OREANDA-NEWS. Fitch Ratings has affirmed the ratings of Scottrade Financial Services, Inc. (Scottrade) and its senior unsecured notes at 'BBB-' and maintained the Positive Rating Outlook.

KEY RATING DRIVERS

IDRS AND SENIOR DEBT

The affirmation of Scottrade's ratings reflects its established position in the retail brokerage space, the beginnings of a shift towards a more balanced business model, and moderate cash flow leverage as calculated by debt to EBITDA of 1.3x at fiscal year 2015 (FY15). Rating constraints include less revenue diversity than peers and continued operational risk elements highlighted by the recent cyber security issue the company disclosed last year.

Scottrade's Positive Rating Outlook incorporates the company's improved cash flow leverage, tempered growth strategy and better earnings performance.

Fitch views favourably Scottrade's bank sweep program which has helped to moderate the growth in Scottrade Bank in 2015. Previously, Fitch had been concerned about the growth of Scottrade's bank impacting overall performance metrics and potentially requiring the company to issue additional debt to support growth.

Fitch also views Scottrade's progress on its liquidity position at the holding company as supportive to the company's ratings, with cash and cash equivalents covering fixed charges by 4.4x.

That said, Scottrade's business model is still heavily reliant on revenues from retail trading activity. Scottrade is trying to move away from its focus on transactional trading revenues and evolve towards more fee based investment management revenue.

To that end, Scottrade formed Scottrade Investment Management, Inc. (SIM) in 2013 to provide guidance and investment management for customer accounts. Currently, SIM is run out of Scottrade's headquarters in St. Louis. Fitch notes that Scottrade has ramped up branch staffing and recruiting efforts to gather more assets in recent years but it has yet to be a meaningful contributor of revenue as it will take time for the company to evolve.

Core earnings continued to improve through FY15, primarily from an increase of 13.4% in net interest income partially offset by a 9.3% decrease in trading revenues. Through Sept. 30, 2015, net interest income accounted for 55% of revenues compared to 30% for trading revenues. Fitch believes earnings can improve further should short-term interest rates rise by 100 basis points or more.

In 2015, Scottrade started the Boulevard Bank (Boulevard) dissolution process, which affected Scottrade's expense base. Fitch notes that this recently acquired bank has not been an optimal investment for the company given the associated goodwill write-down. Nevertheless these expenses are non-recurring and Scottrade is close to the end of the dissolution process. This helped to push the net income decline of 23.1% in FY15. Fitch believes the run-off of these expenses should help earnings performance over the next year.

Additionally, Scottrade disclosed on Oct. 1, 2015 a cyber security breach. While Fitch does not view this as a ratings driver at this time, it does highlight some of the operational risk elements of the business model, which places some constraints on the rating. An additional constraint is the lack of a public and formal succession plan, though Fitch would note recent hires seem to reduce the company's potential succession risk.

RATING SENSITIVITIES
IDRS AND SENIOR DEBT

As noted by the maintenance of the Positive Rating Outlook, Fitch believes there is the potential for a one notch upgrade over the next 12 to 24 months.

The rating could be upgraded if Scottrade is able to maintain current operating performance and cash flow leverage metrics below 2.0x, while continuing to moderate growth of the bank and maintaining robust holding company liquidity.

Alternatively, the Rating Outlook could be revised back to Stable if bank growth escalates materially, holding company liquidity levels are not maintained, or leverage increases substantially above 2.0x.

Fitch believes the most significant downside rating risks to ratings, along with other retail brokers, is a large operational loss or security breach that causes clients to flee the firm. Operational losses are inherently difficult to predict and measure and do serve as an upwards rating constraint. Fitch would review the impact of any large operational loss or security breach on the firm's clients and franchise to determine if a negative rating action is appropriate.

Positively, in Scottrade's case, the security breach disclosed in October 2015 has not yet caused any noticeable client departures or financial losses. The company has since increased investments in cybersecurity to strengthen its security systems.

Other potential negative rating drivers would include an increase in double leverage, defined as equity investments in subsidiaries divided by parent company equity capital, beyond 120% (calculated to be 105% at FY15), or if the company began to reach for yield in its investment portfolio such that it materially increased the credit or interest rate risk profile of the balance sheet.
Fitch has affirmed the following ratings:

Scottrade Financial Services
--Long-term IDR at 'BBB-';
--Senior unsecured notes at 'BBB-'.

The Rating Outlook remains Positive.