Reader Mailbag – Is E*Trade a Bargain?

Carol from Phoenix writes:

“Chad, I was wondering if you would comment in your blog about E-Trade (ETFC) from a contrarian, value viewpoint. Their stock has been beaten down lately, but their fundamental business seems strong, and they appear to have rid themselves of what little subprime exposure they had. Thanks!”

Thanks for the question, Carol.

I decided to publish my answer on the blog because I have actually been looking at E*Trade in recent days. This is exactly the kind of contrarian play that I think value investors should be looking at within the financial services sector. It falls into the category of being beaten down due to mortgage market issues, but I do think there is a lot of long-term value here, given that mortgages are not a core focus for E*Trade. Let’s take a look at why the stock has fallen so much. The shares are down a stunning 54% since June to $12 each.

In recent years E*Trade has started offering its core retail brokerage customers a wider array of financial products, including bank accounts, certificates of deposit, mortgages, and home equity loans. Not surprisingly, they are not immune to the mortgage market meltdown. Earlier this month, the company announced it was joining the ranks of those firms moving to shut down their wholesale mortgage business due to market conditions. That, along with a higher than expected provision for loan losses and some institutional brokerage restructuring costs will result in dramatically lower earnings for 2007. E*Trade now expect full year GAAP earnings per share of $1.10, down from their prior target of $1.60 per share.

So, to answer Carol’s question, does ETFC represent a good contrarian value play? To me it appears that it does. With any contrarian investment idea, you will have to be patient, but buying a premier franchise for what could very well turn out to be less than 11 times trough earnings per share looks like a very attractive valuation.

There have been rumors of a merger with Ameritrade (AMTD), but I would not expect a deal in the short term as E*Trade gets their house in order. Ameritrade CEO Joe Moglia would love to do a deal, I’m sure, but at these prices, E*Trade is better suited fixing their issues and waiting for a more normalized profit picture before entertaining offers that maximize shareholder value. A deal does make sense at some point though, as online brokerage mergers have a ton of synergies that can be realized.

You may be curious if I have bought any ETFC shares yet. The answer is no, but not because I don’t find it an attractive option. It is simply impossible to buy each and every attractive stock when managing fairly concentrated portfolios. There are a lot of financial stocks I think are too cheap, and I own some and don’t own others. It’s just a numbers game really. If you are looking for portfolio additions in that space, E*Trade is definitely one worth considering.

Full Disclosure: No positions in ETFC or AMTD at the time of writing