Although most investors and analysts see no reason to get near shares of online brokerage firm E*Trade Financial (ETFC), I have been attracted to the stock for a while now. The company got into trouble during the housing boom as it decided to make home loans to its brokerage customers in order to expand its client relationships. Given that many of its clients were residents in tech-centric California, and E*Trade’s underwriting standards for mortgages and home equity loans wasn’t very strong, the company nearly went out of business under the weight of massive amounts of soured loans. After restructuring the company’s loan book, which is now in run-off, E*Trade has turned its attention back to their core (and very profitable) brokerage business, and is well on its way to making a full recovery.
Still, investors are leery as E*Trade still has about $16.2 billion of old loans on their books. About $1.8 billion of these are delinquent and the company has set aside about $1 billion to cover losses (loss rates tend to max out at around 50-60%). The bullish argument for the stock is that the loan book is in run-off, the company has set aside plenty of reserves to cover losses, and since these loans were made 4-6 years ago, they are mature and delinquencies are actually falling fairly dramatically (down 21% in 2010, from $2.3 billion to $1.8 billion).
So, assuming that the loan book continues to shrink until it’s immaterial to the company, is E*Trade stock cheap based on false worries about the health of the company’s balance sheet? That has been my investment thesis for months now and we recently got some more data to back up such an assertion. Charles Schwab (SCHW) announced on March 21st that it is acquiring OptionsXpress (OXPS), a small online brokerage firm, for $1 billion in stock. This deal serves as an excellent proxy for how to value E*Trade, whose core business is not lending, but rather online brokerage services. While OptionsXpress sold for $1 billion, E*Trade is much larger and has a market value currently of only $3.5 billion.
Here are some interesting data points supporting the view that E*Trade is undervalued at today’s market price:
*E*Trade has $189 billion of customer assets, versus just $8 billion for OXPS
*E*Trade’s 2010 revenue was $1.3 billion, versus just $231 million for OXPS
*E*Trade has 4.3 million client accounts, versus just 400,000 for OXPS
*E*Trade’s average account size is $44,000, versus just $21,000 at OXPS
*E*Trade’s brokerage business earns $700 million+ in annual EBITDA, versus just $89 million for OXPS
Based on this Schwab acquisition, I have even more confidence that E*Trade is extremely undervalued at $3.5 billion or around $15 per share. If OXPS could fetch $1 billion, there is no reason E*Trade should not be valued at 5-6 times that figure, if not more, which would equate to at least $22 to $27 per share.
Full Disclosure: Long shares of ETFC at the time of writing, although positions may change at any time