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Will Schwab's New Schtick Stick?

By Amey Stone Charles Schwab (SCH) is remaking itself -- yet again. It hopes to become the individual investor's source not just for discount trading, but for unbiased investment advice. The new strategy, heralded with the ad slogan "There's never been a better time for Charles Schwab," is an obvious play to make hay out of Wall Street's conflict-of-interest scandal.

Schwab has long been an alternative to traditional brokerage services for do-it-yourselfers, but now it's also aiming to position itself as an independent source of information for investors who want some reliable help making decisions (see BW, 6/03/02, "Schwab vs. Wall Street").

SHORT SHRIFT. This may be a major evolution of its business model, but so far investors in Schwab's stock are giving the new initiatives short shrift. There's just no getting around the fact that the company's earnings prospects are tied to the health of the stock market, which remains poor. Now, when the betting on Wall Street is that volume will be light and stocks will be stuck in a narrow trading range until corporate earnings pick up later in the year, a new marketing campaign -- even on the controversial topic of objective research -- isn't enough to give Schwab's shares a boost.

Schwab shares have stumbled ever lower since the late '90s bull market stalled. As of the close of trading on May 24, the stock was around $12, way below a split-adjusted high above the $40 it commanded in mid-2000. True, that's an improvement on the dip it took below $10 in early May, but the recent gain has more to do with a mild and perhaps temporary upturn in the broader market than Schwab's May 16 unveiling of its new slate of advice-oriented services.

"I like what they are doing, but in the near term it's an uphill battle," says Rich Repetto, a brokerage analyst with Putnum Lovell Securities, who rates Schwab a hold. On May 16, Schwab announced a new rating system that ranks stocks A through F based on results of a purely quantitative screening system, as well as two new programs to provide advice for a fee -- not a commission -- to customers of high net worth. "They're saying they're different -- and they are, but that that doesn't mean they won't suffer from the spillover of the loss of investor confidence," believes Repetto.

"It's a big change for them, but overnight it isn't going to change the way they do business," says Jeff Van Harte, a portfolio manager at Transamerica Investment Management. Van Harte expects the innovations may encourage existing customers to do more trading, as opposed to bring in new assets.

STILL FALLING. Even that's a big question mark, however. The past two years of market downturns, accounting scandals, and conflict-of-interest investigations have dealt a serious blow to investor confidence. The result has been a dramatically lower -- and still-falling -- trading volume. In April, the daily average was down 18% from the prior year and 6% from March, 2002. For the quarter ended in March, Schwab reported earnings of $94 million (7 cents a share), on revenues of $1 billion. That's down from earnings of $97 million on revenues of $1.2 billion in the same quarter the year before. For Schwab's fiscal 2002, analysts project the company will earn 39 cents a share.

The problem, says author and investment strategist Peter Cohan, isn't just that investors are disillusioned with Wall Street. "They've lost interest in stocks," he says. "People are burned out. Trading online is the opposite of cool."

Justin Hughes of Robertson Stephens upgraded the stock on May 8. But he did so based on the belief that the stock isn't fully valued, rather than faith in Schwab's capacity to profit from the problems facing full-service competitors. "I don't think it's going to be a huge boost for them," Hughes says of the marketing campaign. In the long term, he thinks Schwab will be a winner and advises clients to take advantage of the pessimism and pick up shares. But he concedes that as it approaches his $14 target, he's less enthusiastic. "Valuation matters," he says.

Based on its near-term earnings prospects, the stock already seems pretty pricey. Schwab trades at a price-earnings (p-e) multiple of 30 based on EPS projections of 39 cents this year. The S&P 500's p-e is 20. "It's hard to feel like it's cheap at that p-e," says Cohan. Schwab doesn't comment on its share price.

CUSTOMER SERVICE. Longer term, "at these prices, when we get a little better market, it will be undervalued," Van Harte says. He continues to own the stock, which makes up about 3% of assets in Transamerica Premier Equity (TEQUX). Despite its recent setbacks, "If you were going to build a financial services company, you would still build Schwab today," he says. He cites its strong management, ability to remain profitable despite the slump, and healthy balance sheet. Cohan points out that it is consistently rated high for customer service.

Van Harte doesn't expect the market to improve until late this year or early next, and Cohan thinks it could take until 2004 for investors to again catch the stock-trading bug. No matter how hard Schwab tries to differentiate itself, in one respect it's mostly indistinguishable from full-service brokerage houses: Their fates are tied to the broader market, and they will benefit when it begins to climb. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

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