E-Trade (ETFC): A Take-Out Trade With a Potential 5 to 1 Payout By Oct Expiration

by Dan August 23, 2011 11:53 am • Commentary

Since late July when ETFC announced that they hired Morgan Stanley to explore strategic alternatives (that could include a sale of the company), the stock has sold off almost 40%….largely in sympathy with the markets, but also having to do with the potential to actually find the right buyer.

A few weeks back in a note to clients, Goldman Sachs stated the following: Investor queries center on four items: (1) fair market value on the loan portfolio (we estimate $1.2-2.5 bn), (2) run-rate bank earnings ex-credit costs (estimate: roughly $1.1 bn), (3) the present usable value of the $1.4 bn deferred-tax asset (PV of $558-$697 mn), and (4)estimated value of the remainder of the firm (broker/corporate).

We assembled a comprehensive sum-of-the-parts analysis, including four scenarios to fair-value the loan portfolio. Our SOTP analysis implies a theoretical M&A valuation of $17-$25, with a high likelihood of a transaction (30-50%) per our departmental M&A framework. We reiterate our Buy rating and $18 12-mo. price target, based on a blend of normalized valuation of $17 (70%) and an M&A value of $21 (30%).

Deutshe Bank in a note to clients on July 27th noted that the most likely partner would be AMTD, a deal that has been long rumored:

A deal between AMTD & ETFC has been discussed before, & it has its merits as it is a scale business & the combined entity would generate significant synergies.  That said, there are a few hurdles that continue to limit the financial upside in a potential transaction – writedown of the loan portfolio, any net capital shortfall, & normalized earnings. While a transaction is possible, given the above hurdles, that there is only one real buyer, only modest upside based on our scenarios, & what we view as a wide bid-ask spread, we expect any deal to take more time.

Credit Suisse in a note to clients on July 27th stated that a deal  is “Neither Easy nor Obvious”:

Any Way We Look At It, A Deal is Neither Easy nor Obvious. There’s good reason that E*Trade has yet to be sold – any deal is highly complicated. While we believe there is a strong likelihood that ETFC is a long-term takeout candidate, we see several key hurdles from here to the finish line over the near-term including: 1) a limited universe of natural buyers for both the retail brokerage and banking-related assets; 2) price (magnitude and timing of EPS power realization, fair value marks, deferred tax asset, excess capital, magnitude of synergies) and 3) lack of regulatory clarity (ETFC shifting primary regulators from OTS to OCC and ultimately the Fed).

We group the universe of buyers into the following:

– Discount Retail Brokers: While the major discount retail brokers may be the most natural buyers of E*Trade’s retail brokerage operations, we have never viewed them as strategic buyers of portions of E*Trade’s balance sheet, most notably E*Trade’s purchased loan portfolio.

-Major Banks/Brokers: We believe the single greatest impediment in a major brokerage house or bank acquiring E*Trade is the potential channel conflict inherent in integrating a discount brokerage alongside their existing retail brokerage forces.

-Specialty Finance Firms: We think specialty finance firms could make strategic sense given their desire/need for low cost retail funding but we do not see them as natural owners/operators of E*Trade’s retail brokerage franchise.

-Private Equity: Potential registration is perhaps the single most challenging hurdle for a private equity buyer of E*Trade.

The Street is fairly mixed on the name with only 4 Buy ratings, 11 Holds, and 1 Sell.  Citadel who is their largest shareholder with almost 10% of the stock is strongly pushing for a sale, and I think it is safe to assume with the stocks recent sell off that other activist investors will be attracted to the story.

MY VIEW: I generally believe where there is smoke there is fire, especially when the kindling is activist concentrated investors.  I think there could be considerable risks to just owning the stock here, especially when you consider the environment we are in for financial companies and the the likelihood of a deal not happening in the throws of a market crisis……Any deal will likely take some time when cooler heads can prevail.   My sense is with the stock at $10 you probably have 50% downside  risk and the potential for about 100% in a  better market with a company that could be in play.

TRADE:  ETFC $10.00 Buy Oct 12/16 Call Spread for .65

-Buy Oct 12 Call for .90

-Sell Oct 16 Call at .25

Break-Even On Oct Expiration:

Profit: btwn 12.65 and and 16 make up to 3.35, 16 or above make 3.35 or 5X your money

Loses: btwn 12 and 12.65 lose up to .65, below 12 lose all .65 or 6.5% of the underlying…..