Why E*TRADE Could Head Even Lower

Shares of E*TRADE Financial (Nasdaq: ETFC  ) hit a 52-week low on Friday. Let's take a look at how it got there and see if cloudy skies are still in the forecast.

How it got here
E*TRADE, one of the poster stocks for reckless leveraging during the mortgage crisis, is back at a 52-week low again. Why am I not surprised?

In E*TRADE's quarterly filing last week, the brokerage reported generally downbeat results with a few glimmers of hope sprinkled here and there. Total revenue declined almost 13% year-over-year as daily average revenue trades dropped due to lower commissions and service charges. E*TRADE's all-important net interest margin (the spread by which E*TRADE makes money by borrowing at a low interest rate and lending at a higher rate) continued to contract, falling to 2.44% from 2.89% the year earlier.

Those aforementioned glimmers of hope include a record number of brokerage accounts (2.9 million), a 32% drop in net charge-offs (and a sizable drop of 8% sequentially), combined with 3% decrease year-on-year in operating expenses.

The overall trend, however, has been toward weakness in the brokerage sector. You'd think with CD and bond rates being as low as they are, people would turn toward stocks for income, but that apparently hasn't exactly been the case. Weaker macroeconomic headwinds and a lower interest-income environment have caused profits to drag across the sector. Last week Goldman Sachs (NYSE: GS  ) reported a 12% drop in profits as investment income plunged 81%. Morgan Stanley (NYSE: MS  ) fared equally as poorly with net interest loss of $161 million as tightening credit spreads caused it to widely miss Wall Street's projections.

How it stacks up
Let's see how E*TRADE compares to its peers.

ETFC Chart

ETFC data by YCharts

E*TRADE's performance over the past five years is so bad it's not even funny, and it reflects just how close the mortgage crisis came to forcing the company into bankruptcy protection. Brokerage peers TD AMERITRADE (NYSE: AMTD  ) and Charles Schwab (NYSE: SCHW  ) have performed considerably better.

Company

Price/Book

Forward P/E

5-Year Revenue CAGR

Dividend Yield

E*TRADE Financial 0.4 10.2 (3.2%) 0%
TD AMERITRADE 2.0 12.6 7.7% 1.5%
Charles Schwab 1.9 15.9 1.8% 1.9%

Sources: Morningstar and author's calculations. CAGR = compound annual growth rate.

Based on these figures, it's not too difficult to see why E*TRADE is underperforming its peers. Despite spending the last four-plus years tidying up its balance sheet, E*TRADE still has an unhealthy amount of poor-quality loans in its investment portfolio. With no dividend and a negative five-year growth rate, investors have packed up and left for greener pastures.

TD AMERITRADE is the big winner of this group, picking up a good majority of active traders in recent years and luring them in with competitive commission rates and new trading technologies. Although revenue fell just shy of 3% in the third quarter, its operating expenses declined and customers added $9.7 billion to their brokerage accounts during the quarter, representing a 9% annualized rate of increase.

Charles Schwab, historically known for attracting more affluent investors, actually bucked the trend this quarter and managed to increase net interest income over the previous year's figure. It also offers the best yield of this group at nearly 2%.

What's next
Now for the $64,000 question: What's next for E*TRADE Financial? The answer depends on whether it can continue to reduce operating expenses, offer unique trading tools that would entice traders to switch brokerage firms, and improve the credit quality of its loan portfolio (which is still not in great shape).

Our very own CAPS community gives the company a four-star rating (out of five), with 93.9% of members who've rated it expecting it to outperform. You may count me among the minority, as I placed a CAPScall of underperform on E*TRADE months ago that is currently up 39 points -- and I'm not looking to close this pick out just yet.

E*TRADE has a lot to prove to investors before I'd go so far as to call this company a good value. Its balance sheet is riddled with residual bad loans from the mortgage meltdown in 2008, and it's failing to attract active traders, which are the bread and butter of its commission-based business. E*TRADE needs to continue to focus on improving the credit quality of its loan portfolio, but as it does, it will likely keep losing market share to its peers. Maybe in a few years E*TRADE will be back in its prime, but for now, I have my suspicions it could head even lower.

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Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

Motley Fool newsletter services have recommended buying shares of Goldman Sachs, TD AMERITRADE, and Charles Schwab, as well as writing puts on TD AMERITRADE. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 23, 2012, at 7:31 PM, drchemy wrote:

    Why would you buy Ameritrade instead of etrade? Both companies face the same trading headwinds however E-trade has an additional $0.20 to $0.30 a share it is going to make from winding down its mortgage portfolio in the next 18 months that ameritrade is not. Even if their trading revenue remains flat for the next 2 years E-trade will make $1.00 a share in 2014 versus $0.70 this year. If ameritrades trading revenue remains flat they will make the same amount of money in 2014 as they did in 2012.

    There are a lot of good reasons not to buy brokerage stocks, however if you decide to invest in a brokerage stock E-trade is the best pick

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