Last week marked the culmination of a series of events regarding E*Trade that provide clarity for investors on what it will take for E*Trade to execute a successful turnaround:
- E*Trade raised over $600 million in equity from a larger than expected common stock offering at $1.10 a share and an earlier equity purchase program1
- E*Trade exchanged as much as $1.345 billion in debt for zero coupon bonds that are convertible to stock with Citadel Investment Group2, saving up to $148 million in annual interest expense.3
- E*Trade’s stock declined to the $1.20-$1.30 a share range from the $1.40 to $1.50 range (where it was already an attractive value), representing in my view an outstanding buying opportunity.
These events turn E*Trade into a largely macroeconomic play. E*Trade is clearly executing for reasons I have previously expressed in terms of operations and marketing—and has now shored up its financing to a degree that should allay exaggerated concerns of adverse action by regulating agencies. E*Trade’s brokerage revenue continues to be very favorable and—despite some indication of a mild summer slowdown—its current Alexa.com figures for website traffic continue to be strong. (See my post on How to Make Money in the Stock Market Using Alexa.com.)
The albatross around E*Trade’s neck is, of course, its legacy mortgage portfolio. The numbers are there for all to see.4 The trend is in the right direction, with most recently delinquent (30-89 days) mortgages in one-to-four-family units falling from $587 million to $556 million in the first two months of the second quarter. However, the total amount of delinquent mortgages in that category is $1.606 billion, with the number rising to $2.257 billion if delinquent home equity loans are included.
This is where the macroeconomics comes in. While I have argued that investors should plan their investment strategies to be responsive to a number of recovery scenarios, including the prospect of an extended period before recovery, it is possible that certain parts of the economy may recover faster than others. It is now widely anticipated that unemployment will shortly rise above 10% and stay there for a while. However, returning to the point that aspects of the recovery may be uneven, it’s also well known that 100,000 to 125,000 jobs need to be created each month just to keep U.S. unemployment at the same level due to population growth.5 So if unemployment rises to just over 10% and stays in the same place, 125,000 more people a month may be getting jobs than losing them. It’s fair to assume that a good proportion of these folks will be homeowners whose new job will enable them to keep their homes, as opposed to new workers who don’t own homes getting their first job. Some of the newly reemployed will have E*Trade mortgages. So even if the job recovery takes a long time, there may be relief for E*Trade before the broader recovery cycle is completed.
When these positive economic prospects are combined with E*Trade’s brokerage business revenue and the reduction in interest payments from the recent debt exchange, it’s possible to see light at the end of the tunnel. When that light can be seen is hard to predict. But when it begins to come into focus for the broader investment community the reaction is likely to be swift.
E*Trade takeover speculation flares up periodically, temporarily lifting the price of the stock. While one never knows—a deal is always possible when there’s money to be made—my own sentiment is that it’s premature to assume this will happen. Any E*Trade takeover would an expensive prospect. The steady profits from the brokerage business assure bank regulators that E*Trade’s bank can handle the mortgage write offs—so regulators are likely to insist that the buyer take the mortgages too.
There are also significant differences in marketing image between E*Trade and its major on-line competitors that may affect takeover prospects. Spokesman Sam Waterson pitches TD Ameritrade as catering to independent investors. Charles Schwab uses spots where animated investors talk about their investment goals and concerns. E*Trade ads show an infant buying stock. While E*Trade’s competitors would love to acquire its customer base, the “how” of integrating these market strategies to ensure account retention coupled with the expense of a deal and the risk-averse tone of the current environment is likely to give them pause for now.
So the real money to be made from E*Trade stock is, in my view, likely to come from the market recognizing improvement in E*Trade’s business. By the time E*Trade’s mortgage delinquency situation improves so that the company is more attractive to prospective buyers, its price is likely to have appreciated significantly. I continue to believe that E*Trade presents an outstanding investment opportunity, particularly in the current $1.20 to $1.30 a share range.
(Note: The author holds a securities position that is long on E*Trade as of the original publication date of this post. The author does not hold a securities position in TD Ameritrade or Charles Schwab.)
- “E*TRADE FINANCIAL Raises More Than $600 Million of Common Equity in Second Quarter,” E*Trade Press Release, June 24, 2009, https://investor.etrade.com/releasedetail.cfm?ReleaseID=391731. [↩]
- https://investor.etrade.com/releasedetail.cfm?ReleaseID=391001 [↩]
- Information on the volume of the bonds covered by the debt exchange from which the interest savings can be calculated is in E*Trade’s Form 10-Q, filed May 5, 2009, Note 9, https://investor.etrade.com/secfiling.cfm?filingID=1193125-09-99923. [↩]
- “E*TRADE FINANCIAL Corporation Reports Monthly Activity for May 2009; Provides Updates to Loan Delinquencies and Certain Financial and Balance Sheet Metrics,” E*Trade Press Release, June 17, 2009, https://investor.etrade.com/releasedetail.cfm?ReleaseID=390219. [↩]
- See, e.g., Justin LaHart, “Jobless rate Rises to 8.9% But Pace of Losses Eases,” Wall Street Journal Online, May 29, 2009, http://online.wsj.com/article/SB124178530342200595.html. [↩]