E*Trade: An Attractive Investment with Minimal Subprime Exposure

Includes: AMTD, ETFC
by: Andrew Corn

As the publisher of the Clear Global Exchanges, Brokers and Asset Managers index that is tracked by the ETF (EXB) I have received inquiries concerning the subprime mess, and how it will affect the index.

I want to address this topic by sub-sector. We believe that the brokerage firms with the best risk management will ultimately win. I define that by taking controlled, measured risks, not by avoiding them.

The sub-sector we are addressing today is the on-line brokers and highlighting E*Trade Financial (NASDAQ:ETFC). Founded in 1982 by physicist, inventor and entrepreneur Bill Porter, E*Trade has grown into one of the largest brokers and financial services firms based in the United States with a market capitalization approaching $10 billion. Though best known for its online trading platform and ubiquitous brand image, the firm through organic growth and acquisitions offers diversification in both top, and bottom line into asset management services, banking including traditional mortgage and home equity loans, and credit card products for retail clients.

Operating in an industry defined by scale to make serious profits, E*Trade has had a successful competitive history following the consolidation trend that is the natural outgrowth of a high fixed-cost business. In 2005, E*Trade acquired BrownCo. and Harrisdirect, shelling out a total of $2.3 billion. This was a catalyst beyond only a trading business as the firm also added over $60 billion in customer assets with the acquisitions. The transactions also alleviated immediate takeover concerns amid the impending marriage of Ameritrade, and TD Waterhouse-a tangible possibility in light of the rapid disappearance of smaller, and more readily acquired firms.

Further consolidation is more than rumored in the sub-sector. In June, a letter written to Ameritrade's board by Jana Partners and SAC Capital Advisors, two leading hedge fund investors, the firm was urged to consider larger mergers with the aim of building additional shareholder value. The letter claimed that synergies from a merger with E*TRADE might bring as much as $500 million in annual cost savings from the combination of assets on one platform, adding over $100 million in yearly revenue benefits, impressive numbers indeed.

TD Ameritrade would certainly find a successful partner in E*Trade, with the ETFC enjoying steadily growing profits and a growing position in the industry. Revenues for E*Trade on a year-over-year basis have grown by 43.10%, with net income growth of 22.13%. Much of this was the result of strength in the firm's banking and asset management operations, with trading commissions comprising less than half of total net revenues. This mix of services effectively reduced exposure to the whims of retail stock investors in volatile markets while allowing the firm to pursue quality banking customers and cross-selling opportunities. The firm does not have to compete exclusively as a low cost provider.

The same trend has contributed to general industry success, with competitors TD Ameritrade (NASDAQ:AMTD), Charles Schwab (NYSE:SCHW), and OptionsXpress (NASDAQ:OXPS) which are also all index constituents and posited bang-up second quarters fueled by diversified services. Noting an increasing withdrawal in retail investment capital, especially in light of the recent market downturn, online brokers have more than made up for reduced trading revenue by pursuing growth in asset-based services primarily stemming from interest income (interest earned on an investment such as a savings account or a CD). For the most part they have done a good job of it, with across-the-board revenue growth of between $10 and $20 million, on an individual company basis in the last fiscal quarter.

The most recent quarterly performance figures show that ETFC has been particularly adept at applying this model, with banking growth more than compensating for declines in commissions over the same period of 2006. In fact, operating interest income comprised both the largest and fastest growing segment of revenues, swelling 39.63%. ETFC has a 45.82% operating margin which is among the highest in the industry. Profitability measures have also benefited, with a firm-wide operating margin of 25.27%, on par with its 25.38% peer group average.

These factors also remain largely unaffected by subprime concerns, with ETFC holding roughly $50 million out of a $29 billion loan portfolio (or 0.17%) in subprime mortgages. However, in an effort to compensate for the changes in the credit environment and potential losses experienced through this limited exposure, E*Trade increased its provision for loan losses to $30 million from $10.3 million in the second quarter. The impact was not material enough to reverse revenue gains.

JPMorgan (NYSE:JPM), and Morgan Stanley (NYSE:MS) are Joint Lead Arrangers in a lending group which just amended the terms of ETFC's $250 million senior secured revolving credit facility. The amendment improves the terms and conditions and extends the maturity of the credit facility by two years. The revised terms reflect the ETFC's improved financial performance, perhaps including its lack of subprime exposure.

Minimal subprime exposure is in fact characteristic of the industry, with only Schwab offering mortgage loans, though the firm has sagely refrained from entering the subprime market.

A valuation analysis of E*Trade based on existing fundamentals indicates that the firm may be insufficiently priced, with a trailing 12 month price to earnings (P/E) ratio of 15.50, well below the industry at 20.95. Factoring in earning growth via its low price to earnings to growth [PEG] ratio of 0.70 underscores this conclusion, making the stock an attractive investment in an attractive sub-sector.

Disclosure: Mr. Corn is CEO of Clear Indexes LLC. E*Trade Financial (ETFC). TD Ameritrade (AMTD), Charles Schwab (SCHW), and OptionsXpress (OXPS) are constituents in the Clear Global Exchanges, Brokers and Asset Managers Index that is tracked by the ETF (EXB). Mr. Corn owns shares of the ETF (EXB).

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