Why the E*Trade Shorts Have It Wrong

E*Trade's (ETFC) management is doing everything right to turn the company around, and their efforts will reap benefits for shareholders sooner rather than later. The stock has obviously taken a serious hit due to its careless investments in commercial mortgage-backed securities and other derivative products. The company has also done a great job disclosing the magnitude of future writedowns, namely $3 billion over the next two years, which in turn has painted a clearer picture of future performance. Joe Moglia, the CEO of TD Ameritrade (AMTD), recently mentioned on CNBC's Fast Money that the defection of customers from E*trade has already taken place.

Despite the financial turmoil, management has shrewdly decided to focus on investing in its core competence. The company is continually investing in its trading platform; after having had an account with TD Ameritrade and Schwab (SCHW) I can attest to E*Trade having a superior trading platform. Another great initiative has been the firm's global trading platform, namely the ability of a U.S investor to invest in stocks traded on a variety of global stock exchanges in local currencies. That strategy should become highly accretive to earnings once it gets more widely adopted. The company's marketing strategies have been highly effective and have allowed the company to at least regain some of the customers who had switched to other brokerages.

I find it quite perplexing what downside catalyst the shorts are looking for in this name, now that all the bad news is more than priced in. The company recently beat estimates by announcing a much smaller than expected loss and I expect E*Trade to turn in a profitable quarter by year end. Citadel's $2.5B cash infusion (at $4.78 per share), while being a bit dilutive, provides for a strong floor as the hedge would rather buy out the entire company than let its lose it principal.

By betting against a company with rapidly improving fundamentals, the shorts are in effect digging their own graves. Analysts have been known to be late to the party, whether it be to the downside or the upside. 21 of 23 analysts who currently cover E*Trade have a negative or neutral rating on the stock; that is actually a positive rather than a negative as I expect a wave of recommendation upgrades in this name that will send the shorts panicking for the exits.

The 20% of investors shorting this stock are going up against a management team that is taking all the right steps to turn things around. I expect a wave of analyst upgrades and short covering panic that should propel ETFC to $10 by year end.

Disclosure: Long

Comments

[Frenchy]

It's about time that someone with some knowledge (I hope they do anyway) writes down what most of us realize. This stock is presently controlled by the shorts. We need numerous upgrades to boost the stock or , better yet, a takeover by AMTD.

[Milty]

The quarterly loss was larger than expected.

[Wez]

Yea, the company announced wider losses than expected. Does SA doing any fact checking, jesus. Having said that, I have opened an ETrade account recently since so many here seem to love their trading tools. I may even buy some shares when the money hits the account.

[mavi027]

Milty--

The quarterly loss was irrelevant. What is relevant is: (1) that ETFC is going to survivel and (2) that the turnaround plan is in place and working.

[Egg]

I don't believe Citadal paid $4.78 for shares. I believe they were given 20% of the company for free and the 2.5B was for the ABS portfolio @ ~25 cents on the dollar plus the balance for a 11-12% coupon bond. And with the bonds they get priority placement in the debt line IF E*trade ever does file for bankruptcy in the coming years.

So, they'd still be well positioned if E*trade ever went bankrupt in the coming years.

[prescient11]

There are some incorrect facts above, like the quarterly loss figure was larger than expected, but the author arrives at the right conclusion.

Riddle me this, does one really think that a company with $3/share of EXTRA CASH floating at both the bank and brokerage, should be trading right under $4.

This is one of the biggest manipulation plays out there, and the hedge funds have piled in. Let's hope that they are soon finished so that the stock can appreciate to a proper value.

[prescient11]

Egg,

Saying Citadel is well-positioned in case of bankruptcy is like saying you're well positioned in the basement when a tornado carries away your house.

It's amazing that such people have access to computer terminals.

[jk12]

The issue is not the business - it is the balance sheet. it may be the best business in the world, but it remains undercapitalized relative to the toxicity that is still on the balance sheet. that is the fear. any comment of etfc without a focus on the health of its assets is foolhardy. and the main issue was not CMBS it was residential mortgage backed securities.

[jk12]

Egg is exactly right. anything else is free upside to Citadel. already made more than their money back buying the MBS on the extreme cheap - reportedly has sold it for a profit already. the rest was just upside kicker, largely.

[zenalgorithm]

Etrade is on the fringe of BK. A gamble at best. Buy a big bank if you want to own a "financial". WFC or C would be a much safer, FED-insured-play.

[User 157146]

It's interesting that if you took last years quarterly earnings and subtracted out what etrade told us they'd be setting aside for loss provisions back in January you'd have had a better earnings estimate (lower) than the -0.10 that was being tossed around by analysts (I guess they haven't learned to subtract yet). Were it not for setting those loss provisions aside, which is not lost but rather in a different pocket, they'd have shown a profit this quarter! The reality is they could show a profit any time they choose, but they are doing the responsible thing of setting the cash aside, even though indications are showing that the worst is over and things have stabalized. Personally, let the shorts play for a bit longer, I'm buying all that I can at these prices.

[prescient11]

Jk12,

How is ETFC undercapitalized? Do people actually do research anymore? Tier 1 risk capital ratio is 12.4%. That is the same as JPM and better than WFC. After the 2Q, I would wager that you will not find one large bank with a better capital ratio than Etrade.

Second, what toxic mortgages are you referring to? No subprime (1/5 of 1%), no option arms, no interest only loans, etc., etc.

HELOCs are in line with risk estimates. First lien residential mortgages are fine. They are hurting earnings right now, but have no effect on the cap ratios.

So again, I ask you, what exactly are you referring to?

Know this and know it well, Etrade is as solid as a rock and only getting stronger from a balance sheet perspective. By the 2Q conference call, they will have a stronger balance sheet than any large commercial bank, guaranteed.

[Jimmy Goodwin]

Easy money or bankruptcy, but which one? =)

[THofler]

Egg is exactly wrong. I don't have all of the precise numbers, but Citadel paid about 27 cents on the dollar for the CDO portfolio, & THEN paid a large sum of cash for a 20% stake in ETFC. Citadel's equity exposure was definitely NOT free. (Get your facts straight or I'll send the SEC after you; just kidding.)

[Egg]

Good gawd people. Review the 8-K.

Yes, Citadel did get the 20% dilution of shares for zero. The 1.7B is via a 12.5% coupon bond. They did not pay $4.78.

And yes, they would be positioned well if E*trade were to file bankruptcy. They would be collecting 12.5% interest on the 1.7B up to that possible point, and then if E*trade did go under due to their loan portfolio, they would still be first in line to be given majority control of the brokerage, which will always exist.

[mkoerner]

I listened to the earings call. I think we can all agree that there were some really good points on that call. I'm interested to see what parts of the company they sell in the up coming months. The Etrade story remines me of when IBM was in teh dumbs. Lou came in - sold all unprofitable assests and really turned IBM around. If you remember IBM stock went from 10 bucks a share to 100. I missed that train. I'm not going to miss this one. BTW I'm not saying that ETFC is going to 100, but it sure would be nice.

[jormoria]

yo compre 2000 de etrade a 3.50 y vendi a 5.00,ahora me he quedado con otras 1300 acciones a 3.48,para ver si en el futuro suben; tambien voy a comprar unas cuantas acciones de cfc despues de su declaracion trimestral del siguiente mes.double or trouble.

[forest]

There will be forthcoming debt-for-equity swaps. So more dilution is coming, but the question is whether or not that actually increases the value of the shares because it bolsters capital and takes out high cost debt.

Citadel is already making a killing on this deal because in addition to the cheap MBS portfolio and shares, they are running all of Etrade's option trades through their clearing business. Also, look at all the insider trades being made on ETFC by Citadel...they are clearly being active in trading the shares and lord only knows what they are doing on the derivatives side to either hedge or create upside. It would appear that Citadel still has a large stake in the performance of the company over time via the common, but we just don't know for sure given that they have their hand in many cookie jars here. My personal guess is that they DO expect to make money on the equity but it's the icing on the cake.

[mkoerner]

YEAH! It's finally back up to 4 bucks again!

[dan-o]

you didnt mention how the request for authorisation to issue new shares factors into the share price.

also, how about a blog on how etrade plans to use those shares and what sort of future dilutution shareholders have in story for them.

seems to me, shorts are staying short b/c they expect dilution to push them further into the money.

[ZenInvestor]

Good article. I find it silly that this stock is still punished so deep into the turnaround. As for 'announcing' what they will do with the 600MM in additional authorized shares, why should they say? This is purely defensive, and give management flexibility. As to the shorts, they will tire of this stock as when it continues to edge higher instead of lower. Investors need to return to the markets, and the shorts will go on summer vacation.

[Wez]

www.marketwatch.com/ne...

[User 183727]

CFO RESIGNING ...NOT THE BEST NEWS..

[life is short]

CFO see you

[Norman Lepoff, M.D.]

Very informative. Thanks.

[Josh Stern]

The ETrade model of combining a fully web-enabled electronic bank and discount brokerage in one entity offers a lot money management time convenience and cost/interest savings. Highly recommended even to traders who place most of their transactions at another brokerage.

[__who__]

dan-o said: "you didnt mention how the request for authorisation to issue new shares factors into the share price. also, how about a blog on how etrade plans to use those shares and what sort of future dilutution shareholders have in story for them. seems to me, shorts are staying short b/c they expect dilution to push them further into the money. "

So what you are really saying, dan-o, is that shorts are remaining short because they are naive.

Experienced and seasoned traders know that authorization does not mean issuing, and that delution is no more likely with E*Trade now than with any other company. The fact that they want the shares authorized just means they want some in the bank in case they do have a need someday, such as for example to aquire another competitor.

There are about 95 million shares shorted last time I looked, and while I agree that some of the shorties may be that naive, I seriously doubt that all of them are.

[Doug Liser]

After pulling out a few million from my E*trade accounts and selling all E*trade unsecured bonds I was holding, I sleep a lot better. While management is doing everything they can, the problem is that their mortgage portfolio is loaded with super risky home equity loans, seconds, piggybacked and all kinds of paper you certainly don't want to be holding in California. I believe the market for this stuff is going to get uglier every month as more people walk away from homes and leave lenders holding junior paper with nothing. I hope they make it - the service and the trading platform are both very good but I can't blame the shorts for betting the company is headed for the tank.

[Voice of Reason]

Did a little birdie whisper in your ear or are you just guessing?

In other words a lot of bluster and BS, short on facts. Got any?

The truth is you have no idea what E-Trade's or for that matter anyone's mortgage portfolio is made up of. Put your play money back in the Monopoly box where it came from.

[wall_st_geek]

Wow. I came here to post a comment on the original article, and saw that passions are inflamed regarding this stock. Personally, I'm in the "it will recover" camp, but I do see a significant degree of risk to this opinion. Anyway, I have 2 issues with the original article:

"...stocks traded on a variety of global stock exchanges in local currencies. That strategy should become highly accretive to earnings once it gets more widely adopted. "

Have you seen any evidence of that? In my experience (working in the Financial industry), the instititutional investors (not E-Trade's market) are only just waking up to the possibility of international trading, and most U.S. individual investors are still happy making their "offshore" investments via mutual funds, ETF's etc - also not E-Trade's market. Personally, I don't see this being anymore than a footnote in the revenue numbers for the next 12-24 months at least.

I also take issue with the "...actually a positive rather than a negative as I expect a wave of recommendation upgrades in this name that will send the shorts panicking for the exits" comment. On exactly what grounds does the author expect the upgrade? Frankly, I would be surprised if any analyst was willing to stick their neck out to make an upgrade until the full impact of the current recession is known and the impact of mortgage defaults have fully worked through the system.

[Voice of Reason]

Personally I'm just putting my E-Trade position on the back burner and not worrying about it till things shake out more. It only represents less than 2% of my total stock positions so I'm willing to let it ride along with my Thornburg holdings along with a couple other current bow wow stocks that have the potential to double or more. Like with poker, sometimes it's time to double, other times fold, other times just do nothing but wait and sit things out. So for now I put these chips in my pocket and walked off to another table to see what other trouble I can get into. But I ain't cashing in my E-Trade or Thornburg chips. Not yet, no way. I'm patient.

[investorslive]

ETFC back to $4

heres my scan www.investorslive.com/.../

[Stockpickerforum]

I agree with Prescient about Egg, such a stupid useless comment!

[Stockpickerforum]

Agree with Voice of reason about Doug...he must be such a maven knowing what paper they hold and that it will deteriorate as a fact?! The most important question is whether it is priced into the stock...and it ABSOLUTELY is...there are much more upside than downside catalysts here...you'll make a few dimes going short in the short term but could dig your own grave in the long term

[theblindtibetan]

6 months after bankruptcy scare, evidence of cusomers defecting, assets declining...the stock sits in exact same spot....in these 6 months ETFC reports highest customer additions since Q1 2005, HELOC losses under control...and reaffirms return to profitability this year. We are looking at one of the greatest examples of stock manipulation you will see in a long time. How long this will go on I do not know....will there be an end...absolutely.

[quasimatter]

Open letter to E*Trade CEO/Execs/BoardOfDirec... from a concerned share-holder.
======================...

Respected Sirs/Madams,

The increase in short interest over last two week
provides further solid evidence that the stock
price is being depressed for May 16th authorization
of 600M shares which could potentially be followed
by debt for equity swap at the depressed prices.

If company management agrees to debt for equity
prices at the obviously depressed prices with clear
evidence that it was manipulated down by shorts
(a huge percentage of last two weeks "supply"
of shares was short sales); that would prove
beyond doubt that E*Trade Management is working
as an accomplice in a plan to defraud E*Trade
shareholders and letting other parties buy E*Trade
on cheap.

Given the strengthening balance sheet,
increasing revenues and customer base,
and reducing mortgage losses as evidenced
by last quarter's conference call; there is
NO IMMEDIATE need to reduce debt by equity
swaps.

At this point, I suspect that people shorting
this stock are the same people who are going
to acquire shares in debt to equity swaps
and are not concerned about having to "cover"
their shorts. By rewarding them with stock
at cheap prices, the CEO would essentially
be participating in such plan and violating
fiduciary duty towards share-holders.

I would like to plead the CEO and E*Trade
management/BOD in this open
letter NOT to approve ANYMORE debt for
equity swaps in near future until the stock
price has stabilized at a normal level.

- Quasi

P.S.: This is going to various forums,
Investor relations at E*Trade (previous
emails to them have gone unanswered) and
SEC both as an open letter to CEO and a
possible "pre-warning"... about a crime about
to be committed.

[Stockpickerforum]

Quasimatter,

You are a paranoid and should seek help. Etrade's management has managed through this crisis phenomenally well and positioned extremely well for the future. Nevertheless, as dilutive as it may be, management needs to leave a window open to raise $ so that it can weather a scenario in which its mortgage holdings continue to deteriorate in value.

[Stockpickerforum]

has positioned itself

[Victor Cederhage]

The U.S. dollar is a terribly flawed currency. I’m trying to get all of my money out of U.S. dollars. I don’t know why anybody would put money into the U.S. dollar, and by extension into the U.S., as we stand here today. The U.S. is probably the largest debtor nation the world has ever seen!

/ Victor Cederhage