Stock information:Ticker: ETFC
PPS: $10.66 as of 04/06/2012 Market Cap: 3.05B Trailing P/E:19.74 Forward P/E: 14.41
1 Year Stock Chart:
Thesis:E*Trade has a robust (and growing) retail brokerage arm which in itself would be valued at $5.5B given trading comps of direct rivals TD Ameritrade and Charles Schwab. However, most of the pressure on the stock is due to large loan book in the E*Trading lending business. The E*Trade bank made a disastrous foray into the housing market at the height of the real estate bubble and was left with a loan book of nearly $12B incurring substantial write downs. Our analysis into the loan book shows that the market is being overly pessimistic in its assessments and with the improvement in its loan portfolio, E*Trade could deliver a significant return over the next 5 years.
Key points:• Last year company reported a net income of ~$157 M
• Core brokerage operations alone would contribute ~$300 M if unencumbered by debt service and loan loss provisions from the “bad bank”
• Brokerage cash ~$400 M and debt of $1.4 B, essentially debt of $1B
• “Bad Bank” carries a debt of ~$12 B (Loans made during 2005-07 era, mostly NINJA and have caused substantial write-downs of close to $4 B)
• Citadel holds close to 10% of the company and has been active (pushing for sale of brokerage/reducing the loan book) in ensuring that management is on track to deliver value to shareholders
• Thesis focuses primarily as sum-of-parts analysis with a strong core franchise and a management focused on exorcising the ghosts of 2007
The brokerage business:The business is providing a backbone for the profitability of company. The business had grown at a strong pace and added new accounts with increasing DARTS (Daily average revenue from trading). In future rising interest rates could provide a significant tailwind to the brokerage lending spreads and boost earnings.
E*Trade Bank and the loan book:The major overhang on the stock has been the uncertainty regarding the loan book and future write downs. However, our analysis shows that there is strong disconnect between market perception and the reality on how bad E*Trade’s loan book really is.
The loan book has been steadily decreasing:
Delinquency rates have been decreasing as well:
Our major points are captured in the list below:
1) Reducing loan exposure, winding down of the portfolio:
2) Less leverage: “Corporate debt decreased 30% to $1.5 billion at December 31, 2011 from $2.1 billion at December 31, 2010. The decline was due to the conversion of approximately $661 million in convertible debentures into 63.9 million shares of common stock during the year ended December 31, 2011.”
3) Sufficient cash to pay interest. “We target corporate cash to be two times our annual debt service, or approximately $330 million.” Currently it stands at $484 million
4) Improving regulatory capital ratios:
”As of December 31, 2011, the parent company Tier I leverage ratio was approximately 5.7% compared to the minimum ratio required to be “well capitalized” of 5%, the Tier I risk-based capital ratio was approximately 11.4% compared to the minimum ratio required to be “well capitalized” of 6%, and the total risk-based capital ratio was approximately 12.7% compared to the minimum ratio required to be “well capitalized” of 10%.”
5) No exposure to Europe or any sovereign debt in that region.
6) Substantial reduction in Home Equity Line loans. From $7 billion in 2007 to $0.4 billion today
7) Low requirement or mortgage origination. Loan mortgage originations are done through a third party that assumes credit risk of the loan. As for E-Trade bank, as of Dec 31, 2011, it had commitments to originate mortgage loans of $140.8 million, a reasonable amount.
8) Favorable outlook on loan payment resets. “We do not expect interest rate resets to be a material driver of credit costs in the future as less than 1% of one- to four-family loans are expected to experience a payment increase of more than 10% and nearly 70% are expected to reset to a lower payment in 2012.”
9) Relatively high cushion of loan loss reserves. In addition, provisions for loan losses are expected to decline in 2012 as a result of lower lever of delinquency.
10) Decreasing Net Charge-offs to average loans receivable outstanding.
11) Aggressive assumption of losses on nonperforming loans (good thing). The company has taken an aggressive stance in setting aside substantial allowances for loan losses against nonperforming loans. Currently, the company assumes only 32% recovery rate of its nonperforming loans, fairly aggressive number and making this accounting entry pleasantly conservative for the investor.
12) The main measure of delinquency and rate or charge-offs (Total loans delinquent 90-179 days) is fairly low and is decreasing.
13) Securities division (nearly half of Balance Sheet) has strikingly high quality, judged by its credit-rating.
14) Goodwill is unlikely to be impaired and written-off since 90% of Goodwill relates to the stable and profitable Brokerage division, or $1.7 billion of $1.9 billion total as of Dec 31, 2011. In addition, the Fair Value of assets far exceeds the Book Value of these assets, ranging from 150% to 700%.
15) Company has time before strict regulations are enforced. Dodd-Frank regulations are expected to become effective by July 2015, so loan book has time to work itself off without unnecessary write-offs and asset sales.
16) Ratio of Delinquencies to Allowance for Loan Losses has been dropping, indicating either a more conservative accounting or better than expected credit performance.
17) Consistent Net Interest Spread in the past three years. However, the management expects the spread to shrink to 2.5% in 2012.
18) All is well with Brokerage. “We continued to grow our sales force, increasing our financial consultant team by 42% in 2011.”
19) Not loan loss release but legitimate improvement in quality: “Provision for loan losses declined 43% to $440.6 million for the year ended December 31, 2011 compared to 2010, driven by improving credit trends and loan portfolio run-off. Provision for loan losses should continue to decline in 2012.”
20) Company has disposed of the toxic securities that almost sank it during the crisis. “Much of [the] loss came from the sale of the asset-backed securities portfolio and credit losses from the mortgage loan portfolio. We no longer hold any of those asset-backed securities and shut down mortgage loan acquisition activities in 2007.”
Delinquency detail data and net charge offs:
Risks:1) The flow of cash between various subsidiaries and parent can be restricted. “Neither E*TRADE Bank nor its subsidiaries may pay dividends to the parent company without approval from its regulators.” Also, “Even if we receive the approval of the OCC and the Federal Reserve to receive dividend payments from our brokerage business, in the event of our bankruptcy or liquidation or E*TRADE Bank’s receivership, we would not be entitled to receive any cash or other property or assets from our subsidiaries.”
2) Still have lots of debt and other contractual obligations in the future:
3) High percentage of second lien loans or low percentage of first lien loans. Only 14% of Home Equity Portfolio is first lien loans.
4) Difficult to gauge “real and actual” risk and payments on loans since approximately 79% of the home equity line of credit portfolio will not begin amortizing until after 2014.
5) Poor loan quality given the high percentage of Low/No Doc loans. As of Dec 31, 2011, 57% and 49% of 1-4 family home loans and Home Equity loans respectively were “No Doc” loans. Roughly, only about half of both 1-4 Family home loans and Home Equity loans had FICO scores above 720.
6) High percentage of loans purchased from third party, resulting in less reliable information and documentation. 82% and 88% of “1-4 Family home” loans and Home equity loans, respectively as of Dec 31, 2011.
7) Over the past two years, the company has consistently underestimated its charge-offs as evidenced by its provision for loan losses and actual charge-offs. It might be a signaling mechanism that a company is simply trying to improve its public income statement numbers since provisions hit P&L directly. Even net of recoveries, the company underestimated its losses by $220 and $150 million in 2011 and 2010, respectively.
8) Percentage of nonperforming loans has remained stubbornly high over the past few years.
9) As of Dec 31, 2011, 71% of Total Loans Receivable are adjustable rate loans, which may hamper collectability in a few years as not only many of these loans turn from interest only to interest & principal repayment loans, but also should interest rates increase, that would put an added pressure on borrowers to keep paying.
10) There is $116 million loss hanging over the company in the Available-For-sale securities division that the company still hasn’t recognized.
11) Weighted-Average Exercise Price of Outstanding options are $68.83. Where is the incentive if everyone is so “under water”?
12) Total Net Revenue has been on a steady decline in 2011.
13) More (large) write-offs on the horizon? Home-Equity loan portfolio consists of $5.3bn of principal and is valued at $4.9bn (carrying value) and $4.3 of Fair Value, thus potentially indicating an additional 600million write-off? Same for “1-4 family home” portfolio with $6.6bn of principal, $6.3bn of carrying value and $5.7bn of Fair Val, or extra $600mil write-off coming soon?
14) “Significant portion (50-60% of “1-4 family homes” and HEL) of our mortgage loan portfolio is secured by properties worth less than the outstanding balance of loans secured by such properties.”
15) Issue with HEL and its CLV. Approximately 85% of the home equity loan portfolio consists of second lien loans on residential real estate properties. The average estimated current CLTV on our home equity loan portfolio was 112% as of December 31, 2011”
16) Class action lawsuit is still pending from 2007 and its result “may have material adverse impact on our business. “
17) More stringent capital requirements, lower leverage, and lower future returns? “One of the most significant changes under the new law is that savings and loan holding companies such as our Company for the first time will become subject to the same capital and activity requirements as those applicable to bank holding companies. In addition, we will be subject to the same capital requirements as those applied to banks, which requirements exclude, on a phase-out basis, all trust preferred securities from Tier I capital.”
18) Inability to raise new debt? Covenants restrict ability to raise additional debt if Consolidated Fixed Charge Coverage Ratio is less than or equal to 2.5 to 1.0. As of December 31, 2011, our Consolidated Fixed Charge Coverage Ratio was 1.6 to 1.0.
19) No explanation as to why “Held-to-Maturity” securities went from $0 to $4.2 billion. One possible reason is company’s willingness to remove future uncertainty and value adjustments from its balance sheet and income statement by placing it under “held-to-maturity,” thus removing any need to re-price these with market value changes.
20) Not only are average LTV ratios are above 100% but are deteriorating.
21) Substantial majority of the loan portfolio was originated during the peak of the market, or 87% and 85% of “1-4 family home” loans and Home equity loans respectively as of Dec 31, 2011.
22) Massive overexposure to California’s real estate market. “Approximately 40% of the Company’s real estate loans were concentrated in California at both December 31, 2011 and 2010. “
23) The loss severity of our second lien home equity loans is approximately 95%.
24) Large unrealized losses on derivatives. Company has a unrealized loss of $292 million on its hedging derivate portfolio based on observable Fair Value. In addition, its Cash Flow hedges are not performing too well. See here =>
25) Large debt due 2012. Company’s borrowings and required repo repurchases that need to be repaid total $4 billion in 2012. It only has $2 billion in cash, $1.2 billion in segregated cash (can pay debt with that?) and about $1 billion in CFO. That would use it all simply to pay off outstanding obligations due in 2012.
Despite these material risks, E*TRADE’s core business has substantial earnings power, which we believe will be increasingly revealed over the next few years as loan loss provisions normalize. Adjusted for certain tax assets, ETFC is currently trading for less than 10x 2012 consensus GAAP earnings, but for only about 5x or 6x what we believe it can earn in 2014 when provisions are a smaller headwind. In contrast, TD Ameritrade (AMTD) is currently trading for about 13x 2012 consensus GAAP earnings, a multiple we believe is fair. Assigning that multiple to ETFC would result in a per share valuation in the low $20s by 2014, implying a more than adequate return from today’s around $11 price.
Link to the accompanying presentation.