An Analysis of the E*Trade-Citadel Deal

I've been spending some time today mulling the Citadel investment in E-Trade (ETFC). I'll note some positive components first, and then some of the more worrisome aspects.

On the one hand it is a savior, of sorts, for E-Trade, which had been wobbling badly because of the problems, real and perceived, in its portfolio of subprime/ABS assets. This Citadel deal helps solve some of those problems, first by taking those asset-backed securities off E-Trade's books, and second by putting some new cash onto E-Trade's balance sheet.

Further, the investment - even more so than the Abu Dhabi deal at Citi - will mark in many people's minds a bottom for the struggling subprime mortgage sector. "If Ken is willing to buy, so am I" goes the logic. Granted, there is a half-trillion more of subprime resets to come in 2008, but there is a growing consensus out there that at 26 cents on the dollar - the effective valuation in the Citadel pricing for E-Trade - we are likely already valuing subprime assets at levels that more than reflect the likely default rates.

With the preceding in mind, this is likely a great deal for Citadel. It gets asset-backed securities - read:subprime - at a low price, one that will likely turn out to be very smart a few years from now as default rates turn out to be considerably lower than most market nihilists expect today. At the same time, it gets paid for doing the deal by getting an attractive interest rate on an associated note.

This will go a long way toward reassuring E-Trade investors and customers that the company isn't disappearing immediately. While Citadel has no real strategic interest in E-Trade as a business, it also likely doesn't want to see the company disappear into bankruptcy.

Now some more critical commentary - as I listen, for the second time, to the E-Trade conference call.

First things first: the price on E-Trade's ABS book. We just had a major mark-to-market event, in effect. As more than a few people have argued to me via email, if most of the industry had to mark their ABS books to 27 cents on the dollar, the U.S. banking business would be in deep, deep trouble.

Second, there is a troubling absence of specifics about the E-Trade loan book, and about some of the more nitty-gritty specifics of the deal, like the loan loss provisions embedded in the portfolio. While the management team is ducking the question on the conference call, there were 60 Citadel staffers apparently pouring through E-Trade's books, so I have a hard time buying that they don't have a very specific view of what is going on among these troubled assets. (Relatedly, there is no Edgar filing yet on the deal. Why not?)

Related to the preceding, why no info on the breakdown of the $1.6-billion infusion between equity and notes? That seems, you know, big and material, but I am old-fashioned that way.

Next, E-Trade CEO Mitchell Caplan has made out nicely, which will piss off shareholders to no end. Not that he needed to be hung over a river for E-Trade's subprime misadventures, but it's deeply galling that he has been able to cash out so completely from a wobbling business.

Finally, this deal is awfully dilutive to existing shareholders. The total dilution from the deal is something like $0.50, which, on top of lost customers (most of whom were more active and sophisticated) over the last few weeks, pretty much takes E-Trade's earnings power to zero.

Overall, this deal shores up E-Trade, but it's tough to tell what more (or less) it currently does. We just don't have enough specifics, and management was light on facts in the conference call.

In the absence of more data I'll call it mildly positive for E-Trade, great for Citadel, and near-term negative for the industry (if only because it will drive more mark-downs), but that's it - and, of course, subject to change as we see more specifics.

Comments

[ari5000:]

good post

2007 Nov 30 09:28 AM

[jcrash:]

I'm one of Etrades more active type traders and I never even thought about moving my account. Of course, I don't own their stock, either (I have). I never thought my money was in jeopardy and see this move only done as something to appease the nervouse nellies among the customers. Having had an account there since, I dunno, 2000 or so, I've seen their stock in the tank. It has nothing to do with the service.

2007 Nov 30 09:35 AM

[realitycheck:]

Hi, I think etrade sold their ABS portfolio to Citadel for a lot less than 27 cents on the dollar. The 20% equity stake was built into the price. They likely structured it this way to mark it "high."

2007 Nov 30 07:14 PM

[clear_thinker:]

Paul - I agree this deal is a little short on specifics and there are no Edgar filings which makes it hard to analyze the implications for shareholders.

I've seen coverage elsewhere that ET is taking on 1.7B in debt with 220M of interest charges. That would imply no equity is being issued. I suspect ET is issuing some kind of convert. If the convert can be valued, then you can back into an implied value of ET equity. Valuing the convert requires estimating interest discount for a convert vs. a straight bond for distressed companies like ET. Citi got a 11% coupon and ET has a 12.5% coupon in this deal, so I believe Citadel has given a substantially discounted coupon. I did some back of the envelope calcs and it looks Citadel could be giving up interest payments of about 250MM - 400MM depending on re-payment timeframe in exchange for 20% of the equity. That implies a value of only 1.25B - 2.0B for the company which pretty much brackets its current stock price.

Hopefully they will disclose more soon, so we can stop guessing about this deal!

2007 Dec 01 01:43 PM

[Jimk7:]

I think E-Trade offers users the best bang for their buck. I considered many other firms to open accounts with and E-Trade had everything I wanted. I doubt they will go bankrupt and disappear.

2007 Dec 02 01:11 PM

[helplessobs...:]

I sold my stock a 15.00, but I lost 40% of my capital on the trade. ET has an excellent trading platform, better than TDAmeri and Bank of America where I hold accounts. I think my funds are AOK in the account.
I also think Citadel will make a bundle on their investment, much better that BofA investment in Countrywide Fin.

2008 Jan 06 09:45 PM