E*TRADE Valuation May Finally Be Compelling (ETFC, SCHW, AMTD, GS, MS)

E*TRADE Financial Corp. (NASDAQ: ETFC) has been the worst of the online brokerage stock.  With some of the crazy mortgage products it offered, it is no wonder.  And the stock has paid a price, over and over.  It trades as though it is destined to stay a $1.00 stock forever.  But today’s major drop in the price just might offer investors with a long-term horizon a stock with a low share price and a solid customer base that could have some serious upside.

E*TRADE was at $1.90 this week, but the hopes that hedge fund CEO Ken Griffin of Citadel would make a play diminished as the company’s financing pact came to be more financing by more debt owned by Citadel.  We have always believed that E*TRADE would make a great asset buy for a larger bank.  Charles Schwab &NASDAQ: SCHW) or TD Ameritrade (NASDAQ: AMTD) would be the natural buyers.  We also thought there was an outside chance that Goldman Sachs Group (NYSE: GS) or Morgan Stanley (NYSE: MS) might want to own this one so that they could live up to the status of “bank holding company.”  But now we know for certain that those classification changes to bank holding companies were merely for appeasing regulators and to more easily skate through the financial meltdown.

Before the market slide killed all of the financial institutions from December to March, we had a long-term fair value target form E*TRADE of $5.00.  We are not going to try to maintain that as a possibility over the next year, but stabilization in this business after this financing could get the stock back to $2.00 and even $3.00 if the company avoids any more serious missteps.

What did the company raise for starters?  The company sold 435 million shares at $1.10 per share.  This 23% discount was far too cheap of a discount, particularly if you consider where this was earlier this week.  This raised $478 million from the sale of stock, but the dilution here was massive.

The broader capital-raising plan does includes a debt exchange that has the goal of trimming $150 million from its annual expenses merely in interest payments.  The problem is that Griffin’s Citadel has an option business hold on E*TRADE and now holds enough debt that we feel the common stock actually has very little say in the running of the company now.

The company still is reeling from mortgage loan losses which it got far too deep into during the peak of the home buying craze.  We have always said that there is no way to know the full extent of how bad those losses could get, and Wall Street analysts were far too optimistic or just not pessimistic enough through 2008.

This capital raise should also satisfy the April request from the U.S. Office of Thrift Supervision to raise capital.  Interestingly enough, we are starting to see decreases in loan losses or risks of loan losses:

• Special mention delinquencies (30 to 89 days delinquent) for its home equity portfolio, which represents the Company’s greatest exposure to loan losses, declined 10 percent from March 31 to May 31.
• Home equity “at risk” delinquencies (30 to 179 days delinquent) declined 14 percent from March 31 to May 31.
• Total special mention delinquencies for the Company’s loan portfolio, which includes one- to four-family, home equity and consumer and other loans, declined by 7 percent quarter to date as of May 31, 2009.

The stock’s 52-week range is $0.59 to $4.05.  Frankly, the old high is largely irrelevant.  But that low was at the selling crest when everything was being sold endlessly.

S&P decided that this was such a good development that it cut the debt rating further into junk status.  Its rating was cut to “CC” and they haven’t exactly said they were warming up to the name.

We do not have a full breakdown of the Griffin and Citadel ownership because it depends upon the total share count and on debt conversions.  But it is possible that this company is coming under the control of Ken Griffin.  If there was a way to force the company into a restructuring he would own the company on the cheap as long as he could convince clients that there funds are not at risk.  We view this as a risk, but not to the point that it seems a certainty.

The reason the business is still attractive is its core customer base.  At the end of May, E*TRADE had a record total accounts of more than 4.5 million, which included record brokerage accounts of more than 2.7 million. This included gross new brokerage accounts of 43,000 and net new brokerage accounts of 23,000.  Its DARTs (daily average revenue trades) was 239,439 in May, which a 4% gain from April and a 34% gain year-over-year.  It also brought in about $500 million in net new assets in May.

At the end of May (before this financing pact) the bank’s Tier-1 and risk-based capital ratios were 6.07% and 12.75%, respectively.  The excess risk-based capital was $644 million, and the bank Tier-1 capital to risk-weighted assets ratio was 11.46%.  It gave estimates for a provision for loan losses of $375 to $450 million and gave an estimate for net charge-offs of $375 to $400 million.

All in all, these numbers do not sound solid by any means.  But the E*TRADE assets holding up with a strong business may help.  So these assets, losses, and provisions may all be enough to skate past the hangman.  If the company could ever get its relationship worked out equally for holders as it is with Citadel, then shareholders might be sitting on a battered stock that could be worth far more than today’s prices.

Jon C. Ogg
June 19, 2009