E*Trade

The E*Trade story is familiar:  a successful company ventures out of its core business and gets burned.  E*Trade was doing just fine as one of the top online brokerage platforms in the industry, but it expanded big into mortgages and that’s where the trouble began.

Any serious look into E*Trade requires some consideration of numbers—and I’ll get to that below—but what should not be forgotten is this:  E*Trade continues to operate an arguably best-in-class business that:

  • continues to improve, as demonstrated by its new iPhone mobile platform;
  • is marketed effectively, including through the company’s well known “E*Trade baby” ads;
  • continues to attract new customers, as demonstrated by E*Trade’s 63,000 net new accounts in 2009′s first quarter.1

However, E*Trade continues to face a serious shortage of capital in an environment where it’s difficult to earn capital back.  Here’s where the math comes in.  For E*Trade’s banking arm, E*Trade Bank, the current regulatory minimum Tier 1 capital ratio to be considered well-capitalized by its regulator—the Office of Thrift Supervision—is 5%, but it’s target objective is to shift to a paradigm where a 6% Tier 1 ratio is expected.2 Under the current 5% rule, E*Trade ended the current quarter ahead by $288.1 million, a 5.63% ratio.3 If you do the math, however, that’s $169.2 million short of where they need to meet the 6% test.

But another dimension is that E*Trade requested $800 million in aid under the TARP,4 , far more than the current quarter’s $169.2 million dollar shortfall to the 6% ratio, presumably reflecting the amount E*Trade thinks it needs to remain well capitalized under the newly evolving standards while continuing to sustain losses during its turnaround.

In its first quarter earnings conference call, E*Trade indicated that shoring up its capital requirements will “undoubtedly generate substantial dilution” in shareholder equity.5  So a key question for investors is just how much dilution will that be?  Here’s where more math comes in.  E*Trade has 572.1 million shares outstanding.  The $169.2 first quarter shortfall to meet the 6% Tier 1 ratio divides up to 30 cents a share.  The $800 million E*Trade requested from the TARP would divide to $1.40 per share.

Neither one of these numbers is likely to represent the amount by which shareowner equity will be diluted.  The amount of the first quarter Tier 1 shortfall does not include the gap from continuing (future) losses, so the amount by which shares could be diluted if the gap is closed entirely by issuing more stock could be higher.  On the other extreme, given the apparent health of E*Trade’s core businesses and the importance in government policy of helping those who can help themselves, it would be surprising if the resolution for shoring up the capital shortfall was achieved exclusively by diluting the shares.

With all these in mind, there are two pieces of good news.  First, the market has likely priced shareholder dilution into the stock, at least to some degree.  E*Trade shares traded in a range between $2.40 and $2.50 before the bad news in the recent earnings announcement.  Taking $2.40 as the pre-announcement benchmark, the current price of $1.58 (as of close on May 1), anticipates a loss of 82 cents a share, or a $469 million loss in total shareholder equity.  So if shareholders lose half what E*Trade has applied for under the TARP, it’s arguably already priced in.

Second, recalling my hypothesis that information on web traffic available on Alexa.com is a tool that can be used to analyze equities, the recent indications of traffic for E*Trade’s web page as reflected on Alexa are positive.  Etrade.com’s percentage of global page views trended up by mid-March to levels seen before the Lehman bankruptcy, so if the elevated traffic levels continue the trend’s effects on revenue won’t be seen until the second quarter.  The rise of global Internet users who visited the site is similarly pronounced, with an especially steep increase in daily traffic rank in April.  Other Alexa metrics appear positive as well.  The average time on the site also appears to be higher—indicating more transactional visits.  Even the “bounce” rate—which indicates visits to E*Trade that end after only viewing one screen—seems to be trending down, another sign that visitors are taking a closer look at and using E*Trade’s products.

So E*Trade comes to the negotiating table with potential creditors, investors, buyers and its regulators with far more than “scrap” value.  Even in the eventuality that E*Trade needs to sell itself to survive, the brand is so strong that it’s hard to imagine an interested buyer not paying some premium for its brokerage platform, and the government not somehow supporting the deal to prevent the destabilizing effect of a major retail broker going bankrupt.  Finally, the terms of CEO Donald Layton’s compensation package should allay concerns that E*Trade management will readily sell out the shareholders.  Layton, come from being Vice Chairman of J.P. Morgan Chase, is reportedly being paid his 2009 compensation mostly in equity.  The press release announcing his selection as CEO stated:

In accepting the CEO position, and as a clear vote of confidence in the Company, Mr. Layton requested that all of his 2008 and 2009 compensation be in the form of equity.  His employment agreement states that in those years nearly 90 percent of his total compensation will be composed of restricted stock and stock options, with no cash bonus.6

What this all likely comes down to is a race against time, but one for which E*Trade has a legitimate shot at winning.  The more evidence mounts that E*Trade’s revenues are increasing, that its brand remains strong, and that retail investors are generally returning to the market, the more leverage E*Trade will have to make a deal that will allow the shares to appreciate from current levels with continued successful execution.  While the government’s delay in acting on E*Trade’s TARP application raises concern on the surface, there are alternative explanations for the delay to the government thinking that E*Trade is not worth saving, including to ensure that there is some private money in the mix.  While significant risk remains, there is a cogent thesis that E*Trade will pull through, and those who go in at current levels ($1.58 close on May 1) will be rewarded.

(Note:  The author holds a securities position that is long on E*Trade as of the original publication date of this post.)

  1. E*Trade FINANCIAL Corporation Announces First Quarter 2009 Results, April 28, 2009,  https://investor.etrade.com/common/download/download.cfm?companyid=ET&fileid=290397&filekey=bfe0f1b8-cc7b-4187-9f54-60ea11062ba3&filename=ETFC_News_2009_4_28_Earnings.pdf. []
  2. E*TRADE FINANCIAL Q1 2009 Earnings Call Transcript, April 28, 2009, http://seekingalpha.com/article/133780-e-trade-financial-q1-2009-earnings-call-transcript?page=7. []
  3. E*Trade FINANCIAL Corporation Announces First Quarter 2009 Results, April 28, 2009,  https://investor.etrade.com/common/download/download.cfm?companyid=ET&fileid=290397&filekey=bfe0f1b8-cc7b-4187-9f54-60ea11062ba3&filename=ETFC_News_2009_4_28_Earnings.pdf. []
  4. E*Trade FINANCIAL Comments on Capital Protection Program, November 7, 2008, https://investor.etrade.com/releasedetail.cfm?ReleaseID=346447 []
  5. E*TRADE FINANCIAL Q1 2009 Earnings Call Transcript, April 28, 2009, http://seekingalpha.com/article/133780-e-trade-financial-q1-2009-earnings-call-transcript?page=6. []
  6. E*Trade Financial Appoints Chairman Donald H. Layton Chief Executive Office, March 3, 2008, E*Trade Financial Corporation, https://investor.etrade.com/releasedetail.cfm?ReleaseID=297057. []

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  1 comment for “E*Trade

  1. May 30, 2009 at 9:39 am

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