Earlier in 2012, I suggested E*Trade (ETFC) had upside based on a sum of the parts valuation. Since then the stock has outperformed the S&P 500 by 10% bolstered by Q1 results. I want to update the January analysis with the Q1 numbers, using a probabilistic approach with a bear, base and bull case scenario.
|$M||Bear Case||Base Case||Bull Case|
|Cash on balance sheet (unrestricted)||$557||$557||$557|
|Corporate debt on balance sheet||$1,497||$1,497||$1,497|
|A: Trading/Investing earnings FY12||$300||$350||$400|
|B: Trading/Investing P/E||14x||15x||16x|
|(A x B) Trading/Investing valuation||4,200||5,075||6,800|
|Deferred tax asset||0||800||1,600|
|Ongoing loan business valuation||0||0||2,800|
|Total equity value||700||3,535||6,210|
|Resulting share price||$2.40||$12.19||$21.40|
|Upside (from $10.73)||-78%||+13.6%||+100%|
Weighted Average Scenarios
Then to arrive at a single estimate we weight the underlying scenarios according to estimated probability. Both the bull and bear case appear unlikely, but we give the bull case a slightly higher weighting given the declining trajectory on provisions.
|Resulting Average Price||$12.59|
|Resulting upside (from $10.73)||17.3%|
Notes On The Above Table
- Cash and debt are direct from most recent balance sheet.
- Trading/Investing valuation is based on estimated 2012 post-tax earnings on a multiple relative to peers, specifically Schwab (SCHW) and Ameritrade (AMTD), bear case is at the low end of peers, bull at the high end with base case based on the average.
- Deferred tax is as stated by management, but only taken at face value in the bull case, discounted at 50% in the base case and ignored in the bear case.
- Ongoing business valuation assumes in the bull case that the loan portfolio is a viable income stream once all loses are taken and put on a 10x post tax multiple after provisions are backed out.
- Loan losses are estimated as a percentage of outstanding loans, with losses chiefly coming from the home equity loan book. Essentially, the bear case forecasts 5 more years of losses at the current run rate, the base case 2 more years and the bull case 1.5 more years. This is slightly simplified as provisions have been declining over time (see chart below).
- Equity value is simply the sum of the above numbers and share price is divided by 290,000 shares outstanding.
Loan Losses As The Key Uncertainty
Looking at the above sensitivities it is clear that loan losses are the key to the investment case on E*Trade. Currently provisions stand at just under $600M across all portfolios, with a provision run rate of $400M a year, but declining (see below).
In addition, the vast majority of losses have come from the home equity loan book which currently stands at $5B, or just over 40% of its prior value.
Using a probabilistic approach highlights the risk in E*Trade, with a shock to the economy or the housing market, the loan portfolio could virtually wipe out the equity, yet on current macroeconomic trends this seems unlikely given a housing market that may have bottomed and declining unemployment.
Conversely, the stock could double were it to put the loan issues behind it and achieve a ongoing revenue stream from the loan portfolio, this scenario seems slightly more probable, yet likely still too rosy given the loan issues are far from resolved with significant charge offs in Q1 and thus meaningful value in the loan business appears wishful thinking.
As a result we are left with modest 17% upside, this seems attainable, but investors should consider whether this return offers adequate compensate for the risks and uncertainty surrounding E*Trade's loan portfolio. Personally, I believe there is still some upside in E*Trade for those with reasonable risk tolerance and positive view on the US housing market and US consumer. It remains a significant component of my portfolio.
However, without further positive news on the loan portfolio in 2012 I would increasingly sell down my position were the stock to trade over $13.
Disclosure: I am long ETFC.