E*TRADE Financial Corporation (NASDAQ: ETFC) is one of the many companies which have filed their annual reports under form 10-K with the SEC in recent days.  These reports often contain many hidden data points and items that investors rarely take the time to learn about before deciding whether they want to invest or not.  As E*TRADE is a perpetual takeover candidate, we wanted to see what hidden gems were buried in the 2010 annual report which has just been filed.

Continued credit pressure… E*TRADE is widely believed to be seeing credit improvements despite its losses reported for the last three years.  The company noted in its RISK FACTORS, “Although we have taken a significant number of steps to reduce our credit exposure, we likely will continue to suffer credit losses in 2011… While we were able to stabilize our retail franchise during 2008, 2009 and 2010, it could take additional time to fully mitigate the credit issues in our loan portfolio and return to profitability.” The company also noted that it will continue to experience losses in its mortgage loan portfolio.

Leverage exists here… After a 2009 debt exchange, it had a ratio of debt (corporate debt) to equity of 53% as of December 31, 2010.

Investigations and suits… While the basis goes back to 2007 an investigation is still listed under risks.  It noted, “In addition, the SEC initiated an informal inquiry into matters related to our loan and securities portfolios. The defense of these matters has and will continue to entail considerable cost and will be time-consuming for our management. Unfavorable outcomes in any of these matters could have a material adverse effect on our business, financial condition, results of operations and cash flows.” In its Legal Proceedings, E*TRADE noted that the company is cooperating fully with the SEC in this matter.

Competition and consolidation… Again, E*TRADE has been considered a takeover candidate by many investors, but many believe that it would come after it gets its books in better order.  E*TRADE addressed the consolidation opportunities here and noted, “There has recently been significant consolidation in the financial services industry and this consolidation is likely to continue in the future. Should we be excluded from or fail to take advantage of viable consolidation opportunities, our competitors may be able to capitalize on those opportunities and create greater scale and cost efficiencies to our detriment.”

Deferred tax assets… Due to an effective change of control, E*TRADE noted that it is possible that it could ultimately lose a significant portion of its deferred tax assets and that could have a material adverse effect on our operating results and financial condition.  It had net deferred tax assets of $1.5 billion as of December 31, 2010.

Debt covenants… E*TRADE’s ability to incur additional debt if its Consolidated Fixed Charge Coverage Ratio is less than or equal to 2.50 to 1.0. As of December 31, 2010, E*TRADE’s Consolidated Fixed Charge Coverage Ratio was 0.95 to 1.0. The terms of any future indebtedness could include more restrictive covenants.  That debt can be accelerated if covenant violations are not remedied: “We could be forced to repay immediately all our outstanding debt securities at their full principal amount if we were to breach these covenants and did not cure the breach within the cure periods (if any) specified in the respective indentures. Further, if we experience a change of control, as defined in the indentures, we could be required to offer to purchase our debt securities at 101% of their principal amount.”

CITADEL Domination… Citadel may not be as deeply entrenched as previously thought, but it still has ample influence.  Citadel is E*TRADE’s largest shareholder and debt holder, with approximately 9.9% of the common stock or approximately 27% of the common stock assuming conversion of convertible debentures it holds. Citadel is not required to disclose the amount of E*TRADE’s outstanding debt securities it owns, but E*TRADE believes that Citadel owns about $590 million of the non-interest-bearing convertible debentures. Kenneth Griffin, President and CEO of Citadel, joined the Board of Directors on June 8, 2009.

Anti-takeover provisions… E*TRADE does have defense against an unwanted takeover, which is important considering that many believe that E*TRADE will be acquired.  These include an authorization for the issuance of “blank check” preferred stock; a provision for a classified Board of Directors with staggered, three-year terms; prohibition of cumulative voting in the election of directors; a super-majority voting requirement to effect business combinations and certain amendments to our certificate of incorporation and bylaws; limits on the persons who may call special meetings of shareholders; the prohibition of shareholder action by written consent; and advance notice requirements for nominations to the Board or for proposing matters that can be acted on by shareholders at shareholder meetings.   While these are not uncommon, it is worth noting.

Property ownership versus leasehold… Of the 525,000 square feet it lists as main offices, E*TRADE said all but 165,000 square feet of its offices space in Alpharetta, Georgia is leased.  It also leases all of its 28 E*TRADE branches of 2,500 to 7,000 square feet, and it noted that its facilities space is adequate to meet its needs in 2011.

Its customer base… While commissions per trade have come down 1%, there was account growth through the recession.  New customers were only 54,232 in 2010 but it ended with 2,684,311 accounts at the end of 2010.  Customer assets rose to $176.2 billion from $150.5 billion at the end of 2010, with the “net new brokerage assets” being some $8.1 billion of that sum.

Again, reviewing an annual report is not just to highlight weakness.  Many of these data points should be viewed favorably considering where E*TRADE was back in 2008 and into early 2009.  Whether you want to consider E*TRADE as an acquisition candidate or not, we always maintain that any investment should be evaluated on its own merits rather than just because a strategic or opportunistic acquirer might be able to able to milk more out a target than the target could itself.  Know what you are investing in!

There is a deep summary of a Bank of America Merrill Lynch report from late-2010 that outlines an expected time line and expected price for a buyout here in E*TRADE for your review.

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JON C. OGG

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