Quick Pitch: E-Trade Financial (Nasdaq: ETFC)--Long

Source: Victor Bonilla
Firm: Formerly at Calypso Capital Management
Education: Wharton (MBA), UPenn (Undergrad)
Location: New York, NY

Recommendation: Long
Timeframe: 1-2 Years
Price Target: $12.81

Quick Thesis on E*Trade (Nasdaq: ETFC)

I am recommending shares of E*TRADE Financial for investment for 4 principal reasons:

1. Price versus Value. The equity of E*TRADE Financial is underpriced relative to what I think is an extremely conservative/punitive estimate of intrinsic value. This is the core of my thesis.

2. Severe and improbable downside case yields over $1.3bn in E*TRADE Bank equity value. E*TRADE Bank, E*TRADE Savings Bank, and E*TRADE United Bank have a combined $2.1bn in total tangible capital, per the most recent (Q3) filings with the FDIC and less the $1.5bn of holdco debt which I allocate to the bank. Given worse-than-2009-crisis-level assumptions for 2-3 years of heavy – and I believe, highly unlikely – mortgage defaults and losses, I find that the three banking entities would be left with about $1.3bn in tangible capital in 2014. At a very undemanding 1.0x pro forma multiple for the remaining (clean) equity capital, these banking entities alone would provide $1.3bn in equity value.

3. If one accepts that the bank is worth anywhere near this disaster case estimate, then the brokerage “stub” is bizarrely cheap. $1.3bn in intrinsic equity value for the bank implies that the $1.4bn-revenue, $0.6bn EBITDA, low-capital-intensity, scalable brokerage business is being “created” at $1.4bn. Previous brokerage M&A transactions of much smaller franchises have priced at 6-12x EV/EBITDA. Large players such as Schwab (Nasdaq: SCHW) and TD Ameritrade (Nasdaq: AMTD) have shown their willingness to purchase smaller platforms such as Options Express (Nasdaq: OXPS) (which is not just an options trading platform) and Thinkorswim. Thinkorswim, which was purchased close to the equity market bottom in 2009, went for almost 6x EBITDA; Options Express, bought in 2011, went for 12x EBITDA. In my intrinsic value estimate, I assume 4x EBITDA for E*Trade's brokerage stub and no M&A transaction, even though the synergy argument for E*Trade is obvious.

4. This opportunity exists for good reason. 14 of 16 analysts rate the stock “Neutral” and only one analyst rates it a buy. The equity story is unwieldy and so the company appears to be misunderstood and/or relatively ignored by covering analysts. Most sell-side analysts covering E*Trade are not bank analysts, but rather, broker-dealer and financial technology analysts. In the research to which I have access, virtually no analysts bother with the labor of stress-testing E*TRADE Bank’s loan portfolio as I have tried to do (and as traditional bank analysts would probably be expected to do). Their recommendation to their clients is typically to stay away until events become clearer to everyone – by which time, of course, E*Trade’s stock will have repriced accordingly. If we’ve got a handle on the bank, we’ve got an edge on the Street.

The price target used ($12.81) reflects what I believe to be a worst-case, low-probability scenario to allow for a substantial margin of safety. I am focusing on both risk and reward here as opposed to simply upside and I urge readers to do the same.

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