The Case For an E*Trade Buyout Ahead (ETFC, AMTD, SCHW)

It has been a week since E*TRADE Financial Corporation (NASDAQ: ETFC) reported earnings.  We have also seen earnings this week from TD AMERITRADE Holding Corporation (NASDAQ: AMTD), and The Charles Schwab Corporation (NYSE: SCHW) has its interim business update this morning.  We have long considered E*TRADE as a future buyout candidate, and the case for a buyout ahead remains strongly intact.  Even if a buyout does not surface in time,  many aspects of its turnaround keep improving.

E*TRADE’s earnings showed pre-tax income of $36 million (vs. $52M prior quarter, but above -$1.2 billion in Q3-2009).  Net income was $8 million or $0.03 EPS (vs. $0.12 EPS prior quarter and -$0.65 EPS year ago).  Revenue also fell to $489 million from $534 million in the prior quarter and down from $575 million a year ago.  The loan loss provisions are improving at $152 million versus $166 million in the prior quarter and down from $347 million a year ago.  The company further noted that ‘special mention’ delinquencies of 30 to 89 days were down by eight percent from prior quarter, while its at-risk delinquencies of 30 to 179 days fell 11% from the prior quarter.

A research report from Bank of America Merrill Lynch last week highlights much of the same thought, and it goes far deeper into why the buyout would take place in the future rather than now.  BofA noted that buyers would have to absorb credit quality risks and absorb some fair value marks; and, for now, that could threaten some financial regulatory compliance.

The company’s focus on the U.S. retail brokerage operations are still offset by exposure to loans, although BofA noted that E*TRADE appears to have turned a corner on the non-core lending business and its regulatory capital now seems adequate enough for a full recovery.  BofA has a standalone price target of $20.00 on E*TRADE, while it noted a potential deal value closer to $24.50 and noted as high as a potential $25.50 discounted cash flow value through time.  BofA also noted that a deal seems more likely in the year-end 2011 or later.

The reason we agree with the thesis that a deal would be further out rather than sooner is because an acquirer would be lowering its own credit metrics at this time.  That credit will improve through time if the world stays on the same path it is on right now, and in another year the E*TRADE loan portfolio will likely be less of a problem-child for an acquirer.  Another consideration is that Thomson Reuters has estimates at $0.63 EPS for 2011 from E*TRADE, and around $14.10 that gives a forward valuation of more than 22-times earnings expectations.  It is not until 2012 that earnings multiples are expected to normalize.  Schwab trades closer to 18-times expected 2011 earnings and TD Ameritrade is closer to 16-times the mid-point of its 2011 guidance.  E*TRADE was listed by us as one of ten brands which could disappear, due to a buyout.

E*TRADE was at roughly $14.75 before earnings last week, and shares are currently around $14.10.  The 52-week trading range on a post-reverse split adjusted basis is $11.15 to $19.90 and the market cap is roughly $3.1 billion.  Its website lists more than 2.3 million global customers and over 4148 billion in customer assets.

Charles Schwab lists over 300 offices and 7.9 million client brokerage accounts, 1.5 million corporate retirement plan participants, 665,000 bank accounts, and $1.47 trillion in client assets.  We have made no assumptions today regarding the Schwab interim business update.  Shares are currently at $15.08; its 52-week trading range is $12.64 to $19.95 and its market cap is $18 billion.

TD Ameritrade missed its earnings estimates this week after profits fell by 27%, but shares have held their own after the firm gave guidance of $0.90 to $1.20 EPS for its 2011 fiscal year. The company listed record client assets of approximately $355 billion, including $63 billion in client cash.  The new CEO, Fred Tomczyk, also told CNBC that it has over $1.1 billion in liquid assets that could be used for acquisitions.  At $16.79 today, Ameritrade’s 52-week range is $14.53 to $21.30 and the market cap is nearly $9.7 billion.

The reason for some basic comparisons to TD Ameritrade and Schwab is simple.  They remain the most likely predators.  If Schwab were to make the move, it could use cash or stock, or even cash and stock combined.  If TD Ameritrade were to make the first move, our belief is that the deal would mostly be a stock for stock transaction.

All online brokers right now are fighting for earnings because they cannot make any money on their customers’ cash deposits.  The industry is also fighting for average daily trades, and there is now a push for commission-free trading in selected in-house ETFs that could pull down the average commissions for each firm.  Those are ongoing issues and will be risks ahead.  Of the three online broker giants, E*TRADE remains the most battered by far when comparing to past share prices from before the great recession.  If and when business metrics improve, an acquirer is likely to consider gobbling up this turnaround broker.  It is even possible that a second buyer could emerge if a first mover comes in, and that second buyer could be one or the other online brokerage giants or it could be one of the healthier banks or brokerage firms as well now that Citadel’s grasp around E*TRADE seems to be much lighter.

Analysts do not have as high of a value on E*TRADE when compared to BofA.  BofA’s fair value of $20 (or $24.50 in a deal) compares to average price targets of $16.36 from Thomson Reuters.  The buyout thesis remains for E*TRADE.  The trick is that the thesis also requires prudence and patience more than an aggressive stance.

JON C. OGG