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