This commentary originally appeared on Real Money Pro on Nov. 21 at 8:55 a.m. EST.
At $8.25 a share, E*Trade's (ETFC) common shares represent an inexpensive option on an improving U.S. stock market, the return of a more active individual investor, a gradual improvement in the residential real estate market (through its large portfolio of home equity loans) and lower loan-loss provisioning, a rise in interest rates and an opportunity to refinance or pay down/off nearly $1 billion of debt (with a 12.5% current interest payment) at a large cost savings.
As an additional potential catalyst, led by Citadel Advisors LLC (which rescued the company with a capital infusion several years ago), E*Trade has several large and motivated holders that might continue to put pressure on the company to consider being acquired (even though the recent effort failed to result in a transaction).
Background
E*Trade is a discount broker with about 2.8 million accounts and over $175 billion of customer assets.
Commentary
I have gone back and forth (mostly back!) on this investment over the past six months. Most recently, I purchased shares during the market's correction and sold the shares (at a loss) after the company failed to find a buyer recently (and third-quarter results were slightly weaker than expected).
Last week, as the shares continued to slide (nearly revisiting their early-2009 low), I revisited my analysis and concluded that the reward vs. risk had turned favorable, and I have re-established my long position.
On July 21, 2011, this discount broker announced its intention to evaluate "all strategic alternatives including a possible sale." Recently, E*Trade announced "continued execution of its current business plan was the best alternative to increase shareholder value."
The Bullish Investment Case
- As of Sept., 30, 2011, E*Trade had unencumbered cash of $1.67 billion and another $1.2 billion of cash required to be segregated based on federal regulations.
- Against cash, E*Trade had corporate debt of $1.49 billion (and a similar amount of excess capital at the bank). Nearly two-thirds of parent company debt is in expensive 12.5% paper.
- E*Trade's bank is generating about $100 million of excess capital per quarter. At some point, fed regulators will allow the company to release its excess capital and pay down its high cost debt.
- E*Trade has not initiated any new loans nor has it purchased any loans since 2007. Though the portfolio remains at a high loan-to-value, it's amortizing (rolling off) at almost $700 million a quarter -- a big positive.
- Though core earnings (and net interest margins) have been pressured by the Fed's zero interest rate policy, the company is still profitable. Given my expectations of reasonably solid domestic economic growth, interest rates should rise and the pressure on margins (and profits) should abate.
- For the year ended 2010, E*Trade was profitable despite a $780 million provision for consumer loans. This year provisioning is estimated to be about $370 million. Given the (aforementioned) rapid amortization (roll off) of loans, I conservatively expect loan-loss provisions to gradually move down to about $150 million by Dec. 31, 2013.
- The combination of lower interest expenses achieved by paying down/off corporate debt (Fed permission will be necessary) with the reduced weight of loan-loss provisions may result in an after-tax earnings swing of as much as $1.25 a share.
- Fourth-quarter profits should improve over the relatively weak third-quarter 2011 results, reflecting better October DARTS (daily average revenue trades) and a lower provisioning for bad loans.
The shares of E*Trade were featured in Michael Santoli's column in Barron's over the weekend.
Based on more normalized 2013 EPS of $1.20 a share, a 12% discount rate, a 13x to14x P/E multiple and a 1.5-year discount factor, I see an upside to $12.50 to $13.00 a share over the next six months (up 50%). Downside risk is seen to $7.00 a share (down 15%).
If a takeover occurs, $15 to $16 a share appears a likely takeout price.
Doug Kass writes daily for Real Money Pro, a premium service from TheStreet. For a free trial to Real Money Pro and exclusive access to Mr. Kass's daily trades and market commentary, please click here.
