Playing With the Fire at E*Trade

We had a small position in E*Trade which we initiated last week, in part due to agreeing with some of the long-term conclusions put forth by Bill Miller at Legg Mason in his 3Q letter to shareholders (.pdf).

E*Trade was doing what many were doing in the mortgage business. Based on a credit score alone you could easily get a mortgage with no documentation, no appraisal (other than a supposed "drive by") and very low fees.

E*Trade has been in crisis mode before and one of our larger clients bought a huge position. His analysis suggested that the replacement value alone for their technology platform was close to the total market capitalization at the time.

The problem now is that it is impossible to know to what extent the value of E*Trade could be impaired by the risk in the banking business. When Enron collapsed, a day of research would show that the company actually had no real assets to use to support a stock price. In our view, E*Trade has clear value in their platform, their customers and capabilities. In fact, we don’t think there is any way E*Trade is going to disappear but there could well be a re-capitalization and/or merger with another player.

On the question of customer panic and business impact, we think there will be some. Trolling the online reactions, there are clearly many individual investors who will switch their accounts to other brokers like TD Ameritrade and possibly shift their banking to places like ING or even regular full service banks. This is true even though there really isn’t any risk for most account holders but many people get emotional about what they read in the newspaper. Unfortunately having "possible bankruptcy" all over the news and watching the stock plummet to $3 creates alarm and concern that will probably cause customer and asset shrinkage in the short term.

Research 2.0 acquired a substantial position in E*Trade stock on Tuesday. It’s probably not going to go up in a straight line and the immediate 40% rise will certainly lead to some near-term profit taking. However, it’s likely that we will continue to own some position in ETFC even after today. If the company can get through the crisis as an independent the stock could certainly be worth $10 to $15. If the problems are not surmountable the company will be absorbed but equity holders can’t be certain to profit from these levels due to the fact that additional capital infusions might be needed.

Disclosure: Long ETFC

~ Kris Tuttle for Research 2.0

Comments

[David Neubert:]

I was impressed with the CEO interview yesterday on CNBC. "There is no chance we are going bankrupt." It's always good when a CEO doesn't hedge comments. Was enough to get me to buy the stock.

Disclosure: I'm long ETFC. I also trade around the position often so my next transaction could likely be a sell.

2007 Nov 15 01:01 PM

[David Neubert:]

I was impressed with the CEO interview yesterday on CNBC. "There is no chance we are going bankrupt." It's always good when a CEO doesn't hedge comments. Was enough to get me to buy the stock.

Disclosure: I'm long ETFC. I also trade around the position often so my next transaction could likely be a sell.

2007 Nov 15 01:01 PM

[Research Guy:]

Ken Lay was adamant in telling his employees and the Street that Enron would not go bankrupt. People who wish to write articles and make claims that a business platform has value need to back up these assertions. Research means that when you draw a conclusion you provide tangible evidence. The article lacks any tangible evidence in two places: (1) where do you provide a basis for valuing the business platform; and, (2) why have you not assessed the likelihood of bankruptcy. Tools exist for such endeavors, most readily known is the Altman Z Score.

Note on Bill Miller: his letter to shareholders was quite interesting. Mr. Miller makes a few presuppositions which torpedo his thoughts on Housing stocks. Mr. Miller states that the credit markets are not working, that credit market provide liquidity to function, and that when credit fails the economy starts to backfire. He goes on to state that the difference in 2007, is that problems are not confined to Wall St. If these statements are true, how can a company like Countrywide, E-Trade, or any home builder be undervalued?

These companies and their sectors rely on credit markets. Therefore, anyone can logically conclude that if credit markets do not work, the housing sector and mortgage lenders will continue to suffer. Please be carefully when reading exuberant comments on such value traps!

I enjoy Seeking Alpha, but the writers need to start providing data rather than general comments and assertions. An entire industry gets paid to do that, provide some value.

2007 Nov 15 02:55 PM