Turnaround expert bets on E*Trade

by George Putnam, editor The Turnaround Letter

One of the pioneers in the web-based stock brokerage business, E*Trade (ETFC) went public in 1996 just in time to participate in the last phase of the tech/Internet bubble.  

After recovering from the bursting of that bubble, E*Trade made the mistake of going into the sub-prime mortgage business, which almost destroyed the company.

Citadel, the huge Chicago-based hedge fund group, rescued the company in November 2007 by purchasing its troubled sub-prime mortgage portfolio and making an investment in the firm.

While this took the worst problems off of E*Trade’s books, the company has suffered from delinquencies in other loans that it made before the 2008 financial meltdown.  It brought in a new CEO and effected a 1-for-10 reverse stock split in 2010, but the stock price has continued to slide.

E*Trade is making progress on a number of fronts. It has improved the balance sheet and continues to build on its strong brand presence in the retail brokerage world.  

However, the gains have been overshadowed by margin pressures from low interest rates and weak trading volumes.

The company’s delinquent loans are steadily shrinking as its legacy loans roll off the books.  The legacy loans are down by more than 60% from their peak in late 2007, and total delinquencies have dropped by 28% over the last year alone.  

If the housing market continues to strengthen, as we expect, the pace of improvement should accelerate.  

As a result of better financial performance – including a net profit last year for the first time since 2006 – E*Trade’s capital ratios have improved to some of the strongest levels in the company’s history.

On the brokerage side, E*Trade has strong brand recognition – think talking baby ads – and a valuable franchise.  Customer accounts and assets are both growing at a decent pace, and management is adding trading features to keep that pace going.  

Moreover, the company is making progress at selling more retirement services and other high margin products to its customers.  At the same time, management is cutting costs through operating efficiencies, with an additional $40 million in cuts targeted for the coming quarters.

Because of its legacy problems, the stock trades at a much lower valuation than its major competitors.  

For example, Schwab and TD Ameritrade have price-to-sales ratios of 3.45 and 3.3, respectively, while E*Trade is at 1.55.  Similarly, E*Trade’s price-to-book ratio is 0.42 versus 2.13 for Schwab and 2.03 for Ameritrade.

E*Trade has a large activist shareholder who is trying to boost the share price.  As a result of its rescue transaction in 2007, Citadel owns about 9.6% of E*Trade’s stock.  

It tried to get the company to put itself up for sale a year ago, without much success, and Citadel is likely to keep up the pressure going forward.

As E*Trade continues to reduce legacy liabilities, it is well positioned to profit if either rates move up or trading volumes increase (or, better still, both).  We recommend E*Trade up to 12.

Learn more about this financial newsletter at George Putnam's The Turnaround Letter.

Related articles:

• 5 turnarounds in private equity
• Lazard: 5-star buy in M&A
• Wells Fargo: 'A rare breed'