E*Trade: A Bargain At These Levels?

E*TRADE Financial Corporation (ETFC) has a great online brokerage franchise business. It has been improving its level of customer service, targeting a particularly attractive demographic, and increasing the profit level per customer within that demographic. An online brokerage business is great for several reasons- you generate a lot of cash through customer's brokerage accounts and the costs of being business are relatively fixed so if you can grow your business your profits will really grow. Contrary to popular belief, most of the money is not made through commissions but earning interest between what you charge people for margin loans and what you pay them for their cash and other fees.

E*TRADE used a lot of the money it made as capital for its banking subsidiary. The banking subsidiary entered the mortgage business aggressively, almost certainly too aggressively. Their strategy was to be conservative and not get greedy. Unfortunately, unless you own mortgages for property on Mars, you are currently suffering losses on loans, and home equity loans in particular. They have a portfolio of $12 bn in home equity loans and $20 bn in first lien mortgages. A minuscule amount was in subprime but the bulk was originated in the last 2 years, at the top of the real estate market.

They also owned a billion or so of asset backed securities collateralized by all sorts of residential mortgages on which they have already taken huge losses and they "shockingly" announced they will be taking further losses this quarter. Now if you had paid any attention to the index for such securities (ABX-HE-AA 06-2 is probably representative of their portfolio) this should be no surprise at all.

They will bleed money every quarter out of their loan book. For accounting purposes, loans work differently than securities. With securities, you have to price them according to the market price, which incorporates expectations for all future losses. With loans, only actual losses and some level of reserves hit profits. And at this point, E*TRADE is dramatically under reserved against future losses. Its financials, released last Friday, showed loan loss reserves of 0.08% of its first lien mortgages, somewhat more for its home equity loans.

E*TRADE's bank and brokerage divisions will be in a horse race- can the brokerage division make money fast enough to counter realized losses and additions to reserves over time in the banking division?

I'm not sure - my guess is no. You might ask, if I think these guys could become under capitalized why on earth am I buying this stock?

Because it is now cheap. Really cheap.

E*TRADE's closest competitor, TD Ameritrade (AMTD), is currently valued at $11 billion. While TD has more customers at this point, I would argue that E*TRADE's execution is better and the franchise more valuable.

It is so cheap at this point ($1.5 billion) that someone with a lot of money could buy it, throw in an extra $5 billion to cover future losses in the mortgage portfolio, and still be in the money. If I had $6.5 billion sitting around...

The main spanner in the works will almost certainly be E*TRADE's willingness to sell out at these prices.

Another spanner could be the feeding frenzy atmosphere around the company, largely created by panicked analyst reports authored by people who appear not to have been paying any attention until E*TRADE bonked them over the head with Friday's announcement. E*TRADE long ago made public all the information you would need to write the reports that only came out today.

We shall see.

Disclosure: 1) I bought some yesterday for my own personal account; 2) I am not advising anyone to do this for their own account. This is an extremely risky investment. THERE IS A SIGNIFICANT RISK THAT YOU MAY LOSE ALL OF YOUR INVESTMENT.

Comments

[Uncle Bill:]

This site is called "Seeking Alpha." Your comments do not add any alpha. Please refrain from publishing your speculative moves. Only publish information that may help other investors. Can you understand that? The editors should be taken out behind the woodshed for publishing this.

2007 Nov 13 08:22 AM

[CrossProfit_:]

Good comment, just one problem. You could say the same about half the articles or so on SA. The problem is that not all SA readers are value investors. There are probably over 10,000 day traders reading SA on a daily basis.

So do what we do. Mark your authors/contributors that fit your investment style and skip the rest. A new author has to be read at least once in order for you to decide.

There's nothing satanic about the above article, just not our cup of tea. Will probably read another one or two Alexis articles and then decide. Suggest you do the same as you never know what is lurking behind the woodshed.

2007 Nov 13 12:02 PM

[jcrash:]

I bought some too. We shall see how it goes. I bought them near their peak back in the bubble days and had to wait years, but it paid off. This time, I'm buying at what has to be near a bottom. If it goes to $2, I will double down. At that point, someone has GOT to buy it.

2007 Nov 13 09:19 AM

[Research Guy:]

I enjoyed your article until you stated that you bought the company. Everyone has reasons for buying or speculating in a stock; most will not publish their thesis if it lacks any intellectual horse power. Your investment thesis leaves much to be desired. You are saying that because AMTD is worth $11B that ETFC is cheap at $1.5B? The last time I checked AMTD does not have any meaningful exposure to deteriorating credit assets.

Execution and franchise mean nothing when the underlying business is going to possibly die. Furthermore, if ETFC is a BK candidate, why would anyone buy it now? A purchaser will get a better deal in bankruptcy proceedings, meaning all equity will be wiped out.

This stock should not even be termed speculation right now. Rather, you investment falls into the reckless abandon category.

2007 Nov 13 01:47 PM

[Research Guy:]

There is another problem with your article: you do not disclose that you used to work for E-Trade. Given your current profession of Financial Advisor, this article is inappropriate. Reading your biography, I feel that there are too many conflicts of interest in your analysis.

Anyone who reads this article needs to read Ms. Alexis's bio. You will then realize that this article should not be on this website. A Financial Planner should not be moonlighting as an equity researcher on a public website writing about her former employer.

2007 Nov 13 02:06 PM

[jcrash:]

Well, I got in at $4.09 and out at $5.4924.

Not a bad trade.

2007 Nov 13 04:12 PM