Last October, I wrote an Instablog article about E-Trade (ETFC). Six months have passed, and the stock has advanced more than 15% since then. I feel that now is time to review the trends of company's several key performance indicators over the past 6 months and predict how they may shape up for the remaining of the year.
KPI 1 - Provision for Loan Losses (PLL): In the previous article I predicted PLL would keep on decreasing in the coming quarters because housing and mortgage market had bottomed in 2010 and stabilized in 201. This prediction was mostly validated by the last 10-K report. PLL decreased by 43.5% YOY for full year 2011 (from $779.4 million in 2010 to $440.6 million in 2011) and 36.5% YOY for the last quarter of 2011 (from $193.8 million in Q4 2010 to $123 million in Q4 2011). From statistical stand point, because seasonality can be part of quarterly fluctuations this number needs to be compared to the number in the same period of the previous year, not sequentially to the number in the previous quarter.
Because Loan loss and delinquency rate stably stayed at low levels over the past year and average interest spread on these assets only decreased marginally, operating interest income thus almost stayed fixed from 2010 to 2011 ($1,546 million in 2010 and $1,532 million in 2011). Since housing market is seeing no sign of deteriorating again anytime soon and in fact has seen some signs of improving since the beginning of 2012, interest yield and interest income should at least stay at current levels and possibly move higher going forward as housing market further improves, however gradually.
KPI 2 - DARTs (Daily Average Revenue Trades), trading commissions and fees: As Graph 1 shows, although monthly DARTs have not grown as fast as I would like them to grow during this peak period of European debt crisis, it nonetheless has been running at high levels except for December. Trade commissions suffered a moderate pullback last quarter because of the low DARTs in December. Fees and service charges suffered a smaller drop from Q3 to Q4 last year. Because the downward trend of DARTs was reversed at the turn of the year and has gone up strongly in January and February, commissions and fees revenues should be running high again this quarter. More and more reports on investors' behaviors, such as the one published by investment news.com on 1/16/2012 and the one published by Bobsguide on 1/18/2012, contend that more investors are putting bigger portions of their investment portfolio in self-managed online trading accounts like E-Trade than in traditional mutual funds. Historically mutual funds, especially actively managed funds, have consistently underperformed the general market. The underperformance deteriorated during market crashes in 2008 and last summer. As such, it can be expected that E-Trade's brokerage accounts and clients' assets will continue to grow for the years to come.
Table 1 shows other key metrics relevant to the company's brokerage accounts. As we can see, all four data series exhibited upward trends over the past 6 months and especially over the past three months. Meanwhile, average commission per trade stayed very stable at slightly over $11 over the past two years. In all likelihoods, I believe the upward trends of DARTs, customer accounts and brokerage assets will stay for the foreseeable future. If so, the company naturally will enjoy steady growth in trading commissions and fees over the next several years.
KPI 3 - Margin Interest Rate and Margin Borrowing Revenue: Average margin receivables balance increased by 11.2% from $4.47 billion in 2010 to $4.97 billion in 2011 (compared to $3.31 billion in 2009 and $4.985 billion in 2008). According to last 10-K, net yield on interest-earning margin assets only decreased by about 4% YOY from 2.96% in 2010 to 2.84% in 2011 (2.80% in 2009). As a result, interest income from margin receivables increased from $200 million in 2010 to $221 million in 2011. Again, just by eye-ball observations, over the years I saw very small changes on E-Trade's margin interest rates and almost no change in spreads over reference national "base rate" (closely tied to E-trade's funding cost) E-Trade posts on its website. I do not see any reason for the situation to change in the near future and thus do not see any reason that the company will not continue to enjoy steady growth of its margin interest income in the foreseeable future when spreads stay steady while receivable balance keeps on growing.
Now, it is time to ask the million dollar question: having advanced 15% in 6 months, is the stock a buy, hold, or sell right now?
On one hand, one can argue that, many of the positive operational trends that E-Trade enjoyed over the past two years were not proprietary to the company. E-trade's two biggest competitors Charles Schwab and TD Ameritrade also enjoyed quite strong growths in DARTs and brokerage accounts in the last several quarters. Also, as a financial institution, the stock seems to be heavily affected by European debt status. If any negative news on financial health of any key European country hit wire again, all stocks in finance sector will drop, and so does E-Trade. In my opinion associating E-Trade with other banks that are deeply tangled in European bonds is baseless because in the last 10-K the management team clearly stated "We do not hold any positions in sovereign debt of European countries and therefore have no direct exposure to the concerns regarding the creditworthiness of certain sovereign governments in Europe". There is indeed no sign anywhere in the company's financial reports that it has any loss associated to restructuring of European sovereign bonds. However, the market certainly can be irrational at least for short-term. Thus, the risk is real for investors with short term investment horizon.
Over longer terms (beyond 6 months), I feel that the stock still has strong upside potential and is materially undervalued at current level. The biggest silver lining lies on its valuation multiples. As shown in Table 2, while Charles Schwab (SCHW) and TD Ameritrade (AMTD) are both valued at around 4 times of sales and 2.5 times of book value right now, E-Trade is currently valued at only a little more than 2 times of sales and less than 2/3 of its book value.
* Numbers provided by Yahoo Finance as of 4/3/2012.
Because the company has written down a huge portion of its mortgage loans and because there is no sign strongly suggest that another housing crisis is on the horizon, the 36% discount from its book value is especially unwarranted. E-Trade is still strongly standing as one of the "Big 3" in online brokerage business, commanding a market share and valuable brand name that cannot be easily taken away by any competitors. I still see a clear and strong value E-trade offers its competitors at a price of up to $30 per share. It is in its competitors' best interest to dish out a buyout offer sooner than later because right now they still have a chance to buy the company at $20 or lower per share. It will be like giving AT&T a chance to buy T-Mobile at 40% discount to the price AT&T offered last year! The synergy created in the merger of E-Trade and either Charles Schwab or TD Ameritrade will be much more than the synergy created in the merger of TD-Waterhouse and Ameritrade several years ago. The window of opportunity will be closed soon because the company will see a huge chunk of its high-cost borrowing obligations unfrozen later this year. After that, E-trade can dramatically reduce its funding costs, increase net profit, and buy back shares, inevitably pushing up the stock. The choice is on the hands of the CEOs of Charles Schwab and TD Ameritrade now. Mr. McCullough and Mr. Tomczyk: trade or no trade?
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