Reality Check Time for This Online Broker

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Sometimes it makes sense for a company to expand into new markets, and sometimes it just ends up being a disaster. E*TRADE Financial (NASDAQ: ETFC) is an example of how it's better to stick to what you know best. This discount broker decided to begin offering loans and deposit accounts and this has been a constant drain on results. E*TRADE needs to realize that it has a strong brokerage that is being hidden by what looks like a terrible bank. The company needs to adjust its loan provision for the real potential for losses. In short, E*TRADE needs to face reality.

On an overall basis, E*TRADE's revenue decreased 3.35%, and the company posted a net loss of over $28 million. However, these results are a bit misleading, as this loss was due to a charge of over $50 million on early extinguishment of debt. Without this item, E*TRADE actually would've reported earnings-per-share of about $0.08 versus $0.24 last year. While this isn't a terrific result, it certainly is better than the reported loss. In addition, the company's balance sheet showed growth and E*TRADE's book value rose to $17.81 per-share. With shares trading at less than half of this book value, if the company can manage its brokerage division appropriately, and mitigate losses and its banking division, there may be opportunity for long-term investors. However, these are big “ifs” and investors need to make sure they understand the company's challenges.

In the brokerage business, E*TRADE still lags many of its peers, but is turning in respectable results. For instance, net new brokerage accounts increased by 5.3%, and new brokerage assets were up 7.4%. By point of comparison, TD Ameritrade (NYSE: AMTD) saw new client assets increase 11%, and The Charles Schwab Company (NYSE: SCHW) saw new accounts up 7%. An uncertain trading environment hurt transaction revenue at all three brokers, but E*TRADE reported relatively better results. The broker showed transaction revenue down 15.47%, versus a 18.73% decrease at TD Ameritrade, and a 18% decrease at Charles Schwab. As you can see, E*TRADE is performing relatively well in its core business of being a discount broker. The problem is, the company still has to deal with its banking division, which quite honestly is a mess.

E*TRADE Bank lost 7% of its banking accounts, and almost 14% of its loan portfolio on a year-over-year basis. In addition, the company saw total deposits up 10.08%, but net interest margin came in at just 2.28%. A contemporary of the E*TRADE is Capital One Financial (NYSE: COF), which offers bank accounts, credit cards, and brokerage services through its newly acquired Sharebuilder program. However, you couldn't ask for a more different situation between Capital One and E*TRADE. In the last quarter, Capital One showed loan growth up 56% and deposits up 66%. In addition, Capital One shows a much more significant net interest margin at 6.97%. Though Capital One's margin is higher than others because of the company's large credit card portfolio, there are multiple banks that show net interest margins of between 3.5% and 4%. The fact that E*TRADE is only managing a net interest margin of just over 2% shows that the company is offering loans at very low rates, and is also paying a higher than average rate to its depositors. If E*TRADE had good quality loans and very good credit ratios, I wouldn't worry quite as much about their net interest margin. However, this is far from the truth, as the company's credit quality is downright scary.

There are a few different things that concern me about E*TRADE's credit quality. First, is the fact that the company has about 51% of its portfolio in 1-4 family lending, yet this normally safer type of loan shows a 90+ day past due percentage of over 7%. Considering that many large banks show a 90 day past due percentage of 2% or less, E*TRADE apparently got into a market that it had no business entering. What is equally disconcerting is, the company's average loan yield is just 4.05%. You would expect with such a high past due percentage, that E*TRADE would have priced its loans higher relative to their level of risk. This portfolio of both low yield loans with high delinquencies presents a real problem in winding down these assets. In an interesting twist, the company's home-equity-based lending shows a past due percentage of 2.39%. Since home-equity loans usually are higher risk, it's interesting that the past due numbers aren't higher for this unit. The bad news for investors is looking at the company's loan-loss provision says the company expects things to get worse before they get better. In the case of E*TRADE's 1-4 family portfolio, the company shows loans of over $400 million that are at least 90 days past due, versus a provision of $206 million to cover potential losses. For most financial institutions a coverage ratio of 100% is appropriate. Unless the company plans on stealing provision from its home equity portfolio, E*TRADE may need to set aside more money for potential losses, which could hurt financial results in the future. In the home-equity unit, the amount of 90+ days past due loans is about $100 million, versus the company has provisioned over $260 million for potential losses. My concern is, that E*TRADE is suggesting that it could have higher losses in its home-equity division than investors currently expect. This seems to be the only logical reason the company would have provision greater than 200% compared to its 90 day past due balances. As you can see, the company has big challenges in front of it, and at this point there seem to be better alternatives elsewhere.

Of the companies we've looked at, if investors are looking for a good play on a discount broker, TD Ameritrade would seem to be the best option. The company offers a yield over 2.3%, and analysts expect earnings growth of over 12% in the next few years. In addition, the company recently increased its dividend by an impressive 50%. When it comes to Charles Schwab, the stock looks too expensive at the current time. Investors are paying over 17 times forward earnings for a company expected to grow at less than 8%. While the company might do well, this high premium means the stock could fall hard if the company's results disappoint. Investors looking for a more traditional banking play with a popular discount brokerage built in, could consider Capital One. While Capital One isn't expected to grow as fast as either TD Ameritrade or E*TRADE, the company sells for a cheaper P/E ratio at just over eight times forward projections. Capital One is also benefiting from increased credit card usage, and recent acquisitions have substantially added to both loan and deposit growth. At the present time, either TD Ameritrade or Capital One seem to offer investors a better opportunity than E*TRADE. I would suggest potential buyers avoid E*TRADE shares until the company clears up its banking troubles.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend TD AMERITRADE Holding and Charles Schwab. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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