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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
----------------
FORM 8-K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
Date of Report (Date of earliest event reported) June 25, 1999
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E*TRADE Group, Inc.
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(Exact name of registrant as specified in charter)
Delaware 1-11921 94-2844166
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(State or other
jurisdiction (Commission (IRS Employer
of incorporation) File Number) Identification No.)
Four Embarcadero Place, 2400 Geng Road, Palo Alto, California 94303
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (650) 842-2500
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Not Applicable
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(Former name or former address, if changed since last report.)
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This Form 8-K is being filed to present on a supplemental basis the Selected
Financial Data, Management's Discussion and Analysis of Financial Conditions
and Results of Operations and consolidated financial statements of E*TRADE
Group, Inc. ("E*TRADE") as of September 30, 1998 and 1997 and for each of the
three years in the period ended September 30, 1998, and as of March 31, 1999
and for the six month periods ended March 31, 1999 and 1998, which gives
retroactive effect to its merger with ClearStation, Inc. ("ClearStation"), on
April 30, 1999 which was accounted for as a pooling of interests and for the
two-for-one stock splits effective February 1, 1999 and May 21, 1999.
Item 5 OTHER
(a) Supplemental Annual Financial Information as of September 30, 1998
and 1997 and for each of the three years in the period ended
September 30, 1998.
(1) Selected Supplemental Financial Data
(2) Management's Discussion and Analysis of Financial Condition and
Results of Operations
(3) Quantitative and Qualitative Disclosures About Market Risk
(4) Supplemental Consolidated Financial Statements and Supplementary
Data
(b) Supplemental Interim Financial Information as of March 31, 1999 and
for the six month periods ended March 31, 1999 and 1998.
(1) Management's Discussion and Analysis of Financial Condition and
Results of Operations
(2) Quantitative and Qualitative Disclosures About Market Risk
(3) Supplemental Consolidated Financial Statements and Supplementary
Data
Item 7 FINANCIAL STATEMENTS AND EXHIBITS
(c)Exhibit.
The following document is filed as an exhibit to this Report:
23.1 Consent of Independent Auditors
2
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Selected Supplemental Financial Data
<TABLE>
<CAPTION>
Years Ended September 30,
----------------------------------------------
1998 1997 1996 1995 1994
---------- -------- -------- ------- -------
(in thousands, except per share amounts)
<S> <C> <C> <C> <C> <C>
Consolidated Statement of
Operations Data*:
Revenues:
Transaction revenues......... $ 162,097 $109,659 $ 44,178 $20,835 $ 9,548
Interest, net of interest
expense..................... 56,020 25,265 4,813 1,004 302
International................ 7,031 4,000 -- -- --
Other........................ 20,169 17,471 13,529 6,947 5,558
---------- -------- -------- ------- -------
Net revenues................ 245,317 156,395 62,520 28,786 15,408
---------- -------- -------- ------- -------
Cost of services.............. 111,888 73,381 38,027 14,683 8,485
---------- -------- -------- ------- -------
Operating expenses:
Selling and marketing........ 71,447 28,160 10,944 4,204 2,372
Technology development....... 33,699 13,547 4,699 2,265 1,181
General and administrative... 31,048 16,847 8,238 3,022 2,724
---------- -------- -------- ------- -------
Total operating expenses.... 136,194 58,554 23,881 9,491 6,277
---------- -------- -------- ------- -------
Total cost of services and
operating expenses......... 248,082 131,935 61,908 24,174 14,762
---------- -------- -------- ------- -------
Pre-tax income (loss)......... (2,765) 24,460 612 4,612 646
Income tax expense (benefit).. (953) 9,425 (555) 1,728 (541)
---------- -------- -------- ------- -------
Net income (loss)............. $ (1,812) $ 15,035 $ 1,167 $ 2,884 $ 1,187
========== ======== ======== ======= =======
Net income (loss) per share**:
Basic........................ $ (0.01) $ 0.12 $ 0.01 $ 0.04 $ 0.02
========== ======== ======== ======= =======
Diluted...................... $ (0.01) $ 0.10 $ 0.01 $ 0.03 $ 0.01
========== ======== ======== ======= =======
Shares used in computation of
net income (loss) per
share**:
Basic........................ 169,791 129,408 78,564 68,068 65,944
Diluted...................... 169,791 143,496 119,728 111,028 109,784
<CAPTION>
September 30,
----------------------------------------------
1998 1997 1996 1995 1994
---------- -------- -------- ------- -------
(in thousands)
<S> <C> <C> <C> <C> <C>
Consolidated Balance Sheet
Data*:
Cash and equivalents.......... $ 21,890 $ 23,234 $ 15,856 $10,985 $ 2,000
Investment securities......... 502,534 191,958 35,563 560 560
Brokerage receivables--net.... 1,310,235 724,365 193,228 1,936 499
Total assets.................. 1,969,445 995,422 302,171 18,146 5,386
Shareowners' equity........... 709,536 283,374 71,976 12,348 919
</TABLE>
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* All amounts presented have been restated to reflect the acquisition of
ShareData, Inc. in July 1998, and ClearStation, Inc. in April 1999, which
were accounted for as pooling of interests (see Note 15 of the Supplemental
Consolidated Financial Statements).
** Reflects the two-for-one stock splits effective February 1, 1999 and May
21, 1999.
3
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Management's Discussion and Analysis of Financial Condition and Results of
Operations for the Years Ended September 30, 1998, 1997 and 1996
Forward-Looking Statements
The following discussion of the financial condition and results of
operations of E*TRADE Group, Inc. ("E*TRADE" or the "Company") as restated for
its merger with ClearStation, Inc. ("Clear Station") on April 30, 1999, which
was accounted for as a pooling of interests should be read in conjunction with
the supplemental consolidated financial statements and notes thereto included
elsewhere herein. 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 elsewhere herein.
Overview
A leading branded provider of online investing services, E*TRADE has
established a popular destination Web site for self-directed investors. Founded
in 1982, the Company operated initially as a service bureau, providing
automated online securities transaction services to various brokerage firms,
including Fidelity Brokerage Services, Inc., Quick and Reilly, Inc. and,
through an agreement with Bank of America, Charles Schwab. In 1992, the Company
formed E*TRADE Securities and began to offer retail investing services and
account information 24 hours a day, seven days a week. The Company offers
independent investors the convenience and control of automated stock, option,
fixed income and mutual fund order placement at lower commission rates than
traditional brokerage firms. In addition, E*TRADE has a suite of value-added
products and services that can be customized and personalized, including
portfolio tracking, Java-based charting and quote applications, real-time stock
quotes, Smart Alerts, market commentary and analysis, news, investor community
areas and other information services.
Free resources available to the public on E*TRADE's Web site include
breaking financial news, real-time stock and option price quotes, company
financial information and news announcements, live market commentary,
personalized investment portfolios, investor community areas, and search and
filtering tools for mutual fund and fixed income products. E*TRADE's Web site
services three levels of investors--visitors, members, and customers, with each
successive group gaining access to additional value-added products and
services. Visitors can view market information, headline news, stock quotes and
charts, mutual fund information, and much more. By registering but not opening
an account, a visitor becomes a member and receives free access to many
advanced, customizable investment research tools, including free real-times
quotes and secure email. Customers, those investors with E*TRADE accounts, have
complete access to E*TRADE's trading engine and to all the investment research
and management features, including Smart Alerts, and many sophisticated
analytical and record keeping tools. Customers may also subscribe to E*TRADE's
Professional Edge service and receive access to IPOs, institutional quality
research reports, and other premium services.
The Company's revenues consist principally of transaction revenues, which
include securities brokerage commissions and payments based on order flow,
interest and certain other fees related to the Company's product offerings. The
Company has experienced substantial growth in its revenues since E*TRADE
Securities was formed. At the end of fiscal 1992, the Company was processing
slightly over 100 transactions per day. For the quarter ended September 30,
1998, the Company's average daily transaction volume was 30,500, a 27% increase
over the average daily transaction volume of 24,100 in the equivalent period in
fiscal 1997. Although increases in the overall activity in the securities
markets have contributed to the Company's growth, the Company believes that its
growth has also been due to the success of its advertising campaigns in
bringing brand name recognition to the E*TRADE name, the launch of Internet
access to E*TRADE in February 1996, and the continuing successful integration
of new product developments.
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In December 1997, the Company acquired OptionsLink, a division of Hambrecht
& Quist LLC. OptionsLink is an all-electronic Web-based and interactive voice
response inquiry and order entry system for employee stock option and stock
purchase plan services for corporate stock plan participants. The acquisition
of OptionsLink demonstrates the Company's commitment to expand its products and
services into the corporate financial services market.
In July 1998, the Company acquired ShareData, Inc., a supplier of stock plan
knowledge-based software for pre-IPO and public companies. This acquisition
will enable the Company to extend its corporate services strategy, which began
when the Company purchased OptionsLink. Corporate financial services represents
a potential growth segment for the Company and provides an opportunity to
diversify its revenue stream. The Company intends to provide an automated
solution for stock plan management and company stock transaction capabilities
to plan sponsors and their employees through combining the OptionsLink and
ShareData, Inc. product offerings.
On April 30, 1999, the Company acquired ClearStation, Inc.,
("ClearStation"). ClearStation is a financial media web site that integrates
technical and fundamental analysis and discussion for investors. The Company
issued 939,072 shares of common stock in exchange for all outstanding common
stock of ClearStation. The Company also assumed all outstanding ClearStation
options, which were converted to options to purchase approximately 112,000
shares of the Company's common stock. The acquisition was accounted for as a
pooling of interests, and accordingly, all prior financial data of the Company
has been restated to include the historical operations of ClearStation from
October 1997 (the date of ClearStation's inception). As a result of the
acquisition, the Company incurred charges and direct transaction costs relating
to the business combination of $250,000. These non-recurring costs have been
charged to operations in the third quarter of fiscal 1999. Fiscal 1998 includes
the results of ClearStation for the twelve months ended September 30, 1998. No
adjustments were required to conform accounting policies of the entities. There
were no significant intercompany transactions requiring elimination for any
periods presented.
The Company uses other broker-dealers to execute its customers' orders and,
in recent years, has derived a significant portion of its revenues from these
broker-dealers for such order flow. This practice of receiving payments for
order flow is widespread in the securities industry. Under applicable SEC
regulations, receipt of these payments requires disclosure of such payments by
the Company to its customers. The revenues received by the Company under these
arrangements for fiscal 1998, 1997 and 1996 amounted to 16%, 19% and 22% of
total transaction revenues, respectively. There can be no assurance that the
Company will be able to continue its present relationships and terms for such
payments for order flow. In addition, 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 the Company's business,
financial condition and operating results.
The Company is making significant investments in systems technology and has
established technology centers in both Palo Alto and Rancho Cordova,
California. These facilities support systems, network services, trading,
customer service, transaction redundancy and backup between the two locations,
thereby providing an operational system in the event of a service interruption
at either facility. In fiscal 1998, the Company opened a new facility in
Alpharetta, Georgia which will also support systems, network services, trading
and customer service.
The Company implemented self-clearing operations for equity securities in
July 1996 and self-clearing operations for options in April 1997. Prior to July
1996, the Company cleared all of its customer transactions as a fully-disclosed
correspondent of Herzog, Heine, Geduld, Inc. ("Herzog"). Clearing services
include the confirmation, receipt, settlement, custody and delivery functions
involved in securities transactions. In the first quarter of fiscal 1996, the
Company began hiring associates to perform these functions. As a consequence,
the Company incurred significant costs associated with the hiring and training
of its associates, and systems integration costs, while continuing to incur
expenses for clearing operations performed by Herzog through June 1996. The
conversion to self-clearing has allowed the Company to realize significant cost
savings and revenue enhancement.
5
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The Company assumes direct responsibility for the possession and control of
customer securities and other customer assets and the clearing of customers'
securities transactions. This responsibility requires the Company to record on
its balance sheet the receivables and payables to the Company that are a result
of customer margin loans (i.e., loans made to customers that are collateralized
by securities held in the customers' accounts at the Company) and customer free
credit balances (i.e., customer cash balances maintained by the Company),
respectively. In addition, to the extent that the Company's customer debit
balances exceed customer free credit balances, the Company may be required to
obtain financing for any excess debit balance. The Company had receivables from
customers, brokers, dealers and clearing organizations of $1.3 billion and
payables to customers, brokers, dealers and clearing organizations of
$1.2 billion as of September 30, 1998. The Company contracts with a third-party
service bureau, BETA Systems, for its customer record keeping and data
processing services.
The Company has experienced substantial changes in, and expansion of, its
business and operations since it began offering online investing services in
1992 and Internet investing services in February 1996, and expects to continue
to experience periods of rapid growth. The Company's past expansion has placed,
and any future expansion would place, significant demands on the Company's
administrative, operational, financial and other resources. Competition for
highly qualified senior managers and technical personnel is intense. If the
Company fails to attract, assimilate and retain such personnel, there could be
a material adverse effect on the Company's business, financial condition and
operating results.
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 non-
compliance with applicable regulations. In particular, in fiscal 1997, the
Company failed to comply with applicable advertising restrictions in one
international jurisdiction and, due to a clerical oversight, failed to timely
renew its registration as a broker-dealer in two states, Nebraska and Ohio. One
of the states, Ohio, as a condition of renewing the Company's license as a
broker-dealer in that state, required the Company to offer customers resident
in that state the ability to rescind (for up to 30 days) certain securities
transactions effected through the Company during the period January 1, 1997
through April 15, 1997, the date the Company's license was renewed. For fiscal
1997, the Company recorded a $4.3 million pre-tax charge against earnings in
connection with this matter.
Results of Operations
The following table sets forth the percentage of net revenues represented by
certain items on the Company's consolidated statements of operations for the
periods indicated:
<TABLE>
<CAPTION>
Years Ended September 30,
-----------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Revenues:
Transaction revenues..... 66.1% 70.1% 70.7%
Interest, net of interest
expense................. 22.8 16.2 7.7
International............ 2.9 2.5 --
Other.................... 8.2 11.2 21.6
-------- -------- --------
Net revenues............ 100.0 100.0 100.0
-------- -------- --------
Cost of services.......... 45.6 46.9 60.8
-------- -------- --------
Operating expenses:
Selling and marketing.... 29.1 18.0 17.5
Technology development... 13.7 8.7 7.5
General and
administrative.......... 12.7 10.8 13.2
-------- -------- --------
Total operating
expenses............... 55.5 37.5 38.2
-------- -------- --------
Total cost of services
and operating
expenses............... 101.1 84.4 99.0
-------- -------- --------
Pre-tax income (loss)..... (1.1) 15.6 1.0
Income tax expense
(benefit)................ (0.4) 6.0 (0.9)
-------- -------- --------
Net income (loss)......... (0.7)% 9.6% 1.9%
======== ======== ========
</TABLE>
6
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Fiscal Years Ended September 30, 1998, 1997 and 1996
Revenues
The Company's revenues increased to $245.3 million in fiscal 1998, up 57%
from $156.4 million in fiscal 1997, which was up from 150% from $62.5 million
in fiscal 1996. Transaction revenues increased to $162.1 million in fiscal
1998, up 48% from $109.7 million in fiscal 1997, which was up 148% from $44.2
million in fiscal 1996. Transaction revenues consist of commission revenues and
payments based on order flow. Commission revenues increased to $136.3 million,
up 64% from $82.9 million in fiscal 1997, which was up 153% from $32.8 million
in fiscal 1996. Transactions for fiscal 1998 totaled 7.0 million or an average
of 27,600 transactions per day. This is an increase of 68% over the average
daily transaction volume of 16,400 in fiscal 1997, which was up 169% from 6,100
in fiscal 1996. Average commissions per transaction declined to $19.58 in
fiscal 1998 from $20.00 in fiscal 1997 and $20.82 in fiscal 1996, due primarily
to a change in product mix and the lowering of commissions on listed market
orders from $19.95 to $14.95 in February 1996. Payments for order flow
decreased to $25.8 million in fiscal 1998, down 4% from $26.8 million in fiscal
1997, which had increased 135% from $11.4 million in fiscal 1996. The decrease
in payments for order flow is reflective of a trend that the Company expects to
continue as a result of the implementation by the SEC of new order handling
rules in January 1997, the outcome of which was that the bid/ask spread was
reduced thereby reducing market maker margins and limiting their ability to pay
for order flow, and the loss of Roundtable earnings, which ended when
Roundtable was reorganized as Knight/Trimark, Inc. and went public in July 1998
(see Note 5 of the Supplemental Consolidated Financial Statements). Until its
initial public offering, Knight/Trimark would allocate a portion of its
earnings to its owners, including the Company, based on what percentage its
owners contributed to Knight/Trimark's total order flow. The Company previously
recorded the amounts it received under this allocation as payment for order
flow revenue.
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. Net interest revenues
increased to $56.0 million in fiscal 1998, up 122% from $25.3 million in fiscal
1997, which was up 425% from $4.8 million in fiscal 1996. This increase was due
primarily to growth in customer accounts and the opportunity that being self-
clearing has given the Company to manage interest rates. This increase was also
a result of average customer margin debit balances increasing 70% to
$925 million, average customer credit balances increasing 12% to $244 million,
average money market fund balances increasing 95% to $1.4 billion, and an
increase in investment securities from fiscal 1997 to fiscal 1998.
International revenues of $7.0 million represent international licensing
fees and ongoing royalties from agreements signed as part of E*TRADE's
continued international expansion effort. International alliances signed during
this fiscal year cover a number of countries in Europe and Asia. These
agreements grant the licensees the exclusive right to use E*TRADE's technology
and offer online investing services under the E*TRADE name. In addition, the
Company has established joint ventures with strategic partners in Japan and the
U.K. E*TRADE's global network will extend to 32 countries and territories when
fully implemented. These agreements provide that the Company will receive
royalties based upon their transaction revenues. International revenues were
$4.0 million in fiscal 1997, from licensing fees attributable to the Company's
agreements with VERSUS in Canada and Nova Pacific in Australia. Prior to fiscal
1997, there were no international revenues. The Company may, from time to time,
seek to enter into similar licensing agreements with others as part of its
international expansion strategy. There can be no assurance that any such
future agreements will be consummated or that the terms thereof will be
comparable to those of the aforementioned agreements or that the recognition of
any licensing fees will occur during the period in which an arrangement is
consummated.
Other revenues increased to $20.2 million in fiscal 1998, up 15% from $17.5
million in fiscal 1997, which was up 29% from $13.5 million in fiscal 1996.
Other revenues increased primarily due to equity earnings from the Company's
investment in Roundtable, broker-related fees for services, new revenue streams
from
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OptionsLink, growth in ShareData, Inc. licensing revenue, and increased
revenues from mutual funds and advertising on the Company's Web site. As a
result of the Knight/Trimark initial public offering, the Company will no
longer recognize any equity income from the Company's investment in Roundtable
in future quarters (see Note 5 of the Supplemental Consolidated Financial
Statements).
Cost of Services
Total cost of services increased to $111.9 million in fiscal 1998, up 52%
from $73.4 million in fiscal 1997, which was up 93% from $38.0 million in
fiscal 1996. Cost of services includes expenses related to the Company's
clearing operations and customer service activities, system maintenance and
communication expenses, and clearing fees paid to the Company's former clearing
broker. Cost of services as a percentage of total transaction revenues was 69%
in fiscal 1998 compared to 67% in fiscal 1997 and 86% in fiscal 1996. Included
in total cost of services for fiscal 1997 was a charge of $4.3 million, which
resulted from a clerical oversight connected with the Company's failure to
timely renew its registration as a broker-dealer in the state of Ohio. Included
in total cost of services in fiscal 1996 were self-clearing start-up costs of
$2.2 million. Cost of services, exclusive of the registration charge and self-
clearing start-up costs, increased to $111.8 million in fiscal 1998, up 62%
from $69.0 million in fiscal 1997, which was up 93% from $35.8 million in
fiscal 1996. 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 technology
centers in Palo Alto and Rancho Cordova, California.
Operating Expenses
Selling and marketing expenses increased to $71.4 million in fiscal 1998, up
154% from $28.2 million in fiscal 1997, which was up 157% from $10.9 million in
fiscal 1996. This increase reflects expenditures for advertising placements,
creative development and collateral materials resulting from a variety of
advertising campaigns 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 in fiscal 1999.
Technology development expenses increased to $33.7 million in fiscal 1998,
up 149% from $13.5 million in fiscal 1997, which was up 188% from $4.7 million
in fiscal 1996. The increased level of expenses was incurred to enhance the
Company's existing product offerings, including maintenance of the Company's
Web site, development efforts related to the launch of Destination E*TRADE and
proprietary Stateless Architecture SM, and reflects the Company's continuing
commitment to invest in new products and technologies.
General and administrative expenses increased to $31.0 million in fiscal
1998, up 84% from $16.8 million in fiscal 1997, which was up 105% from $8.2
million in fiscal 1996. This increase is the result of personnel additions, the
development of administrative functions resulting from the overall growth in
the Company, acquisition costs and the costs associated with the opening of a
new facility in Alpharetta, Georgia.
Income Tax Expense (Benefit)
Income tax expense (benefit) represents the provision for federal and state
income taxes at an effective rate of (34.5%), 38.5% and (90.7%) for fiscal
1998, 1997 and 1996, respectively. Prior to its merger with the Company,
ShareData, Inc. was a Subchapter S corporation and was not subject to federal
and state corporate income taxes. Additionally, the fiscal 1998 rate reflects
expected tax benefits from tax-exempt interest income and certain nondeductible
acquisition costs.
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.
If not corrected, these computer applications could fail or
8
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create erroneous results by or at the year 2000. The Company utilizes, and is
dependent 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 which 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. During the first quarter of fiscal 1998, the Company
initiated a review and assessment of all hardware and software to evaluate
whether it will function properly in the year 2000 without material errors or
interruptions.
The Company believes that all year 2000 issues revealed as a result of that
evaluation to date can be remedied in a timely manner, and therefore are not
expected to create a material risk of disruption of operations. With respect to
outside vendors, those vendors that have been contacted have indicated that
their hardware or software is or will be year 2000 compatible in time frames
that meet regulatory requirements. Evaluation of these issues is continuing and
there is a risk that other problems, not presently known to the Company, will
be discovered which 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 may be
discovered. Any inability to remediate such issues in a timely manner could
cause a material disruption of the Company's business. 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 online and
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.
These combining factors, while not quantified, could have a material adverse
impact on the Company's financial results.
Because systems critical to the Company's functioning other than its
computer systems may be affected by the century change, the Company's year 2000
efforts also encompass facilities and equipment which rely on date-dependent
technology, such as, building equipment that contains embedded technology and
the Company's third-party providers.
At this time, it does not appear that the costs of addressing year 2000
issues will have a material adverse impact on the Company's financial position.
However, in the event that the Company and third parties upon which it relies
are unable to address these issues in a timely manner, it could result in a
material financial risk to the Company.
Status of Year 2000 Efforts
The Company's year 2000 efforts address all computer systems, equipment and
business partner relationships considered essential to the Company's ability to
conduct its business. The objective of the Company's year 2000 project is 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 are rated for risk and are prioritized
for conversion or replacement according to their impact on core business
operations. The Company's year 2000 project follows a structured approach in
analyzing and mitigating year 2000 issues. This approach consists of six
phases: awareness, assessment, remediation, validation, implementation and
industry-wide testing. The work associated with each phase may be performed
simultaneously with other phases of the project, depending on the nature of the
work to be performed and the technology and business requirements of the
specific business unit. For example, awareness is an ongoing effort and occurs
in each phase. As part of this project, the Company reviews its vendor
relationships (suppliers, alliances and third-party providers) in an attempt to
assess their ability to meet the year 2000 challenge. In addition, this plan
seeks to ensure that all of the Company's business partners and service
providers are also year 2000 ready. In addition, written contingency plans are
being developed for all mission critical systems and many non-critical systems
to address any unexpected year 2000 failures. However, there can be no
assurance that contingency plans will adequately address all year 2000
failures.
9
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Currently, the Company's primary focus is the completion of remediation and
testing, and on-going contingency planning and vendor management efforts.
However, the Company is continuing to assess the impact of year 2000 issues on
its products, internal information systems and third-party vendor relations.
The Company has begun, and in many cases completed, corrective efforts in these
areas. The Company does not anticipate that addressing year 2000 issues for its
internal information systems and current and future products will have a
material impact on its operations or financial results. However, there can be
no assurance that these costs will not be greater than anticipated, or that
corrective actions undertaken will be completed before year 2000 issues may
arise.
In March 1999, the Company completed its assessment phase on mission
critical systems including a significant amount of the implementation and
testing. The Company's primary focus remains on the successful remediation and
testing of all critical systems, including systems owned by third parties.
Additional focus will be placed on non-critical systems and written contingency
plans in the later half of the third quarter of fiscal 1999. The Company
anticipates that work on the awareness, contingency planning, and vendor
management phases of the project will continue through the century change.
The success of the Company's year 2000 efforts depends in part on the
adequacy of compliance by vendors with their representations concerning their
systems, and on parallel efforts being undertaken by vendors and other third
parties with which the Company's systems interact and therefore, the Company is
taking steps to determine the status of critical third parties' year 2000
compatibility. The Company has implemented a vendor management program.
Activities include creating an inventory of vendors, inquiring directly as to
the status of vendors' year 2000 efforts, and continuing contacts with vendors
to monitor the progress of vendors who may not yet be year 2000 capable. If
these suppliers 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. The Company is still
assessing the effect year 2000 issues will have on its suppliers and at this
time, cannot determine the impact it will have. There can be no assurance that
all third parties will provide accurate and complete information or that all
their systems will be fully year 2000 capable. Third parties' year 2000
processing failures may have a material adverse impact on the Company's systems
and operations.
As the year 2000 project continues, the Company may discover additional year
2000 issues, may not be able to develop, implement, or test remediation or
contingency plans, or may find that the costs of these activities exceed
current expectations and become material. In many cases, the Company is relying
on assurances from suppliers that new and upgraded information systems and
other products will be year 2000 capable. The Company plans to test such third-
party products, but cannot be sure that its tests will be adequate or that, if
problems are identified, they will be addressed by the supplier in a timely and
satisfactory way.
Because the Company uses a variety of information systems and has additional
systems embedded in its operations and infrastructure, the Company cannot be
sure that all of its systems will work together in a year 2000-capable fashion.
Furthermore, the Company cannot be sure that it will not suffer business
interruptions, either because of its own year 2000 issues or those of its
customers or suppliers whose year 2000 issues may make it difficult or
impossible for them to fulfill their commitments to the Company. If the Company
fails to satisfactorily resolve year 2000 issues related to its products in a
timely manner, it could be exposed to liability to third parties.
The Company is continuing to evaluate year 2000-related risks and corrective
actions. However, the risks associated with the year 2000 may be pervasive and
complex; they can be difficult to identify and to address, and can result in
material adverse consequences to the Company. Even if the Company, in a timely
manner, completes all of its assessments, identifies and tests remediation
plans believed to be adequate, and develops contingency plans believed to be
adequate, some issues may not be identified or corrected in time to prevent
material adverse consequences to the Company.
10
<PAGE>
The Company's plan may also be affected by regulatory changes, changes in
industry customs and practices, and significant systems modifications unrelated
to the year 2000 project including upgrades and additions to capacity, and the
cost and continued availability of qualified personnel and other resources.
The Company has spent approximately $1.8 million in fiscal 1998 and
currently estimates that it will spend approximately an additional $5 million
to ascertain that its core computer systems and those of its vendors are year
2000 capable. These expenditures will consist primarily of compensation for
information technology employees and contractors dedicated to this project and
related hardware and software costs. This estimate excludes the time that may
be spent by management and administrative staff in guiding and assisting the
information technology effort described above or for making systems other than
core brokerage computer systems year 2000 capable. The Company expects to fund
all year 2000 related costs through operating cash flows. These costs are not
expected to result in increased information technology expenditures because
they will be funded through a reallocation of the Company's overall development
spending. In accordance with generally accepted accounting principles, such
expenditures will be expensed as incurred.
Variability of Results
The Company expects to experience significant fluctuations in future
quarterly operating results that may be caused by many factors, including the
following: the timing of introductions or enhancements to online investing
services and products by the Company or its competitors; market acceptance of
online investing services and products; the pace of development of the market
for online commerce; changes in trading volume in securities markets; trends in
securities markets; domestic and international regulation of the brokerage
industry; changes in pricing policies by the Company or its 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; changes in the level of operating expenses
to support projected growth; and general economic conditions.
Because of the foregoing factors, in addition to other factors that affect
the Company's operating results and financial position, investors should not
consider past financial performance or management's expectations a reliable
indicator of future performance, and not use historical trends to anticipate
results or trends in future periods. In that regard, results of operations and
financial condition could be adversely affected by a number of factors in
addition to those discussed above, including overall economic conditions and
lower than expected demand. Further, the Company's stock price is subject to
volatility. Any of the factors discussed above could have an adverse effect on
the Company's stock price. In addition, the Company's stock price could be
adversely affected if the Company's revenues or earnings in any quarter fail to
meet the investment community's expectations, or if there are broader, negative
market trends. The Company does not undertake an obligation to update its
forward-looking statements or risk factors to reflect future events or
circumstances.
Liquidity and Capital Resources
In August 1996, the Company completed an initial public offering of its
Common Stock, resulting in net proceeds to the Company of approximately $46.4
million.
In August 1997, the Company completed a secondary public offering of
29,220,000 shares of the Company's Common Stock at a price of $6.88 per share.
The proceeds to the Company from the offering, net of underwriting discounts
and offering expenses of $14.8 million, were $188.8 million. The Company also
has financed its activities through the private placement of Preferred Stock
and, to a lesser extent, equipment financing.
In July 1998, the Company entered into an agreement to issue and sell
62,600,000 shares of its common stock to SOFTBANK CORP., a Japanese
corporation, for an aggregate purchase price of $400 million. This investment
represents a minority interest ownership of approximately 27.6% in the Company
as of September 30, 1998.
11
<PAGE>
In July 1996, the Company obtained financing facilities totaling $100
million, to be collateralized by customer securities. There were no borrowings
outstanding under these lines at September 30, 1998. At September 30, 1997,
$9.4 million was outstanding under these lines, which was repaid on October 1,
1997. In addition, the Company has entered into numerous agreements with other
broker-dealers to provide financing under the Company's stock loan program.
The Company currently anticipates that its available cash resources and
credit facilities 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 $30.1 million in fiscal 1998,
primarily as a result of increases in brokerage-related assets in excess of
related liabilities of $81.5 million, offset in part by depreciation and
amortization of $12.6 million and increases in accounts payable, accrued and
other liabilities in excess of other assets of $41.5 million. Cash used in
operating activities in fiscal 1997 and 1996 was $8.1 million and $6.8 million,
respectively. Such amounts primarily reflect net income for the respective
periods, increases in brokerage-related assets in excess of related
liabilities, and in fiscal 1997, the impact of depreciation and amortization
and increases in accounts payable, accrued and other liabilities in excess of
other assets.
Cash used in investing activities was $381.0 million in fiscal 1998, $174.6
million in fiscal 1997 and $46.4 million in fiscal 1996. In fiscal 1998, cash
used in investing activities reflects the investment of proceeds from the
common stock issuance to SOFTBANK CORP., investments in several companies and
joint ventures, and property and equipment purchases. Cash used in investing
activities in fiscal 1997 and 1996 primarily represent the investment of the
proceeds from the Company's secondary public offering of Common Stock in August
1997 and initial public offering of Common Stock in August 1996. Additionally,
the Company made ongoing investments in its technological infrastructure and
the second technology center in Rancho Cordova, and in fiscal 1997, a
relocation loan to the Company's Chief Executive Officer (see Note 6 of the
Supplemental Consolidated Financial Statements).
Cash provided by financing activities was $409.7 million in fiscal 1998,
compared with $190.2 million in fiscal 1997. In fiscal 1998, cash provided by
financing activities primarily consisted of $400 million in proceeds from the
common stock issuance to SOFTBANK CORP. and in fiscal 1997 the net proceeds
from the Company's secondary public offering. Cash provided by financing
activities in fiscal 1996 of $58.1 million reflects net proceeds from the
Company's initial public offering of Common Stock in August 1996 and private
sales of Preferred Stock.
12
<PAGE>
The Company expects that it will incur approximately $75 million of capital
expenditures for the 12 months ended September 30, 1999.
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 and equity security price
risk. The Company does not have derivative financial instruments for
speculative or trading purposes.
Interest Rate Sensitivity
The Company maintains a short-term investment portfolio consisting mainly of
income securities with an average maturity of less than two years. These
available-for-sale securities are subject to interest rate risk and will fall
in value if market interest rates increase. If market interest rates were to
increase immediately and uniformly by 10 percent in levels at September 30,
1998, the fair value of the portfolio would decline by an immaterial amount.
The Company has the ability to hold its fixed income investments until
maturity, and therefore the Company would not expect its operating results or
cash flows to be affected to any significant degree by the effect of a sudden
change in market interest rates on its securities portfolio.
Equity Price Risk
The Company holds a small portfolio of marketable-equity traded securities
that are subject to market price volatility. Equity price fluctuations of plus
or minus 15 percent would not have a material impact on the Company.
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.
13
<PAGE>
Supplemental Annual Financial Statements and Supplementary Data
Index to Supplemental Consolidated Financial Statements
<TABLE>
<CAPTION>
Page
----
<S> <C>
Independent Auditors' Report.......................................... 15
Supplemental Consolidated Balance Sheets as of September 30, 1998 and
1997................................................................. 16
Supplemental Consolidated Statements of Operations for the Years Ended
September 30, 1998, 1997 and 1996.................................... 17
Supplemental Consolidated Statements of Shareowners' Equity for the
Years Ended September 30, 1998, 1997 and 1996........................ 18
Supplemental Consolidated Statements of Cash Flows for the Years Ended
September 30, 1998, 1997 and 1996.................................... 19
Notes to Supplemental Consolidated Financial Statements............... 20
</TABLE>
14
<PAGE>
Independent Auditors' Report
To the Board of Directors and Shareowners of
E*TRADE Group, Inc.:
We have audited the accompanying supplemental consolidated balance sheets of
E*TRADE Group, Inc. and subsidiaries (the "Company") as of September 30, 1998
and 1997, and the related supplemental consolidated statements of operations,
shareowners' equity and cash flows for each of the three years in the period
ended September 30, 1998. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits. The supplemental consolidated
financial statements give retroactive effect to the merger of ClearStation,
Inc. with and into E*TRADE Group, Inc. on April 30, 1999, which has been
accounted for as a pooling-of-interests as described in Note 15 to the
supplemental consolidated financial statements. Generally accepted accounting
principles proscribe giving effect to a consummated business combination
accounted for by the pooling-of-interests method in financial statements that
do not include the date of consummation. These financial statements do not
extend through the date of consummation; however, they will become the
historical consolidated financial statements of the Company after financial
statements covering the date of consummation of the business combination have
been issued.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, such supplemental consolidated financial statements present
fairly, in all material respects, the financial position of E*TRADE Group, Inc.
and subsidiaries at September 30, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
September 30, 1998 in conformity with generally accepted accounting principles
applicable after the financial statements are issued for a period which
includes the date of consummation of the business combination.
DELOITTE & TOUCHE LLP
San Jose, California
November 23, 1998
(June 1, 1999 as to Note 15)
15
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Supplemental Consolidated Balance Sheets
(in thousands, except share amounts)
<TABLE>
<CAPTION>
September 30,
-------------------
1998 1997
---------- --------
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents...................................... $ 21,890 $ 23,234
Cash and investments required to be segregated under
Federal or other regulations............................. 5,000 15,001
Investment securities..................................... 502,534 191,958
Brokerage receivables--net................................ 1,310,235 724,365
Other assets.............................................. 11,710 6,970
---------- --------
Total current assets..................................... 1,851,369 961,528
Property and equipment--net................................ 48,524 19,995
Investments................................................ 58,342 5,519
Related party receivables.................................. 3,719 3,259
Other assets............................................... 7,491 5,121
---------- --------
Total assets........................................... $1,969,445 $995,422
========== ========
LIABILITIES AND SHAREOWNERS' EQUITY
Liabilities:
Brokerage payables........................................ $1,184,917 $681,106
Bank loan payable......................................... -- 9,400
Accounts payable, accrued liabilities and other........... 74,992 21,542
---------- --------
Total liabilities........................................ 1,259,909 712,048
---------- --------
Commitments and contingencies (Notes 12 and 13)
Shareowners' equity:
Common stock, $.01 par: shares authorized, 300,000,000;
shares issued and outstanding: 1998, 227,077,074; 1997,
159,799,072.............................................. 2,271 1,598
Additional paid-in capital................................ 680,319 265,754
Retained earnings......................................... 14,210 16,022
Cumulative translation adjustment......................... 210 --
Unrealized gain on available-for-securities, net of tax... 12,526 --
---------- --------
Total shareowners' equity................................ 709,536 283,374
---------- --------
Total liabilities and shareowners' equity.............. $1,969,445 $995,422
========== ========
</TABLE>
See notes to supplemental consolidated financial statements.
16
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Supplemental Consolidated Statements of Operations
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Years Ended September 30,
--------------------------
1998 1997 1996
-------- -------- -------
<S> <C> <C> <C>
Revenues:
Transaction revenues............................. $162,097 $109,659 $44,178
Interest--net of interest expense (A)............ 56,020 25,265 4,813
International.................................... 7,031 4,000 --
Other............................................ 20,169 17,471 13,529
-------- -------- -------
Net revenues.................................... 245,317 156,395 62,520
-------- -------- -------
Cost of services.................................. 111,888 73,381 38,027
-------- -------- -------
Operating expenses:
Selling and marketing............................ 71,447 28,160 10,944
Technology development........................... 33,699 13,547 4,699
General and administrative....................... 31,048 16,847 8,238
-------- -------- -------
Total operating expenses........................ 136,194 58,554 23,881
-------- -------- -------
Total cost of services and operating expenses... 248,082 131,935 61,908
-------- -------- -------
Pre-tax income (loss)............................. (2,765) 24,460 612
Income tax expense (benefit)...................... (953) 9,425 (555)
-------- -------- -------
Net income (loss)................................. $ (1,812) $ 15,035 $ 1,167
======== ======== =======
Net income (loss) per share:
Basic............................................ $ (0.01) $ 0.12 $ 0.01
======== ======== =======
Diluted.......................................... $ (0.01) $ 0.10 $ 0.01
======== ======== =======
Shares used in computation of net income (loss)
per share:
Basic............................................ 169,791 129,408 78,564
Diluted.......................................... 169,791 143,496 119,728
</TABLE>
- --------
(A) Interest is presented net of interest expense of $39,714, $14,909 and
$2,224 for fiscal years ended September 30, 1998, 1997 and 1996,
respectively.
See notes to supplemental consolidated financial statements.
17
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Supplemental Consolidated Statements of Shareowners' Equity
(in thousands)
<TABLE>
<CAPTION>
Unrealized
gain on
Preferred available-
Stock Common Stock Additional Cumulative for-sale Total
------------- --------------- paid-in Retained translation securities, shareowners'
Shares Amount Shares Amount capital earnings adjustment net of tax equity
------ ------ ------- ------ ---------- -------- ----------- ----------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE, OCTOBER 1,
1995................... 100 $ 1 64,740 $ 647 $ 9,457 $ 2,243 $ -- $ -- $ 12,348
Net income.............. 1,167 1,167
Issuance of Series B
preferred stock, net of
issuance costs......... 20 2,837 2,837
Issuance of Series C
preferred stock, net of
issuance costs......... 11 8,950 8,950
Initial public
offering............... 20,108 201 46,201 46,402
Conversion of preferred
stock.................. (131) (1) 31,564 316 (315) --
Exercise of stock
warrants, including tax
benefit................ 1,612 16 274 290
Exercise of stock
options, including tax
benefit................ 5,404 54 465 519
Issuance of common stock
for services........... 28 20 20
Cash dividends--
ShareData.............. (518) (518)
Other employee stock
transactions........... (68) (39) (39)
---- --- ------- ------ -------- ------- ---- ------- --------
BALANCE, SEPTEMBER 30,
1996................... -- -- 123,388 1,234 67,850 2,892 -- -- 71,976
Net income.............. 15,035 15,035
Adjustment for ShareData
earnings............... (746) (746)
Issuance of common
stock, net of issuance
costs.................. 29,220 292 188,533 188,825
Exercise of stock
options, including tax
benefit................ 7,068 71 8,521 8,592
Employee Stock Purchase
Plan................... 296 3 685 688
Cash dividends--
ShareData.............. (1,159) (1,159)
Other employee stock
transactions........... (173) (2) 165 163
---- --- ------- ------ -------- ------- ---- ------- --------
BALANCE, SEPTEMBER 30,
1997................... -- -- 159,799 1,598 265,754 16,022 -- -- 283,374
Net loss................ (1,812) (1,812)
Issuance of common
stock, net of issuance
costs.................. 63,264 633 398,825 399,458
Exercise of stock
options, including tax
benefit................ 3,549 36 14,391 14,427
Employee Stock Purchase
Plan................... 416 4 1,190 1,194
Foreign currency
translation............ 210 210
Unrealized gain on
available-for-sale
securities, net of
tax.................... 12,526 12,526
Other employee stock
transactions........... 49 159 159
---- --- ------- ------ -------- ------- ---- ------- --------
BALANCE, SEPTEMBER 30,
1998................... -- $-- 227,077 $2,271 $680,319 $14,210 $210 $12,526 $709,536
==== === ======= ====== ======== ======= ==== ======= ========
</TABLE>
See notes to supplemental consolidated financial statements.
18
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Supplemental Consolidated Statements of Cash Flows
(in thousands)
<TABLE>
<CAPTION>
Years Ended September 30,
---------------------------------
1998 1997 1996
----------- --------- ---------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss).......................... $ (1,812) $ 15,035 $ 1,167
Non-cash items included in net income
(loss):
Deferred income taxes..................... 573 1,704 (487)
Depreciation and amortization............. 12,553 3,793 901
Income from equity investment............. (1,198) (1,785) (228)
Other..................................... (219) (179) 107
Net effect of changes in brokerage related
assets and liabilities:
Cash and investments required to be
segregated under Federal or other
regulations.............................. 10,001 20,499 (35,500)
Brokerage receivables..................... (585,870) (531,137) (191,292)
Brokerage payables........................ 503,811 461,623 219,483
Bank loan payable......................... (9,400) 9,400 --
Other changes, net:
Other assets.............................. (8,269) (1,897) (5,850)
Accounts payable, accrued liabilities and
other.................................... 49,746 14,797 4,937
----------- --------- ---------
Net cash used in operating activities...... (30,084) (8,147) (6,762)
----------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment......... (35,765) (15,742) (9,474)
Purchase of investments.................... (32,278) -- (2,000)
Purchase of investment securities.......... (3,237,731) (993,282) (337,073)
Sale/maturity of investment securities..... 2,924,167 836,877 302,070
Related party transactions................. -- (3,147) --
Acquisition of OptionsLink................. (3,500) -- --
Distributions received from equity
investment................................ 4,108 658 44
----------- --------- ---------
Net cash used in investing activities...... (380,999) (174,636) (46,433)
----------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock, net
of issuance costs......................... 399,458 188,825 46,402
Proceeds from issuance of preferred stock,
net of issuance costs..................... -- -- 11,787
Proceeds from exercise of stock options.... 4,917 1,627 310
Proceeds from exercise of stock warrants... -- -- 113
Proceeds from Employee Stock Purchase
Plan...................................... 1,194 688 --
Proceeds from long-term note payable....... -- -- 2,500
Repayment of long-term note payable........ -- -- (2,500)
Cash dividends--ShareData.................. -- (1,159) (518)
Other...................................... 4,170 180 (28)
----------- --------- ---------
Net cash provided by financing activities.. 409,739 190,161 58,066
----------- --------- ---------
INCREASE (DECREASE) IN CASH AND
EQUIVALENTS............................... (1,344) 7,378 4,871
CASH AND EQUIVALENTS--Beginning of period.. 23,234 15,856 10,985
----------- --------- ---------
CASH AND EQUIVALENTS--End of period........ $ 21,890 $ 23,234 $ 15,856
=========== ========= =========
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest..................... $ 37,714 $ 13,440 $ 2,013
=========== ========= =========
Cash paid for income taxes................. $ -- $ 1,235 $ 1,025
=========== ========= =========
Non-cash financing activities:
Tax benefit on exercise of stock options
and warrants............................. $ 9,430 $ 6,926 $ 352
=========== ========= =========
Unrealized gain on investment securities
and investments.......................... $ 21,156 $ -- $ --
=========== ========= =========
</TABLE>
See notes to supplemental consolidated financial statements.
19
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation--The supplemental 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. The supplemental consolidated financial statements of the Company have
been prepared to give retroactive effect to the acquisition of ShareData, Inc.
("ShareData") in July 1998 and ClearStation, Inc. ("Clear-Station") in April
1999, both of which were accounted for as poolings of interests (see Note 15).
All significant intercompany accounts and transactions have been eliminated.
Transaction Revenues--The Company derives revenues from commissions related
to customer transactions in equity and debt securities, options and, to a
lesser extent, payments from other broker-dealers for order flow. Securities
transactions are recorded on a trade date basis and are executed by independent
broker-dealers. Through June 1996, the Company did not receive or hold
customers' securities or funds. The Company implemented self-clearing
operations and took custody of securities and funds in customer accounts in
July 1996.
Interest, Net of Interest Expense--Prior to July 1996, these amounts
represent the Company's participation in the interest differential on its
customer debit and credit balances through a contractual agreement with its
former clearing broker, and fees on its customer assets invested in money
market accounts. Subsequent to the implementation of self-clearing operations
in July 1996, these amounts 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.
International Revenue--International revenue represents fees from the
licensing of rights which allow foreign licensees to offer on-line investing
services using the E*TRADE brand name in their respective countries and ongoing
royalty payments based on transaction volume.
Other Revenue--Other revenue primarily represents ShareData software
licensing and maintenance fee revenue, broker-related fees for services,
revenues from advertising on the Company's Web site, equity earnings from the
Company's investment in Roundtable until its public offering in July 1998 (see
Note 5), and mutual fund fees.
Foreign Currency Translation--Assets and liabilities of operations outside
of the United States are translated into U.S. dollars using the exchange rate
in effect at each period end. Revenues and expenses are translated at the
average exchange rate during the period. The effects of foreign currency
translation adjustments arising from differences in exchange rates from period
to period are deferred and included as a separate component of shareowners'
equity.
Property and Equipment--Property and equipment are carried at cost and are
depreciated on a straight-line basis over their estimated useful lives,
generally three to seven years. Leasehold improvements are stated at cost and
are amortized over the lesser of their estimated useful lives or the life of
the lease.
Technology Development Costs--Technology development costs are charged to
operations as incurred. Technology development costs include costs incurred in
the development and enhancement of software used in connection with services
provided by the Company that do not otherwise qualify as internally developed
software costs. The cost of internally developed software is capitalized and
included in property and equipment. The costs to develop such software are
capitalized in accordance with Statement of Position 98-1, Accounting for the
Costs of Computer Software Developed or Obtained for Internal Use, and begin
when management
20
<PAGE>
authorizes and commits to funding a project it believes will be completed and
used to perform the functions intended and the conceptual formulation, design
and testing of possible software project alternatives have been completed.
Pilot projects and projects where expected future economic benefits are less
than probable are not capitalized. Internally developed software costs include
the cost of software tools and licenses used in the development of the
Company's systems, as well as payroll and consulting costs. Capitalized costs
totaled $10,210,000, $2,832,000 and $114,000 for the years ended September 30,
1998, 1997 and 1996, respectively.
Completed projects are transferred to property and equipment and are
reported at the lower of unamortized cost less any provision for impairment.
Amortization is based on the straight-line method over the estimated useful
life, generally two to three years. Amortization expense for the years ended
September 30, 1998 and 1997 was $1,715,000 and $69,000, respectively. There was
no amortization expense for the year ended September 30, 1996.
Cash Equivalents--For purposes of reporting cash flows, the Company
considers all highly liquid investments with original maturities of three
months or less (except for amounts required to be segregated under Federal or
other regulations or investment securities designated as available-for-sale) to
be cash equivalents.
Cash and Investments Required to be Segregated Under Federal or Other
Regulations--Cash and investments required to be segregated under Federal or
other regulations consist primarily of government backed securities purchased
under agreements to resell ("Resale Agreements"). Resale Agreements are
accounted for as collateralized financing transactions and are recorded at
their contractual amounts, which approximate fair value.
Investments--Investment securities represent a portfolio of commercial
paper, municipal bonds, corporate bonds, U.S. Government obligations, preferred
stocks and money market funds. Unrealized gains and losses, net of tax, are
computed on the basis of average cost and are included as a separate component
of shareowners' equity. Realized gains and losses and declines in fair-value,
judged to be other than temporary, are included in other revenues. The cost of
securities sold is based on the average cost method and interest earned is
included in interest revenue.
Investments in entities of which the Company owns between 20% and 50% and on
which the Company has the ability to exercise significant influence are
accounted for under the equity method. Other investments are accounted for
using the cost method.
Impairment of Long-Lived Assets--In the event that facts and circumstances
indicate that the carrying value of a long-lived asset, including associated
intangibles, may be impaired, an evaluation of recoverability is performed by
comparing the estimated future undiscounted cash flows associated with the
asset to the asset's carrying amount to determine if a write-down to market
value or discounted cash flow is required.
Estimated Fair-Value of Financial Instruments--The Company believes the
amounts presented for financial instruments on the consolidated balance sheets
consisting of cash equivalents, commercial paper, municipal bonds, corporate
bonds, U.S. Government obligations, preferred stocks, money market funds, and
brokerage receivables and payables to be reasonable estimates of fair-value.
The Company uses available market information as of the balance sheet dates and
appropriate valuation methodologies in deriving amounts reported for financial
instruments.
Stock-Based Compensation--The Company accounts for employee stock-based
compensation using the intrinsic value method of accounting prescribed in
Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued
to Employees. The Company provides pro forma disclosures of net income and
earnings per share as required under SFAS No. 123, Accounting for Stock-Based
Compensation. SFAS No. 123 encourages, but does not require companies to
recognize compensation expense for grants of stock, stock options, and other
equity instruments based on the fair-value method of accounting.
21
<PAGE>
Advertising Costs--Advertising production costs are expensed when the
initial advertisement is run. Costs of communicating advertising are expensed
as the services are received.
Income Taxes--The Company accounts for income taxes in accordance with SFAS
No. 109, Accounting for Income Taxes, which requires the recognition of
deferred tax liabilities and assets at tax rates expected to be in effect when
these balances reverse. Future tax benefits attributable to temporary
differences are recognized to the extent that realization of such benefits is
more likely than not.
Earnings Per Share--The Company has adopted and retroactively applied the
provisions of SFAS No. 128, Earnings per Share, for all periods presented. SFAS
No. 128 requires a dual presentation of basic and diluted EPS. Basic EPS
excludes dilution and is computed by dividing net income by the weighted
average common shares outstanding for the period. Diluted EPS reflects the
potential dilution that could occur if securities or other contracts to issue
common stock were exercised or converted into common stock.
New Accounting Standards-- In June 1997, the Financial Accounting Standards
Board ("FASB") issued SFAS No. 130, Reporting Comprehensive Income. SFAS No.
130 establishes standards for the reporting and display of comprehensive income
and its components in a financial statement that is displayed with the same
prominence as other financial statements. Comprehensive income as defined
includes all changes in equity (net assets) during a period from nonowner
sources. The disclosures prescribed by SFAS No. 130 will be made beginning with
the first quarter of fiscal 1999.
In June 1997, the FASB issued SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information. This statement establishes standards for
reporting information about operating segments in annual financial statements.
It also establishes standards for related disclosures about products and
services, geographic areas, and major customers. The Company is in the process
of reassessing its current business segment reporting to determine if changes
in reporting will be required in adopting this new standard. The disclosures
prescribed by SFAS No. 131 will be adopted in the Company's fiscal 1999 annual
report.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities. The new standard requires companies to
record derivatives on the balance sheet as assets or liabilities, measured at
fair value. Gains or losses resulting from changes in the values of those
derivatives will be reported in the statement of operations or as a deferred
item, depending on the use of the derivatives and whether they qualify for
hedge accounting. The key criterion for hedge accounting is that the derivative
must be highly effective in achieving offsetting changes in fair value or cash
flows of the hedged items during the term of the hedge. The Company plans to
adopt SFAS No. 133 in the first quarter of fiscal 2000 and has not yet
determined the effect, if any, of adopting the new standard.
Use of Estimates--The preparation of the Company's consolidated financial
statements in conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the amounts reported
in the consolidated financial statements and related notes for the periods
presented. Actual results could differ from management's estimates.
Reclassifications--Certain items in these financial statements have been
reclassified to conform to the current period presentation.
2. INVESTMENT SECURITIES
The Company invests in high quality, short-term investments, which it
classifies as available-for-sale. As such, there were no significant
differences between amortized cost and estimated fair value at September 30,
1998 or 1997. Additionally, because investments are short-term and are
generally allowed to mature or contain provisions which provide for resale at
par to the issuer within 12 months, realized gains and losses for the years
ended September 30, 1998, 1997 and 1996 were minimal and there were no
significant changes in net unrealized gains and losses.
22
<PAGE>
The following table presents the estimated fair value breakdown of
investment securities by category (in thousands):
<TABLE>
<CAPTION>
September 30,
-----------------
1998 1997
-------- --------
<S> <C> <C>
Municipal bonds......................................... $358,535 $ 43,904
Commercial paper........................................ 54,925 67,062
U.S. Government obligations............................. 47,102 560
Money market funds...................................... 37,967 61,879
Corporate bonds......................................... 4,005 10,927
Preferred stocks........................................ -- 7,626
-------- --------
Total investment securities........................... $502,534 $191,958
======== ========
</TABLE>
3. BROKERAGE RECEIVABLES AND PAYABLES--NET
Brokerage receivables and payables--net consists of the following (in
thousands):
<TABLE>
<CAPTION>
September 30,
-------------------
1998 1997
---------- --------
<S> <C> <C>
Receivable from customers and non-customers (less
allowance for doubtful accounts of $862 and $435 in
1998 and 1997, respectively)......................... $ 961,305 $655,981
Receivable from brokers, dealers and clearing
organizations:
Net settlement and deposits with clearing
organizations....................................... 14,854 37,198
Deposits paid for securities borrowed................ 328,989 25,584
Securities failed to deliver......................... 728 1,011
Other................................................ 4,359 4,591
---------- --------
Total brokerage receivables--net.................... $1,310,235 $724,365
========== ========
Payable to customers and non-customers................ $ 340,044 $279,348
Payable to brokers, dealers and clearing
organizations:
Deposits received for securities loaned.............. 839,422 398,007
Securities failed to receive......................... 1,222 1,304
Other................................................ 4,229 2,447
---------- --------
Total brokerage payables............................ $1,184,917 $681,106
========== ========
</TABLE>
Receivable from and payable to brokers, dealers and clearing organizations
result from the Company's brokerage activities. Receivable from customers
represents credit extended to customers to finance their purchases of
securities on margin. At September 30, 1998 and 1997, credit extended to
customers with respect to margin accounts was $956 million and $678 million,
respectively. Securities owned by 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 represents free credit
balances and other customer funds pending completion of securities
transactions. The Company pays interest on certain customer credit balances.
23
<PAGE>
4. PROPERTY AND EQUIPMENT--NET
Property and equipment--net consists of the following (in thousands):
<TABLE>
<CAPTION>
September 30,
---------------
1998 1997
------- -------
<S> <C> <C>
Equipment................................................. $23,510 $12,737
Leasehold improvements.................................... 14,701 6,525
Software.................................................. 25,460 5,664
Furniture and fixtures.................................... 3,588 1,251
------- -------
67,259 26,177
Less accumulated depreciation and amortization............ 18,735 6,182
------- -------
Total property and equipment-net........................ $48,524 $19,995
======= =======
</TABLE>
5. INVESTMENTS
Investments consist of the following (in thousands):
<TABLE>
<CAPTION>
September 30,
--------------
1998 1997
------- ------
<S> <C> <C>
Knight/Trimark.............................................. $21,173 $3,509
Joint ventures.............................................. 10,153 --
KAP Group................................................... 2,000 2,000
Critical Path............................................... 15,250 --
Other investments........................................... 9,766 10
------- ------
Total investments......................................... $58,342 $5,519
======= ======
</TABLE>
Through July 7, 1998, the Company owned a 4.47% interest in Roundtable
Partners LLC ("Roundtable"), a company formed to hold equity interests in
securities trading and market making companies and which made distributions to
its owners of a significant portion of its earnings. The Company had accounted
for its investment in Roundtable under the equity method since its inception.
On July 8, 1998, Roundtable was reorganized into a corporation known as
Knight/Trimark Group, Inc. ("Knight/Trimark") coincident with an initial public
offering of Knight/Trimark common stock. Knight/Trimark does not currently
intend to pay dividends. As a result of this reorganization, all of the
Company's ownership interest in Roundtable was converted into 2,566,432 shares
of common stock of Knight/Trimark, which represents 4.99% of the issued and
outstanding shares of common stock of Knight/Trimark. Effective July 8, 1998,
the Company accounts for its investment in Knight/Trimark as a long-term
marketable equity security held available-for-sale under the provisions of SFAS
No. 115, Accounting for Certain Investments in Debt and Equity Securities.
Accordingly, this investment is carried at fair value at September 30, 1998,
with unrealized gains of $12,340,000, net of tax of $8,505,000, reported as a
separate component of shareowners' equity. The Company's investment in
Knight/Trimark is subject to a sale restriction agreement with the underwriters
of the initial public offering, which expires in January 1999.
In June 1998, the Company entered into a joint venture agreement with
SOFTBANK CORP. to form E*TRADE Japan to provide online securities trading
services to residents of Japan. As part of the transaction, the Company
invested approximately $8 million in exchange for a 42% ownership position in
the joint venture. Additionally, the Company entered into a joint venture
agreement with Electronic Share Information Ltd. ("ESI") to form E*TRADE UK.
ESI is a leading provider of Internet financial services in the UK. The Company
accounts for its investments in the joint ventures under the equity method.
In June 1997, the Company invested $2,000,000 in KAP Group, LLC ("KAP
Group"), by means of a promissory note in the principal amount of $1,806,000
and through the purchase of a warrant for $194,000.
24
<PAGE>
The note bears interest at 7% per annum which, together with the principal
amount, is due and payable in July 2002. The warrant gives the Company the
right to purchase shares of KAP Group. KAP Group has invested substantially all
of its assets in another entity, which was formed for the purpose of engaging
in electronic options trading. KAP Group investors include the Company's
Chairman of the Board of Directors and others.
The Company has also made investments in non-public, venture capital-backed
high technology companies with which it does business and which provide
Internet-based services. These investments include: Critical Path, a leading
provider of outsourced email services and infrastructure for Web portals,
Internet service providers, Web hosting companies, and corporations; Digital
Island, a global IP applications network for the digital economy; and Third Age
Media, producers of ThirdAge.com, a comprehensive source of content, community
and commerce on the Web for active older adults. These investments each
represent less than 20% of the outstanding shares of these companies and are
accounted for under the cost method. At September 30, 1998, the Company
believes that the fair value of these investments approximates their carrying
basis.
6. RELATED-PARTY RECEIVABLES
During fiscal 1997, the Company made a relocation loan to Mr. Christos
Cotsakos, its Chief Executive Officer and a Director, in the aggregate
principal amount of $3,147,000. The proceeds of this loan were used to fund the
purchase by Mr. Cotsakos of a personal residence in the Silicon Valley area.
The relocation loan accrues interest at the rate of 7% per annum which,
together with the principal amount, is due and payable in November 1999.
Accrued interest totaled $420,000 and $200,000 as of September 30, 1998 and
1997, respectively. The loan is required to be collateralized by a combination
of assets, including the residence purchased. The due date of the relocation
loan is subject to acceleration upon the occurrence of certain events including
the voluntary cessation of employment with the Company by Mr. Cotsakos.
7. LONG-TERM NOTES PAYABLE AND SHORT-TERM FUNDING
The principal source of financing for E*TRADE Securities' margin lending is
cash balances in customers' accounts and financing obtained from other broker-
dealers through E*TRADE Securities' stock loan program. E*TRADE Securities also
maintains committed lines of financing with banks totaling $100 million to
finance margin lending. There were no borrowings outstanding under these lines
at September 30, 1998. At September 30, 1997, $9,400,000 was outstanding under
these lines, bearing interest at 6.875% per annum, which was repaid on October
1, 1997; such amount is recorded as bank loan payable in the consolidated
balance sheet.
8. INCOME TAXES
The components of income tax expense (benefit) are as follows (in
thousands):
<TABLE>
<CAPTION>
Years Ended September 30,
-----------------------------
1998 1997 1996
--------- -------- --------
<S> <C> <C> <C>
Current:
Federal.................................... $ (1,173) $ 5,499 $ (66)
State...................................... (353) 2,222 (2)
--------- -------- -------
Total current............................. (1,526) 7,721 (68)
--------- -------- -------
Deferred:
Federal.................................... (33) 1,727 (441)
State...................................... 606 (23) (46)
--------- -------- -------
Total deferred............................ 573 1,704 (487)
--------- -------- -------
Total tax expense (benefit)................. $ (953) $ 9,425 $ (555)
========= ======== =======
</TABLE>
25
<PAGE>
Deferred income taxes are recorded when revenues and expenses are recognized
in different periods for financial statement and tax return purposes. The
temporary differences and tax carryforwards that created deferred tax assets
(liabilities) are as follows (in thousands):
<TABLE>
<CAPTION>
September 30,
---------------
1998 1997
------- ------
<S> <C> <C>
Deferred tax assets:
Reserves and allowances................................ $ 599 $ 412
Net operating loss carryforwards....................... 2,189 487
Depreciation and amortization.......................... 828 --
Deferred compensation.................................. 999 533
Other.................................................. 685 164
------- ------
Total deferred tax assets............................. 5,300 1,596
------- ------
Deferred tax liabilities:
Depreciation and amortization.......................... -- (2,292)
Internally developed software.......................... (5,783) --
Other.................................................. (636) (235)
------- ------
Total deferred tax liabilities........................ (6,419) (2,527)
Valuation allowance .................................... (385) --
------- ------
Net deferred tax liability included in other
liabilities............................................ $(1,504) $ (931)
======= ======
</TABLE>
No valuation allowance has been provided for the deferred tax assets at
September 30, 1998 and 1997 as full realization of these assets is expected,
other than for the preacquisition tax loss carry forwards of ClearStation,
which are subject to certain limitations.
The effective tax rates differed from the federal statutory rates as
follows:
<TABLE>
<CAPTION>
Years Ended September 30,
------------------------------
1998 1997 1996
--------- -------- ---------
<S> <C> <C> <C>
Income tax expense (benefit) at federal
statutory rate........................ (35.0)% 35.0% 35.0%
State income taxes, net of federal tax
benefit............................... 10.2 6.2 2.3
Income of Subchapter S corporation..... 65.6 (1.9) (130.8)
Nondeductible acquisition costs........ 24.5 -- --
Preacquisition losses of ClearStation
...................................... 22.7 -- --
Tax-exempt interest.................... (137.4) -- --
Other.................................. 14.9 (0.8) 2.8
--------- ------- ---------
Effective tax rate..................... (34.5)% 38.5% (90.7)%
========= ======= =========
</TABLE>
Prior to being acquired by the Company, ShareData was a Subchapter S
corporation and was not subject to federal and state corporate income taxes.
9. SHAREOWNERS' EQUITY
Stock Issuances
In April 1996, the Company sold 20,336 shares of Series B Preferred Stock
("Series B") to Christos Cotsakos, Chief Executive Officer and a Director, and
affiliates, Richard Braddock, and General Atlantic Partners and affiliates for
$2,847,000 and incurred issuance costs of $10,000. The Company used the
proceeds to provide additional working capital.
In June 1996, the Company sold 11,180 shares of Series C Preferred Stock
("Series C") to SOFTBANK Holdings Inc. for $9,000,000 and incurred issuance
costs of $50,000. The Company used the proceeds to provide additional
regulatory net capital to E*TRADE Securities.
26
<PAGE>
In August 1996, the Company completed an initial public offering of
20,106,200 shares of the Company's common stock at a price of $2.63 per share.
Each outstanding share of Series A, Series B and Series C Preferred Stock was
automatically converted into 240 shares of common stock upon the closing of the
initial public offering. The proceeds to the Company from the offering, net of
underwriting discounts and offering expenses of $6.4 million, were $46.4
million.
In August 1997, the Company completed a secondary public offering of
29,220,000 shares of the Company's common stock at a price of $6.88 per share.
The proceeds to the Company from the offering, net of underwriting discounts
and offering expenses of $14.8 million, were $188.8 million.
In July 1998, the Company entered into an agreement to issue and sell
62,600,000 shares of common stock to SOFTBANK CORP., a Japanese corporation,
for an aggregate purchase price of $400 million.
Stock Option Plans
The Company's stock option plans provide for the granting of nonqualified or
incentive stock options to officers, directors, key employees and consultants
for the purchase of shares of the Company's common stock at a price determined
by the Board of Directors at the date the option is granted. The options are
generally exercisable ratably over a five-year period from the date the option
is granted and expire within ten years from the date of grant.
In July 1996, the shareowners of the Company approved the 1996 Stock
Incentive Plan (the "1996 Plan") and reserved 16,000,000 shares of common stock
for future grants. Following adoption, no additional grants may be made under
any prior plans. The 1996 Plan is divided into three components: the
Discretionary Option Grant Program, the Stock Issuance Program and the
Automatic Option Grant Program. Under the Discretionary Option Grant Program,
options may be granted to purchase shares of common stock at an exercise price
not less than the fair market value of those shares on the grant date to
eligible employees. The Stock Issuance Program allows for individuals to be
issued shares of common stock directly through the purchase of such shares at a
price not less than the fair market value of those shares at the time of
issuance or as a bonus tied to the performance of services. Under the Automatic
Option Grant Program, options are automatically granted at periodic intervals
to eligible non-employee members of the Board of Directors to purchase shares
of common stock at an exercise price equal to the fair market value of those
shares on the grant date.
A summary of stock option activity follows (in thousands):
<TABLE>
<CAPTION>
Weighted
Number Average
of Exercise
Shares Price
------ --------
<S> <C> <C>
Outstanding at September 30, 1995......................... 16,092 $ .11
Granted.................................................. 16,368 $1.30
Exercised................................................ (5,404) $0.05
Canceled................................................. (716) $1.57
------ -----
Outstanding at September 30, 1996......................... 26,340 $0.82
Granted.................................................. 10,840 $5.27
Exercised................................................ (7,068) $0.23
Canceled................................................. (3,992) $1.74
------ -----
Outstanding at September 30, 1997......................... 26,120 $2.75
Granted.................................................. 14,821 $5.73
Exercised................................................ (3,548) $1.41
Canceled................................................. (2,849) $4.27
------ -----
Outstanding at September 30, 1998......................... 34,544 $4.04
====== =====
</TABLE>
27
<PAGE>
On October 22, 1998, the Company implemented an option cancellation /
regrant program pursuant to which employees who held outstanding stock options
with an exercise price in excess of $4.25 per share were able to cancel the
previously issued options and receive the same number of new options at an
exercise price of $4.25, the closing price of the Company's common stock on
October 22, 1998. Each new option has a maximum term of ten years, subject to
earlier termination upon the optionee's cessation of service, and will become
exercisable in a series of four successive equal annual installments over the
optionee's period of continued service with the Company measured from October
22, 1998, the regrant date. Options covering a total of 13,918,136 shares of
the Company's common stock were cancelled and regranted under the program.
<TABLE>
<CAPTION>
September 30,
--------------------
1998 1997 1996
------ ------ ------
<S> <C> <C> <C>
Options available for grant......................... 608 4,852 11,480
Options exercisable (as adjusted for the October 22,
1998 transaction).................................. 6,951 1,880 3,656
Options exercisable weighted average exercise
price.............................................. $ 2.28 $ 1.09 $ 0.29
</TABLE>
The following table summarizes information on outstanding and exercisable
stock options as of September 30, 1998 (as adjusted for the October 22, 1998
transaction):
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
----------------------------------- -----------------------
Weighted
Number Average Weighted Number Weighted
Range of Outstanding Contractual Average Exercisable Average
Exercisable as of 9/30/98 Life Exercise as of 9/30/98 Exercise
Prices (in thousands) (Years) Price (in thousands) Price
- ------------- -------------- ----------- -------- -------------- --------
<S> <C> <C> <C> <C> <C>
$ .07--$ 0.58 7,628 7.09 $0.44 2,299 $0.39
$ .92--$ 2.81 6,036 7.77 $2.20 2,432 $1.97
$2.90--$ 4.44 16,392 9.86 $4.23 268 $3.89
$4.52--$ 5.25 3,164 9.10 $4.75 1,884 $4.55
$5.26--$10.70 1,324 9.18 $6.42 68 $7.08
------ -----
$0.07--$10.70 34,544 8.79 $3.17 6,951 $2.28
====== =====
</TABLE>
Stock Purchase Plan
In July 1996, the shareowners of the Company approved the 1996 Stock
Purchase Plan (the "Purchase Plan"), and reserved 2,600,000 shares of common
stock for sale to employees at a price no less than 85% of the lower of the
fair market value of the common stock at the beginning of the two-year offering
period or the end of each of the six-month purchase periods.
28
<PAGE>
Additional Stock Plan Information
In accordance with SFAS No. 123, Accounting for Stock-Based Compensation,
the Company applied APB Opinion 25 and related interpretations in accounting
for its stock option plans, and accordingly does not record compensation costs.
If the Company had elected, beginning in fiscal 1996, to recognize compensation
cost based on the fair value of the option granted at the grant date as
prescribed by SFAS No. 123, net income (loss) and net income (loss) per share
would have been reduced to the pro forma amounts shown below (in thousands,
except per share amounts):
<TABLE>
<CAPTION>
Years Ended September
30,
------------------------
1998 1997 1996
-------- ------- ------
<S> <C> <C> <C>
As Reported
Net income (loss)................................ $ (1,812) $15,035 $1,167
Net income (loss) per share-basic................ $ (0.01) $ 0.12 $ 0.01
Net income (loss) per share-diluted.............. $ (0.01) $ 0.10 $ 0.01
Pro Forma
Net income (loss)................................ $(25,383) $ 8,728 $ 501
Net income (loss) per share-basic................ $ (0.15) $ 0.07 $ 0.01
Net income (loss) per share-diluted.............. $ (0.15) $ 0.06 $ 0.00
</TABLE>
The Company's calculations were made using the minimum value method and
Black-Scholes option pricing models with the following weighted average
assumptions:
<TABLE>
<CAPTION>
Years Ended September 30,
------------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Dividend yield.......................... -- -- --
Expected volatility..................... 75% 65% 65%
Risk-free interest rate................. 6% 6% 6%
Expected life of option following
vesting (in months).................... 12 12 12
</TABLE>
Under SFAS No. 123, the fair value of stock-based awards to employees is
calculated using the minimum value method for fiscal 1996 prior to the initial
public offering, and subsequently through the use of option pricing models,
even though such models were developed to estimate the fair value of freely
tradable, fully transferable options without vesting restrictions, which
significantly differ from the Company's stock option awards. These models also
require subjective assumptions, including future stock price volatility and
expected time to exercise, which greatly affect the calculated values.
The Company's calculations are based on a multiple option valuation approach
and forfeitures are recognized as they occur. The valuations of the computed
weighted average fair values of option grants under SFAS No. 123 in fiscal
1998, 1997 and 1996 were $3.02, $2.77 and $0.41, respectively.
401(k) Salary Deferral Program
The Company has a 401(k) salary deferral program, which became effective on
January 1, 1995, for eligible employees who have met certain service
requirements. The Company matches certain employee contributions; additional
contributions to this plan are at the discretion of the Company. Total Company
contribution expense for the years ended September 30, 1998, 1997 and 1996 was
$312,000, $153,000 and $59,000, respectively.
29
<PAGE>
10. NET INCOME (LOSS) PER SHARE
The following table sets forth the computation of shares used in the
computations of basic and diluted net income (loss) per share (in thousands):
<TABLE>
<CAPTION>
Years Ended September 30,
--------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Shares Used in Computation:
Weighted average common shares outstanding
used in computation of basic net income
(loss) per share............................. 169,791 129,408 78,564
Dilutive effect of stock options.............. -- 14,088 41,164
-------- -------- --------
Shares used in computation of diluted net
income (loss) per share...................... 169,791 143,496 119,728
======== ======== ========
</TABLE>
Because the Company reported a net loss in fiscal 1998, the calculation of
diluted earnings per share does not include common stock equivalents as they
are anti-dilutive and would result in a reduction of net loss per share. If the
Company had reported net income in fiscal year 1998, there would have been
11,404,000 additional shares in the calculation of diluted earnings per share.
Options to purchase 1,198,848 and 478,324 shares of common stock at prices
ranging from $4.85 to $11.50 and $2.42 to $3.30 were outstanding as of
September 30, 1997 and 1996, respectively, but not included in the computation
of diluted net income (loss) per share for the years ended September 30, 1997
and 1996, respectively. These options were excluded because the options'
exercise price was greater than the average market price of the Company's
common stock for the years ended September 30, 1997 and 1996, respectively, and
therefore would be anti-dilutive for purposes of this calculation.
11. 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 Securities and
Exchange Commission and the National Association of Securities Dealers, Inc.,
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):
<TABLE>
<CAPTION>
September 30,
----------------
1998 1997
------- -------
<S> <C> <C>
Net capital.............................................. $97,355 $51,721
Percentage of aggregate debit balances................... 9.5% 7.5%
Required net capital..................................... $20,429 $13,771
Excess net capital....................................... $76,926 $37,950
</TABLE>
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.
12. LEASE ARRANGEMENTS
During fiscal 1998 the Company entered into agreements to lease facilities
in Menlo Park, California, where it will consolidate its existing Silicon
Valley locations. The Company also entered into an agreement to lease a
facility in Alpharetta, Georgia, where it has expanded certain operations, such
as customer service, and, in fiscal 1999, will establish a new technology
center.
30
<PAGE>
The Company has non-cancelable operating leases for office facilities
through 2009 and operating leases for equipment through 2003. Future minimum
rental commitments under these leases at September 30, 1998, are as follows (in
thousands):
<TABLE>
<S> <C>
Years ending September 30:
1999............................................................ $ 28,341
2000............................................................ 22,245
2001............................................................ 14,889
2002............................................................ 10,842
2003............................................................ 10,611
Thereafter...................................................... 50,672
--------
$137,600
========
</TABLE>
Certain leases contain provisions for renewal options and rent escalations
based on increases in certain costs incurred by the lessor. Rent expense for
the years ended September 30, 1998, 1997 and 1996 was approximately
$20,561,000, $11,389,000 and $2,697,000, respectively.
13. COMMITMENTS, CONTINGENCIES AND REGULATORY MATTERS
The Company is a defendant in civil actions arising from the normal course
of business. In the opinion of management, these actions are expected to be
resolved with no material effect on the Company's consolidated financial
position or results of operations.
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 the Company's advertising, other communications and business
practices regarding the Company's commission rates and its ability to timely
execute transactions through its 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.
This proceeding is at an early stage and the Company is unable to speculate
as to its ultimate outcome. However, the Company believes it has meritorious
defenses to the claims and intends to conduct vigorous defenses. An unfavorable
outcome in any matters which 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 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 non-
compliance with applicable regulations. In particular, in fiscal 1997, the
Company failed to comply with applicable advertising restrictions in one
international jurisdiction and due to a clerical oversight, failed to timely
renew its registration as a broker-dealer in two
31
<PAGE>
states, Nebraska and Ohio. One of the state jurisdictions, Ohio, as a condition
of renewing the Company's license as a broker-dealer in that jurisdiction,
required the Company to offer customers resident in that state the ability to
rescind (for up to 30 days) certain securities transactions effected through
the Company during the period January 1, 1997 through April 15, 1997, the date
the Company's license was renewed. For fiscal 1997, the Company recorded a $4.3
million pre-tax charge against earnings in connection with this matter.
The Company maintains insurance in such amounts and with such coverage,
deductibles and policy limits as management believes are reasonable and
prudent. The principal risks that the Company insures against are comprehensive
general liability, commercial property, hardware/software damage, directors and
officers, and errors and omissions liability. The Company believes that such
insurance coverage is adequate for the purpose of its business.
In March 1996, the Company entered into a five-year employment agreement
with a key executive officer. The employment agreement provides for, among
other things, an annual base salary which is subject to adjustment based on the
Company's performance and a severance payment up to $1,250,000 in the event of
termination of employment under certain defined circumstances.
14. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET CREDIT RISK AND CONCENTRATIONS
OF CREDIT RISK
The Company's customer securities activities are transacted on either a cash
or margin basis. In margin transactions, the Company extends credit to the
customer, subject to various regulatory and internal margin requirements,
collateralized by cash and securities in the customer's account. As customers
write option contracts or sell securities short, the Company may incur losses
if the customers do not fulfill their obligations and the collateral in
customer accounts is not sufficient to fully cover losses which customers may
incur from these strategies. To control this risk, the Company monitors
required margin levels daily, and customers are required to deposit additional
collateral, or reduce positions, when necessary.
Through its broker-dealer subsidiaries, the Company loans securities
temporarily to other brokers in connection with its securities lending
activities. The Company receives cash as collateral for the securities loaned.
Increases in security prices may cause the market value of the securities
loaned to exceed the amount of cash received as collateral. In the event the
counterparty to these transactions does not return the loaned securities, the
Company may be exposed to the risk of acquiring the securities at prevailing
market prices in order to satisfy its customer obligations. The Company
controls this risk by requiring credit approvals for counterparties, by
monitoring the market value of securities loaned on a daily basis and by
requiring deposits of additional cash as collateral when necessary.
The Company is obligated to settle transactions with brokers and other
financial institutions even if its customers fail to meet their obligations to
the Company. Customers are required to complete their transactions on
settlement date, generally three business days after trade date. If customers
do not fulfill their contractual obligations, the Company may incur losses. The
Company has established procedures to reduce this risk by requiring that
customers deposit cash and/or securities into their account prior to placing an
order.
The Company may at times maintain inventories in equity securities on both a
long and short basis. While long inventory positions represent the Company's
ownership of securities, short inventory positions represent obligations of the
Company. Accordingly, both long and short inventory positions may result in
losses or gains to the Company as market values of securities fluctuate. To
mitigate the risk of losses, long and short positions are marked to market
daily and are continuously monitored by the Company.
15. SUBSEQUENT EVENTS AND ACQUISITIONS
In December 1998 and April 1999, the Company's Board of Directors voted to
effect two separate two-for-one stock splits by distributing one additional
share of common stock, par value $.01, for every share of
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<PAGE>
common stock outstanding to shareowners of record as of January 15, 1999 and
again as of May 7, 1999. The disclosures herein reflect the two-for-one stock
splits which were effective on February 1, 1999 and May 21, 1999.
OptionsLink
In the first quarter of fiscal 1998, E*TRADE acquired the OptionsLink
Division of Hambrech & Quist for a purchase price of $3.5 million. The purchase
price exceeded the fair value of the assets acquired by $3.1 million, of which
$2.9 million was capitalized as software and amortized over two years, in
accordance with the Company's existing policy.
ShareData
On July 30, 1998, the Company acquired ShareData, Inc., ("ShareData").
ShareData supplies stock plan knowledge-based software for pre-IPO and public
companies. The Company issued 5.2 million shares of its common stock in
exchange for all outstanding common stock of ShareData. The Company also
assumed all outstanding ShareData options, which were converted to options to
purchase approximately 744,000 shares of the Company's common stock. The
acquisition was accounted for as a pooling of interests, and accordingly, all
prior financial data of the Company has been restated to include the historical
operations of ShareData. As a result of the acquisition, the combined Company
incurred charges and direct transaction costs relating to the business
combination of $1.2 million. These non-recurring costs have been charged to
operations in the fourth quarter of fiscal 1998. Prior to the acquisition,
ShareData reported on a calendar year end. Fiscal 1998 and 1997 include the
results of ShareData for the twelve months ended September 30, 1998 and 1997,
respectively. Fiscal 1996 includes the results of ShareData for the twelve
months ended December 31, 1996. The results of operations for the quarter ended
December 31, 1996 (revenues of $4,637,000 and net income of $746,000), included
in both fiscal 1997 and 1996, is reflected as an adjustment to retained
earnings in fiscal 1997. No adjustments were required to conform accounting
policies of the entities. There were no significant intercompany transactions
requiring elimination for any periods presented.
ClearStation
On April 30, 1999, the Company acquired ClearStation, Inc.,
("ClearStation"). ClearStation is a financial media web site that integrates
technical and fundamental analysis and discussion for investors. The Company
issued 939,072 shares of common stock in exchange for all outstanding common
stock of ClearStation. The Company also assumed all outstanding ClearStation
options, which were converted to options to purchase approximately 112,000
shares of the Company's common stock. The acquisition was accounted for as a
pooling of interest, and accordingly, all prior financial data of the Company
has been restated to include the historical operations of ClearStation from
October 1997 (the date of ClearStation's inception). As a result of the
acquisition, the Company incurred charges and direct transaction costs relating
to the business combination of $250,000. These non-recurring costs have been
charged to operations in the third quarter of fiscal 1999. Fiscal 1998 includes
the results of ClearStation for the twelve months ended September 30, 1998. No
adjustments were required to conform accounting policies of the entities. There
were no significant intercompany transactions requiring elimination for any
periods presented.
33
<PAGE>
The operating results of the separate Companies are as follows (in
thousands):
<TABLE>
<CAPTION>
Net Net Income
Revenues (Loss)
-------- ----------
<S> <C> <C>
Year ended September 30, 1998
E*TRADE Group......................................... $235,452 $ 2,418
ShareData (through June 30, 1998)..................... 9,865 (3,130)
ClearStation.......................................... -- (1,100)
-------- -------
Combined.............................................. $245,317 $(1,812)
======== =======
Year ended September 30, 1997
E*TRADE Group......................................... $142,737 $13,905
ShareData............................................. 13,658 1,130
ClearStation.......................................... -- --
-------- -------
Combined.............................................. $156,395 $15,035
======== =======
Year ended September 30, 1996
E*TRADE Group......................................... $ 51,595 $ (828)
ShareData............................................. 10,925 1,995
ClearStation.......................................... -- --
-------- -------
Combined.............................................. $ 62,520 $ 1,167
======== =======
</TABLE>
Telebanc
On June 1, 1999, the Company entered into a definitive agreement to acquire
Telebanc Financial Corporation ("Telebanc"). Telebanc is the holding company of
TeleBank, an Internet-based, federally chartered savings bank. Under the terms
of the agreement, Telebanc shareowners will receive 2.1 shares of E*TRADE
common stock for each share of Telebanc common stock. Following the merger,
which is expected to be accounted for as a pooling of interest, Telebanc
shareowners will own approximately 13 percent of E*TRADE's fully diluted common
stock. The Boards of Directors of both companies have approved the merger, but
final consummation of the merger, which is expected to be completed this fall,
is contingent on regulatory approval and the vote of the Telebanc shareowners.
34
<PAGE>
16. QUARTERLY DATA (unaudited)
The unaudited quarterly financial information presented below reflects all
adjustments which, in the opinion of management, are of a normal and recurring
nature necessary to present fairly the results of operations for the periods
presented (in thousands, except per share amounts).
On November 23, 1998, the American Institute of Certified Public Accountants
held the first meeting of a task force formed to prepare guidance for companies
that account for business acquisitions under the purchase method of accounting
which includes in-process research and development ("IPR&D"). At this meeting,
representatives of the Securities and Exchange Commission ("SEC") expressed
their views on this matter. After considering the new views taken by the SEC on
IPR&D, the Company has reassessed its allocation of the purchase price of the
OptionsLink acquisition made in the first quarter of fiscal 1998. Initially,
$2.8 million of the purchase price had been allocated to IPR&D. Based on the
SEC's recent guidance, the Company has reallocated a substantial part of the
purchase price to capitalized software, to be amortized over two years, in
accordance with the Company's existing policy. The net effect of these
reallocations are to reduce reported net loss in fiscal year 1998 by $573,000
with no change to earnings per share. The impact of this change for the quarter
ended September 30, 1998, due to increased amortization expense, is an increase
in reported net loss by $169,000, with no change to earnings per share.
<TABLE>
<CAPTION>
Fiscal 1998 Fiscal 1997
----------------------------------- --------------------------------
4th 3rd 2nd 1st 4th 3rd 2nd 1st
Quarter Quarter Quarter Quarter Quarter Quarter Quarter Quarter
-------- ------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
E*TRADE Group (as
previously reported):
Revenues............... $ 64,296 $62,316 $53,309 $51,130 $48,477 $37,036 $32,201 $25,023
Cost of services....... 31,991 28,722 24,280 22,747 23,384 21,834 13,198 12,425
Net income (loss)...... (15,923) 6,560 6,118 4,914 5,523 3,068 3,054 2,260
Net income (loss) per
share:
Basic.................. $ (0.08) $ 0.03 $ 0.03 $ 0.03 $ 0.04 $ 0.02 $ 0.03 $ 0.02
Diluted................ $ (0.08) $ 0.03 $ 0.02 $ 0.03 $ 0.04 $ 0.02 $ 0.02 $ 0.02
ShareData, ClearStation
and software
adjustment:
Revenues............... $ 4,401 $ 4,167 $ 2,822 $ 2,876 $ 3,507 $ 2,541 $ 2,973 $ 4,637
Cost of services....... 1,282 1,064 979 823 916 677 633 314
Net income (loss)...... (203) (1,420) (1,930) 72 353 (158) 189 746
Combined:
Revenues............... $ 68,697 $66,483 $56,131 $54,006 $51,984 $39,577 $35,174 $29,660
Cost of services....... 33,273 29,786 25,259 23,570 24,300 22,511 13,831 12,739
Net income (loss)...... (16,126) 5,140 4,188 4,986 5,876 2,910 3,243 3,006
Net income (loss) per
share:
Basic.................. $ (0.08) $ 0.03 $ 0.03 $ 0.03 $ 0.04 $ 0.02 $ 0.03 $ 0.02
Diluted................ $ (0.08) $ 0.03 $ 0.02 $ 0.03 $ 0.04 $ 0.02 $ 0.02 $ 0.02
</TABLE>
35
<PAGE>
Management's Discussion and Analysis of Financial Condition and Results of
Operations for the six months ended March 31, 1999 and 1998
Forward-Looking Statements
The following discussion of the financial condition and results of
operations of the Company as restated for its merger with ClearStation on April
30, 1999, which was accounted for as a pooling of interests, should be read in
conjunction with the supplemental consolidated financial statements and notes
thereto included elsewhere herein. 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 elsewhere herein.
Results of Operations
Revenue Detail (in millions)
<TABLE>
<CAPTION>
Six Months Ended
March 31,
---------------------
Percent
1999 1998 Change
------ ------ -------
<S> <C> <C> <C>
Revenues:
Transaction revenues:
Commissions........................................ $133.0 $ 62.6 112%
Order flow......................................... 17.8 12.9 39%
------ ------ ---
Total transaction revenue........................ 150.8 75.5 100%
------ ------ ---
Interest-net of interest expense(A):
Brokerage.......................................... 38.7 20.4 89%
Other.............................................. 11.3 4.2 171%
------ ------ ---
Total interest................................... 50.0 24.6 103%
------ ------ ---
International........................................ 2.0 1.6 25%
Other................................................ 12.2 8.4 45%
------ ------ ---
Total revenues................................... $215.1 $110.1 95%
====== ====== ===
Transactions per day................................... 0.6 0.3 122%
Transaction per period................................. 7.1 3.2 121%
</TABLE>
- --------
(A) Interest is presented net of interest expense. Interest expense for the six
months ended March 31, 1999 and 1998 was $26.0 and $17.3, respectively.
The Company's revenues increased to $215.1 million for the six months ended
March 31, 1999, up 95% from $110.1 million in the equivalent period of fiscal
1998. Revenues increased mainly due to higher customer trading volume and an
increase in customer assets.
Transaction revenues consist of commission revenues and payments based on
order flow. Transaction revenues increased to $150.9 million for the six months
ended March 31, 1999, up 100% from $75.5 million for the equivalent period in
fiscal 1998. This increase was primarily attributable to an increase of 121% in
the number of transactions processed from the equivalent period in the prior
year. The increase in transaction processing volume was primarily a result of a
significant increase in customer accounts resulting from the substantial
advertising expenditures made by the Company during fiscal 1999. 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.
36
<PAGE>
Commission revenues for the six months ended March 31, 1999 increased to
$133.0 million, up 113% from $62.6 million for the same period a year ago.
Order flow revenue increased to $17.9 million for the six months ended March
31, 1999, up 39% from $12.9 million for the same period in the prior year.
Order flow revenue accounted for 12% of transaction revenue in the six months
ended March 31, 1999 compared to 17% in the comparable period in fiscal 1998.
Order flow revenue as a percentage of total revenue decreased primarily due to
the loss of Roundtable earnings, which ended when Roundtable was reorganized as
Knight/Trimark, Inc. and went public in July 1998. Until its initial public
offering, Knight/Trimark, Inc. would allocate a portion of its earnings to its
owners, including the Company, based on the percentage its owners contributed
to Knight/Trimark, Inc.'s total order flow. The Company previously recorded the
amounts it received from this allocation as order flow revenue.
Net interest revenues primarily represent interest earned by the Company on
credit extended to its customers to finance their purchases of securities on
margin, interest earned on 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. Pursuant to
Securities and Exchange Commission regulations, customer cash balances that are
not used for margin lending are segregated into an investment account that is
maintained for the exclusive benefit of customers.
Net interest revenues increased to $50.0 million for the six months ended
March 31, 1999, up 103% from $24.6 million for the same period in fiscal 1998.
This increase was primarily due to interest derived from customer operations of
$38.7 million for the six months ended March 31, 1999, up $18.3 million or 89%
compared to the equivalent period in fiscal 1998. Average customer margin debit
balances were up 68% to $1.6 billion, and average customer money market fund
balances increased 35% to $2.9 billion. Additionally, interest earned on
investment securities increased to $11.3 million in the second quarter of
fiscal 1999, up 171% from $4.2 million in the equivalent period in fiscal 1998.
International revenues were $2.0 million for the six months ended March 31,
1999 compared to $1.6 million for the same period in fiscal 1998. International
revenues represent international licensing fees and royalties based on the
licensee's transaction revenues. The Company may, from time to time, seek to
enter into similar licensing agreements with others as part of its
international expansion strategy. There can be no assurance that any such
future agreements will be consummated or that the terms thereof will be
comparable to those of the aforementioned agreements or that the recognition of
any licensing fees will occur during the period in which an arrangement is
consummated.
Other revenues increased to $12.2 million for the six months ended March 31,
1999, up 45% from $8.4 million for the comparable period in fiscal 1998. Other
revenues increased primarily due to increases in broker-related fees for
services, growth in ShareData licensing revenue, ClearStation revenues and
increased revenues from mutual funds and advertising on the Company's Web site.
Cost of Services
Total cost of services increased to $97.9 million for the six months ended
March 31, 1999, up 100% from $48.8 million for the comparable period in fiscal
1998. Cost of services as a percentage of net revenues was 45% for the
six months ended March 31, 1999 compared to 44% in the comparable period in
fiscal 1998. Cost of services includes expenses related to the Company's
clearing operations, customer service activities, system maintenance and
communications. These increases reflect the overall increase in customer
transactions processed by the Company, customer service inquiries, and
operations and maintenance costs associated with the technology centers in Palo
Alto and Rancho Cordova, California, and Alpharetta, Georgia.
37
<PAGE>
Operating Expenses
Selling and marketing expenses increased to $101.0 million for the six
months ended March 31, 1999, up 383% from $20.9 million for the comparable
period in fiscal 1998. As a percentage of net revenue, selling and marketing
expenses increased to 47% for the six months ended March 31, 1999, from 19% in
the equivalent period of fiscal 1998. Selling and marketing expenses include
media, print and direct mail advertising, and related production, printing and
postage costs. The increase in selling and marketing expenses reflect the
Company's aggressive account and membership acquisition strategy which includes
major marketing expenditures for advertising placements, creative development
and collateral materials resulting from a variety of advertising campaigns
directed at building brand name recognition, growing customer base and market
share, and maintaining customer retention rates. These increased expenditure
levels are expected to continue throughout fiscal 1999. The Company's selling
and marketing expenses vary depending upon a variety of factors including,
without limitation, the launch of new products or services.
Technology development expenses increased to $29.8 million for the six
months ended March 31, 1999, up 116% from $13.8 million for the comparable
period in fiscal 1998. As a percentage of net revenue, technology development
increased to 14% for the six months ended March 31, 1999, from 13% for the six
months ended March 31, 1998. The increased level of expenses was incurred to
enhance the Company's existing product offerings and reflects the Company's
continuing commitment to invest in new products and technologies to support
potential future growth.
General and administrative expenses increased to $32.5 million for the six
months ended March 31, 1999, up 205% from $10.6 million for the comparable
period in fiscal 1998. This increase is the result of personnel additions, the
development of administrative functions resulting from the overall growth in
the Company, and the costs associated with the opening of a new technology and
customer service support facility in Alpharetta, Georgia.
Non-operating income (expense)
In February 1999, the Company sold 39% of its holdings in Knight/Trimark,
Inc., a market-maker, recognizing a pre-tax gain of $33.4 million on the sale.
The investment had been classified as available-for-sale under the provisions
of SFAS 115.
Loss on equity investments was $1.3 million for the six months ended March
31, 1999 which resulted from the Company's minority ownership in certain
investments that are accounted for under the equity method. Equity in losses of
affiliates for the six months ended March 31, 1999 includes the results from
the Company's minority ownership in Archipelago and E*OFFERING, as well as the
Company's international joint ventures in Japan and the United Kingdom. The
Company expects that its affiliate companies will continue to invest in the
development of their products and services, and to incur operating losses for
at least the next 12 months, which will result in future charges being recorded
by the Company to reflect its proportionate share of such losses.
Income Tax Expense (Benefit)
Income tax expense (benefit) represents the provision for federal and state
income taxes at an effective rate of (43.8%) for the six months ended March 31,
1999 and 42.5% for the comparable period in fiscal 1998. This rate was impacted
because there was no available tax benefit for the preacquisition operating
losses of ClearStation. Prior to its merger with the Company, ShareData was a
Subchapter S corporation and was not subject to federal and state corporate
income taxes.
Liquidity and Capital Resources
The Company currently anticipates that its available cash resources and
credit facilities 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
38
<PAGE>
expansion, develop new or enhanced services and products, respond to
competitive pressures, acquire complementary businesses or technologies or take
advantage of unanticipated opportunities.
Cash used in operating activities was $36.9 million for the six months ended
March 31, 1999 compared with cash provided by operating activities of $46.0
million in the equivalent period in fiscal 1998. Cash used in operations
increased primarily due to increased operating expenditures, including
significant increases in sales and marketing expenses associated with the
Company's aggressive account and membership acquisition strategy.
Cash provided by investing activities was $50.4 million for the six months
ended March 31, 1999, compared to cash used in investing activities of $7.1
million in the equivalent period in fiscal 1998. The increase in cash provided
by investing activities was primarily a result of proceeds of $33 million from
the sale of a portion of the Company's investment in Knight/Trimark, Inc., and
net purchases and sale/maturity of investment securities of $93.2 million,
offset by purchases of investments of $50.7 million and purchases of property
and equipment of $29.3 million. The Company expects that it will incur
approximately $50 to $75 million of capital expenditures during the second half
of fiscal 1999.
Cash provided by financing activities was $14.2 million for the six months
ended March 31, 1999, compared to $2.4 million in the equivalent period in
fiscal 1998. The increase in cash provided by financing activities was
primarily a result of increases in the proceeds from employee stock
transactions.
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.
If not corrected, these computer applications could fail or create erroneous
results by or at the year 2000. The Company utilizes, and is dependent 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 which 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. During the first quarter of fiscal 1998, the Company
initiated a review and assessment of all hardware and software to evaluate
whether it will function properly in the year 2000 without material errors or
interruptions.
The Company believes that all year 2000 issues revealed as a result of that
evaluation to date can be remedied in a timely manner, and therefore does not
expect a material risk of disruption of operations. With respect to outside
vendors, those vendors that have been contacted have indicated that their
hardware or software is or will be year 2000 compatible in time frames that
meet regulatory requirements. Evaluation of these issues is continuing and
there is a risk that other problems, not presently known to the Company, will
be discovered which 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 may be
discovered. Any inability to remediate such issues in a timely manner could
cause a material disruption of the Company's business. 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 online and
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.
These combining factors, while not quantified, could have a material adverse
impact on the Company's financial results.
Because systems critical to the Company other than its computer systems may
be affected by the century change, the Company's year 2000 efforts also
encompass facilities and equipment, which rely on date-
39
<PAGE>
dependent technology, such as, building equipment that contains embedded
technology and the Company's third-party providers.
At this time, it does not appear that the costs of addressing year 2000
issues will have a material adverse impact on the Company's financial position.
However, in the event that the Company and third parties upon which it relies
are unable to address these issues in a timely manner, it could result in a
material financial risk to the Company.
Status of Year 2000 Efforts
The Company's year 2000 efforts address all computer systems, equipment and
business partner relationships considered essential to the Company's ability to
conduct its business. The objective of the Company's year 2000 project is 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 are rated for risk and are prioritized
for conversion or replacement according to their impact on core business
operations. The Company's year 2000 project follows a structured approach in
analyzing and mitigating year 2000 issues. This approach consists of six
phases: awareness, assessment, remediation, validation, implementation and
industry-wide testing. The work associated with each phase may be performed
simultaneously with other phases of the project, depending on the nature of the
work to be performed and the technology and business requirements of the
specific business unit. For example, awareness is an ongoing effort and occurs
in each phase. As part of this project, the Company reviews its vendor
relationships (suppliers, alliances and third-party providers) in an attempt to
assess their ability to meet the year 2000 challenge. In addition, this plan
seeks to ensure that all of the Company's business partners and service
providers are also year 2000 ready. In addition, written contingency plans are
being developed for all mission critical systems and many non-critical systems
to address any unexpected year 2000 failures. However, there can be no
assurance that contingency plans will adequately address all year 2000
failures.
Currently, the Company's primary focus is the completion of remediation and
testing, and on-going contingency planning and vendor management efforts.
However, the Company is continuing to assess the impact of year 2000 issues on
its products, internal information systems and third-party vendor relations.
The Company has begun, and in many cases completed, corrective efforts in these
areas. The Company does not anticipate that addressing year 2000 issues for its
internal information systems and current and future products will have a
material impact on its operations or financial results. However, there can be
no assurance that these costs will not be greater than anticipated, or that
corrective action undertaken will be completed before year 2000 issues may
arise.
In March 1999, the Company completed its assessment phase on mission
critical systems including a significant amount of the implementation and
testing. The Company's primary focus remains on the successful remediation and
testing of all critical systems, including systems owned by third parties.
Additional focus will be placed on non-critical systems and written contingency
plans in the later half of the third quarter of fiscal 1999. The Company
anticipates that work on the awareness, contingency planning, and vendor
management phases of the project will continue through the century change.
The success of the Company's year 2000 efforts depends in part on the
adequacy of compliance by vendors with their representations concerning their
systems, and on parallel efforts being undertaken by vendors and other third
parties with which the Company's systems interact and the Company is therefore
taking steps to determine the status of critical third parties' year 2000
compatibility. The Company has implemented a vendor management program.
Activities include creating an inventory of vendors, inquiring directly as to
the status of vendors' year 2000 efforts, and continuing contact with vendors
to monitor the progress of vendors who may not yet be year 2000 capable. If
these suppliers 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. The Company is still
assessing the effect year 2000 issues will have on its suppliers and at this
time, cannot determine the impact it will have. There can be no assurance that
all third parties will provide
40
<PAGE>
accurate and complete information or that all their systems will be fully year
2000 capable. Third parties' year 2000 processing failures may have a material
adverse impact on the Company's systems and operations.
As the year 2000 project continues, the Company may discover additional year
2000 issues, may not be able to develop, implement, or test remediation or
contingency plans, or may find that the costs of these activities exceed
current expectations and become material. In many cases, the Company is relying
on assurances from suppliers that new and upgraded information systems and
other products will be year 2000 capable. The Company plans to test such third-
party products, but cannot be sure that its tests will be adequate or that, if
problems are identified, they will be addressed by the supplier in a timely and
satisfactory way.
Because the Company uses a variety of information systems and has additional
systems embedded in its operations and infrastructure, the Company cannot be
sure that all of its systems will work together in a year 2000 capable fashion.
Furthermore, the Company cannot be sure that it will not suffer business
interruptions, either because of its own year 2000 issues or those of its
customers or suppliers whose year 2000 issues may make it difficult or
impossible for them to fulfill their commitments to the Company. If the Company
fails to satisfactorily resolve year 2000 issues related to its products in a
timely manner, it could be exposed to liability to third parties.
The Company is continuing to evaluate year 2000-related risks and corrective
actions. However, the risks associated with the year 2000 may be pervasive and
complex; they can be difficult to identify and to address, and can result in
material adverse consequences to the Company. Even if the Company, in a timely
manner, completes all of its assessments, identifies and tests remediation
plans believed to be adequate, and develops contingency plans believed to be
adequate, some issues may not be identified or corrected in time to prevent
material adverse consequences to the Company.
The Company's plan may also be affected by regulatory changes, changes in
industry customs and practices, and significant systems modifications unrelated
to the year 2000 project including upgrades and additions to capacity, and the
cost and continued availability of qualified personnel and other resources.
The Company spent approximately $1.5 million in the six months ended March
31, 1999 and currently estimates that it will spend approximately an additional
$3.5 million to ascertain that its core computer systems and those of its
vendors are year 2000 capable. These expenditures will consist primarily of
compensation for information technology employees and contractors dedicated to
this project and related hardware and software costs. This estimate excludes
the time that may be spent by management and administrative staff in guiding
and assisting the information technology effort described above or for making
systems other than core brokerage computer systems year 2000 capable. The
Company expects to fund all year 2000 related costs through operating cash
flows. These costs are not expected to result in increased information
technology expenditures because they will be funded through a reallocation of
the Company's overall development spending. In accordance with generally
accepted accounting principles, such expenditures will be expensed as incurred.
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 and equity security price
risk. The Company does not have derivative financial instruments for
speculative or trading purposes.
Interest Rate Sensitivity
The Company maintains a short-term investment portfolio consisting of mainly
income securities with an average maturity of less than two years. These
available-for-sale securities are subject to interest rate risk and
41
<PAGE>
will fall in value if market interest rates increase. If market interest rates
were to increase immediately and uniformly by 10 percent in levels at March 31,
1999, the fair value of the portfolio would decline by an immaterial amount.
The Company has the ability to hold its fixed income investments until
maturity, and therefore the Company would not expect its operating results or
cash flows to be affected to any significant degree by the effect of a sudden
change in market interest rates on its securities portfolio.
Equity Price Risk
The Company holds a small portfolio of marketable-equity traded securities
that are subject to market price volatility. Equity price fluctuations of plus
or minus 15 percent would not have a material impact on the Company.
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.
42
<PAGE>
Supplemental Interim Financial Statements and Supplementary Data
Index to Supplemental Consolidated Supplemental Financial Statements
<TABLE>
<CAPTION>
Page
----
<S> <C>
Supplemental Consolidated Balance Sheets as of March 31, 1999 and
September 30, 1998................................................... 44
Supplemental Consolidated Statements of Operations for the six months
ended March 31, 1999 and 1998........................................ 45
Supplemental Consolidated Statements of Cash Flows for the six months
ended March 31, 1999 and 1998........................................ 46
Notes to Supplemental Consolidated Financial Statements............... 47
</TABLE>
43
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Supplemental Consolidated Balance Sheets
(in thousands, except share amounts)
<TABLE>
<CAPTION>
March 31, September 30,
1999 1998*
----------- -------------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and equivalents................................ $ 49,658 $ 21,890
Cash and investments required to be segregated under
Federal or other regulations....................... 5,000 5,000
Investment securities............................... 409,192 502,534
Brokerage receivables--net.......................... 2,276,014 1,310,235
Other assets........................................ 19,070 11,710
---------- ----------
Total current assets............................... 2,758,934 1,851,369
Property and equipment--net.......................... 65,722 48,524
Investments.......................................... 482,043 58,342
Related party receivables............................ -- 3,719
Other assets......................................... 6,193 7,491
---------- ----------
Total assets..................................... $3,312,892 $1,969,445
========== ==========
LIABILITIES AND SHAREOWNERS' EQUITY
Liabilities:
Brokerage payables.................................. $2,133,456 $1,184,917
Accounts payable, accrued and other liabilities..... 209,662 74,992
---------- ----------
Total liabilities.................................. 2,343,118 1,259,909
---------- ----------
Commitments and contingencies (Note 7)
Shareowners' equity:
Common stock, $.01 par value; shares authorized,
300,000,000; shares issued and outstanding: March
1999, 232,759,206; September 1998, 227,077,074..... 2,328 2,271
Additional paid-in capital.......................... 726,860 680,319
Retained earnings................................... 6,311 14,210
Accumulated other comprehensive income.............. 234,275 12,736
---------- ----------
Total shareowners' equity.......................... 969,774 709,536
---------- ----------
Total liabilities and shareowners' equity........ $3,312,892 $1,969,445
========== ==========
</TABLE>
- --------
* Derived from audited financial information
See notes to supplemental consolidated financial statements.
44
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Supplemental Consolidated Statements of Operations
(in thousands, except per share amounts)
(Unaudited)
<TABLE>
<CAPTION>
Six Months Ended
March 31,
------------------
1999 1998
-------- --------
<S> <C> <C>
Revenue:
Transaction revenues..................................... $150,844 $ 75,462
Interest-net of interest expense(A)...................... 50,016 24,653
International............................................ 2,016 1,620
Other.................................................... 12,213 8,402
-------- --------
Net revenues........................................... 215,089 110,137
-------- --------
Cost of services........................................... 97,862 48,829
-------- --------
Operating expenses:
Selling and marketing.................................... 101,037 20,916
Technology development................................... 29,822 13,782
General and administrative............................... 32,463 10,643
-------- --------
Total operating expenses............................... 163,322 45,341
-------- --------
Total cost of services and operating expenses.......... 261,184 94,170
-------- --------
Operating income (loss).................................... (46,095) 15,967
-------- --------
Non-operating income (expense):
Gain on sale of investment............................... 33,367 --
Loss on equity investments............................... (1,334) --
-------- --------
Total non-operating income............................. 32,033 --
-------- --------
Pre-tax income (loss)...................................... (14,062) 15,967
Income tax expense (benefit)............................... (6,163) 6,793
-------- --------
Net income (loss).......................................... $ (7,899) $ 9,174
======== ========
Net income (loss) per share (Note 5):
Basic.................................................... $ (0.03) $ 0.06
======== ========
Diluted.................................................. $ (0.03) $ 0.05
======== ========
Shares used in computation of net income (loss) per share
(Note 5):
Basic.................................................... 229,351 161,441
Diluted.................................................. 229,351 172,807
</TABLE>
- --------
(A) Interest is presented net of interest expense. Interest expense for the six
months ended March 31, 1999 and 1998 was $26,028 and $17,290, respectively.
See notes to supplemental consolidated financial statements.
45
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Supplemental Consolidated Statements of Cash Flows
(in thousands)
(Unaudited)
<TABLE>
<CAPTION>
Six Months Ended
March 31,
----------------------
1999 1998
----------- ---------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss).................................... $ (7,899) $ 9,174
Reconciliation to net cash provided by (used in)
operating activities:
Deferred income taxes.............................. (2,909) (481)
Depreciation and amortization...................... 12,125 4,372
Loss on equity investments......................... 1,334 --
Options issued to consultants...................... 2,200 --
Gain on sale of investment......................... (33,367) --
Other.............................................. (19) (849)
Net effect of changes in brokerage-related assets and
liabilities:
Cash and investments required to be segregated
under Federal or other regulations................ -- 10,001
Brokerage receivables.............................. (965,779) (298,923)
Brokerage payables................................. 948,539 290,958
Other changes, net:
Other assets....................................... (7,162) 290
Accounts payable, accrued and other liabilities.... 16,030 31,425
----------- ---------
Net cash provided by (used in) operating
activities...................................... (36,907) 45,967
----------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment................... (29,323) (14,060)
Purchase of investment securities.................... (3,143,914) (864,237)
Sale/maturity of investment securities............... 3,237,157 874,680
Proceeds from sale of investment..................... 33,495 --
Acquisition of OptionsLink........................... -- (3,500)
Purchase of investments.............................. (50,708) --
Related party receivable............................. 3,738 --
----------- ---------
Net cash provided by (used in) investing
activities...................................... 50,445 (7,117)
----------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from employee stock transactions............ 14,208 2,436
Other................................................ 22 --
----------- ---------
Net cash provided by financing activities........ 14,230 2,436
----------- ---------
INCREASE IN CASH AND EQUIVALENTS....................... 27,768 41,286
CASH AND EQUIVALENTS--Beginning of period.............. 21,890 23,234
----------- ---------
CASH AND EQUIVALENTS--End of period.................... $ 49,658 $ 64,520
=========== =========
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest............................... $ 28,753 $ 16,429
=========== =========
Non-cash activities:
Unrealized gain on available-for-sale securities... $ 373,384 $ 96
=========== =========
Tax benefit on exercise of stock options........... $ 30,190 --
=========== =========
</TABLE>
See notes to supplemental consolidated financial statements.
46
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements
Note 1.--Basis of Presentation
The accompanying unaudited supplemental 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.
These 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 consolidated financial statements should be read in
conjunction with the audited 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, 1998.
The supplemental consolidated financial statements of the Company have been
prepared to give retroactive effect to the acquisition of ShareData, Inc.
("ShareData") in July 1998 and ClearStation, Inc. ("ClearStation") in April
1999, as well as the reallocations made in the fourth quarter of fiscal 1998
for the allocation of the purchase price paid for OptionsLink, which was
acquired in the first quarter of 1998 (See Note 15 to the supplemental
financial statements as of September 30, 1998 included herein.)
In December 1998 and April 1999, the Company's Board of Directors voted to
effect a two-for-one stock split by distributing one additional share of common
stock, par value $.01, for every share of common stock outstanding to
shareowners of record on January 15, 1999 and May 7, 1999. The disclosures
herein reflect the two-for-one stock splits which were effective on February 1,
1999 and May 21, 1999.
Note 2.--Net Brokerage Receivables and Payables
Net brokerage receivables and payables consists of the following (in
thousands):
<TABLE>
<CAPTION>
March 31, September 30,
1999 1998
---------- -------------
<S> <C> <C>
Receivable from customers and non-customers (less
allowance for doubtful accounts of $6,450 at March
31, 1999 and $862 at September 30, 1998).......... $1,887,959 $ 961,305
Receivable from brokers, dealers and clearing
organizations:
Net settlement and deposits with clearing
organizations................................... 31,342 14,854
Deposits paid for securities borrowed............ 346,129 328,989
Securities failed to deliver..................... 3,977 728
Other............................................ 6,607 4,359
---------- ----------
Total net brokerage receivables................ $2,276,014 $1,310,235
========== ==========
Payable to customers and non-customers............. $ 570,534 $ 340,044
Payable to brokers, dealers and clearing
organizations:
Deposits received for securities loaned.......... 1,535,386 839,422
Securities failed to receive..................... 5,324 1,222
Other............................................ 6,712 4,229
Bank loan payable.................................. 15,500 --
---------- ----------
Total net brokerage payables................... $2,133,456 $1,184,917
========== ==========
</TABLE>
47
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements--(Continued)
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 March 31, 1999 and September 30, 1998, credit extended
to customers and non-customers with respect to margin accounts was $1,878
million and $956 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.
Note 3.-- Investments
In January 1999, the Company acquired a 25 percent voting interest in
Archipelago Holdings, LLC ("Archipelago"). Archipelago owns 100 percent of
Archipelago, LLC, which operates an Electronic Communication Network ("ECN")
for Nasdaq stocks. In connection with such investment, the Company entered into
an assistance agreement with Archipelago, which requires the Company to provide
certain operational and technical assistance to Archipelago. The agreement
provides that the Company will initially be entitled to representation on
Archipelago's board of managers in proportion to its holding of voting
interests.
In February 1999, the Company acquired a 28 percent voting interest in
E*OFFERING, a full-service, Internet-based investment bank. E*OFFERING plans to
provide individual and institutional investors greater access to public
offerings. E*OFFERING leverages the Internet to improve the process of raising
capital for companies by reducing time to market and underwriting costs
traditionally associated with the registration process, while broadening
capital distribution. Additionally, E*OFFERING provides after-market support
and shareholder communication services.
The Company accounts for these investments according to the equity method of
accounting, whereby the Company's proportionate share of each affiliate's net
income (loss) is included in equity income (loss).
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
income (loss) to comprehensive income is as follows (in thousands):
<TABLE>
<CAPTION>
Six Months
Ended
March 31,
----------------
1999 1998
-------- ------
<S> <C> <C>
Net income (loss)......................................... $ (7,899) $9,174
Changes in other comprehensive income:
Unrealized gain on available-for-sale securities, net
of tax................................................. 221,022 96
Cumulative translation adjustments...................... 517 --
-------- ------
Total comprehensive income............................ $213,640 $9,270
======== ======
</TABLE>
48
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements--(Continued)
Note 5.--Net Income (Loss) Per Share
The following table sets forth the computation of shares used in the
computations of basic and diluted net income (loss) per share (in thousands):
<TABLE>
<CAPTION>
Six Months
Ended
March 31,
---------------
1999 1998
------- -------
<S> <C> <C>
Shares Used in Computation:
Weighted average common shares outstanding used in computation
of basic net income (loss) per share......................... 229,351 161,441
Dilutive effect of stock options.............................. -- 11,366
------- -------
Shares used in computation of diluted net income (loss)
per share.................................................. 229,351 172,807
======= =======
</TABLE>
Because the Company reported a net loss for the six months ended March 31,
1999, 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 in this period, there would have been
16,350,000 additional shares in the calculation of diluted earnings per share.
The following options to purchase shares of common stock were not included
in the computation of diluted net income (loss) per share because the options'
exercise price was 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):
<TABLE>
<CAPTION>
Six Months
Ended
March 31,
-------------
1999 1998
------ ------
<S> <C> <C>
Options excluded from computation of diluted net income
(loss) per share........................................... 88 5,370
Exercise price ranges:
High...................................................... $30.39 $11.52
Low....................................................... $19.46 $ 6.57
</TABLE>
Note 6.--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):
<TABLE>
<CAPTION>
March 31, September 30,
1999 1998
--------- -------------
<S> <C> <C>
Net capital......................................... $124,500 $97,355
Percentage of aggregate debit balances.............. 6.2% 9.5%
Required net capital................................ $ 40,062 $20,429
Excess net capital.................................. $ 84,438 $76,926
</TABLE>
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.
49
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements--(Continued)
Note 7.--Commitments, Contingencies and Regulatory Matters
The Company is a defendant in civil actions arising from the normal course
of business. In the opinion of management, these actions are expected to be
resolved with no material effect on the Company's consolidated financial
position or results of operations.
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 the Company's advertising, other communications and business
practices regarding the Company's commission rates and its ability to timely
execute transactions through its 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. This proceeding is
at an early stage and the Company is unable to predict its ultimate outcome.
However, the Company believes it has meritorious defenses to the claims and
intends to conduct vigorous defenses. An unfavorable outcome in any matters,
which 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 operations.
On February 8, 1999, a putative class action was filed in the Superior Court
of California, County of Santa Clara, by Coleen Divito, on behalf of herself
and other similarly situated individuals. Subsequently on February 19, 1999, a
putative class action was filed in Superior Court of California, County of
Santa Clara, by Mario Cirignani, on behalf of himself and other similarly
situated individuals. Both complaints allege damages and seek injunctive relief
arising out of, among other things, the February 3, 4 and 5, 1999 system
interruptions and allege a class of all E*TRADE account holders as of February
2, 1999. Pursuant to a stipulation of counsel dated March 23, 1999, the Court
consolidated the Divito and Cirignani actions for all purposes. This proceeding
is currently at a very early stage and the Company is unable to predict its
ultimate outcome.
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
the Company's advertising, other communications and business practices
regarding its ability to timely execute and confirm transactions through its
online brokerage services were false and deceptive. This proceeding is
currently at a very early stage and the Company is unable to predict its
ultimate outcome.
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, the
plaintiff's alleged problems accessing his 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. This proceeding is currently
at a very early stage and the Company is 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. This proceeding is currently at a
very early stage and the Company is unable to predict its ultimate outcome.
On March 11, 1999, a putative class action was filed in Superior Court of
California, County of Santa Clara, by Elie Wurtman. The Wurtman complaint seeks
damages and injunctive relief arising out of,
50
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements--(Continued)
among other things, plaintiff's alleged problems accessing her account and
placing orders. The complaint also makes allegations regarding access problems
relating to E*TRADE 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. This
proceeding is currently at a very early stage and the Company is unable to
predict its ultimate outcome.
On April 14, 1999, a putative action was filed in Superior Court of
California, County of Los Angeles, by Matthew J. Rosenberg. The Rosenberg
compliant alleges violations of the Consumer Legal Remedies Act and the
California Unfair Business Practices Act in relation to E*TRADE's IPO business.
This proceeding is currently at a very early stage and the Company is unable to
predict its ultimate outcome.
From time to time the Company has been threatened with, or named as a
defendant in, lawsuits 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 maintains insurance in such amounts and with such coverage,
deductibles and policy limits as management believes are reasonable and
prudent. The principal risks that the Company insures against are comprehensive
general liability, commercial property damage, hardware/software damage,
directors and officers, and errors and omissions liability. The Company
believes that such insurance coverage is adequate for the purpose of its
business.
The Company has entered into employment agreements with several of its key
executive officers. These employment agreements provide for annual base salary
compensation, stock option acceleration and severance payments in the event of
termination of employment under certain defined circumstances, or change in the
Company's control. Base salaries are subject to adjustments according to the
Company's financial performance.
Note 8.--Subsequent Events
ClearStation
On April 30, 1999, the Company acquired ClearStation, Inc.,
("ClearStation"). ClearStation is a financial media web site that integrates
technical and fundamental analysis and discussion for investors. The Company
issued 939,072 shares of common stock in exchange for all outstanding common
stock of ClearStation. The Company also assumed all outstanding ClearStation
options, which were converted to options to purchase approximately 112,000
shares of the Company's common stock. The acquisition was accounted for as a
pooling of interest, and accordingly, all prior financial data of the Company
has been restated to include the historical operations of ClearStation from
October 1997 (the date of ClearStation's inception). As a result of the
acquisition, the Company incurred charges and direct transaction costs relating
to the business combination of $250,000. These non-recurring costs have been
charged to operations in the third quarter of fiscal 1999. No adjustments were
required to conform accounting policies of the entities. There were no
significant intercompany transactions requiring elimination for any periods
presented.
51
<PAGE>
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Supplemental Consolidated Financial Statements--(Continued)
Telebanc
On June 1, 1999, the Company entered into a definitive agreement to acquire
Telebanc Financial Corporation ("Telebanc"). Telebanc is the holding company of
TeleBank, an Internet-based, federally chartered savings bank. Under the terms
of the agreement, Telebanc shareowners will receive 2.1 shares of E*TRADE
common stock for each share of Telebanc common stock. Following the merger,
which is expected to be accounted for as a pooling of interest, Telebanc
shareowners will own approximately 13 percent of E*TRADE's fully diluted common
stock. The Boards of Directors of both companies have approved the merger, but
final consummation of the merger, which is expected to be completed this fall,
is contingent on regulatory approval and the vote of the Telebanc shareowners.
52
<PAGE>
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: June 25, 1999
By: /s/ Leonard C. Purkis
-------------------------
Leonard C. Purkis
Executive Vice President, Finance and
Administration,
Chief Financial Officer (principal financial
and accounting officer)
53
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit Description
------- -----------
<C> <S>
23.1 Consent of Independent Auditors.
</TABLE>
54
<PAGE>
EXHIBIT 23.1
Consent of Independent Auditors
We consent to the incorporation by reference in Registration Statements No.
333-72149, No. 333-62333, No. 333-52631, and No. 333-12503 of E*TRADE Group,
Inc. on Form S-8 of our report dated November 23, 1998 (June 1, 1999 as to Note
15), appearing in this Current Report on Form 8-K of E*TRADE Group, Inc. dated
June 25, 1999.
/s/ Deloitte & Touche LLP
San Jose, California
June 25, 1999
