Will E*Trade Survive? Four Ways It Can

Most financial stocks have experienced nice spikes from their lows and no longer offer the opportunity for investors to make easy money.

In this case, easy money is defined as the profit that comes when failure is taken off the table. The easy money in Bank of America (BAC) took the stock from $2.50 up to $11. The easy money in Citigroup (C) took the stock from $1 to $4.

Investing in E*Trade (ETFC) right now is all about one thing and one thing only; bankruptcy. If they avoid bankruptcy, the stock will at least double over the next year. Many are fearful of dilution, but at the current price of $1.75, a capital raising would eliminate the threat of bankruptcy and the stock would go up on the dilution news. Just as we saw with Citigroup.

Evidence of this phenomenon was observed last Friday when E*Trade filed for a $150 million stock offering and the share price actually rose by 16%.

The current assumption is that E*Trade has to triple their current float in order to comply with the regulatory requirements coming from the Office of Thrift Supervision. Investors were scared out of the stock immediately after the Q1 earnings conference call because the word ‘quickly’ was used in reference to the pending capital raise. Nobody wants to hear the word ‘quickly’ when you’re talking about an estimated $400 to $450 million in new capital along with $1.7 billion in debt for a total of $2.1 billion in new financing according to FBR analyst research.

The interesting story with E*Trade is that the government has not given them any TARP funds. These funds would provide E*Trade with a period of forbearance to either raise private capital, convert the funds to common stock, sell off assets, or earn their way out. No TARP equals no time; hence the unpleasant word ‘quickly’ comes into play.

The most perplexing part of this whole thing is that over 500 banks have received TARP funds and most want to repay it immediately; you’d think there is a surplus available for a company like E*Trade who has almost 5 million brokerage accounts. Because of this strange subjective governmental behavior, the general assumption regarding E*Trade is that they won’t be given the time or the money to survive.

I think E*Trade will survive and am buying shares on this thesis. The core of the company is just too strong. Trading activity in Q1 was up 8% year over year with an increase of 63,000 net new brokerage accounts with $3.5 billion in new customer assets. On the mortgage side of the company, special mention delinquencies are down 25% since 2008 which should result in reduced charge offs in the second half of the year after more are expected in Q2.

An important part of E*Trade’s strategy is what Layton referred to as a “very active loan modification program that was implemented this quarter...the modifications impacted our financial statements...(giving us) very limited exposure to future write downs.”

I agree that the future is brighter than the past for E*Trade. The hardest part is over; they are still standing after the crisis. Corporate cash is at $406 million and bank excess risk capital is at $451 million. Without the loan loss provision from the quarter, E*Trade would have earned $221 million. If they had marked to market in accordance with FAS 159 they would have generated additional income of $500 million. The brand is strong. The baby commercials have been a marketing hit and more importantly, they are driving new customers to the platform.

Again, the most important question is whether or not E*Trade will have to file for bankruptcy. I see four probable alternatives that could help them to survive:

1. The government finally provides TARP relief. This option might not happen because the government has no intention of bailing out a hedge fund like Citadel who practically owns and operates E*Trade.
2. Citadel, who is the largest shareholder in the company with approximately 20%, is capable of providing the needed capital. They also have the ability to take the company private. Not a bad idea when the market cap is under $1 billion.
3. CEO Donald Layton, who became Chairman of the Board of Directors when Citadel provided a $2.55 billion infusion to E*Trade November 2007 and was then inserted as CEO in March 2008 could arrange to sell the company. Let there be no doubt that Layton is Citadel’s puppet, this hedge fund controls the company and they are motivated to do whatever it takes to increase shareholder value. There are potential buyers. The one who is publicly interested is Schwab (SCHW) who said they are willing to buy up parts of E*Trade. I can think of others who would love to have the online trading platform of E*Trade. This is another solid indicator that that bankruptcy will be avoided.
4. Earn their way out. This can happen if the government allows them time. With continued loan modifications and continued growth on the brokerage side along with the potential for write ups in the second half of the year, E*Trade can make up a large chunk of the regulatory money this year.

It seems that last week's filing for a $150 million stock offering will give

E*Trade some time as they seek out the best strategy going forward. The key point being, there will be a strategy going forward and this company does have alternatives to bankruptcy. The fact that they have continued to grow their retail brokerage business in the midst of the financial crisis is a clear signal to me that the core of this company is worth investing in at these distressed levels.

Economic conditions appear to be improving which makes this an opportune time to put some distressed capital to work in a company like E*Trade, which offers high risk but high reward.

Disclosure: Author holds a long position in ETFC

Comments

[Davidpeers:]

I agree totally!! They do have a strong CORE company, that has now become a household name!! And, the risk vs reward is HUGE to the upside...What..it can go down 1.75...but go up to 3-4-5-10???????? I'll take my chances that E-trade will be around along time!! The commercials are GREAT also...Take these broken wings, and learn to FLY AGAIN.......Boo-ya

May 12 04:02 AM

[Race To The...:]

Good article; thanks for posting. I am wondering about two of your alternatives that don't seem to be consistent.

Alternative 2 recognizes that Citadel has the opportunity to take the company private, especially since the market cap is near a billion dollars.

Alternative 3 proposes that Layton's actions correspond with Citadel's and that "and they are motivated to do whatever it takes to increase shareholder value."

I think Citadel is only motivated to what helps Citadel make money, as it should be. The difference in size of option 2 and option 3 is small enough to make me think that taking ETFC private the more viable option. This does not "increase shareholder value". Citadel can then sell off portions that don't match its long term plan.....

FYI, I won ETFC and am positive on it's future but am concerned about Citadel's role.

May 12 10:35 AM

[Al the pal:]

This was posted on another forum.

Michael, look at his whole premise, he is talking about them just surviving. Let's change his premise that they will survive and show why they won't survive or if they do the shareholders won't.

1. No Tarp funds, he said in the article himself it is because of Citadel, much like we have been telling you ad nauseum.

2. Citadel, which owns 20% of ETFC and most of their debt is better off letting ETFC go under, then sccooping up the assets it wants in bankruptcy court, leaving you shareholders with nothing.

3. He talks about Schwab potentially buying parts of the company. Well, what parts do you think Schwab wants? The bank? No, The overseas operations? No, the bad heloc portfolio? No, the brokerage firm? Yes- Guess what happens when Schwab buys just the brokerage firm? You shareholders get left holding the bank, overseas ops an the bad helocs. For which the continuing ops cannot stomache the losses and bankruptcy follows.

4. Because they need to raise a lot more money than what they are raising in their secondary offering. Also-in his article. They are raising 150 million in the stock offering, they need to raise 2.1 Billion, so they are just shy of 2 Billion dollars away from having enough to survive. How are they going to raise that much money? From the tooth fairy. Bottom line is the shareholders are going to get shafted, even if they survive.

May 12 10:50 AM

[Al the pal:]

Michael, look at his whole premise, he is talking about them just surviving. Let's change his premise that they will survive and show why they won't survive or if they do the shareholders won't.

1. No Tarp funds, he said in the article himself it is because of Citadel, much like we have been telling you ad nauseum.

2. Citadel, which owns 20% of ETFC and most of their debt is better off letting ETFC go under, then sccooping up the assets it wants in bankruptcy court, leaving you shareholders with nothing.

3. He talks about Schwab potentially buying parts of the company. Well, what parts do you think Schwab wants? The bank? No, The overseas operations? No, the bad heloc portfolio? No, the brokerage firm? Yes- Guess what happens when Schwab buys just the brokerage firm? You shareholders get left holding the bank, overseas ops an the bad helocs. For which the continuing ops cannot stomache the losses and bankruptcy follows.

4. Because they need to raise a lot more money than what they are raising in their secondary offering. Also-in his article. They are raising 150 million in the stock offering, they need to raise 2.1 Billion, so they are just shy of 2 Billion dollars away from having enough to survive. How are they going to raise that much money? From the tooth fairy. Bottom line is the shareholders are going to get shafted, even if they survive.

May 12 10:50 AM

[Rohan C. Pease:]

I took your advice on ETFC and got back in it on Firday, i payed up a lil but I don't mind, with these stocks its better to see what their cards are before investing. I owned this for a double off of a 70 cent basis a couple months ago, that was the money I put to work in BofA. Now ETFC is back to that level, and your analysis is correct; with bankrupcy off the table ETFC should double in the foreseeable future.

May 12 11:33 AM

[CoverIsBetter:]

"Because it's wreckable!" I hate finding out this whole Citadel thing and how they could stand to benefit from more downside in the stock.
Having played through the WAMU rounds and seeing how easy it was to shaft the common stockholder there, this one seems like an easy fail.
No baby is going to call me a 'Shankapotomus' ;-)

May 12 11:36 AM

[fabregas:]

as an E*Trade account holder (but not a shareholder) I can tell you that they really do have a good platform. I've compared them to Schwab in real-time, and E*Trade gets better fills, has a FAR superior fixed-income interface and overall better features. The mobile trading is very nice too.

I'd be sad to see e*trade disapear and be forced to use an inferior platform.

May 12 07:06 PM

[Hirendu Vai...:]

Great article. I am a serious (read -- "too many shares") long in E*Trade. However, I believe that your contention that Citadel's and E*Trade share-holder's interests are aligned is wrong (in my opinion). Look at the numbers. Citadel has $2.1B loaned to E*Trade and they own 89M E*Trade shares. Even if E*Trade share had to be at $10, that would make Citadel's share-stake worth only $890M.

So Citadel's main interest has to be in protecting their $2.1B in notes.

If so, Citadel's interest is EXACTLY opposite of current share-holder's interest. Their interest should be to merely let E*Trade survive so it continues to payback debt and company's intrinsic value is preserved while the stock price struggles. If E*Trade is so valuable, they will benefit much more if they can get the company for cheap (what you describe as "taking private" -- which I would dare to call a controlled "take-under"). I don't see how E*Trade current shareholders can benefit from such a move.

Given this scenario, indeed your assertion that CEO Layton is Citadel puppet is not very comforting. In such a scenario Layton's task would be to push stock price as low as possible to get maximum dilution for Citadel debt conversion (e.g., maximum ownership to Citadel or whoever gets hand-picked for that debt conversion). Indeed, this is the scenario which many longs who follow this stock worry about. The company is great and is doing good lately, but the stock price is being kept depressed (read my article on seeking alpha).

So in my own interest, I have to hope and pray that CEO Layton is not Citadel's puppet (as you state). Because if that is true, the whole game rigged to leave current shareholders with nothing while Citadel walks away with the loot.

May 12 07:45 PM

[Jim Rich:]

If they wanted to take the company down they've had the opportunity to do so for several quarters. I've been pretty happy with Layton's performance and pretty un-happy with the TARP management and government toying with the capital reserve targets. I think Layton would love to exit his CEO position with the company on top of the competition having beat all the nay-sayers. Loan defaults are finally showing improvement and the question is can they earn, borrow or sell enough to survive in the short term while the remaining defaults are written off. I'd love them to do a public bond offering; I'd buy a 10 year note with a low interest coupon to help them out. Their survival is in my interest too as I like having all my finances serviced by one company... and I've seen what the competition looks like.

May 13 05:36 PM

[E Thomas St.:]

How much does E*Trade spend on their advertising budget? Cut that by 80%

May 21 12:51 PM

[capn68:]

Jason - What's your take on this article
www.easybourse.com/bou...

Is this the ETFC gets a chance to "earn their way out...." to profitability? Also, why isn't the brokerage already doing more to support the bank - why move the broker-dealer away from the parent and under the bank .... isn't this already one company or is ETFC a holding company of a broker-dealer and a separate bank?

May 23 11:04 PM

[CJ-49:]

The author is right on the button. ETFC's greatest asset are it's future earnings and this is many times more than the comparatively tiny $2.1 bonds and $0.9bn shareholding for Citadel. The management of ETFC; Citadel included, are unlikely to be short sighted enough to let go a global platform that is so well known and potent with huge forward earnings for a mere $2bn in bonds. Wake up and smell the coffee, this is a screaming buy.

May 26 02:09 PM

[Luke Johnston:]

Someone mentioned this, and I have felt this way for over a year:

2. Citadel, which owns 20% of ETFC and most of their debt is better off letting ETFC go under, then sccooping up the assets it wants in bankruptcy court, leaving you shareholders with nothing.


Also, this comment in the article is highly misleading:

"Evidence of this phenomenon was observed last Friday when E*Trade filed for a $150 million stock offering and the share price actually rose by 16%."

The stock fell from $2.50 to $1.50 on news that capital was going to be raised, thats over 40%. The fact that it bounced a mere 16% when they actually filed doesn't mean much.

E*Trade Intentionally chose not to use markt to market. They Intentionally wrote off just enough to miss earnings. They control how much they set aside, and they always set aside enough to miss. They know what capital ratios would put them in their regulators "distressed" category.

So, by not using mark to market, and writing off more than needed, they CHOSE to place themselves in this distressed situation which results in dilution.

They have a $1Billion set aside in provisions that have not yet been realized as losses. If you put half of that back into the bank they would be well capitalized.

How can you possibly think that managment is working to improve shareholder value?

May 31 07:45 PM