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Schwab needs a deal, too
A day after Ameritrade agrees to buy TD Waterhouse, investors are wondering what Charles Schwab will do. It may need to find its own partner.
By Robert Walberg
Ameritrade's (AMTD, news, msgs) decision to spurn a takeover offer from E*Trade Financial (ET, news, msgs) and instead cut a deal to acquire TD Waterhouse will have wide ranging effects on other online brokerage companies, not the least of which is Charles Schwab (SCH, news, msgs). To many Wall Street analysts, the proposed merger between E*Trade and Ameritrade was a significant threat to Schwab's active-trading business and, as such, a considerable long-term concern. But the ultimate deal struck between Ameritrade and TD Waterhouse carries even bigger challenges for Schwab.
A deal between E*Trade and Ameritrade would've created an online powerhouse with the flexibility to lower prices even further, thereby putting more downward pressure on profit margins at competitors like Schwab. According to CIBC World Markets, active traders account for about 35% to 40% of Schwab's commissions, and commissions account for about 17% of total sales. Clearly, any threat to this business would hurt.
However, neither E*Trade nor Ameritrade were big in the long-term investor or wealth management side of the business, and thats where Schwab derives roughly 80% of its revenues, leaving it head and shoulders above the rest of the playing field. Or at least, that's where Schwab used to have its biggest advantage.
A stronger competitor
Schwab now will face more serious competition in the investor class, as an Ameritrade/TD Waterhouse combination will generate about $1.8 billion in annual revenues from roughly 6 million customers (nearly double Ameritrade's total) with over $200 billion in assets. Ameritrade will also gain access to TD Waterhouse's retail presence, another way the firm might muscle into Schwab's domain.
There's no question that with almost $1.1 trillion in assets under management and trailing 12-month revenues of $4.2 billion, Schwab is still king of the online trading industry. But the competition is getting more intense and how Schwab responds could prove critical to its long-term fate.
Business at Schwab, as with most online brokerage companies, has been difficult since the market crashed nearly five years ago. Trading volumes have generally been in decline, price competition has been intense and profits have been erratic. During the last five years, total revenues have tumbled to $4.4 billion from $7.1 billion. Meanwhile, net income over the same time dropped by nearly 60% to $286 million, as profit margins continued to get squeezed.
At the top
In an effort to right the ship, the company turned to its founder, Charles Schwab, reinstating him as CEO back in July of last year. Since returning to the helm, Schwab has repeatedly cut commissions and placed renewed emphasis on customer service. The results have been mixed. Daily average revenue trades rose by an impressive 25% last month from a year earlier, with lower commissions and favorable market conditions pivotal factors in the jump.
But the news wasn't all good. Even though trading activity was up, the total number of new accounts was below expectations and at its lowest level since November. Relatively high attrition actually resulted in a decline in net accounts. Declining net accounts -- largely attributed to increased competition and Schwab's relatively poor customer service in recent years -- is a trend that Schwab can ill afford to see continue.
However, as the industry consolidates and competition intensifies, Schwab will have to do more than merely bolster service and lower commissions if it wants to gain clients and restore its competitive advantage. Schwab will need to consider an acquisition, or possibly put itself up for sale.
An attractive proposition
Though Schwab shareholders would probably prefer the former, the reality is that Charles Schwab isn't getting any younger. And if the company wants to put distance between itself and the other online brokerages one sure way to do it would be to align with a large investment bank such as UBS (UBS, news, msgs). Schwab's $1.1 trillion in assets under management would certainly be attractive to a foreign outfit like UBS, as would its expansive retail presence.
By contrast, what company would Schwab want to acquire? E*Trade doesn't make much sense for much the same reason that an Ameritrade/E*Trade combo didn't make much sense. Sure it would bolster Schwab's active trading presence but that's the part of the business suffering the most from declining interest in equity investments and from declining prices. The potential cost synergies wouldn't be a good enough reason to pay a premium for the likes of E*Trade.
Nope, the best avenue for Schwab is to investigate a merger with a bigger partner, one with a strong institutional presence. It would be the best way to enhance shareholder value over the long term at a time when the industry is undergoing considerable change and consolidation. Until or unless such a deal is struck, shareholders aren't likely to see an increase in value any time soon as the stock trades at a hefty 22 times estimated 2005 earnings, a sizeable premium given the changing competitive landscape.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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