24/7 Wall St. has long considered E*TRADE Financial Corporation (NASDAQ: ETFC) as a buyout candidate in the world of online brokerage firms.  The company made some big gambles in an effort to resemble a bank in years past and its mortgage and loan portfolio really acted as a huge drag during the recession.  Now the company is under review after Citadel went activist on it and word is out that TD AMERITRADE Holding Corporation (NASDAQ: AMTD) is meeting over whether or not it will make an outreach for the company.  When news came out that Citadel was pressuring the company last week, our first outlook was that any premium may be an overvaluation.  What we want to find now is just how much premium a buyer can afford to pay before shareholders revolt.

We have gone as far in the past saying that Goldman Sachs Group Inc. (NYSE: GS) might consider making a play for E*TRADE.  That is just not realistic at all in today’s post-blowup financial world. After all, Goldman Sachs is a bank holding company that technically has no real banking operations for the public.  The time has come and gone for that to be a reality.  The other two contenders for making a play are Charles Schwab Corporation (NYSE: SCHW) and Morgan Stanley (NYSE: MS).  Realistically, Morgan Stanley might have a hard time getting approved by regulators to even consider making an acquisition after the financial mess.

One big problem in analyzing the valuation of any of these companies is that there are many legacy accounts that can skew calculated values if you just consider current or active accounts.  There is also the 80/20 rule in business that is probably a 90/10 rule in online brokerages… instead of 80% of the value being based upon 20% of total clients, it may be that 90% of the real value comes from only 10% of the clients.  We have tried to highlight the different calculations from to firm as a result of the reported variations from firm to firm.

E*TRADE Financial Corporation (NASDAQ: ETFC) was screened with a pre-earnings return on equity (ROE) of only about 1.6% and a forward price to earnings multiple of 15.8.  E*TRADE’s market cap was $3.45 billion after the shares recently closed at $15.64 against a 52-week range of $12.24 to $18.13.  The problem is that it just is not cheap.  The company now claims some 4.3 million customer accounts, which included 2.8 million brokerage accounts.  We continue to value these on a brokerage account basis today and its $3.8 billion market cap after today’s 6% gain to $16.64 give a per account value of close to $1,350.00 today.

TD AMERITRADE Holding Corporation (NASDAQ: AMTD) has a return of equity (ROE) of 15.2% and a forward price to earnings multiple of 15.  AMERITRADE’s market cap is $11.2 billion. The shares recently closed at $19.61.  The 52-week price range is $14.42 to $22.85.  TD AMERITRADE has just over 8.2 million total accounts but calls its total funded accounts as being 5.59 million.  If we just use the funded accounts we have a value implication of nearly $2,000.00 per account.

Charles Schwab Corp. (NYSE: SCHW) has a forward price to earnings multiple of 14.9.  Its market cap is $18.6 billion.  The shares recently closed at $15.44.  The 52-week price range is $12.51 to $19.63.  Schwab claims some 8.1 million client brokerage accounts, implying closer to a $2,200.00 per account value.

Morgan Stanley (NYSE: MS) has a return of equity (ROE) of 7.42% a forward price to earnings multiple of 8.6.  Its market cap is $37 billion.  The shares recently closed at $23.90.  The 52-week price range is $20.18 to $30.98.  The problem is that Morgan Stanley was deemed a too big to fail institution and it nearly did fail before the TARP and the bailout.  It also trades at a discount to tangible book value.

TD AMERITRADE remains the top candidate at making an outreach for E*TRADE.  The problem that is going to arise for any buyer is that there is going to have to be a loose assumption about how deep that black hole remains on the books.  E*TRADE has made enough progress that it is back top profits and it has continued to improve its credit metrics.  Our only take is that a buyer is going to discount the rest of the business and not offer as much on a full valuation.  We also openly admit that there is some loose interpretation over just how many accounts should really be counted in a full market valuation for any of the online brokers.

This move could allow TD AMERITRADE to be closer in size to Schwab.  Our take is that Schwab’s financial advisory network and its other operations make the company more attractive than the three online brokerage giants.

A 20% premium, even on top of the double-premium after two days of large gains would put the E*TRADE market cap at closer to $4.6 billion with an implied share price of $20.00.  Again, we understand there is a discrepancy between the active brokerage accounts and the “total” number of accounts.  Still, this additional 20% premium values the active accounts at closer to $1,600.00 per account by our method of counting.  You may be able to milk more “value” than we do, but that seems close to it.

All things being said, $20.00 does seem the peak that we can get to in value.  Realistically, that value should be less considering the other items and baggage that would come along with acquiring E*TRADE.  Citadel is still assumed to have some operational pull as well, and even if that is far less than what it was it creates an additional excuse for a discounting.  They two great sayings that apply to this are “beauty is in the eye of the beholder” and “value differs from buyer to buyer.”  That being said, the figures were are willing to consider peak around $20.00 even when being generous.   The consensus price target from Wall Street analysts is only about $16.50 per Thomson Reuters data and $18.13 is the 52-week high.  E*TRADE shares also peaked around $20.00 in late-2009 if you adjust for its old reverse stock split and no one cares what it was valued at before the recession.

Another consideration is the value of the Call options.  The August11 $18 Calls are the most active contract with a price of $0.43; the September11 $17 Calls are the second most active at $1.06.  This translates to a break-even price before commissions today of $18.06 to $18.43.  Suddenly our “most aggressive price” does not even look that conservative considering a stance of usually being conservative.

Maybe a buyer can find more value in the highly successful baby commercial marketing campaign.  The real issue is going to be milking the value out of the rest of E*TRADE.  Unfortunately, that is also where the skeletons are buried.

JON C. OGG

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