Given volatile markets and macro headwinds, investors have the opportunity to generate high risk-adjusted returns in online brokerage firms. The Street currently is slightly bullish about Charles Schwab (SCHW), but rates E*TRADE (ETFC) closer to a "sell" than a "buy". I find that even if E*TRADE's multiple declines and 2012 EPS is a miss, the company would still not depreciate in value. Accordingly, E*TRADE has considerable upside as an unsuspecting value play.
From a multiples perspective, both firms trade at the high end of peers. Charles Schwab trades at a respective 16x and 14.1x past and forward earnings while E*TRADE trades at a respective 17.2x and 10.5x past and forward earnings. Over the last six months, the former has declined by 31.8% as the latter declined by 43.7%. The significant underperformance to the market has limited the downside and both companies are trading at the low-end of the 52-week range.
At the third quarter earnings call, E*TRADE's CEO, Steve Freiberg, noted favorable results:
We are pleased with our third quarter performance as we executed well during a period of extreme market volatility, driven by continued uncertainty in the global economy. We reported net income of $71 million or $0.24 per share on revenue of $507 million...
[W]e recorded an income tax benefit of approximately $62 million, or $0.21 per share, related to the taxable liquidation of the European subsidiary in conjunction with our international restructuring. On the expense side, we reserved $55 million or $0.13 per share, related to our intention to initiate and offer to purchase auction rate securities held by customers of E*TRADE Securities.
In addition to the two expenses and tax benefit, E*TRADE also executed well operationally despite volatile markets. SmartMoney recognized that the firm had the fastest customer service response times and 358K trades were processed when the US debt was downgraded. Management has ramped up its financial consultants 33% for the year thus far and is doing well with product innovation. I am particularly optimistic about Pro Lite, which offers no-fee access at an attractive price.
At the same time, November results were slightly below peers for DARTs with -11% y-o-y growth. Total client assets fell 2% m-o-m to $173B and delinquencies were up from October. High credit costs and NIM challenges also loom. When the firm sought to sell itself, it called in Goldman Sachs (GS), which reportedly was unable to find a buyer.
Consensus estimates for E*TRADE's EPS are that it will turn positive to $0.67 in 2011 and then grow by 9% and 28.8% in the following two years. Assuming a multiple of 14.5x and a conservative 2012 EPS of $0.71, the firm has 33.4% upside. Even if the multiple were to plummet to 11.3x and 2012 EPS turns out to be 5.5% below the consensus at $0.69, the stock is safe from downside. Accordingly, I disagree with E*TRADE being rated nearer to a "sell" than a "buy".
In November, Charles Schwab's net new flows grew 4% organically y-o-y to $6B and DATs declined by 15% m-o-m. While this performance was worse than peers, new brokerage account creation was fairly good at 64K. As a result of the rate rate environment, investors should still anticipate greater prepayments and also lower NIM.
Consensus estimates for Charles Schwab's EPS are that it will grow by 89.5% to $0.72 and then by 4.2% and 20% in the following two years. Assuming a multiple of 16x and a 2012 EPS of $0.73, the stock has only 7.6% upside. Although there is greater stability with an investment in Charles Schwab, E*TRADE, in my view, offers superior upside.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
