ETFC - Doing fine

Most analysts missed the point about ETFC: if you are going to bottom-fish, you buy when most of the bad news is out but before the good news is all in. Of course there’s mixed news, but the picture brightens each quarter.

The way to understand ETFC is to look at it as two separate businesses: a brokerage and a lending business. The brokerage is doing amazingly well while the lending business is limping along

The brokerage:
* Trade volume was up 7% over last year. The value of that trade was similarly strong versus last year
* Margin business was up 11% over the previous quarter (not sure what it was last year)
* Customer cash and deposits were $33.7B and up $1.8B since last year’s low
* Total accounts are up 196,000 since last year (30,000 in the last quarter)
* Generated $170M in profits for 1 quarter.

So how did $170M in profits turn into $95M in losses? First, they are increasing their capital reserves in the event of more debt failure. Second, they are losing money on the debt.

Now, this is important. The amount they choose to put aside is somewhat discretionary. That is, they are deliberately taking money away from the profits and putting it aside for a rainy-day. So instead of inflating profits, they are artificially deflating them. Nice. I like this correct and conservative approach. It’s quite refreshing and I will invest in management like this.

They have already put aside $620M and the Etrade Canada deal will bring them close to $1.2B

But the balance sheet is awful because of the debt.
1. Reduced undrawn lines of credit to $3.7B – that is, money folks can borrow and ETrade is obligated to offer. ETFC would have to put aside cash reserves to cover this credit, and they don’t want to expose themselves. This is a 49% reduction from $7.2B. It basically allows them to preserve capital to where they need it.
2. Swapped debt for equity – They reduced $121M in debt by cash and $27M shares
3. Have $1.8B in cash. This is in addition to reserves for losses and next quarter’s $500M Etrade Canada cash (aka the $1.3B on capital reserves).
4. Planning for $1.5B in mortgage related losses. Frankly, I wonder if this is low. It represents ~12% of their mortgage package. They pointed to 2 things
* They use Case-Shiller for the metro areas to project failure rates (with 15% being the minimum). This is very solid and smart.
* 2007 loans are only 11% of their total loan portfolio (2007 was a year of really shoddy lending standards and high foreclosure likelihood)
5. Loan delinquencies grew to $111M but it seems to peaking after 4 quarters. Not sure if this is a trend or not, but it helped them this last quarter.
6. In process of writing off FNM/FRE investments of $330M. They will probably take a $120M loss next quarter.

So what are they going to be worth in 4 quarters?
- They sold Etrade Canada for ~$3.5K per account. ETFC currently has 4.5M+ accounts, which puts a value of $16B on the brokerage. But TDAmeritrade has 6.3M accounts and is valued at $10.6B or ~$1.7K per account. Using the lower figure puts ETFC’s brokerage value at $8B
- Add in $2B for current cash and new profits.
- Take out the bad debt. The absolute worst case is a 50% loss on $23B or $11.5B. The likely worst case is a 30% loss or $6B. They have $1.2B as of next quarter. So the worst cases are that they have a net loss of $4.8B~$10B.

So that gives them a liquidation value of $0~$5.2B. That’s a stock value of $0~$10. The gap between the $3 price today and the $0/$10 valuation is the debt. Every month the debt could be improving or worsening – it’s hard to say. A $3 stock price implies a $10B loss on the $23B portfolio or a 43% loss.

So what are the real risks here
1. Brokerage business droops in a downturn – this is a definite probability. I think the $2B cash/profit figure I use above already bakes that in.
2. Current spreads droop: they are generating an average 2.72% above borrowing costs on the cash. I don’t give this a high probability, even in the face of a rate hike.
3. Mortgage and HELOC business gets worse – this is a definite probability. It would take years to cover the debt write-down. However, the other $13B in debt is implicitly performing and throwing off some profit.

In effect, it really depends on the exposure to the debt and their ability to meet capitalization requirements. The latter point is what drives insolvency and emergencies. They have a total 5% capital-to-debt coverage and access to 50% from the Fed. I don’t see an emergency here.

A final key point is the short ratio - ~30% of the shares are short.

This is a 4 quarter story. If we can have an average $3.50 cost and the stock moves >$4 in 4 quarters, that’s still a 14% return. But I am shooting for a $6+ valuation this time next year.