Schwab trading shift faces revenue test

Charles Schwab Corp. executives like to stress their shift to depending less on volatile trading commissions as a source of revenue. Now, the recent stock-market swoon may give investors some insight into how well the strategy is faring.

The San Francisco company is best known as a discount-brokerage pioneer that helped bring cheap trades to the masses, especially through its Web site. But in recent years, Schwab's reliance on trades has ebbed: Last year, trading revenue made up 18.2 percent of overall net revenue, down from 21.5 percent in 2005.

Some of this is due to Schwab's recent cuts in trading fees, which were intended to make the firm more appealing to price-conscious investors. But Schwab also has been able to pump more money from other revenue streams: Asset-management and administration fees grew by 16.2 percent last year, while net interest revenue rose 40.3 percent.

"Schwab today is a very different firm than a few years ago — it is much more like an asset manager than a broker," Brad Hintz, an analyst at Sanford C. Bernstein & Co., said in a recent report.

But shares of Schwab often trade like a broker's. The stock has shed 3.2 percent of its value this year through Wednesday, falling to $18.70.

Shares of several asset-management firms have fared better. Although their business models aren't exactly like Schwab's, it's worth noting that some asset and investment managers garner higher valuations from investors: Eaton Vance Corp., BlackRock Inc., T. Rowe Price Group Inc., Cohen & Steers Inc. and Janus Capital Group Inc. recently sported price-to-2007-expected-earnings ratios ranging from 21.2 to 25.6, while Schwab's was 19.8.

"The market has ignored the progress that the company has made reducing revenue volatility and increasing fee-driven revenue," Hintz said. Bernstein has done non-investment-banking work for Schwab.

Such thinking drove Hintz, who owns shares of Schwab rivals E-Trade Financial Corp. and TD Ameritrade Holding Corp., to recently raise his rating on Schwab stock to "outperform" from "market perform." He values the stock at $22.75.

Others on Wall Street also like Schwab's strategic shift. "We continue to prefer Schwab in the retail-brokerage segment, as we believe their focus on investors, rather than traders, will bring better long-term growth," said David Trone, an analyst at Fox-Pitt Kelton, in a recent note.

A risk that Schwab faces is the stock market's recent volatility and downturn, which, if sustained, could spook small investors into remaining on the sidelines. In February, Schwab brought in $12.8 billion in net new assets, its highest monthly tally in several years. But the stock market's big drop came near the end of the month, making it difficult to draw conclusions about its effect on Schwab's asset-gathering capabilities.

Hintz, for one, argues that the reduced dependence on trading fees limits the downside from the stock-market turbulence. Another risk is the ever-present price pressure on trading commissions, which, if escalated, could sting the earnings of companies with online-trading businesses such as Schwab.

For Schwab investors, one of the nagging questions hanging over the company has been its future leadership. The company has always been closely identified with its namesake founder, who retook the chief executive job in the summer of 2004 after the board ousted David Pottruck.

At 69, Charles Schwab shows no signs of being about to hand over the reins. But he appeared to tip his hand earlier this year when he named Executive Vice President Walter Bettinger as his president and No. 2. While Bettinger's appointment didn't bring finality to the succession issue, he is widely seen as a candidate to be Schwab's next CEO.

Another issue Schwab will have to confront is life after the sale of its big private-banking unit, U.S. Trust. The business is being sold to Bank of America Corp., though the deal hasn't yet closed. One challenge for Schwab will be replacing the revenue that U.S. Trust contributed to the bottom line.

Schwab has said it is interested in expanding its role in the business of servicing companies that have 401(k) plans for their employees. In December, Schwab took a step in that direction when it agreed to acquire 401(k) Co. from Nationwide Financial Services Inc. for $115 million. Schwab has said it could make another acquisition in the 401(k) business.

source:www.chron.com