April 27, 1999

Charles Schwab for Mom

by Louis Corrigan

Trading at $119 3/16 as of April 26, 1999

Everyone investing via the Internet seems to be buying the online brokers, too. In a recent two-week period, Schwab's (NYSE: SCH) stock nearly doubled to $155, leaving it more than 800% above its September low. Upstarts like Ameritrade (Nasdaq: AMTD) and E*Trade (Nasdaq: EGRP) have done even better. Is it too late to make money on these stocks?

Maybe. But moms are great long-term investors. Being a mom is the toughest job in the world, with the payoff coming intermittently but tending to increase over time -- well after the Diaper Genie has been discarded and the terrible twos conquered. The online brokers seem well-suited for moms because they also promise increasing returns.

The Internet is transforming financial services, making once-dominant firms like Merrill Lynch (NYSE: MER) look like dinosaurs. People everywhere (but especially Americans) will increasingly do their banking, bill paying, investing, insurance buying, and everything else financial online. The online brokers have a leg up on capturing this business.

For example, old line brokers like Merrill suffer from a "channel conflict." They can't move aggressively into the online business without alienating their thousands of salespeople, uh, brokers. Yet, online brokers can readily attract customers because they simply offer better value. And those customers like to check in regularly: say, daily, or hourly, or minutely! I know I visit my online broker more each week than I've visited my bank all year, which makes it pretty unlikely the old bank will win my business when the online revolution kicks in full force.

Better yet, online brokers are benefiting from the economics of the Internet. Knocking out the "middleman" sales agent is just part of paring the whole cost structure of the business. Though all the online brokers are adding more employees to serve the rush of new customers, their main cost comes from adding mainframe computers and other technology to make their websites and trading systems more responsive. Yet, it's comparatively cheap to add a new mainframe. Also, technology continually provides more bang for the buck.

This means online brokers should enjoy increasing returns as they grow, spending increasingly less of their revenue on advertising and other operating expenses while pocketing more profits because it will cost less per customer or per trade to do business. Sure, the brokerage biz is highly competitive, but what we've learned so far from the Internet is that firms that capture significant market share early tend to get stronger.

Today, Schwab is the number one online broker, with about a 28% share of online trades, double its nearest rival E*Trade, despite a $29.95 basic trade price that's twice the average for online brokers. It has succeeded by using technology to provide extra service in what it calls a "high tech-high touch" approach. Add in its well-recognized brand and it's been easy for Schwab to attract more new customers in one quarter (388,000 in Q1) than E*Trade attracted all last year (353,000). It costs Schwab about $149 to acquire each new customer versus about $160 for Ameritrade and perhaps $400 for E*Trade. Moreover, Schwab's customers are wealthier.

For the March period, revenue soared 57% to $952 million, pushing earnings per share to $0.34, up 113% over the year-ago period and nearly 31% above the initial consensus estimate. Net margins came in at 15%, up from 11.3% last year. Return on equity (ROE) was equally impressive, rising to 36% from 23% a year ago. Schwab cut its online commission charges in January 1998, so commission revenues actually grew by just 59% despite the fact that daily average revenue trades rose 90% year-over-year to 160,000. And with a greater percentage of trades going through the website (65% vs. 48%), the cost of executing trades has fallen more than commissions.

The company ended the quarter with 5.9 million active accounts holding $542 billion in customer assets. About 2.5 million of those were considered active online accounts ($219 billion in assets). For comparison, E*Trade had 676,000 online accounts with just $15.2 billion in assets as of December.

Investors should look closer at all of the top online brokers, but I like Schwab in particular. All of these firms rely heavily on trading volume for commission revenue, so all would be hurt badly in a bear market. But Schwab gets comparatively more of its revenue ($319 million in Q1, or 33.5%) from steadier sources, such as interest income from customer assets (up 43% in Q1) and mutual fund service fees (up 35%).

This speaks to the maturity of Schwab's customer base. The company serves some 5,400 independent investment managers who park their customers' $163 billion in assets with Schwab, partly to take advantage of the firm's OneSource mutual fund supermarket. Schwab has even started promoting the services of these investment managers to keep customers who might be tempted to depart to a Merrill. It's part of Schwab's strategy to be both a discount and (at little extra cost) a full-service brokerage firm. This strategy should drive another stake into the traditional brokerage industry while positioning Schwab in the ever-expanding middle of the market.

Schwab's stated goal is to deliver 20% annual revenue growth, 20% return on equity (ROE), and 10% net margins. Yet, the company is now crushing these targets. FY98 ROE came in at 27%, with Q4 FY98 ROE at 31% and Q1 FY99 ROE at 36%. True, the company has recently benefited from the surge in trading associated with the market's rally, meaning it's unlikely profitability will continue to grow at the recent rate. Moreover, competition is heating up for new customers, which may be one reason Schwab fell slightly short in the first quarter of the pace required to open the targeted 1.6 million new accounts this year.

Still, the pattern of improving profitability seen of late foreshadows the long-term trend. Though earnings estimates should continue to rise, the current high-side number calls for FY99 profit of $1.34 per share, up 58% for the year. At $114, the stock trades for 85 times this year's earnings. That's rich, but the long-term growth rate could easily be 40%, or double the current 21% projection.

Figuring the stock should trade at twice its long-term growth rate during this period of rapidly accelerating profits, a P/E ratio of 80 is fair for Schwab, meaning a price of $107. Figuring that the FY 2000 EPS estimate gets jacked up from a current high of $1.67 to about $1.90 and using a multiple of 70, we get an 18-month target of $133. If that seems nutty, consider that on April 13, CIBC Oppenheimer's Amar Mehta set a 12-month price target of $200.

Given the recent volatility in the sector, moms with heart conditions might want to avoid it altogether. Indeed, a 50% sell-off from the recent high wouldn't be surprising at all. But below $100, I think you can be a happy long-term buy-and-hold Schwab investor. There's simply no company better positioned to benefit from the ways the Internet is transforming the financial services industry.

Schwab Company Information:
Trades on NYSE under symbol SCH
Schwab's website: www.schwab.com
Current Quote
Schwab's Chart

Other Related Links:
Charles Schwab Message Board
Schwab Dueling Fools -- 5/20/98
Online Brokers Take a Breather -- 3/24/99
Online Brokers Industry Snapshot

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