(Bloomberg News) E*Trade Financial Corp. shareholders may only recoup 20 percent of their losses even if Citadel LLC is successful in pushing for a takeover.
Citadel, the online brokerage's largest investor, called on E*Trade last week to explore a sale, which may fetch as much as $21 a share, Sandler O'Neill & Partners LP said. A bid at that level would mark a 62 percent premium to the stock price prior to a July 20 letter from billionaire Ken Griffin's hedge fund. Investors would still only recover 20 percent of their losses since November 2007, when Citadel injected cash into E*Trade to help avert bankruptcy, according to data compiled by Bloomberg.
While Citadel has made a profit on its investment, according to a person familiar with the matter, New York-based E*Trade has underperformed the Standard & Poor's 500 Index by 70 percentage points as customer defaults on home loans led to net losses of $3.5 billion. Potential buyers TD Ameritrade Holding Corp. and Charles Schwab Corp. may be deterred by the mortgage portfolio and a 21 percent stock gain since Citadel tried to drum up a bidding war, Raymond James Financial Inc. said.
"Investors may not necessarily be looking to break even. They're just looking to get something at this point," Matt McCormick, a money manager at Cincinnati-based Bahl & Gaynor Inc., which oversees $4 billion, said in a July 22 telephone interview. Still, "anybody willing to buy mortgage assets better have a strong stomach," he said.
Citadel in the July 20 letter called on E*Trade Chief Executive Officer Steven Freiberg to hire a bank to review strategic alternatives and take immediate action to maximize shareholder value after "catastrophic losses." The online retail brokerage should also hold a special meeting and remove two directors, according to the letter.
"We believe a sale of the company could be achieved promptly and generate significantly higher shareholder value, avoiding the risks of operating as an independent company lacking leadership and financial capabilities," Citadel wrote. "It is time for E*Trade's shareholders to come first."
E*Trade responded July 22, forming a special committee of independent directors, which recommended hiring Morgan Stanley of New York to review strategic alternatives. The company said New York-based JPMorgan Chase & Co. completed a "thorough review" in the fourth quarter, and the board determined that executing the business plan was a better alternative to a sale at that time. E*Trade said it won't hold a special meeting.
Susan Hickey, a spokeswoman for E*Trade, declined to comment on deal speculation beyond the company's statement. The shares climbed 3.6 percent to $16.21 at 9:45 a.m. in New York.
Citadel again called for a special shareholders meeting, to be held 10 days to 60 days after E*Trade receives notice from holders of 10 percent of the company, according to a July 22 regulatory filing received today.
E*Trade, the fourth-largest U.S. retail brokerage by client assets, has a fair value between $18 and $21 a share in an acquisition, said Richard Repetto, a New York-based analyst at Sandler O'Neill. Matt Fischer, an analyst at Credit Agricole SA in New York, estimates a price between $11 and $18, based on revenue and earnings multiples for deals since 1996.
"The thesis by Citadel is for E*Trade to sell at a reasonable change of control premium and that it's going to be better than the prospects of it being a standalone company," Repetto said in a July 22 telephone interview. "A lot of things will have to go right for them to be successful in getting a sale."
Citadel pumped $2.55 billion into E*Trade after the company's holdings of home loans and asset-backed securities caused customers to pull their cash from the online bank and brokerage. Citadel took a 17 percent stake in E*Trade and bought about $800 million of securities linked to residential and commercial mortgages for 27 cents on the dollar after rising defaults on U.S. home loans by subprime borrowers helped freeze credit markets from August 2007.
"That loan portfolio is a huge deterrent for an acquisition," Credit Agricole's Fischer said in a July 22 telephone interview. "Their feet are now held to the fire. They can't kick the can down the road anymore and ask investors to wait for the loan portfolio to roll off or take provisions."
After the hedge fund's investment in November 2007, E*Trade fell $39.85, or 75 percent, to $12.95 on July 19, the day before Citadel's letter was made public. Stock prices have been adjusted to account for the company's reverse split last year, in which every 10 shares were swapped for one.
While an acquisition at $21 a share would represent a 62 percent premium to the July 19 closing price, shareholders would only make an additional $8.05. That means investors who have held the stock since November 2007 would only recoup 20 percent of their losses, data compiled by Bloomberg show.
Citadel exchanged bonds it purchased for convertible bonds that became common stock. While the hedge-fund operator's holdings topped 33 percent in 2009, its investment in E*Trade is now down to a 9.8 percent equity stake.
The Chicago-based firm made money on its investment in E*Trade, according to a person familiar with the situation, who declined to be identified because the information is private. Katie Spring, a spokeswoman for Citadel, declined to comment on the profitability of the hedge fund's E*Trade investment.
E*Trade said in its statement last week Citadel made "a substantial profit" selling debt and equity securities in E*Trade in the last 18 months, including the sale of about 51 million shares in the past five months for about $831 million.
Citadel agreed in January 2008 to be a passive investor in E*Trade so that it could increase its stake in the company beyond 10 percent. The firm's founder, Griffin, 42, joined E*Trade's board in June 2009.
Charles Schwab, the biggest independent U.S. brokerage by assets, and TD Ameritrade, the third largest, are the most likely buyers, according to Sandler O'Neill's Repetto and Patrick O'Shaughnessy, an analyst for Raymond James in Chicago. TD Ameritrade has been increasing its cash holdings and has a history of deal making, according to O'Shaughnessy. Greg Gable, a spokesman for San Francisco-based Charles Schwab, declined to comment on deal speculation regarding E*Trade.
Directors of TD Ameritrade plan to discuss at a meeting tomorrow the possibility of acquiring E*Trade, the Wall Street Journal said, citing people familiar with the matter.
"It has long been our practice to not comment on any rumor or speculation in the marketplace," said Kim Hillyer, a spokeswoman for TD Ameritrade. "Our board of directors is meeting this week for their regularly scheduled quarterly meeting. Strategic matters are discussed by the board on a regular basis, but it would be inappropriate for me to comment further on specific topics -- hypothetical or otherwise."
TD Ameritrade rejected an offer from E*Trade in 2005. Instead, Ameritrade Holding Corp., as it was then called, bought the TD Waterhouse USA unit of Canada's Toronto-Dominion Bank.
Charles Schwab, founder and chairman of the namesake firm, said in May 2007 that while he would welcome an opportunity to buy TD Ameritrade or E*Trade, he wouldn't pay the prices at the time. E*Trade has fallen 93 percent since then, after adjusting for the reverse stock split, data compiled by Bloomberg show.
Walt Bettinger, CEO of Charles Schwab, said at an analyst meeting July 22 that he understands "the dynamics around E*Trade and the consolidation opportunity and the opportunity to potentially derive value from reducing expenses."
"At the same time, there are many issues around that that we are looking at and would always look at with respect to any possible transaction," Bettinger said, according to a transcript. "What's the purchase price of the transaction, what are the potential capital holes that would need to be filled under purchase accounting?"
'A Terrible Story'
E*Trade has posted total net losses of $3.5 billion since Citadel's investment in the fourth quarter of 2007. The shares slumped 70 percent since then, the worst performance among the 10 U.S. companies in the NYSE Arca Securities Broker/Dealer Index. Including dividends, the S&P 500 slipped 0.8 percent in the same period, the data show.
"E*Trade, since before the financial crisis, has been a terrible story," Ed Ditmire, an analyst with Macquarie Group Ltd. in New York, said in a telephone interview July 22. "This company had exposure to the mortgage market before the cataclysmic market crash."
While E*Trade posted net losses in 11 straight quarters through the period ended in March 2010, the company has reported profits in four of the last five quarters as provisions for loan defaults declined, data compiled by Bloomberg show. The stock's 21 percent surge to $15.64 since the disclosure of Citadel's letter has made a takeover more expensive.
"E*Trade had a great franchise, but there's not a huge demand for it now, and the markets are volatile," Bahl & Gaynor's McCormick said. "Any potential buyer would have to view it with a very skeptical eye."