Charles Schwab Bull's Pen
by Dale Wettlaufer ([email protected])

Charles Schwab is one of the great success stories in the investment world of the last twenty years. Starting from a position of bootstrapping the company's operations with help from relatives, CEO Charles Schwab and his team have built the company into a force in the brokerage industry, with more than five million customer accounts as of the end of the first quarter of 1997. Schwab was one of the first discount brokerages and now has the leading market share in the online brokerage business with nearly 40% of online accounts, according to market data from Forrester Research. The bears, of course, will latch onto this figure and present it as damning.

Well, ok then, let's address that point. The whole idea of pricing and Internet services has been on my mind lately. There's a common misperception that margins are the end-all and be-all of successful investing. The truth is that there are a lot of successful people who have built great businesses on low margins. The average American distributor really only runs on net margin of 3%, and the average American manufacturer runs on net margin of 5%. Investors who pay attention only to companies with huge margins that are derived from proprietary processes or a monopoly of some kind (whether it's a natural monopoly or a market share monopoly) are missing a large part of how corporate finance works.

There are a couple ways to survive in a low-margin environment. One is to leverage up your business. That means you operate with a high ratio of assets to equity. Expressed in the inverse, your company operates with a low level of equity that you invest and a higher amount of capital that creditors invest (by advancing you your working capital assets, including their labor, which is accounted for in inventories). The other way is to get to the point where you turn assets more quickly than the competition. The banking and financial services industry is a very high-margin, low-turns business. A manufacturer normally tries to turn its assets once or more per year. A financial services company, however, is doing well if it can turn a dollar of assets into a dollar of revenues once every ten years. Those companies that can deliver excellent service on top of a low-cost distribution platform are bloody terrors in the financial services industry.

So, what does this mean for Charles Schwab? It means there's room for the company to cut prices on trades for its active customers. Net margin on these customers, who trade more actively and who run higher average debit (margin debt) balances, can go much lower while these accounts can still generate an attractive return on capital. Ultra low-priced Internet competition from the likes of Ameritrade <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AMTD)") else Response.Write("(Nasdaq: AMTD)") end if %> and E*Trade <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: EGRP)") else Response.Write("(Nasdaq: EGRP)") end if %> is not going to sink the company tomorrow, although this is a challenge that will intensify.

To counteract the established trend of commoditization of plain-vanilla brokerage services, the company is surging ahead with key initiatives that consume less capital, but that offer excellent annuity streams of revenues. These include the company's OneSource mutual fund program, which over the last two years has helped mutual fund service fee revenues increase at a compound annual rate of 39.8%.

Another major push at Schwab is the 401(k) administration business, which explains part of the recent stall-out in earnings and why, not coincidentally, the company's earnings growth above the 20% level should resume by the third calendar quarter of this year. The main reason 401(k) customers switch accounts is not because their funds have done poorly, and it's not because some other funds rep is offering a better array of funds -- it's because of botched execution. A significant amount (in the neighborhood of the high single digits to the low double digits) of the liquid portion of the $857 billion in 401(k) accounts turns over each year because plan administrators cannot deliver timely information to plan participants, who want to know what's going on with their money, or to company sponsors, who need the information to comply with federal and state government regulations.

This turnover presents a very large opportunity for Schwab, and it has spent heavily to improve these services.Although the company does have over $15 billion in 401(k) assets under administration, that was equal to less than 4.5% of total client assets of $354 billion as of the end of the year. With heavy investments in back-end systems and customer support services, the company's EPS growth slowed to a standstill in the first quarter. However, the 401(k) market should surpass the trillion-dollar mark within the next two years, and if Schwab can deliver on the holy grail of service (not just good phone support, but extremely complicated back-end operations), investment selection, and price, this area could provide nearly 10% of the company's net earnings by the end of fiscal 1999. That could provide excellent upside for the current EPS estimate of $1.46 for 1999 and provide a catalyst for further account growth as Schwab converts those 401(k) customers to taxable accounts and IRA accounts.

Overall, the company is implementing its plans to add value to its services. In the short-run, this will be an expensive task, and it would not be a surprise to see the company deliver another earnings miss in the coming quarter. Over the longer haul, though, the company will continue to increase its delivery of investment information and services to its customers. In addition, the company will continue to invest in its online system to get to the 99.9% uptime that customers demand. That has been a failing of the company in recent quarters, but it's somewhat reminiscent of America Online's <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %> problems with access about 15 months ago. Accounting for a double-digit percentage of directly marketed mutual fund inflows with five million customer accounts, the company is growing quickly towards its Year 2005 goal of $1 trillion in customer assets.

In the short haul, the company's earnings have suffered due to its spending on services and changes in the Nasdaq trading system. In the long term, however, the company is well positioned to improve on its business model of higher asset turns and lower margins. It's still well within its performance targets of 20% revenue growth, 20% return on equity, and 10% after-tax profit margin. In fact, as far as financial services companies go, Schwab's 2.04% return on assets figure is excellent, which is why the company is priced at 31 times trailing EPS (deducting amortization of purchase-related intangibles). With a track record of generating excessive returns on capital, the company's potential to outperform the S&P 500 over a five-year period looks very good.

Going forward, there is some risk of P/E multiple compression if the company does disappoint in the EPS growth department. If that happens, anything around $30 per share looks like an excellent price for this company. That would put the stock at what I believe would offer a good opportunity for a 20% compound annual return over the ensuing year and a half. At the current price, though, the company looks to perform in line with the 11% long-term rate of return on the S&P 500 over the next year-and-a-half. While I'm not wildly bullish on its potential for return over the coming 18 months, I think the business underlying the stock price will outperform the competition. As such, my value instincts would start to perk up around 25 times trailing earnings. Having watched the brokerage sector for a while now, I can assure you that good companies in this sector get cheap at least once a year during market scares.

Next: The Bear Argument