 6,000 --
Carrying value of joint-venture investment......... 5,343 --
-----------
Fair value of assets acquired (including goodwill
of $357,397)...................................... $ 362,017 --
===========
See notes to consolidated financial statements.
5
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
Note 1.--Basis of Presentation
The accompanying unaudited interim consolidated financial statements include
E*TRADE Group, Inc. and its subsidiaries (collectively, the "Company"),
including E*TRADE Securities, Inc. ("E*TRADE Securities"), a securities broker-
dealer, and TIR (Holdings) Limited ("TIR"), a provider of global securities
brokerage and other related services to institutional customers.
These interim consolidated financial statements have been prepared pursuant
to the rules and regulations of the Securities and Exchange Commission ("SEC")
and, in the opinion of management, reflect all normal recurring adjustments
necessary to present fairly the financial position, results of operations and
cash flows for the periods presented in conformity with generally accepted
accounting principles. All significant intercompany accounts and transactions
have been eliminated. These interim consolidated financial statements should be
read in conjunction with the audited annual consolidated financial statements
and notes thereto included in the Company's Annual Report to Shareowners on
Form 10-K for the fiscal year ended September 30, 1999.
Note 2.--Net Brokerage Receivables and Payables
Net brokerage receivables and payables consists of the following (in
thousands):
December 31, September 30,
1999 1999
------------ -------------
Receivable from customers and non-customers (less
allowance for doubtful accounts of $2,955 at
December 31, 1999 and $975 at September 30, 1999).. $3,782,599 $2,559,283
Receivable from brokers, dealers and clearing
organizations:
Net settlement and deposits with clearing
organizations.................................... 34,092 20,066
Deposits paid for securities borrowed............. 396,829 306,326
Securities failed to deliver...................... 4,423 7,508
Other............................................. 25,675 19,398
---------- ----------
Total brokerage receivables, net................ $4,243,618 $2,912,581
========== ==========
Payable to customers and non-customers.............. $1,286,794 $ 946,760
Payable to brokers, dealers and clearing
organizations:
Deposits received for securities loaned........... 3,434,902 1,806,590
Securities failed to receive...................... 14,370 7,235
Other............................................. 22,357 63,627
---------- ----------
Total brokerage payables........................ $4,758,423 $2,824,212
========== ==========
Receivable from and payable to brokers, dealers and clearing organizations
result from the Company's brokerage activities. Receivable from customers and
non-customers represents credit extended to finance their purchases of
securities on margin. At December 31, 1999 and September 30, 1999, credit
extended to customers and non-customers with respect to margin accounts was
$3,776 million and $2,452 million, respectively. Securities owned by customers
and non-customers are held as collateral for amounts due on margin balances
(the value of which is not reflected on the accompanying consolidated balance
sheets). Payable to customers and non-customers represents free credit balances
and other customer and non-customer funds pending completion of securities
transactions. The Company pays interest on certain customer and non-customer
credit balances.
6
Note 3.-- Investments
Investments consist of the following (in thousands):
December 31, September 30,
1999 1999
------------ -------------
Publicly-traded equity securities, at market
(cost of $36,455 and $35,533 at December 31,
1999 and September 30, 1999, respectively).... $646,619 $317,788
Equity method investments:
Joint ventures (see Note 9).................. 13,285 20,862
Archipelago.................................. 25,162 25,149
Venture funds................................ 65,473 36,270
E*OFFERING................................... 15,898 11,391
KAP Group...................................... 2,000 2,000
Other investments.............................. 12,576 10,833
-------- --------
Total investments.......................... $781,013 $424,293
======== ========
Publicly-traded Equity Securities
The Company has investments in several companies that are publicly traded.
These companies include Knight/Trimark Inc., CriticalPath, Digital Island,
Message Media, E-LOAN and Versus. During the first quarter of fiscal 2000, the
Company sold shares of Knight/Trimark generating proceeds of $30,001,000,
resulting in a pre-tax gain of $29,923,000. The Company accounts for these
investments as long-term marketable equity securities held available-for-sale
under the provisions of SFAS No. 115, Accounting for Certain Investments in
Debt and Equity Securities. Accordingly, these investments are carried at fair
value. Unrealized gains were $610,164,000 and $282,255,000 at December 31, 1999
and September 30, 1999, respectively. There were no unrealized losses at
December 31, 1999 and September 30, 1999. Certain of these investments are
currently subject to sale restriction agreements.
Equity Method Investments
The Company had investments in four electronic commerce companies, which
were contributed on October 1, 1999 to form the E*TRADE eCommerce Fund, L.P.
(the "Fund"). The Fund raised additional capital from third parties totaling
approximately $75 million and will invest primarily in companies in the
electronic commerce industry, as well as Internet infrastructure companies and
other enabling technologies. The Company received a general and limited
partnership interest of approximately 25% in the Fund. The Company also has a
limited partnership interest in a privately-managed venture capital fund.
In the quarter ended December 31, 1999, the Company invested an additional
$5,000,000 in E*OFFERING in the form of a subordinated note, which was utilized
by E*OFFERING for its Internet-based investment banking activities. The note
has been classified as part of the investment at December 31, 1999 and was
subsequently repaid in January 2000. E*OFFERING has since completed additional
rounds of financing whereby the Company's ownership position was reduced to
approximately 26%.
7
Note 4.--Comprehensive Income
On October 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 130, Reporting Comprehensive Income, which requires that an
enterprise report, by major components and as a single total, the change in net
assets during the period from non-owner sources. The reconciliation of net loss
to comprehensive income is as follows (in thousands):
Three Months
Ended December
31,
------------------
1999 1998
-------- --------
Net loss................................................... $ (5,214) $(11,587)
Changes in other comprehensive income:
Unrealized gain on available-for-sale securities, net of
tax..................................................... 194,202 26,303
Cumulative translation adjustments....................... 84 658
-------- --------
Total comprehensive income............................. $189,072 $ 15,374
======== ========
Note 5.--Loss Per Share
The Company reported a net loss for the three months ended December 31, 1999
and 1998; therefore, the calculation of diluted earnings per share does not
include common stock equivalents as it would result in a reduction of net loss
per share. If the Company had reported net income for the three months ended
December 31, 1999 and 1998, there would have been 16,187,000 and 11,857,000
additional shares in the calculation of diluted earnings per share,
respectively.
The following options to purchase shares of common stock were not included
in the computation of diluted earnings per share because the options' exercise
prices were greater than the average market price of the Company's common stock
for the periods stated, and therefore are not common stock equivalents for
purposes of this calculation (in thousands, except exercise price data):
Three Months
Ended
December 31,
-------------
1999 1998
------ ------
Options excluded from computation of diluted net loss per
share.......................................................... 969 3,060
Exercise price ranges:
High.......................................................... $58.75 $14.05
Low........................................................... $29.55 $ 6.13
Note 6.--Bank Loans
In November 1999, the Company obtained a $50 million line of credit under an
agreement with a bank that expires on November 30, 2000. The line of credit is
collateralized by investment securities that are owned by the Company.
Borrowings under the line of credit bear interest at 0.35% above LIBOR on the
day of the advance. The agreement requires the Company to meet certain
financial covenants; as of December 31, 1999, the Company was in compliance
with all such covenants. As of December 31, 1999, the Company had $34.8 million
outstanding under this line of credit.
In December 1999, the Company obtained a $150 million line of credit
agreement with a syndicate of banks that expires on March 31, 2000. The line of
credit is collateralized by publicly-traded investments owned by the Company.
Borrowings under the line of credit bear interest at 0.25% above LIBOR. The
agreement requires the Company to meet certain financial covenants and
prohibits the assumption of any major debt, except for equipment leases; as of
December 31, 1999, the Company was in compliance with all such covenants. As of
December 31, 1999, the Company had $70.0 million outstanding under this line of
credit.
8
Note 7.--Regulatory Requirements
E*TRADE Securities is subject to the Uniform Net Capital Rule (the "Rule")
under the Securities Exchange Act of 1934, administered by the SEC and the
National Association of Securities Dealers, Inc. ("NASD"), which requires the
maintenance of minimum net capital. E*TRADE Securities has elected to use the
alternative method permitted by the Rule, which requires that the Company
maintain minimum net capital equal to the greater of $250,000 or 2 percent of
aggregate debit balances arising from customer transactions, as defined.
E*TRADE Securities had amounts in relation to the Rule as follows (in
thousands, except percentage data):
December 31, September 30,
1999 1999
------------ -------------
Net capital..................................... $239,353 $162,729
Percentage of aggregate debit balances.......... 6.0% 6.2%
Required net capital............................ $ 79,218 $ 52,206
Excess net capital.............................. $160,135 $110,523
Under the alternative method, a broker-dealer may not repay subordinated
borrowings, pay cash dividends or make any unsecured advances or loans to its
parent or employees if such payment would result in net capital of less than 5%
of aggregate debit balances or less than 120% of its minimum dollar amount
requirement.
TIR's brokerage subsidiary companies are also subject to net capital
requirements. These companies are located in the United States, Australia, Hong
Kong, Ireland, the Philippines and the United Kingdom. The companies outside
the United States have various and differing capital requirements, all of which
were met at December 31, 1999 and September 30, 1999. The net capital
requirements of TIR's brokerage subsidiary companies located in the United
States are summarized as follows:
TIR Securities, Inc. and TIR Investor Select, Inc.--TIR Securities, Inc.
and TIR Investor Select, Inc. are subject to the Rule and are required to
maintain net capital equal to the greater of $5,000 or 6.67% of aggregate
indebtedness, as defined. The Rule also requires that the ratio of
aggregate indebtedness to net capital shall not exceed 15 to 1. TIR
Securities, Inc. is also subject to the Commodity Futures Trading
Commission ("CFTC") Regulation 1.17, which requires the maintenance of net
capital of 4% of the funds required to be segregated in accordance with
Section 4d(2) of the Commodities Exchange Act or $30,000, whichever is
greater. TIR Securities, Inc. is required to maintain net capital in
accordance with Rule or CFTC Regulation 1.17, whichever is greater.
Marquette Securities, Inc.--Marquette Securities, Inc. is subject to the
Rule and is required to maintain net capital equal to the greater of
$250,000 or 6.67% of aggregate indebtedness, as defined. The Rule also
requires that the ratio of aggregate indebtedness to net capital shall not
exceed 15 to 1.
The table below summarizes the minimum capital requirements for the above
companies (in thousands):
December 31, 1999 September 30, 1999
------------------------ ------------------------
Required Excess Required Excess
net Net net net Net net
capital capital capital capital capital capital
-------- ------- ------- -------- ------- -------
TIR Securities, Inc. ...... $65 $1,398 $1,333 $82 $2,289 $2,207
TIR Investor Select, Inc.
.......................... 5 39 34 5 254 249
Marquette Securities, Inc.
.......................... 250 445 195 250 445 195
9
Note 8.--Commitments, Contingencies and Regulatory Matters
The Company is a defendant in civil actions arising in the normal course of
business, including several putative class action filings. The matters alleged
by the plaintiffs include:
. False and deceptive advertising and other communications regarding the
Company's commission rates and ability to provide account access and to
timely execute and confirm online transactions;
. Damages arising from alleged problems in accessing accounts and placing
orders;
. Damages arising from system interruptions including those occurring on
February 3, 4, and 5, 1999; and
. Unfair business practices regarding the extent to which initial public
offering shares are made available to the Company's customers.
These proceedings are at early stages, and the Company is unable to predict
their ultimate outcome; however, the Company believes that all of these claims
are without merit and intends to defend against them vigorously. An unfavorable
outcome in any of these matters, if they are not covered by insurance, could
have a material adverse effect on the Company's business, financial condition
and results of operations. In addition, even if the ultimate outcomes are
resolved in favor of the Company, the defense of such litigation could entail
considerable cost and the diversion of efforts of management, either of which
could have a material adverse effect on the Company's results of operation.
From time to time, the Company has been threatened with, or named as a
defendant in, lawsuits, arbitrations and administrative claims. Compliance and
trading problems that are reported to the NASD or the SEC by dissatisfied
customers are investigated by the NASD or the SEC, and, if pursued by such
customers, may rise to the level of arbitration or disciplinary action. One or
more of such claims or disciplinary actions decided adversely against the
Company could have a material adverse effect on the Company's business,
financial condition and results of operations. The Company is also subject to
periodic regulatory audits and inspections.
The securities industry is subject to extensive regulation under federal,
state and applicable international laws. As a result, the Company is required
to comply with many complex laws and rules and its ability to so comply is
dependent in large part upon the establishment and maintenance of a qualified
compliance system. The Company is aware of several instances of its
noncompliance with applicable regulations.
Note 9.--Acquisitions
During the quarter ended December 31, 1999, the Company acquired 100%
ownership of three of its foreign affiliates, E*TRADE Nordic AB, a Swedish
company, E*TRADE @ Net Bourse S.A., a French company, and the remaining portion
of its E*TRADE UK joint venture, for an aggregate purchase price of $362
million. The purchase price was composed of 11.7 million shares of the
Company's common stock, cash of $26.7 million and the assumption of options of
the affiliates. The purchase price exceeded the fair value of the assets
acquired by $357 million, which was recorded as goodwill to be amortized over
20 years.
The pro forma information below assumes that the acquisitions occurred at
the beginning of 1998 and includes the effect of amortization of goodwill from
that date (in thousands):
Three months
ended December
31,
------------------
1999 1998
-------- --------
Net revenues............................................ $246,867 $116,183
Net loss................................................ $ (6,215) $(11,972)
Basic and diluted loss per share........................ $ (0.02) $ (0.05)
10
The pro forma information is for informational purposes only and is not
necessarily indicative of the results of future operations nor results that
would have been achieved had the acquisitions taken place at the beginning of
fiscal 1998.
Note 10.--Segment Information
Segment Information
The Company provides securities brokerage and related investment services.
The Company has classified the operations of E*TRADE and TIR as separate
reportable segments, which is the way that management currently evaluates their
operating performance. Financial information for the Company's reportable
segments is presented in the table below, and the totals are equal to the
Company's consolidated amounts as reported in the consolidated financial
statements (in thousands):
E*TRADE
Group TIR Total
---------- -------- ----------
Quarter ended December 31, 1999
Non-interest revenue...................... $ 169,496 $ 33,171 $ 202,667
Interest--net of interest expense......... 43,187 154 43,341
---------- -------- ----------
Net revenues.............................. 212,683 33,325 246,008
========== ======== ==========
Operating income (loss)................... (62,452) 2,224 (60,228)
Pre-tax income (loss)..................... (9,431) 2,189 (7,242)
Segment assets............................ 6,627,493 66,774 6,694,267
Quarter ended December 31, 1998
Non-interest revenue...................... $ 66,665 $ 27,446 $ 94,111
Interest--net of interest expense......... 21,576 233 21,809
---------- -------- ----------
Net revenues.............................. 88,241 27,679 115,920
========== ======== ==========
Operating income (loss)................... (23,015) 2,250 (20,765)
Pre-tax income (loss)..................... (23,118) 2,316 (20,802)
Segment assets............................ 2,241,518 73,144 2,314,662
No one single customer accounted for greater than 10% of total revenues for
the quarters ended December 31, 1999 and 1998.
11
Note 11.--Subsequent Events
Telebanc Acquisition
On January 12, 2000, the Company completed the merger of Telebanc Financial
Corporation ("Telebanc"). Telebanc is the holding company for Telebank, the
nation's largest pure-play internet bank. Under the terms of the agreement,
Telebanc shareowners received 1.05 shares of E*TRADE common stock for each
share of Telebanc common stock representing a total of 35.6 million E*TRADE
shares. Summarized pro forma consolidated information of the combined companies
for the quarter, as well as comparative prior year amounts, are as follows (in
thousands, except per share data):
Quarter Ended
December 31,
------------------
1999 1998
-------- --------
Pro Forma Combined Summarized Statement of Operations:
Gross revenues......................................... $364,280 $163,125
Interest expense and provision for loan losses......... 94,849 38,299
-------- --------
Net revenues........................................... 269,431 124,826
Cost of services....................................... 113,505 51,416
Selling and marketing expenses......................... 128,918 57,277
Merger-related expenses................................ 5,787 --
Other operating expenses............................... 79,247 34,945
-------- --------
Operating loss......................................... (58,026) (18,812)
Gain on sale of investments............................ 31,316 --
Unrealized gain on venture funds....................... 25,453 --
Loss on equity investments and minority interest....... (4,384) (557)
Other non-operating income (loss)...................... 153 (44)
-------- --------
Pre-tax loss........................................... (5,488) (19,413)
Income tax benefit..................................... 697 8,481
-------- --------
Net loss............................................... (4,791) (10,932)
Preferred stock dividends.............................. -- 60
-------- --------
Loss applicable to common stock........................ $ (4,791) $(10,992)
======== ========
Loss per share, basic and diluted...................... $ (0.02) $ (0.04)
Shares used in computation of loss per share........... 282,505 257,860
December September 30,
31, 1999 1999
----------- -------------
(in thousands)
Pro Forma Combined Summarized Balance Sheets:
Cash and equivalents................................ $ 299,498 $ 125,801
Investment securities............................... 288,258 367,767
Brokerage receivables--net.......................... 4,243,618 2,912,581
Mortgage-backed securities.......................... 2,025,192 1,426,053
Loans receivable--net............................... 2,422,252 2,154,509
Total assets........................................ 11,738,637 7,908,224
Long-term obligations............................... 62,298 30,584
Shareowners' equity................................. 1,949,637 1,419,301
12
Debt Offering
On February 7, 2000, the Company completed a Rule 144A offering of $500
million convertible subordinated notes due February 2007. The notes are
convertible, at the option of the holder, into a total of 21,186,441 shares of
the Company's common stock at a conversion price of $23.60 per share. The notes
bear interest at 6%, payable semiannually, and are non-callable for three years
and may then be called by the Company at a premium, which declines over time.
The holders have the right to require redemption at a premium in the event of a
change in control or other defined redemption event. The Company granted the
initial purchasers an option, exercisable until March 16, 2000, to purchase up
to an additional $150 million of notes. The Company expects to use $150 million
of the net proceeds to refinance outstanding senior secured indebtedness and
the remaining net proceeds for general corporate purposes, including financing
the future growth of the business. Debt issuance costs of $14,375,000 will be
included in other assets and amortized to interest expense over the term of the
notes. Had these securities been issued as of the beginning of the quarter
ended December 31, 1999, net loss per share on a diluted basis would have been
increased to $0.05 due to the additional net interest expense associated with
the securities.
13
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward-Looking Statements
The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the consolidated
financial statements and notes thereto included elsewhere in this Form 10-Q.
This discussion contains forward-looking statements, including statements
regarding the Company's strategy, financial performance and revenue sources
which involve risks and uncertainties. The Company's actual results may differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including, but not limited to, those set forth in
the section entitled Risk Factors and elsewhere in this Form 10-Q.
Results of Operations
Revenue Detail (in millions, except percentage and transaction data)
Three Months
Ended
December 31,
--------------- Percent
1999 1998 Change
------- ------ -------
Revenues:
Transaction revenues:
Commissions........................................ $ 136.7 $ 52.3 161%
Order flow......................................... 15.6 8.0 95%
------- ------ ---
Total transaction revenue........................ 152.3 60.3 153%
------- ------ ---
Interest--net of interest expense:
Brokerage interest income.......................... 75.1 26.0 189%
Brokerage interest expense......................... (33.6) (9.4) 257%
Corporate--net..................................... 1.8 5.2 (66)%
------- ------ ---
Interest--net.................................... 43.3 21.8 99%
------- ------ ---
Global and institutional............................. 33.7 28.1 20%
Other................................................ 16.7 5.7 193%
------- ------ ---
Total revenues................................... $ 246.0 $115.9 112%
======= ====== ===
Transactions per day................................... 133,000 43,000 209%
The Company's net revenues increased to $246.0 million in the first quarter
of fiscal 2000, up 112% from $115.9 million in the equivalent period of fiscal
1999.
Transaction revenues increased to $152.3 million in the first quarter of
fiscal 2000, up 153% from $60.3 million in the equivalent period in fiscal
1999. Transaction revenues consist of commission revenues and payments for
order flow. Growth in transaction revenues reflected the overall high level of
trading volume in U.S. financial markets, as well as the increase in new
customer accounts.
Commission revenues for the first quarter of fiscal 2000 increased to $136.7
million, up 161% from $52.3 million for the same period a year ago.
Transactions for the first quarter of fiscal 2000 totaled 8.5 million or an
average of 133,000 transactions per day. This is an increase of 209% over the
average daily transaction volume of 43,000 in the prior year. The decline in
commissions per trade was a result of promotional activities, changes in the
mix of revenue generating transactions and the August 1999 implementation of
the new Power E*TRADE program, which provides reduced commissions for active
traders.
14
Payments for order flow increased to $15.6 million for the first quarter of
fiscal 2000, up 95% from $8.0 million for the same period a year ago. As a
percentage of transaction revenue, payments for order flow have decreased to
10% for the first quarter of fiscal 2000, down from 13% for the same period a
year ago. Payments for order flow did not increase at the same rate as
transactions due to changes in the order flow mix, a decrease in the average
shares per equity transaction, and the continued impact of the SEC's order
handling rules.
Net interest revenues primarily represent interest earned by the Company on
credit extended to its customers to finance their purchases of securities on
margin, fees on its customer assets invested in money market accounts and
interest earned on investment securities, offset by interest paid to customers
on certain credit balances, interest paid to banks and interest paid to other
broker-dealers through the Company's stock loan program. Brokerage interest
income increased to $75.1 million in the first quarter of fiscal 2000, up 189%
from $26.0 million for the same period a year ago. This increase reflects the
overall increases in average customer margin balances, which increased 193% to
$2.9 billion in the first quarter of fiscal 2000, from $1.0 billion in the same
period a year ago. Brokerage interest expense increased to $33.6 million, up
257% from $9.4 million in the comparable prior year quarter, due to average
customer money market fund balances, which increased 145% to $5.3 billion in
the first quarter of fiscal 2000, from $2.2 billion in the same period a year
ago; average customer credit balances, which increased 277% to $1.1 billion in
the first quarter of fiscal 2000, from $0.3 billion in the same period a year
ago; and average stock loan balances, which increased 299% to $2.1 billion in
the first quarter of fiscal 2000, from $0.5 billion in the same period a year
ago. Net corporate interest income declined due primarily to capital lease
obligations and bank borrowings incurred in the first quarter of fiscal 2000.
Global and institutional revenues increased to $33.7 million for the first
quarter of fiscal 2000, up 20% from $28.1 million for the same period one year
ago. Global and institutional revenues are comprised of revenues from TIR's
operations, as well as licensing fees and royalties from E*TRADE
International's affiliates. TIR's revenues increased to $33.1 million in the
first quarter of fiscal 2000, up 23% from $27.0 million for the same period a
year ago. These increases are primarily attributable to strong market
conditions in Asia and Europe, as well as an increase in futures commissions.
TIR revenues are largely comprised of commissions from institutional trade
executions; for the first quarter of fiscal 2000 approximately 55% of TIR's
transactions were from outside the U.S., and approximately 82% were cross-
border transactions.
Other revenues increased to $16.7 million in the first quarter of fiscal
2000, up 193% from $5.7 million for the comparable period in fiscal 1999. Other
revenues increased primarily due to growth in mutual funds revenue, revenues
from fees charged for advertising on the Company's Web site, investment banking
revenue, E*TRADE Business Solutions revenue, and broker-related fees for
services.
Cost of Services
Total cost of services increased to $107.1 million for the first quarter of
fiscal 2000, up 117% from $49.3 million in the comparable period in fiscal
1999. Cost of services includes expenses related to the Company's clearing
operations, customer service activities, Web site content costs, system
maintenance, communication expenses and depreciation. These increases reflect
the overall increase in customer transactions processed by the Company, a
related increase in customer service inquiries, and operations and maintenance
costs associated with the Company's technology centers in Rancho Cordova,
California, and Alpharetta, Georgia. Cost of services as a percentage of total
revenues was 44% in the first quarter of fiscal 2000 compared to 43% in the
comparable period in fiscal 1999.
Operating Expenses
Selling and marketing expenses increased to $119.5 million in the first
quarter of fiscal 2000, up 117% from $55.0 million in the comparable period in
fiscal 1999. The increases reflect expenditures for advertising placements,
creative development and collateral materials resulting from a variety of
advertising campaigns
15
directed at building brand name recognition, growing the customer base and
market share, and maintaining customer retention rates. Beginning in the fourth
quarter of fiscal 1998, the Company significantly expanded its marketing
efforts including the launch of Destination E*TRADE, expanded national
television advertising and new strategic marketing alliances with key business
partners, such as AOL and Yahoo!. These increased expenditure levels are
expected to continue throughout fiscal 2000.
Technology development expenses increased to $36.3 million in the first
quarter of fiscal 2000, up 149% from $14.6 million in the comparable period in
fiscal 1999. The increased level of expense was incurred to enhance the
Company's existing product offerings, including maintenance of the Company's
Web site, and reflects the Company's continuing commitment to invest in new
products and technologies.
General and administrative expenses increased to $38.4 million in the first
quarter of fiscal 2000, up 117% from $17.7 million in the comparable period in
fiscal 1999. These increases were the result of personnel additions, the
development of administrative functions resulting from the overall growth in
the Company.
Amortization of goodwill of $1.7 million in the first quarter of fiscal 2000
primarily consists of amortization of goodwill related to the acquisition of
three of the Company's foreign affiliates. Goodwill resulting from these
transactions will be amortized over 20 years.
Merger-related expenses of $3.3 million were recognized in the first quarter
of fiscal 2000 and primarily relate to the transaction costs associated with
the Telebanc acquisition. Additional costs associated with the Company's
mergers and acquisitions are expected to be incurred throughout fiscal 2000,
including a charge of approximately $30 million to be recorded in the second
quarter of fiscal 2000 relating to the acquisition of Telebanc.
Non-operating Income (Expense)
In the first quarter of fiscal 2000, the Company continued to liquidate
portions of its portfolio of strategic investments and recognized realized
gains of $31.3 million.
The Company also recorded unrealized gains of $25.5 million on its
participation in venture funds, primarily in connection with E*TRADE's
eCommerce Fund L.P., which was formed in the first quarter of fiscal 2000.
Equity in losses of investments was $3.8 million in the first quarter of
fiscal 2000, which resulted from the Company's minority ownership in its
investments that are accounted for under the equity method. These investments
include E*TRADE Japan, E*OFFERING and Archipelago. The Company expects that
these companies will continue to invest in the development of their products
and services, and will incur operating losses throughout fiscal 2000, which
will result in future charges being recorded by the Company to reflect its
proportionate share of losses.
Income Tax Benefit
Income tax benefit represents the benefit for federal and state income taxes
at an effective rate of 28% for the first quarter of fiscal 2000, and 44% for
the comparable period in fiscal 1999. The rate for the first quarter of fiscal
2000 reflects the impact of non-deductible merger-related expenses and goodwill
arising from the foreign acquisitions.
Year 2000 Compatibility
Many computer systems use only two digits to identify a specific year and
therefore may not accurately recognize and handle dates beyond the year 1999.
Additionally, the year 2000 is a leap year and computer systems may not
accurately recognize and handle February 29, 2000. If not corrected, these
computer applications could fail or create erroneous results in the year 2000.
The Company utilizes, and is dependent
16
upon, data processing systems and software to conduct its business. The data
processing systems and software include those developed and maintained by the
Company's third-party data processing vendors and software that is run on in-
house computer networks. Due to the Company's dependence on computer technology
to conduct its business, and the dependence of the financial services industry
on computer technology, the nature and impact of year 2000 processing failures
on the Company's business, financial position, results of operations or cash
flows could be material.
In addition, the method of trading employed by the Company is heavily
dependent on the integrity of electronic systems outside of the Company's
control, such as Internet service providers, and third-party software, such as
Internet browsers. A failure of any such system in the trading process, even
for a short time, could cause interruption to the Company's business. The year
2000 issue could lower demand for the Company's services while increasing the
Company's costs. The combination of these factors, while not quantifiable,
could have a material adverse impact on the Company's financial results.
During the first quarter of fiscal 1998, the Company initiated a review and
assessment of its hardware and software to evaluate whether they will function
properly in the year 2000 without material errors or interruptions. The
Company's year 2000 efforts addressed the Company's computer systems and
equipment, as well as business partner relationships considered essential to
the Company's ability to conduct its business. The objective of the Company's
year 2000 project was to identify the core business processes and associated
computer systems and equipment that may be at risk due to the use of two-digit
year dates. Once identified, the systems and equipment were rated for risk and
prioritized for conversion or replacement according to their impact on core
business operations. The Company's year 2000 project followed a structured
approach in analyzing and mitigating year 2000 issues. This approach consisted
of six phases: awareness, assessment, remediation, validation, implementation
and industry-wide testing. The work associated with each phase was performed
simultaneously with other phases of the project, depending on the nature of the
work performed and the technology and business requirements of the specific
business unit. For example, awareness was an ongoing effort and occurred in
each phase. As part of this project, the Company reviewed its vendor
relationships (suppliers, alliances and third-party providers) in an attempt to
assess their ability to meet the year 2000 challenge. This plan sought to
ensure that all of the Company's business partners and service providers were
also year 2000 ready. In addition, written contingency plans were developed for
all mission critical systems to address any unexpected year 2000 failures.
Status of Year 2000 Efforts
The Company completed each of these phases planned for year 2000 readiness.
The Company believes that all material year 2000 problems with internally-
managed hardware and software revealed as a result of its evaluation were
remedied; however, there can be no assurances that these efforts have solved
all possible year 2000 issues, and there is a risk that other problems, not
presently known to the Company, will be discovered that could present a
material risk of disruption to the Company's operations and result in material
adverse consequences to the Company. Furthermore, there can be no assurance
that the Company will not experience unexpected delays in remediation of any
year 2000 issues that have not yet surfaced. Any inability to remediate such
issues in a timely manner could cause a material disruption of the Company's
business.
All mission-critical vendors were contacted and each indicated that their
hardware and software are year 2000 ready. The Company has relied upon
representations by vendors as to their year 2000 readiness and generally has
not attempted to perform independent verification of the accuracy of those
representations. There can be no assurance that all third parties provided
accurate and complete information or that all their systems are fully year 2000
capable. If these vendors fail to adequately address year 2000 issues for the
products and services they provide to the Company, this failure could have a
material adverse impact on the Company's operations and financial results. The
Company is dependent on systems, such as the Internet, telecommunications and
electrical systems, which are not within its control. Any failure by such
systems could also prevent the Company from delivering its services to its
customers, which could have a material adverse effect on the Company's
business, results of operations and financial condition.
17
In addition, other third parties' year 2000 processing failures, not
currently identified by the Company as mission-critical, could have an
unexpectedly severe material adverse impact on the Company's systems and
operations. In many cases, the Company is relying on assurances from suppliers
that new and upgraded information systems and other products are year 2000
capable. The Company cannot be sure that its tests were adequate or that, if
problems are identified, they will be addressed by the supplier in a timely and
satisfactory way.
On June 1, 1999, the Company entered into a definitive agreement to acquire
Telebanc Financial Corporation ("Telebanc"), a holding company for Telebank,
the nation's largest branchless bank, providing banking products and services
over the Internet. On July 13, 1999, the Company entered into a definitive
agreement to acquire TIR (Holdings) Limited ("TIR"), an international financial
services company offering global multi-currency securities execution and
settlement services, and a leader in providing independent research to
institutional investors. The Company has been advised by both Telebanc and TIR
that they had ongoing programs to identify and remediate any year 2000 issues.
The Company does not have any direct control over the year 2000 activities of
Telebanc. With respect to TIR, the Company has relied upon the representations
of management or former management with respect to TIR's year 2000 readiness,
including representations and warranties that TIR's products and services and
its internal computer systems are year 2000 ready, that TIR has made
appropriate inquiries of its key suppliers of services and products, and that
TIR did not incur any material expenses associated with securing year 2000
readiness of its products or services, internal computer systems or the
computer systems of TIR's key suppliers or customers. The TIR acquisition
closed on August 31, 1999 and the Telebanc acquisition closed on January 12,
2000; therefore, the Company's operating results were not impacted by the
additional assessment, remediation, validation, implementation and testing
costs that these entities incurred. While the managements of Telebanc and TIR
have made certain representations with respect to their year 2000 readiness,
the Company can give no assurances as to the adequacy of the year 2000 efforts
of Telebanc or TIR or their impact to the Company.
The Company spent approximately $8.2 million on year 2000 readiness efforts
through December 31, 1999, and currently estimates that it will spend
approximately an additional $0.3 million. These expenditures will consist
primarily of compensation for employees and contractors dedicated to this
project and the operation of command centers through January 7, 2000. The
Company funded all year 2000 related costs through operating cash flows. These
costs did not result in increased information technology expenditures because
they were funded through a reallocation of the Company's overall development
spending. In accordance with generally accepted accounting principles, such
expenditures were expensed as incurred. The costs of addressing year 2000
issues did not have a material adverse impact on the Company's financial
position.
The foregoing year 2000 discussion and the information contained herein are
provided as a Year 2000 Readiness Disclosure.
Liquidity and Capital Resources
The Company has financing facilities totaling $425 million to meet the needs
of E*TRADE Securities that would be collateralized by customer securities.
There were no borrowings outstanding under these lines on December 31, 1999.
The Company also has a short term loan for up to $150 million, collateralized
by publicly traded investment securities owned by the Company, of which $70
million was outstanding as of December 31, 1999, and a short term line of
credit for up to $50.0 million, collateralized by marketable securities owned
by the Company, of which $34.8 was outstanding as of December 31, 1999. In
addition, the Company has entered into numerous agreements with other broker-
dealers to provide financing under the Company's stock loan program.
On February 7, 2000, the Company completed a Rule 144A offering of $500
million convertible subordinated notes due February 2007. The notes are
convertible, at the option of the holder, into a total of 21,186,441 shares of
the Company's common stock at a conversion price of $23.60 per share. The notes
bear interest at 6%, payable semiannually, and are non-callable for three years
and may then be called by the Company at a premium, which declines over time.
The holders have the right to require redemption at a
18
premium in the event of a change in control or other defined redemption event.
The Company granted the initial purchasers an option, exercisable until March
16, 2000, to purchase up to an additional $150 million of notes. The Company
expects to use $150 million of the net proceeds to refinance outstanding senior
secured indebtedness and the remaining net proceeds for general corporate
purposes, including financing the future growth of the business. Debt issuance
costs of $14,375,000 will be included in other assets and amortized to interest
expense over the term of the notes. Had these securities been issued as of the
beginning of the quarter ended December 31, 1999, net loss per share on a
diluted basis would have been increased to $0.05 due to the additional net
interest expense associated with the securities.
The Company currently anticipates that its available cash resources and
credit facilities, along with the convertible debt offering described above,
will be sufficient to meet its presently anticipated working capital and
capital expenditure requirements for at least the next 12 months. However, the
Company may need to raise additional funds in order to support more rapid
expansion, develop new or enhanced services and products, respond to
competitive pressures, acquire complementary businesses or technologies or take
advantage of unanticipated opportunities. The Company's future liquidity and
capital requirements will depend upon numerous factors, including costs and
timing of expansion of research and development efforts and the success of such
efforts, the success of the Company's existing and new service offerings and
competing technological and market developments. The Company's forecast of the
period of time through which its financial resources will be adequate to
support its operations is a forward-looking statement that involves risks and
uncertainties, and actual results could vary. The factors described earlier in
this paragraph will impact the Company's future capital requirements and the
adequacy of its available funds. If additional funds are raised through the
issuance of equity securities, the percentage ownership of the shareowners of
the Company will be reduced, shareowners may experience additional dilution in
net book value per share or such equity securities may have rights, preferences
or privileges senior to those of the holders of the Company's common stock.
There can be no assurance that additional financing will be available when
needed on terms favorable to the Company, if at all.
If adequate funds are not available on acceptable terms, the Company may be
unable to develop or enhance its services and products, take advantage of
future opportunities or respond to competitive pressures, any of which could
have a material adverse effect on the Company's business, financial condition
and operating results.
Cash used in operating activities was $90.6 million in the first quarter of
fiscal 2000, compared with the net loss in the first quarter of fiscal 2000 of
$5.2 million. The difference was attributable primarily to a $31.3 million gain
on sale of investments, $25.5 million unrealized gain on venture funds, and an
increase in brokerage-related assets in excess of related liabilities of $102.3
million, offset in part by depreciation and amortization of $19.3 million,
equity in losses of investments of $3.8 million, a $2.6 million non-cash
compensation charge for options. Cash provided by operating activities in the
prior year period was $2.4 million, which primarily reflects net loss of $11.6
million, increases in brokerage-related liabilities of $19.8 million in excess
of related assets, the impact of depreciation and amortization of $5.5 million
and increases in accounts payable, accrued and other liabilities in excess of
other assets.
Cash used in investing activities was $6.2 million in the first quarter of
fiscal 2000 and cash provided by investing activities was $11.8 million in the
comparable period in fiscal 1999. In the first quarter of fiscal 2000, the cash
provided by investing activities was the result of the net sale/maturity of
investments of $85.2 million in investment securities and $39.4 million in
proceeds from the sale of investments, offset by the purchase of $23.9 million
of investments $30.5 million of property and equipment and $26.7 million for
the acquisition of three foreign affiliates. This compares to cash provided by
operating activities in the first quarter of fiscal 1999 where the Company had
proceeds from sale/maturity of investments in excess of purchases of
investments of $16.0 million and purchases of property and equipment of $3.4
million.
Cash provided by financing activities was $109.8 million in the first
quarter of fiscal 2000, compared with $1.6 million in fiscal 1999. Cash
provided by financing activities in the first quarter of fiscal 2000 primarily
resulted from cash proceeds of $102.5 million from bank loans, net of issuance
costs, and $7.2 million from the exercise of stock options.
19
RISK FACTORS
You should carefully consider the risks described below before making an
investment decision in our company. The risks and uncertainties described below
are not the only ones facing our company and there may be additional risks that
we do not presently know of or that we currently deem immaterial. All of these
risks may impair our business operations. This document also contains forward-
looking statements that involve risks and uncertainties and actual results may
differ materially as a result of certain factors, including those set forth
below. If any of the following risks actually occur, our business, financial
condition or results of operations could be materially adversely affected. In
such case, the trading price of our common stock could decline, and you may
lose all or part of your investment.
In accordance with "plain English" guidelines provided by the Securities and
Exchange Commission, the risk factors have been written in the first person.
We could suffer substantial losses and be subject to customer litigation if our
systems fail or our transaction processing is slow
We receive and process transactions mostly through the Internet, online
service providers and touch-tone telephone. Thus, we depend heavily on the
integrity of the electronic systems supporting these types of transactions,
including our internal software programs and computer systems. Our systems or
any other systems in the transaction process could slow down significantly or
fail for a variety of reasons including:
. undetected errors in our internal software programs or computer systems;
. our inability to effectively resolve any errors in our internal software
programs or computer systems once they are detected; or
. heavy stress placed on our system during certain peak trading times.
If our systems or any other systems in the transaction process slow down
significantly or fail even for a short time, our customers could suffer delays
in transaction processing, which could cause substantial losses and possibly
subject us to claims for such losses or to litigation claiming fraud or
negligence. We have experienced such systems failures and degradation in the
past, including certain days in February 1999. We could experience future
system failures and degradations, especially in foreign markets where we must
implement new transaction processing infrastructures. To promote customer
satisfaction and protect our brand name, we have, on certain occasions,
compensated customers for verifiable losses from such failures. To date, during
our systems failures, we were able to take orders by telephone, however, with
respect to our brokerage transactions, only associates with securities brokers'
licenses can accept telephone orders. An adequate number of such associates may
not be available to take customer calls in the event of a future systems
failure. We may not be able to increase our customer service personnel and
capabilities in a timely and cost-effective manner. We could experience a
number of adverse consequences as a result of these systems failures including
the loss of existing customers and the inability to attract or retain new
customers. There can be no assurance that our network structure will operate
appropriately in any of the following events:
. subsystem, component or software failure;
. a power or telecommunications failure;
. human error;
. an earthquake, fire or other natural disaster; or
. an act of God or war.
There can be no assurance that, in any such event, we will be able to
prevent an extended systems failure. Any such systems failure that interrupts
our operations could have a material adverse effect on our business,
20
financial condition and operating results. We have received in the past,
including as a result of our systems failures in February 1999, adverse
publicity in the financial press and in online discussion forums primarily
relating to systems failures.
Our security could be breached, which could damage our reputation and deter
customers from using our services
We must protect our computer systems and network from physical break-ins,
security breaches and other disruptive problems caused by the Internet or other
users. Computer break-ins could jeopardize the security of information stored
in and transmitted through our computer systems and network, which could
adversely affect our ability to retain or attract customers, damage our
reputation and subject us to litigation. We have in the past, and could in the
future, be subject to denial of service, vandalism and other attacks on our
systems by Internet hackers. Although we intend to continue to implement
security technology and establish operational procedures to prevent break-ins,
damage and failures, these security measures may fail. Our insurance coverage
in certain circumstances may be insufficient to cover issues that may result
from such events.
Our business could suffer if we cannot protect the confidentiality of customer
information transmitted over public networks
A significant barrier to online commerce is the secure transmission of
confidential information over public networks. We rely on encryption and
authentication technology, including cryptography technology licensed from RSA
Data Security, Inc., to provide secure transmission of confidential
information. There can be no assurance that advances in computer and
cryptography capabilities or other developments will not result in a compromise
of the RSA or other algorithms we use to protect customer transaction data. If
any such compromise of our security were to occur, it could have a material
adverse effect on our business, financial condition and operating results.
Our quarterly results fluctuate and do not reliably indicate future operating
results
We do not believe that our historical operating results should be relied
upon as an indication of our future operating results. We expect to experience
large fluctuations in future quarterly operating results that may be caused by
many factors, including the following:
. fluctuations in the fair market value of our equity investments in other
companies, including through existing or future private investment funds
managed by us;
. fluctuations in interest rates, which will impact our investment and
loan portfolios;
. increased levels of advertising, sales and marketing expenditures for
customer acquisition, which may be affected by competitive conditions in
the marketplace;
. the timing of introductions or enhancements to online investing services
and products by us or our competitors;
. market acceptance of online financial services and products;
. the pace of development of the market for online commerce;
. changes in trading volume in securities markets;
. trends in securities and banking markets;
. domestic and international regulation of the brokerage, banking and
internet industries;
. implementation of new accounting pronouncements, such as Statement of
Financial Accounting Standards No. 133, Accounting for Derivative
Instruments and Hedging Activities;
21
. changes in domestic or international tax rates;
. changes in pricing policies by us or our competitors;
. changes in strategy;
. the success of, or costs associated with, acquisitions, joint ventures
or other strategic relationships;
. changes in key personnel;
. seasonal trends;
. the extent of international expansion;
. the mix of international and domestic revenues;
. fluctuation in foreign exchange rates;
. changes in the level of operating expenses to support projected growth;
and
. general economic conditions.
We have also experienced fluctuations in the average number of customer
transactions per day. Thus, the rate of growth in customer transactions at any
given time is not necessarily indicative of future transaction activity.
Our business will suffer if we cannot effectively compete
The market for financial services over the Internet is new, rapidly evolving
and intensely competitive. We expect competition to continue and intensify in
the future. We face direct competition from financial institutions, brokerage
firms, banks, mutual fund companies, Internet portals and other organizations.
These competitors include, among others:
. America Online, Inc.;
. Ameritrade, Inc.;
. Bank of America;
. Charles Schwab & Co., Inc.;
. Citigroup, Inc.;
. CyBerCorp.com;
. Datek Online Holdings Corporation;
. DLJdirect;
. Fidelity Brokerage Services, Inc.;
. Intuit Inc.;
. Merrill Lynch, Pierce, Fenner & Smith Incorporated;
. Microsoft Money;
. National Discount Brokers;
. Net.B@nk, Inc.;
. PaineWebber Incorporated;
. Quick & Reilly, Inc.;
. Salomon Smith Barney, Inc.;
22
. SURETRADE, Inc.;
. Waterhouse Securities, Inc.;
. Wells Fargo & Company;
. WingspanBank.com; and
. Yahoo! Inc.
Many of our competitors have longer operating histories and significantly
greater financial, technical, marketing and other resources than we do. In
addition, many of our competitors offer a wider range of services and financial
products than we do, and thus may be able to respond more quickly to new or
changing opportunities, technologies and customer requirements. Many of our
competitors also have greater name recognition and larger customer bases that
could be leveraged, thereby gaining market share from us. Such competitors may
conduct more extensive promotional activities and offer better terms and lower
prices to
customers than we do, possibly even sparking a price war in the online
financial services industry. Moreover, certain competitors have established
cooperative relationships among themselves or with third parties to enhance
their services and products. For example, Charles Schwab's One-Source mutual
fund service and similar services may discourage potential customers from using
our brokerage services. Accordingly, it is possible that new competitors or
alliances among existing competitors may significantly reduce our market share.
General financial success within the financial services industry over the
past several years has strengthened existing competitors. We believe that such
success will continue to attract new competitors, such as software development
companies, insurance companies and others, as such companies expand their
product lines. Commercial banks and other financial institutions have become
more competitive with our brokerage operations by offering their customers
certain corporate and individual financial services traditionally provided by
securities firms. The current trend toward consolidation in the commercial
banking industry could further increase competition in all aspects of our
business. Commercial banks generally are expanding their securities and
financial services activities. While we cannot predict the type and extent of
competitive services that commercial banks and other financial institutions
ultimately may offer, or whether legislative barriers will be modified, we may
be adversely affected by such competition or legislation. To the extent our
competitors are able to attract and retain customers, our business or ability
to grow could be adversely affected. In many instances, we are competing with
such organizations for the same customers. In addition, competition among
financial services firms exists for experienced technical and other personnel.
There can be no assurance that we will be able to compete effectively with
current or future competitors or that such competition will not have a material
adverse effect on our business, financial condition and operating results.
Our success depends on our ability to effectively adapt to changing business
conditions
We have grown rapidly and our business and operations have changed
substantially since we began offering electronic investing services in 1992,
and Internet investing services in February 1996, and we expect this trend to
continue. Such rapid change and expansion places significant demands on our
administrative, operational, financial, and technical management and other
resources.
We expect operating expenses and staffing levels to increase substantially
in the future. In particular, we have hired and intend to hire a significant
number of additional skilled personnel, including persons with experience in
the computer, brokerage and banking industries, and, specifically, persons with
Series 7 or other broker-dealer licenses. Competition for such personnel is
intense, and there can be no assurance that we will be able to find or keep
additional suitable senior managers or technical persons in the future. In
particular, we depend heavily on our chief executive officer, president and
chief operating officer and other members of senior management, the loss of any
of whom could seriously harm our business. We also expect to expend resources
23
for future expansion of our accounting and internal information management
systems and for a number of other new systems and procedures. In addition, we
expect that future expansion will continue to challenge our ability to
successfully hire and retain associates. If our revenues do not keep up with
operating expenses, our information management systems do not expand to meet
increasing demands, we fail to attract, assimilate and retain qualified
personnel, or we fail to manage our expansion effectively, there could be a
material adverse effect on our business, financial condition and operating
results.
The rapid growth in the use of our services has strained our ability to
adequately expand technologically. As we acquire new equipment and applications
quickly, we have less time to test and validate hardware and software, which
could lead to performance problems. We also rely on a number of third parties
to process our transactions, including online and Internet service providers,
back office processing organizations, service providers and market-makers, all
of which will need to expand the scope of the operations they perform for us.
Any backlog caused by a third party's inability to expand sufficiently to meet
our needs could have a material adverse effect on our business, financial
condition and operating results. As transaction volume increases, we may have
difficulty hiring and training qualified personnel at the necessary pace, and
the shortage of licensed personnel could cause a backlog in the processing of
brokerage orders that need review, which could lead to not only unsatisfied
customers, but also to liability for brokerage orders that were not executed on
a timely basis.
Through our Digital Financial Media initiative, we plan to deliver
interactive multimedia content and commerce through a variety of broadband
communications channels and electronic platforms. We believe that achieving
success in this strategy is essential to our ability to compete in the rapidly
evolving electronic marketplaces in which we operate. We have limited
experience in these media and our failure to execute this strategy successfully
may limit our future growth.
Our ability to attract customers and our profitability may suffer if changes in
government regulation favor our competition or restrict our business practices
The securities and banking industries in the United States are each subject
to extensive regulation under both federal and state laws. Broker-dealers are
subject to regulations covering all aspects of the securities business,
including:
. sales methods;
. trade practices among broker-dealers;
. use and safekeeping of customers' funds and securities;
. capital structure;
. record keeping;
. advertising;
. conduct of directors, officers and employees; and
. supervision.
Because we are a self-clearing broker-dealer, we have to comply with many
complex laws and rules. These include rules relating to possession and control
of customer funds and securities, margin lending and execution and settlement
of transactions. Our ability to so comply depends largely on the establishment
and maintenance of a qualified compliance system.
Similarly, Telebanc, as a savings and loan holding company, and Telebank, as
a federally chartered savings bank and subsidiary of Telebanc, are subject to
extensive regulation, supervision and examination by
24
the Office of Thrift Supervision ("OTS") and, in the case of Telebank, the
Federal Deposit Insurance Corporation. Such regulation covers all aspects of
the banking business, including lending practices, safeguarding deposits,
capital structure, record keeping, and conduct and qualifications of personnel.
Additionally our mode of operation and profitability may be directly
affected by:
. additional legislation;
. changes in rules promulgated by the SEC, the National Association of
Securities Dealers, Inc., ("NASD"), the Board of Governors of the
Federal Reserve System, the OTS, the various stock exchanges and other
self-regulatory organizations; or
. changes in the interpretation or enforcement of existing laws and rules.
The SEC, the NASD or other self-regulatory organizations and state
securities commissions can censure, fine, issue cease-and-desist orders or
suspend or expel a broker-dealer or any of its officers or employees. The OTS
may take similar action with respect to our banking activities. Our ability to
comply with all applicable laws and rules is largely dependent on our
establishment and maintenance of a system to ensure such compliance, as well as
our ability to attract and retain qualified compliance personnel. Our growth
has placed considerable strain on our ability to ensure such compliance. We
could be subject to disciplinary or other actions due to claimed noncompliance
in the future, which could have a material adverse effect on our business,
financial condition and operating results.
We have initiated an aggressive marketing campaign designed to bring brand
name recognition to E*TRADE. All marketing activities by E*TRADE Securities are
regulated by the NASD, and all marketing materials must be reviewed by an
E*TRADE Securities Series 24 licensed principal prior to release. The NASD has
in the past asked us to revise certain marketing materials. The NASD can impose
certain penalties for violations of its advertising regulations, including:
. censures or fines;
. suspension of all advertising;
. the issuance of cease-and-desist orders; or
. the suspension or expulsion of a broker-dealer or any of its officers or
employees.
We do not currently solicit orders from our customers or make investment
recommendations. However, if we were to engage in such activities, we would
become subject to additional rules and regulations governing, among other
things, sales practices and the suitability of recommendations to customers.
We intend to continue expanding our business to other countries and to
broaden our customers' abilities to trade securities of non-U.S. companies and
execute other transactions through the Internet and other gateways. In order to
expand our services globally, we must comply with the regulatory controls of
each specific country in which we conduct business. Our international expansion
could be limited by the compliance requirements of other national regulatory
jurisdictions. We intend to rely primarily on local third parties and our
subsidiaries for regulatory compliance in international jurisdictions. See
"Risk Factors--We face numerous risks associated with doing business in
international markets."
There can be no assurance that other federal, state or foreign agencies will
not attempt to regulate our online and other activities. We anticipate that we
may be required to comply with record keeping, data processing and other
regulatory requirements as a result of proposed federal legislation or
otherwise. We may also be subject to additional regulation as the market for
online commerce evolves. Because of the growth in the electronic commerce
market, Congress has held hearings on whether to regulate providers of services
and transactions in the electronic commerce market. As a result, federal or
state authorities could enact laws, rules
25
or regulations affecting our business or operations. We may also be subject to
federal, state or foreign money transmitter laws and state and foreign sales or
use tax laws. If such laws are enacted or deemed applicable to us, our business
or operations would be rendered more costly or burdensome, less efficient or
even impossible. Any of the foregoing could have a material adverse effect on
our business, financial condition and operating results.
Due to the increasing popularity of the Internet, laws and regulations may
be passed dealing with issues such as user privacy, pricing, content and
quality of products and services. In addition, the New York Attorney General
carried out an investigation of the online brokerage industry and issued a
report, citing consumer complaints about delays and technical difficulties
conducting online stock trading. Increased attention focused upon these
liability issues could adversely affect the growth of the Internet, which
could, in turn, decrease the demand for our services or could otherwise have a
material adverse effect on our business, financial condition and operating
results.
We may be fined or forced out of business if we do not maintain the net capital
levels required by regulators
The SEC, NASD, OTS, FDIC and various other regulatory agencies have
stringent rules with respect to the maintenance of specific levels of net
capital by securities broker-dealers and banks. Net capital is the net worth of
a broker or dealer (assets minus liabilities), less deductions for certain
types of assets. If a firm fails to maintain the required net capital it may be
subject to suspension or revocation of registration by the SEC and suspension
or expulsion by the NASD, and could ultimately lead to the firm's liquidation.
In the past, our broker-dealer subsidiaries have depended largely on capital
contributions by us in order to comply with net capital requirements. If such
net capital rules are changed or expanded, or if there is an unusually large
charge against net capital, operations that require the intensive use of
capital would be limited. Such operations may include trading activities and
the financing of customer account balances. Also, our ability to withdraw
capital from brokerage subsidiaries could be restricted, which in turn could
limit our ability to pay dividends, repay debt and redeem or purchase shares of
our outstanding stock. A large operating loss or charge against net capital
could adversely affect our ability to expand or even maintain our present
levels of business, which could have a material adverse effect on our business,
financial condition and operating results.
The table below summarizes the minimum net capital requirements for our
domestic broker-dealer subsidiaries as of December 31, 1999 (in thousands):
December 31, 1999
--------------------------
Required Excess
net Net net
capital capital capital
-------- -------- --------
E*TRADE Securities, Inc.......................... $79,218 $239,353 $160,135
TIR Securities, Inc.............................. 65 1,398 1,333
TIR Investor Select, Inc......................... 5 39 34
Marquette Securities, Inc........................ 250 445 195
Similarly, banks, such as Telebank, are subject to various regulatory
capital requirements administered by the federal banking agencies. Failure to
meet minimum capital requirements can initiate certain mandatory--and possibly
additional discretionary--actions by regulators that, if undertaken, could have
a direct material effect on a bank's financial statements. Under capital
adequacy guidelines and the regulatory framework for prompt corrective action,
a bank must meet specific capital guidelines that involve quantitative measures
of a bank's assets, liabilities, and certain off-balance-sheet items as
calculated under regulatory accounting practices. A bank's capital amounts and
classification are also subject to qualitative judgments by the regulators
about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require a bank to maintain minimum amounts and ratios of total and Tier 1
capital to risk-weighted assets and of Tier 1 capital to average
26
assets. To be categorized as well capitalized a bank must maintain minimum
total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios as set forth in
the following table.
The table below summarizes the capital adequacy requirements for Telebank as
of December 31, 1999 (dollars in thousands):
To Be Well
Capitalized Under
Prompt Corrective
Actual Action Provisions
-------------- --------------------
Amount Ratio Amount Ratio
-------- ----- ----------- --------
As of December 31, 1999:
Core Capital (to adjusted tangible
assets)............................... $441,987 8.83% > $250,392 >5.0%
Tier 1 Capital (to risk weighted
assets)............................... $441,987 21.04% > $126,016 >6.0%
Total Capital (to risk weighted
assets)............................... $449,174 21.39% > $210,027 >10.0%
As a significant portion of our revenues come from online investing services,
any downturn in the securities industry could significantly harm our business
A significant portion of our revenues in recent years has been from online
investing services, and we expect this business to continue to account for a
significant portion of our revenues in the foreseeable future. We, like other
financial services firms, are directly affected by economic and political
conditions, broad trends in business and finance and changes in volume and
price levels of securities and futures transactions. The U.S. securities
markets are characterized by considerable fluctuation and a downturn in these
markets could adversely affect our operating results. In October 1987 and
October 1989, the stock market suffered major declines, as a result of which
many firms in the industry suffered financial losses, and the level of
individual investor trading activity decreased after these events. Reduced
trading volume and prices have historically resulted in reduced transaction
revenues. When trading volume is low, our operating results may be adversely
affected because overhead remains relatively fixed. Severe market fluctuations
in the future could have a material adverse effect on our business, financial
condition and operating results. Some of our competitors with more diverse
product and service offerings might withstand such a downturn in the securities
industry better than we would. See "Risk Factors--Our business will suffer if
we cannot effectively compete."
Our brokerage business, by its nature, is subject to various other risks,
including customer default and employee misconduct and errors. We sometimes
allow customers to purchase securities on margin, therefore we are affected
because we are subject to risks inherent in extending credit. This risk is
especially great when the market is rapidly declining and the value of the
collateral we hold could fall below the amount of a customer's indebtedness.
Under specific regulatory guidelines, any time we borrow or lend securities, we
must correspondingly disburse or receive cash deposits. If we fail to maintain
adequate cash deposit levels at all times, we run the risk of loss if there are
sharp changes in market values of many securities and parties to the borrowing
and lending transactions fail to honor their commitments. Any such losses could
have a material adverse effect on our business, financial condition and
operating results.
Changes in interest rates may reduce Telebanc's profitability
The results of operations for Telebanc depend in large part upon the level
of its net interest income, that is, the difference between interest income
from interest-earning assets, such as loans and mortgage-backed securities, and
interest expense on interest-bearing liabilities, such as deposits and
borrowings. Many factors cause changes in interest rates, including
governmental monetary policies and domestic and international economic and
political conditions. If Telebanc is unsuccessful in managing the effects of
changes in interest rates, its financial condition and results of operations
could suffer.
Changes in market interest rates could reduce the value of Telebanc's
financial assets. Fixed-rate investments, mortgage-backed and related
securities and mortgage loans generally decline in value as interest rates
rise.
27
We could lose customers and have difficulty attracting new customers if we are
unable to quickly introduce new products and services that satisfy changing
customer needs
Our future success depends, in part, on our ability to develop and enhance
our services and products. There are significant technical risks in the
development of new services and products or enhanced versions of existing
services and products. There can be no assurance that we will be successful in
achieving any of the following:
. effectively using new technologies;
. adapting our services and products to emerging industry standards;
. developing, introducing and marketing service and product enhancements;
or
. developing, introducing and marketing new services and products.
We may also experience difficulties that could delay or prevent the
development, introduction or marketing of these services and products.
Additionally, these new services and products may not adequately meet the
requirements of the marketplace or achieve market acceptance. If we are unable
to develop and introduce enhanced or new services and products quickly enough
to respond to market or customer requirements, or if they do not achieve market
acceptance, our business, financial condition and operating results will be
materially adversely affected.
Our success depends upon the growth of the Internet as a commercial marketplace
The market for financial services, particularly over the Internet, is
rapidly evolving. Consequently, demand and market acceptance for recently
introduced services and products are subject to a high level of uncertainty.
For us, this uncertainty is compounded by the risks that consumers will not
continue to adopt online commerce and that commerce on the Internet will not
adequately develop or flourish to permit us to continue to grow.
Sales of many of our services and products will depend on consumers
continuing to adopt the Internet as a method of doing business. There can be no
assurance that the Internet infrastructure will continue to be able to support
the demands placed on it by this continued growth. In addition, the Internet
could be adversely affected by slow development or adoption of standards and
protocols to handle increased Internet activity, or due to increased
governmental regulation. Moreover, critical issues including security,
reliability, cost, ease of use, accessibility and quality of service remain
unresolved and may negatively affect the growth of Internet use or commerce on
the Internet.
Adoption of online commerce by individuals who have relied upon traditional
means of commerce in the past will require such individuals to accept new and
very different methods of conducting business. Moreover, our brokerage and
banking services over the Internet involve a new approach to securities trading
and banking which require extensive marketing and sales efforts to educate
prospective customers regarding their uses and benefits. For example, consumers
who trade with traditional brokerage firms, or even discount brokers, may be
reluctant or slow to change to obtaining brokerage services over the Internet.
Also, concerns about security and privacy on the Internet may hinder the growth
of online investing and banking, which could have a material adverse effect on
our business, financial condition and operating results.
The market price of our common stock, like other technology stocks, may be
highly volatile and any significant decrease in our stock price may make it
difficult for our shareowners to sell their stock
The market price of our common stock has been, and is likely to continue to
be, highly volatile and subject to wide fluctuations due to various factors,
many of which may be beyond our control, including:
. quarterly variations in operating results;
. volatility in the stock market;
28
. volatility in the general economy;
. announcements of acquisitions, technological innovations or new
software, services or products by us or our competitors; and
. changes in financial estimates and recommendations by securities
analysts.
In addition, there have been large price and volume fluctuations in the
stock market which have affected the market prices of securities of many
technology, Internet and financial services companies, often unrelated to the
operating performance of such companies. These broad market fluctuations may
adversely affect the market price of our common stock. In the past, volatility
in the market price of a company's securities has often led to securities class
action litigation. Such litigation could result in substantial costs and a
diversion of our attention and resources, which could have a material adverse
effect on our business, financial condition and operating results.
Our success depends on our ability to protect our intellectual property and any
failure to do so could substantially harm our business
Our success and ability to compete are dependent to a significant degree on
our proprietary technology. We rely primarily on copyright, trade secret and
trademark law to protect our technology. Effective trademark protection may not
be available for our trademarks. Although we have registered the trademark
"E*TRADE" in the United States and certain other countries, and have certain
other registered trademarks, there can be no assurance that we will be able to
secure significant protection for these trademarks. Our competitors or others
may adopt product or service names similar to "E*TRADE," thereby impeding our
ability to build brand identity and possibly leading to customer confusion. Our
inability to adequately protect the name "E*TRADE" could have a material
adverse effect on our business, financial condition and operating results.
Despite any precautions we take, a third party may be able to copy or otherwise
obtain and use our software or other proprietary information without
authorization or to develop similar software independently. Policing
unauthorized use of our technology is made especially difficult by the global
nature of the Internet and difficulty in controlling the ultimate destination
or security of software or other data transmitted on it. The laws of other
countries may afford us little or no effective protection for our intellectual
property. There can be no assurance that the steps we take will prevent
misappropriation of our technology or that agreements entered into for that
purpose will be enforceable. In addition, litigation may be necessary in the
future to:
. enforce our intellectual property rights;
. protect our trade secrets;
. determine the validity and scope of the proprietary rights of others; or
. defend against claims of infringement or invalidity.
Such litigation, whether successful or unsuccessful, could result in
substantial costs and diversions of resources, either of which could have a
material adverse effect on our business, financial condition and operating
results.
We may face claims for infringement of third parties' proprietary rights and it
could be costly and time-consuming to defend against such claims, even those
without merit
We have received in the past, and may in the future, receive notices of
claims of infringement of other parties' proprietary rights. There can be no
assurance that claims for infringement or invalidity--or any indemnification
claims based on such claims--will not be asserted or prosecuted against us. Any
such claims, with or without merit, could be time consuming and costly to
defend or litigate, divert our attention and resources or require us to enter
into royalty or licensing agreements. There can be no assurance that such
licenses would be available on reasonable terms, if at all, and the assertion
or prosecution of any such claims could have a material adverse effect on our
business, financial condition and operating results.
29
Our attempts to enter new markets may be unsuccessful, which could decrease our
earnings and consequently decrease the market value of our common stock
One element of our strategy is to leverage the E*TRADE brand and technology
to enter new markets. No assurance can be given that we will be able to
successfully adapt our proprietary processing technology for use in other
markets. Even if we do adapt our technology, no assurance can be given that we
will be able to compete successfully in any such new markets. There can be no
assurance that our pursuit of any of these opportunities will be successful. If
these efforts are not successful, we could realize less than expected earnings,
which in turn could result in a decrease in the market value of our common
stock. Furthermore, such efforts may divert management attention or
inefficiently utilize our resources.
As a result of our recent merger with Telebanc, we face numerous new risks,
including possible failure to successfully integrate and assimilate Telebanc's
operations with our own
In January 2000, E*TRADE acquired Telebanc Financial Corporation. Telebanc
is an online provider of Internet banking services. This represents a new line
of business for us. No assurance can be given that we will be successful in
this market. We may experience difficulty in assimilating Telebanc's products
and services with our own and we may not be able to integrate successfully the
employees of Telebanc into our organization. These difficulties may be
exacerbated by the geographical distance between our various locations and
Telebanc's Virginia location. If we fail to successfully integrate Telebanc's
operations with our own, our operating results and business could be adversely
affected.
Telebank holds a loan portfolio consisting primarily of one- to four-family
residential loans. A critical component of the banking industry is the ability
to accurately assess credit risk and establish corresponding loan loss
reserves. This is a new industry for us and accordingly, we do not have any
experience in this area. We are dependent upon Telebanc management and
employees to advise us in this area.
Due to our recent merger with Telebanc, we may be restricted in expanding our
activities, and our inexperience with being regulated as a savings and loan
holding company could negatively affect both us and Telebanc
Upon the completion of our merger with Telebanc, we became subject to
regulation as a savings and loan holding company. As a result, we are required
to register with the OTS and file periodic reports, and are subject to
examination by the OTS. We are also limited in our ability to invest in other
savings and loan holding companies. Under financial modernization legislation
recently enacted into law, our activities are also restricted to activities
that are financial in nature and certain real estate-related activities. We
believe that all of our existing activities and investments qualify as
financial in nature, but the OTS and other banking agencies have not yet issued
regulations or otherwise interpreted the new statute. Even if all of our
existing activities and investments are permissible, under the new legislation
we may be constrained in pursuing future new activities.
In addition to regulation of us and Telebanc as savings and loan holding
companies, federal savings banks, such as Telebank, are subject to extensive
regulation of their activities and investments, their capitalization, their
risk management policies and procedures, and their transactions with affiliated
companies. In addition, as a condition to approving our merger with Telebanc,
the OTS imposed various notices and other requirements, primarily a requirement
that Telebank obtain prior approval from the OTS of any future material changes
to Telebank's business plan. We have limited experience and knowledge of the
regulatory requirements of the OTS and the Federal Deposit Insurance
Corporation, and there is a risk that we could incur significant additional
costs in complying with these regulations, or significant penalties if we fail
to comply. These regulations and conditions, and our inexperience with them,
could affect our ability to realize synergies from the merger, and could
negatively affect both us and Telebank.
We face numerous risks associated with doing business in international markets
One component of our strategy is a planned increase in efforts to attract
more international customers. To date, we have limited experience in providing
brokerage services internationally. Furthermore, we have had no
30
experience providing banking services outside the United States. There can be
no assurance that our international licensees or subsidiaries will be able to
market our branded services and products successfully in international markets.
In addition, there are certain risks inherent in doing business in
international markets, particularly in the heavily regulated brokerage and
banking industries, such as:
. unexpected changes in regulatory requirements, tariffs and other trade
barriers;
. difficulties in staffing and managing foreign operations;
. the level of investor interest in cross-border trading;
. political instability;
. fluctuations in currency exchange rates;
. reduced protection for intellectual property rights in some countries;
. seasonal reductions in business activity during the summer months in
Europe and certain other parts of the world;
. the level of adoption of the Internet in international markets; and
. potentially adverse tax consequences.
Any of the foregoing could adversely impact the success of our international
operations. In addition, because some of these international markets are served
through license arrangements with others, we rely upon these third parties for
a variety of business and regulatory compliance matters. We have limited
control over the management and direction of these third parties. We run the
risk that their action or inaction could harm our operations and/or the
goodwill associated with our brand name. Additionally, certain of our
international licensees have the right to sell sub-licenses. Generally, we have
less control over sub-licensees than we do over licensees. As a result, the
risk to our operations and goodwill is higher. There can be no assurance that
one or more of the factors described above will not have a material adverse
effect on our future international operations, if any, and, consequently, on
our business, financial condition and operating results.
Any failure to successfully integrate the companies that we acquire into our
existing operations or failure to maintain our relationships with strategic
partners could harm our business
We recently acquired Telebanc, TIR and some of our European licensees. We
may also acquire other companies or technologies in the future, and we
regularly evaluate such opportunities. Acquisitions and mergers entail numerous
risks, including:
. difficulties in the assimilation of acquired operations and products;
. diversion of management's attention from other business concerns;
. amortization of acquired intangible assets; and
. potential loss of key employees of acquired companies.
We have limited experience in assimilating acquired organizations into our
operations. No assurance can be given as to our ability to integrate
successfully any operations, technology, personnel, services or new businesses
or products that might be acquired in the future. Failure to successfully
assimilate acquired organizations could have a material adverse effect on our
business, financial condition and operating results.
We have established a number of strategic relationships with online and
Internet service providers, as well as software and information service
providers. There can be no assurance that any such relationships will be
maintained, or that if they are maintained, they will be successful or
profitable. Additionally, we may not develop any new relationships of this type
in the future. We also make investments, either directly or from affiliated
private investment funds, in equity securities of other companies without
acquiring control of those companies. There may be no public market for the
securities of the companies we invest in. In order for us to
31
realize a return on our investment, such companies must be sold or successfully
complete a public offering of their securities. There can be no assurance that
such companies will be acquired or complete a public offering or that such an
acquisition or public offering will allow us to sell our securities at a
profit, or at all.
Due to the foregoing factors, quarterly revenues and operating results are
difficult to forecast. We believe that period-to-period comparisons of our
operating results will not necessarily be meaningful and you should not rely on
them as any indication of future performance. Our future quarterly operating
results may not consistently meet the expectations of securities analysts or
investors, which in turn may have an adverse effect on the market price of our
common stock.
We have substantially increased our indebtedness, which may make it more
difficult to make payments on our debts or to obtain financing
As a result of the sale of our 6% convertible subordinated notes, E*TRADE
will incur $500 million of additional indebtedness (assuming that the initial
purchasers' option is not exercised), increasing our ratio of debt to equity
(expressed as a percentage) from approximately 7% to approximately 29% as of
December 31, 1999, on a pro forma basis giving effect to the sales of the notes
and the application of proceeds therefrom. We may incur substantial additional
indebtedness in the future. The level of our indebtedness, among other things,
could
. make it difficult for us to make payments on our debt;
. make it difficult for us to obtain any necessary financing in the future
for working capital, capital expenditures, debt service requirements or
other purposes;
. limit our flexibility in planning for, or reacting to, changes in our
business; and
. make us more vulnerable in the event of a downturn in our business.
There can be no assurance that we will be able to meet our debt service
obligations, including obligations under the notes.
Loss or reductions in revenue from order flow rebates could harm our business
Order flow revenue as a percentage of revenue has decreased over the past
three years. There can be no assurance that payments for order flow will
continue to be permitted by the SEC, the NASD or other regulatory agencies,
courts or governmental units. Loss of any or all of these revenues could have a
material adverse effect on our business, financial condition and operating
results.
We may incur costs to avoid investment company status and may suffer adverse
consequences if we are deemed to be an investment company
We may incur significant costs to avoid investment company status and may
suffer other adverse consequences if we are deemed to be an investment company
under the Investment Company Act of 1940 (commonly referred to as the "1940
Act").
A company may be deemed to be an investment company if it owns investment
securities with a value exceeding 40% of its total assets, subject to certain
exclusions. After giving effect to the offering, we will have substantial
short-term investments until the net proceeds from the offering can be
deployed. In addition, we and our subsidiaries have made minority equity
investments in other business that may constitute investment securities under
the 1940 Act. In particular, many of our publicly traded equity investments,
which are owned directly by us or through related venture funds, are deemed to
be investment securities. Although our investment securities currently comprise
less than 40% of our total assets, the value of these minority investments has
fluctuated in the past, and substantial appreciation in some of these
investments may, from time to time, cause the value of our investment
securities to exceed 40% of our total assets. These factors may result in us
being treated as an "investment company" under the 1940 Act.
32
We believe we are primarily engaged in a business other than investing,
reinvesting, owning, holding, or trading securities for our account and,
therefore, are not an investment company within the meaning of the 1940 Act.
However, in the event that such exemption is not available and the 40% limit
were to be exceeded (including through fluctuations in the value of our
investment securities), we may need to reduce our investment securities as a
percentage of our total assets. This reduction can be attempted in a number of
ways, including the sale of investment securities and the acquisition of non-
investment security assets, such as cash, cash equivalents and government
securities. If we sell investment securities, we may sell them sooner than we
otherwise would. These sales may be at depressed prices and we may never
realize anticipated benefits from, or may incur losses on, these investments.
Some investments may not be sold due to normal contractual or legal
restrictions or the inability to locate a suitable buyer. Moreover, we may
incur tax liabilities if we sell these assets. We may also be unable to
purchase additional investment securities that may not be important to our
operating strategy. If we decide to acquire non-investment security assets, we
may not be able to identify and acquire suitable assets, and will likely
realize a lower return on any such investments.
If we were deemed to be an investment company, we could become subject to
substantial regulation under the 1940 Act with respect to our capital
structure, management, operations, affiliate transactions and other matters. As
a consequence, we could be barred from engaging in business or issuing our
securities as we have in the past and might be subject to civil and criminal
penalties for noncompliance. In addition, some of our contracts might be
voidable, and a court-appointed receiver could take control of us and liquidate
our business in certain circumstances.
Our business will suffer if our systems do not accurately process date
information relating to dates after January 1, 2000
Because many computer systems were not designed to handle dates beyond the
year 1999, computer hardware and software may need to be modified in order for
it to remain functional. This may affect us in numerous ways:
. We have assessed the impact of year 2000 issues, including other date-
related anomalies, on our products, services and internal information
systems. We do not expect our financial results to be materially
affected by the need to address year 2000 issues, but if the costs
associated with addressing these issues are greater than planned, our
earnings and results of operations could be affected. Furthermore, if
corrective actions are not adequate to avoid year 2000 problems, the
impact of year 2000 processing failures on the Company's business,
financial position, results of operations or cash flows could be
material;
. We must rely on outside vendors to address year 2000 issues for their
hardware and software. If these vendors fail to adequately address year
2000 issues for the products and services they provide to the Company,
this could have a material adverse impact on the Company's operations
and financial results. We have developed contingency plans in the event
that we, or our key vendors, are not year 2000 capable, but the failure
of such contingency plans may have a negative effect on our financial
results; and
. The method of transaction processing we employ depends heavily on the
integrity of electronic systems outside of our control, such as online
and Internet service providers, and third-party software such as
Internet browsers. A failure of any of these systems due to year 2000
issues could interfere with the trading process and, in turn, may have a
material adverse effect on our business, financial condition and
operating results.
Due to our dependence on computer technology to conduct our business, the
nature and impact of year 2000 processing failures on our business, financial
condition and operating results could be material.
33
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market Risk Disclosures
The following discussion about the Company's market risk disclosures
involves forward-looking statements. Actual results could differ materially
from those projected in the forward-looking statements. The Company is exposed
to market risk related to changes in interest rates, foreign currency exchange
rates and equity security price risk. The Company does not have derivative
financial instruments for speculative or trading purposes.
Interest Rate Sensitivity
For interest rate sensitivity associated with the Company's investment
securities, reference is made to Part II, Item 7A, Quantitative and Qualitative
Disclosures About Market Risk, in our Annual Report on Form 10-K for the year
ended September 30, 1999. During the quarter ended December 31, 1999, the
Company obtained two variable rate bank lines of credit. As of December 31,
1999, the Company had $104.8 million outstanding under these lines. These lines
of credit and the monthly interest payment are subject to interest rate risk.
If market interest rates were to increase immediately and uniformly by 10
percent at December 31, 1999, the interest payments would increase by an
immaterial amount.
Equity Price Risk
The Company has investments in publicly-traded equity securities. The fair
value of these securities at December 31, 1999 was $646.6 million. If the
market price of the securities held at December 31, 1999 were to decrease by
10%, the fair value of the portfolio would decline by $64.7 million, which
would not have a material effect on the financial position of the Company. The
Company accounts for these securities as available-for-sale, and unrealized
gains and losses resulting from changes in the fair value of these securities
are reflected as a change in shareowners' equity, and not reflected in the
determination of operating results until the securities are sold. At December
31, 1999, unrealized gains on these securities were $610.2 million.
Financial Instruments
For its working capital and reserves, which are required to be segregated
under Federal or other regulations, the Company invests in money market funds,
resale agreements, certificates of deposit, and commercial paper. Money market
funds do not have maturity dates and do not present a material market risk. The
other financial instruments are fixed rate investments with short maturities
and do not present a material interest rate risk.
34
PART II. OTHER INFORMATION
Item 1. Legal and Administrative Proceedings--
On November 21, 1997, a putative class action was filed in the Superior
Court of California, County of Santa Clara, by Larry R. Cooper on behalf of
himself and other similarly situated individuals. The action alleges, among
other things, that our advertising, other communications and business practices
regarding our commission rates and our ability to timely execute and confirm
transactions through our online brokerage services were false and deceptive.
The action seeks injunctive relief enjoining the purported deceptive and unfair
practices alleged in the action and also seeks unspecified compensatory and
punitive damages, as well as attorney fees. On June 1, 1999, the court entered
an order denying plaintiffs' motion for class certification. While the court
declined to certify a class as to any of plaintiffs' alleged claims, it did
indicate that plaintiffs may be able to pursue one of their claims (relating to
our commission structure) on a representative basis. On January 25, 2000, the
court ordered plaintiffs to submit all claims (including representative claims)
seeking monetary relief to arbitration; claims for injunctive relief were not
ordered to arbitration, but were stayed pending arbitration. We are unable to
predict the ultimate outcome of this proceeding.
On February 11, 1999, a putative class action was filed in the Supreme Court
of New York, County of New York, by Evan Berger, on behalf of himself and other
similarly situated individuals. The action alleges, among other things, that
our advertising, other communications and business practices regarding our
ability to timely execute and confirm transactions through our online brokerage
services were false and deceptive. Plaintiff seeks damages based on causes of
action for breach of contract and violation of New York consumer protection
statutes. After we filed a motion to dismiss or stay the complaint on April 14,
1999, the plaintiff chose to file an amended complaint. In response to that
amended complaint, we have now moved to compel arbitration or, alternatively,
dismiss the amended complaint. It is uncertain how the court will rule on our
motions, and thus we are unable to predict the ultimate outcome of this
proceeding.
On March 1, 1999, a putative class action was filed in the Court of Common
Pleas, Cuyahoga County, Ohio, by Truc Q. Hoang. The Hoang complaint seeks
damages and injunctive relief arising out of, among other things, plaintiff's
alleged problems accessing her account and placing orders. Plaintiff alleges
causes of action for breach of contract, fiduciary duty and unjust enrichment,
fraud, unfair and deceptive trade practices, negligence/intentional tort and
injunctive relief. We have filed motions both to compel arbitration and to
dismiss the complaint. All discovery regarding the merits of plaintiff's claims
is stayed pending the determination of our motion to dismiss. On September 1,
1999, the court denied our motion to compel arbitration. We have appealed the
order and a hearing on the appeal took place on February 2, 2000. This
proceeding is still at an early stage and we are unable to predict its ultimate
outcome.
On March 10, 1999, a putative class action was filed in the Superior Court
of California, County of Santa Clara, by Raj Chadha. The Chadha complaint seeks
damages and injunctive relief arising out of, among other things, the February
3, 4 and 5, 1999, system interruptions. Plaintiff brings causes of action for
breach of fiduciary duty and violations of the Consumer Legal Remedies Act and
California Unfair Business Practices Act. In response to the complaint, we
filed a petition to compel arbitration. Among other things, we argued that, in
light of the Cooper court's decision to deny class certification, all customers
who were members of the alleged Cooper class--including Chadha--are obligated
to submit their claims to arbitration in accordance with the customer
agreement. The court granted the petition to compel arbitration on July 29,
1999, and stayed all further proceedings pending arbitration.
On March 11, 1999, a putative class action was filed in the Superior Court
of California, County of Santa Clara, by Elie Wurtman. The Wurtman complaint
seeks damages and injunctive relief arising out of, among other things,
plaintiff's alleged problems accessing her account and placing orders. The
complaint also makes allegations regarding access problems relating to our
customers residing or traveling outside of the United States. Plaintiff brings
causes of action for negligence and violations of the Consumer Legal Remedies
Act and California Unfair Business Practices Act. In response to the complaint,
we filed a petition to compel arbitration.
35
As in Chadha, we argued that, in light of the Cooper court's decision to deny
class certification, Wurtman is obligated to submit his claims to arbitration
in accordance with the customer agreement. The petition to compel arbitration
was heard by the court on September 9, 1999 and was denied. On October 4, 1999,
we appealed from the court's order denying the petition, and that appeal has
the effect of staying all further proceedings in the trial court. Briefing has
not yet begun on our appeal. This proceeding is still at an early stage and we
are unable to predict the ultimate outcome.
On April 14, 1999, a putative class action was filed in the Superior Court
of California, County of Los Angeles, by Matthew J. Rosenberg. Plaintiff seeks
injunctive relief based on alleged violations of the California Unfair Business
Practices Act regarding the extent to which shares in IPOs are made available
to our customers. We filed a demurrer and motion to strike on August 13, 1999,
arguing (among other things) that the plaintiff has not alleged facts
sufficient to state a claim against us. On October 6, 1999, the court dismissed
the class action claims with prejudice. The claim for unfair business practices
was dismissed with leave to amend, but for injunctive relief only and not money
damages. Plaintiff filed an amended complaint on October 26, 1999. We filed a
petition to compel arbitration in response. On December 29, 1999, the court
granted the petition to compel arbitration and dismissed the court proceeding.
We are unable to predict the ultimate outcome of this proceeding.
On December 23, 1999, plaintiff Kathleen Nyquist filed a complaint in
federal court. Ms. Nyquist is a customer who brings claims for breach of
fiduciary duty, negligence/recklessness, unfair trade practices, securities law
violations and aiding and abetting. Her claims against us arise out of
allegedly unauthorized transactions and unrestricted day-trading effected by
her husband in her IRA account as well as another account. Plaintiff alleges
losses totaling approximately $700,000 and also seeks attorney's fees, punitive
damages as well as treble damages under the South Carolina unfair trade
practices laws. We must respond to plaintiff's complaint by February 25, 2000.
This proceeding is still at an early stage and we are unable to predict the
ultimate outcome.
We believe that these claims are without merit and intend to defend against
them vigorously. An unfavorable outcome in any matters, which are not covered
by insurance, could have a material adverse effect on our business, financial
condition and results of operations. In addition, even if the ultimate outcomes
are resolved in our favor, the defense of such litigation could entail
considerable cost and the diversion of efforts of management, either of which
could have a material adverse effect on our results of operation.
From time to time, we have been threatened with, or named as a defendant in,
lawsuits, arbitrations and administrative claims. Compliance and trading
problems that are reported to the NASD or the SEC by dissatisfied customers are
investigated by the NASD or the SEC, and, if pursued by such customers, may
rise to the level of arbitration or disciplinary action. One or more of such
claims or disciplinary actions decided adversely against us could have a
material adverse effect on our business, financial condition and results of
operations. We are also subject to periodic regulatory audits and inspections.
The securities industry is subject to extensive regulation under federal,
state and applicable international laws. As a result, we are required to comply
with many complex laws and rules and our ability to so comply is dependent in
large part upon the establishment and maintenance of a qualified compliance
system. We are aware of several instances of our noncompliance with applicable
regulations. In particular, in fiscal 1997, our failure to timely renew our
broker dealer registration in Ohio resulted in a $4.3 million pre-tax charge
against earnings.
We maintain insurance in such amounts and with such coverages, deductibles
and policy limits as our management believes are reasonable and prudent. The
principal risks that we insure against are comprehensive general liability,
commercial property, hardware/software damage, directors and officers, and
errors and omissions liability. We believe that such insurance coverages are
adequate for the purpose of our business.
Item 2. Changes in Securities and Use of Proceeds--Not applicable.
36
Item 3. Defaults Upon Senior Securities--Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders--
The annual meeting of shareowners was held on December 21, 1999. Lewis E.
Randall, Lester C. Thurow, and Peter Chernin were elected as directors, as
tabulated below.
Election of Directors For Against
--------------------- ----------- ----------
Lewis E. Randall...................................... 202,537,670 2,541,659
Lester C. Thurow...................................... 191,846,312 13,233,017
Peter Chernin......................................... 202,451,036 2,628,293
In addition, Christos M. Cotsakos, William A. Porter, Richard S. Braddock,
Masayoshi Son, William E. Ford, and George Hayter will continue as directors.
The proposal to approve the amendment to the Company's 1996 Stock Incentive
Plan (the "Plan"), including an 11,900,000 shares increase in the maximum
number of shares of Common Stock reserved for issuance under the Plan was
approved, as tabulated below.
For Against Abstentions
----------- ---------- -----------
Votes..................................... 180,132,435 22,384,013 1,014,910
The proposal to ratify the selection of Deloitte & Touche LLP as independent
public accountants for the Company for the fiscal year ending September 30,
2000 was approved, as tabulated below.
For Against Abstentions
----------- ------- -----------
Votes........................................ 202,564,183 727,679 239,467
Item 5. Other Information--None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
4.1 Indenture, dated February 1, 2000, by and between the Company and The
Bank of New York.
10.1 Employment agreement, dated June 1, 1999, by and between the Company
and Christos M. Cotsakos.
10.2 Employment agreement, dated June 1, 1999, by and between the Company
and Kathy Levinson.
10.3 Purchase Agreement, dated February 1, 2000, by and among the Company,
FleetBoston Robertson Stephens Inc., Hambrecht & Quist LLC and Goldman,
Sachs & Co.
10.4 Registration Rights Agreement, dated February 1, 2000, by and among
the Company, FleetBoston Robertson Stephens Inc., Hambrecht & Quist LLC
and Goldman, Sachs & Co.
27 Financial Data Schedule
99.1 Press release, dated January 25, 2000, relating to the 6% convertible
subordinated notes due 2007.
99.2 Press release, dated February 2, 2000, relating to the 6% convertible
subordinated notes due 2007.
(b) Reports on Form 8-K
None
37
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
E*TRADE Group, Inc.
(Registrant)
Dated: February 14, 2000
/s/ Christos M. Cotsakos
By: _________________________________
Christos M. Cotsakos
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
/s/ Leonard C. Purkis
By: _________________________________
Leonard C. Purkis
Chief Financial Officer
(Principal Financial and
Accounting Officer)
38