E*Trade’s Largest Shareholder Pushes for a Sale, Company Hires Bankers to Explore Options

It has only been about three and a half months since I wrote about E*Trade Financial and the strong possibility that at some point the company is sold at a large premium to the then stock price of around $15 per share. Although it makes sense for the company to let its legacy loan book runoff as much as possible before exploring a sale, Citadel, with its 10% stake, urged E*Trade to sell themselves last week. The company has hired Morgan Stanley to looks at its options (though it did the same thing last year and decided to wait), and maybe not coincidentally, TD Ameritrade (long thought to be the most natural acquirer of E*Trade) has a previously scheduled board meeting this week during which buying E*Trade will surely be discussed.

My original post pegged E*Trade’s value at between $22 and $27 per share and I stand by that range. E*Trade’s loan book continues to runoff as expected and loan losses and delinquencies continue to trend lower every quarter (second quarter earnings were reported last week and delinquent loans fell to $1.4 billion from over $2 billion a year ago). After digging into the details of that mortgage exposure, a buyer such as Ameritrade should realize that there is very little there that should scare them out of making an offer. I don’t know if a fair offer will come this year (buyers will obviously try to lowball an offer and point to the loan book as the reason why) but even if management stands by their plan from last year of waiting out a couple more years, investors will only get more for their shares. Any offer not at least in the mid 20’s probably isn’t in the best interests of shareholders at this time. Nonetheless, this story could get very interesting in the next few months so stay tuned.

Full Disclosure: Long shares of E*Trade at the time of writing, but positions may change at any time

Spending AND Taxes Got Us Into This Mess, And Only BOTH Can Get Us Out

Since we are right in the heat of the debt ceiling/budget deficit debate, I made a point to devote a section of my July quarterly client letter to the topic, but I also wanted to share some of that publicly as well. As old as these arguments back and forth in Washington are getting, they are important issues for our economic and financial futures. To try and boil it down to something (relatively) simple, below are two graphs I created to help people visualize exactly how we got into this deficit mess, and more importantly, the only way we can get out.

The first chart shows tax collections and government spending, as a percentage of GDP, in fiscal 2001 (the last year we had a balanced budget in the U.S.) compared with the projections for fiscal 2012 (which begins on October 1st of this year).

You can clearly see how we have gone from a surplus of 1% of GDP to a deficit of 7% of GDP; taxes went down by 4% of GDP and spending went up by 4% of GDP. If there was ever a question of whether the federal government has a spending problem or a taxation problem, this should end that debate. We have both, and each has contributed equally to our budget deficit woes over the course of the last decade.

To counter one of the most common rebuttals to this conclusion (that taxes are too high) consider that federal taxes (payroll taxes, income taxes, gift and estate taxes, etc) today are at their lowest point since 1950 (again, as a percentage of GDP). In order to balance the budget, we need to close an annual deficit of $1.4 trillion, the product of $3.6 trillion in spending versus just $2.2 trillion in tax collections. If we do not raise taxes at all, government spending would have to be cut by that $1.4 trillion figure, which would be a cut of 40% (and is impossible).

The second chart below shows the sources of our budget deficit, by comparing our finances in 2001 to those that the CBO projects for fiscal 2012. It shows in another way how increased spending and tax cuts are equally responsible for the fiscal problem we have, but it goes a step further by showing that nearly half of the increase on the spending side is due to huge increases in defense spending (which has more than doubled since 2001, from $300 billion in 2001 to $700 billion today).

So not only do we have to get taxes up and cut spending, but we have to cut defense spending meaningfully within that context. If we don’t increase taxes and we don’t cut defense spending, a balanced budget would require we cut the non-defense portion of the government’s budget by a whopping 50% (again, impossible).

If you weren’t ticked off at the childish crap going on now on Capitol Hill, you probably should be after reviewing these numbers. The solution to the problem is easy to identify if you want to be honest about it. But without even admitting to that in public, how will our politicians ever actually solve the problem? A depressing thought indeed.

Amazon: The One Overvalued Stock I Wouldn’t Mind Owning

“I know you are a value investor, but if you were forced to own one growth stock with a hugely un-Peridot-like valuation, what would it be?”

I recently was posed this question and I have to say, even though it does go against my overall philosophy when it comes to investing, it is an interesting inquiry to ponder. I would actually say Amazon (AMZN) is the one overvalued stock I would not mind owning. Now, long time readers of this blog will recall I have long warned against Amazon shares. The valuation has always baffled me and raised red flags, but for years such caution was wrong, as the stock has done extraordinarily well. So why today, at $213 per share, 50 times trailing EBITDA, and 86 times 2011 earnings would I pick Amazon as an overvalued stock that might make sense owning? Well, it doesn’t hurt that they have defied my expectations for years, and I don’t think I am the only one.

I never really thought Amazon was going to be anything more than a great online retailer of other people’s goods. And while their position in that space will only strengthen as more and more people become comfortable buying online and allocate a higher percentage of their purchases from storefronts to the web, offering low prices keeps their margins minuscule. In fact, Amazon’s operating margins in 2010 were 4.1% compared with 6.1% for Wal-Mart and 7.8% for Target. It turns out that Amazon’s retail model is not more profitable than bricks and mortar stores, probably because they still need to maintain huge warehouses across the country (fewer bricks, yes, but bricks nonetheless), which is costly, and they have to offer rock bottom prices and free shipping to entice people to buy more online. Amazon has certainly perfected this strategy, but high margin it isn’t.

The part of the story I missed, frankly, was how strong they could be in new markets that they essentially help build from scratch. The Kindle e-reader was Amazon’s first real big venture outside of just trying to beat bricks and mortar stores at their own game. They successfully created a new market and more importantly, one that has the potential to be higher margin than traditional book printing (digital books). Sure, today they don’t make much money on each e-book sold, or the Kindle device itself for that matter (publishers are still setting prices for the most part and keep most of the revenue) but Amazon has the potential to eliminate the middleman in the years ahead. They could become the publisher and help millions of regular authors publish electronically. This is not unlike what Netflix is trying to do by funding their own original tv series now that they have millions of subscribers.

Next up for Amazon is an entrance into the tablet market sometime in the fall. With such a huge library of streaming music, movies, and television shows, there is nothing stopping Amazon from being a heavyweight in digital music and streaming video. Frankly, Amazon can offer a lot more to consumers with a web-enabled Kindle or Amazon-branded tablet versus the Barnes and Noble Nook or yet another me-too Android tablet like the Motorola Xoom or Samsung Galaxy Tab.

Other than Apple, Amazon appears to be the only consumer electronics player that could offer its customers differentiated products. The margins on commoditized Android tablets will head towards zero as everyone cuts prices to the bone to try and grab market share. Amazon seems well positioned to offer more with their products. As a result, they could easily be a formidable competitor to Apple in the tablet and e-reader markets. I’m not saying they pass Apple, but they certainly can pass Samsung, Motorola, HP, and whomever else to be the clear number two player, and I feel good about that prediction even before they have launched many of the products they have in the pipeline.

So what about the stock? Why could it go higher even at its current valuation? Look, at its current market value of $96 billion, I can’t possibly make a valuation case for Amazon stock based on cash flow and earnings in the near-term. However, if you simply look at their addressable market opportunity over the next 5-10 years and compare their market value with other leading technology and retail companies, you begin to see how a bullish argument could be made longer term. Apple is worth $330B. Google $170B. Wal-Mart $185B. Facebook could fetch $100B after its IPO. If Amazon continues to innovate like they have what would stop them from being worth $125B, $150B, or even $200B in five years?

I know I have completely changed my negative tune on Amazon as a stock investment (and don’t get me wrong, as a value investor I am not going to go out and buy it), but since I was asked the question, if I had to own one seemingly grossly overvalued stock, that would be the one I would pick. Given what they have done in the last five years, coupled with what they are planning and compared with the values of other companies they compete with, $96B seems a lot more reasonable if you ignore the fact that such a figure is 50 times trailing cash flow, or 86 times this year’s profits.

Thoughts?

 

Full Disclosure: No position in Amazon at the time of writing, but positions may change at any time