|Shares Out. (in M):||289||P/E||NA||NA|
|Market Cap (in $M):||4,367||P/FCF||NA||NA|
|Net Debt (in $M):||1,111||EBIT||0||0|
Business Overview and Summary Investment Thesis
E*Trade operates under two separately reported business segments; "trading and investing" or their brokerage business, and "balance sheet management", or their bank. The brokerage is the business that comes to mind when people think about E*Trade (or see the talking baby commercials). This is the online trading business, where the company has amassed a significant presence with over 2.7mm brokerage clients and $150 billion in customer assets. E*Trade's customers are both active traders and mass affluent customers, and E*Trade has been successful in growing this business through the crisis, increasing its account base by over 4% in the past twelve months. The brokerage business is high margin, requires little capex, and is solidly profitable, generating over $200mm in EBITDA in Q1 of 2010, and I believe it is on track to generate nearly $900mm in 2010.
E*Trade names its banking segment "balance sheet management" in their segmented financials, however I would argue a more apt name should be "balance sheet mismanagement". Basically, this segment was borne from the former management's ill-fated boom era decision to use the firm's capital, levered up with client funds, to invest in non-conforming mortgage loans. This was done to earn a larger spread on balance sheet assets and worked for a while...until house prices started tumbling. Then, E*Trade had a big problem on their hands in the form of a staggering amount of toxic mortgage loans. This problem nearly bankrupt the company, and forced a rescue financing and equity infusion by Citadel at the height of the crisis. However, the Bank is now on the mend. The loan portfolio has been nearly cut in half in the past 18 months and this reduction has been achieved through the combination of chargeoffs and loan paydowns. To be sure, E*Trade Bank is still a highly levered entity, however, it is my contention that the bank has sufficient capital to navigate the remainder of the housing/mortgage crisis in the US. I believe the market is viewing E*Trade Bank as a significant liability for E*Trade, when in fact E*Trade Bank is a significant asset, which when appropriately valued in conjunction with the brokerage business, presents an extremely compelling opportunity for equity investors inETFC.
E*Trade Bank has significant resources to remain well-capitalized through the end of the credit cycle.
This is a key point in the thesis for E*Trade, and I think the area which is least understood by the investment community. Many analysts that cover the company are brokerage analysts not bank analysts. I am a bank analyst first and foremost, and the point I want to make is that E*Trade bank has more than enough capital. The most simplistic way for me to get this point across is to present a basic (but detailed) two part analysis. The first part is to determine capacity the bank will have over the remaining course of the economic cycle to absorb future losses. The second part is to determine the magnitude of losses embedded in the banks loan portfolio. Bottom line, if the ability to pay for losses significantly exceeds the likely remaining losses, we can feel pretty good that the bank has a good shot of making it through the crisis. The following table shows that E*Trade Bank has adequate loss absorption capacity versus likely remaining losses:
Loss Absorption Capacity Estimated Remaining Losses
Excess Capital: amp;nbsp; ~$1,000mm Existing Delinquent Loans: ~$800mm
Excess HoldCo Cash: ~$150mm Consumer Performing: ~$40mm
Excess Loan Loss Reserves: ~$750mm 2nd Lien Performing: ~$350mm
Bank Earnings: ~$350mm 1st Lien Performing: ~$320mm
Balance Sheet Shrinkage: ~$250mm
Total Loss Absorption, Yr1: ~2,500mm
Loss Absorption, Yr2: ~$500mm
Total 2yr Loss Absorption ~$3,000mm Total Est Losses: ~1,500mm
So lets start with E*Trade Bank's ability to absorb losses. I define the total loss absorption capacity as the total amount of resources that a bank has to withstand losses over a given period of time. For E*Trade Bank, loss absorption capacity primarily consists of existing excess capital at the bank, excess capital at the Holding Company, existing reserves in excess of general reserves, pre-tax pre provision earnings generated from the bank, and regulatory capital that is generated from the shrinking of its portfolio. Additionally, E*Trade Bank has a benefit that most other banks don't have. It has a brokerage business which as I mentioned throws off significant free cash flow. I won't include the cash flows from the brokerage in my analysis, as I want to start accruing those cash flows to the equity immediately, but it is an important factor to consider, which in a downside case provides more protection to E*Trade than your average bank.
The largest component of loss absorption for E*Trade is the amount of excess capital at the bank. In their 2nd quarter earnings release, ETFC stated that they have ~$1.0bn of capital in the bank in excess of regulatory requirements for a "well-capitalized" institution. However, in the Q&A session of the conference call, CFO Bruce Nolop indicated that the internal capital targets for the bank are higher, citing that under ETFC's internal capital targets, the bank has ~$500mm in excess capital. I believe that the appropriate metric to look at in this analysis is the $1.0bn, as under a stress scenario the amount of capital required in the bank will be driven by regulators, not by management. However, the $500mm of excess capital per management is the right metric to size the ability of the bank to dividend capital from the bank to the HoldCo, which can be used to pay down costly HoldCo debt, and in turn become a significant earnings driver which I will discuss later in this note.
In addition to the excess capital at the Bank, E*Trade also has nearly $500mm of cash at the Holding Company at Q2. Not all of this cash is available to downstream to the bank, as these funds must be used to service interest expense on HoldCo debt. However, assuming E*Trade leaves 2 years worth of interest expense at the HoldCo, there is an additional ~$150mm available to downstream to the bank in a stress case.
Also, E*Trade has $1.1bn of loan loss reserves set aside against their portfolio. This represents over 6% of loans, or more importantly, 54% of the $2.1bn of loans that are delinquent. Simplistically, this is a reserve that E*Trade can use to charge off loans that move from delinquency to default without taking a charge to capital at the bank. However, banks must maintain a "general reserve" for loans that are not in delinquency. Generally, this is ~1-2% of loans. Using the high end of that range, E*Trade Bank has ~$750mm of loss absorption capacity from its existing reserves in excess of the necessary steady state general reserve.
An additional component of loss absorption for E*Trade is the cash flow that the bank throws off from performing loans in the normal course of business. As of June 30, 2010, E*Trade Bank had $18.1bn of gross loans on its balance sheet (before reserves for loan losses). Of that balance, $16.0bn is current. These performing loans are throwing off sizeable amount of (stable) cash flow. In Q2 of 2010, the bank earned pre tax pre-provision ("PTPP") earnings of $95mm. I assume that over the next twelve months, the PTPP earnings fall to $350mm as the portfolio continues to shrink through paydowns and chargeoffs. However, all of this can be used to fund future losses at the bank.
Additionally, E*Trade Bank generates capital as their loan portfolio shrinks. With a required capital ratio of 8% of loans, each $1bn reduction in the loan portfolio frees up $80mm of regulatory capital. The loan portfolio has declined from $32.3bn at September 30, 2008 to $18.1bn in June. That is a run rate of nearly $700mm per month. I assume that the loan portfolio shrinks a further ~$3bn over the next 12 months, freeing up ~$250mm of capital at the Bank.
Summing all of these components, one arrives at loss absorption capacity of $~2.8bn over the next twelve months, and an additional ~$500mm in the twelve months after that (because PTPP and capital release from portfolio shrinkage are gifts that keep on giving), for a total of ~$3.0bn of loss absorption capacity over the next 24 months.
Now that we have a handle on how much capital E*Trade Bank has to absorb losses, lets try to arrive at a base case and a downside case for losses at the Bank. The first place to start is with the loans in the portfolio that are already delinquent. The current level of delinquencies in the portfolio is $2.05bn at June 30, 2010. This number has been declining modestly over the past 12 months and at March 31st, 2009 was $2.2bn.
E*Trade's delinquency portfolio consists primarily of ~$1.6bn delinquent 1st mortgages and ~$400mm delinquent 2nd mortgages. Per E*Trade's management, the 1st mortgages have experienced a 40% severity (ie E*Trade loses 40c on each $1 of loan balance on a defaulted loan) while the 2nd mortgages tend to have severities of 100%. Doing the quick math, if ALL of the delinquent loans were to default at those severities, losses would be a little over $1bn. Now I think 100% frequency of default is too conservative, as many loans "cure" or return to performing status. I believe the more relevant number in this case is 80%... which would equate to $800mm in losses.
Now that we have sized the embedded losses of the delinquent loans, lets try to think about the embedded losses of the loans in the portfolio that are performing (ie paying every month). E*Trade has $16.0bn of performing loans, comprised of $7.7bn of 1st mortgages, $6.8bn of 2nd mortgages and $1.6bn of consumer loans.
First, the consumer loans. These were loans made to E*Trade brokerage customers and have experience virtually no loan losses, and have very low delinquency levels (sub 2%). This is the one area in which E*Trade has proven to be a sound underwriter... unfortunately, this is the smallest component of their portfolio by a longshot. I ascribe an estimated 2% charge off level on these loans, or ~$40mm of losses. This is a small portfolio and a small number in the grand scheme of this analysis, so I don't want to spend any more time here.
Now, the 2nd mortgages. To be sure, this is a portfolio that was chock full of loans that never should have been written in the first place. This was a portfolio that was $12.4bn on September 30, 2007 and one from which E*Trade has already experienced $2.0bn of charge offs. That is a 16% loss rate that has been incurred on this portfolio already. The portfolio has paid down $3.2bn since then, and now stands at $7.2bn, with $6.8bn which is current in their payments. What is very important to note about this portfolio is that it is very seasoned. In an old investor presentation from late 2008, E*Trade management shows the vintages in which these loans were originated. At the time, the portfolio balance was $10.8bn, and of that balance 12% of the loans were originated in 2007, 48% in 2006 and the remainder in 2005 and prior. This is very important because it shows that the borrowers have been living with these loans for a LONG time, and they are still holding on, despite suffering through the worst financial crisis since the Great Depression. To me, this makes the probability a lot less likely that a borrower will default for no reason, and means that future defaults will be highly correlated to NEW events, ie future job losses. The people who couldn't make it have already given up. Sure there will be new defaults but I think an appropriate way to model them would be to base them on the change in the unemployment rate. Lets take a conservative case where unemployment goes from 9.5% to 12%, and lets assume that the borrowers in this particular portfolio have an experience that is 2x worse. That is a 5% default rate, or ~$350mm of losses at a 100% severity. I think this is conservative. The trend in delinquencies supports this thesis, as national employment has troughed, and in conjunction overall dollar levels of delinquencies in this portfolio have peaked and have been declining steadily over the course of the past year.
Finally, onto the 1st mortgages. There are $7.7bn of first mortgages which are current on their payments as of June 30. While the vintage analysis from above is relevant to this portfolio as well, there is a slight wrinkle with respect to this portfolio. This portfolio contains a significant amount of loans with reset provisions. I believe that approximately 25% of the portfolio is fixed rate loans, and approximately 75% of the portfolio has interest rate resets. For the fixed rate loans, we can use the same analysis as for the 2nd liens. At a 5% default and a 40% severity, this equates to ~$40mm of losses. For the reset portfolio, we need to dig a little deeper. First lets understand what these loans are. Basically, these loans were written to one interest rate for a period of time, and then step up to another interest rate after that time period expires (and unfortunately for the borrower, the second rate is usually significantly more costly). To be sure, this was a product that was used during the height of the housing boom to allow borrowers to afford a bigger house. The thought process was that the initial term would be long enough such that at the end of the period the borrower would either be able to sell their house at a profit or refinance into either a fixed rate loan or another adjustable rate. With house prices well below peak levels, and financing for non-conforming loans having virtually evaporated, these borrowers are finding themselves with few options. To analyze the impact of rate resets, I turn to a study done in March of 2010 by the rating agency Fitch. They write:"Recasts typically have a significant impact on loan performance. While only 3.3% of prime loans are 60 or more days delinquent prior to recast, delinquencies the year after recast increased to 9.3%. Similar effects have been seen in Alt-A and subprime, with delinquencies increasing from 12% to 29% for Alt-A, and from 20% to 58% for subprime". Fortunately, E*Trade's portfolio is not subprime, and in fact is likely very similar to the Alt-A portfolios tested. However, one benefit that E*Trade should have versus the loans tested in the Fitch study is that the loans tested hit recast during the depths of the crisis, when house prices, sentiment and financing availability were all at the nadir. Assuming that an incremental 15% of the estimated 75% of loans with recast turn into delinquencies, and then default with an 80% frequency and a 40% severity, I arrive at future charge offs of $280mm. Adding this to the total fixed rate charge offs of $40mm brings us to $320mm in estimated embedded losses from the portion of E*Trade's 1st lien portfolio that is current.
Therefore, in total, I arrive at estimated embedded losses of approximately ~$1.5bn. Comparing this number to our loss absorption estimate of ~$3.0bn, it appears highly unlikely that E*Trade Bank will need to raise capital. Again, this analysis does not include any cash flows from E*Trade brokerage, which will generate well over $800mm of EBITDA in 2010.
The going concern value of this business is over $25.00 per share on a standalone basis, with sale value near $30.00 per share
Now that I hopefully have convinced you that E*Trade Bank does not need to raise capital, and will survive the remainder of the economic downturn intact, I would like to turn to valuation of the company as a whole. In my opinion, the most accurate way to value this company is to look at the valuation in parts. For E*Trade, the standalone value of the business is comprised of the value of the Bank plus the value of the Brokerage plus the value of the significant deferred tax asset the company has, net of corporate expenses. Additional value exists in a takeover scenario where E*Trade shareholders will share in operating cost synergies with an acquiror. The following table outlines a summary of the value:
Pro forma Bank Capital: ~$2,800mm
Brokerage Value: ~$7,000mm
Corporate Expenses: ~($1,300mm)
DTA Value: ~$1,200mm
Enterprise Value: ~$9,700mm
Net Debt: ~($1,100mm)
Market Value: ~$8,600mm
Value Per Share Standalone: ~$30.00
Acquisition Adjustments: ~$5.00
Sale Valuation per share: ~$35.00
Let's start by looking at E*Trade's value on a standalone basis, and let's discuss the value of the bank first. The best way to think about the bank is to analyze what it is worth in a liquidation scenario, as the bank is actively running off its loan portfolio and preserving capital. The bank has $2.9bn of capital, as well as $1.1bn in reserves for loan losses. Additionally, over the next two years, the bank will generate PTPP of ~$700mm. This brings total capital at the end of 2011 of ~$4.7bn. However, as I also discussed, the bank will suffer more losses, likely in the $1.5bn range, this leaves $3.2bn of pro forma capital at year end 2011. However, included in bank capital is a deferred tax asset of $346mm, which we will value separately. Subtracting this deferred tax asset from bank capital leaves ~$2.8bn of pro forma capital.
As for the brokerage, E*Trade just began reporting this segment on a standalone basis in its financials, excluding corporate expenses. In the past three quarters, this business generated EBITDA of $650mm. I expect this business to generate between $850mm and $900mm of EBITDA in 2010. There is a very close comparable to E*Trade's brokerage business, TD Ameritrade Holding Corp or "Ameritrade" (Nasdaq: AMTD). Ameritrade will generate EBITDA of ~1.2bn this year. With the stock at $15.60 and roughly 600mm shares, AMTD has a market capitalization of $9.4bn. Adding net debt of $100mm, AMTD has an enterprise valuation of $9.5bn, and is currently trading at ~8.3x this years EBITDA. Applying a 8.0x multiple to the midpoint of my estimated E*Trade brokerage earnings arrives at a value of $7.0bn for the brokerage, before corporate expenses.
E*Trade reports corporate expenses as a separate business segment. The company incurred corporate expenses of $40mm in the June quarter, which annualizes to $160mm. Applying a 8.0x multiple to those expenses detracts from value by ~$1.3bn.
Finally, E*Trade has a tremendously valuable deferred tax asset. This DTA is the silver lining resulting from the crippling losses that the company endured throughout the crisis. The company has $1.4bn of DTA currently, and I estimate the company will generate a further $400mm of DTA over the next two years as the company incurs further provision expenses. I estimate the total present value of the deferred tax asset at ~$1.2bn.
Therefore, adding the value of the bank, the brokerage, and the DTA, and subtracting the corporate expenses, one can arrive at an enterprise value of ~$9.7bn for E*Trade. Subtracting corporate debt of $1.6bn (excluding the Citadel converts, which I will treat as converted and add to share count), net of cash of ~$500mm arrives at a target equity market value of $8.6bn, or ~$30.00 per share (based on 290mm shares outstanding). This valuation implies 100% upside from current levels.
Another way to think about this analysis is to subtract the value of the bank and the DTA from the value of the company, and figure out an implied earnings multiple for the broker and corporate. The stock currently is trading near $15.00 per share. The bank equates to nearly $10.00 of value, and the DTA at $1.2bn works out to ~$4.00 per share. Therefore, you are getting a brokerage business, which fully loaded for corporate expenses and interest costs is on track to earn close to $1.00 in EPS this year, where the closest comp AMTD trades at over 13x earnings, FOR $1 per share.
Further upside exists in a sale scenario. Precedent transactions in this industry have resulted in tremendous realized synergies for acquirors, allowing significant premia to be paid for targets. Ameritrade has been especially acquisitive over the years, and has created tremendous value integrating targets trading platforms onto their own. Generally speaking, in an average transaction, the acquiror can take out the vast majority of costs in the targets platform. For reference, E*Trade has ~$1.1bn of Q1 annualized run rate expenses, with $700mm at the brokerage and $200mm at each the bank and corporate. Assuming 50% of brokerage costs, 90% of corporate costs and 10% of bank cost savings we arrive at savings of over $700mm, which if split 50/50 between acquiror and target at a 13x (AMTD) multiple, would result in ~$3.0bn in value for E*Trade shareholders, or over $10.00 in incremental value per share. Now in a sale scenario, the DTA would become less valuable, and an acquiror would likely require some discount to purchase the loan portfolio (at least if a deal were to happen today), so I would argue that conservatively a deal scenario would bring a net incremental $5.00 per share of value to E*Trade shareholders, bringing the total equity value up to $35.00 per share.
Investor community concerns regarding operating environment of brokerage business are overdone, and currently priced into the stocks
Finally, I would like to address a few points regarding the brokerage business. Over the past several months, two significant events have occurred in this business, pressuring E*Trade's stock price. Earlier this year, in response to competitive pressure, E*Trade has cut commission costs (the amount it charges for online trading) and has eliminated account service charge fees (fees it charges for low balances or inactivity). Management has given guidance that these fee reductions will impact revenue by $50mm in 2010, and I have incorporated this impact (at 100% decremental margin) into my forecasts. Additionally, last month, the Wall Street Journal reported that Bank of America Merrill Lynch will begin offering an online brokerage platform called "Merrill Edge", which combines BofA's online trading platform and various Merrill Lynch offerings such as research, investment products, retirement-planning tools and call center support. The stated strategy is to target investors with less than $250,000 in assets (with an emphasis on younger more tech-savvy investors), who hopefully will grow to become clients of Merrill Lynch over time as their net worth grows. A few points I would make regarding these developments. First of all, with respect to competition, the spectre of commission cuts has hung over the head of this industry for as long as I can remember. However I believe that this risk is adequately reflected in industry multiples. Think about it this way, if pricing competition didn't exist in this business, I would argue we would be looking at a mid-teens EBITDA multiple for the industry as a whole. That is because absent the occasional price concession, this business is characterized by a growing addressable market, increased market penetration from investors leaving financial advisors, ultra-high operating margins and negligible capital expenditures. However, as outlined above, these businesses trade at a far cry from mid-teens EBITDA. At only 8x, this signaling to me that the threat of competition and further price pressure is appropriately valued in the multiple of these stocks. Secondly, in terms of the Merrill offering, and its probability of success, I would point out that this is not the first time the bulge brackets have tried to enter this business. I would reference a similar announcement which took place in October of 2006, where Bank of America began a campaign of marketing free trades to investors who held over $25,000 in assets in BofA accounts. Although met with much fanfare by the Street, and consternation by investors, this BofA offering didnt go anywhere. Throughout the past several years, the online brokerage business has proved resilient not just to that BofA offering, but also to other competitor offerings (including Wells Fargo free online trading and Merrill Lynch's prior online trading platform ML.com). The smart analysts on the Street tend to believe that a commitment to technology and a high level of customer service are the differentiators for the online brokerage houses. The bulk of their revenues are driven by active traders, who rank the value of these offerings more highly than the cost to trade. Anecdotally, I would agree with them as well. I have an E*Trade brokerage account, and a Bank of America banking account. The difference when I pick up the phone to call each of them is staggering. At E*Trade, I nearly every time get connected immediately to a sales rep who is knowledgeable and can answer my question or resolve my issue within minutes. At Bank of America, it feels like I am constantly being re-routed to three or four different teams (being put on hold at each interval, and having to explain my issue again and again to each person) before I can find the right person to answer my question, and then it is a coin flip as to whether or not the problem gets resolved. In summary, I am not arguing that the brokerage business is not a commoditized business, in fact I think it is, and I think the market believes it is, with the multiple they put on these businesses. However, I believe that E*Trade understands that the customers time is valuable, and prompt and helpful customer service are paramount, and this is what keeps and grows accounts and business in this ultra competitive industry.
In summary, I believe that investing in the common stock of E*Trade Financial presents a compelling opportunity. The bank is in a solid capital position currently, has sufficient capital to weather all future losses, even in a severe downside scenario, and will accrue significant value to shareholders over time. The brokerage business has remained resilient throughout the downturn and I believe the concerns regarding the operating environment are overblown. I believe E*Trade is a stock with little downside even under most harsh economic scenarios, and offers tremendous upside as the company continues to execute its plan of resolving legacy credit issues, growing the brokerage business, and eventually positioning the company for a takeover.