Reader Mailbag - Is E*Trade a Bargain?

Carol from Phoenix writes:

"Chad, I was wondering if you would comment in your blog about E-Trade (ETFC) from a contrarian, value viewpoint. Their stock has been beaten down lately, but their fundamental business seems strong, and they appear to have rid themselves of what little subprime exposure they had. Thanks!"

Thanks for the question, Carol.

I decided to publish my answer on the blog because I have actually been looking at E*Trade in recent days. This is exactly the kind of contrarian play that I think value investors should be looking at within the financial services sector. It falls into the category of being beaten down due to mortgage market issues, but I do think there is a lot of long-term value here, given that mortgages are not a core focus for E*Trade. Let's take a look at why the stock has fallen so much. The shares are down a stunning 54% since June to $12 each.

In recent years E*Trade has started offering its core retail brokerage customers a wider array of financial products, including bank accounts, certificates of deposit, mortgages, and home equity loans. Not surprisingly, they are not immune to the mortgage market meltdown. Earlier this month, the company announced it was joining the ranks of those firms moving to shut down their wholesale mortgage business due to market conditions. That, along with a higher than expected provision for loan losses and some institutional brokerage restructuring costs will result in dramatically lower earnings for 2007. E*Trade now expect full year GAAP earnings per share of $1.10, down from their prior target of $1.60 per share.

So, to answer Carol's question, does ETFC represent a good contrarian value play? To me it appears that it does. With any contrarian investment idea, you will have to be patient, but buying a premier franchise for what could very well turn out to be less than 11 times trough earnings per share looks like a very attractive valuation.

There have been rumors of a merger with Ameritrade (AMTD), but I would not expect a deal in the short term as E*Trade gets their house in order. Ameritrade CEO Joe Moglia would love to do a deal, I'm sure, but at these prices, E*Trade is better suited fixing their issues and waiting for a more normalized profit picture before entertaining offers that maximize shareholder value. A deal does make sense at some point though, as online brokerage mergers have a ton of synergies that can be realized.

You may be curious if I have bought any ETFC shares yet. The answer is no, but not because I don't find it an attractive option. It is simply impossible to buy each and every attractive stock when managing fairly concentrated portfolios. There are a lot of financial stocks I think are too cheap, and I own some and don't own others. It's just a numbers game really. If you are looking for portfolio additions in that space, E*Trade is definitely one worth considering.

Full Disclosure: No positions in ETFC or AMTD at the time of writing

Bank of America Tries the Value Game with Countrywide Investment

In recent years Bank of America (BAC) CEO Ken Lewis has taken a decent amount of heat from shareholders who have seen his acquisition spending spree as a bit reckless, at least in terms of the prices he has been willing to pay. Deals for the likes of FleetBoston and MBNA have made sense strategically, but the huge premiums offered did little to convince BAC investors that they were getting a good deal. That, in part, has contributed to the fact that BAC has been afforded a low multiple in the marketplace, relative to other large banking institutions, in recent years.

I found it interesting, given the deals that Bank of America has done already this decade, when news crossed the wires that BAC was investing $2 billion in Countrywide Financial (CFC) in the form of convertible preferred stock. The terms of the special stock issuance (a 7.25% annual coupon, convertible into almost 20% of the company's common shares) were attractive, but that would be expected given the turbulence in the mortgage market right now. Countrywide is the largest independent mortgage lender in the nation, but still is facing short term funding concerns as the commercial paper market, a key tool for the company, has been drying up quickly in recent weeks.

With this deal, Lewis seems to be taking a contrarian approach. Obviously, I will not fault him for that given my investment strategy preference, but I just found it interesting that he had the patience to not bid for CFC when mortgage times were good (evidently the two firms have been talking about possible partnerships for years) and was able to pull the trigger when most others would be too afraid to do so.

Only time will tell if the Countrywide investment was a good one, but I like what Lewis did here. He gets CFC shares at $18 each if the company comes out of this mess a strong survivor, gets paid 7.25% per year while he waits for things to play out, and slides ahead in line of common stockholders to claim any assets should the worst case scenario unfold for the country's leading mortgage player. Evidently he thinks the possible bankruptcy rumors are unfounded, and if he's right, shareholders will have a tough time arguing with this latest deal.

Full Disclosure: Long shares of Bank of America at the time of writing

Capital One Shuts Down Mortgage Unit, Shifting Attention To More Profitable Areas

Those who have said the mortgage market's survivors will thrive due to fewer competitors are certainly right, but as the Capital One (COF) announcement last night shows, even those that could survive might not even try to do so. The company has decided to shut down its GreenPoint wholesale mortgage unit and cut 1,900 jobs as a result. The secondary mortgage market is to blame, as Capital One is one of many banks that can no longer sell mortgages at profitable prices to investors in order to fund new originations.

Despite the headlines that will undoubtedly result from this news, let's go through what it actually means for Capital One in dollar terms. GreenPoint was hardly in shambles before this announcement. After losing $12.6 million in Q1, the division actually earned a profit of $2.6 million in Q2, and management was assuming a breakeven year in 2007. During the second quarter, wholesale mortgages represented an immaterial 0.3% of Capital One's net income. For the first half of 2007, the unit's $10 million loss negatively impacted the company's earnings by only 0.7%.

Why the rush to shut down Greenpoint then? I was actually surprised they didn't halt new originations for a while to see how the secondary market shaped up in coming months, but given that there were 1,900 jobs within GreenPoint, and the odds of it generating any significant earnings in the short or intermediate term was essentially zero, it does make sense that Capital One management decided it was not a good use of resources to continue to fund the division. Why not just save a ton of money and cut the thing loose now?

Interestingly, even in 2006 when the mortgage market was great, GreenPoint only earned$138.5 million. That's a lot compared with this year, but even then it contributed only about $0.33 to Capital One's earnings of more than $7 per share. As you can see, even in good times GreenPoint might not be missed all that much, especially if the company can reallocate that money into higher return projects, which I suspect it can.

And keep in mind that this decision does not mean that Capital One is no longer in the mortgage market. They will still be loaning money to home buyers in the form of new mortgages and home equity loans through their local banking operations. They simply decided to halt the wholesale business in order to have more control over their loan operations.

All in all, this decision sets Capital One up nicely heading into 2008. The mortgage pressures on earnings will be lifted meaningfully, much of the merger related charges and other restructuring charges will be behind them (2007 was an integration and transition year), and the yield curve has steepened somewhat in recent weeks, so the company's margins should improve.

Given that Capital One is still slated to earn more than $7 per share this year before one-time special charges related to the GreenPoint closing and merger-related charges will decline in 2008 as cost savings are further realized, I would not be surprised to see an earnings per share number meaningfully above $8 next year, (perhaps even approaching $9). In addition, after the company's current $3 billion buyback is completed (it is more than half done), I would expect a new "bank-like" stock dividend put into place as well. In such a case, Capital One stock should no longer be anywhere near the current $66 quote.

Full Disclosure: Long shares of Capital One at the time of writing

What A Difference A Week Makes

I can hear the class action lawsuits being lined up already. On July 30th, mortgage REIT Luminent Mortgage Capital (LUM) issued a press release confirming that their 32 cent per share quarterly dividend would be paid as scheduled and not canceled, as many on Wall Street were predicting. The stock closed above $7 per share on the news. A week later on August 6th, they canceled the dividend and may be on the verge of bankruptcy, as evidenced by the stock's more than 85 percent drop to less than a buck.

Either Luminent's management team has no clue about their business, or there was some wishful thinking inside the company that will likely have to be defended in court. You often hear investors getting upset when companies fail to come out and deny Wall Street rumors that appear are untrue. However, in the case of Luminent it appears that even if a company does issue a statement it might not be accurate.

Now, it's true that the mortgage-backed security (MBS) market has dried up quickly, but given the market environment, if there was any chance at all that things at Luminent could have worsened that much in a week's time, the company really blew it by confirming the dividend. Just think how many people held on to the stock (or even bought) because of that press release.

If you own stock in any mortgage REIT, make sure you understand how quickly things can turn for them. Since they are forced pay out their income in dividends each quarter, they can't stockpile cash for tough times. As a result, when the margin calls come there is no money there to pay, causing the stocks to be worthless nearly overnight. New Century Financial might have been the first mortgage REIT to go under, but it wasn't the last, and Luminent won't be either. Many think NovaStar (NFI) might be next.

Full Disclosure: No positions in the companies mentioned at the time of writing

Fear is Driving Market Volatility

We find ourselves in a market that doesn't trust what companies are saying. Other than mortgage lenders and home builders, company conference calls this quarter have emphasized that things are not as bad as the markets are indicating. However, investors are scared and are selling indiscriminately, regardless of what companies are actually saying their exposure is. People just don't believe them.

Should they believe them? It depends. If a senior management figure gives their opinion as to when the dust will settle and how bad things will get, you might not want to simply take what they say at face value because, after all, it is simply an opinion. What you can take to the bank though are statistics that companies give you. What kind of exposure they have to mortgages and other types of credit. Remember, numbers don't lie, people do.

Fear is king right now. Somebody started a rumor that Beazer Homes (BZH) might go under. The stock fell 40% this morning within minutes. Some people might be bottom fishing in the home building sector, based in large part to their seemingly attractive price-to-book ratios. Beazer's book value is $38 but the stock traded as low as $8 today (it has since rebounded to $11 as investors bet the rumors are untrue).

This shows you that you can't always trust book values. Land values are often carried on the balance sheet at cost. However, the actual value of the land may be far below what a company paid for it. I don't know if BZH will go under or not, but I have not purchased any home builders and have no plans to do so. They are simply too hard to value, in my view, since stated book values might not be anywhere close to accurate.

Conversely, when Citigroup (C) tells investors that perceived risky loans make up only 5% of their exposure to the credit markets, you can put things into perspective. You can find out what percentage of the big banks' loan portfolios come from mortgages, or investment banking, or sub-prime borrowers. We don't know exactly how many of these loans will go bad, but you can make aggressive assumptions and still realize where the overreactions are in today's market environment.

Personally, I still stand by my opinion that the mortgage mess will not spill over into every other credit area. This is not to say that people aren't losing their houses when interest rates reset to levels above a threshold that they can afford on a monthly basis. They will lose their houses, the banks will be on the hook for the loans, housing inventories will rise, and lower home values will result. But will these consumers default on their credit card bills, student loan bills, and file bankruptcy as a result?

I don't think so, in the vast majority of cases. They will simply lose their house and be forced to move somewhere they can actually afford. Employment remains tight, so the ability of consumer to pay their everyday bills really shouldn't questioned at this point. I feel confident about this view because when I look at credit card payment statistics, for instance, people aren't defaulting at above-average rates.

If the sky was really falling, you would see deteriorating credit in every segment, not just housing related loans. As long as people keep their jobs, I am confident they will be able to make regular credit card and student loan payments, even if they are forced to move into a smaller house after their adjustable rate mortgage resets. After all, they should not have been in the other house to begin with.

Full Disclosure: No positions in the companies mentioned at the time of writing

Bank of America Dividend Yield Sits Far Above 30-Year Bond

Bank of America (BAC) is not a stock that has gotten my attention very often in recent years, but last week after the shares dropped to $47 and the company boosted its dividend yet again, I switching into the bullish camp (from neutral) for the stock.

BAC currently yields 5.4%, which is about 50 basis points above the 30-year treasury bond. That also equates to a trailing P/E of 10 times. I am very much aware that investors are spooked about mortgage lending and financial market exposure with the big banks, but compared with larger rivals JPMorgan Chase (JPM) and Citigroup (C), Bank of America has less exposure and should fare better should credit issues persist or get worse from here. Not only do they tend to avoid the very low end of the credit spectrum in the mortgage area, but a smaller portion of their profits come from financial markets than the others.

Given where the stock trades and the enormous dividend yield, I doubt the stock has big downside potential from here, and if the current worries prove to be overblown and BAC's earnings growth continues, you could get decent capital appreciation in addition to your more than 5% annual payout, which is better than the projected performance bonds are currently offering.

Full Disclosure: Long shares of BAC at the time of writing

Is It Time to Buy Bear Stearns?

Whenever a good company falls upon hard times that could very well just be temporary, it pays for value investors to take a look and see if Wall Street has overly punished the stock. After the hedge fund blowups at Bear Stearns (BSC) recently (they made some bad bets in the mortgage market), BSC stock has retreated more than 30 points from its highs, as the chart below shows.

Is the stock a bargain? Well, I compared it with the other big investment banking companies and I expected to see more of a discrepancy in the valuations than I found. The Big 5 (Bear along with Goldman, Lehman, Merrill, and Morgan) all trade right around 10 times forecasted earnings for 2007. As P/E multiples go, buyers of BSC aren't getting any discount compared with the likes of Goldman Sachs (GS). That didn't exactly get me excited about bottom fishing with Bear.

I also looked at a ratio called price-to-tangible book value. This measure is the same as price-to-book, but ignores intangible assets that can't be easily and quickly valued. Book value is perhaps the most important valuation metric for banks given that the vast majority of their assets are liquid financial instruments and all banks pretty much do the same things business-wise, for the most part.

On this measure Bear Stearns trades at a discount of 1.6 times net tangible assets. This compares with 3.1 times for Goldman and between 2.2 and 2.4 times for the other three major players in the industry. As you can see, investors are paying up for Goldman's superior track record and management. While Bear is cheaper, the stock would probably have to get down to 1.5 times book or less for me to really get excited about it as a contrarian play. That is not to say the discount won't narrow as the sub-prime issues subside, but 1.6 times book isn't a price that I feel like I absolutely need to jump at. It's cheap, especially relative to the other brokers, but not ridiculously cheap by any means.

Full Disclosure: No positions in any of the companies mentioned at the time of writing

Sam Zell Called a Top, Will Steve Schwarzman Do the Same with Blackstone?

What does this Blackstone Group (BX) IPO mean? That seems to be a question that everyone is trying to answer. There is no doubt that monumental events, such as Blackstone Group becoming the first private equity firm to go against its own culture and issue stock to the public, deserve to be analyzed on Wall Street. That does not mean this IPO has to mark the end of something, whether it be the boom in private equity led leveraged buyouts, mergers and acquisitions, or even the overall equity market. Still, there is evidence that sometimes these game-changing events can signal something.

Consider an example. Earlier this year Sam Zell, a brilliant contrarian investor and businessman, sold his crown jewel, commercial real estate giant Equity Office Properties (EOP). The sale of EOP signaled to many that Zell thought the price he could get was so large that he had to cash out given the huge bull market for commercial real estate. There would be no other reason for Zell to sell after all these years. It appeared that the market forced his hand and he quickly moved on to Tribune (TRB), a company at the opposite end of the exuberance spectrum.

What is amazing is how well Zell timed his exit from EOP. As you can see from the chart below, the iShares U.S. Real Estate Fund (IYR), an exchange traded fund serving as a benchmark for publicly traded REITs, peaked on February 2, 2007. The index has fallen sharply (17 percent) in the five months since. Now get this, shareholders of EOP voted to approve the sale of the company on that very same day, February 2nd. And who bought EOP in a deal valued at more than $39 billion including assumed debt? Steve Schwarzman's Blackstone Group.

Things like that (it's not the first time this has happened) are exactly why people are trying to figure out what to gleam, if anything, from the Blackstone IPO. From my perspective, I think it says something about the global boom in M&A activity, but not necessarily the broad equity market. I think the market on the whole is tied to the economy more than anything else, of which private equity is tiny sliver. More likely, Blackstone decided to go public because they thought their firm would receive a peak valuation right now, both because PE firms are in high demand and because profit levels are through the roof due to immense deal volumes.

As we have seen in recent weeks, even a small increase in interest rates can startle investors. As soon as borrowing costs go up, it becomes much harder to issue debt to buy equity, which is exactly the mechanism that is fueling most of this private equity boom. It doesn't matter if a 5.5% or 6.0% ten year bond rate is still pretty low in historical terms. It's not 4.5% and therefore deals will be harder to complete. Fewer deals mean less money for the likes of Blackstone.

It will be interesting to monitor how the M&A market unfolds in the near to intermediate term. Worldwide M&A deal volume in 2006 rose 38 percent to $3.8 trillion, shattering the previous record of $3.4 trillion set in 2000. The first quarter showed year-over-year growth, so 2007 is on pace for another record. It would not be surprising, especially given the eerie coincidence of the aforementioned sale of Equity Office Properties, if we are near the peak in M&A. If that is the case, it will be yet another reason why people are so quick to postulate what something like a Blackstone IPO really means for investors.

Full Disclosure: No positions in the companies mentioned

Prudential Shuts Down Research Department

One of the themes I have written about on this blog is the worthlessness of most sell side equity research. Most firms use their research departments to push stocks they have underwritten, and most investors understand that and discount their opinions as a result. Prudential (PRU) didn't believe in that model, and they were right. They decided a while back to put their equity research group out on its own, not joined at the hip with investment banking. I'm sure the thinking was that their research will carry more weight since it is unbiased, and therefore will be a valuable product.

We learned Wednesday that Prudential has shut down its equity research, sales and trading business known as Prudential Equity Group. This move speaks much more loudly than my comments ever could regarding the value (or lack thereof) of analyst research. If the product was valuable, people would buy it and it would make a profit. The fact that sell side research is given away for free to clients should tell you just how valuable it is.

I really do think it is that simple. The last study I read showed that analyst recommendations not only trailed the returns of the S&P 500 index, but did so with more volatility. Hardly a ringing endorsement. Expect other research departments to be shut down now that someone got the ball rolling by being the first.

Full Disclosure: No position in PRU at the time of writing

Eddie Lampert Buys Citigroup Stake Over Last 12 Months

Thanks to quarterly SEC filings, we learned Tuesday that Eddie Lampert, Chairman of Sears Holdings (SHLD) and General Partner of the hedge fund ESL Investments, has been buying shares of Citigroup (C) since early 2006. At the end of the first quarter Lampert had amassed more than 15 million shares worth about $800 million. The filings show that Lampert began buying Citigroup in the first quarter of 2006 at prices in the mid to high forties. Today shares are jumping 1.7 percent in the pre-market to more than $53 each.

The purchase makes sense given that Lampert is a value guy (Citi trades at a 10 P/E and yields 4%) and his hedge fund is big enough that large cap stocks are the only kinds of investments that he can really take a meaningful position in without buying an entire firm. I've seen various press accounts of the Citigroup purchase speculating that Lampert is planning on using his stake to put pressure on the company to make significant changes. However, those hoping for shareholder activism on ESL's part shouldn't get too excited. Although $800 million is a lot of money, Lampert now owns less than one half of one percent of Citigroup. Hardly enough to play the hedge fund activism card.

Full Disclosure: Long shares of Sears Holdings and no position in Citigroup at the time of writing