E*Trade's 'First In, First Out' Position: Yes, 111M Shorts Can Be Wrong

| About: E*TRADE Financial (ETFC)

Since Citadel’s cash infusion in late November 2007, E*Trade’s (NASDAQ:ETFC) share price has been range-bound:  dropping as low as $2.08, rising as high as $5.48, and sitting at around $4 for the past two months.  Illogically, this current $4 range was the exact low price range in November  2007 when no one was sure whether E*Trade would survive bankruptcy.  In November 2007 E*Trades bankruptcy price per share ranged from $4 to $6.  In 2008 the highest price has been just above $5 for a handful of days in February.

Additionally,  short interest positions continued to increase last month.  Perhaps this is just a product of hedge funds playing games with the share price in a tight range or perhaps not.  How long will it take to chase the 111 million shorts out of this stock?   Especially when average daily volume is only 15 million shares.

The main rationale for shorting E*Trade is the mortgage portfolio.  The problem with this rationale is that E*Trade’s mortgage problems were fully disclosed on the table and the impact was inflicted in full back in November 2007—and E*Trade survived.  After Citadel’s investment, a turnaround plan was established and many milestone markers of successful execution have been reported, especially in the last two months.  

The April quarterly report soundly established that bankruptcy was no longer a problem, April metrics were better than the industry averages, and as of May the loan portfolio was performing according to management expectations.  Subsequent marketing strategies, innovative brokerage tools (BlackBerry), improved brokerage metrics, and stabilizing balance sheet transactions make the current “bankruptcy pricing $4 range” completely unfounded. 

Other lenders like Lehman (LEH), Merrill Lynch (MER), UBS AG (NYSE:UBS) and Citigroup (NYSE:C) have just started to reveal their problems, are questioned regarding whether they are revealing the true extent of their problems, and are still figuring out what they are going to do to survive.  Along with LEH and MER, Cramer included JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC), Countrywide Financial (CFC), Wachovia Corp (NASDAQ:WB), and Washington Mutual (NYSE:WM) Monday morning in “Cramer on BloggingStocks: Questions swirl around Lehman’s capital raise.”   Cramer points out the lack of transparency about what’s in their portfolios and the “soft denials,” about how bad it is.  Notably, E*Trade was not listed nor included in Cramer’s discussion. 

E*Trade’s true position among them is more of a “First One In,  First One Out” and moving on down the road.  However, the market still perceives it to be related to the “bad news” banks; but E*Trade has been in a full disclosure position since the 4th quarter of 2007.  The question is not if E*Trade will make a profit, it is a matter of “when,” and according to the words and actions of CEO Donald Layton it will happen soon.

This begs the question, exactly when does a share price return to even a third ($6 to $8) of what was considered normal ($18 to $24 pre-July 2007)?  When does a share price fully return to normal (a gain of 400 to 600 percent)?  Book value/cash on hand is around $6.50/share.

Let’s review in more detail what E*Trade has done these last seven months:

  1. Stable Customer Base and Customer Cash Levels 
  2. Aggressive and Superior Technology Trading Platform Leadership
  3. Secure Capital Levels and Excess Cash Reserves
  4. Improved Debt to Equity Position
  5. Positive Effects of Citadel’s Investment
  6. Mortgage Portfolio Activity, Loss Provisions, and Portfolio Composition
  7. Insider Stock Purchasing and Management Compensation

Stable Customer Base and Customer Cash Levels 

E*Trade’s customer base is secure and is now growing again.  E*Trade’s customer cash stabilized in December - after Citadel’s investment - at approximately $33B (see Q4 conference call transcript).  After the first quarter, E*Trade’s customer cash equaled $35B – this level is far ahead of the company’s own projections for 2008 (see Q1 conference call transcript).  To put this in context, before Prashant Bhatia’s November 12th article and the ensuing run on E*Trade’s bank, customer cash equaled $39B.  E*Trade is well on its way to getting back to this level of cash deposits.  E*Trade added 60,000 new customers in the first quarter of 2008 (see Q1 conference call transcript), which is the highest level of new customers since the 4th quarter of 2005.  These business trends show that E*Trade’s  brokerage business remains steady and strong.  As Jim Cramer recently stated – the brokerage is “fantastic.” 

In summary, E*Trade’s customers base, in spite of a major bank run, is stable and growing.  E*Trade’s competitors will no longer siphon customers from E*Trade that are worried about E*Trade’s mortgage issues. In fact, E*Trade is actually gaining customers at the expense of their competitors .  This cannot be stressed enough. Everyone saw what happened with BSC – it was at the mercy of hedge funds that could withdraw $17B in cash a day, and did. That destroyed BSC. In contrast, E*Trade’s customers are comprised of millions of individuals, those who remained after November 2007 have remained strong with, and loyal to, the upstart brokerage; and many who left have obviously been returning .  Customer cash levels show that E*Trade’s customers continue to believe in and trust E*Trade.  Adding to customer confidence are the high levels of insurance E*Trade maintains for accounts, including $100K of coverage for the FDIC and $500K of coverage from SIPC. 

Aggressive and Superior Technology Trading Platform Leadership

Last week’s announcement of “E*Trade Mobile Pro” for BlackBerry is indicative of  the market technology aggressiveness and leadership position E*Trade is establishing among brokerages.  E*Trade is the first brokerage to offer this mobile platform and like recent PowerTrading upgrades and service enhancements, it is absolutely FREE.   Technological aggressiveness and “early entry” into new brokerage services E*Trade will secure a dominant market share position in both the USA and in “world” brokerage markets.  According to E*Trade, an “iPhone trading, ” “Palm trading,,” and Windows Mobile trading” platform is in line right behind the BlackBerry mobile platform. 

E*Trade’s superior and stable trading platform is a strong factor for customer retention and growth.  For example, several times over the last few months and as recently as last week, TD Ameritrade (NASDAQ:AMTD) customers have experienced slow order execution, quote tracker problems, and slow or dropped streaming during critical trading times; resulting in extensive customer complaints. Problems at TD Ameritrade could very well be contributing to E*Trade’s success as customers that left E*Trade now return because of dissatisfaction with Ameritrade’s stability and platform.

E*Trade’s  continual “free upgrades and enhancements” to their powerful system tools,  their “problem-free, high-powered” platform, with the opportunity to trade in 6 global markets, and sophisticated option trading tools provide for maximum customer satisfaction and new customer attraction.  The E*Trade services are more global and comprehensive than TD Ameritrade (AMTD) or Schwab (NYSE:SCHW).

Secure Capital Levels and Excess Cash Reserves

E*Trade’s capital levels are stronger than most major banks. In addition to the “loss reserves” that E*Trade intends to set aside for its HELOC portfolio, E*Trade also intends to set its cash reserve level in excess of well-capitalized standards at $1B.  At the end of the first quarter, E*Trade had about $700M of excess cash and a risk-based capital ratio of 12.4%. To put it in context, J.P. Mogan has a 12.4% capital ratio and WFC has a risk-based capital ratio in the range of 11%.  E*Trade’s goal is to have a risk-based capital ratio at 13% by year-end 2008. Based on E*Trade having exited the mortgage business, wholesale and origination, with associated loan run offs, the addition of $300M more excess cash to the balance sheet, and the trend of increasing customer cash, E*Trade will almost certainly smash through its goal of a 13% risk-based capital ratio.

Where is E*Trade getting all this cash?  Let’s review. 

Non-core Asset Sales.  E*Trade estimates that it will have at least $500M of cash coming from non-core asset sales (E*Trade already received approximately $150M from the sale of its Indian assets. That’s right, no share dilution for $500M needed. So, if $300M from these asset sales is used to reach E*Trade’s excess cash goal of $1B, which is all that is required, that means E*Trade will then have $200M of free cash to do whatever it wants with.

Expense Reductions.  On its 4th quarter conference call, E*Trade announced a $360M expense reduction and an additional $50M compensation cost reduction for a total of $410M of cost cutting.  Subtracting $80M they stated would be dedicated to increased advertising, E*Trade will have net another $330M of excess cash from cost cutting initiatives. 

Summary.  Let’s do a rough, back of the envelope calculation here. Due to all of the above-mentioned measures, E*Trade will likely have approximately $530M of excess cash to beneficially apply where appropriate by the end of this year. Strikingly important is that this will be accomplished with no additional share dilution and is in addition to the approximately $500M of excess cash E*Trade has at the brokerage (from E*Trade’s 10k) and the $1B of excess cash E*Trade will have at the bank. That’s a lot of cash on-hand.  

Improved Debt to Equity Position

E*Trade’s improvement in its debt to equity position is ahead of the 2008 recovery plan. The parent company of E*Trade has a lot of debt and Mr. Layton has already embarked on a plan to clean this up. He has planned $700M of debt for equity swaps. Now this does result in additional shares, but overall is very beneficial to current shareholders as it rids E*Trade of the onerous debt on its balance sheet.

Mr. Layton has already accomplished approximately $184M of these debt for equity swaps, and still has a planned $450M at $18 per share for November 2008.  Layton has only $66M of debt for equity swaps left to do/account for. As a lifelong banker with JPM, Mr. Layton’s dedication to cleaning up the balance sheet will greatly benefit E*Trade’s shareholders. 

Positive Effects of Citadel’s Investment

First of all, the Citadel investment stabilized E*Trade at a critical juncture in time.  Citadel did involve share dilution and E*Trade shouldering debt at a fairly high interest rate.  But compared with the dilution that major financial institutions have had to deal with recently, E*Trade appears to have gotten an o.k.  deal (for example, BSC, WM, NCC, and TMA).  Indeed, on the November 29, 2007 conference call, E*Trade’s own accountants stated that the anticipated dilution would amount to something approximating 50 cents per share. In any event, the Citadel deal was necessary and accomplished the purpose of stabilizing E*Trade’s business.

Also of interest is the fact that Citadel has continued to purchase E*Trade’s senior debt. From a recent SEC shelf filing, after the debt for equity swaps are considered, Citadel now holds about 75-80% of E*Trade’s outstanding senior debt. Even more interesting from the shelf filing, all of this debt and shares held by Citadel and Blackrock it appears can be sold to any party, even an E*Trade competitor. Moreover, the shelf filing reveals that all of these senior notes are not secured by the assets of the subsidiaries until 2011. This is important because the parent company of E*Trade does not have any real substantial assets to speak of; all of the business is conducted through the subsidiaries. Thus, if Citadel were really concerned that E*Trade could be in trouble, it would not make much sense to continue to accumulate E*Trade’s debt when said debt is not secured by any real assets.

And another point according to the Wall Street Journal, Mr. Nicoll formerly of Instinet, LLC, was Citadel’s top choice for the CEO position, but declined to take the position when he found out E*Trade couldn’t be taken private. Thus, any nefarious conspiracy theories that Citadel is going to take E*Trade private for a dirt-cheap price doesn’t really make sense. In addition any such deal would be subject to incredible scrutiny not just by shareholders, but by the OTS since E*Trade is a federally regulated bank. Finally, the fact that a very powerful hedge fund has a vested interest in E*Trade’s success should be considered a good thing..

Mortgage Portfolio Activity, Loss Provisions, and Composition

Finally, let’s talk mortgages. E*Trade has four categories of mortgages:

  1. Consumer loans (boats, RVs, etc.), 
  2. Mortgage-backed securities,
  3. First-lien prime loans, and
  4. HELOCs. 

Consumer loan delinquencies actually decreased from the 4th quarter 2007 to the 1st quarter 2008.  Similarly, the “mortgage-backed securities” portfolio has shown stable performance.  All but $1.1B of that portfolio is backed by FNM and FRE. And the $1.1B that is not backed by FNM and FRE is AAA or AA rated and has been appropriately written down assuming that the U.S. has entered a mild recession.  In other words, this portfolio is a non-issue (see Q1 conference call transcript).

The first-lien portfolio is performing worse than expected but this really has no effect on E*Trade’s capital position.  E*Trade’s average position in these properties is about 70% LTV.  Moreover, E*Trade has insurance on any property over 80% LTV and approximately $4B of this portfolio is covered by a credit default swap.  In other words, while the first-lien portfolio may be a drag on earnings, it is not going to hurt E*Trade’s capital position due to E*Trade’s position in these properties.

Finally let’s turn to the HELOC portfolio. To date, E*Trade has already charged off about $300M in losses on this portfolio, and has approximately $500M of reserves set aside for future charge offs--which E*Trade estimates will cover the next four quarters of chargeoffs.  Even assuming a U.S. recession, E*Trade has affirmed its estimates of cumulative losses relating to this portfolio to be around $1B to $1.5B over a three year period—this total loss exposure was arrived at with third-party consultants.  E*Trade affirmed this range on the 1st quarter conference call and again at the shareholders’ meeting in May.

At the low end of $1B, E*Trade would have to provision for $200M more of losses. At the high end of $1.5B, E*Trade would have to provision for $700M more of losses. E*Trade stopped acquiring mortgage loans in early 2007, especially the high LTV% home equity loans. Thus, the mortgages that should never have been written and were destined to go bad, most likely have already gone bad. This would explain why new delinquencies actually DECREASED in the 1st quarter of 2008, a statistic so surprising that one analyst on the call inquired on this very fact since this is the exact opposite of what analysts are seeing in other financials.  It is important to note that all of E*Trade’s loan reserves and performance projections are on the conservative side and assume a U.S. recession. 

Evaluating the current composition of E*Trade’s home equity portfolio shows additional positives.  Of the approximate $11.5B loan portfolio, E*Trade has the second lien position for only $1.5B.  The greatest danger is if the lender’s loan is in second position.  This means that E*Trade has about $10B worth of pure home equity loans in its portfolio.  Assuming a $1.5B total loss figure means that E*Trade is prepared to write off 15% of these pure home equity loans. Succinctly put, even assuming that the mortgage/housing market continues to deteriorate, E*Trade has been super-conservative in preparing for such an event and a recession is already priced in to the assumptions E*Trade has envisioned. Therefore, although one should always be aware of the current state of the market, E*Trade can handle the current housing market, and should have no problems handling a further deterioration as well.

In conclusion, the mortgage performance reports from management in April and May establish that E*Trade’s home equity loans are showing stable and even improving results, while other lenders’--like Lehman (LEH) this week--will continue to struggle with home equity loans for some time to come.  

Insider Stock Purchasing and Management Compensation

Insider stock purchasing in 2008 is very encouraging. Mr. Layton spent $1M of his own cash to purchase E*Trade shares at $4.07 and the entire Board of Directors recently purchased a substantial number of shares on January 29.  Moreover, Mr. Layton has options for 235K shares in November of this year that are worthless unless E*Trade’s share price is above $5.26. That, plus the additions of Mr. Druskin and Mr. Kanner to the Board brings substantial experience, credibility, and know-how to the Board. 

Interestingly, Mr. Kanner  purchased 50K shares or April 22, and just over a week ago purchased an additional 25K on May 30 at $4.03 making a total of $387K of personal funds invested in E*Trade stock. 

When Mr. Layton accepted the CEO position, his entire CEO compensation package was comprised solely of stock options. That’s correct, he doesn’t receive any cash for acting as CEO of E*Trade. The only cash payment he receives is from his duties as Chairman of the Board and that was fixed in late 2007.  Clearly, Mr. Layton sees E*Trade stock as a good investment and has personal motivation for management decisions that will continue to increase shareholder value and be non-dilutive. 

His statements have stressed again and again that management actions will be shareholder friendly, and that E*Trade will only access capital markets on an opportunistic basis and in a shareholder friendly manner (see Q1 conference call transcript).  But with all of the above discussion, it is obvious that E*Trade has no pressing need to raise more capital.

Disclosure:  Author has a long position in ETFC

Author's note: I have been criticized for writing research on E*Trade while holding a long position.  I respectfully submit that if  I have spent the time to extensively research a stock, and then spent extended additional time to write up the research and share it with other investors, then I would be crazy not to hold a long position in the stock. 

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