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

Rick, my Miami Dolphins-loving friend, you make some darned good points. I agree, there's little reason to jump up and down about a company that is showing a decline in return on equity (ROE) and flat earnings per share growth while it is priced at 8.1 times tangible book value, 31 times amortization-adjusted EPS, and nearly 24 times 1999 estimated earnings. With an influx of new low-priced competition pouring tens and tens of millions of dollars into advertising, one would naturally find it hard to be really bullish on Schwab.

The company is priced as if it will continue to generate ROE in the 30% range and grow earnings at a 40% to 50% clip every year. Well, that's not something I personally expect out of Schwab, but with a reasonable drop in its price to $30 or less, I think some of the risk would be offset and prospective returns over the next two to five years would look attractive.

The problem in pointing out that its ROE has declined is that a ROE over 30% for a large financial services companies is unusually high. If you have a rocket that is travelling at a couple miles per second and that rocket slows down to 4,000 feet per second, though, it doesn't mean that the rocket is not travelling at a very high rate of velocity.

Velocity is exactly what we have at Schwab, even in a somewhat disappointing first quarter of 1998. As I pointed out in my "Bull Argument," asset velocity, or turnover, is incredibly important for a financial services company. It means that a company can generate the same return on equity that competitors can with either lower margins or lower leverage. Compared with something like Merrill Lynch <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MER)") else Response.Write("(NYSE: MER)") end if %>, Schwab has generated superior returns on equity with about one quarter the financial leverage, higher margins, and much better asset turnover. I'm not trying to be fancy with this talk -- I just mean to point out that one needs to look inside the returns on capital to get to the quality of those returns. Return on equity and returns on any level of capital are better quality returns when they're built on high turnover. It means that competitor A can generate the same amount of earnings with less capital tied up in the business, margins and leverage being equal.

Schwab's current growing pains do not mean the company is impaired or that it's starting into a longer-term decline. The concerns about commoditization of discount brokerage services were known long ago, and Schwab has been dealing with it. Commissions and principal transactions are accounting for a diminishing percentage of revenues while other annuity-like revenue streams are achieving significant scale. At some point in the not-too-distant future, the operating earnings from the brokerage will become less and less significant to the overall picture as Schwab develops into more of a bank with a variety of financial services. And I'm not talking about of a bank like Citibank, where your banker is going to try to push Travelers insurance and some plain vanilla mutual funds on you.

I think Schwab is in the right place in that it plans to offer you whatever funds and other investments are on the market without trying to tie you up in its proprietary offerings. The profit margins might not be big, but the amount of capital that has to be tied up in such pursuits is minuscule. That's why the company sells at a large premium to its book value. It's only natural when the return on that book value is so huge.

So, yes, Rick, I agree with you on some points. I'm not doing cartwheels over Schwab's valuation, but I think the company is doing the right things strategically. I also believe the company's current spending to improve systems for brokerage customers and going forward with plans to capture a larger part of the nearly $850 billion 401(k) market is totally justified. I expect to see results later this year and into 1999. As such, Schwab is on my watch list.

You never know when a correction or another blip will come along and knock something down into the "highly attractive" range, away from the merely "attractive range." Sorry I'm not the rabid bull on this. I think it's a fantastic company and that it can keep up with the S&P 500 over the next two to five years. While that will be a come down from its formerly blistering rate of shareholder return, it's still attractive.

Next: The Bear Responds