Description

E*Trade (ET) has consistently executed its strategy to grow its business profitably. Yet investors have sold its shares recently because of fear of rising interest rate, and its effects on ET’s on-line brokerage business and the mortgage financing business on the banking side. As a result of the continuing growth in the underlying value of the business and the
price reduction due to fear, it has created an opportunity for the long term value investor to buy an outstanding business at a decent price.

ET was written up by john771 back in July of 2002 and information on ET is widely available. I will not go into details here, but rather highlight the progress ET has made in executing its business strategies, the valuation, investment thesis and risks.

Briefly, ET operates in two business segments of the financial services industry. It has a retail-oriented Internet-based on-line brokerage service and an Internet-based banking service that focuses on consumer lending such as mortgage lending and refinancing, home-equity and other consumer loans.

The on-line brokerage service has dramatically changed the retail brokerage industry. Whereas Charles Schwab & Company (SCH) had revolutionized the discount brokerage industry 30 years ago, the low cost Internet distribution and transaction network and the explosion of availability of investment information through the Internet are causing the
discount brokerage industry to undergo a fundamental discontinuity. As a result, I believe that we will see a rise in a set of new players that will, over time, take over the leadership of this industry and take market share from SCH, just as SCH grew and grabbed market share from the full-line brokerage firms 30 years ago. ET and Ameritrade (AMTD) are emerging as the leaders in driving these changes. I particularly like ET because of its business model, its innovation and its execution of the strategy. While there has been a lot of comparison made between ET and AMTD and their respective business models, I submit that the framework to view ET is how it is going to gain market share at the expense of SCH as SCH is the vulnerable giant whose leadership is at stake.

While there are still many who do not subscribe to the business model of synergy between the brokerage and the retail banking segments, the benefits of such a model began to emerge in the first quarter of this year. By sweeping the cash balance of brokerage accounts into its banking business, ET has greatly reduced its cost of funds on the consumer lending business. As a result, its bank interest spread improved to 185 bp in the first quarter of 2004 and ET exited the quarter at 201 bp. While other brokers such as SCH and TD Waterhouse followed suit, ET’s distribution capability in the consumer loan business is more advanced than SCH’s and ET is able to take advantage of this new source of low cost funding to increase margin more effectively.

ET continues to integrate its information system between the brokerage and banking sides of the business to better integrate its clients’ information. This will enable ET to integrate and cross sell services. Overtime, more synergy will become more evident.

ET has also been a leader in innovation. In 2003, it announced a plan to refund 50% of the 12b-1 fee that it collects from mutual fund companies for distributing their funds. This strategy is aimed squarely at SCH and its large customer base who invests in mutual funds. Its low cost model, when compared with SCH’s model, allows ET to cut its cost and refund part of its 12b-1 revenue to its customers. ET began to actively advertise this 12b-1 fee refund during the first quarter of 2004. We will wait to see its results.

On the consumer banking side, ET introduces the Mortgage on the Move product, which allows its customers to keep their low interest rate loan as they sell their homes and buy new homes. This product will benefit ET in gaining shares as consumers realize that the drop in interest rate has come to an end and the bias in rate is up. While this product is being
rolled out, I expect that it will help ET to gain share.

While these are just examples of innovations and we have yet to see the results, they point to the fact that ET has emerged as the leader in the industry for innovation, and is clearly taking advantage of its low cost structure and its on-line model to gain share at the expense of industry leader SCH.

Another example of ET’s focus on SCH's best clients is ET’s establishment of its brick and mortar network of offices. While many may see this as a deviation from its on-line model, a more careful study reviews the merits of this approach. The success in a long lasting business model is to build assets as well as to continue to grab the day-trader market share. Much of SCH’s success are the self-directed affluent investors. Another success of
SCH’s model is the advisor-directed accounts. In both segments, the key to SCH’s success is to accumulate client assets. With assets, client trading revenues will follow. ET, in its strategy of targeting the affluent self-directed investor segment, is in the process of setting up a brick and mortar branch network in affluent locations of major cities. ET is
also offering a lower commission model to this clientele ($19.95 versus $29.95 of SCH). For investors with a higher account balance, while not widely publicized, ET will offer the $9.95 active-trader rate to these clients. Clearly, SCH is on the defensive. It has recently come up with a confusing array of price and services under the “Personal Choice” banner. I expect that ET will continue to gain share at the expense of SCH.

ET has also quietly expanded its international presence. ET is offering the same low cost and advanced trading platform to its international customers while SCH is charging rates that are several times those offered to its domestic customers. ET will continue to gain shares in the international market. The results are already evident in its March quarter
results. Number of trades by international customers, at 13% of the total, grew at a rate of over 170% year-over-year. As the economy of the world continues to reflate, this segment will continue to add to the growth.

ET management has also shown a remarkable discipline in managing its growth. This is evident by the fact that it walked away from the opportunity of acquiring TD Waterhouse when the price was deemed too high. Rather than buying something at the wrong price to gain “bulk”, it opted for organic growth that generates real value. This has added my confidence in the new management team, and has clearly indicated to me that the
haphazard days of the leadership under Mr. Cotsakos were behind ET.

A further proof of the recognition of ET’s coming of age is the admission into the S&P500 index at the end of March, 2004. This event clearly said that ET has arrived in the big league and that its long term potential is attractive and recognized.

During the March quarter, ET continues its strings of significant improvement in its results, especially compared with SCH as shown below:

First Quarter, 2004 ET SCH AMTD
Brokerage revenue increase (yr-over-yr) 48% 32% 67%
Net income increase (yr-over-yr) 420% 127% 844%
Net earnings per share increase (yr-over-yr) 380% 140% 950%

While the year-over-year increases by AMTD are higher than ET due to AMTD’s focus on the day-trade market, I believe that the leverage that AMTD is currently enjoying will be its yoke as the market for day-trading slows. I believe that ET’s 2-prone strategy of targeting SCH’s
self-directed customers as well as the day-traders market will result in a more consistent profitable growth in the long run.

The following are some comparable statistics:

ET SCH AMTD
Price/share (closing price as of 4/23, $) 12.16 10.96 14.0
P/E, 2003 20.6 30.4 43.8
P/E, 2004 (E) 13.8 21.9 19.2
P/E, 2005 (E) 12.4 19.2 16.3
EPS, 2003 ($) 0.59 0.36 0.32
EPS, 2004, Estimated, ($) 0.88 0.50 0.73
EPS, 2005, Estimated, ($) 0.98 0.57 0.86
ROA, ttm (%) 1.08 1.3 1.9
ROE, ttm (%) 15.3 13.2 21.7

While ET and AMTD are both very attractive at these prices compared to their growth potential, I am biased in favor of ET because of its more diversified business model, its innovative approaches, its focus on picking off SCH’s best clients and SCH’s vulnerability.

ET continues to increase the range of its year 2004 EPS guidance. The range has been increased to $0.75 and $0.90 per share compared to a previous range of $0.70 and $0.85. If the market continues to hold up and interest rate does not take a major spike up, I will not be surprised that ET will out-perform the high end of its range. As more investors see
the merit of ET’s strategy and business model, ET will also close the valuation gap between it and SCH and AMTD. The sharp increase in EPS combined with a closing of the value gap will yield substantial benefits to the ET investors. If the market and trading volume holds up, I will not be surprised that ET will trade in the range of $18 to $20 by the end of the year. As a matter of full disclosure, I own shares in ET.

RISKS

1. Market and interest rate volatility: Both will affect ET and the rest of the financial services industry. ET’s share price has declined from its peak of $15.4 of earlier this year. Its share price is subject to the perceived risk in interest rate increase, and the resulting decline in its share value. Unless there is a major shock to the system (such as another
energy crisis or a sharp rise in interest rate), I believe that any further price decline in prices will be a good buying opportunity for a long term investor.

2. Relative value gap between ET, SCH and AMTD will not close. Investors are discounting ET’s share price because of a variety of reasons: not a pure play in on-line brokerage, the mortgage cycle is coming to an end, former management follies, previous “qualify of earnings” concerns, etc. Many of its former sins were real. The former management had been purged. Current management has worked hard to be more transparent in its communications and its numbers. In time, investors will focus not on its past sins, but the potential of its business model. I also believe that ET now has an innovative management team and an excellent growth strategy. In time, investor will see it the same way. Patience will be the key here for the closure of the relative value gap.

CATALYSTS

1. Continued out-performance of EPS guidance due to execution of strategy
2. Relative value gap closure compared to SCH

Catalyst

1. Continued out-performance of EPS guidance due to execution of strategy
2. Relative value gap closure compared to SCH