Thursday, March 12, 2009

E*Trade: Worth Ten Dollars or Ten Cents?

E*Trade (ETFC) shares have suffered one of the greatest declines of all (non-bankrupt) financial service companies - a whopping 97% from pre-meltdown levels. (From the start of 2006 through the first half of 2007, ETFC was a $20+ stock.)

The verdict remains out on ETFC. Obviously the possibility (or probability?) of bankruptcy is priced in, as shares changed hands at $.66 on Thursday. However, the core brokerage business remains strong... if only management had had the foresight to have avoided banking and investments over the past five years.

Shares slumped Thursday amid the strong rally after a Citi analyst slapped a "sell" on the stock this morning. The Citi analyst provided a price target of $.25/share. However, along with that bleak statement, he pointed out:

"E*Trade is a tale of two companies. On one hand, the retail brokerage operation is steady. The segment has averaged over $500M of annual operating earnings and 41% margins over the past five years. The institutional business, however, remains an albatross as a result of its $25.5B loan portfolio. While we believe current management is doing all they can to address the company's legacy balance sheet issues, the long-term viability of the company remains in doubt, in our view."


There are about 500 million ETFC shares outstanding, so theoretically, the brokerage-only component would be making $1/share per year and trade at $10-$20.

However, the institutional component, which focused on investing in mortage securities, threatens the viability of the company. ETFC hasn't reported a profit since 2007 as mark-to-market writedowns of assets have forced ETFC to take losses. However, management has proactively dealt with the losses and associated need for increased capital; they sold E*Trade Canada for over $500 million (after taxes) and sold a portion of their asset portfolio to private buyers.

They now seem well capitalized, and a recent stress test confirmed that conclusion. (Read the article here.) The analyst concludes that while ETFC would need more capital in a (harsher than realistic) immediate full-writedown scenario, it would be able to maintain a Tier-1 capital ratio if the writeoffs happen over a few quarters.

The wild card that could still significantly change things is ETFC's still-outstanding request for TARP funds. ETFC requested $800 million, which would cover all losses even in the aforementioned analyst's doomsday scenario.

The bottom line is that ETFC will do one of two things - go bankrupt, or go way, way up.

When it comes to the financial services sector, the most important thing now is survival. For the past year (or more), companies have written down assets repeatedly thanks to mark-to-market accounting. Assets have to be written down to prices they'd fetch on the open market, while in reality, many instruments have intrinsic value (based on interest payouts, etc.) above their current marked values. Eventually, these assets will be written up. Some firms will fail or be bought out before they have the opportunity to do this; others, whether due to good management or the government's good graces, will survive until the day they report a gain on their held assets.

Even ignoring any writing-up of ETFC's assets, if they can survive to the day that their non-brokerage business no longer impairs their results, the shares will skyrocket - eventually back to double-digit (dollars, not cents) territory. (Note: Seemingly ridiculous claim is based on $1/share brokerage-component earnings). However, current market pricing indicates that most investors don't think that will happen.

I find buying ETFC a bet worth making - The slim possibility of a 10- or 20-bagger makes the probability of bankruptcy worth betting against. I currently hold some shares, but I'm planning to add to my position if shares stay at current levels. ETFC shares are not for everyone, and I'd almost classify going long as closer to gambling than true Buffet-like investing... but I'm young and I like taking risks. I'm hoping that management can continue to bail water out of this sinking dingy until the storm clouds have cleared.

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