Stock Covered: E*TRADE Financial Corporation (NASDAQ:ETFC)
Current Stock Price: $9.31
Target Stock Price: $18.00
Rating: Strong Buy
Date of Analysis: 10/17/2011
Most people know the company well, at least on the surface level, because it is arguably the most recognized online broker in the U.S. or probably in the world. More information about the company are readily available at many places on line including Yahoo Finance: http://finance.yahoo.com/q/pr?s=ETFC+Profile.
Like saying EBay and Amazon started online bidding and merchandizing, saying that the concept of online trading or individual investors was created and popularized by E-trade is not an over-statement. As with all hot dot com stocks dominant in their respective businesses, the stock price was pushed to north of 500 in year 1999 (on today’s split-adjusted basis), more than 150 times book value of equity, while the company was operating at a loss, and was still traded at more than 200 (again today’s split-adjusted basis) as recently as summer 2007, close to 20 times book value of equity, when the company was losing more than $1 billion a year. At those times, buying Etrade stock was like buying Amazon today or Netflix earlier this year, a game of chasing after a hot run-away e-commerce stock and competing with countless eager buyers to hope for getting a share now before it going up several notches higher next month.
However, starting at late summer in 2007 when real-estate and sub-prime bubble burst, the stock fell from heaven to hell in a blink of eyes, and the quarterly losses from sub-prime investments that the company made snowballed into daunting amounts in 2008. Since then, like other major financial institutions the board and management team have worked diligently to increase the quality of loans on its book and decrease loss on re-valuation of the bad fixed income investments each quarter. Nevertheless, during this painful period of time tons of investors have lost interest in the stock and fled. Fast forward to today, the stock is trading at single digit, only about 10 times of forward P/E, and just over 50% book value of equity, a stark contrast to the sky-high valuations in its golden years. It is exactly this dirt-cheap level of valuation that attracts attentions of many value-oriented investors like me. I have been monitoring the stock for years but just initiated my first position lately because I believe that while the drop from 200 in year 2007 to 20 in year 2008 was understandable and maybe even somewhat justified, the last leg of drop from 16 to sub 10 this summer was way overdone and that current overly-depressed level is not sustainable for the stock.
To begin with, let’s take a look at the company’s pro-forma earnings and book values. First of all, the sour point of the income statement over the past three years – loss from write-offs on mortgage investments (Provision for Loan Losses) – has improved dramatically over the past year or so, diminishing from over $300 million a quarter in 2008 to only about $100 million last quarter. Going forward, I estimate that the loss will keep on decreasing each quarter because the housing and mortgage market has basically bottomed last year and have stabilized this year. After more than three years, a big chunk of troubled mortgages in the U.S. have been dealt with – i.e. refinanced or “forgiven” under federal programs. The management team of Etrade, like those of other well-managed financial institutions, has been working especially hard to sell as many of these bad assets as quickly as possible. Since there is no sign that rate of new delinquencies (not those that are already in the pipe line) in the U.S. will reverse the down-trend, at least not any time soon, naturally the amount of provision for loan losses should keep on decreasing in the future. On the other hand, because mortgage rates have dropped a huge extent over the past three months under European debt turmoil and Fed’s manipulation, the market values of most of Etrade’s mortgage loan assets have probably increased materially. Thus, it is likely that the company will report higher amount of gain on sale of its mortgage investments this quarter and next few quarters, assuming the company take advantage to sell more lower-quality mortgage investments. This is not just a concept or my own wishful thinking, it is a mathematical conclusion backed up by the big capital gain on sale of assets and declining charges on bad loans seen in the last quarterly report from BOA and many other banks:
In other words, the market has been not only wrongfully associate Etrade with the financial institutions that have substantial amount of investments in European debts and have completely misjudged the effect of European turmoil on Etrade’s loan assets by over-estimating the negative effects, if any, and ignoring the positive effects. Note that I am by no means a bull on overall U.S. economy or housing market. I have said repetitively that U.S. economy and real estate market will remain sluggish probably for at least a couple more years. However, mortgage lending does not equate to the entire economy or even to the real estate sales market. Mortgage is historically a very safe business for lenders because it is backed by hard valuable assets that people have real needs for them and that keep on appreciating year over year. Provided that a lender have enough save cushion – enough equity from borrowers – and do adequate credit/payment capability verification on borrowers, the odds of loans going into default and are not able to recoup at least the debt portion during sale are small and very manageable. This is exactly what the situation for most existing mortgages circulating and new mortgages being written today. What we experienced in 2007 was more an exception than a norm. For mortgage lenders to experience increased loan loss again average national prices of condos and single homes probably need to drop 15%+ further from current level, which was already a 30% -50% pull back from the high in early 2007. I just don’t see much chance of that happening within this decade. So, although mortgage lending might not return to the status of exciting and lucrative business in the near future it should be at least an OK business going forward. On that note, I predict that the quarterly loss we see from the Balance Sheet Management segment on Etrade’s income statement should largely go away and possibly start going above break-even in Q3 or Q4, adding to the profit from Trading and Investing segment.
Now, let’s turn our attention to the strong side of Etrade income statement – the trading and investing segment. Unlike the mortgage lending segment, this business has been remaining strong and kept on growing over the past few years. It actually reaps big benefits from recent market gyrations because trading volume shot over sky in the third quarter:
As long as stock market remains turbulent in the next several months, a scenario most economists and analysts think will play out, daily DARTs and trading commissions and fees will remain high for online brokers like ETrade. Schwab’s quarterly report clearly demonstrates this. Another factor also in Etrade’s favor is the shift of investors’ personal assets from managed accounts to online brokerage account due to the growing distrust many investors have on mutual funds after seeing big loss on many fund managers charging high fees and decision to “take things into their own hands” by doing investing and trading by themselves. The asset and new account growth in Schwab’s last quarterly report also demonstrate this. I believe, however, that both factors will benefit Etrade more than Schwab because in my opinion Etrade has the highest percentage of clients characterized by young ages, nimble, love doing things online, and is not afraid or hesitant to do more investing and trades when the market is unstable. That’s why ETrade CEO expressed high confidence on the company’s ability to attracts new customers and increase portion of customers’ assets under management in the next several quarters.
The only negative current environment has on Etrade brokerage business is lower margin interest resulted from lower treasury rates. However this negative effect is very small because (1) interest rates were already low by historical standard to begin with before the last leg of drop in the summer, and (2) most rates adjustments (drops) were on long term 10-year+ rates, not short-term 3-month to one-year rates. Theoretically, both long-term and short-term rates might affect borrowing costs on any kinds of loans, including brokerage margins. However, practically brokerage margin interest rates are mostly tied to short-term rates because they are by natural variable and floating kind of loan, not long-term fixed interest loans like mortgage. Most online traders don’t have any problem paying as high margin interest rate today as three months ago because they understand that if they want to borrow to gamble, the cost will not be cheap. Again this concept was proven in Schwab’s last quarterly report showing average interest income rate only dropped marginally from 1.89% a year ago to 1.82% last quarter. The drop on margin rates should be even smaller for pure online brokers like Etrade again because of the high percentage of its clientele in free spirited, high-risk/high return minded individuals. From what I have seen, the margin rates Etrade charge has almost stayed constant over as long as I can remember:
Note that they deliberately tie the margin rates to a vague “base rate” without explaining clearly what this base rate refers to. Empirically from my observation the base rate ties mostly to three month to one-year rate rather than 10-year, 20-year, or 30-year long-term rates.
All in all, I expect the company to have much less loss on provision for loan loss, much higher gain on loans and securities this quarter, roughly the same net interest income from Trading and Investing segment, marginally less net interest income from Balance Sheet Management segment, and a huge increase (30%+) on commissions, fees and charges, and principal transactions from Trading and Investing segment. In conclusion, I think the company will likely deliver 19 to 21 cents per share for Q3, beating current street census of 18 cents per share by at least a couple cents. Going forward, I estimate that quarterly income probably will come in at around 20 cents and maybe some changes in the next couple quarters and increase to around 25 – 27 cents by next summer. That’s a forward 12-month EPS of 90 cents to one dollar. That means the stock is currently trading at forward and mid-term normalized P/E of 10.3 to 11, way too low for a company with valuable brand name and very strong competitive stance growing at no less than 20% annually for at least the next five years. A more justifiable and average forward P/E for an e-commerce powerhouse of this kind is around 20, implying a fair current stock price of about $18 - $20 per share.
In addition to earnings, the company will also likely to accelerate selling undesired mortgage assets above their current book value, realizing more gains on sales, using portions of the cash proceeds to decrease its liabilities and deleverage the balance sheet a little bit, and increasing its cash pile with the remaining proceeds from sales of assets and net earnings. What will the company do with those excessive cash? I think for a management team that seem to care about defending its shares and increasing shareholders’ values, they probably will return some cash to investors in form of dividends or more likely share-buybacks. Aside from low P/E ratio, current stock price is also significantly below book value of equity per share and only about tangible book value per share, making an investment in its own stock a very safe choice of increasing value for shareholders for the mid to long term. From the perspective of market capital to book value, AMTD is trading at 2.4x book value and 13.5x tangible book value, while Schwab is trading at 2.2x book value and 2.42x tangible book value. On that note, it is fair for Etrade to trade at minimum 1.5 times book value or 2 times tangible book value to avoid arbitration opportunity. Coming from this route, one can reach a conclusion that the stock should be trading at $19 - $20 minimum.
Speaking of arbitration, it may sounds cliché by now but I hear a loud and approaching sound of “buyout” from the stock now. Some of you might have heard several reputed public figures shouting Etrade being sold to one of its two major competitors – TDAmeritrade and Schwab. Here are some articles on that:
It is amazing to me the game of baiting and talking down price of their target TDAmeritrade and Schwab have been playing so far on acquiring Etrade. If they are having the unproductive zero-sum game thinking of “if somebody is trying to sell me something and the sale benefits others, it must be a bad deal to me” and “if you win, I lose; if I have to win, you have to lose” in their minds. On the other hand, they should flick their business textbook and refresh themselves the concept of “win-win” that gives superior competitive advantages to the economy and business of the U.S. over the rest of the world for decades. When a valuable and still one of the most dominating competing brand recognized by almost every American and which they just cannot easily beat and take away market shares from any time soon trading at the lowest point in the company’s history ever and 50% below book value, if the board or CEO of TDAmeritrade and Schwab are naïve enough to even doubt if buying out Etrade at below $20 can deliver positive return to their shareholders, I suggest that their investors quickly find a way to replace these incapable minds with others that have better know-how on how to increase enterprise value and guts to be determined to push through major positive initiative such as buying out a major competitor at a reasonable price, even it seems like a somewhat bold endeavor at a moment. The synergy that TDAmeritrade and Schwab can realize from folding Etrade under their arms is so huge that if I am a consultant to any of two I’ll pound on the table and tell the board without any reservation that buying Etrade under $20 right now is the major investment that is most guaranteed to deliver positive return for the company. For TDAmeritrade and Schwab to pass the opportunity to buy Etrade now is like having AT&T or Verizon passing an opportunity to buy T-mobile for less than 20 billion, less than half of the “fair price” that AT&T proposed to pay. They should be thankful to this rare opportunity, in which the management team of a valuable acquisition target is willing to openly consider buyout offer, presented to them by the unusual economic turmoil and unique situation within the acquisition target.
Of course, rather than simply refusing to consider any big-scale takeover or failing to recognize the enormous value of the acquisition, the management teams of TDAmeritrade and Schwab may actually eager to take over Etrade, even if they have been trying hard to conceal their intention to the public, but just be greedy and decided to take advantage of current market slump to try to pay less for the acquisition. If they indeed have been trying to do so, they have succeeded to some extent. Rather than giving a first offer price of $18 when Etrade was trading at around $15 and probably eventually paying $22 - $25 to win the bidding war, now the two suitors can possibly give $15 for the first offer and close the deal between $18 - $20, a saving of 20% or more. Now, if I am the decision maker in any of them I’d pull the trigger right now because the risk of keep on playing the wait and see game has mounted to a point that outweighs potential residual benefits. Not only do I risk losing the first-mover advantage to my main competitor, but I also risk inviting more competitions to the acquisition when the acquisition target has been sitting under spotlight for too far and attracts attention from companies that did not pay attention at the first place. Beside these two suitors, many big commercial and retail banks such as JP Morgan, BOA, Citi, Wells Fargo, SunTrust, etc. might see great value in Etrade because most of these traditional banks have been trying to catch up in this online brokerage business (like Microsoft is trying to catch up on cloud computing, searching, or mobile phone business) and have a tough time persuading their clients to use the trading platforms they have developed in-house. Why? Because the trading platforms developed by these brick-and-mortar banks are just down-right lousy. The FAs in BOA and JP Morgan keep on trying to lure me into moving some money to their brokerage account and using their brokerage service, but every time I read their human-directed, telephone, or online trading systems and procedures, I lost the last interest in using them pretty quick. Think about this: how much more revenue BOA or JP Morgan can enjoy if they link Etrade to their existing online banking services and persuade just 20% of their pure banking customers to start trading on Etrade?
The list of potential suitors doesn’t just stop here. Many e-commerce heavy weights that have a track record and good appetite of expanding into new online segments may be very interested in Etrade too. Just to name a few: Google, Amazon, Ebay, Microsoft (for MSN network), and Yahoo (granted, the company itself might be bought soon). Even financial software makers such as Microsoft (Money) and Intuit might want a bite of Etrade too. If any bigger competitor jump into the bidding war, the price that TDAmeritrade or Schwab has to pay to win the game will be much higher, and they risk losing this valuable assets to a much bigger, more formidable new direct competitor, a result that make the BOD and management teams of the two companies regret for years.
My last word: for such a widely recognized and still dominant brand name like Etrade trading at such a dirt cheap price that is still a technology leader in its business and final choice for many people who begin trading online, receiving a buyout offer within a fair short period of time is not just a wishful thinking, a dream, a talk, a hypothesis, or even a plan. It is a natural, logical development that should and more likely than not will unfold. Abundant of similarly depressed well-known companies in their respective businesses have show the way lately:
My advice to TDAmeritrade, Schwab, or any company who see any synergy and value in ETrade: do not wait. Contact Goldman Sachs and Etrade BOD as soon as possible to gain advantages on insider insights, good relationship to the board and management team, and any preliminary exclusive “rights” in bidding that you might be able to negotiate with the board and secure before others join the game. Don’t let your competitors run 10 meters first and then try to catch up in a 100-meter race.
I am a completely independent analyst and am not paid by any company of which the stock I cover or write articles about. However, I may have long or short position on a stock I cover or write about at any time.
My ratings and/or analyses of a stock only represent my personal view on the stock and/or my assessment on the probable movement of the stock price in the next 12 months. They are by no means a guarantee of performance on any long or short trades on a stock and should not be relied upon solely for buying or selling a stock. Every investment, no matter how compellingly appealing it seems, involves risk. Investors should do their own due diligence and consider personal risk tolerance, preferences and needs when making an investment or a trading decision. All materials are subject to change without notice. Information is obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed.