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The best investment cases are relatively simple, and I believe this is the case with E*Trade (NASDAQ:ETFC). The market assumes the home loan portfolio will continue to reduce E*Trade's earnings, and in fact this view has been justified for half a decade. However, I believe, as soon as next calendar year, the losses may be a much smaller drag on earnings. The reduction in these losses could ultimately lift the stock as much as 122%. However, the valuation is very sensitive to the valuation of the loan portfolio and the stock is risky as a result.

A Brief Summary of E*Trade

E*Trade has essentially two operations:

  • A highly profitable, well branded and innovative platform for online trading
  • A poorly regarded portfolio of home loans that have dragged down earnings for the past 5 years.

The results from the home loans have been so bad for so long that the market believes this will continue indefinitely, and looking at the E*Trade stock price for the past 5 years it's easy to understand why.

ETFC Chart

ETFC data by YCharts

Why Things Are Changing For The Better At E*Trade

Things are now changing for three reasons:

  • The housing market is picking up

The housing market now appears to be trending upwards with builder confidence increasing in September to its highest level since June 2006. This has an important psychological impact, because the housing market has not found the bottom and assertions of seeming unending losses can be disproved by evidence. Of course, this was not possible to do before the housing market turned.

  • Pay downs and charge offs have reduced the value of portfolio substantially.

Provisions have fallen from $2.5B at their peak to under $0.5B for the past 4 quarters (see slide 6 of this presentation). Since E*Trade is not issuing new home loans the portfolio's value is falling over time through both pay downs and charge offs, and it is now at the point where it is a relatively smaller part of the business with $12B of outstanding loans in 2012 vs. $32B in 2007 (see slide 16 of this presentation).

E*Trade Appears Reasonably Valued On A P/E Basis

As you can see below, E*Trade trades broadly in line with peers Charles Schwab (NYSE:SCHW) and TD Ameritrade (NYSE:AMTD) on a P/E basis. However, P/Es can be misleading when part of the company is losing money as is the case with E*Trade's home loan portfolio where the losses significantly drag down earnings, and hence:

AMTD PE Ratio Chart

AMTD PE Ratio data by YCharts

What Reduced Loan Losses May Imply For Valuation

ElementValue
Current pre-tax earnings less 30% tax (last 4 quarters)$105M
Elimination of provisions (last 4 quarters)+$361M
[A] Resulting earnings less 30% tax$326M
[B] Average of comparable multiples (Ameritrade and Schwab)17.8x
Resulting valuation [A] x [B]$5.8B
+ Deferred tax asset+$1.5B
- Assumed 100% loss on all currently delinquent loans-$1.4B
Resulting Valuation [C]$5.9B
Shares Outstanding [D]286M
Per Share Valuation {C]/[D]$20.62
Upside From Current Price ($9.27)122%

Source: company reports, author's analysis

Sensitivities

However, E*Trade's valuation is very sensitive to future loan losses. For context, over the past 5 years total losses (charge offs) were $7B, so arguably the worst loans are already out of the portfolio, the $1.5B assumption assumes that loans which have not been delinquent for the past 5 years, will not go bad in the future.

Future Loan LossesE*Trade Valuation
$0$25
$1.5B (12.5% of entire remaining portfolio) - base case, equal to all currently delinquent loans$21
$3.0B (25% of entire remaining portfolio)$10
$6.0B (50% of entire remaining portfolio)$0

source: author's analysis

Conclusion

For investors who want exposure to, and believe in, an improving economy and house price environment, E*Trade appears to offer substantial upside, though not without risk.

Risks to the analysis above

  • Above all, the valuation of the home loan portfolio is the key to substantial upside or downside for the E*Trade stock price. If loan losses exceed 25% of the remaining loan portfolio the stock could have downside on a fundamental valuation basis, and in an extreme case, be worthless [see sensitivity table above and also review E*Trade's latest earnings statement and transcript for more detail].
  • I assume business as usual within the core trading business, clearly any positive or negative changes there would impact the stock.
  • I assume the appointment of a new CEO will be swift and the new candidate will be shareholder friendly in his or her actions, however that the role is currently vacant is a source of risk.
  • Though the housing market is apparently recovering, the broader economy remains rocky, and recession could damage the loan portfolio even if house prices continue trending upward.
  • I assume that E*Trade will be able to realize value from their deferred tax assets, but this is not certain and the value may be overstated.
  • Finally, and to argue for an even higher valuation, optimists would argue that I undervalue the loan portfolio by arguing that it will move from negative to zero. There is a school of thought that the loan portfolio could generate positive earnings once losses role off. (note - though I am bullish on the stock, I think this is too optimistic)
Source: Why E-Trade May Outperform In 2013