Should Charles R. Schwab Aim Higher?
When Charles R. Schwab, the chairman and founder of the giant stock brokerage that bears his name, starts feeling overconfident, he grips the black bowling ball perched on his desk. It's a memento of the long-forgotten bubble of 1961, when shares of bowling pin companies, shoemakers, chalk manufacturers, and lane operators were thought to be can't-miss plays on the limitless potential of suburbia—and turned out to be duds. Schwab keeps the ball as a reminder not to buy into hype or take excessive risks. That conservatism has helped the San Francisco firm avoid many disasters over the years, none bigger than the recent credit bubble. While much of Wall Street was rushing into risky subprime mortgages, Schwab ( (SCHW)) was setting up a modest consumer bank to keep the company steady in the event of a market meltdown. Bingo: During the panic of 2008, many of the customers fleeing Merrill Lynch ( (BAC)), Wachovia ( (WFC)), and others took their money to Schwab. Its brokerage business grew by $113 billion on the year, while its bank deposits surged by 72%, to $24 billion. Schwab posted record operating profits for 2008—a mind-bending feat given the stock market meltdown. In the span of a few quarters Schwab has morphed from a stock brokerage into a fully diversified financial institution: Not only does it process trades and offer financial advice, but it now provides all manner of banking products and services, from certificates of deposit to credit cards. In terms of brokerage assets and retail clients, Schwab now ranks solidly among the "big four" diversified retail financial firms, alongside Bank of America ( (BAC)) Merrill Lynch, Morgan Stanley ( (MS)) Smith Barney, and Wells Fargo ( (WFC)) Wachovia. The distance between the big four and the next tier, which includes TD Ameritrade ( (AMTD)), E*Trade Financial ( (ETFC)), and SunTrust Banks ( (STI)), is vast. Yet some analysts and investors expect more of Schwab. The industry turmoil, they say, is presenting unusual opportunities to take out weaker rivals and tap new revenue sources. Other firms are already on the prowl. Wells Fargo is beefing up the risky securities business it inherited as part of its controversial acquisition of Wachovia last year. New York money manager BlackRock ( (BLK)) bought Barclays Global Investors in June to become the biggest asset management firm in the world. The question is whether Schwab should follow those firms into the risk pool. In order to seize what might be a once-in-a-lifetime chance to gain market share, it would have to abandon the conservative principles that helped it sidestep the financial crisis in the first place. What's more, even if Schwab were to go on the offensive, it wouldn't be easy. Some analysts and former employees are raising doubts about the firm's ability to ride herd over all that new money, and about its ability to learn, on the fly, how to become a bank. So what's a discount stockbroker turned Wall Street kingpin to do? You might call the dilemma a paradox of success.
BACK TO HIS ROOTSFor now Chuck Schwab is taking the cautious route, in part because the firm has misplayed industry shakeups before. After the tech-stock bubble burst, Schwab acquired boutique research outfit SoundView Technology Group to capitalize on an expected shift from Wall Street research to independent research. The shift never happened, and Schwab ended up booking a loss.
That lesson prompted Schwab to return to its conservative roots. In 2003 it launched Charles Schwab Bank, whose predictable base of deposits would help diversify the firm and steady the ship in the event of a stock market disaster. Unlike rival E*Trade, which got into banking in 2000, Schwab largely eschewed risky subprime mortgage securities from the outset.
Little did Charles Schwab know that he was about to strike gold as much of Wall Street imploded under the weight of borrowed money. "It's outrageous what their risk managers were doing—or not doing," says Schwab. His bank has been one of the prime beneficiaries. "Amid all the turmoil, Schwab has gained," says Richard Repetto, a veteran industry analyst at investment firm Sandler O'Neil. "That stability is a rarity among financial firms these days," adds Alexander Yavorksy, a senior analyst and vice-president at Moody's Investors Service ( (MCO)).
But the foray into banking is also posing unexpected challenges. The firm was unprepared for the initial surge in customers last Sept. 15, the day Lehman Brothers failed. "Before that, our message was about good prices, help, and guidance," says Rebecca Saegar, Schwab's chief marketing officer. "After that, clients were asking, 'Are you safe? Are you going to go out of business?' " When Walter Bettinger, 48, took the CEO reins from 71-year-old Schwab last October in a long-planned succession, the former chief operating officer quickly redeployed troops to bolster the firm's 24-hour customer service operation, which was being inundated with calls.
GROWING PAINSNow Bettinger must figure out how to give all those new customers the banking products they want. It has been a rough initiation for a company that's accustomed to processing stock trades and dispensing investment advice. "Banking is very different from securities," says Rory A. Stace, an analyst at New York's National Securities and a former Schwab broker. "Schwab is new at it, and not yet as adept."
Bettinger reckons that the banking business these days boils down to "cash management": offering places for customers to park short-term money safely, such as savings accounts and certificates of deposit. But with interest rates so low, none of those offerings are especially profitable for Schwab. "The options are limited," says Bettinger. "It's more like playing defense at this point."
Bettinger says Schwab is trying to use the bank as a way to draw in new customers who might then be sold on more profitable services. The Schwab cash-back Visa card, for example, rebates ATM fees and kicks back 2% of all purchases to a Schwab brokerage account, where the customer can make commission-generating trades. That's Schwab's bread-and-butter business, the one it knows best.
But growing pains are flaring up here as well. With Wall Street in tatters, investors continue to flee bigger firms in search of safety. Citigroup's ( (C)) former Smith Barney unit, now owned by Morgan Stanley, had $40 billion in outflows during the first quarter, according to Credit Suisse ( (CS)). UBS Wealth Management ( (UBS)) saw $6 billion depart. Schwab, meanwhile, led the industry with $29 billion of net new assets.
The flood of money is aggravating old tensions inside the firm. Schwab's brokerage business has two major pieces. One arm services 5.3 million individual investors, some of whom rely on Schwab's in-house financial advisers. The other unit handles paperwork, processes trades, and delivers other services to more than 6,000 independent financial advisers. It's a so-called white-label arrangement: The outside advisers hang their own shingles, but Schwab handles the details behind the scenes.
The outside adviser unit generates half the revenues of the core brokerage business, but because it requires less manpower than the retail business it has fatter profit margins and accounts for about one-third of Schwab's total earnings. "Schwab is basically using profits from the adviser business to fund the retail business," says Timothy Welsh, a former Schwab executive who left in 2005 to become an industry consultant.
The problem is that Schwab's in-house retail advisers fish in the same client pool as the external advisers. The outside advisers don't always appreciate the competition.
Rival TD Ameritrade, in contrast, doesn't have any in-house advisers. It's competing vigorously to win new adviser business. When Michael Parikh and Jon Wakely left Merrill Lynch a year ago and formed PW Global Advisors, based in Boston, they chose TD Ameritrade. "They didn't have their own advisers," Wakely says. "If someone walks into a branch, TD will refer them to you, as opposed to having their own people competing against you like Schwab does."
Bettinger is working to improve relations with outside advisers. At a June conclave with its adviser clients, Schwab said it would reduce the trading commissions it charges the advisers' new customers. Schwab will also cut the fees it charges advisers for access to its client-management software. Will such moves help Schwab strike the right balance between the in-house advisers and outside firms? "That's their real strategic question," says Welsh.
As challenging as the past year has been for Schwab, some analysts think the firm should be even more aggressive in courting new business. It has long been criticized for lacking the killer instinct so common on Wall Street. "They've never gone hostile or big on a buyout," says Stace. "Can they roll up discount brokers now? Yes."
He has a point. Back in 2000, Schwab had such a lofty market capitalization that it could have taken out investment banking stalwart Goldman Sachs ( (GS)). Later Schwab passed on the chance to grab CSFBdirect, Datek, Harris Direct, and numerous other online brokers put in play by the tech stock crash. More recently, Schwab stood by while BlackRock swooped in to take out San Francisco's Barclays Global Investors.
Schwab might benefit from going on the attack. Signing up new brokerage customers is a long, arduous process. Firms must advertise extensively, waive initial trading commissions, and process reams of paperwork. The payoff, however, is big: Brokerage accounts are "sticky," meaning once customers sign up they're reluctant to shift. A typical client generates thousands of dollars in commission and fee revenue over his investing lifetime. That's why the discount brokerage business has been consolidating for much of the past decade, with Ameritrade buying Datek before selling itself to TD Waterhouse Group, and E*Trade rolling up DLJdirect, CSFBdirect, Harris Direct, and TeleBank. It's far easier to buy whole swaths of customers than to pick them off one by one.
Struggling E*Trade, with its 4.5 million accounts and $100 billion in assets, seems like tantalizing buyout bait. It rushed headlong into mortgages during the credit boom and now is paying dearly. Some $1.6 billion worth of its loans are delinquent; the figure swells to as much as $2.26 billion if delinquent home equity loans are included. Schwab could snap up all of E*Trade; it has $21 billion in market value to E*Trade's $685 million.
Bettinger says that's not going to happen. "We've looked at every property," he says, "but we're not interested in taking on balance sheet challenges as the price to take on brokerage." Adds Schwab: "We wouldn't take [E*Trade Bank] and manage it out of its problems. We don't know troubled assets."
Fair enough, but why not at least go for E*Trade's jugular through advertising? TD Ameritrade, for one, has increased its ad budget by 13%, to $54 million this past year. "Dislocation drives opportunity," says Fredric J. Tomczyk, chief executive of TD Ameritrade. "We upped our marketing spend as the crisis worsened. We said, 'You know what your full service broker is going through—it's a good time for a second opinion.' " The strategy seems to be working: TD added 143,000 accounts in the quarter ending in March.
Schwab, meanwhile, has cut its ad budget by 24%, to $58 million. Since last fall it has been running somber commercials playing up its own services but not casting aspersions on rivals by name. "We believe our marketing works better than slamming the competition," says Saeger, Schwab's marketing head. "Why reinforce the belief that our category stinks?"
In this and most other matters Schwab is sticking with a strategy of peaceful coexistence. Instead of plundering everything in sight, it plans to take these next few quarters to grow into the new business it already has.
Some think it will regret that decision down the line. But Schwab is unapologetic: "Our clients love stability," he says. "Absolute stability and predictability." That mindset has kept the company in the game for 38 years, outliving the likes of EF Hutton, Lehman, and Kidder Peabody. Maybe the man is on to something.