Description

This once-flamboyant proponent of go-go investing has steadily improved its own business and is now significantly undervalued relative to other financial services companies. Falling competition, a diversified revenue stream, rising earnings, and a valuable franchise create long-term appreciation potential of 5 times the current share price.

Information about ET is widely available so I will omit background info and focus on the valuation and investment thesis.

COMPETITION AND FRANCHISE

Competition between on-line brokerages has fallen to a level at which the key remaining players are likely to survive and prosper. The end of price competition was highlighted by the failure of American Express to succeed with a business model based on free transactions. There are very high barriers to new competition:

Customers demand high quality service. 5 years ago on-line brokerage service was notoriously poor with erratic executions, frequent errors, system crashes, and back offices that were impossible to reach. The survivors now have a combination of heavy investment and experience that would be nearly impossible for a new competitor to match.

The remaining firms have achieved a scale that allows for efficient use of their cost structure and significant advertising to support their brand names. Secondary players have been selling out to the big firms who can realize cost savings through back-office consolidation.

The benefit of falling competition has become apparent in rising prices. Headline commission rates have been maintained, but Etrade has been able to add inactivity fees, higher margin lending spreads, and a $3 order-handling fee.

ET BUSINESS MODEL

I am especially encouraged by Etrade’s success in diversifying its business model. The mortgage and banking business (now the 11th largest S&L) has offset this year’s weakness in brokerage activity. Cross-selling banking, brokerage, asset management, and insurance services allows Etrade to generate significant growth from its existing account base and to get the maximum benefit from the $270 promotional expense per new account.

Currently Etrade brokerage accounts average only $12,000 in assets, but this also indicates the potential for internal growth as 1) the relatively young clients age and accumulate more wealth, and 2) clients concentrate more of their financial services business at Etrade.

VALUATION, COMPs, and Share Price

Etrade has about the same earnings and book value per share as Schwab, a higher growth rate, and a 55% lower price.

Company ET SCH AGE AMTD RJF
Share Price $3.90 $8.97 $32.55 $3.35 $25.35
Market Cap $1.4Bn $12.3Bn $2.6Bn $0.7Bn $1.2Bn
Book Value ps $3.74 $3.07 $20.20 $1.77 $16.26
Tangible BV ps $2.64 $2.62 $20.20 $0.71 $15.00
Price/BV 1.0 2.9 1.6 1.9 1.6
Price/TangiBV 1.5 3.4 1.6 4.8 1.7
2002 P/E 8.7 27.2 15.6 30.5 15.6
2003 P/E 6.2 19.5 12.5 10.5 13.1

The financial services industry has a long history of consolidation and I think it’s inevitable that ET will be acquired, but there’s nothing currently on the horizon. Recent transactions provide reference points for valuing ET.

Ameritrade paid $1.289Bn net of cash to acquire Datek. This equates to multiple of 3.5 X revenues, $16.52 per daily trade, and $1480 per account.

Harrisdirect paid $106mm for Morgan Stanley’s 150,000 online accounts ($706 per account) and $520mm for CSFB’s 467,000 online accounts ($1113 per account).

Each company has a different business mix and franchise so there isn’t a perfect comp, but if you look only at Etrade’s 3.6mm brokerage accounts (excluding the banking business) and value them at the also ran-ran price of $700 per account then the brokerage business is worth $2.5Bn. An aggressive $1480 per account would value Etrade’s brokerage business at $5.4Bn.

Using the forecast 2003EPS of $0.63 and a long-term growth rate of 15% leads to estimated book value of $8.24 per share at 12/07 and 2008 EPS of $1.27. A reasonable valuation of 2-3 times book value and a 12-18 P/E would mean a 12/07 share price of $15-$25. Greater appreciation is possible if Etrade is acquired, achieves greater growth, and if equity market conditions improve.

RISK FACTORS

1) Management. The current management team has done an excellent job developing the company, but overstepped in awarding a $77mm pay package to CEO Cotsakos. In response to shareholder outrage Dr. Cotsakos gave back $23mm and the company made some changes to the Board of Directors. The market also exacted its own punishment as the outrage certainly contributed to the decline in the ET share price that has cost Dr. C about $144mm this year. I think the decline in share price more than adequately reflects the risk of future management compensation disasters.

2) Mortgage Business. Strong mortgage business has been a significant benefit to Etrade (and other VIC write-ups NCEN, SAXN, and DLTO), but it probably can’t get any better than this. In its recent earnings release Freddie Mac said it believes that mortgage assets are unattractive at current spreads. In future years ET can increase the volume of customer business, but spreads are likely to contract.

3) Accounting. Etrade has made many acquisitions and took a $227mm restructuring charge in 3Q01 that probably zeroed enough excess assets and obligations to ensure attractive numbers this year. If there is a “quality of earnings” problem then I think the low ratio of price/tangible BV more than adequately discounts it.

TIMING

A key factor in this recommendation is Thursday’s disposal of the remaining 15mm Etrade shares held by Softbank. The heavy weight from this distressed seller (perhaps joined by the 33mm shares last reported by Janus Capital) has driven the ET share price to an extremely cheap valuation.

CATALYSTS

1) Removal of Softbank Overhang
2) Attractive growth at very low valuation
3) Potential acquisition target

Catalyst

1) Removal of Softbank Overhang
2) Attractive growth at very low valuation
3) Potential acquisition target