Description

E*Trade Financial Corporation (NASDAQ: ETFC)

December 30, 2013 – Long

Market Statistics

Price: $19.37

52 Week: $8.68 – 19.61

Diluted Market Cap: $5.6 billion

Dividend Yield: 0.0%

Price / TBV: 2.00x

Price / 2014E: 24.2x (consensus)

Price / 2015E: 18.3x (consensus)

Trading Statistics

3 Month ADV: 3.0 million

Short Interest % of Float: 6.0%

Days to Cover: 5.7

5%+ Major Shareholders

T. Rowe (8.3%), Vanguard (6.0%), Bank of NY Mellon (5.8%)

5 Year Returns

IRR: 19.0%, MOIC: 2.4x

Target Share Price: $46.24 (12/31/18)

Thesis

E*Trade Financial (“ETFC”) is a stock that has suffered in the past due to a plague of balance sheet issues.  I believe the Company is past much of these legacy credit issues and the stock today represents an interesting deep value restructuring situation with several catalysts clearly in view. 

The Company trades in line with its peers Charles Schwab and TD Ameritrade, at 24.2x versus 28.1x and 22.5x Price/2014EPS, respectively.  However, I believe ETFC should warrant a premium valuation relative to peers because the Company is at an inflection point in its earnings trajectory to accelerate profitability.  ETFC management has several operating levers at its disposal to drive earnings growth in the coming years, and an improvement in the macro environment from a rebound in retail trading activity and the normalization of interest rates could provide a nice tailwind to uplift earnings. 

Specifically, the Company can implement the following initiatives to drive earnings growth:

• Upstream excess capital from the Bank subsidiary to pay down corporate debt at the HoldCo
• Eliminate provision and loan servicing expenses through runoff of legacy loan portfolios
• Reduce FDIC insurance premiums over time as the risk profile of the Bank subsidiary improves
• Run-off expensive Repo and FHLB borrowings
• Bring cash deposits back on balance sheet

The purpose of this paper is to (i) outline a set of methods in which ETFC can enhance earnings and (ii) dimension the risk of the Company’s legacy loan portfolio.  These actions will occur over several years so the stock will reward patient long term investors.  As this Company has a long run way for earnings growth, my recommendation is to buy the stock on opportunistic market dips.

Returns Summary – Roadmap for Long Term Earnings Growth

Background

ETFC is the third largest publicly traded online brokerage in the US, behind SCHW and AMTD.  The Company has 3.0mm brokerage accounts and $255bn of client assets.  The franchise is comprised of two parts: (1) an online broker, which is an attractive business with healthy margins, low CAPEX requirements, and a well recognized brand, and (2) a Bank that leverages the broker’s customer cash sweep deposits to generate additional yield.  For many years, the Bank was useful in generating additional earnings until the Company made a fatal mistake to invest in toxic non-conforming mortgages (right before the financial crisis) that nearly brought down the Company and forced a highly dilutive capital infusion by Citadel in 2007. 

Since that time, ETFC has replaced its management team and spent several years cleaning up the Bank, principally through running off its loan portfolio (decreasing from ~$32.2bn in Q3-07 to ~$9.0bn in Q3-09) and burning through ~$4.6bn of losses.  During this time, ETFC also reduced its wholesale borrowings and corporate debt from ~$21.8bn down to ~$7.5bn, and gradually restored its capital at the Bank to a healthy 9.5% Leverage ratio. 

After cleaning up the Bank for several years, I believe the Company is stabilized now and ETFC is at an inflection point in its earnings trajectory to accelerate profitability.  Discussed below are several methods in which the Company can enhance core profitability.

Earnings Leverage from Company Initiatives

Upstream excess capital at Bank subsidiary to pay down expensive corporate debt at the HoldCo 

• Since the financial crisis, ETFC has been suspended by the Federal Reserve and OCC from paying dividends to the HoldCo; and as such, cannot pay down its costly $1.8bn of corporate debt. 
• The Company has recently submitted a Capital Plan to its regulators to allow the Bank to dividend excess capital above a Leverage ratio of 9.5% at year-end 2013, with that target dropping 50bps each year beginning in 2014 until settling at 8.0% in 2016. 
• Management has stated that the Company intends to seek a recurring $100mm quarterly dividend over the near term and has recently received regulatory approval to upstream $100mm to the Parent in August 2013. 
• In addition, the recent sale of the market making business, G1X, for $75mm also provides funds to pay down debt at the HoldCo.
• Regulatory approval of ETFC’s Capital Plan would be a major milestone for the stock because it signals confidence from the regulators and allows ETFC to retire costly HoldCo debt.
• Over the course of the next three years, the Bank will be able to dividend ~$2.3bn to the HoldCo.  ETFC’s 6.00% and 6.375% Senior Notes are callable (at 103% and 105%, respectively), at the end of 2014 and 2015, and I believe management will retire these pieces as soon as possible, using ~$1.3bn of capital and adding ~$0.17 to EPS. 
• Longer term, management will retire the Company’s 6.75% Senior Notes ($435mm outstanding, no call premium), increasing EPS by an additional $0.06.

Run off legacy 1^st mortgage and home equity loan portfolios 

• ETFC’s mortgage portfolio is not pristine and should be completely run off (as is currently being done by management), especially given that ~38% of the loans have an LTV/CLTV above 100%, ~87% were originated during 2005-2007, ~49% have FICO scores below 720, ~54% have little/no documentation, and the majority of loans were purchased from 3^rd parties (proven to be poorer underwriting).
• Per management, this initiative would boost LTM EPS by $0.53 through a reduction of loan provisioning (LTM: $201mm) and servicing expenses (LTM: $51mm).  The 1^st Mortgage and Home Equity Loan portfolios have an average life of ~7.5 years.  The run-off of the loan portfolio, transitioning from loans to cash and securities, would also reduce asset risk weightings for regulatory capital purposes.

Cut FDIC Insurance Premiums 

• Over time, as the risk profile of the Bank improves with the run-off of the loan portfolio, FDIC insurance premiums should decline. 
• Per management, FDIC expenses over the last twelve months ($109mm) would be cut in half to ~$55mm, improving EPS by $0.12. 

Shrink Bank balance sheet through run off of expensive wholesale borrowings 

• In addition to corporate debt at the HoldCo, ETFC also has a significant amount ($5.7bn) of high cost wholesale borrowings at the Bank, namely its repos ($4.4bn) and FHLB advances ($1.3bn). 
• Per management’s run-off schedule, these balances should shrink to ~$1.9bn by 2018 and mature over the next ten years.  ETFC’s wholesale borrowings are bearing 3-4% and shrinking the balance sheet by ~$3.8bn by 2018 would accrete EPS by ~$0.28 and release ~$304mm of capital at the Bank. 
• I believe ETFC will be opportunistically paying down these borrowings as long as the move is capital accretive (even at the expense of paying early retirement penalties), as we have seen in 2012 when ETFC paid down in advance of maturity $100mm of fixed-rate repos and $1.0bn of FHLB advances. 

Bring deposits back on balance sheet

• As part of ETFC’s strategy to delever over the years, the Company has transferred a significant amount of cheap customer deposits to third party financial institutions.  At 9/30/13, ETFC had $12.9bn of assets at third financial party institutions, of which ~2/3 of assets were tied to the Company’s deleveraging efforts.
  • At 9/30/13, $4.3bn was held in the Company’s extended insurance sweep deposit account program (“ESDA”), which ETFC utilizes in conjunction with the Bank and six additional third party banks to allow customers to insure at least $1,250,000 of the cash they hold in the ESDA. 
  • Separately, $8.6bn was held in third party money market funds.
• After paying down its HoldCo debt, ETFC can utilize capital generated from bank earnings and the DTA to bring cheap deposits back on balance sheet.  Assuming ~2/3 of these deposits are brought back on balance sheet at a net interest spread of 3.00%, the boost to EPS would be $0.55.
  • Deposits held at third-party banks have standard 90-day notice periods, so these would be brought back on balance sheet faster.
  • Money market funds take longer given consent period and customer notification requirements, but management has cited that much of these deposits can come back within 90 days.

Other EPS enhancing initiatives not factored into analysis

• Repurchase stock
• Loan sale

Earnings Leverage Tied to Improvement in Environment

Rebound in Retail Trading Activity

• Over the years, several market shock events, coupled with a reduction in NASDAQ and NYSE volumes, has dampened confidence among retail clients.  As such, retail trading volumes today for ETFC are far below their peak in 2009 
• Since 2009, ETFC’s Daily Average Revenue Trades (“DARTs”) declined from a peak of 179k in 2009 to a trough of 138k in 2012, before rebounding to 147k for YTD 2013.  Recent metrics in November 2013 (163k) were strong, increasing 26% from a year ago

• A rebound in client trading activity to 2009 levels would uplift revenues / earnings significantly. 
  • In 2009, ETFC reported peak DARTs of 179,183 and client accounts averaged 2.57mm, implying a client activity rate of 7.0%.  Based on today’s level of client accounts, if client activity were to return to 7.0%, average YTD DARTs would be 205k, or 39% higher.

• The ETFC platform is highly scaleable as minimal costs are incurred (i.e. clearing expenses) when trading volumes increase, and the majority of incremental commissions fall directly to earnings.  Assuming an 80% margin on incremental commissions and November 2013 run rate accounts, a return of client activity to 2009 levels would boost EPS by $0.21.

• Furthermore, it is useful to note that despite a significant decline in retail trading activity and a plague of balance sheet issues during the financial crisis, account growth metrics have been surprisingly stable over the years.  As such, commission revenues are more levered to client trading activity today than before.
  • ETFC has been able to (i) grow client brokerage accounts at a CAGR of ~3.6% from 2.5mm to ~3.0mm accounts over the past 5 years and (ii) reduce attrition from a high of 17% in 2008 to 8-9% over the last two years. 

Normalization of Rate Environment

• The ETFC platform also has tremendous operating leverage to rising rates. 
• The Company’s net interest margin, currently at 2.34%, is under pressure because loans are running off at a 4.00-5.00% yield and are being reinvested into securities at a marginal reinvestment rate of 1.50-2.00%, though part of this impact is offset by the gradual retirement of wholesale funding at an average cost of 3.00-4.00%. 
  • Assuming the current interest rate environment, management believes the spread will stay around 2.30-2.40% for next year
• Longer term, with a normalized rate environment, management believes that the Company’s net interest spread, currently at 2.30%, has the potential to improve to ~300bps.

Burn Down Analysis: Sizing the Embedded Risk of ETFC’s Legacy Loan Portfolio

ETFC’s $8.3bn mortgage portfolio ($4.7bn 1^st mortgage, $3.6bn home equity) is not pristine, but I believe credit risk is manageable and can be dimensioned.  Over time, credit performance should continue to improve as (i) no new loans have been originated since mid-2007 so the existing book is well seasoned, (ii) nonaccrual loans peaked in Q2-10 and have since been declining (see below), (iii) home prices in key markets (CA, NY, FL, VA) are rising, and (iv) the US economy is recovering and unemployment is falling.

Loan Loss Estimate: Delinquent Portfolio

• ETFC’s delinquent portfolio consists of ~$507mm first mortgages and ~$146mm home equity loans.  Severities for typical 1^st mortgages and home equity loans range from 30-40% and 90-100%, respectively. 
• Assuming the high end of the range for conservatism, and that 80% of delinquent loans default at these severities, my cumulative loss estimate of the delinquent mortgage portfolio is ~$284mm.

Loan Loss Estimate: Performing Home Equity Portfolio

• In my opinion, the biggest risk of ETFC’s loan portfolio relates to the Company’s home equity loan book, which comprises of (i) fixed rate, fixed term home equity installment loans (21%) and (ii) home equity lines of credit (“HELOC”) (79%) which are structured with a 5-10 year draw period before becoming a 10-20 year amortizing loan. 
• Over the next 4 years, ~$2.6bn of HELOCs will transition from I/O to amortizing conversions (with the bulk occurring in 2015 (~$0.8bn) and 2016 (and ~$1.2bn), respectively).
  • ~9% of borrowers will be required to repay the loan in full at the end of the draw period. 
  • The good news is that these balances are being repaid over time.  As such, the actual value of balances that reset should be materially lower before the amortizing conversions take effect. 
  • Assuming loan balances continue to run off ~20% annually and ~25% of resets default at 100% severity, expected lifetime losses on the HELOC book would be ~$363mm.

• As for the installment loans, my approach is to apply the Federal Reserve’s March 2013 Severely Adverse Scenario home equity portfolio loss estimate (8.3%, excluding YTD net charge-offs), which gives me a loss of ~$72mm.  Including the HELOCs, my loss estimate for the home equity portfolio is ~$435mm.

Loan Loss Estimate: Performing 1^st Mortgage Portfolio with Interest Rate Reset Provisions

• As for estimating the loss content of ETFC’s $4.2bn performing 1^st mortgage portfolio, the key area to focus is the Bank’s ~$1.8bn of loans with interest rate reset provisions taking place from 2014 - 2017. 
• My approach to estimating cumulative losses in this portfolio has been to (i) assume that vintage year originations for this portfolio are similar to the aggregate 1-4 Family portfolio, and then (ii) apply recently observed frequency and severity estimates (as observed by CoreLogic, Goldman Sachs Global Investment Research dated 12/19/13) to the vintage year stratification.

Loan Loss Estimate: Performing 1^st Mortgage Portfolio without Interest Rate Reset Provisions

• As for estimating the loss content of the performing 1^st mortgage portfolio without interest rate resets, my approach has been to (i) assume a vintage year and FICO stratification that is similar to the aggregate 1-4 Family portfolio, and then (ii) apply recently observed frequency and severity estimates (as observed by CoreLogic, Goldman Sachs Global Investment Research dated 12/19/13) to the stratification. 
• In this analysis, I have assumed that a FICO score of 720+ would be similar to Jumbo Prime, 680-700 would behave similar to Alt-A, and that 660 scores and below are subprime. 

Summary of Loss Estimates

• Based on the assumptions discussed above, my cumulative loan loss estimate for ETFC’s portfolio is $865mm, or 9.6%.  Net of $459mm of reserves, total remaining provisions would be $406mm.

• I believe these loss estimates are conservative. 
• If we apply the Federal Reserve’s March 2013 Severely Adverse Scenario estimates (6.6% for 1-4 Family, 9.6% for Home Equity, and 6.1% for Consumer/Other) to ETFC’s 12/31/12 year end portfolio, and then back out net-charge offs incurred to date, we get a loss estimate of 7.4%, or $668mm, or $209mm of provisions remaining after excluding reserves.
• Credit marks taken on recent bank M&A transactions range from 2-6%.
• Management has guided to a provision expense of $25-50mm per quarter.  Given my loss analysis, I believe actual results will be at the low end of this range.

I believe the best way to realize long term value for shareholders is to clean up the institution, and then sell the franchise to a strategic for a premium

• After a long period of consolidation, the e-brokerage industry today is dominated by 3 major retail firms: SCHW, AMTD and ETFC. SCHW is significantly larger than both AMTD and ETFC, and industry observers have long cited that AMTD and ETFC should merge in order to be competitive against SCHW.
  • There are major benefits to scale given high fixed costs.  Merging two e-brokers allows acquirers to cut nearly half of the target expense base by simply combining back-office, sales, and technology functions.
• In the past, AMTD has publicly voiced its interest in ETFC, and ETFC attempted to acquire AMTD in 2005.  If ETFC were put up for sale, I believe it would be a competitive process with multiple bidders.
• Some major issues to resolve before selling ETFC to a strategic include:
  • Credit mark on loan portfolio
  • Preservation of tax assets in the event of a change of control
  • Purchase accounting marks related to wholesale borrowings
  • Selling the franchise at the right time in the cycle

Appendix B: Valuable Tax Assets

Accelerate regulatory capital build through inclusion of additional DTA into Tier 1 Capital

• An important asset that will help ETFC accelerate regulatory capital build at the Bank is the Company’s ~$1.3bn DTA, of which ~$1.0bn resides at the Bank
  • If fully utilized, this attractive asset would shield nearly ~$3.4bn of pretax earnings
  • Currently, ~$0.7bn of the Bank’s DTA is excluded from regulatory capital. 
• The key area to focus on here is the DTA at the Bank because all operating entities reside under the Bank meaning that taxes are shielded firstly through the Bank before the HoldCo. 
• Per management, ETFC intends to dividend up to 100% of after tax income at the Bank (even though cash taxes will not be paid) to the Parent, which implies that ETFC is (i) sending cash up to the HoldCo, while (ii) converting the DTA into cash on the Bank’s balance sheet.
• Longer term, as the Bank uses up its DTA, the Bank will also be able to utilize the tax assets at the HoldCo given the firm’s consolidated filing status (i.e., The parent’s DTA will become a source of corporate cash as the subsidiary reimburses the parent for the use of its DTA). 

Appendix C: Opportunity to Penetrate Existing Customers

• ETFC has historically been known as a place for clients to bring trading cash but that accounts for a core long-term portfolio, retirement assets, and cash management would be maintained elsewhere. 
• Penetrating existing customers is a growth area as the Company’s “wallet share” (~12%) of client assets has been stagnant for some time and significantly below AMTD and SCHW. 

Appendix D: Expect Commission Rates to Remain Steady

• Despite the emergence of a number of online discount brokerage firms, average commission rates have remained steady, settling at ~$11 per trade. 
• While I do not doubt low cost brokers will continue to drive down trading revenues for the industry, I believe average commission levels will hold steady over time as (i) ETFC will primarily compete on service and enhanced product functionality, as well as growing the use of derivatives (e.g. options, futures, FX) amongst its clientele (e.g. options currently comprise ~25% of trades compared to 35-40% for SCHW and AMTD.

Catalyst