E-Trade's Last Move Hinted Consolidation For Online Brokerage Industry

| About: E*TRADE Financial (ETFC)

E-Trade (NASDAQ:ETFC) announced today that its Board of Directors has fired CEO Steven J. Freiberg and is searching for his replacement. In the news release, the company said that the move was to "transition the role of CEO to a new leader to guide the Company through the next phase of its evolution." That sounds exciting, but exactly what drastic changes can or should the company make to increase shareholders' value?

The company's financial results in recent quarters were generally in line with its two biggest rivals- Charles Schwab (NYSE:SCHW) and TD Ameritrade (NASDAQ:AMTD)-until the last quarter. As Table 1 shows,
E-Trade's revenue suddenly dropped in the last quarter. Revenue contracted due primarily to a 12% sequential drop in daily average revenue trades (DARTs) and a 4.1% sequential drop in average commission per trade. The drops in the revenue metrics suggest that the company has some work to do in marketing and branding to increase its market share and pricing power. Interest income also dropped slightly because margin interest rates decreased slightly over the past several months due to the continuous decline of prime lending rate.

From a valuation standpoint, the temporary dip in quarterly revenue was not a major concern, at least for now, because operating expenses decrease roughly proportionately as revenue decreased. As a result, operating profit margin remained roughly the same from Q1 to Q2 of 2012. Income before tax margin also stayed roughly the same from Q1 to Q2. It should be noted, however, that Schwab's and TD Ameritrade's income before tax margin is noticeably higher than E-Trade's. The reason is that E-Trade has a much higher long-term debt to equity ratio and that E-Trade's debts bear very high interest rates locked in during period of high interest rates in 2007.

From what I can recall after listening to what management said in previous conference calls, the contracts for a lot of the company's debts bearing high fixed interest rates will be unfrozen before the end of this year. After they are unfrozen, the company can choose to pay down these debts or refinance them at a much lower interest rate. So, the disadvantage of higher-than-usual interest expenses E-Trade is bearing right now will be removed very soon.

In conclusion, even though there are other potential measures the management team can adopt to improve daily business operations, the improvement obtained from these measures will not likely be dramatic enough to be considered a major break-through or evolution.

 

 

Table 1: E-Trade and Competitors by Financial Ratios

 

E-Trade

Schwab

TD Ameritrade

Q2 2012

     

YoY Revenue % Change

-12.6%

7.8%

-2.6%

QoQ Revenue % Change

-7.6%

7.9%

-0.9%

Operating Profit Margin

22.9%

33.7%

38.1%

Income Before Tax Margin

13.4%

33.7%

37.0%

Net Profit Margin

8.7%

20.3%

23.1%

Q1 2012

     

YoY Revenue % Change

-8.8%

-1.5%

-6.3%

QoQ Revenue % Change

3.0%

6.8%

3.0%

Operating Profit Margin

22.7%

26.3%

32.6%

Income Before Tax Margin

13.5%

26.3%

31.5%

Net Profit Margin

12.8%

16.4%

20.3%

In my opinion, the only two major changes that the Board of Directors can make to significantly and immediately boost shareholders' value are (1) liquidating a large amount of its fixed-income assets, paying down high-interest bearing debts, and buying back a large number of shares or paying a huge special dividend, and/or (2) selling the company to its competitors for a price significantly higher than its current market capital. That's the idea I stressed laboriously in my previous article for ETFC.

Once again, let's review the valuation multiples of E-Trade and its two biggest rivals. As shown in Table 2, while Charles Schwab and TD Ameritrade are both valued at around 4.0 times sales and 2.5 times book value right now, E-Trade is currently valued at less than 2.0 times of sales and 45% of its book value. Its competitors can offer a 100% premium (0.9 times its book value of equity) and still realize some gain from arbitration on the net value of the company's assets (total assets minus total liabilities). In addition, the acquirer will probably enjoy increased brand recognition and pricing power and can let go a big portion of E-Trade SG&A workforce to save at least several million dollars in operating expenses each quarter. It is a win-win deal for E-Trade and its acquirer.

Any inactivity on either the side of E-Trade or its major competitors on engaging in an M&A negotiation would strongly degrade the image of their executives' leadership ability and financial knowledge. I gave a stern warning about this in my previous article. Unfortunately, Mr. Freiberg did not listen to me and did not push hard to market the company to potential buyers. In my opinion, that was a very unwise decision similar to Yahoo's ex-CEO Jerry Yang's rejection of Microsoft's takeover bid. Now it seems that E-Trade's Board of Directors has finally fully embraced the idea of selling the company to one of its major rivals and is getting rid of any obstacles blocking the road.

At the current price level, I feel quite comfortable holding E-Trade along with Longwei Petroleum (LPH) and Actions Semiconductor (NASDAQ:ACTS) in my extremely book value arbitration portfolio. After these stocks have been put at around 40% of their respective book values per share for so long, I believe more and more institutions are starting to recognize these companies' strong positions in their respective industries and the unmistakable potential gain on arbitration of their current market capital and book value of equity.

 

 

Table 2: E-Trade and Competitors by Valuation Multiples

 

E-Trade

Schwab

TD Ameritrade

Price /Trailing EPS

15.04

15.44

19.65

Price /Trailing Sales

1.66

3.37

3.47

Price /Trailing Book Value

0.45

2.07

2.15

* Numbers provided by Yahoo Financial as of 8/9/2012.

 
         

Disclaimer: Please read my standard disclaimer for my articles here.

Disclosure: I am long ETFC, LPH, ACTS.