Stock of the Day
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E*Trade (ETFC)
Will Housing Rebound be Fast Enough to Rescue E*Trade?
E*Trade was one of the first in the financial sector to really feel the brunt of the credit crisis. In late 2007, the online broker was on the verge of collapsing due to the huge mortgage exposure on its books and was rescued by a $1.75 billion cash infusion from Citadel, the Chicago-based hedge fund. Somewhat surprisingly, the core business of online trading, minus a couple of hiccups, continued to thrive despite the parent company's troubles (no doubt thanks in part due to those 'baby' commercials which have caught on) and that led many to believe that E*Trade would eventually earn its way out of its troubles. Now that investing thesis is coming under severe pressure and here's why.
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| Stock Analysis |
Since the market bottom in early March (and at this point, it's pretty safe to say that we will not be re-testing those lows again), the financial stocks have been on a tear. E*Trade was one of the beneficiaries of that enthusiasm. The stock was at $0.59 on March 9 (an all-time low) but the subsequent run-up took it all the way to $2.58 on April 17. So it experienced a 337% gain in just about 5 weeks. However, things toughened up once E*Trade announced its Q1 earnings in late April - it reported a loss of 41 cents a share, a penny more than expected - but more importantly, it announced that it had been asked to raise more capital by its primary regulator - the Office of Thrift Supervision. So E*Trade announced a $150 million equity capital raising plan. Also, E*Trade was asked by the regulator to make the brokerage business a subsidiary of its banking operations (previously, the two were functioning independently under the umbrella of the holding company).
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Now, the struggling bank franchise which is saddled with the non-performing mortgage assets has direct access to the earnings generated by the thriving brokerage business. This reduces the value of the brokerage assets and also makes it harder to sell the unit, something E*Trade investors were hoping to see (Charles Schwab (SCHW: Charts, News, Offers) and TD Ameritrade (AMTD: Charts, News, Offers) are just two players who would buy the brokerage unit for a premium in a minute if it was decoupled from the mortgage holdings of the bank). Therefore, investors have soured on the stock and it has fallen about 38% from the high in April to the $1.59 level that it is currently trading at. Additionally, Citadel which owns about 20% of E*Trade today announced that its founder, Ken Griffin, is going to join the board and sit on the finance and risk oversight committee. E*Trade is also looking for an additional cash infusion from Citadel which is going to result in further dilution for shareholders.
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Given that it looks like that the government is not going to provide TARP money to E*Trade (apparently, it's not quite big enough to be not allowed to fail), the best case scenario for current E*Trade shareholders would go something like this -- Citadel provides another cash infusion, E*Trade doesn't have to take any additional writedowns, the delinquency rate on its portfolio of mortgages slows down and the retail brokerage business (which continues to perform very well especially given the increased retail trading activity in the last couple of months) drags the overall company out of this mess in 4-5 years. But even if this were to happen or if the brokerage unit was sold at a premium, Citadel would benefit the most as the other shareholders would have been significantly diluted. On the flipside, Citadel could choose to write off its approximately $2 billion investment in E*Trade and let the company go into Chapter 11, which would wipe out the equity. So overall, E*Trade still remains a risk heavy investment but there is a small chance for a significant payoff. The faster the housing industry rebounds, the better the odds for E*Trade.
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