Charles Schwab’s Purchase of optionsXpress Highlights Value in E*Trade Shares

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

For-Profit Education Stocks Worth Monitoring Even As Government Implements Reforms

Shares of Apollo Group (APOL), the leading for-profit education company (think University of Phoenix), fell a stunning 23% Thursday to $38 after the company withdrew its 2011 financial outlook in light of upcoming changes to their industry. With the unemployment rate at 9.6%, enrollment at for-profit schools has been surging in recent years as people try to boost their resumes by completing online college courses and earning an associate, bachelor, or graduate level degree. As a result, the private firms running schools such as University of Phoenix have been minting money.

The interesting part of the story is that for-profit colleges typically get more than 80% of their revenue from Title IV student loan programs subsidized by the U.S. government. With taxpayers footing the bill for all loan defaults, the colleges themselves have absolutely no direct financial exposure whatsoever if students rack up thousands in debt and cannot repay the loans. As loan defaults rise, the U.S. Department of Education is finally taking notice and is set to release new guidelines for Title IV funding. As you may imagine, if lending guidelines are tightened, new enrollment at these colleges could drop off considerably. The new rules, set to be issued in coming months, are likely to set maximum default rates for schools who want to accept Title IV loans, as well as gainful employment guidelines to help ensure that students will actually have the ability to repay these loans based on the jobs they secure with their new degrees (a communications degree online, for instance)

The market’s violent reaction to the sector on Thursday was triggered when Apollo Group withdrew its 2011 financial guidance in anticipation of these new rules. For the first time ever, for-profit schools are going to have to scale back growth plans and actually become more than simply fierce marketing machines. Maximizing enrollment at all costs is no longer going to work. In fact, Apollo is now requiring all new students to attend an orientation program which spells out in more detail exactly what kind of financial commitment these degrees require. The company says that about 20% of prospective students voluntarily withdraw from the program after attending the orientation. In addition, the company’s admissions staff will no longer be compensated based on enrollment rates, as the company seeks to increase the quality of their students, thereby reducing loan default rates and boosting retention rates.

While there is no doubt that enrollment growth rates will tumble at for-profit colleges, it is far too early to pin down exactly how their businesses will be impacted by these changes. I think it is worth it for investors to monitor the situation carefully, as some values may ultimately be worthy of investment consideration at some point in the future (the stocks are already down a lot from their highs). In the case of Apollo, the company’s enterprise value of about $4.2 billion compares with fiscal 2010 EBITDA of $1.4 billion and free cash flow of nearly $900 million. At 3 times trailing cash flow, these stocks are already in deep value territory.

It will be important to see if scaled down marketing and increased financial awareness for students serves to merely slow down enrollment growth or also seriously cuts revenue and earnings for these companies. Exactly how much revenue is reduced and expenses rise will determine if and when these stocks reach a point where the risk-reward is worth an investment. At current prices it appears that the market is pricing in cash flow declines of 33-50% over the next 1-2 years. While possible, we surely do not know that kind of hit is a given at this point in time. If it proves overly pessimistic, shares of Apollo could become quite attractive, as the schools remain strong cash flow generators.

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

First Niagara Deal Sets Bar for Regional Bank Valuations

One of the cheapest areas of the market for a while now has been the banking sector. In the face of economic uncertainty and elevated loan losses, normalized bank valuation metrics have (temporarily, I believe) gone out the window. As a result, many of the stocks (even some quality names) languish near or below book value and despite this, very few non-FDIC assisted deals have been announced. However, today we got a rather sizable bank deal. First Niagara (FNFG) has agreed to acquire NewAlliance (NAL) for $14.06 per share in stock, or about $1.5 billion. This represents a 24% premium, and most importantly for value investors, amounts to 1.63 times tangible book value per share. Banks typically sell for 2-3 times book in normal times, or 1.5-2.0 times tangible book (excluding goodwill and intangible assets), so this transaction shows us that normal bank metrics are not dead.

Interestingly, I had never heard of First Niagara until early last year when they agreed to buy dozens of branches from PNC Financial (PNC) as part of PNC’s purchase of troubled National City. PNC remains one of my favorite bank stocks (and the big local bank here in Pittsburgh) but First Niagara has remained in strong financial shape throughout the crisis and is certainly using that strength to expand while other competitors are retrenching (a smart move on their part). This NewAlliance deal gives them a footprint in New England, and like the PNC branch deal, likely bodes well for their future.

The takeaway for me is that, no, I have not lost my mind. Solid banking institutions selling at or below book value does make little sense. The odds of heightened takeover activity are slim with 9.5% unemployment, but over the longer term I fully expect bank valuation to rise back to more historical levels, for quality franchises anyway. Opportunities abound.

Full Disclosure: Long PNC and no position in FNFG or NAL at the time of writing, but positions may change at any time.

GM Buys Subprime Lender for $3.5B (Some Companies Just Never Learn)

Just when I thought General Motors was on solid footing and heading in the right direction after shedding a large portion of its liabilities in bankruptcy, they seem to have forgotten what has happened over the last several years in the world of credit. One of the big reasons GM’s losses were compounded during the recession was because they funded a lot of subprime loans for their vehicles through GMAC. When those loans went sour, the losses not only negated the razor thin margins they had on the vehicle sales themselves, but resulted in a company that lost money on most of their cars. Hence, SUVs (with their fat profit margins) became a focus for the company, even in the face of rising gas prices, which aided their competitors in stealing market share.

Since GM has exited bankruptcy and the economy has stabilized management has stated publicly a desire to once again expand into the subprime auto finance market, but this time GMAC was hesitant (and understandably so). Undoubtedly, the result has been that GM could be selling more vehicles if they were willing to finance customers with bad credit who could not get loans elsewhere. This morning we learn that for $3.5 billion in cash GM is buying AmeriCredit (ACF), one of the larger subprime lenders in the country. They will use this new financing arm to get more cars into the hands of more people, many of whom could not get loans from third party lenders due to bad credit, no job, etc.

While I am sure those in the industry will praise this deal as a way for GM to maximize unit sales, we need not completely forget how cyclical economies work. Subprime lending pays off when the economy is improving but when the business cycle inevitably turns (as every economy does), the loans turn sour, the losses are crushing, and the cycle starts all over again. To me this highlights one of the core problems our domestic economy has developed over the last 10 or 20 years. We continue to follow the path of loose credit when things are going great and at the first sign of a downturn, credit standards increase dramatically. Once things stabilize, we hear that banks are slowly reducing their standards and loan volumes increase again.

For the life of me I cannot figure out why banks and specialty lenders refuse to maintain the same lending standards throughout the entire business cycle. The idea that lending money to people who are likely to default is good business sometimes and bad business other times baffles me. Sure, the few banks that always make smart loans, despite the economic backdrop, make a little less profit during boom times, but they also weather the recessions quite well in return for such prudence.

This kind of cyclical lending activity from the likes of GM (and most others) only contributes to the boom and bust economy the United States has seen become even more pronounced over the last decade. Fortunately, GM is set to go public via an IPO sometime in the next 12 months, at which time the U.S. taxpayer can shed its majority ownership in GM and therefore no longer be in the subprime lending business.

Update (9:15am)

Here is a 15-year chart of AmeriCredit’s stock price which puts into graphical form the cyclicality I mentioned above.

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

BP, Goldman Sachs, Google, and FinReg… What a Day!

Today is the kind of day that investment managers such as myself love; lots of resolutions on multiple issues that have been holding back certain companies, stocks, and industries. Let me tackle each one briefly.

BP: While it is nice to see the ruptured well capped without any oil spewing out, we have to keep things in perspective. This is a test, this is only a test. The well has been capped for only a couple of hours and leaks could still surface, not to mention the fact that the pressure could further damage the well. Hopefully the relief wells can be paired with this latest cap to finally put a stop to the oil leak, but it is too early to say and the rally in BP shares today (up 3 points) will easily vanish if any issues arise.

Goldman Sachs: News of a $550 million settlement with the SEC is great news for investors. Most were assuming a $1 billion fine to ensure they avoided a fraud charge but it came in at half that amount. Goldman reports earnings Tuesday and the numbers have been ratcheted down a lot due to a weak trading environment early in the second quarter. With the bar set so low, they could surprise on the upside, but the stock is getting a nice bump from the SEC deal, so any further move higher may take some time to develop. I still see GS as the premier firm in the space and earnings should climb back later in the year, which is why I will still be holding the stock for clients.

Google: The stock is down after revenue for the second quarter came in a bit higher than estimates but profits fell short on higher expenses. The company is back in acquisitive mode so free cash flow is on the decline. Without a new, clear growth engine (I am not convinced yet that Android app sales will fit the bill, but they are promising) I would not be willing to pay a premium for the stock. With 2011 earnings estimates around $31-$32, putting a 15 P/E on that gets you to $475 per share, right where the stock is trading after-hours. Color me neutral at these levels.

FinReg: Now that this bill has passed the Senate, we can finally stop hearing about it so much. The banks will see their margins on certain financial products squeezed temporarily (overdraft protection, for instance, is now opt-in, not automatic), but banks will always find ways to recoup the lost income in other ways (free checking accounts, for instance, may become less common in the future). The negative talk today was that the banks and investors are worried because the bill gives regulators a lot of power in forming new rules and this adds to uncertainty. This argument baffles me. Regulators already have the power to make new rules to deal with issues they discover in the marketplace. The bill gives regulators oversight over a few more areas of the financial services industry, but the idea that giving them the power to make rules is a new and overly aggressive idea is simply wrong. That has always been the role of regulators! Now we just need them to do their job, and frankly, that is the part that always seems to let the American people down. I have no reason to think anything will be different this time around.

Full Disclosure: Long shares of BP and GS at the time of writing, but positions may change at any time.

Contrarian Statistic: Credit Card Delinquencies Drop to 8-Year Low!?


“The number of consumers behind on their credit card payments fell to an eight-year low in the first quarter of 2010, the American Bankers Association said Wednesday. Overall, delinquencies across a wide-range of consumer debt categories have also fallen. High unemployment and plummeting home values during the financial meltdown appear to have spurred consumers to shore up their finances and banks to limit their lending, resulting in fewer Americans being late with payments, the industry group said. About 3.88% of bank credit card accounts were past due by 30 days or more in the first quarter of the year — the first time since 2002 that the rate has fallen below 4%, the ABA said Wednesday.”

As a contrarian investor I always find these kinds of figures interesting because people often do the opposite of what they should be doing (as is often the case when they make stock decisions). Common sense would dictate to many people that when the economy gets rough outstanding consumer credit would increase, as would delinquency rates, and when the economy is doing well people would use their additional wealth to pay off debt.

In reality, however, historical data shows the opposite, as this story does. When times are tough and they have less money consumers choose to repay debt faster. Conversely, they pile up debt when times are good even though that is when they actually have the money to pay cash! Very odd, but not at odds with other data that has shown that consumers and investors often do the opposite of what might be considered obvious to many (such as buying more stock after a price decline and selling shares into a significant rally).

The Big Short: Another Excellent Book from Michael Lewis

I took a few days off earlier this week and used the down time at the beach to read Michael Lewis’ latest book, The Big Short. Lewis has written some of my favorite books, not only about the financial markets (Liar’s Poker), but also baseball (Moneyball), and the inspiring story of Baltimore Ravens offensive lineman Michael Oher (The Blind Side) which was made into a hit movie last year starring Sandra Bullock (for which she won an Oscar award).

The Big Short did not disappoint and it further secured Lewis’ spot on my short list of favorite non-fiction writers. Lewis tells the story of a handful of market watchers and investors who both correctly identified the housing bubble as it was happening and made big bets based on their views. Unlike many other accounts discussing the financial crisis, Lewis follows a handful of people who most of us had never heard of before. John Paulson always gets a lot of attention, but small investors such as Michael Burry at Scion Capital and the founders of Cornwall Capital, which started as a $110,000 private investment fund of $110,000 managed in a shed, now are having their stories told and frankly they are fascinating (and they beat Paulson to the punch by 1-2 years).

The Big Short uses a different approach than most other authors have in trying to place blame on those responsible for the housing market’s bubble and bust. While some have insisted that Lewis’ focus on those who made money off the crisis does little to help regulators and politicians prevent another bubble from happening by focusing on the big issues, I find this view unconvincing.

In order to tell these stories, Lewis is forced to include nearly every detail throughout the entire process (the book focuses on chronicling the period from 2003 through 2008). It becomes abundantly clear to the reader which parties are responsible for propping up the housing and mortgage market and the problems are discussed in detail. The story works so well, I believe, because the reader can simultaneously see what all of the interested and conflicted parties are doing, rather than only getting one side of the story.

If you have either enjoyed Michael Lewis’ previous books or are interested in reading an excellent account of exactly how the housing bubble kept going for so long, bringing the nation’s banks to their knees, or both, a copy of The Big Short is definitely worth picking up. In only 264 pages, Lewis does a great job telling the story from various Wall Street perspectives.

Thomas Weisel Buyout Only Helps Bullish Case for Goldman Sachs Stock

Yesterday Stifel Financial (SF) agreed to acquire investment banking competitor Thomas Weisel Partners (TWPG) for about $7.60 per share in stock, a premium of about 70% for shareholders. This deal got my attention because I have written positively about Goldman Sachs (GS) lately and this deal reinforces my view on the undervalued nature of the investment banking sector. As is the case with houses, stock values are largely determined based on what are known as “comps” or comparable sales. You see how much your neighbors’ houses have sold for and use that as a yardstick for valuing your own house, or in this case, your own company.

One of my arguments for liking Goldman Sachs stock is that investment and commercial banks typically fetch between 2 and 3 times book value. The former figure is often used with gross book values, with the latter coming more into play when firms look at net tangible book values. In the 150’s, Goldman Sachs shares are trading at around 1.25 times book value, which to me seems like a very attractive price given their strong global franchise.

Anyway, back to the Stifel/Thomas Weisel deal. Stifel is paying $7.60 per share in stock, which equates to about 1.85 times book value and 2.1 times net tangible assets. Given the economic and political climate, it was not surprising to see this deal get priced at the lower end of the historical range, but I was still very happy to see that the range remained relevant in a deal that actually got done in 2010.

I think it is hard to argue that Thomas Weisel Partners, a small specialized investment banking firm, should fetch more than the leading global franchises such as Goldman Sachs or Morgan Stanley (MS). As a result, both of those large cap investment banks look attractive at today’s prices. To reach a price-to-book ratio of 1.85, Goldman Sachs shares would need to rise about 50% from current levels. Morgan Stanley is even cheaper and would need to rise by more than 60% to reach that valuation level. All in all, yesterday’s Thomas Weisel buyout offer only strengthens my bullish convictions on Goldman and it appears that Morgan Stanley fits the same mold as well.

Full Disclosure: Peridot Capital was long shares of Goldman Sachs at the time of writing, but positions may change at any time

Update: Goldman Sachs Indicates ACA Management Was Largest Long Investor in ABACUS

That was quite an interesting press release issued by Goldman Sachs (GS) after the closing bell tonight. All day today investors concluded from the details of the SEC’s fraud charges that Goldman worked with Paulson and Co. to weaken the composition of the ABACUS transaction in some fashion, perhaps in an effort to boost the odds that Paulson would profit from taking the short side of the trade. The SEC seemed to indicate, judging by the fact that it charged the Goldman employee in charge of the deal for lying, that someone from Goldman told ACA Management that Paulson was actually making a $200 million long investment in ABACUS. Goldman’s latest press release seems to tell a much different story. The side that makes their case the best could potentially make the other side look a bit foolish here.

What did Goldman claim tonight? First, they state that their firm lost $90 million on the transaction, as it had a net long position that soured when the CDO went bust. Next, Goldman denies that their employee ever told ACA that Paulson was taking a long position in ABACUS. That directly contradicts the SEC’s claim that ACA was told Paulson was going to be long alongside them, which if true, would seem to imply that ACA was fooled into thinking that collaborating with Paulson while structuring the CDO would not be problematic for them.

Another Goldman claim in the release seems to be the most important, in my view, if it is accurate. Goldman says that the single largest long investor in ABACUS was, believe it or not, ACA Management (with an investment of $951 million). If ACA truly was the largest long investor in the CDO, they had every incentive to structure the deal correctly (and Goldman is quick to point this out). In such a scenario, why would ACA ever allow Goldman and/or Paulson to hand-select mortgage securities for the CDO that might jeopardize their investment?

Now, it will take a lot of time to determine whether Goldman’s defense is true or not. However, their press release seems to make a bit more sense. If ACA was the firm that selected the portfolio, and also was the largest long investor in the CDO, the ABACUS deal goes from looking like a huge conflict of interest (as it did earlier today) to having interests aligned quite nicely. If you were the largest investor in a deal, it makes sense that you would want to be the firm that got to approve the mortgage securities that were included in it.

Did ACA consult with Paulson and Co. as well as other firms while structuring the deal? The Goldman press release essentially admits this to be true. Should those discussions have been disclosed in the CDO’s marketing materials? Maybe. But as long as ACA had the final say, it really does not seem to be a big deal.

After all, would it be considered fraud if a Wall Street analyst recommended clients buy stock in Company XYZ, but before doing so consulted numerous sources, including Company XYZ’s CEO? Would that single discussion with the CEO need to be disclosed in the analyst report in order to assure that investors knew that one of the analyst’s sources for the research was biased in their assessment of the company’s prospects? Of course not.

Like I said, we cannot take Goldman at face value at this point, just as we cannot take the SEC at their word either. After all, the SEC recently brought insider trading charges against high-profile Dallas Mavericks owner and high-tech entrepreneur Mark Cuban — and lost. If most of what Goldman has said in this latest press release can be proven, it looks like the SEC’s case this time around might not be a slam dunk either.

Full Disclosure: Peridot Capital was long shares of Goldman Sachs at the time of writing, but positions may change at any time

SEC: Goldman Sachs May Have Crossed the Line from Conflicted Investment Banker to Fraudulent Communicator

It always disappoints me when the financial media cannot wrap their hands around certain business stories. Here I am today watching the CNBC coverage of the SEC’s fraud charge on Goldman Sachs (GS) and the network has half a dozen reporters and anchors all talking at the same time and confusing what exactly was happening, even though they played the SEC’s conference call live on the air and it was pretty clear what was being alleging.

At any rate, let me review what exactly the SEC claims Goldman Sachs and its Vice President Fabrice Tourre did that was fraudulent in this particular case. The SEC is charging both the firm and the employee in charge at the time with omitting and misstating important disclosures related to the structuring and issuance of a CDO called ABACUS which was backed by sub-prime residential mortgage securities.

One of Goldman Sach’s most prominent hedge fund clients, Paulson and Co, actually helped create the CDO by deciding which mortgage-backed securities were to be included in ABACUS. In addition, Paulson and Co took a short position in ABACUS after it was issued, meaning that it helped structure a CDO that it planned on shorting.

Many on CNBC are incorrectly reporting that this clear conflict of interest is what the SEC is targeting in its complaint. In fact, Paulson and Co. is not being charged at all. Not only that, having a hedge fund help structure a CDO in and of itself does not violate any securities laws. Neither would it be illegal for that same hedge fund to short the CDO after it was created and sold to the public. While this is yet another situation where Goldman Sachs appears to be engaging in transactions that are filled with conflicts of interest with their various sets of customers, these conflicts are not illegal. Rather, they simply beg the question whether Goldman will lose customers due to the perceived conflicts.

All of that said, what exactly is the SEC’s charge related to? It turns out that in the marketing and disclosure materials prepared for potential investors in ABACUS by Goldman Sachs, it was claimed that ACA Management LLC, an independent third party expert in mortgage-backed securities, was hired to select which mortgages were packaged into the CDO. There were no disclosures made to investors that the hedge fund Paulson and Co. was also involved in selecting the securities.

Now you may be wondering why on earth ACA Management would agree to let a hedge fund assist them in structuring ABACUS, given that they are supposed to be an independent third party taking on such a job.  The SEC hints it may have the answer. They are charging that the lead Goldman Sachs employee on this deal told ACA that Paulson and Co. was going to invest $200 million in ABACUS, which would likely calm any fears they had about the interests of ACA and Paulson and Co. being aligned while they collaborated on the creation of ABACUS. Fabrice Tourre, the Goldman VP in charge of the deal, seems to have both omitted disclosures related to Paulson’s involvement, as well as misrepresented to ACA what Paulson’s investment objectives were once ABACUS was issued.

The key point here is that the SEC is charging Goldman Sachs with fraud related to the disclosures made (and not made) relating to the creation and issuance of ABACUS. Therefore, the obvious conflicts of interest here by themselves would not have been illegal had Goldman adequately disclosed to investors the true facts behind the creation of ABACUS.

Now, how does this news alter my opinion of the stock, if at all? Goldman Sachs shares opened today at $185 and are now trading down 15% ($25) to around $160 each. You may recall I wrote a bullish piece on Goldman Sachs back in March explaining why I was accumulating the stock in the 150’s. Until today that investment had proved very timely and given that even with today’s drop, the stock is still above my purchase price, I am not likely going to be doing any heavy bargain hunting at current levels.

If the shares fall back to around the 150 level or even lower as more people react to the SEC’s charges, it is quite possible that I would get more of my clients involved with the stock and/or add to existing positions for those who are already long. While I do not expect there to be much of a negative financial impact on the firm from these charges (Goldman’s fees related to ABACUS were only $15 million), it is reasonable to expect that customers of the firm will have even more questions about conflicts of interest surrounding Goldman’s dealings, including the possibility that other employees are lying about deals they are putting together personally.

Goldman surely has its hands full trying to alleviate these concerns with clients, but they can likely argue that this was an isolated incident involving a rogue employee and minimize the customer fallout from these allegations (as long as this proves to be an isolated incident rather than a pervasive problem at the firm). Given the stock’s valuation based on book value and earnings, I still believe it represents a solid long-term value for investors interested in owning part of the most dominant investment banking firm in the world.

Full Disclosure: Peridot Capital was long Goldman Sachs at the time of writing, but positions may change at any time. And yes, you can be assured that there are no material omissions or misstatements in this disclosure.