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WIKI ANALYSIS
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.
Business Overview
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.
Institutional Services
Schwab was one of the first companies to offer services, such as trading tools and marketing support, to independent investment advisors (IAs). 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. This division also includes Advisor Services and Corporate and Retirement Services.[1]
| 'Quarterly income data in millions | 2Q09[1] | |
|---|---|---|
| Net Revenue | $1,085 | |
| Operating Expenses | $750 | |
| Operating Income | $335 | |
| Net Income | $205 | |
Trends and Forces
Interest rates effect on SCHW's revenue drivers: fees and commissions
Schwab, like all asset management firms, generates revenue on assets by charging fees and gaining interest on the money it manages. Revenues based on commissions are susceptible to swings in the stock market, which are linked to general economic conditions. In a bearish market, the trading volume is relatively low and this in turn decreases revenue from commissions. On the flip side, an upturn in the market will increase trading volumes and hence commission revenue for E*Trade. In periods of economic uncertainty, trading volumes can spike significantly, reflecting investors' apprehension about the future of the economy.
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. Schwab generated approximately 349,700 DARTS in 2Q2009, compared to 299,400 in 2Q2008.[1] The 17% increase in DARTS resulted in commissions accounting for 21% of revenue in 2Q2009 versus 16% in 2Q2008.[1]
Commissions will become increasingly important to drive revenue due to mounting pressures from other discount brokers and retail banks. Schwab's average revenue earned per revenue trade has decreased 4% from $14.38 to $13.84 due to lower revenues per transaction and rising costs.[1] Given that fees and commissions account for the largest portion of revenue for its overall business and that those revenues are decreasing, Schwab has continued to emphasize "upselling" higher margin products, such as its own mutual funds, comprehensive financial consulting, and 401(k) management.
Furthermore, the Fed's interest rates directly affect broker-dealer's net interest revenues. The U.S. Federal Reserve's recent decisions to lower the target federal funds rate to 3% could hurt Schwab's net interest margins and put pressure on revenues. Schwab's interest rate revenues contributed 28% of revenues, 4% more than trading revenue.[1] This implies that Schwab should look to increase other revenue outlets since since interest income makes up such a large percentage of its total revenues.
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.
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).
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.
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.
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..
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%.
References
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