Kristen French

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E*Trade Up Again on Strategy Praise

Kristen French

E*Trade(ET) rose for a fifth straight session Thursday after J.P. Morgan analyst Greg Smith said its recent acquisition binge should be about to pay off. Smith, who also cited an improving economic environment and an attractive valuation, raised his rating to buy from long-term buy Thursday and set a near-term price target of $12.

"At this point in time, we think E*Trade has reached a level of critical mass," wrote Smith in his note. "We think the heavy lifting in building its infrastructure is largely behind the company, which should cause margins to expand sharply without any significant revenue growth," he wrote. At the end of last year, the company had 4 million accounts and customer assets of $53 billion.

While the upgrade is not based on expectations for a surge in retail trading activity, Smith said investor confidence and retail trading volumes seem to have picked up in March. Continued strength in trading activity could be "the icing on the cake," he wrote.

E*Trade's shares lately were up 4% to $9.99. Since the end of February, the stock has surged 24% amid a wave of buying in the broader financial sector.

Big Gains

Analysts are looking for pretty solid earnings growth this year. In the fourth quarter, E*Trade reported that net income rose 250% to 7 cents a share from 2 cents a year earlier, and consensus estimates are calling for a 266% increase to 44 cents a share in 2002.

Adding new banking products and beefing up its retail accounts with a slew of recent acquisitions and partnerships, the Internet brokerage firm has begun successfully cross-selling its products to existing customers. That gives a boost to margins as the cost of attracting new customers declines. And with the purchase of market maker and specialist Dempsey last August, the company has internalized more of its order flow, cutting costs.

But Too Mixed?

Still, E*Trade's expansion and diversification could be a mixed blessing. Some have raised concerns about the risks of managing so many different business lines. And while E*Trade's increasing dependence on banking and mortgage products provides it with a more consistent earnings stream, it could also depress the company's longer-term growth rate.

While it hasn't run into any specific management or integration trouble with its most recent acquisitions, including Telebank, LoansDirect, Dempsey and WebStreet, Smith said, the risks never really go away. "There are ongoing risks to operating in multiple business lines: brokerage, banking and auto lending," said Smith. "They're all complex and highly regulated areas. But that's the same for any diversified financial institution," he said.

Meanwhile, E*Trade may not be at the end of its shopping spree. The company is reportedly interested in bidding on private retail brokerage Datek, whose 825,000 accounts some value at close to $1 billion. E*Trade has about $400 million in cash that it could apply to new acquisitions.

A Bargain

E*Trade still trades at a significant discount to Schwab(SCH) and Ameritrade(AMTD). Whereas E*Trade is currently valued around 21 times 2002 earnings estimates, Schwab is trading at 35 times 2002 estimtaes and Ameritrade is trading at 24 times 2002 estimates.

"While we do not think that E*Trade deserves Schwab's multiples, we also think that a 39% to 45% discount on estimated 2002 and 2003 earnings is too severe. Additionally, we think E*Trade should trade at a premium to Ameritrade given its more diversified model, greater scale, more flexible balance sheet and greater revenue stability," Smith said.