Description
Executive Summary:
I am recommending a short of Charles Schwab Corp (SCH). The earnings multiple on the company is extremely high and the stock is 40% overvalued on a sum of the parts basis. The valuation multiple is likely to compress going forward as:
1) Earnings quality is deteriorating rapidly as SCH’s savings bank grows to 25% of profits.
2) Competition is intensifying at the same time that SCH is cutting technology spending and slashing headcount and competitors are doing the opposite.
3) Growth is likely to decelerate due to the law of large numbers. SCH now has 10% of its target market and share has been stable for the last five years.
4) Credit risks are rising as SCH needs to learn how to manage a multi-billion dollar bank balance sheet of residential mortgage assets. Revenue risks are intensifying as a) SCH engages in a bait and switch policy to increase revenue capture from customers as well as b) taking an increasing share of the profit pie from its asset management ‘partners’
5) SCH is striving to become a financial supermarket to all – a strategy that has never succeeded. AXP is being broken apart, and calls for C to do the same are growing.
EPS numbers at SCH have looked pretty good in recent quarters as the company finally broke out of the $.08 to $.12 range to $.14 - $.16 and the stock has responded by soaring 40% since April. However, this is not the SCH you remember from the 1990s. Earnings growth today is being driven through reducing investment costs, growing a savings bank and charging customers premium prices on commodity products at the same time that competitors are cutting fees. Like an athlete on steroids, current performance looks good but the future may be compromised.
On a sum of the parts basis, SCH is worth no more than $10 which is where it traded at the end of April. I expect that over the next 6 months, SCH could trade down to a P/E in the 16-17X range which would result in drop in price of approximately 25%.
I believe there is little risk to the stock rising significantly from its $14 price as SCH:
a) pays almost no dividend,
b) any excess capital will be needed to support the growth of banking operations,
c) the company has effectively preannounced 2H05 EPS, and
d) the stock has already spiked on takeover speculation that has recently been squashed by CEO Chuck Schwab who controls 20% of the stock.
What is Schwab Today?
Most think of SCH as a fast-growing discount broker. While the company does still offer this service it is now a small part of its business and one which will continue to shrink as a percentage of profits over the next two years. By 2H06, SCH will be a company with four major businesses – a) prime brokerage to Registered Investment Advisors, b) manufacturing high-cost mutual funds, c) distributing other firms' mutual funds in return for 50% of their profits and d) running a giant carry trade by ramping up a low value-added banking service.
SCH is one of the very few large-cap financial stocks that currently trades on a significant premium to the S&P500. On more than 20X '05 and '06 consensus estimates, and many competitors on 10-12X, one would have to imagine that SCH is quickly growing high quality earnings and building a moat around its franchise. However the opposite is occurring.
SCH currently breaks itself into three segments:
a) Individual Investor – (58% of EBT in 2Q05) – which includes retail brokerage, Schwab Bank, proprietary mutual funds and the mutual fund supermarket
b) Insitutional Investor – (28% of EBT in 2Q05) – which provides prime brokerage to RIAs and 401(k) plans, and
c) US Trust (7% of EBT in 2Q05) – a private bank for the very wealthy.
It is difficult to understand why any of these three revenue streams deserves to trade at a premium to the market multiple. On a sum of the parts basis using competitor valuations, SCH is worth no more than 15-16X which is 40% lower than current prices.
Schwab is clearly no longer just a discount broker. I will now attempt to discuss what is going on in the firm’s three segments, and then move on to conclude this write-up with some brief elaboration on each of the bear points listed in the Executive Summary above.
Individual Investor
This is the segment most associate with Charles Schwab. To start, let’s put the stock’s valuation in context with the other major publicly traded competitors whose primary focus is the selling mutual funds and providing stock trades to the retail investor:
’06 P/E Current P/B
E*Trade (ET) 13.6X 2.7X
Ameritrade (AMTD) 25.2X 6.3X (high due to the TDW deal)
Merrill Lynch (MER) 11.2X 1.8X
Morgan Stanley (MWD) 10.4X 2.0X
Piper Jaffray (PJC) 15.9X 0.8X
A G Edwards (AGE) 14.0X 1.9X
Average 15.0X 2.5X
Charles Schwab (SCH) 21.2X 4.2X
This segment used to be the driver of the firm. However, the sale of Schwab’s capital markets division to UBS in ’04, and a relentless five year price war for retail trading commissions and fees has led to retail brokerage commissions becoming less than 15% of firm revenues. To make up for this drop, SCH has come up with new ways to monetize customer assets and at the same time dramatically slash expenses and tech spending. SCH has halved the number of FTE’s from 26,300 at the end of 2000 to 13,600 today, and has dramatically stepped up selling additional products to its customers.
The best known growth product is the mutual fund supermarket. In return for assets to mutual fund companies, SCH charges 35bps annually to the fund provider. As most active mutual funds charge about 75bps in asset management fees, SCH is taking close to 50% of revenues to act as a distributor. SCH’s rate has not been negotiated down as of yet despite the big mutual fund houses having to deal with downward pressure on management fees as well higher costs due to Spitzer/SEC reforms and SOX compliance.
Next, SCH has rolled out a large suite of proprietary funds. Most of these are equity index product or money market funds. When looking at many of the largest of these proprietary funds, it is reasonably clear that SCH charges some of the highest fees in the industry that should make the fund board trustees blush:
Fund Ticker Annual Management Fee
Schwab 1000 Index SNXFX 50bps
Schwab Int’l Index SWINX 69bps
Schwab S&P 500 Index SWPIX 37bps
Schwab Money Market Fund SWMXX 75bps (I’m not kidding)
Schwab Value Advantage SWVXX 45bps
Money Fund (for large balances)
Index and Money Market funds have been an area of intense price competition. In the Index area, ETFs (from market leaders STT and Barclays) are extremely cheap and increasingly popular. Top SCH competitors Vanguard and Fidelity have been cutting their annual management fees on equity index products to as low as the 10bp level. In the money market fund area where SCH has more than $100B in assets, the largest competitors (again Fidelity and Vanguard) charge management fees only about 50% of the level levied on Chuck Schwab’s lucky customers.
As most profits from the Individual Investor segment now comes from mutual fund manufacturing and distribution, many market analysts argue that SCH should be valued as an asset manager where P/E is the driver. So let’s look at the values of the best-run, larger cap asset managers:
’06 P/E
Franklin (BEN) 18.2X
T Rowe Price (TROW) 18.1X
Legg Mason (LM) 18.7X
Federated Investors (FII) 16.4X
Eaton Vance (EV) 18.8X
Nuveen Investments (JNC) 16.8X
Average 18.0X
Charles Schwab (SCH) 21.2X
Prashant Bhatia of Citigroup claimed in a 9/15/05 report that SCH on a 20% P/E premium to this group makes sense as, “We believe that this premium is justified since Schwab has organically grown its client assets (8.6%) at a faster pace than the asset management industry (4.8%) over the past 6 years.” However, this math doesn’t really hold up. The well regarded asset managers listed above have been gaining share and growing their assets as least as fast as SCH which makes Bhatia’s reasoning somewhat questionable. Also, asset management and administrative fees are only 50% of SCH’s revenues.
Finally, most of the revenue growth at SCH is now coming from Schwab Bank which is currently closing in on 10% of total firm profits (up from zero in 2003). Not content with charging very high expense rates on the $100B in money market funds in the complex, SCH is now forcing those assets to be swept into bank accounts where SCH is targeting a 300bp net interest margin. Current rates paid on these accounts (over $100K balances currently receive 2.275% at Schwab Bank) are significantly lower than what many other banks pay for jumbo MMAs (as can easily be seen at www.bankrate.com) where rates of over 3.5% are now common. High rate online banking is really taking off as can be seen through the growth of ING Direct, or Emigrant Direct (which just raised the rate on its no fee, no minimum savings account to 4.0%).
SCH is basically building a large thrift with retail savings funding mortgages and Home Equity lending. Now SCH claims it is only going to make home loans to good customers, but isn’t it a little late in the housing cycle to be loading up on residential credit risk?
The business of plain-vanilla saving banking on a stand-alone basis is poorly valued by the Street. The average S&L is lucky to command a P/E of 10-11X ’06 and 2X P/B. However, every dollar of incremental earnings coming from the new bank at SCH is currently being valued at more than 20X forward. FRB’s analyst, Matt Snowling, upgraded the stock last week to an ‘Outperform’ on enthusiasm over growth from the bank. He expects that the bank will contribute close to 20% of SCH’s earnings in 2006 and around 25% in 2007. At the end of last week, SCH cut its trading commission prices again and eliminated account maintenance fees. Thus, with the loss of this fee revenue, the bank’s contribution of the Individual Investor segment and total earnings may grow even faster than FBR’s estimates. In any event, almost all the earnings growth the sell-side expects from SCH next year comes from the bank.
Many point out that MER, MWD and other retail brokerage firms have grown their FDIC banks units through the use of sweeps and this has led to higher earnings so why penalize SCH for doing the same thing? True, but note that MER has seen its book value grow by more than 50% since the end of 2000 and the stock is now 10% lower than it was then. It is reasonable to argue that the growth of MER’s bank may have boosted EPS but also compressed its valuation. Of even more concern is that SCH is targeting spreads almost 2X that achieved by MER at its bank and so either greater interest rate or credit risk is going to be taken on by Schwab to hit its targets.
Institutional Investor:
This unit according to SCH, “provides custodial, trading and support services to independent investment advisors (IAs), serves company 401(k) plan sponsors and third-party administrators, and supports company stock option plans”. This description is clearly very similar to that given by the trust/custody (T/C) banks whose valuations sure are a lot lower than SCH’s
’06 P/E Current P/B
Bank of New York (BK) 13.3X 2.4X
State Street (STT) 15.6X 2.6X
Investors Financial (IFIN) 14.9X 2.9X
Mellon Financial (MEL) 15.4X 3.2X
Average 14.8X 2.8X
Charles Schwab (SCH) 21.2X 4.2X
This has been a great business for SCH and it has grown faster than many of the T/C banks in recent years. However, SCH now has a dominant position in the market and competition is growing from the likes of BK’s Pershing unit and Fidelity which means that further market share gains may become more difficult. Also, as many of these RIAs have growth in size themselves, they can potentially be serviced by the large prime brokerage players (BSC, LEH, GS, etc.) as well as the traditional T/C providers such as STT and IFIN.
US Trust
US Trust is great private bank with a long and storied history. However, it is only 7% of current profits, and private bank valuations also help to pull down SCH on any reasonable sum of the parts valuation:
’06 P/E Current P/B
Northern Trust (NTRS) 16.8X 3.1X
Wilmington Trust (WL) 14.2X 2.6X
Boston Private Fin. (BPFH) 16.1X 2.1X
Average 15.7X 2.6X
Charles Schwab (SCH) 21.2X 4.2X
Sum of the Parts
So let’s do a sum of the parts analysis on SCH’s expected 2006 EPS of $0.66:
- 20% savings bank at 12X
- 30% asset manager at 18X
- 20% brokerage at 15X
- 10% private bank at 16X
- 20% institutional trust/custody at 15X
This yields us a forward multiple of 15.4X and a share price of $10.16. Thus, either the price is going to fall, or the market is correct in assigning a conglomerate premium of 40% to SCH for superior management, growth prospects, and improving quality of earnings.
Catalysts for Shorting SCH
So let us now conclude this overly lengthy write-up by fleshing out the catalysts that may lead to SCH trading back to a more reasonable valuation over the next year:
1) Earnings quality is deteriorating rapidly –
Almost all of SCH’s expected EPS growth comes from the ramping up of Schwab Bank. This is a low P/E business. By 2007 upwards of 35% of SCH profits will come from banking (Schwab Bank & US Trust). It seems unlikely that such a large percentage will be ignored by investors indefinitely.
2) Competition is intensifying -
The courting of the affluent retail investor is clearly becoming more intense. SCH is being attacked from below by AMTD and ET that are now larger, more efficient competitors with offerings and online/telephone/physical branch distribution networks similar to SCH’s. Due to the AMTD/TD and ET/Harris deals the effect is that these competitors are actually adding physical branches at the same time that SCH is closing many. Lateral competitors Vanguard and Fidelity have been aggressively targeting SCH’s customer base and cutting fees on products where SCH has its highest margins. From above, MER, NTRS, BPFH and others have been expanding and gathering new assets with some success. We have also seen some of the larger banks such as WFC (with its WellsTrade offering), WB (with its joint venture with PRU) and BAC push more aggressively into the competition for managing/advising affluent investor assets.
3) Growth is likely to slow due to the law of large numbers –
SCH is no longer a small, scrappy retail competitor taking share from the big guys. From 1990 to 1999 SCH exploded from a rounding error to about 4% of the US securities industry net revenues. Since that time its share has been stagnant and it is no longer growing faster than the industry. In an 8/30/05 report, Brad Hintz at Bernstein notes that SCH revenue growth rates display a clear slowing trend and asks, “is Schwab mutton dressed as lamb?” According to its 2004 annual report, SCH claims that it now has 10% ($1.5T of $8T total) of client assets in its target market. With all the increased competition and progressively lower fees for many investment products can Chuck continue to grow revenues faster than the market? Talk to many competitors, and SCH is now the company others target to increase clients and assets.
4) Credit and revenue risks are intensifying -
Schwab Bank is growing rapidly and is a business fraught with credit and interest rate risks not previously managed by the team at SCH. As this business continues to surge in size each year, the potential for a mistake increases.
SCH has cut its staff size by 50% over the last few years and technology spending as a percent of net revenues has fallen to only around 1% which is the lowest it has ever been (the average is around 3% over the last decade). SCH charges higher than average fees on its mutual funds, pays lower than the average on banking accounts and has developed a reputation for high costs on brokerage accounts (prompting the firm to cut fees seven times in the last 18 months).
At the same time many competitors have been adding staff, bulking up in size and increasing spending on technology. Affluent Americans may start to vote with their feet (or at least their assets). Mark Constant of Lehman, in a report dated 9/19/05, put it this way, “Promoting various revocations of certain administrative and order handling fees, while forcing many customers into cash/liquidity products with materially lower (and below market) yields may prove to be a poorly veiled ‘bait and switch’ in the eyes of many customers.” I can’t tell you when this customer attrition (or a need to bring fees and rates into line with the market) will become a catalyst, but it certainly creates a risk to the level of SCH’s EPS and that alone should create pressure on valuation multiples.
The mutual fund supermarket was a great idea, and SCH certainly gained some first-mover advantage. However, there are now many other competitors in this space (including ET which rebates 50% of 12b-1 fees back to its customers). SCH continues to take about 50% off the top in fees for providing the shelf space to the asset managers who manufacture the products to be sold. However, mutual fund asset management fees have been under pressure, and the cost of running mutual funds have moved up significantly due to regulatory changes over the last few years. It is likely that the manufacturers are increasingly interested in getting back some of the reduced margin in the value chain. Again, I can’t tell you when this catalyst will take place but it is a risk clearly not discounted in SCH’s current valuation.
5) SCH is striving to become a financial supermarket to all – a strategy that has never succeeded;
With the elimination of account maintenance fees last week on smaller accounts, SCH has indicated that it truly wants to be a financial services supermarket. It wants to manage and service the smallest accounts to the most prestigious fortunes (through US Trust). It wants to sell you proprietary international mutual funds, offer you a checking account, hold your home mortgage, sell you a co-branded credit card, broker your life insurance plan and get you to buy from a selection of annuities for your retirement. Sounds like a great plan. The problem – it has been tried repeatedly by well regarded companies such as C and AXP and it hasn’t worked. Why pay a premium to the market to bet that Chuck can do it where other smart operators have failed?
Risks
The risks to a short position in the near term seem limited.
- Chuck recently stated that he isn’t selling the company and that SCH isn’t going to buy anyone. The merger that would really goose EPS at SCH would be a deal with ET or AMTD and both of those companies are currently busy with their own deals. So no M&A is likely for at least several months. Also note that the stock ran up on takeover speculation recently (and didn’t retreat after the ‘no deal’ press release), so M&A upside is already baked in to the price.
- EPS upside to estimates is limited for the next six months. Last week SCH announced that EPS would be up 5% -10% sequentially in 3Q05, but estimates are already at $.15 for 3Q05 vs. $.14 in 2Q05. Also the company announced that cutting of account fees and prices will eliminate $.02 from quarterly EPS starting in 4Q05 so estimates at $.15 (which has not moved down as of yet on this news) means there is little chance of a big surprise unless the stock market goes through the roof.
- P/E on the stock could always expand from here, but it is already on a significant premium to the market, asset managers, trust and custody banks and private banks. What’s the catalyst for multiple expansion?
- Insider buys seem unlikely. Chuck has been selling shares and he just got more options from the company. A couple of other insiders have been selling, and if others didn’t buy at $10 in April, why will they buy at $14 in September?
Catalyst
1) Earnings quality is deteriorating rapidly as SCH’s savings bank grows to 25% of profits.
2) Competition is intensifyingat the same time that SCH is cutting technology spending and slashing headcount and competitors are doing the opposite.
3) Growth is likely to decelerate due to the law of large numbers. SCH now has 10% of its target market and share has been stable for the last five years.
4) Credit risks are rising as SCH needs to learn how to manage a multi-billion dollar bank balance sheet of residential mortgage assets. Revenue risks are intensifying as a) SCH engages in a bait and switch policy to increase revenue capture from customers as well as b) taking an increasing share of the profit pie from its asset management ‘partners’
5) SCH is striving to become a financial supermarket to all – a strategy that has never succeeded.