E*Trade Financial: Why This Company’s Takeover Prospects Keep Improving

Just over a month ago, I pegged E*Trade Financial (ETFC) as a takeover target.

However, after reviewing the company’s most recent results, you might consider my prediction laughable…

On Tuesday, E*Trade reported its ninth straight quarterly loss. And this one was a doozie. Over $830 million in red ink flooded the bottom line. Keep in mind that E*Trade’s market cap checks in at a mere $1.75 billion.

Again, I get that it’s not obvious why anyone would want to buy a company chalking up quarterly losses equivalent to roughly half its market value. But we can’t rely exclusively on headline numbers to guide our investment decisions - because they never tell the whole story.

And ironically, in this case, the whopping loss actually underscores E*Trade’s takeover appeal. Here’s why…

E*Trade Pays Now in Order to Set Up Profits Later

Dig into E*Trade’s results and you’ll find a one-time, pre-tax charge of $968 million, related to “refinancing.”

Strip it out, and E*Trade only lost $59 million, or five cents per share. And that’s a dramatic improvement from last quarter’s loss of 22 cents per share.

Essentially what E*Trade did was swap $1.75 billion in bonds due in 2011 and 2017 for new loans that can eventually be converted into common stock.

Sounds complex, I know. But don’t worry about all the details. Here are the most important takeaways:

• The debt exchange slashes E*Trade’s annual interest expenses by more than 50%.
• It pushes out any significant debt maturities until 2013.

And when we add in recent asset sales and a stock offering that netted the company a total of $765 million in cash, E*Trade now possesses all the financial breathing room it needs to weather its ill-advised foray into real estate lending and return to profitability.

And that’s not just my opinion.

As management proclaims, “[We are] confident that we have adequate cushion against any reasonably foreseeable losses in our own portfolio.”

But if you’d rather get an unbiased opinion, look no further than federal banking agency regulations. With a Tier 1 Capital Ratio of 6.72%, E*Trade now ranks as “well-capitalized.”

In short, E*Trade’s big loss is a symptom of making a necessary change in order to ward off bankruptcy once and for all. It had nothing to do with poor execution or rapidly deteriorating fundamentals. In fact, on the contrary, the company’s underlying fundamentals keep improving.

The One Thing Delaying A Takeover of E*Trade

Aside from insolvency concerns, the only other thing that’s delayed a takeover of E*Trade is its cumbersome real-estate loan portfolio. Like many other banks, it suffered heavy losses as the real-estate market soured. And potential suitors wouldn’t even consider a deal until E*Trade could get a handle on these losses.

But it’s starting to clear out some of the mess.

E*Trade’s provision for loan losses checked in at $347 million this quarter - down 14% from the previous quarter and 33% from a year ago. Charge-offs declined 9%. Delinquencies leveled off, too.

And with a firm grasp on the potential real estate losses, suitors can now quantify the risk and get to work putting a price tag on the assets they covet most - E*Trade’s brokerage accounts.

Two Potential Suitors for E*Trade’s Crucial Brokerage Business

Remember, beneath the muck of E*Trade’s real-estate portfolio rests a solid and rapidly expanding brokerage business.

In fact, during a terrible year for stocks in 2008, E*Trade managed to grow its account base by 6% and added $6.4 billion in customer assets. And that strength continues today…

• Quarterly revenue increased 52% as investors returned to the markets and traded more.
• Daily average revenue trades (DARTS) topped 196,000 - a 7% quarter-over-quarter increase.
• The average commission per trade increased to $11.50.

When all said and done, E*Trade offers suitors the opportunity to add 4.5 million customer accounts, with $148.7 billion in customer assets in a single day.

To put that in perspective, it would take them a decade (or more) to grow that much organically. And it would cost considerably more, too.

You see, thanks to the real-estate portfolio, E*Trade’s assets are going cheap. At current prices, suitors can scoop up shares at a 63% discount to the industry price-to-book ratio and a 79% discount to the price-to-sales ratio.

Ultimately, I’m convinced that will prove to be too good of a bargain to pass up.

As for suitors, TD Ameritrade (AMTD) is the most likely. Why?

• It just reported a $157 million profit and is sitting on a cash stockpile of $1.14 billion.
• It has expanded via acquisitions before. And management recently confessed, “We plan to use our strong financial position to take advantage of new opportunities to deliver additional growth.” That’s a Wall Street euphemism for “We’re out hunting for acquisitions.”

Of course, a formal offer could trigger a bidding war with Charles Schwab (SCHW).

Regardless, the only way to profit will be to own E*Trade shares in advance. So don’t delay. Despite what the headlines say, E*Trade’s takeover appeal keeps improving. And I don’t expect it to remain independent much longer.

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