February 5 2008: 11:30 AM EST
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Etrade vs. Goliath

The online brokerage wagers that customer loyalty can propel it through a rough stretch.

By Colin Barr, senior writer

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Interim CEO Jarrett Lilien says the company benefits from its 'David vs. Goliath' appeal.

NEW YORK (Fortune) -- Etrade is off Wall Street's death watch. And while interim CEO Jarrett Lilien admits that a full recovery remains a ways off, he expects the online broker to succeed because "our customers are pulling for us."

So far, 2008 is shaping up as a much better year for Etrade (ETFC) and its investors than 2007 was. The company has resumed adding customers after 70,000 users - many of them among Etrade's most lucrative accounts - fled late last year amid bankruptcy rumors. Since then, the company has brought in a deep-pocketed outside investor, bid adieu to longtime CEO Mitch Caplan and rolled out a plan to slash expenses while boosting marketing spending.

That's not all. Etrade proudly notes that its trading systems held up during recent marketwide volume spikes - offering a pointed contrast to bigger rivals such as TD Ameritrade (AMTD) that suffered outages. Etrade even scored a hit with Sunday's Super Bowl ad. One spot, featuring a baby who babbles trader talk before throwing up, was the most-viewed commercial in a Tivo survey of subscriber data.

"We've got good momentum now," Lilien said in an interview last week. Lilien says he took particular pleasure in noting investors' response to last month's plan to cut spending by $275 million and focus on the company's core retail franchise. "It was encouraging," he says. "Nobody disputed that the plan we have makes total sense."

Indeed, Etrade shares have surged 63% since they hit their recent low, the day before the Fed rolled out the first of two interest-rate cuts last month. But the bounce came off a low base. The online broker's shares lost more than 80% of their value during a yearlong plunge in 2007. The worst of it came last November, amid worries that losses on mortgage-backed securities might force the company into Chapter 11 bankruptcy. Etrade angrily denied the possibility of a bankruptcy, with Lilien - who was then chief operating officer - dismissing as "irresponsible" an analyst report that broached the issue.

Just two weeks later, the company moved to raise $2.55 billion by selling a big slug of stock and a huge distressed debt portfolio to hedge fund Citadel at a steep discount. The Citadel deal, which also paved the way for the departure of Caplan, kept Etrade going - but at the expense of diluting existing shareholders. That is why Etrade shares kept falling after the announcement. Even after last month's run-up, Etrade shares still haven't closed as high as the $5.28 a share they fetched the day before the company announced its cash infusion from Citadel.

Still, the Citadel deal bought Etrade time to fix its problems, which Lilien attributes to a "broken balance sheet" that was stuffed full of mortgage-related securities whose value has plunged with the decline of house prices and rising defaults. Lilien has pledged to clean up that mess, though with house prices falling and the economy headed for a possible recession, observers don't expect it to be easy.

Analysts at Bank of America and Citi, for instance, rate the stock sell, saying they don't expect the company to return to profitability till at least next year. Even Lehman Brothers, which rates the stock overweight, notes that it will take time for Etrade to execute its turnaround. "We still believe this remains a high risk equity story," analysts wrote following the company's Jan. 25 earnings report, "and we are not convinced the market is ready to look out the necessary distance yet to buy into our higher value thesis."

Some investors clearly do buy into that thesis, however. As Etrade shares have risen in recent weeks, action in Etrade options has turned sharply bullish, according to a post Monday on Schaeffer's Research. And despite the panic that led to the customer defections late last year, many Etrade customers remain loyal - a fact that Lilien attributes to the company's "David vs. Goliath" appeal.

One Etrade user who embodies that notion is Richard Wilson, a Cambridge, Mass., hedge fund consultant and blogger who says he was impressed by Etrade's quick response to the bankruptcy speculation last November. Far from fleeing Etrade in response to that episode, Wilson says he now "vouches for Etrade whenever my friends are looking" at financial services offerings. He doesn't believe the company's reputation has been meaningfully tarnished among the younger consumers who are likely users of online trading and similar services.

"I don't think it's going to hurt them that much," he says. Etrade has "so many services, he adds, that are "more aggressively priced" than those being offered by competitors such as TD Ameritrade or Schwab (SCHW, Fortune 500).

Leslie Gaines-Ross, chief reputation strategist at Interpublic Group's Weber Shandwick, says the biggest factor supporting the stock's recent rally is the presence of Citadel, which is run by the highly respected Ken Griffin - an executive who she says "has the Midas touch." But she adds that history shows that even a company dealing with a serious reputational issue - such as the run on the bank that Etrade suffered last fall - can emerge stronger given the right leadership. And she suspects the David-and-Goliath narrative works in Etrade's favor, given its individual-investor client base.

"Etrade has a lot of work to do," she says. But, she adds, the type of people who are Etrade customers might be more apt to give a company a break. "People say, let's help David out," she says.

For now, Etrade will gladly accept the help. To top of page

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