Description

I believe ETFC's stock has been unduly clobbered in the current sell-off and the market is overlooking massive strategic optionality, including a high probability that ETFC is sold within the next six months for 100% over the current price.  This summer, at the insistence of its largest shareholder Citadel and board member Ken Griffin, ETFC hired Goldman Sachs to conduct a strategic review.    Since the process was announced in July, ETFC's stock is down almost 50%.  ETFC is currently trading at 84% of tangible book value, which is the lowest valuation in over two years.  For most of the last two years it has traded between 1.5x and 2.0x tangible book value.  On a P/E basis, it is trading at 9.5x 2012E vs. peers at 12-15x.  ETFC is arguably cheap at its current valuation even without the deal process.  Notably, the CEO bought $1mm of stock in August at $10.89, or 29% above the current price.

Overview

• ETFC is the 3^rd largest online broker with 2.8mm brokerage accounts and $160bn of client assets, including $26bn of cash sweep deposits on its balance sheet. The business consists of two parts, the online broker, and a bank which houses the cash sweep deposits.
• ETFC was one of the more spectacular casualties of the financial crisis because of prior management's decision to stretch for yield by investing the deposits in toxic mortgage loans. ETFC was bailed out by Citadel and shareholders were massively diluted back in 2007.
• Today, the remaining mortgage portfolio is in much better shape after shrinking 50% from $30bn to $15bn and after burning through almost $4bn of losses. Notably, no new loans have been originated since mid-2007, so the book is well seasoned. Like most banks, ETFC has been releasing reserves since 2010 as the dollar amount of delinquent loans has dropped by 50% since peaking in 2009. The bank has been rebuilding its capital which now stands at a respectable 8% tier 1 capital ratio.
• The mortgage portfolio is still a major source of risk if the economy deteriorates further, and I expect it is the main reason that the stock has sold off sharply. I address how a buyer would treat the mortgage portfolio below.

Event Dynamics

• Citadel has been ETFC's largest shareholder since it bailed out the company in 2007. Currently Citadel owns 9.8% and Ken Griffin is on the board.
• On July 20, 2011 Citadel sent a letter to ETFC demanding that it hire an investment banker to sell the company, and that a special committee of the board comprised of directors who have joined in the last three years (i.e. the more "independent" directors) be established to oversee the process. ETFC agreed, and has hired Goldman Sachs who is currently conducting a strategic review.
• ETFC's stock initially popped from $13 to $16 on this news. Since then the stock has cratered to $8, giving up the premium and more. If you measure from the day before Citadel's letter (July 19) to today, ETFC is down 37% while its e-broker peers, banks and financials in general are down roughly 25%. The stock seems to have given up all optionality of a deal and then some.

History of Strategic Interest

• The e-brokerage industry has been consolidating over the last 10 years and is now down to 3 public players: SCHW, AMTD and ETFC. SCHW is the 800 lb gorilla. The writing has been on the wall for some time that AMTD and ETFC need to combine to be relevant vs. SCHW.
• Consolidation makes sense because acquirers are able to cut 50-60% of the expenses of acquired companies by combining the trading engines, back-office technology and marketing. There are big advantages from scale given the high fixed costs.
• AMTD's management has been surprisingly public over the years, including during recent investor meetings, that they are interested in acquiring ETFC. AMTD has publicly discussed potential transaction structures whereby its parent TD Bank (TD Bank owns 44% of AMTD) would assume the mortgage book. Similarly, the CEO of TD Bank has publicly said they would take a look at buying ETFC's mortgages.
• There have been rumors of negotiations between AMTD and ETFC over the years. ETFC actually made a bid for AMTD back in 2005. AMTD's strong interest in ETFC makes very good sense because it could be very accretive for AMTD, as detailed below, and because it helps AMTD stay competitive vs. SCHW in terms of size/scale. Note, when Citadel sent the letter to ETFC, AMTD's stock popped +5%.
• Other potential buyers are interested as well. The WSJ reported in July the Capital One looked at ETFC in the fall. According to the WSJ, Griffin felt the approach was not given serious consideration by the board, and served as the "tipping point" for him to start publicly pushing ETFC to sell. Wells Fargo's CEO said in an interview this year that he would consider acquiring an e-broker to complement its brokerage force, which is the 3^rd largest with 15,000 reps. SCHW would likely be interested in ETFC as well.

Mortgage Portfolio

• The main hurdle for a buyer would be absorbing the mortgage book. Under GAAP purchase accounting, a buyer would have to mark-to-market the portfolio, which would likely wipe out the regulatory capital. This would require the buyer to re-capitalize the bank, and the capital injection becomes an added component of the purchase price.
• The purchase accounting mark required is the biggest unknown variable. ETFC lays out the credit statistics in their filings with all the gory details. 40% of the portfolio is home equity loans, and a substantial percentage of the 1^st and 2^nd mortgages are under-water and low-doc.
• I have come up with a range of possible marks, and a deal still makes sense even at the very high end of write-downs. The ETFC analyst at Goldman Sachs did a good report on this subject published on July 27. He arrived at a range of markets between $1.5bn and $2.5bn (10% to 17% hits) using several valid methods.
• I also showed ETFC's portfolio to MBS analysts and traders at three major investment banks. They gave a range of write-downs between $4bn and $5bn (28% to 35% hits). These estimates come with the caveat that they are based on "generic" portfolios of similar vintage loans which were securitized. ETFC's loans are performing better than generic securitizations of similar vintages, in part because the worst loans went into securitizations, and because the FICOs in ETFCs portfolio are relatively high.
• For conservatism, I am taking the high end of the range ($5bn) to estimate what a buyer like AMTD could pay, although I would not be surprised if the actual write-down came in much lower. The $5bn write down is offset by an $879mm reserve, and it is tax deductible. This results in an after-tax, after-reserve hit of $2.7bn, or $9 per ETFC share, which is effectively an increase in the purchase price for the buyer.

Take-out Price Potential

I lay-out the acquisition math below assuming AMTD is the acquirer.  The conclusion is that AMTD can pay between $15 and $19 for ETFC (80% to 125% premium) and still have the deal be 10% to 18% accretive to AMTD's 2012 EPS, which would be very attractive for AMTD.  The key assumptions are:

• I assume AMTD levers up from 1.0x debt/EBITDA to 1.5x to help finance the deal. The rest of the consideration comes from issuing stock. AMTD has said it is willing to lever up to 1.5x to 2.0x to finance a deal.
• I assume 60% of ETFC's $1.2bn in operating expenses are cut. Precedent deals are in the 50-60% range, and the synergies are at the higher end when the companies are true peers like AMTD and ETFC.
• I use consensus 2012 net income for both AMTD and ETFC. However, I use ETFC's net income backing-out the loan loss provision expense because future loan losses are already absorbed through the purchase accounting mark. I also back out gain on sales of loans/securities which ETFC has on a recurring basis. (I tax effect both adjustments.) Consensus is embedding approximately 18 cents per share from gains in 2012. So, for ETFC my 2012 earnings contribution assumption equals: 89c consensus EPS + 46c provision expense in consensus - 18c gains = $1.17 x 290 mm shares = $339 mm of net income.

This posting is solely for the evaluation of club members and is not a recommendation to buy or sell this stock.  The views expressed are those of the author individually and should not be attributed to any affiliated investment firm, which may or may not hold positions consistent with the views expressed herein and may buy or sell shares at any time. 

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