Citadel’s Exit Signals That E*Trade May Not Get Acquired Anytime Soon

Last week Kenneth Griffin, chief of Citadel, notified E*Trade Financial (NASDAQ:ETFC) that he does not wish to be reelected to the company’s board of directors. Citadel is one of the world’s largest hedge funds and was the largest investor in E*Trade until last month. Griffin was representing the hedge fund on E*Trade’s board since Citadel bailed out E*Trade during the mortgage crisis in 2007. This decision by Griffin follows Citadel’s announcement earlier this month that it will sell its entire stake in E*Trade.

It must be noted here that Griffin was until recently working very closely with E*Trade’s management. In 2011, he was reported to have been dissatisfied with E*Trade’s financial performance and management and pushed the firm to consider being acquired. ^[1] When the company rejected his proposal, he was said to be instrumental in getting the CEO fired. Observers hoped that the new CEO would be someone who was more open to considering a sale of the firm.

However, that does not seem to have happened and and we believe that Citadel’s exit from E*Trade might be an indication that the prospects of the brokerage firm’s acquisition by a competitor are bleak. Following are the reasons behind our rationale:

Reason 1: Citadel is ready to cut its ties

As the largest shareholder in E*Trade, Citadel was represented on E*Trade’s board. In terms of access to information, it had an advantage over other investors.

Had it believed that the company’s sale was likely, it would have held onto its investment in the hope of receiving a higher return in the form of share premium. Instead, Citadel sold all its stake for $11.28 a share on March 13, 2013 – the same day when E*Trade’s stock reached a new 52-week high. The price at which it sold its stake is about 24% above our price estimate for E*Trade.

This seems to suggest that Citadel believed that E*Trade’s stock had “maxed out” based on its fundamental valuation – which is also supported by our valuation – and an eventual sale of the business which could generate additional returns in the form of share premium was also unlikely.

See our full analysis for E*Trade Financial

Reason 2: Petrilli’s departure also signals low prospects of a deal

Frank J. Petrilli, chairman of E*Trade’s board of directors, has indicated his desire to relinquish his position and quit the board. This happened immediately after Citadel’s stake sale.

Petrilli is a seasoned financial executive and has held several positions of importance at TD Waterhouse in the past, including posts of Chief Executive and President. TD Waterhouse later merged with Ameritrade to form TD Ameritrade (NYSE:AMTD), one of the few players large enough to acquire E*Trade.

Petrilli is the person who could have orcestrated a deal with TD Ameritrade. He would have been indispensable for E*Trade if a sale of the company was even remotely on the cards. His departure strengthens our belief that E*Trade’s sale in unlikely for now.

Reason 3: There are very few potential buyers for E*Trade

The discount brokerage business is mature and competes in a consolidating industry with only a handful of big players such as Charles Schwab (NYSE:SCHW), TD Ameritrade and Fidelity Investments that are capable of buying out E*Trade. The basic offering — a trading platform, reseearch and technology — is similar at many of these large players and the only reason why one of them might acquire E*Trade is the consequential gain in market share. E*Trade serves almost 3 million brokerage accounts and this could be an attractive proposition for an acquirer who is looking to increase its customer base.

However, none of these players has shown enthusiasm in approaching E*Trade. Fidelity Inestments is a privately own company and has historically stayed away from acquisitions, preferring to grow organically instead. The other two firms, Charles Schwab and TD Ameritrade, have also until now given a pass on E*Trade due to a significant amount of risky assets on its balance sheet.

These risky assets are primarily in the form of mortgage loans on which E*Trade had bet heavily during the housing boom. They resulted in severe credit losses for the firm in the past several years and could cause more harm if the macroeconomic situation deteriorates. Although the brokerage firm is working towards reducing its ownership of these assets, it still has over $9 billion worth risky home equity assets and 1-4 family loans on its balance sheet. This will likely ensure that both Schwab and Ameritrade stay away from the company until there is more visibility on the future value of these assets.

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1. Citadel Pushes for ETrade Sale, WSJ, July 20, 2011 [↩]