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Charles Schwab (NASDAQ: SCHW) is one of the original brokerage firms to offer individual investors the opportunity to buy and trade equities at a discount. However, in recent years, Schwab has transformed itself from a discount broker focused on driving commissions into an asset management company, making money by charging a percentage of clients' assets as a fee for financial services. Today, Schwab manages $1.4 trillion in assets, making it the second largest retail broker by assets after Merrill Lynch (MER).
The driving force behind this transformation is the highly competitive discount broker market. Trading prices dropped significantly in the past years as competitors continuously slashed prices (Schwab's average price per trade went from $60 in 1998 to $14 in 2007). Bank of America and Wells Fargo--historically retail banks--entered the fray in late 2006 by offering free trades to many of its customers. This development may impact prices even further, as Bank of America alone holds relationships with half of all U.S. households.
Schwab used its transformation to establish a firm foothold into the mass affluent marketplace, a segment which represents 60% of the $25 trillion in U.S. retail investing assets. With this focus on mass affluent customers, Schwab has carved out a unique position between the discount and traditional brokers. The downside is that Schwab faces competition on multiple fronts, especially as it continues to expand into areas such as 401(k) management, mortgages, and full service financial consulting.
[edit] History & Customers
Charles Schwab started his namesake company in 1963 as a newsletter for investors and launched the brokerage business in 1975 following industry deregulation. Since then, Schwab has been a leader in the discount brokerage sector and notably pioneered online trading in 1996. Today, Schwab continues to make money from trading commissions and, increasingly, asset management by serving two major customer segments: individual investors and independent investment advisors (IAs).
[edit] Investor Services
Schwab Investor Services (SIS) provides retail brokerage and banking services to individual investors, as well as 401(k) and other retirement plan services to corporations. Its offerings range from self-directed research tools to full service financial consulting. The SIS business unit brings in about 75% of revenue and earnings for the overall company. The other 25% of earnings are brought by the remaining activities.
[edit] Institutional
Schwab was one of the first to offer services to IAs, providing them with trading tools, marketing support and other services. Schwab is currently the largest provider to independent investment advisors at more than double the market share of the next largest competitor. This customer segment accounts for approximately one quarter of revenues and earnings.
| Annual income data, in millions | 3M09[1] | |
|---|---|---|
| Net Revenue | $1,111 | |
| Operating Expenses | $756 | |
| Operating Income | $355 | |
| Net Income | $218 | |
[edit] Trends and Forces
[edit] Asset Accumulation
Schwab makes money primarily from two sources: assets and trades. While Schwab has historically been a discount brokerage firm focused on generating revenue from trade commissions, the company has gone through a fundamental shift. In 2007, trading commissions comprised only 17% of total revenue versus nearly 40% in 2002; asset-based revenues brought in the other 83% of 2007 revenue. This change places Schwab closer to the traditional brokerage firms focused on asset accumulation than the discount brokers that depend heavily on commissions from trade.
[edit] Mass Affluent Customers
The primary drivers of asset accumulation are the number of total clients and average assets per client. Schwab has leveraged both drivers in recent years by going after the mass affluent investors, an important customer segment that represents about 60% of the $25 trillion in U.S. retail investing assets. Mass affluent clients have between $100k and $1 million in investable assets and it will be important for Schwab to continue to pursue them in order to grow its asset base. Currently, Schwab holds about $120k for its average retail client and has aggressively marketed to this segment.
[edit] Fees
Schwab, like all asset management firms, generates revenue on assets by charging fees and gaining interest on the money it manages. In 2007, Schwab generated 83% of all revenue from assets and of that, around 57% came from management fees, with interest driving the remaining 43%.
Given that fees drive the largest portion of revenue for its overall business, Schwab has continued to emphasize "upselling" higher margin products such as its own mutual funds, comprehensive financial consulting, and 401(k) management. One key profit metric for brokerage firms is return on client assets (ROCA), which measures how much revenue companies make as a percent of its assets. Schwab's ROCA in 2006 was around 40 basis points (or bps), meaning that it made 4 cents of revenue for every $10 in client assets. Given their historical rate, there is room for Schwab to gain ground on traditional broker bank groups, which enjoy average ROCA around 65 bps due to higher margin offerings. As a point of reference, online discount brokerages average ROCA around 26 bps.
[edit] Interest
Schwab's interest revenue comes from investing portions of its assets in money market funds, whose returns are highly correlated to the federal funds rate. With the U.S. Federal Reserve's decisions to cut the target federal funds rate in 2007 and 2008 to 2%, Schwab's interest revenue could suffer, as its spread (or the difference between what it earns and what it pays out to customers) would become thinner.
In 2003, Schwab introduced a commercial bank offering to its individual investor segment in order to drive a higher overall interest spread. This operational bank allows Schwab to use deposits from investors' accounts to offer its clients mortgages, which generally offer a greater interest return than money market funds. The bank has become a growing part of the overall business and in Q4 of 2006, Schwab sourced 8% of overall revenues and 19% of pretax income from its bank.
[edit] Commissions
Fundamentally, commission revenues are a function of trading volume and price per trade. The key volume driver measured by brokerage firms is daily average revenue trades or DARTs—for instance, Schwab generated approximately 245,000 revenue trades every day in 2007, a 15% increase over the average for 2006. Due in large part to a general uptick in the equity markets in 2006 and 2007, Schwab's DARTs grew much faster than its average annual growth rate of 6% from 2001 to 2006.
However, price reductions have largely offset this large increase in DARTs, and revenue from trading commissions have remained flat overall from 2005 through 2007. Schwab has aggressively dropped its prices to remain competitive and from 1998 to 2007 as its average price decreased from $60 to $14 per trade. Further reductions in price are likely due to mounting pressures from other discount brokers and retail banks.
[edit] Equity Market Volatility
Market volatility and cycles affect Schwab's business as it does all brokerage firms. However, Schwab's shift to asset management allows it to be relatively less exposed to declines in transactions compared pure to discount brokers in case of a slowdown in the equity markets.
[edit] Comparison to Competitors
Before the 2007 Credit Crunch and 2008 Financial Crisis, SCHW had the second-largest market share behind Merrill Lynch (MER), who at the time owned over $25 trillion in retail assets. Now, SCHW competes against smaller brokers such as ETFC, AMTD, and RJF.
One recent trend that may have a significant impact on all discount brokers is the entrance of retail banks Bank of America (BAC) and Wells Fargo (WFC), both of which announced fee-free trading in late 2006. While these banks do not have robust trading offerings compared to discount brokers, Bank of America and Wells Fargo have a strong foothold in the financial services marketplace; Bank of America alone has banking relationships with 50 million—or half—of all households in the U.S..
[edit] Independent Investment Advisors
Schwab leads the niche institutional market with its Schwab Advisor Network, an offering which it pioneered and continues to lead. Today, Schwab has captured 23% of the estimated $2.6 billion in available IA assets. Its closest competitor Fidelity sits well behind at 8% with TD Ameritrade coming in third at 2%.
[edit] References
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