E*Trade Covered Call Idea

We hope you had a safe and enjoyable Memorial Day weekend - and are ready for a great covered call idea today. We've found a relatively low-cost stock with some excellent potential. It's another look out to the end of the year on this stock, and the written calls we're recommending to go with it will put some nice yields in your pockets, especially if the stock gets called away.

Technical Analysis

The chart above shows E*Trade (ETFC) stock for the last six months. The stock is stabilizing at around $4, well off its highs. The Relative Strength Index [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are just about flatlined now, indicating this stock is past the volatile period. We think the timing is right for a covered call on this name.

Fundamental Analysis

• Current Price: $3.96
• Shares Outstanding: 473 million
  
• Market Cap: $1.87 billion
  
• Forward Price / Earnings (avg. Est): 36.1x
  
• PEG Ratio (5 Year Expected): N/A
  
• Price / Book: 0.68x
  

When you hear the term "Value stock", sometimes it's worth your while to dig a little. We kind of arrived at E*Trade that way, suspecting that after repeated trips to the woodshed for the company's shares, there has to be some value here. We dug through the balance sheet and found over $3.9 billion in cash here, or over $8.27 per share. Since E*trade is a financial company, it's a little bit difficult to compare that cash pile to "working capital" or just call it a savings account for the company. Of course, it's put to work with margin on the balance sheet holding securities and balances against it. Offsetting that cash is over $15.5 billion in debt, but again, those are liabilities that are covered by securities held on margin.

What we saw that we liked wasn't necessarily on the balance sheet - it was a cash flow figure - E*Trade has a free cash flow figure over the trailing twelve months of $311 million, and that's where the company's core value is being stored up right now, in our opinion. ETFC has been busy cleaning up its mortgage operations - selling those off and basically taking charge right now, and that's been driving these shares lately.

We also took a look at the short positions. Currently there are 104 million shares of E*Trade, (Yes, that's over 1/4 of the total float of the company's shares) held short. Even though the average daily volume in the company's trading is 26 million shares, that's still a big number to have to cover.

Some of those short positions are left over from last year, when shares of this company went from the mid-$20's to around $2.50 per share. The big loss in E*Trade's shares was declared in December of '07 when they took a nearly $4 per share charge to basically expense out the value of their mortgage subsidiary. This subsidiary has since been sold off. Other parts of that short position may be held by a few big institutional investors who bought into E*Trade and hedged their positions (please see below).

Looking forward earnings-wise, the average quarterly earnings estimate for ETFC's June '08 quarter is presently calling for a loss of about $0.12 per share. While the estimates are in a wide range, we think the firm has stabilized its losses and axed what they needed to ax, and within the next six months there will be some good news here as the firm focuses on executing in their core niche - online trading. Next year, the full year of 2009, this company is expected to earn right around $0.11 per share, according to the 14 analysts who cover the firm. Revenues are expected to grow from $1.45 billion this year, to over $1.7 billion next year, a gain of over 19%. We like those metrics, especially as this firm focuses on its core business.

Last week on May 19, ETFC's shares fell as the company registered to sell up to 94.9 million shares of the company's stock, raising roughly $375 million. Citadel Investment Group, which bought about 84.7 million of the Company's shares last year as part of a $2.5 billion investment, also registered to sell about $2 billion worth of bonds in the firm - this may be where some of that 100 million shares short is coming from. All of that potential selling drove the price of ETFC down a little over 10% last week, giving us an opportunity to buy the shares under $4 today.

Implied volatilities in the options on ETFC remain elevated as a result of that downswing, and today you can sell the January 2009 $5 call options for a tidy $0.70 (mid-range of the current bid/ask). On a "static" basis, if the shares of ETFC don't move from the $4 level, that $0.70 premium would yield you 17.5% on a $4 stock between today and January '09's expiration. If you're called away at $5, you would gain the $1 appreciation, plus the $0.70 premium, for an "if called" yield of over 42%.

Investment Recommendation

We recommend that investors buy ETFC stock at or below $4 today and write the January 2009 $5 call for $0.70. We would look to hold this trade to expiration - either the options expire, or you are called away at $5.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

^{Disclosure: Analyst has no position in ETFC stock or ETFC options.}

Comments

[JimmyGoodwin]

E*Trade has been a commonsense stock to buy for awhile, but now it is technically red hot also. I hold E*Trade stocks and it feels like the stock is begging to *pop* any day now, $5 by January is very conservative imo.

[Zeninvestor]

An interesting strategy on a stock I currently hold long at $3.98. ETFC is a great buy and their strong 'trading platform' is one more component of their 'value proposition' for me. I got into this stock when I did the homework in November as a customer of ETrade. Now they have taken all the right steps to get out of their mortgage mess, and the current management team are all professionals, and all invested in the stock themselves.

Good article!

[Daniel Jones]

Glad you two liked the article - $5 by January may be conservative, but it's the base hits like this (17.5% yield either way, or a 42% total return if called) in a portfolio that will drive good investment returns over time.

There are some other good covered call ideas up on my bio page that include Delta Airlines, which is still a good idea out there, and even some put spreads on a couple of the overnight transport groups.

Good trading,
Daniel

[RAPTOR53]

Daniel Jones,

Is it still a good bet to just stay long for a decent payout? I have a cost base at $4.46.

[CNG]

Premiums on the put options are a little better. Why not sell Naked Jan puts with a strike of 4.00 for around $1.00

Trade has the same risk/reward as your covered call.

C

[jbmaria]

Dan,
No quarrel with your trading strategy,might work for all any of us know. But I'm worried about your analysis of ETFC itself,the underlying basis of the trade.

First,your track record on the stock frankly sucks:

seekingalpha.com/artic...

Now maybe you just had a bad day/month back then but it doesn't inspire confidence?

Then in reading your analysis,I believe you have some factual inaccuracies.
You wrote:

"The big loss in E*Trade's shares was declared in December of '07 when they took a nearly $4 per share charge to basically expense out the value of their mortgage subsidiary. This subsidiary has since been sold off."

That sounds like their mortgage exposure has evaporated when they still are holding north of $35 Billion in various types of loans.
Maybe you meant something else?

You also wrote:

"Last week on May 19, ETFC's shares fell as the company registered to sell up to 94.9 million shares of the company's stock, raising roughly $375 million."

I believe it was Citadel who simply registered those 94m shares,not ETFC,and they haven't sold them yet but if they did I believe ETFC wouldn't see a dime of it.Again,maybe I misread your comments?

[EverydayFinance]

I like to increase the returns by not going full covered. Say, you buy 75 shares for every call you sell. You increase your return while decreasing your investment substantially and the risk if the stock runs is low given the delta on options at the money is about 50 cents on the dollar. Therefore, in the 5-7 range, you're still treading water even in the money, whereas you recieved more premium up front for a given investment. I routinely post about these somewhat non conventional approaches.

Good stuff in highlighting this one though, nice premium ratio given modest volatility in the market.

[prescient11]

Never mind jbmaria, although she is right on the shelf filing, no new shares are being sold - thus no additional dilution.

Regardless, your covered call technique is dead on here. That's a nice 40% return in a year. I just refuse to miss the potential home run. But playing it safe, that's a better return than my portfolio ever averaged.

[jbmaria]

Be very careful with ETFC.
As I see it,there's no guarantee that last Q's noted improvement in the loan portfolio won't reverse.Macro trends in housing and incomes don't indicate to me any clear improvement in the mortgage holders lot,delinquencies and defaults continue to trend upward.And the Fed may be out of bullets.
I don't know how bad it might be or become but ETFC has around $40 Billion in loans that could get in some degree of trouble.
SA author,R. Middleton has written a comprehensive series on the crisis and other articles I highly recommend,read everything he offers if you want to temper your outlook with some intelligent caution:

seekingalpha.com/artic...


Some other cited issues are asset sales,like the Indian deal just announced. OK,they get the $145m but they lose the rev. and profit going forward and this from a co. that recently was selling themselves as an international player.

Further,they will be paying over $50 million per Q interest to Citadel ,a nasty drag on potential profits.

Exiting the mortgage origination biz. Sounds good given the aura surrounding mortgages but recall this was once probably their biggest moneymaker,now gone for the conceivable future.And let's not forget it's expensive to exit a biz line,severance packages and all that.

Debt for equity swaps. Yes,they take debt off the books,a good thing but they are dilutive to shareholders.
And speaking of dilution,keep in mind the recent authorization of 600 million shares by management.
Those pumping ETFC would have you believe that mgt. just ran out of authorized shares for routine corporate purposes like ESOPs and debt for equity swaps.Maybe, but did they need to double the existing 600 million shares,seems like they have something in mind that a more modest 1-200 million shares might not cover.
Curious!

At the same time,Citadel registers for "potential" sale over 90 million shares it got for lending ETFC $1.9 Billion at 12.5 % last November. It also registers this debt for "potential' sale at the same time as the share authorization. Curious!

I'm not going to pretend I know what either ETFC or Citadel is up to but unlike the pumpers I won't assume it's purely coincidental and /or innocent toward shareholders.
If nothing else it adds a huge dose of uncertainty to the equation and we know how uncertainty is treated by Wall Street.
And speaking of Citadel,FWIW,in March a hedgefund manager stated:

"The anonymous fund manager said Citadel, which did not return a call 
seeking comment, paid such a low price for the mortgage book, and got 
such favorable terms on the loan, that it would have been foolish for 
other hedge funds to blindly follow into the stock. After all, he 
said, Citadel was getting in cheap.
"Why would any bull point to Citadel?" he said. "

Frankly,mgt. is another reason I'm wary of ETFC.
Look at the facts.

Layton,according to published reports,was not the BOD first or even second choice for the job.

Layton,to my knowledge, is not known as a turnaround specialist,per se,and he did have some Enron rumors surrounding his former job,perhaps even contributing to his retirement.

To date,the pps has not improved.

Layton is very much at the mercy of KG,who I trust as far as I can throw.

Layton's heavily touted pay package would do best if he succeeds at a turnaround BUT he is getting a $1 million/year cash and will get a nice payout in the event of a buyout and I don't think there's any caveat as to buyout price.This is from memory so you might want to check the filings on that,not that momentous an issue though.

Bottom line,he hasn't been there long enough or achieved enough to rate him so he remains a question mark,IMHO.

I have more concerns but for now I think you can see my caution on ETFC as an investment is quite logical.

[matt7]

I read a lot of stuff on these message boards and there is no way that someone would be so dedicated to posting these long tirades on multiple messages boards over and over unless they are a paid basher (that being JBMARIA) with a painfully obvious agenda. Get a real job JBMARIA...

[Avenger]

JBMARIA is hardcore about attacking anyone that has something positive to say about ETFC. For someone that doesn't own the stock and supposedly doesn't short it, they must not have much else to do. I certainly wouldn't waste my time posting all hours of the day, every time someone comes out with something ripe for debate. I don't know what JB's agenda is, but she's got something up her craw to be such a nemesis of ETFC.

But if there's one thing to take from her, it's that ETFC is NOT money in the bank. The company has been impressive at delivering in its turnaround plan so far, but it has not completed that plan. There are still factors that weigh against them. However, as far as speculative plays go, this one comes with a lot of positive momentum that has not made it to the PPS yet. Do some DD, and make your own conclusions. I think you'll like what you see. The only question in my mind is how long are you willing to wait? That's been the hardest part about owning the stock.

[Ben Williams]

ETFC should trade sideways for a while before it breaks. However, as I am long in this position, I am fully aware that the imminent break could be down as well as up and all investors should calculate the risk for both the downside as well as upside.

I am continuing to buy Jan 09 Calls at a $5 strike price with expectations the stock will be in the $6 to $8 range. Also buying some shares outright on dips below $4 to add to my portfolio. All of this is a speculation play though and novices should be well aware of the risks with ETFC, although I believe the downside it limited. It certainly is limited to $0 if it goes under and with a share price under $4, that is fairly limited risk/reward ratio.

I would be slowly getting out of this one if I were a short on this as the volume of shorts is getting way too heavy in my humble opinion. I am optimistic for a positive break up on this, just want to make sure newcomers here realize their are always two sides. Do your homework, make sure you are diversified in all your investments and load the wagon with ETFC as a speculation if so inclined. I am saving the bubbly for Jan 09; hopefully us bulls on this one can pop the cork together.

[rigel]

jbmaria, you raise interesting points. Instead of accusing you as a short shill, I'll accuse you as a long shill who wants time to acquire more stock (no, not seriously). The price of a troubled company can be thought of as the fair value * (1 - percent likelihood of insolvency). This is just expectation value. If people are convinced that there's a 25% chance of insolvency, then the stock will be at 75% of it's fair value. If the perceived risk of insolvency goes away, you can expect a pop in the price. A lot of people are convinced that insolvency is no longer an issue, but people like jbmaria are (apparently) not. If you are in the first camp, be happy that people like jbmaria exist. As time moves on and their insolvency fears are proven wrong, there will be a greater upswing than what would have occured if everything was priced at fair value the entire time.

Of course, jbmaria may be voicing legitimate concerns. It doesn't really matter (well, unless the insolvency thing carries out). As long as people are afraid, the Longs can pick up ETFC at a discount. However, if you are looking for a pop, it has to come from something that significantly alters the perception of insolvency risk.

Yes, I am greatly simplifying the problem (jbmaria may be concerned about losses, not insolvency), but it's a lot harder to discuss this point using probability densities than it is to use a simple solvent/insolvent perception model.

Oh, and I am long ETFC and bought additional Jan 10 ITM LEAPS. I'm obviously a believer in their solvency. I won't do a covered call right now because I am not looking to cut my risk on the position.

[jbmaria]

rigel,
it's a two pronged problem as I see it.
I've taken down my 15% probability of BK to a 5% guess based on some,at least temporary,stabilizatio... in the loan portfolio.

But the other prong is the earnings scenario.They're in survival mode while their competitors are thinking growth.They are shedding biz including mortgage origination,once their biggest earner until the "troubles" and they are saddled with $50million/Q in debt payments to Citadel.Show me how they earn their way to growth????

[jbmaria]

matt7,
grow up and argue the issues don't just make baseless attacks on the messenger.

blog.valuewiki.com/200.../

[Gautam]

Long term covered calls aren't the way to go. You want to do them month after month, and roll them over to keep taking premium on a monthly basis.

Long term naked puts however, are the way to go on growth stocks (please research before you do this, or it can be very risky)

The ETFC 3$ naked write on puts are a safe bet to play month after month.

[americanbands]

Jbmaria,
Stay with it my friend,.
Being the devil's advocate is a very tough job.
You sir, do it well.

Thank you.