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An Update on Charles Schwab

Charles Schwab (SCHW) recently reported results for the third quarter of fiscal 2019.

During the quarter, net revenues increased 5% to $2.7 billion. Growth was primarily attributable to a 7% increase in Net Interest Revenue to $1.63 billion. This reflects a slight improvement in yield (up 10 basis points year-over-year to 2.43%), as well as continued growth in client cash allocations. The remainder of the business was relatively unchanged, with Asset Management & Administration Fees and Trading up 2% and down 2%, respectively.


Growth in active brokerage accounts and total client assets continued, with both up 6% in the quarter (to $12.1 million and $3.8 trillion, respectively). The latter was supported by a mid-single digit increase in core net new assets, with net market gains / losses being a wash over the past year. As CEO Walt Bettinger noted on a conference call, "Investors continue to reward us with strong business growth. Our contemporary full-service model helps us remain a trusted partner as clients navigate an environment that has only grown cloudier in recent months."

As shown below, client assets have consistently marched higher over the past decade, with a compounded annual growth rate of roughly 10% (with help from rising equity markets).

In addition to core business growth, Schwab is increasingly providing higher value services to clients. In the quarter, assets receiving ongoing advisory services climbed 7% to $2 trillion, with assets in digital advisory solutions (like Intelligent Portfolios) up 20% to $43 billion.

Expenses in the quarter increased 8%, with roughly half of that growth attributable to severance costs (Schwab eliminated positions covering roughly 3% of its workforce in the quarter). This outsized expense growth led to a slight degradation in pre-tax profit margins (down 170 basis points to 45.6%), with net income climbing 3% year-over-year to $951 million. After accounting for a 4% reduction in the diluted share count, earnings per share (EPS) increased 8% to $0.70 per share (if you back out the severance costs, EPS increased by roughly 14%). Year to date, revenues, net income and earnings per share have increased 9%, 11% and 15%, respectively.

As has been widely discussed in the financial press, Schwab recently decided to eliminate online trading commissions for stocks, ETF's, and options in the United States and Canada. In a note to shareholders, CFO Peter Crawford estimated that this will result in a $90 - $100 million reduction in quarterly revenues, which translates to a low-single digit percentage of Schwab's total revenues. In his commentary, he also touched on the strategic rationale for this decision:

"It's the right move from a competitive standpoint. There has been a clear pause in the so-called commission wars among the "traditional" e-brokers since the price reductions we made in 2017. At the same time, we are seeing new firms trying to enter our market - using zero or low equity commissions as a lever. We're not feeling competitive pressure from these firms... yet. But we don't want to fall into the trap that a myriad of other firms in a variety of industries have fallen into and wait too long to respond to new entrants. It has seemed inevitable that commissions would head towards zero, so why wait? We have a business model that doesn't depend on commission revenue, a long-term orientation and a history of being willing to disrupt ourselves based on client needs and competitive dynamics. That's exactly what we are doing here - we're making these pricing changes because we believe they enhance both our value proposition and our competitive positioning, encouraging the consolidation of client assets and trades at Schwab."

Personally, I think he makes a compelling point. Trading, which accounted for 60% of Schwab's revenues twenty years ago (when the commission rate was at roughly $30 per trade), has become immaterial to the company's financials. At the same time, it remains important to their traditional competitors and has been a selling point for some new entrants. For that reason, I can appreciate the strategic rationale for waking up one morning and deciding to walk away from a few hundred million dollars in annual revenues. (With that said, I think the idea that taking the cost of a trade from $4.95 to zero will make investing "accessible to all" is rubbish - and potentially a negative in terms of the long-term investment results that will be achieved by the average individual.)

Conclusion

A glance at the key metrics shows that Schwab has performed well over the past 5-10 years. Personally, I have been most impressed by their consistent core net new asset growth.

Looking ahead, I believe Schwab will continue to gather assets and take share. While the business faces headwinds in the current interest rate environment, I think that's a manageable issue for long-term investors. I don't currently own the stock, but I could see that changing in the near future.

Disclosure: None

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This article first appeared on GuruFocus.