Description

Strong growth at less than 8x forward earnings, what could possibly go wrong? We steely-eyed value investors aren't scared off by exposure to mortgage securities, HELOCs, ABS and CDOs. Right?

BACKGROUND

E-Trade Financial is a leading online brokerage. It is also a savings bank with $60b of assets. The brokerage is doing fine, growing revenues, account balances, DARTs, etc. at 15-40% rates. The problems are on the bank side and its holdings of purchased mortgages, HELOCs, mortgage securities, CDOs and so forth. Prices for these assets have declined recently. Perhaps you've read about it. Anyway, E-Trade has taken writedowns and will take more. As with any bank, leverage works for you when the punch bowl is brimming, against you when the writedowns start. But the bank is still healthy and well-capitalized (6% Tier 1, 10.5% risk based). Even if the situations worsens considerably, the valuation is nearing the point where you can write off the bank and still be OK.

BANK

ETrade Bank is great at collecting deposits because the brokerage side of the house supplies a steady stream of customers. Deposits of 36 billion are growing over 15% per annum. These are sticky deposits with reasonable 3%-ish blended cost of funds. Without a big network of bricks-and-mortar branches to originate loans, E-Trade invested a big chunk of these deposits in purchased whole mortgages, HELOCs and various debt securities. They then took this idea one step further and borrowed almost 20 billion in FHLB advances and repos to buy even MORE mortgages and securities.

Fortunately, the repos are secured by AAA agency paper, so the potential for margin call is minimal. Even more fortunately, management now says risking a franchise which took 15 years to build by dabbling in spread investing isn't such a good idea after all, so they've re-focused on their core retail customer. Going forward they'll let new deposits ($6b+/year) displace wholesale borrowing and let purchased loans churn off while they focus on direct lending. This is a reasonable business, and at E-Trade's growth rates, a valuable one. The main task left is to calculate damages from the prior follies.

The Supplemental Portfolio Disclosure at https://investor.etrade.com breaks down the portfolio assets on pages 6 and following. The damages are primarily concentrated in $12.4b of HELOCs and the Asset Backed Securities ($3.1b). The Q3 "big bath" plus Q4's projected smaller bath brings total HELOC provisions up to about $300m by yearend. The HELOC portfolio had about 150m of 90+ day non-performing loans and another 250m of 30-89 day deliquencies as of 9/30/07. Based on expected cure rates and loss severity the 300m is conservative, but deliquencies are worsening at a rapid clip. E-Trade embedded another 150-200m of provisions in their 2008 guidance. An extra $500m of provisions on top of that would eat up 2008 earnings but not endanger the bank.

E-Trade is no longer adding HELOCs, so it's a static pool which will decline over time. The vast majority of delinquencies are the CLTV > 80% loans which comprise about half the pool. E-Trade's baked-in provisions plus the additional $500m I mentioned above would require default rates on that part of the pool to approach 20%, almost without precedent in the history of lending.

The 3.1b of ABS is easier to quantify. 2.23b of this is investment grade prime residential first lien securities which should experience minimal stress even as the housing market stumbles along. The remaining 800m is a polyglot of CDOs backed by commercial RE, trust preferreds, second liens, subprime loans and so forth. 94% is rated BBB or better and about half is AA or better. E-Trade wrote down 197m in Q3 instead of spreading the writedown over Q3, Q4 and 2008 as originally projected. A 50% haircut for the sub-AA securities over the next 18 months would represent another $200m of writedowns. That won't do wonders for earnings, but again will not endanger the bank. E-Trade plans to sell these securities, but has ample liquidity to hold to maturity if market prices do not reflect NPV.

VALUATION

Online brokerages trade and merge at 2-4% of client assets and 15x earnings. Based on these metrics E-Trade's brokerage, with 200b of client assets and 400m of earnings, is conservatively worth $5 billion. E-Trade Bank's Tier 1 capital is 3.6b, about 3.2b of which is held by the parent (400m is trust preferreds). Valuing the bank at 1x book and accounting for parent debt of 1.8b, total company value is about 6.5b or $15/share. Even if the bank somehow fails, shareholder value from the brokerage is almost $8/share. As E-Trade's portfolio problems fade in the rear view mirror the market will value the company off consolidated earnings. At 15x 2008 estimates E-Trade is a $20 stock, with solid growth from there.

RISKS

The biggest risk is a "run on the bank" scenario in which both bank/brokerage customers lose faith and move their money elsewhere. This could destroy both the bank AND brokerage, eliminating the downside protection I mentioned earlier. I can't really quantify this.

If bank performance worsens, E-Trade may borrow at the corporate level to fortify the bank. While it's nice to have this flexibility, it reduces residual shareholder value from the brokerage stub should the rescue efforts prove unsuccessful.

Increasing writeoffs may drive the stock lower into 2008. As long as the writeoffs stay within the parameters I've outlined, I'd view this as an opportunity to add shares.

Catalyst