From Clicks to Bricks?

By John R. Engen

To win top-tier customers, E*Trade Group may have to increase its physical network — at the risk of diluting its cost advantage.

E*Trade Group Inc. is a veritable poster child for convergence in financial services. Starting out as an online discount broker, the Menlo Park, Calif.-based firm acquired an online bank in 1999 and has since added insurance, mortgages, and financial planning to its menu of services. Next on tap: credit cards and auto loans.

The company's progressive business model — based on the premise that online brokerage customers can be cross-sold online banking products and vice versa — helped offset the recent stock market swoon as the firm guided jolted investors into its own federally-insured deposit products. Its online mortgage subsidiary, meanwhile, generated enough refinancings to keep revenues roughly on track in an exceedingly stressful year.

It's too early to declare E*Trade's convergence strategy a complete success, however, since important challenges, choices and performance hurdles still loom ahead. As banks discovered when they expanded into brokerage and investment banking during the last decade, non-core businesses can bring new revenues but also pose unfamiliar operational issues and add new layers of expense. There's a real risk of diluting the core business.

In E*Trade's case, the company distinguished itself by leveraging a lean overhead structure to offer low-cost investment services and high-yielding banking products. But to go beyond its market niche of active traders and other customers who are comfortable handling financial matters primarily online, the company increasingly must offer supplemental physical distribution — most notably branch-style outlets.

The question is whether it can attract more traditional customers who have large sums to invest and still stop short of the costly physical infrastructure typically erected to serve this market. These clients often want some human advice and handholding and are less likely than active traders to settle for purely online interaction.

"One-stop shopping and cross-selling are all about relationships. You need a human component to complete the circle," says Dan Burke, an analyst for Gomez Inc. in Waltham, Mass.

Can E*Trade control costs as it expands the human component? And will customers respond to its "lite" physical network? The answers to these questions will go a long way in determining the growth potential of this innovative company. The outcome has implications for conventional players as well, since the successful migration of large numbers of affluent customers to a radically more efficient distribution system would place traditional brick-and-mortar networks under fresh assault.

No Brick-and-Mortar

At the heart of E*Trade's expansion strategy is a physical distribution system like no other in financial services.

The backbone is a network of roughly 11,000 proprietary ATMs, the nation's third-largest such system, scattered around the country. Additionally, the company operates five high-profile "E*Trade Centers," the closest thing it has to full-service outlets, in New York, San Francisco, Boston, Denver and Los Angeles. Five more installations are planned throughout the next year. It also has a network of 26 "E*Trade Zones," essentially low-cost supermarket-style branches, in Target stores. Plans call for adding as many as 175 additional Target branches by 2004.

Along with call center support, the company believes that its ATMs and Target locations constitute sufficient backup to its core Internet franchise. The company can deploy and maintain more than 400 ATMs for the cost of one small brick-and-mortar branch, says Mitchell Caplan, E*Trade's president and chief operating officer. Renting space in a discount store, he adds, is also much more cost-effective.

"We will deliver products and services to customers anyway, anyhow, anywhere — as long as it doesn't commit us to the costs of brick-and-mortar," Caplan says. "I firmly believe you don't need to have it."

As for the more elaborate E*Trade Centers, Caplan says they are more valuable as promotional vehicles than as places for deposit- or asset-gathering. "Do you get bigger deposits through them? Absolutely. But it's more a way to extend the brand, like having 10 big billboards in a city."

Still, it is not yet clear that ATMs and counters in discount stores will provide sufficient "touch-points" for the high-end clients that E*Trade wants to attract. Charles Schwab & Co., which sports 430 branches, in February alone garnered $6.34 billion of new assets, a sum that amounts to nearly 15% of E*Trade's entire brokerage base. "E*Trade is not going to be able to gather serious amounts of assets without a greater physical presence," says Eric Wasserstrom, a New York-based analyst with UBS Warburg.

While E*Trade's deal with Target might boost the company's profile and even help attract smaller accounts, it isn't likely to help much with high-net-worth clients, experts say. "Supermarket-style branches are good for convenience, not complex sales," says consultant Charles Wendel, with Financial Institutions Consulting in New York City. "If you want to provide consultative service to wealthy clients, you need high-quality space."

Surveys by Forrester Research Inc. indicate that up to 18% of Americans don't care at all about branch presence, while an equal proportion view it only as a "secondary" consideration. But even for that latter group, money is an "emotional" matter, says Forrester analyst Jaime Punishill, who is based in Cambridge, Mass.

Even if they never set foot in a branch, most customers want to know that one is nearby if they need to talk with someone in-person about their accounts, Punishill says. "The serious challenge for E*Trade is: How do they achieve the level of intimacy and trust required to deal with that emotional side if they're de-emphasizing the personal, face-to-face aspect of the relationship?"

E*Trade officials counter that institutions with extensive physical infrastructures have struggled for decades to deepen customer relationships, to limited success. This, they say, is largely because consumers increasingly recognize financial products and services for what they are: commodities. The massive costs associated with that infrastructure leave traditional financial institutions little room to adapt in difficult times.

Online Value

Caplan contends that well-managed call centers can provide an acceptable, albeit remote, human touch-point for many customers, and do so at much lower cost. He asserts that the company's ability to provide an integrated experience that blends banking, brokerage and other capabilities on one Web site leaves it well positioned to lure the growing number of customers willing to trade branch proximity for technology-driven value and personalization.

This brings up a subtle but important point, which is that E*Trade firmly intends to keep an electronic center of gravity. And to do that, the company continues to augment its online value proposition.

Caplan views the company as a nimble, high-tech innovator competing with stodgy dinosaurs that are burdened by high fixed-cost infrastructures. By using technology to control costs and personalization to improve service, he says, E*Trade can enhance its commodity-type products and thus drive greater cross-sales to emerging affluent customers.

As an example of such light-footedness, Caplan cites E*Trade's recent launch of its advice platform, a longer-term project that was quickly bumped up in response to recent market turmoil. Under a joint venture agreement, Ernst & Young LLP representatives provide advice to E*Trade clients over the phone. The consulting firm also has helped E*Trade compile an online product, dubbed "eAdvisor," which provides simple stock recommendations to help customers create their own portfolios.

One clear goal is to win over customers with competitive rates derived from the efficiencies of lower-cost technologies. E*Trade Bank, for instance, consistently offers rates on savings products that are about 100 basis points higher than the industry average. "At our core, we're about using technology to be the low-cost producer," Caplan explains. "Most traditional banks still view the Internet or ATMs as just service offerings. They don't recognize the value that can be had by using the benefits of those channels to differentiate products and pricing."

E*Trade's strategy and technology have their fans. Punishill, who is a customer, says the new "E*Trade Financial" Web site provides a complete overview of banking, brokerage and other accounts; allows customers to seamlessly move money between them; and even pre-populates application forms with all the information E*Trade possesses. It does this even though the banking and brokerage offerings operate on separate technical platforms.

"If you're going to try to offer one-stop shopping and cross-selling, the first step is to create an integrated experience," Punishill says. "E*Trade has done that better than just about anyone else."

The company has also been aggressive about implementing an internally developed customer relationship management approach that blends several types of information — internal transaction histories, insights about customer behaviors and attitudes, and outside source data — to predict which products or services are most appropriate for customers. The goal of such "propensity modeling" is to customize marketing messages and create a sense of personalization.

"If we know that people with the same characteristics as a given prospect have opted for, say, an education savings plan, then there's a significant chance the prospect will convert as well, and also feel the offer has been personalized for her," says Arlen Gelbard, president of E*Trade Bank.

Synergy in Action

Working almost solely from its Internet platform, E*Trade has already produced some strong evidence of synergies between banking and brokerage. Since it acquired Arlington, Va.-based Telebanc Financial Corp. in late 1999, the number of bank accounts has more than tripled, to 491,000 at year-end 2001, while deposits have surged to $8 billion, from $2.6 billion. About 40% of the new accounts have come directly from E*Trade's brokerage side, according to Caplan. Similarly, more than 25% of the mortgage subsidiary's originations in 2001 were derived from established customers.

Viewed from the perspective of cross-sell, however, E*Trade still has some work to do. At the end of 2001, the company boasted more than 3 million client households, but just 4 million accounts. At less than 1.4 accounts per-household, this cross-sell ratio is meek when compared with industry standard-bearers, such as Wells Fargo & Co., which claim upwards of five relationships, or products, per-household. E*Trade officials attribute the small ratio, in part, to rapid growth: the customer base has nearly tripled in four years, diluting the impact of cross-selling activities.

Meanwhile, the average assets currently held by an E*Trade household — about $17,000 — pale next to rivals such as Schwab, which averages more than $100,000, or some Wall Street brokerages, whose averages can approach $1 million. In total, the $53 billion in brokerage assets and bank deposits controlled by E*Trade is dwarfed by the likes of Schwab, which reported $830 billion in client assets at the end of February.

E*Trade officials acknowledge the challenge they face in improving their penetration rate with established clients. But the potential in doing so could be huge. For example, they estimate that selling one additional product to each customer could boost E*Trade's annual revenues by roughly $300 million.

According to Caplan, E*Trade's customers constitute a well-educated, technology-savvy group that closely resembles Schwab's client base but averages about 10 years younger. And they're responsible borrowers. The trick for E*Trade is to deepen relationships with these clients while simultaneously attracting some of the older, wealthier ones who have more assets to invest.

Performance Hurdles

E*Trade has not been immune from the growing pains and volatility besetting other dot-coms, and it remains to be seen whether it can deliver healthy, sustained profitability.

Product diversification has helped E*Trade weather stock market fluctuations. While brokerage commissions dipped 45% last year, to $407 million, rising interest and fee income and gains on the sales of mortgage loans helped offset the effects of the worst market environment in decades. E*Trade lost 73 cents per-share in 2001, due largely to a restructuring charge, but saw revenues dip only slightly, to $1.3 billion, from $1.4 billion the year before. Underscoring improved revenue diversification, brokerage transactions produced just 32% of revenues in 2001, compared with 52% a year earlier, and more than 80% three years ago.

Lamentably, in this era of accounting controversies, E*Trade's financial reporting has been murky, although in fairness, some of the vagaries simply reflect the volatility of a young company. On top of a "one-time" restructuring charge of $233 million in the third quarter and an "operating profit" that is actually a net loss, a change of fiscal years in 2001 makes prior-year comparisons difficult. Although analysts considered E*Trade's fourth quarter to have been relatively "clean," the company muddied the waters again in 2002's first quarter by revealing plans to take a goodwill charge of $299.4 million related to its accounting treatment of some international acquisitions.

Operating unencumbered by older legacy computing systems is a benefit as the company works to piece together a more comprehensive offering. But attempting to link so many capabilities in such a short time leaves the organization feeling harried. And analysts have criticized as an unnecessary distraction such efforts as the "personalized digital financial media" strategy, which aims to provide "actionable" E*Trade-branded financial news to customers via personal computer and wireless channels.

E*Trade has long been plagued by customer-service complaints, moreover. And Caplan admits that customer relationship management systems are a work in progress — as they are with most financial institutions.

E*Trade also faces stiff competition. For years, Wall Street firms and some of the largest banks have worked to similarly combine banking, brokerage and financial advice capabilities. Schwab, for example, recently announced plans to purchase a national bank charter. Merrill Lynch, meanwhile, has formed a separate banking unit.

Still, this is not the first time that CEO Christos Cotsakos has faced a transformation challenge. Since going public in 1996 as a discount e-brokerage, in fact, E*Trade has remade its retail image and orientation several times — first extending globally, then shifting from a trading orientation to one that emphasized investing.

The latest incarnation has taken a slew of deals to accomplish. Along with acquiring the former Telebanc, major purchases include Card Capture Services, which operated the nation's third-largest ATM network, and online mortgage originator LoansDirect.com. More recently, E*Trade inked pacts to provide insurance products and planning advice, respectively through Inviva Inc. and Ernst & Young. It has targeted new online lending areas as well, including credit cards and auto loans.

Such moves reflect Cotsakos' vision of a company that leverages multiple products and distribution channels, and growing customer relationship management expertise, on a low-cost online platform. "We leverage technology to reach people in an extremely cost-effective way, which allows us to price-differentiate our products and create better value for customers," says Caplan.

Will that be enough to satisfy the new customer segments — and attract more assets from existing clients — or will E*Trade simply increase its costs to the point that it loses the allegiance of its core group? The company's future as an independent entity may well hang on the answer to that question.

"They've got to reinvent themselves in a fundamental way," says consultant Wendel. "But the farther they go from their core business — the high-tech, self-directed customers — the more challenging it will be."

Mr. Engen is a freelance writer based in Minneapolis.

Copyright © 2003 by Banking Strategies, published by BAI.

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