Schwab's Strategy: Buy High, Sell Low?


By Justin Hibbard Since Charles "Chuck" Schwab resumed the CEO post at his namesake company on July 20, the struggling brokerage has wasted no time trying to cut costs and improve profitability. Now, one of its toughest clean-up measures appears imminent: selling off all or part of its Schwab Soundview Capital Markets division.

Speculation began swirling last month when The New York Post reported that Charles Schwab (SCH) had retained investment bank Greenhill & Co. to advise on a possible sale of Schwab Soundview, which offers trading and research to institutional clients. In a regulatory filing last week, Schwab confirmed that it is "seeking strategic alternatives," including divestiture, for the division.

LOGICAL MOVE. Two weeks ago, Mark Loehr, co-head of Schwab Soundview Capital Markets, held a meeting to discuss a management-led buyout of the division, BusinessWeek Online has learned. In addition, sources say several strategic buyers have expressed interest in all or parts of the division.

No one is certain how much Schwab Soundview's assets could fetch. But nearly everyone agrees that no buyer will pay $289 million for its research arm, Soundview Technology Group. That's how much Schwab paid, net of cash and equivalents, just seven months ago. One former Soundview Technology Group manager estimates buyers at are likely to value the research outfit at between $50 million and $150 million.

Soundview Technology was one of several outfits Schwab bought during the tenure of former CEO David Pottruck, which Schwab's board ousted on July 20, the same day the company reported net income of $113 million for the second quarter, down 10% on a year ago. With Pottruck gone, "It's a perfect opportunity to kind of clean house," says Michael Hecht, an analyst at Banc of America Securities. "Now that they can say, 'Those things were Pottruck's idea.' " Still, the Schwab board, which included chairman Charles Schwab, voted to approve the acquisitions.

SLIM MARGINS. Though the price Schwab paid for Soundview Technology drew criticism at the time of the purchase, few could argue with the logic behind it. "You can't fault Schwab for looking to diversify their business at the time," says another former Soundview Technology manager. Since the stock-market bubble burst in 2000, Schwab has worked to reduce its dependency on revenues from retail trading. After post-bubble research scandals surfaced on Wall Street, Schwab saw an opportunity to sell conflict-free research to institutional clients and bought Soundview for that purpose.

Yet since the acquisition closed in January, earnings from Schwab Soundview Capital Markets have dragged on overall results. In the second quarter, the division posted $1 million in pretax operating income on $75 million in revenue -- a profit margin of 1.3%. That's especially thin at a time when Schwab is seeking to improve overall profitability.

In addition to the research operation, other parts of Schwab Soundview Capital Markets could appeal to potential buyers. Several are likely eyeing the division's order-execution systems, which process more than 90% of Schwab's retail orders. "The asset that you're getting form the sale of Capital Markets is Schwab's order flow," says Todd Halky, an analyst at Sandler O'Neill & Partners. To make a deal more attractive, Schwab could agree to route its order flow to whoever buys the execution system.

BOUTIQUE BUYER? One buyer that might find such an offer intriguing is investment bank Jefferies, which has looked into purchasing all or part of Schwab Soundview, sources say. Jefferies had considered buying Soundview Technology before Schwab did, according to several former Soundview Technology employees. Jefferies already has research and order-execution businesses, which Schwab Soundview could complement under the right arrangement. "It's our policy not to comment on market rumors," says Lloyd Feller, general counsel at Jefferies, who joined the bank in 2002 after serving as general counsel at Soundview.

Another likely suitor is Perseus Group, a boutique investment bank, which formed a strategic alliance with Schwab Soundview last December. Under the agreement, Schwab Soundview Capital Markets distributes shares from stock offerings underwritten by Perseus to Schwab Soundview's institutional clients, giving the small bank a valuable sales channel. Though Perseus has an incentive to gain control over Schwab Soundview's client relationships, the privately held firm may not have enough capital to outbid larger buyers. Perseus did not return calls seeking comment.

Also named by sources as a possible buyer is online retail brokerage Ameritrade (AMTD), which doesn't have research or institutional trading businesses. "Ameritrade would make a lot of sense because it is a strategic diversification for them," says a former Soundview Technology manager. Yet others think Ameritrade would be better off staying with what it knows. "Ameritrade has built an extremely successful model by sticking to one thing: online infrastructure," says Lauren Smith, an analyst at Keefe, Bruyette & Woods. "I think that's the strategy they're going to pursue." Ameritrade did not return calls seeking comment.

BITTER PILL. No matter who buys either all or part of Schwab Soundview Capital Markets, the division's management stands to make out well in a sale. When Schwab bought Soundview Technology Group, stock options owned by Soundview Technology's top three executives -- Mark Loehr, John Hervey, and Bob Meier -- immediately vested in full under their employment contracts. All three then entered new contracts with Schwab, which provide for full vesting of their stock options upon a change in control of Schwab Soundview Capital Markets.

Thus the managers could profit from a sale twice in less than a year's time. Sources close to Schwab Soundview Capital Markets say Loehr has championed a buyout internally of the entire group and that such a deal would result in his appointment as CEO of the independent company. It's not clear whether the accelerated-vesting clauses would apply in the case of a management-led buyout.

Selling Schwab Soundview Capital Markets is a tough but necessary move for Schwab, which in June announced a plan to cut $150 million to $200 million in operating expenses by the end of the year. As part of that plan, the company confirmed two weeks ago that it would close 53 branches and let go 180 employees by Sept. 3. Last week, a regulatory filing revealed that Schwab plans to cut a total of 400 to 600 employees by year's end. The medicine may be bitter, but it's the right prescription for a good company that has fallen ill. Hibbard is a correspondent for BusinessWeek in the San Mateo bureau


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