Citadel’s E*Trade Exit Still Seen Blocked by Mortgages: Real M&A

Citadel’s E*Trade Exit Still Seen Blocked by Mortgages
A colonnade frames the tower housing the headquarters of E*Trade Financial Corp. in New York. Photographer: JB Reed/Bloomberg

E*Trade Financial Corp.’s next chief executive officer could find the brokerage’s 51 percent discount to net assets isn’t enough to attract a buyer any time soon, as mortgages from the housing bubble impede a potential sale.

After the broker rejected putting the company up for sale in November, E*Trade fired CEO Steven Freiberg last week, pushing the shares up 8.1 percent amid optimism a deal will be reconsidered. The New York-based company is looking for a new leader as its stock trades at 0.49 times the value of E*Trade’s net assets, trailing rivals TD Ameritrade Holding Corp. and Charles Schwab Corp. that fetch double their book value, according to data compiled by Bloomberg.

The shares fell 52 percent in the past 18 months, even as E*Trade shrunk mortgages by 61 percent since 2007 and the biggest owner, Ken Griffin’s Citadel LLC, demanded a strategic review last year to address “catastrophic losses.” Nomura Holdings Inc. and Topeka Capital Markets say a takeover of the $2.48 billion company isn’t probable until loans are reduced further. While Credit Agricole SA estimates E*Trade would fetch at least $12 a share in a takeover, a 38 percent premium to yesterday’s price, the firm says a deal isn’t imminent.

“Eventually E*Trade will be sold,” Keith Murray, a New York-based analyst at Nomura, said in a telephone interview. Still, the CEO shift “doesn’t alter the timeline of a potential deal. That will be driven by the wind-down of the loan book and the comfort level that a potential suitor has with the risks of E*Trade.”

Talking Baby

“E*Trade is singularly focused on executing our business strategy of growing our core brokerage business, enhancing our overall risk profile and continuing to reduce our balance sheet,” Jaime Stein, a spokeswoman for E*Trade, said in an e-mailed statement in response to being asked whether the company is considering a sale.

Katie Spring, a spokeswoman for Chicago-based Citadel, said Griffin declined to comment.

E*Trade, the online brokerage known for advertisements featuring a talking baby, has suffered since the subprime-mortgage crisis from its expansion into home lending. The stock has tumbled 96 percent since the end of 2006, worse than every financial institution in the Standard & Poor’s 500 Index except American International Group Inc. The mortgage portfolio swelled to $27.4 billion at the end of 2007, a month after turmoil in credit markets forced E*Trade to pursue a $2.55 billion cash injection from Citadel.

Fifth CEO

Freiberg was E*Trade’s fifth chief executive officer since

2007. When he was named CEO in March 2010, analysts at Collins Stewart Inc. and Raymond James Financial Inc. said his appointment would reduce speculation E*Trade was up for sale. The next year, as the stock headed for a second straight annual decline, Citadel demanded E*Trade hire a financial adviser to review its options following “catastrophic losses.”

After E*Trade agreed to hire Morgan Stanley in July 2011, Citadel complained about the selection process and Goldman Sachs Group Inc. was brought in as a replacement. In November, E*Trade said its board, which included Citadel’s Griffin, unanimously agreed not to pursue a sale. E*Trade’s decision followed Schwab CEO Walt Bettinger’s statement that he wouldn’t buy companies with “balance sheet challenges.”

Greg Gable, a spokesman for Schwab, declined to comment on whether the company is interested in E*Trade.

While E*Trade has cut the principal balance for its home-equity loans and mortgages by 61 percent since the end of 2007, the company still had $10.7 billion of loans outstanding as of June 30. In its last annual report, E*Trade said: “there can be no assurance that our allowance for loan losses will be adequate if the residential real estate and credit markets deteriorate beyond our expectations.”

‘Primary Obstacle’

Mortgages have been “the primary obstacle for a transaction over the past couple of years, and that certainly is still an issue,” Michael Tarkan, a New York-based analyst at Topeka Capital, said in a phone interview. “As the portfolio continues to shrink, interest from an acquirer will pick up.”

E*Trade said Aug. 9 that Chairman Frank Petrilli will take over as interim CEO while the company seeks a permanent replacement for Freiberg. Given that Citadel’s Griffin is one of the board members leading the CEO search, they are likely to pick someone who is “more amenable” to an acquisition, said Matt Fischer, a New York-based analyst with Credit Agricole. Still, it may be another 12 months before investors get an offer, he said.

CEO Search

“It does take them one step closer to potentially doing a deal,” Fischer said in a phone interview. “But they’re in the process of finding a new CEO, so that doesn’t happen overnight. It’s going to take some time to find the right person who wants the job first.”

After plunging 50 percent in 2011, E*Trade shares had risen less than 1 percent this year before Freiberg’s departure was announced last week. Even after the subsequent 8.1 percent rally to $8.67 yesterday, the shares were still valued at a 51 percent discount to the company’s $5.08 billion in book value, or assets minus liabilities, data compiled by Bloomberg show.

The stock trades at about 18 times its earnings for the last 12 months, while Omaha, Nebraska-based TD Ameritrade and San Francisco-based Schwab have price-earnings ratios of 15 and 20, respectively, the data show. E*Trade shares fell 1.6 percent to $8.53 today, posting the biggest decline among financial companies in the Standard & Poor’s 500 Index.

Less Power

Faye Elliott, a McLean, Virginia-based analyst with BGB Securities Inc., says E*Trade’s negotiating power will be reduced the longer it waits to sell itself.

“E*Trade needs a buyer more than a buyer needs E*Trade,” she said in a phone interview. “You’re not going to offer a premium for a company that is just going to keep spiraling down. For an acquirer, it’s a great opportunity because they’re between a rock and a hard place. The next step is the price either comes back down or they’re taken out in relatively short order.”

E*Trade fired its CEO at a time when a slowdown in stock trading is hurting profits throughout the industry. Volume for exchange-listed securities has averaged 6.67 billion a day in 2012, down for a third straight year, according to data compiled by Bloomberg. Daily average revenue trades, or DARTs, at E*Trade have declined during the past three quarters versus a year earlier.

The industry slump means it’s more important for companies to merge, making E*Trade a more attractive target, Credit Agricole’s Fischer said.

Containing Fallout

“Trading volume being down, if anything, would be a reason to do a scale acquisition,” he said.

The company continues to try to contain the fallout from its mortgage business. In a plan submitted to the U.S. Federal Reserve and the Office of the Comptroller of the Currency, E*Trade said it plans to “strengthen our risk profile by reducing credit costs and the size of the balance sheet,” Chief Financial Officer Matthew Audette said on a conference call in July. As a result, the company “ceased any plans to offer new banking products to customers, including mortgages,” he said.

“E*Trade’s focus right now is more about how we clean up the capital structure,” Nomura’s Murray said. “If E*Trade can execute on what I call the two albatrosses -- the loan book and the capital structure -- and figure out a way to clean up the debt and continue to shrink the loan book, I think you’ll have more value get unlocked there.”

E*Trade’s $14.1 billion in debt is more than 10 times its earnings before interest, taxes, depreciation and amortization, according to data compiled by Bloomberg. TD Ameritrade’s leverage ratio is 3.1, while Schwab’s is 1.9.

Takeover Valuation

In a takeover, E*Trade could still fetch $12 to $18 a share, according to Credit Agricole’s Fischer. The likely buyer is TD Ameritrade because it would be able to cut the most costs and potentially partner with Toronto-Dominion Bank to manage the loans that would be inherited in a takeover, he said.

Kim Hillyer, a spokeswoman for TD Ameritrade, said the company doesn’t comment on market speculation, when asked whether it is interested in acquiring E*Trade.

“I don’t think a deal is imminent,” Rich Repetto, a New York-based analyst for Sandler O’Neill & Partners LP, said in a phone interview. “The loan portfolio needs to continue to wind down and the capital needs to be bolstered. I don’t think removing the CEO changes how acquirers look at the company. When you’re dealing with that much money, you need to evaluate it objectively.”

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