Reader Mailbag – Is E*Trade a Bargain?

Carol from Phoenix writes:

“Chad, I was wondering if you would comment in your blog about E-Trade (ETFC) from a contrarian, value viewpoint. Their stock has been beaten down lately, but their fundamental business seems strong, and they appear to have rid themselves of what little subprime exposure they had. Thanks!”

Thanks for the question, Carol.

I decided to publish my answer on the blog because I have actually been looking at E*Trade in recent days. This is exactly the kind of contrarian play that I think value investors should be looking at within the financial services sector. It falls into the category of being beaten down due to mortgage market issues, but I do think there is a lot of long-term value here, given that mortgages are not a core focus for E*Trade. Let’s take a look at why the stock has fallen so much. The shares are down a stunning 54% since June to $12 each.

In recent years E*Trade has started offering its core retail brokerage customers a wider array of financial products, including bank accounts, certificates of deposit, mortgages, and home equity loans. Not surprisingly, they are not immune to the mortgage market meltdown. Earlier this month, the company announced it was joining the ranks of those firms moving to shut down their wholesale mortgage business due to market conditions. That, along with a higher than expected provision for loan losses and some institutional brokerage restructuring costs will result in dramatically lower earnings for 2007. E*Trade now expect full year GAAP earnings per share of $1.10, down from their prior target of $1.60 per share.

So, to answer Carol’s question, does ETFC represent a good contrarian value play? To me it appears that it does. With any contrarian investment idea, you will have to be patient, but buying a premier franchise for what could very well turn out to be less than 11 times trough earnings per share looks like a very attractive valuation.

There have been rumors of a merger with Ameritrade (AMTD), but I would not expect a deal in the short term as E*Trade gets their house in order. Ameritrade CEO Joe Moglia would love to do a deal, I’m sure, but at these prices, E*Trade is better suited fixing their issues and waiting for a more normalized profit picture before entertaining offers that maximize shareholder value. A deal does make sense at some point though, as online brokerage mergers have a ton of synergies that can be realized.

You may be curious if I have bought any ETFC shares yet. The answer is no, but not because I don’t find it an attractive option. It is simply impossible to buy each and every attractive stock when managing fairly concentrated portfolios. There are a lot of financial stocks I think are too cheap, and I own some and don’t own others. It’s just a numbers game really. If you are looking for portfolio additions in that space, E*Trade is definitely one worth considering.

Full Disclosure: No positions in ETFC or AMTD at the time of writing

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18 Thoughts on “Reader Mailbag – Is E*Trade a Bargain?

  1. Anonymous on September 26, 2007 at 9:35 AM said:

    You seem oblivious to the fact that ETFC is down because of $40 BILLION in risky mortgage loans.
    The entire book value of the company is $4 Billion.
    If just 10% of these mortgages are vapor (which given the collapse in RE prices around the country, is a conservative guess), then there goes 100% of shareholder equity in the whole enterprise!
    (You might want to read this week’s NY Times article on same issue).

    And, $12 Billion of their mortgages are 2nd mortgages, the highest risk of all.

    You all need to scratch a little beneath the surface before casually throwing off such bad, ill-informed advice to your readers.

  2. Chad Brand on September 26, 2007 at 9:57 AM said:

    Anonymous:

    Your comments seem to imply that:

    1) ETFC is only a mortgage company
    2) Every loan they made was a risky, sub-prime loan

    I would suggest that investors are going to do their own research into ETFC’s mortgage portfolio and also value the company’s other businesses. Basing an investment opinion on a NY Times article isn’t likely a great idea.

    If the siutation was as dire as the commenter would have you believe, I sincerely doubt ETFC would have just come out and predicted 2007 GAAP net income of between $450M and $500M. I suspect a company with that level of profitability is surely worth something.

    Anonymous, would you like to share with us how you would value the company? That way we could have a valuable discussion and try and reach some sort of consensus.

  3. Anonymous on September 26, 2007 at 1:52 PM said:

    Chad, C’mon. The NY Times article is a starting point for your further research, not mine. I’ve been short this stock since the mid-20s, based on my reading of their financials.
    Your attempt to dismiss the problem with the headline “subprime” tag shows your lack of understanding. Forget subprime, which is pretty small. Look instead at the amount of 2nd mortgages, for instance _ $12+ Billion. If you understand anything about mortgages you know the 2nds are the riskiest RE loans that a lender can make. I won’t insult you by explaining why.
    Countrywide recently wrote off about 15% of their 2nd mortgage loans. If/when ETFC follows(and the regulators and auditors will insist on it soon), that amount alone would just about wipe out current shareholder equity. In other words, the stock goes down in low single digits.

    I would suggest you read their recent SEC filings and better understand that the mortgage business is the point here. Diworsification, as Lynch would label it has pushed this company to the edge, where its fate is controlled by the fate of the credit markets, etc., not itself.

    Finally, the CEO has little credibility among those that follow this critically. He already back-pedalled once this quarter, and more is ahead.
    I predict he will be forced to resign within 3 months for i)betting everything on the mortgage biz, which he clearly did not understand well, and ii)trying to hide the dimension of the current problems from his shareholders even now.

  4. Chad Brand on September 26, 2007 at 2:35 PM said:

    I would not suggest people go to the NY Times for research. E*Trade recently issued a 32-page PowerPoint presentation outlining the composition of their balance sheet. I would urge investors who want to research just what kinds of loans the company has on their books to review that, not articles in the financial press written by journalists.

    Now, I am not saying that E*Trade’s mortgage portfolio is not causing problems, or that there will not be ugly writedowns. However, my point is that we already know that, which is why teh stock is down 50%, and they have other business lines that are doing fine (as well as mortgages that will be repaid on time) and all that should be considered when valuing the stock. Their 2nd lien portfolio is $12B, but that is only 20% of their asset base. What about the other 80%?

    I grant you that things could certainly get worse before they get better. However, contrarian investors with a long term value strategy should be asking themselves, “is this company going away, and if not, what is it worth?”

    Could it go into the single digits next week or next month? Absolutely. But, a value investor is going to say, “okay equity holders have seen $5 billion in market cap vanish already, how much of a mortgage writeoff is that pricing in?” We are long term holders, so we care about what the business will look like in 2009-2010.

    That is what I am looking at. You may be right that the short term outlook is bleak, but I would recommend people try and figure out what the stock will be worth 2 or 3 years from now (if they are patient, contrarian investors – as Carol seems to be).

  5. Anonymous on September 26, 2007 at 7:26 PM said:

    >>Their 2nd lien portfolio is $12B, but that is only 20% of their asset base. What about the other 80%? < < That’s akin to saying of a heart attack patient, only 20% of their heart is critically damaged, there’s still the good 80%! That 20% is in enough peril that it could easily sink the whole enterprise. And, sure, the brokerage business and whatever would arise from the ashes of bankruptcy — but, current shareholders would not really care so much at that point, since their shares would have been wiped out before the company re-emerges from BK. $5 Billion market cap has disappeared from a price that was well in excess of book value. That was in sunnier times. With $40 some BILLION still hanging out there, looking very dicey, I would not be too sure that $5 Billion has covered the damages. Take just 15% off the $40Bil and current shareholders are holding toilet paper. And, to tell your readers to go believe the company’s current version of the state of affairs, when they already clearly have shown they are not all that forthcoming, is bad advice from someone who should know better. Since when should investors believe management over sources such as the NY Times? You seem to have it backwards (or have a bias against the Times).
    DId you follow Enron and Worldcom’s powerpoint presentations right over the cliff, too? (or are you of even more recent vintage than that?).

    Why on earth would any reasonably astute investor put themselves in front of this train wreck, when there are thousands of other less risky stocks to choose from.
    This new form of ‘contrarianism’ that I see rampant in baffling. More people lose money in the markets chasing such ‘bargains’ than any other way. Why? Because most people only come into the really bad stocks AFTER they have fallen, looking for a ‘bargain’ and are easy marks for the con game that is played on them by people who need patsies to “distribute” their stock to.

    Oh well. I’m sure you know more than me.
    Good luck with those falling knives..

  6. Chad Brand on September 27, 2007 at 6:10 AM said:

    Well, obviously you have an axe to grind. If your view is that Etrade is going out of business because of this mortgage mess, that’s fine, we’ll see if that proves right or not.

    As a contrarian investor, situations like this are exactly what gets us interested in taking a look around. As Buffett says “be greedy when others are fearful and fearful when others are greedy.”

    In my view, comparing Etrade to Worldcom and Enron and predicting backruptcy is simply irresponsible. There are sub-prime mortgage firms that will survive who are in much less dire situations that e-Trade, who has a bank of customer assets to help it. In fact, Countrywide is now moving toward a bank model to help it stabilize itself.

    As for the NY Times, if you are under the impression that they are unbiased, I think you are mistaken. Many of their bearish pieces on companies either ignore or fail to disprove the opposing viewpoint. They write what they need to to prove the point they are trying to make. I’m not picking on them specifically, it’s just how the media is. There is a good chance that the NY Times report yesterday about Buffett buying a Bear Stearns stake was purely made up.

    We will see who is right about this one. I was just hoping for a little bit of information to back up a bankruptcy claim, that’s all. Unless you think the 4th quarter will wipe out a half of billion dollars in profit for the year, ETFC is making money. Few firms in the black even need to think about BK unless they have liquidity issues, which ETFC does not.

    We’ll see how it all plays out. Thanks for the comments.

  7. Bobby Kolev on September 27, 2007 at 9:07 PM said:

    That was a great disscussion, thanks to both of you!

    As much as I want to I can’t take a side, though, for apparently both of you are way above my level.

    So instead here is another question through which both of you could, if you want, spread more knowledge to others like me:

    I do not own ETFC, but the Anonymous’ comment made me thing…what can an ETFC client lose if they go BK?

    And that leads to the general question, what does the client of any broker have to lose when the broker goes down?

    My first thought was that if they are just brokers, then it shouldn’t really be a problem…you own the stock, after all, not them.
    Then I thought about the money that’s not in stock and in reality, in worst case scenario, I don’t see a reason why they couldn’t have used it as well.
    Once on that track, I came up with the idea that what, if it;s really bad then what’s to prevent them from using your stocks as well either…they’re in their hands and, as far as I am concerned, they are somewhat virtual.

    So the question is…what does a broker’s client have to lose should the broker go down, let’s say *really* bad?

    I’ll be having this conversation tomorrow with ETRADE support, but it’ll sure help to hear from the pros.

  8. Chad Brand on September 28, 2007 at 5:58 AM said:

    Bobby:

    It’s a good question because many people aren’t aware of the specific securities laws that insure customers should a brokerage firm go bankrupt (which has happened).

    Obviously, investors are protected much like bank deposit assets are insured by the FDIC. Brokerages are covered under SIPC. The amount covered is higher though for brokerages ($500K vs $100K for the FDIC).

  9. Anonymous on September 28, 2007 at 6:04 AM said:

    Chad,

    We could all see the real reason why Etrade’s stock is down at levels that are out of the fair market equilibrium with the stock’s fundamanetals. The shorts are shorting shares blindly based upon that article from the NY Times.

    If the shorts reviewed the presentation, as Chad suggested, they would realize that out of the 60 billion loans, 8 billion is margin debt, 30 billion is first mortgages that is mostly secured by PMI insurance and is performing better than industry average at less than 1% default rate. The majority of the 17 billion of 2nd liens are to borrowers with FICO scores over 700 and the majority of this portfolio, according to the presentation is performing better than industry performance. In my estimatation, we’re really talking about 3-5 billion in loans that are performing worse than expected. If you do 7-10% default on these loans, which in my view, is very aggressive; you’ll come out with loan provisions of 200 million to 500 million losses which is right in line with the company provided which should have resulted in Etrade having a short term market cap of 8.5 to 10 billion, not 5 billion.

    The shorts didn’t do their due dillegence. Then the NY Times article came out and alluded to a liquidity crunch. They somehow forgot to mention Etrade has 13 billion borrowing capacity they could pull at any moment.

  10. Anonymous on September 28, 2007 at 6:11 AM said:

    Chad,

    Great article and great suggestion. Etrade is significantly undervalued versus it’s industry peers. Anything under $16 dollars is a gift wrapped up by the shorts. Other stocks to check out are RT, EPG, and SMOD.

  11. MoneyBags on September 28, 2007 at 7:08 AM said:

    Etrade is up 15% in three days since Chad’s post. Keep the straight forward no BS recommendations coming. If you didn’t make the 15% don’t worry, we still have another 50-75% more to go before Etrade returns to their historical valuations.

  12. Anonymous on September 28, 2007 at 7:44 AM said:

    Chad,

    Forgive my ignorance but I have a question related to the initial stream between you and anonymous. Lets say worse case scenario (which I don’t agree with him at all on BTW) they lose several billion in mortgage value and have no book value. How would this effect the stock price so negatively if the company still has core earnings of $1.00 + per share prior to temporary one-time writedowns? Just trying to understand this interaction.

  13. Chad Brand on September 28, 2007 at 8:07 AM said:

    I think you are on the right track to understanding. If E-Trade does in fact writedown far more mortgage loans and securities than is currently expected, there will be one-time writedowns of assets and earnings will be adversely affected due to the one-time event on a short term basis. As a result, the stock would fall further.

    The point of contention is this whole idea that the stock will then be worth “low single digits” (which was the commenter’s initial claim) or even zero after a bankruptcy filing (which was the most recent assertion after I asked how for an explanation of how the company could possibly have no value assigned to its non-mortgage business or the majority of the mortgages that will be paid back on time).

    Mortgage companies that have recently filed BK or ceased lending operations have done so due to a lack of liquidity. They often have margin calls that need to be paid but no cash onhand, or any way of raising any money, in order to pay the margin calls (or continue operationally which would provide cash).

    You saw mortgage REITs like New Century go under because they paid out all their cash in dividends (due to their REIT status) and therefore had no access to cash when they needed it most.

    E-Trade, as a diversified bank, has numerous liquidity options (a prior comment pointed out $13 billion in borrowing capacity). As long as you have access to capital, a writedown of mortgages itself would not send E-Trade to the brink of bankruptcy.

    It is not a coincidence that Countrywide is refocusing its lending activities within its banking division right now. IndyMac (another top mortgage lender) is one of the largest thrift banks in the country, so they too have ample access to money. The banks are better equipped to survive because they have real assets to use as collateral for loans. Mortgage companies who simply issued mortgages and resold them to investors got in trouble when their only source of cash (selling bonds backed by the loans they made) dried up when investors balked at buying the mortgage-backed securities.

    Hopefully that is helpful. E-Trade will have to write-off loans, no doubt about it. The real issue is twofold, though. One, based on the credit profile of their borrowers and their securities portfolio, what is a reasonable assumption for the writedowns? And two, even if the situation is worse than most expect based on their mortgage portfolio, will the company survive? Their balance sheet data seems to show that their bad loan exposure is manageable and their liquidity position is strong.

  14. Anonymous on September 28, 2007 at 8:50 AM said:

    Same anonymous here that had the ignorance question.

    Another point I have thought through before I invested in etrade is that they only fairly recently have built up their mortgage portfolio. As such, a few thoughts.

    1) Does this mean that their portfolio is of a newer vintage and therefore not due to reset for a few more years, therefore making all this a moot point for a few years at least (at which point theoretically the market will have rebounded?

    2) Given the newer vintage, does this mean that, with the credit profile, more of the borrowers put 20% down and, in a period of one or two years, the property will not have depreciated by that cushion?

    Each of these could explain the degree of risk that etrade is seeing and actually create a write-up at some point down the road is how I see it.

    Thanks for your thoughts.

  15. Chad Brand on September 28, 2007 at 10:20 AM said:

    Well, I suspect E-Trade’s vintages aren’t that much different than other lenders. 2006 is still the most prominent vintage year for them (~40% of the total), but I could see them having taken share in 2007 (~20% of the total) while other lenders were pulling back a lot quicker due to liquidity issues. So, I doubt they are terribly different in those terms, but perhaps moreso this year.

    An interesting point about the resets though. Countrywide has said publicly that ARM resets actually aren’t the main reason borrowers are behind on their payments or in foreclosure. The bigger reasons are job/income loss, medical bills, etc. That suggests that ARM resets aren’t even as big an issue as low income borrowers not being able to maintain income levels high enough to pay their mortgage on-time. Of course, if your payment goes up, it would make it even harder without a steady income stream.

    I am hesitant to extrapolate other firms’ numbers to E-Trade (or anyone else for that matter). E-Trade has a much better borrower risk profile than Countrywide does, as seen from their delinqunecy rates that are running more than 50% below those of Countrywide as of 8/31.

  16. Anonymous on September 29, 2007 at 1:53 PM said:

    I can’t believe the E*mperor Has Clothes! defense here. E*Trade is naked under just $4 Billion of Net worth. If 10% of their loans have to be written off — not at all an unlikey amount — the current shareholder equity becomes zero, which means current shareholders’ own nothing but a company that has no book value. Not good.
    If they go into Bankruptcy to reorganize/re-capitalize, current shareholders will get nothing.
    Sure, the brokerage business probably stays in business through bankruptcy, and clients are not at risk…but current shareholders will be wiped out. Pretty basic stuff here.

    Why is this so hard for some of you to see?
    Buffett’s “Be greedy when others are fearful…etc.” is dangerous advice when overly simplified and applied to all stocks, regardless of investment merit. You think he was out buying Enron or Worldcom when “others were fearful”?

    Chad, nothing personal, son, but you have a long ways to go to have a real claim on any stock market wisdom. Unfortunately, you’re a sign of the times.

    Original anonymous.

  17. Anonymous on September 29, 2007 at 2:16 PM said:

    One point about mortgage vintage, E*Trade’s recent vintage makes them more at risk, not less, since they were lending money at the top of the market, and in most case, no doc, stated income.. $12 Billion of their mortgages are 2nd liens – the riskiest of all.
    And, most of what they were loaning were wholesale, not even underwritten by them. They were buying tons of stuff from NCC, which are widely regarded as having made some of the worst loans around.

    All the evidence you need is that E*Trade has now sworn off much of the loan business that they are stuffed to the gills with. If these loans were so low-risk, how come they are exiting so fast from that business?

  18. Chad Brand on October 1, 2007 at 5:31 AM said:

    Well, the bankruptcy issue has already been covered in prior comments, and I’m not going to resort to trading personal attacks back and forth from readers, but I will comment on the last post about E-Trade’s exit from the wholesale mortgage business.

    In my view, it is pretty obvious why lenders are choosing to exit the wholesale area (E-Trade is not the first, Capital One and others have announced similar plans). Wholesale morgtages open up lenders to two risks that they have little to no control over.

    First, since they don’t originate the loans themselves, they can’t control how loose the lending standards are. Second, since these loans are of lesser quality, they are sold to investors, but the secondary market might not be cooperative (again, something beyond their control).

    Exiting the wholesale business reduces the riskiness of their lending operation. Doing so allows them to focus on doing high quality loan originations themselves. They will avoid the secondary market because those types of loans are the ones they choose to keep on their balance sheets anyway. After all, a lender is going to hold onto their best loans and sell their riskier ones.

    It’s true there will be a one-time hit from the wholesale business they’ve already done, but long term stability is what they are looking for in making that move.

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