Taking a Pass on E*Trade

Normally I wouldn't write up a stock I'm passing on, but I've been thinking about it a lot and decided to pass along my thoughts.

E*Trade is a discount retail stock brokerage firm that has had a horrible run. It bought an internet bank in the early part of this decade (I can't remember the year off hand) and somehow the CEO of that internet bank ended up being CEO of the E*Trade. This is important only because E*Trade blew up by making really bad decisions in its banking operations which you would think a former bank CEO would have avoided. They had a good strategy that was poorly executed.

They were able to raise a lot of deposits from their customers, which was a good thing, but could not make enough loans to those customers to put those deposits to work. Their choices were to plow those deposits into a conservative investment portfolio until they could make good loans, or be more aggressive. They were more aggressive. They purchased a large loan portfolio, which means they didn't have anything to do with the underwriting of those loans, and they bought a riskier level of securities. Not only did they purchase mortgages, they purchased home equity lines of credit, which have a bad habit of being worth zero if the borrow stops paying because they are the second or third lien on the underlying property. Their timing was clearly bad in retrospect, as the housing market crashed and non-performing assets skyrocketed.

That is the history, leaving out a lot of detail about Citadel stepping in etc. So why am I interested at all? Because despite my earlier expectations, retail clients don't seem to care that E*trade has imploded financially. I assumed they would start bleeding clients and assets as the news came out. That has not happened. They continue to attract new accounts and assets! Amazing! Couple that with the idea that the sentiment on this stock is very poor, and I thought there might be an opportunity to buy the stock now and wait until normalized earnings power shows up.

The punch line is that I would pass on E*Trade. Under a rosy outlook, not exuberant, I can come up with $0.12 in 2011 EPS after taking dilution into account from the equity and bond exchange being offered today. If the market will pay 15x for that at the end of 2010, then the stock could trade at $1.85. I need at least a 30% cagr to get me interested in this stock which puts me at $1.25 today. The stock is at $1.42 this morning. And I need to repeat that $1.25 is the most I would pay; realistically, I would like to pay $1 so that I don't have to assume a 15x multiple.

Citadel is reported to be planning to convert $600m of their 12% coupon debt into zero coupon convertibles and buy $50-$100m of the equity offering, but I am baking that into my numbers. If E*trade gets very good terms on the equity and convertible swap, I will reconsider.

I really wanted to buy this stock, and you can tell a pretty compelling story about why it makes sense, but I do not think the potential returns are enough to compensate you for the risk in this case.

If nothing else, this has been a very interesting story to follow.