E*Trade Appears Ready to Climb

| About: E*TRADE Financial (ETFC)

It appears that the mandatory regulatory repositioning of E*Trade (NASDAQ:ETFC) stock is complete. U.S. Securities and Exchange Commission filings show that E*Trade’s largest shareholder, Citadel, has now sold off $206.8 million over the last couple of weeks. These sales reduce their stake to a more comfortable level of 9.4% of the shares outstanding.

Citadel’s primary purpose for selling is to stay below the 10% mark; bank stakes above 9.9% require investors to submit intensive federal oversight that a hedge fund like Citadel desperately wants to avoid. Citadel actually owns much more than 9.4% of E*Trade but because of an agreement that restricts their ability to convert E*Trade debt into stock, they are able to escape the regulatory headache. Citadel may want to continue to reduce their holdings in order to have increased wiggle room underneath 9.9% for future conversions but the rate of sales appears to have moderated significantly.

The selling pressure caused by Citadel as well as E*Trade’s own capital raising efforts have created quite a burden on E*Trade’s attempts to go higher. The burden is over. Now we can focus on fundamentals. The fundamental outlook for this company is as solid as it has been in over two years, yet the stock is still priced for failure. Now that the structural selling pressure has subsided, E*Trade stock will be free to run in a unique window of opportunity spanning the next six months. Consider the following catalysts:

1) An Improving Landscape

The mortgage losses that have slammed E*Trade are on the verge of becoming a positive for shareholders. The bottoming process in housing is taking root. On Monday, the Treasury Department announced that Blackrock Inc, Wellington Management Company LLP,. and AllianceBernstein LP will commit $1.94 billion to purchase troubled real estate assets in the governments Public Private Investment Program (PPIP). The purchasing power of the 3 funds will increase to $7.74 billion because of Treasury financing incentives. So far, there is $12.27 billion in purchasing power through PPIP with that number expected to rise to $40 billion. This program will serve to boost a mortgage market that is showing signs of improvement on its own.

The Financial Times reports that the Q3 rally in toxic securities could deliver a significant boost to US banks earnings if the institutions choose to recognize the short term improvement. These mortgage securities that forced massive ‘write-downs’ in 2008 may be on the verge of ‘write-ups’ as we near 2010. In the last three months, the Market ABX Index, which tracks securities backed by home loans, has gained more than 30 percent as investors have rediscovered their risk appetite and the US government flooded the debt markets with liquidity.

In a recent upgrade from FBR Capital, the analyst commented, “investors should focus on evidence of continued improvements in delinquency trends in Etrade’s $8.8 billion HELOC portfolio, as well as stabilization in delinquencies in the $11.4 billion one-to-four-family portfolio.” E*Trade expects total net charge-offs of $375 million during Q309 representing a sequential improvement over Q209. Analysts from Goldman Sachs and Citigroup have joined FBR in upgrading E*Trade because of signs of improvement in the mortgage portfolio.

2) A Thriving Core Business

Even during the carnage of 2008, E*Trade was able to grow its core brokerage business by adding $6.4 billion in customer assets. 2009 has witnessed more growth. CEO Donald Layton said on the Q2 conference call, “Our online brokerage business in thriving...volumes are up versus last quarter, our average commission per trade is higher, and interest spreads are much improved.” The movement to online trading continues to be a high growth trend. As high speed mobile Internet access becomes increasingly available, this trend will continue.

E*Trade is a company perfectly situated for success in the tech revolution. Layton is stepping down at the end of year and I expect the naming of a new CEO to be met with optimism from shareholders who are looking for a new beginning. A renewed emphasis on E*Trade’s strength should be applauded by Wall Street. Surviving the financial crisis was no small thing.

3) Buyout Potential

I rarely buy a company for its buyout potential because of the uncertainties involved, but this one is different. The mere speculation of consolidation within the industry will fuel a stock rise whether it happens of not. There may be multiple suitors for E*Trade beyond TD Ameritrade (NASDAQ:AMTD) and Schwab (NYSE:SCHW). An institution looking to become a major player in the online brokerage business like Wells Fargo or Goldman Sachs might actually be a better fit with E*Trade because the mortgage portfolio wouldn’t be as much of a problem. As evidenced by the recent success of PPIP, firms are actually beginning to view mortgages as a positive.

I’ve been looking forward to October as a prime opportunity to increase my position in E*Trade. I made my first purchase in March with the stock under $1, and I’m adding to it now because it appears the dilutive improvements to the company’s capital structure are complete. I believe E*Trade is ready to resume its climb. I'll be purchasing out of the money $2 April 2010 calls and $2.50 January 2011 calls.