3 Key Risks Facing E*TRADE

How well do you really know E*TRADE Financial¬† (NASDAQ: ETFC  ) ? Do you know all the terrible things that could go wrong?

Crack open a company's annual report, and you'll find a handy section known simply as "risk factors." As the name suggests, the risk factors section is the section of the report where a company will lean in close, cup your ear, and say something to the tune of: "Hey, we know we're not perfect. In fact, there's a chance we'll do really, really badly. Here's how!"

Today, let's dig in and talk about three of the biggest risk factors facing E*TRADE.

"We have incurred significant losses in recent years and cannot assure that we will be profitable in the future."

In 2012, E*TRADE reported $113 million in net losses, which the company said was primarily due to the early extinguishing of some of its debt. In 2010, the $29 million loss was attributed to credit losses in its loan portfolio.

Simply put, these losses matter, for two reasons in particular:

  1. They weaken the company's financial position, making a highly competitive marketplace an even tougher place to survive.
  2. They could potentially spook customers -- something that's happened in the past.

However, there's a silver lining. If you dig into the company's income statement, you'll notice E*TRADE has increased its "income before other income (expense) and income tax expense (benefit)" -- in other words, income before all of the messy stuff -- the past three years running.

So, while no one can be sure the company will be profitable in the future, it seems as though the core retail franchise has stabilized -- which is a good sign.

"Many of our competitors have greater financial, technical, marketing and other resources."

"Market cap" is a quick and handy way to judge the size of a company. And compared to other online brokers, E*TRADE is about a third the size of TD AMERITRADE¬† (NASDAQ: AMTD  ) , and just a fifth the size of Charles Schwab (NYSE: SCHW  ) .

But it's not the size of the dog in the fight, right?! Well, in finance, sometimes it is.

Consider the $248 million TD AMERITRADE spent on advertising in 2012, compared to just $139 million for E*TRADE. Schwab reported $241 million in advertising and "market development."

In this business, advertising brings in the customers, and customers bring in the profits. So, ultimately, the big dog controls the green stuff, and the more a company has, the better it can promote its products, stay visible, be adaptable, and show resiliently. If a weak financial position for E*TRADE means that TD and Schwab can continue to outspend it on advertising, that's what the experts call "no bueno."

However, this isn't necessarily insurmountable. Obviously, it's ideal if E*TRADE can shore up its finances, but even in advance of that, the company could rely on playing the underdog and getting more creative with the spending power it has.

"We will continue to experience losses in our mortgage loan portfolio."

You have to appreciate the certainty here, and, well, the company should be certain with approximately half of the one- to four-family loans in its portfolio carrying a current loan-to-value ratio of greater than 100%.

This is significantly higher than Charles Schwab's portfolio. At the end of 2012, it showed current LTV ratios of 62% and 72% for the first mortgage and home equity line of credit portfolios, respectively.

However, yet again, there seems to be a silver lining. While $758 million in total charge-offs in 2012 may seem bad, it seems a little less catastrophic compared to the $1.4 billion in 2009. And though it's hard to say if this trend will continue, for now it's heading in the right direction.

The best-case scenario for E*TRADE would see the housing market continue to improve. That would help lower those 100%-plus LTVs and incent underwater homeowners to not default on their loans. Rinse and repeat, and the company may be able to get its focus back to its bread and butter.

And that's ultimately the takeaway: We learned that E*TRADE isn't particularly good at mortgage lending, but the company seems to have stabilized the crux of its business. So as long as E*TRADE continues to move away from making (bad) loans, and focuses on being a discount broker, the future of E*TRADE will look a lot brighter.

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  • Report this Comment On October 03, 2013, at 1:12 PM, 1929394958h wrote:

    "How well do you really know E*TRADE Financial (NASDAQ: ETFC ) ? Do you know all the terrible things that could go wrong?

    The real question is "How well do we really know Dave K?"

    Dave K. Investing Basics:

    Investing Experience - Low

    Risk Tolerance - Medium

    Investing Style - Just Starting

    So all you E-trade investors, you can take this story for what it's truly worth.

  • Report this Comment On October 03, 2013, at 2:12 PM, TMFPeoplesInvest wrote:

    You're absolutely right, "series of numbers with an h" I'm no expert, nor do I claim to be.

    I'm just a guy who reads annual reports.

    Hopefully, E*Trade investors are just as skeptical as you are and break out the annual report to see just how right or wrong I am.

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