E-Trade Financial Corporation: Big Buyback Masks Potential Concerns – E*TRADE Financial Corporation (NASDAQ:ETFC)


E-Trade Financial Corporation (ETFC), in its second quarter earnings conference call, announced a $1.5 billion share repurchase program. Considering the $11.1 billion market capitalization of ETFC as of 18 July 2019, the share buyback program represents approximately 14% of total market capitalization. Such a large transfer of resources to shareholders was welcomed by the market as shares closed higher by 1.73% day on day.

(Source: ETFC Ticker page on SA)

However, we think that investors should focus on more than the announced buyback. Our analysis of the second quarter results affirm our negative view of ETFC at its current price. In this article we will highlight some of the issues we think should give ETFC shareholders or prospective investors pause.

‘Temporary’ losses in the investment book

ETFC management disclosed key financial metrics for the second quarter in the press released. We have summarized the headline figures in the table below. Note that the headline figures for the second quarter are all below those for the prior quarter and the prior year. Management attributes this deterioration to a one-time loss on sale of investment securities as part of its balance sheet reorganization.

USD 2Q19 1Q19 2Q18
Revenues (millions) 685 755 710
Net income (millions) 219 290 250
Diluted earnings (per share) (EPS) 0.90 1.09 0.95

(Source: ETFC 2Q19 earnings press release)

Here is Chief Financial Officer (NASDAQ:CFO) Chad E. Turner in the second quarter earnings call:

For the quarter, we reported net income available to common shareholders of $219 million or $0.90 per diluted share on net revenues of $685 million. Included in the quarter was $80 million pretax loss on securities or $0.24 per share impact related to the sale of $4.5 billion of lower yielding investment securities in order to reduce our balance sheet and free capital.

We find the loss on investments peculiar given the decline in the benchmark interest rates over the second quarter. As seen in the chart below, the U.S. 10 Year Treasury Note yield has actually fallen from well above 2.5% in the first quarter of 2019 to around 2.0% by the end of the second quarter. The decline in yields should have benefited most fixed income-based securities.

(Source: MarketWatch)

We cross-referenced the level of unrealized losses in ETFC’s balance sheet and found that as of the end of the first quarter of 2019 (which is the latest information available since the 10-Q for the second quarter has not been filed yet) there is $200 million worth of losses in the available-for-sale (AFS) investment book.

(Source: ETFC 1Q19 10-Q)

Our concern is that the remaining unrealized losses in the AFS investment book are actually non-temporary (as defined by U.S. generally accepted accounting principles) and should be recognized as a loss in the income statement rather than as a direct charge to equity in the balance sheet.

(Source: ETFC 2018 10-K)

In fact, Richard Henry Repetto from Sandler O’Neill+ Partners asked a question related to this topic during the earnings call. Chief Operating Officer (NYSE:COO) Michael A. Pizzi responded:

So you could think of them as investments that we made quite some time ago that we’ve been holding that have been paying down a bit, but we still had quite a number of lower yielding securities on the book. When we look at that securities yield versus the sort of capital that we’re holding, looking relative to the loss that we took, it became really quite clear that selling these to a — selling the lower yielding securities to accelerate the amount of capital return is clearly sort of in the best interest of shareholders if we look at it from an overall EPS and ROE perspective. In terms of kind of further opportunity, there is still some securities in the book that are still relatively lower yields, but there would be a population higher than this population that we sold.

We are not challenging the existence of higher-yielding investments in ETFC’s AFS investment portfolio. Instead we wonder whether the non-temporary classification for these unrealized losses are appropriate. We also recognize the wide degree of discretion management has in determining the accounting treatment for this event (and the degree of subjectivity involved in these issues).

Finally, we want to highlight that the impact of valuation changes in the income statement affect management compensation; adjustments to net income and return on equity key performance indicators are primarily limited to after-tax effects of goodwill and provision for loan losses. Hence, there is a real financial incentive for management to maintain the temporary status for unrealized losses.

‘Commitment’ to greater than $7 earnings per share by 2023

We note that Chief Executive Officer (NYSE:CEO) Karl A. Roessner reaffirmed ETFC’s commitment to the long-term EPS target of greater than $7 per share during the second quarter earnings call.

Recall that we discussed this target in one of our first article regarding ETFC. Note that achieving the $7 per share EPS was partially hinged on the Fed funds rate. Management assumed that there would be no changes in the policy rate until 2023. We said in our article that we found the Fed’s dovish stance has put management’s aspirations at risk.

(Source: ETFC 1Q19 earnings presentation)

Since then management has converged to our perspective and has retooled its assumptions to account for two rate cuts totaling 50 bps in 2019 and no further policy action until 2023 (as seen in the chart below). Despite assuming a significant decline in the fed funds rate (which will likely result in a meaningful net interest margin compression), ETFC maintains its EPS target.

(Source: ETFC 2Q19 earnings presentation)

We are skeptical of how management reconciles a lower interest rate environment with double-digit earnings growth all the way to 2023.

First, the market is already expecting a more aggressive decline in the Fed funds rate. Here is rate strategist Jon Hill speaking to CNBC:

The futures market is pricing in 100% odds of a quarter-point cut at the Fed’s next meeting and two more this year.

In fact, the futures market is pricing in a 50% chance of a 50 bps cut in July.

(Source: CME FedWatch Tool)

Second, even if we assume that the Fed only cuts rates by 50 bps until 2023, the impact to EFTC could already be substantial. According to the company’s own scenario analysis, it stands to lose $88 million per year in earnings for a 50 bps cut in rates (according to the 2018 10-K). A summary of the company’s interest rate scenario analysis is in the graphic below.

(Source: ETFC 2018 10-K)

The sensitivity analysis of ETFC can be found in the table below. Note that $88 million is roughly 10% of the annualized 2Q19 net income of $876 million (i.e., $219 million 2Q19 net income multiplied by four). ETFC would have to achieve the mid-teens annual earnings growth on top of an initial decline of 10% resulting from a change in the interest rate environment.

(Source: ETFC 2018 10-K)

For more information about ETFC’s interest rate sensitivity, refer to our prior article here. In there we highlight that 67% of the company’s trailing 12-month net revenues (e.g., net interest income and off-balance sheet sweep revenues) are directly affected by movement in interest rates. The rest of the business (which includes revenues from commissions and order flow business) comprises just 33% of the remaining revenues.

Beyond management’s expectations of the extent net interest margin compression, we are also wary of their contradictory statements with respect to the relationship between the balance sheet and achieving the earnings per share target. Note that in the revised guidance regarding the EPS target, one of the components of revenue growth is balance sheet growth. Essentially we expect this to mean that management will continue to grow customer balances in both sweep and savings and deploy those to interest-earning assets.

However, it seems that management has shifted the strategy towards reducing the size of the balance sheet. Here is CEO Karl A. Roessner during the second quarter earnings call:

On the capital front, as of the end of the second quarter, we had completed more than $800 million of our current $1 billion buyback authorization, and we plan to continue our robust pace of capital return, which is particularly accretive to EPS at the current stock price. By leveraging our third-party sweep deposit arrangement and shifting deposits off-balance sheet, we can continue to grow our franchise and retain future earnings power from deposit growth, while directing capital to share repurchases today at extremely attractive valuations. We will take a fluid approach to the allocation of capital based on the prevailing economic environment and the value of our shares.

Shifting deposits off-balance sheet means that cash sweep will be deployed to third party banks rather than in investment securities, loans, or other receivables in ETFC’s balance sheet. This feels contrary to management’s own guidance with respect to achieving the EPS target.

Brennan Hawken from UBS Investment Bank posed a question in line with our own during the second quarter earnings call:

Okay. And then on the long-term earnings target, it’s kind of hard to know this with precision, because — but sort of eyeballing it here, when I look at the revenue growth component, we have that subset underneath, it looks like balance sheet growth as a contributor to revenue growth here didn’t change much from your prior expectations. And so curious about how that squares with this plan to shift the deposits to third-party banks and how it squares with your assumptions around the NIM guidance where I believe you said that all of the deposit growth would be off-balance sheet in that assumption?

To which CFO Chad E. Turner responds:

When you look over the long term, which is what’s on the greater than $7 slide, we believe there is value to having a balance sheet and that over time growing deposits on our balance sheet does provide the best source of value. That said, we would evaluate the environment in any given period over the 5-year horizon to make sure we’re making that decision correctly. But I would note that on the long-term earnings slide, with the multiples expanding, for example, in that illustration, you would be growing your balance sheet versus buying back stock over the entire horizon.

We recognize that deciding between to buy back shares and to expand the balance sheet is very much dependent on the macroeconomic and operating environment. However, we think that achieving the $7 per share by 2023 would require a meaningful contribution from both share buybacks and balance sheet expansion rather than just having one or the other. Accounting for the incoming net interest margin compression just makes this expectation more valid.

We have generally remained skeptical of ETFC achieving the $7 EPS target by 2023. The developments in the second quarter have only nudged us towards the more skeptical camp rather than the less.

Valuation

We now estimate a fair value and a target buy price for ETFC based on the second quarter earnings, management’s comments, and our own views. In particular, we will be using a justified price to book valuation methodology. It is an approach we feel comfortable using for financial services companies. We used a similar valuation methodology in this article pertaining to Raymond James Financial (RJF).

Note that this approach was detailed in-depth in the Equities section of the Chartered Financial Analyst (NASDAQ:CFA) Level II materials. The summarized version of this can be found in The CFA Glossary Blogspot. It is essentially an implication of the Dividend Discount Model as seen in the derivation below:

(Source: CFA Glossary Blogspot)

We prefer this valuation method as financial services companies are primarily constrained by capital. More capital retained by the entity will almost always result in more earnings. Thus, we are less inclined to use an earning-based valuation model. Nonetheless, we present one here as well to provide an alternative valuation model and to create a range of valuation estimates for our readers’ appreciation.

First, we estimate the run-rate adjusted net income to common shareholders. We take the trailing twelve months’ net income of the company (from the second quarter earnings press release) and adjust it for the reversal of loan loss reserves and the loss on extinguishment of debt. We model a decline in earnings from a 50 bps decline in interest rates (amounting to $88 million as estimated by the company). The resulting figure is our run-rate adjusted net income to common (shareholders).

USD millions Source / Calculation
2Q19 TTM net income to common 1,020.00 2Q19 Press release
Provision (reversal) of loan losses – 66.00 2Q19 Press release
Loss on extinguishment of debt 4.00 2Q19 Press release
2Q19 TTM adjusted net income to common 958.00 2Q19 Press release
Decline in cash sweep income 88.00 Author assumption
Run-rate adjusted net income to common 870.00 Adj. net income less cash sweep decline

(Source: ETFC disclosures; Author)

Next we divide the run-rate adjusted net income to common by the end-2018 shareholders’ equity to estimate the run-rate return on equity. We assume a 2% risk-free rate (as given by the current yield of the ten-year U.S. Treasury note), a 6% implied equity risk premium based on the research of Professor Aswath Damodaran, and a market beta of 1.0 which we feel is appropriate for financial services companies. Justified price to book is estimated by divided the difference of the return on equity and sustainable growth rate and the difference of the cost of equity and sustainable growth rate

Run-rate adjusted net income to common 870.00 Adj. net income less cash sweep decline
End-18 shareholders’ equity 6,562.00 2Q19 Press release
Run-rate return on equity 13.26% Run-rate adjusted net income divided by shareholders equity
Cost of equity 8% Author assumption
Sustainable growth rate 2% Author assumption
Justified Price to Book 1.88
2Q19 shareholders’ equity 6,870.00 2Q19 Press release
2Q19 book value per share 27.37 Shareholders’ equity divided by diluted shares outstanding
Target price 51.35
Upside 10%
LTM PE at target price 13.46

(Source: ETFC disclosures; Author calculations)

Alternatively, we can calculate a target price for end-2023 using an earning-based methodology to triangulate our valuation from the justified price-to-book approach.

Run-rate adjusted net income to common 870.00 Adj. net income less cash sweep decline
Revenue growth 5% ETFC management target
Operating margin growth 3% ETFC management target
Total earnings growth 8% Revenue + operating margin growth
Adjusted net income to common ’22 1,095.95 Run-rate adj. net income * (1 + total earnings growth)^3
2Q19 diluted shares outstanding 251.05 2Q19 Press release
Announced buybacks (USD millions) 1,657.00 Announced and remaining buybacks from prior program
Assumed price of buyback (USD per share) 46.51 Author assumption
Buybacks in shares 35.63 Announced buybacks / assumed buyback price
Diluted shares outstanding ’22 215.42 2Q19 diluted shares less buybacks
Diluted earnigs per share ’22 5.09 Adj. net income ’22 / diluted shares outstanding ’22
LTM PE Multiple assumption 12.00 Author assumption
Target price ’22 61.05 Diluted earnings per share ’22 * LTM PE multiple

(Source: ETFC disclosures; Author)

We have downshifted the revenue growth assumption to 5% from our prior assumption of 7% (as per management’s revised guidance). These figures are very generous with respect to giving managers the benefit of the doubt on the execution side of the business. Should management fail to generate the 5% revenue growth and the 3% operating margins growth over the next three to five years then the share price may fall far below our estimates.

Another risk would be a more aggressive reduction in the Fed funds rate. Recall that every 50 bps reduction results in a decline in earnings of $88 million as per management’s calculations.

Finally for the earnings-based approach, we calculate a target buy price given a 15% rate of return hurdle over the next three years. As seen in the table below, our target buy price for ETFC is at most $40.14 per share

Target price ’22 61.05 Diluted earnings per share ’22 * LTM PE multiple
Target three-year rate of return 15% Author assumption
Implied buy price 40.14 Target price ’22 / (1 + target ratet rate of return)^3
2Q19 adj. diluted earnings per share 3.82 2Q19 TTM adj. net income / 2Q19 diluted shares outstanding
LTM PE at implied buy price 10.5 Implied buy price / 2Q19 TTM adj. diluted EPS
LTM PE at current price 12.2 Current price / 2Q19 TTM adj. diluted EPS

(Source: ETFC disclosures; Author)

We consider 15% as the target return threshold for a buy recommendation. ETFC’s expected return at the target price is only 10%. This estimate does not even account for execution and interest rate risks (i.e., Fed funds rate declines by more than 50 bps). We find that ETFC has insufficient margin of safety for a long-term investment. Consequently we maintain our sell recommendation for ETFC.

ETFC is priced at a relative discount compared to the other companies in our coverage in which we use a justified price to book valuation. We think that ETFC faces a similar set of market risks to RFJ but has a weaker return profile, and hence, a lower valuation. ETFC and RJF carry a balance sheet exposure to agency securities and loans (with a slightly different mix reflective of the size of their respective balance sheets).

On the other hand, ETFC has a lower risk profile compared to SYF but its return profile is insufficient to close the gap with Synchrony Financial (SYF). SYF is primarily exposed to credit card, personal, and other consumer loans whereas ETFC is exposed to agency securities, real estate loans, and margin receivables.

Company SYF ETFC RJF
Return on equity 22% 13% 20%
Cost of equity 10% 8% 8%
Sustainable growth rate 2% 2% 2%
Justified price to book 2.67 1.88 3.08

(Source: Author)

Conclusion

We applaud the massive capital return program announced by the company during the second quarter earnings call.

However, we think that investors should also consider the factors we’ve highlighted in this article: the potential loses in the investment book and the risks relating to management’s 2023 EPS target.

ETFC’s current price is too high relative to our price target estimate and our return requirements. We think that investors should avoid this stock until a better price presents itself or the fundamentals shift to high gear.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.





Source link