Reinventing Schwab

Once upon a time, when CharlesSchwab (NYSE: SCH  ) was the only kid on the discount brokerage playground, life was sweet. The upstart firm flew in under the Wall Street radar, building an empire simply by eschewing traditional brokerage methodology in favor of a new business model. The no-frills, low-cost structure was a hit, raking in droves of market-savvy clients uninterested in bells and whistles but quite fascinated with a broker that could pick up 100 shares of IBM (NYSE: IBM  ) at a fraction of full-service commission schedules.

Unfortunately, the combination of Schwab's unbridled success and the surging popularity of online trading proved enticing to new friends such as Ameritrade (Nasdaq AMTD), E*Trade (NYSE: ET  ) , and Toronto-Dominion's (NYSE: TD  ) TD Waterhouse. Suddenly, Schwab's innovative pricing scheme wasn't quite so unique, and the low-cost pioneer found itself struggling on a now crowded playground.

A week ago, Schwab retaliated by trumpeting plans to slash commission rates by up to two-thirds for select clients -- a move designed to aggressively address market-share erosion at the hands of rock-bottom-priced rivals. Over the weekend, the company dropped another bombshell, confirming an internal memo that prepared employees for the likelihood of job cutbacks on the horizon. Specifics, such as the timing, method, and extent of the reductions, have not been outlined, but the prospect of another round of layoffs after the company scaled back the workforce by 35% several years ago is a none-too-subtle sign that Schwab has lost focus.

The relentless bear market forever changed the landscape of the do-it-yourself set, the mainstay of discount brokers. Many decided that, as it turns out, the fast-track to financial independence wasn't actually paved with shares of CMGI (Nasdaq: CMGI  ) , JDS Uniphase (Nasdaq: JDSU  ) , and other highfliers, and then fled the day-trading hobby for less-costly ventures. Others concluded that perhaps a little professional guidance wasn't such a bad idea after all, and then turned over the reigns of their portfolios to traditional full-service money managers. In the face of mounting competition, and a shifting consumer sentiment toward a more advice-driven approach, Schwab was forced to reevaluate its position in the marketplace.

Schwab's new look
Clearly, the future for a discount broker at the upper end of the commission scale was muddled. Management was forced into making some difficult strategic decisions, in the process, abandoning a cardinal principle upon which the firm was founded: no advice. The core philosophy was tossed aside -- along with a commitment to serving the average investor -- as the company overhauled its operations in search of a new identity as a full-service broker.

The transaction-based, low-cost structure remained intact, but the acquisition of US Trust and the implementation of the tiered Schwab Personal Choice program highlighted a new commitment to also provide comprehensive wealth-management services to affluent clients -- a strategy inconceivable a few years earlier. To be sure, there is still a targeted effort to reach the low-cost crowd, especially considering recent commission reductions, but a quick glance at Schwab's website reveals a desire to trap bigger game: college funding, asset management, retirement and estate planning, and trust accounts.

Schwab's foray into the full-service arena has left the company vulnerable to attack from both sides. Unable to differentiate by either price or service, it has been undercut at one end of the spectrum by online discount brokers while it is waging war at the other end on foreign terrain against entrenched industry heavyweights such as Merrill Lynch (NYSE: MER  ) , Morgan Stanley (NYSE: MWD  ) , and Citigroup's (NYSE: C  ) Smith Barney. Nevertheless, management at Schwab is not content to sit idly, and it has shown a willingness to pull the trigger on difficult decisions that are reflective of long-term planning. Make no mistake, Schwab has learned from missteps, adapted, and made moves that are only now beginning to pay off.

Branching beyond transactions
Recent market strength has fueled a rise in trading activity industry-wide. Schwab's daily average revenue trades (DART), the key benchmark to measure commission-generating trades, rose 37% in April to 164,000 per day, versus quarter-end figures of 212,000 at Ameritrade and 103,000 at E*Trade. Still, investors who rely solely on this and similar metrics are missing the bigger picture. As most old-school stockbrokers will attest, a purely transaction-based business model is essentially a proxy for market performance. When the market rises, trading increases follow, and when stocks are in free-fall mode, investors are reluctant to act, trading volume dries up, and commission-based revenues plummet. It's really that simple.

Schwab has transitioned a block of assets to fee-based platforms, which should annuitize revenues and soften the blow in a market correction. Schwab Private Client, a premium service account for advice-seeking investors, saw its participants double year over year last quarter, with managed assets soaring 140% to $18 billion. Schwab also maintains a network of independent fee-based advisors, has a capital markets division (which is the Nasdaq's (OTC: NDAQ) largest market maker), manages $153 billion in proprietary mutual funds and $118 billion in employer-sponsored retirement plans, and last year received a charter for Schwab Bank (which issues traditional loan and deposit products). A buoyant market will lift all brokerage firms, as we've seen lately, but Schwab's full-service tilt will truly shine relative to peers on the discount side in a down market, when recurring revenues stream in regardless of customer trading patterns.

There is clear rationale for Schwab's inclusion as a Motley Fool Stock Advisor pick. Recent troubles notwithstanding, the firm is still the nation's largest discount broker, and it's getting larger. Last quarter, more than 160,000 new accounts were opened -- the largest number in more than a year, trouncing Ameritrade's 124,000 and E*Trade's 37,000. Assets under management rose 31% and stand just shy of $1 trillion. Sure, new cost-cutting initiatives should expand margins, and cash flow is strong enough to warrant a planned 43% increase in dividend payments, but there is a more important factor underneath the numbers.

Regardless of the whims of the market, neither bull nor bear will alter one immutable truth: Some investors will always be willing to pay for hand-holding and advice, while others will always seek out low-cost trade executions. Schwab now has the tools to compete effectively at both ends of the retail market.

Are you in the market for a discount broker? Learn more at the Fool's Broker Center.

Fool contributor Nathan Slaughter was a full-service broker in a former life. He owns none of the companies mentioned.


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