E*Trade: A Solid, Deep Value Stock

Before we begin, something to get you in the mood.

I’ve taken on a large speculative position on ETFC recently, one that has exponentially grown in size over the course of the week. I believe this to be one of the last remaining opportunities left from the Oct-Mar meltdown to make a wild profit on ‘risky paper’. (Hat tip to Jason Schwarz for providing the original impetus for this trade.)

Having read some excellent commentary on personal investment picks on SA (especially from Tom Armistead, Alan Brochstein, and Marc Gerstein), I’ve decided to also outline and organize my decision-making:

Quantitative:

ETFC is in a peculiar situation right now. In addition to a typical focus on fundamentals, its capital structure is also worth noting, due to its dilutive effects.

10/15/09	ETFC 6/30/2009	ETFC 12/31/2004	AMTD 6/30/2009
(sourced from WSJ and 10Ks)
Cash	5.2bn	0.9bn	1.1bn
Book	3.0bn	2.2bn	3.4bn
Tangible Book	0.7bn	1.6bn	(negative)
Loan Portfolio^	34.0bn	24.1bn	n/a
Brokerage Income	202mil		338mil
Total Revenue	797mil		616mil
Net Income	<123mil>		280mil
Loan Provision	404mil		n/a
Shares (WSJ as of today)	1.1bn	0.4bn	0.6bn
Market Cap	1.9bn	5.5bn	12.2bn
(w/ dilution*)	4.9bn

^ - includes MBSs, but not loan allowances

* - dilution is assuming 2.8 bn shares ($1.7bn in debentures convertible around $1)

Loan Portfolio as of 12/31/08:

• MBS – 10.1bn
• 1-4 family (1^st lien mortgages) – 13.0bn
• 2nds – 10.0bn
• Other – 2.3bn
• Fixed: 8.0bn
• ARMs (including 2nds): 17.3bn

From these numbers, we can see how much of an impact the banking division has on ETFC’s bottom line. Its brokerage arm is about 60% the size of AMTD, and overall, excluding the loan provision, they both have similar margins. Outside of large loss provisions, the banking division contributes a sizable amount to the bottom line, meaning that if it is ever given anything close to a clean bill of health, one could expect similar overall valuations to AMTD. That would result in a near tripling of ETFC, given today’s prices.

Personally, given its large cash balances, I’d say that ETFC has already been given the go-ahead. Although this will mark the first financial institution I’ve seriously looked at (my prior speculation on C completely discounted Citi Holdings as an externality), I would say that it looks quite healthy compared to the "too big to fail" institutions out there. I do not see derivative exposures that are several times the size of the US GDP, for example.

Qualitative:

There are several complications surrounding ETFC, all related in one way or another to its loan portfolio:

1. Loan operations
2. Citadel’s involvement
3. The Fed

1) Loan operations - ETFC is winding down its loan portfolio, at a rate of about $1bn per quarter. It has a standing allowance of $1.2bn, or over 5% of its portfolio. As of its 2008 annual report, it had nearly $1bn in non-performing loans (90 days overdue), or about 4% of its portfolio. These numbers are about in-line for the financial sector as a whole (not that such a fact should be encouraging). It is also inexplicably expanding on its MBS portfolio. Apparently this is all government guaranteed agency debt, so perhaps it is not that bad of a deal.

According to its website, it offers fixed mortgages, 5 - 7 year ARMs and interest-only loans. I could not find any information about 2^nd mortgage offerings, and will assume they account for the majority of its portfolio shrinkage.

From CEO Bob Layton, during the last quarterly conference call:

We’ve gone from that liability position where we had to pay high rates on deposits, to a position where we’re actually ultra-liquid at the bank and we are literally looking to have reduction in deposits to accommodate our shrinking asset side balance sheet as the loan portfolios and total runoff.

2) Citadel’s involvement - Instead of a government bailout, for all intents and purposes Citadel has fulfilled this role. Anyone familiar with ETFC is probably keenly aware of the $2.6bn transaction in Nov 2007. This transaction has two parts in my opinion, a) a bullish bet on distressed mortgage-related debt, and b) high frequency trading (HFT).

We’ll focus on the HFT. Matthew Goldstein has written a superb article highlighting what one can argue is the ‘real’ reason Citadel got involved. As you can see, it has proven to be spectacularly profitable for Citadel, even with only 40% of ETFC traffic routed to the hedge fund over the past two years. If we can pin a majority of the growth in HFT profits to the ETFC deal, we’re looking at a significant return on its $2.6bn investment. Not to mention that the convertible debentures already have an additional 58% return baked into it. According to the WSJ, Citadel still holds over $800mil of these debentures, along with its approximate 9.9% position in the stock. This would place its ownership percentage somewhere upward of 30-35%, assuming a fully diluted 2.8bn shares.

This New York Times article highlights the OTS stonewalling Citadel’s attempt to route nearly all of ETFC’s traffic to its desks. Apparently the concession granted was to allow Citadel to hold more than 25% of ETFC without the typical regulatory oversight over ‘holding companies’.

This points to a commitment on the part of Citadel. It’s certainly possible for hedge funds to take long positions in companies that may give favorable returns, such as John Paulson’s stake in ROH (now DOW), and Soros’s past commitment in QCOM. I see Citadel’s current stance as similar in nature.

One last thing to note is that Citadel has its own problems. I would imagine that Ken Griffin would rather not have to deal with an angry mob at his backside. Like all mobs, they're appeased with large wads of cash, the raising of which may be a cause for Citadel’s selling of ETFC. This is great for all other investors who have deep enough pocketbooks to speculate on ETFC at these depressed prices.

3) The Fed - Sometimes I wonder if we actually are subject to a centrally planned economy. I’ve been making speculative bets along with being outright bearish due to what I perceive as a dearth of actual investment opportunities in the marketplace. I’ve since altered my stance. What has erased my suspicions of a justified re-mauling of the market, IMHO, is the Fed. Marc Faber, among other things, is now famous for uttering the quote “Don’t underestimate the power of printing money,” and it seems that at least for asset prices, this has proven to be prescient. As long as the Fed keeps the punch bowl out, it looks like everyone is going to get drunk with greed.

Since countless analysts have posted more eloquent summaries of the situation, I will merely say that I believe it to be in the Fed’s best interest to keep QE on for as long as feasible, i.e. until inflation risks becoming an uncontrollable danger. This may end up buoying risky assets enough so that they’re no longer risky, mainly by inflating debt to a fraction of its current value. Both of these results will give ETFC a double-shot in the arm, as the former restores its balance sheet, and the latter assumes a general consumer recovery, one in which ETFC would naturally participate.

Conclusion:

1. ETFC is priced at pre-bankruptcy prices without a bankruptcy in sight.
2. Citadel has shown clear signs of holding onto its position.
3. The Fed has been explicit in supporting an ‘easy money’ policy, perfect for banks to recover their balance sheets.
4. Add 1-3 together, and I believe that ETFC, despite seeming like a risky stock, is actually a pretty solid deep-value play.

One more time...Whoa.

Disclosure: I’ve written cash-secured LEAP puts @ 5 exp Jan 2011, and used the 65% premium to purchase LEAP calls @ 2.50 exp Jan 2011 – these options currently trade at a 7-1 ratio. Partial exit strategy would be to wait until the options reach close to a 1-1 ratio (probably when ETFC hits around 3.5 - 4), and close the put position by selling calls. If ETFC hits 5, this strategy will yield at least 350% on secured cash.

Comments

[doodoo]

Go ETFC.Hope our right,

2009 Oct 20 06:15 AM

[lucky lenny]

Ricard, here's my analysis on E-trade, which i believe could go to $5-10 over the next 12-24 months:

E-trad is at $1.75. Here’s what I like about the stock and why I’m holding:

• Loss provisions are moderating on a quarte-over-qtr basis. Per the 9/15/09 press release, E-trade is projecting a provision for loan loss of between $300-$375 mill; vs. $404.5 mill in 2Q09 - so the provision is moderating

• stock market is back on the upswing; w/ the DOW now over 10k

• despite advertising expense being cut in half, new a/c openings are strong; with a record 2.7 mill brokerage a/c’s as of 8/31/09

• Per the 2Q09 income statement, interest income, commissions, fees, and other revs are tremendous; running around $350 mill/qtr

• E-trade is getting its groove back on. Advertising costs coming down, in 2Q09, only $25.0 mill vs. the usual $44 mill or so. Tells me they’re over the whole meltdown debacle issue.

• Per 2Q09 Balance Sheet, E-trade looks to have enough capitial to weather a few more qtrs & even years of losses; with $6.7 bill in cash & investments; and net equity of $3.0 bill. Not that they’ll have these large losses; just that if they did, they’re still coming back w/out going Chapter 11.

• And finally, the #1 reason, is E-trades 2.7 mill brokerage a/c’s which could lead to a takeover. Even w/ the 662 mill shs o/s (diluted), I think E-trade’s trading platform, name recognition, tax loss carry-forwards, and customer bases would result in an offer of around $5-10/share. Especially if E-trade could become breakeven or profitiable before the buyout.

2009 Oct 20 06:44 AM

[effeff63]

Sticking to my Apr 2010 $2.00 covered call sales for a net gain of 40% if exercised. The call premium is about 20% with the shares @ $1.70.

2009 Oct 20 09:43 AM

[China Expert]

Deep value stocks trades as a low multiple of EBITDA relative to its total enterprise value. This company has NO EBITDA. This stock is neither a deep value stock nor a value stock .... it is merely a stock that trades measured on hope.

2009 Oct 20 10:08 AM

[Luke Skywooker]

If the stock goes to 5.10, you make 300% by onwing the common, why not just buy the common at $1.70, todays price

2009 Oct 20 10:36 AM

[Tom Armistead]

China Expert, what I see here is a speculative value stock, there is a chance of tripling or better if you accept the author's view, or that of lucky lenny, who suggests 5-10 from 1.70 now.

Set against that there is the chance of losing the whole amount invested if the banking operations take a turn for the worse. The author has stated that he regards it as a speculation.

Ricard, good article, thanks for the mention.

Tom

2009 Oct 20 11:20 AM

[User 488509]

Article is full of errors, misunderstandings and silly assumptions.
Just look at his conclusions:

"Conclusion:

1. ETFC is priced at pre-bankruptcy prices without a bankruptcy in sight.
2. Citadel has shown clear signs of holding onto its position.
3. The Fed has been explicit in supporting an ‘easy money’ policy, perfect for banks to recover their balance sheets.
4. Add 1-3 together, and I believe that ETFC, despite seeming like a risky stock, is actually a pretty solid deep-value play."

-----------

First , ETFC is actually priced for an "optimistic" earnings scenario. Using approx. 3 billion shares as the diluted share outstanding denominator , to earn just ten cents per share or a 17 p/e , ETFC will need to book a clean $300m profit in the next 12 months.
Unlikely!

Second,Citadel seems to be leaving as fast as they can. In the last 6 months , their overall $2.6 Billion dollar position in ETFC has been reduced to under a $1Billion including the complete sale of every ETFC interest paying bond they owned.

Third , ETFC is in the banking biz in name only. Third party loans are not going to yield much profit. Can't believe you wouldn't know this??

This artcle was very,very shoddy work.

2009 Oct 20 11:59 AM

[Tack]

When you have $60B in your loan portfolio, you're in the banking business, whether you want to be or not.


On Oct 20 11:59 AM User 488509 wrote:

> Article is full of errors, misunderstandings and silly assumptions.
>
> Just look at his conclusions:
>
> "Conclusion:
>
> 1. ETFC is priced at pre-bankruptcy prices without a bankruptcy in
> sight.
> 2. Citadel has shown clear signs of holding onto its position.<br/>3.
> The Fed has been explicit in supporting an ‘easy money’ policy, perfect
> for banks to recover their balance sheets.
> 4. Add 1-3 together, and I believe that ETFC, despite seeming like
> a risky stock, is actually a pretty solid deep-value play."
>
> -----------
>
> First , ETFC is actually priced for an "optimistic" earnings scenario.
> Using approx. 3 billion shares as the diluted share outstanding denominator
> , to earn just ten cents per share or a 17 p/e , ETFC will need to
> book a clean $300m profit in the next 12 months.
> Unlikely!
>
> Second,Citadel seems to be leaving as fast as they can. In the last
> 6 months , their overall $2.6 Billion dollar position in ETFC has
> been reduced to under a $1Billion including the complete sale of
> every ETFC interest paying bond they owned.
>
> Third , ETFC is in the banking biz in name only. Third party loans
> are not going to yield much profit. Can't believe you wouldn't know
> this??
>
> This artcle was very,very shoddy work.

2009 Oct 20 01:03 PM

[Ricard]

Great comment stream so far. I appreciate opposing opinions when they come with justifications for it, and in that sense I am very satisfied with the comments left behind by everyone.

@luckylenny

I agree the brokerage business looks very healthy, and left the 'why' out of the article.

@luke

Good question.

You have to fully work out the strategy. Yours is assuming owning 100% ownership of stock until it hits 5.

My scenario calls for selling enough out in order to 'break even' at 3.50 - meaning that my remaining 83% calls outstanding would be 'free' of risk - I would have exited the put portion of this trade along with 1/7 of my call position. Given that only 65% of secured cash is invested, and given that there was a partial sell midway, the fact that this strategy still returns 350% is noteworthy, IMHO.

I've incorporated this into my long call bets in order to map out a logical and clear exit strategy into my decision-making. It is easy to see options double, and have greed take over, and miss what would have been a great exit point. This way, if I happen to be right AND wrong, I have an exit point where I still get a chance to participate further if I turn out to have been too conservative, and suffer none of the downside.

Unlike what I did for C, the puts do not have a time premium, which made me think twice about writing them. However, given the option between buying straight out-of-money calls or at least incorporating a less risky strategy, I chose to merge the two into this hybrid.

2009 Oct 20 01:16 PM

[Ricard]

I would point out that the reason this stock has no EBITDA is because of the loan provision. Take it out, and you have an incredibly robust bottom line, with margins that exceed AMTD.

Of course, that may be a bit too rosy given that non-performing is right up there with the provisions, but I hope you see my point.

You're right in that this trade is predicated upon a nominal housing recovery (and corresponding nominal financial sector recovery), IMHO planned out and executed by the Fed. Given that the Fed has explicitly stated that it will keep rates low and QE out for the foreseeable future, I think that what would be 'risky bets' in stocks like this become much more attractive and under-valued.

On Oct 20 10:08 AM China Expert wrote:

> Deep value stocks trades as a low multiple of EBITDA relative to
> its total enterprise value. This company has NO EBITDA. This stock
> is neither a deep value stock nor a value stock .... it is merely
> a stock that trades measured on hope.

2009 Oct 20 01:20 PM

[Ricard]

I saw your debate with Redbeard in Jason's column...excellent if I may say so.

Here are some of my justifications for my logic:

1) Let's start with the share sales. The NYT article is key here, because I would imagine a diversified hedge fund like Citadel is desperate to avoid any prying eyes, especially of the regulatory flavor, from looking too closely at its operations.

Bank Holding Company Act of 1956, Title 12, Ch 17 of the US Code:

A Bank Holding Company:
“bank holding company” means any company which has control over any bank or over any company that is or becomes a bank holding company by virtue of this chapter.

"Any company has control over a bank or over any company if—
(A) the company directly or indirectly or acting through one or more other persons owns, controls, or has power to vote 25 per centum or more of any class of voting securities of the bank or company..."

This has, according to the NYT article, been waived for Citadel's excess ownership of E*TRADE (to what degree I'm not sure, for now I am working under the assumption it must be well below 50%), a concession to deter it from routing its brokerage traffic to its desk, it seems.

Then, look at this link, and I'd imagine that Citadel is desperate to cut ownership enough so that it will not have to comply with this section of the law:

www.law.cornell.edu/us...

Thus, the fact that they have gained concessions to exceed 25% ownership, and that they still own in excess of this amount, is IMHO a positive sign of Citadel's intention to ride this stock upward.

Finally, I must remind you that all of Citadel's selling has been profitable. They are not exiting out of a losing position here. They are not 'desperate'.

2) Your earnings analysis justifies the stock today at today's
prices...but stocks rarely reflect only the views of the moment. If the loan portfolio improves, it is possible that by this time next year, it will be able to meet and exceed that number. AMTD and ETFC's brokerage arms are still profitable in this abysmal environment...think about a recovery scenario, even if it's only nominal.

If the loan provisions were reduced to, say $100 mil a quarter, ETFC will be earning well north of $0.5bn annually, all else being the same. AMTD is already poised to earn twice that amount this year. There is room for optimism, IMHO. We will see how ample next week.

3) You're right, the banking business will likely eventually become a supplement to its profitable brokerage arm. I saw comments from management in the past earnings call implying a general exit out of loans (which was why I was surprised by the increase MBS position), and using the sweep from cash deposits for brokerage accounts. I will not profess to knowing the economics of this aspect of the business.

I'm guessing the increased MBS position is due to its inability to reduce customer deposits by an acceptable amount (see CEO's statement). Thus, as deposits decrease further to their liking, these MBS positions may also decrease accordingly...but that is close to pure conjecture on my part.

Ball's in your court.

On Oct 20 11:59 AM User 488509 wrote:

> -----------
>
> First , ETFC is actually priced for an "optimistic" earnings scenario.
> Using approx. 3 billion shares as the diluted share outstanding denominator
> , to earn just ten cents per share or a 17 p/e , ETFC will need to
> book a clean $300m profit in the next 12 months.
> Unlikely!
>
> Second,Citadel seems to be leaving as fast as they can. In the last
> 6 months , their overall $2.6 Billion dollar position in ETFC has
> been reduced to under a $1Billion including the complete sale of
> every ETFC interest paying bond they owned.
>
> Third , ETFC is in the banking biz in name only. Third party loans
> are not going to yield much profit. Can't believe you wouldn't know
> this??
>
> This artcle was very,very shoddy work.

2009 Oct 20 01:55 PM

[Pj568]

A quick review - back in 06 (near peak) ETFC earned 1.50 with 400 mil shares outstanding sold for 25 , a pe of 17.

Today with the diluted 2.8B shares (greater by 7x) and keeping the same 17 pe earnings would be around 30cents if selling at 5 or 60cents if selling at 10. Therefore we're talking net income of 840M or 1.68B.

The most money TD Ameritrade (AMTD) ever made was 803M. So realistically how can ETFC get to even 5.

2009 Oct 20 02:07 PM

[dogtrack2]

Enough with BS. Whether it's "Buy Out Imminent" or "Citadel is done selling" nobody knows jack. The tape is the only thing that matters and it sucks!

2009 Oct 20 02:11 PM

[Jason Schwarz]

Ricard,

Excellent analysis. Patient speculation can produce quite a reward. I'm perfectly content to hold throughout 2010 and let the stock rise come to me.

2009 Oct 20 02:25 PM

[redbeard20000]

Thanks Ricard for putting into a column the same basic thoughts I've had since I've been following Etrade. And for articulating it better than I could hope to do. Great that you posted a ton of links, I know how much they mean to some people.

Once they raised the extra 600 million in capital and pulled off the debt for equity swap, I've been almost 100% sure that bankruptcy was off the table. I bought the majority of my position within a week of those announcements. With the bankruptcy question out of the way, it all comes down to how much the company is worth in a "normalized" environment. Then you just buy some shares and arbitrage away the bankruptcy discount thats currently there. Whether that takes 1 month or 2 years, who knows, but its coming eventually.

As for what the company is actually worth, I'm afraid some people are a little too bullish, with 2.8 billion shares on a fully diluted basis, I really don't believe they have the earnings power to be a 5+$ stock, unless they see some very good growth on their brokerage side in the coming quarters. My price target is 3.50 per share, but will be looking to either get out, or sell covered calls at around 3.

I've already been able to get some great returns selling jan10 2.50 calls back when they spiked above .40 a month ago. The option premium on the calls and puts are still too high at this point considering where the shares are trading, so I think you're better off with a covered call position or selling out of the money puts, which I am doing as well.

2009 Oct 20 03:00 PM

[Egg]

Most of the ETFC holders predicting $5 and (gasp) $10 shares prices are truely ignorant. Factoring in eventual dilution, the all-time high for ETFC is $3-$3.50.

Yes, that would be an all-time high market cap. I say again, all-time high. As high as when the stock was $25/share. Before ETFC blew up their company with bad risks.

So if ETFC goes to $3.50, it WILL be at an all-time high. And why would anyone think ETFC would trade at an all-time high after the mortgage debacle they are still unwinding?

Dilution kills.

2009 Oct 20 03:01 PM

[Ricard]

My apologies, I made one error in tabulating the chart:

The net income number for AMTD is supposed to be 171mil. I inputted the net income before taxes number by mistake.

2009 Oct 20 06:52 PM

[Ricard]

My apologies - there are some errors with the 'net income' columns in the table. It amazes me that the table took longer for me to put together than the rest of the article - I'll have to remember to re-double-check my figures before submitting in the future.

Net Income - I copied the wrong income columns from the WSJ - for ETFC 6/30/09, the 'net income after taxes' figure is <$143mil>, and for AMTD, it is $171mil.

Cash - upon re-reading the 10K for ETFC, I decided to add the 'cash/investments' column into general 'cash'. Thus, for 6/30/09, ETFC had $6.7bn, and for 12/31/04, $1.7bn. For AMTD, the description is less clear, but if you include it, the amount would be $6.4bn.

Generally, the overall picture does not change, except that it may be a little easier for ETFC to match AMTD in quarterly income in the near future. I apologize for the silly mistakes.

2009 Oct 20 07:51 PM

[Ricard]

BTW, I agree with comments stating that ETFC will probably not go much higher than $3, given today's prices. Any profit afterward will be incumbent on relative performance (say, if AMTD rises another 20-30%), as well as more asset inflation (the Fed).

2009 Oct 20 10:35 PM

[colony]

Well, I think it is very important to remember that as the loan portfolio heals and provisions begin coming down, the cash that is being held againt the portfolio will become free every quarter as the loans wind down.

Layton particularly emphasized this fact and gave a hint that the next CEO can possibly decide to use that cash to buy back shares. This I believe is a key reason to hold the stock. $6.7 billion is a LOT of cash, and with the loan portfolio of $22.9B running down at the rate of ~ 1 billion per quarter......

The cash coming free and the debt to equity exchange is big in my eyes. We will see how Q3 goes, but Q4 should be positive EPS finally.

Disclosure: Currently out of ETFC, looking to re enter here in the 1.60s before CC next week!

2009 Oct 21 03:27 AM