Charles Schwab Bear's Den
by Rick Munarriz ([email protected])

Before I get started, I'd like to say that going up against Dale on a financial stock is like challenging Tiger Woods to a round of putt-putt. I would probably have to concede defeat if not for my firm conviction that Charles Schwab is severely overpriced -- and that spinning windmill in Hole 7 can be a bugger. Let me try and spell out my reasons...

Slowing Down the Mechanical Bull

For each of the last two quarters and most of the last five, Schwab's earnings have come in below analyst expectations. Here we are, in a strong bull market, and the company cannot keep up with the ever-diminishing earning estimates. How long will shareholders put up with this fiscal limbo dance, with the bar lowered every passing quarter?

If things aren't going well for Schwab in this rosy market scenario, where earnings were flat for the March period, to quote market guru Jack Nicholson, maybe this is as good as it gets.

Chuckie's Cheese Is Swiss

We got holes here bub! Despite flat fiscal performance last quarter, analysts choose to confuse investors by attempting to predict earnings per share growth over the next five years. Call me cynical, but predicting that interest rates will continue to fall and the market will continue to rise over the next year -- to the tune of 20% earnings growth for the year ahead is hard enough -- but in perpetuity?

That is the problem. Schwab isn't even the company it once was. Last year the company's return on equity of 27% was the lowest it has been since the unkind market of 1990. Net profit margins of 11.8% were the lowest the company has seen in five years. Could it get worse? It did. This past quarter return on equity and profit margins shrank to 23% and 11.3%, respectively.

Help! They're Robbing the Bank

A strong selling point for the brokerage industry has been the emergence of asset management accounts. Just as banks are dressing up in mutual fund and brokerage service garb, brokers are crossdressing into checking, certificates of deposit, and credit cards. The line between bank and broker is less distinct, but given the recent run of bank and thrift acquisitions, maybe here we can get a sense of what Schwab might be worth at a premium buyout.

Most banks are getting bought out at a generous two times book value and a P/E multiple in the teens. With Schwab at nine times book value and selling for 35 times trailing earnings per share, we got a heist here, and it's the Schwab longs who have their hands in the air.

World Wide War

While Schwab customers placed 25% more stock trades last quarter, commission revenues rose by a scant 8%. The reason for the disparity is that a staggering 48% of those trades were placed online. Schwab discounts transactions entered on the Internet. The overhead is lower, so why not? Well, the problem is that Schwab's online rates, despite being marked down, will have to go even lower to remain competitive.

For many new investors, choosing Schwab is a natural decision as it has some of the creature comforts of a full-service house with rates on the high end of the discount brokerage range. To be honest, given the meager advertising budgets of its deep discount competitors, many newbies may consider Schwab the only game in town. But that very statistic -- that almost half of all Schwab stock trades were placed online -- means that customers are suddenly empowered with more interactive means of tire kicking. It is only a matter of time before they realize that other nationally acclaimed discounters like Waterhouse and Quick & Reilly offer the same no transaction fee mutual fund and market research access but charge a third of Schwab's lowest rates on Internet placed trades.

And the Winner Is -- Gravity by a Landslide

So, let's see, we have customer defection through education (cheaper rates) and eradication (market correction), so how about just plain common sense. Schwab's popularity has been tied to its OneSource Mutual Fund Marketplace. It's a vanilla offering (also imitated by its major rivals) in which customers can consolidate mutual funds from various families onto one monthly statement.

It sounds nice -- even though it is no less demanding in filling out your Schedule D tax form -- but the myth goes that this service is provided for free in the case of the "No Transaction Fee" offerings. The truth is that these mutual fund companies have to pay Schwab about 0.25% of the managed assets. No free lunch, right? In December, Morningstar did the math and found that the expense ratio on Schwab No Transaction Fee funds was actually greater than the 25 basis points relative to the average mutual fund. When those $50 billion in OneSource assets see the light, flick the lightbulb and look out below.

Beta? You Beta, You Beta, You Bet

For the longest time, Schwab has been a frothy market's bellwether. Its beta of 2.0 indicates that the stock is twice as volatile as the S&P 500. Well, with the market at new highs, Schwab must be soaring, right? Not quite. Since the company has failed to live up to the poster boy hype, it is now trading well off its highs -- not a market leader, yet seemingly susceptible to a nervous market if it decides to sell off brokerage stocks first.

That's it. I spelled it out. The list may spell S-C-H-W-A-B, but in reality it should translate to S-E-L-L... at the market.

Next: The Bull Responds