Schwab vs. Wall Street

With the big firms rocked by scandal, Schwab is going after their disgruntled--and rich--clients

Charles R. "Chuck" Schwab is never happier than when he's waging war against Wall Street. In fact, it has been his business model ever since 1973, when he founded the discount brokerage that bears his name. His aim back then: to exploit the end of fixed-rate commissions in 1975--a traumatic event that slashed brokers' revenues and drove dozens of old-line firms out of business. His successful OneSource no-fee mutual-fund supermarket, launched in 1992, brought about a profound change in that business. And Schwab's stellar performance after its 1996 leap into online trading eventually forced the mighty Merrill Lynch & Co. (MER ), one of the last holdouts, to follow suit in 1999.

Now the 64-year-old chairman and co-chief executive of Charles Schwab Corp. (SCH ) is again trying to rewrite the rules on Wall Street. On May 16, he announced moves aimed at capturing the most profitable customers of the likes of Merrill, Morgan Stanley Dean Witter (MWD ), Salomon Smith Barney, and UBS PaineWebber--affluent clients with $500,000 to $5 million to invest. They constitute a huge market: By some estimates, they control nearly $11 trillion of investments in stocks, bonds, mutual funds, and cash, or about half the total of all such investments owned by Americans.

Schwab's attack plays directly off the crisis of confidence that's currently rocking the Street. Corporations blame bankers' bad advice for their troubled mergers and lackluster equity offerings. Betrayed individual investors fault their brokers for losing trillions of dollars of stock wealth since the dot-com bust in the spring of 2000. And they and others condemn the stock market's oracles--research analysts--for overly rosy stock recommendations.

Now, Schwab is trying to turn the Street's woes to his own advantage. Along with President and co-CEO David S. Pottruck, 53, he's launching an aggressive marketing campaign that fingers rivals' shortcomings and holds his firm up as the model of the squeaky-clean financial adviser. Hard-hitting print and TV ads emphasize that Schwab brokers, unlike their peers on the Street, aren't paid based on how much they encourage customers to trade, and that the company isn't beholden to big corporate clients because it doesn't have an investment-banking arm. "At Schwab, we're not focused on investment banking To us, it's a potential conflict of interest," says one ad. "Is your broker's idea of an investment plan a never-ending series of hot stock tips?" asks another. "We're promoting a model different from all those other firms, and we will not be shy about promoting how different we are," says Schwab.

The centerpiece of Schwab's offering is a new stock-rating system coupled with a private-client service and, soon, insured banking products. For a flat fee, customers can talk one-on-one with a personal adviser who provides investment ideas on matters ranging from asset allocation to stock selection. Next year, it hopes to add FDIC-insured banking products. Both services are commonplace on Wall Street. What's unique, though, is how Schwab comes up with stock picks. Using a new in-house computer model, it grades more than 3,000 stocks on an A to F scale based on 24 measures, such as a company's free cash flow and sales growth. "It's a systematic approach with nothing but objectivity, not influenced by corporate relationships, investment banking, or any of the above," says Pottruck. Last year, he claims, investors who bought the top 30 A selections would have beaten the Standard & Poor's 500-stock index by 4.6 percentage points.

Schwab could do with a big lift. Ever since the tech stock bust in the spring of 2000, its mainstay online trading has fallen sharply, slashing its revenues and operating margins. The resulting squeeze was so hard that Schwab had to fire nearly one in four of its 26,000 workers last year--the first layoffs since the 1987 stock market crash. In the scramble to shore up profits, it is slapping on extra charges, such as a $3 transaction fee on online trades. And it has a minor rebellion on its hands among the independent financial advisers whose clients pony up about one-third of the $858 billion of Schwab's total client assets. Some claim Schwab is hanging onto clients it should be referring to them. A few are so angry that they have stopped placing new money with the firm.

The new strategy will cause plenty of strains at Schwab. Signing up thousands of upmarket clients and making money for them--and from them--is sure to be tough. By launching a private-client service, Schwab is straying further than ever from its discount-brokerage roots. It is hoping to extend its well-established brand without sacrificing the core brokerage business, which still accounts for 38% of its operating earnings. Schwab's top execs are well aware of the magnitude of the challenges they face. "The changes we're making are profound," says Pottruck, a former champion wrestler and football player at the University of Pennsylvania who is charged with making the strategy work. "This is retesting what the company stands for." The 18-year company veteran, long seen as Schwab's heir apparent, has been co-CEO since 1998. He serves as the firm's hands-on, day-to-day manager while Schwab serves as the big-picture strategist and public face of the company. Says Schwab: "I'm the inspirational leader, and Dave makes it happen."

If the duo can succeed, they'll do far more than revive their own business. They'll demonstrate that Wall Street can turn an honest penny without fleecing investors--and that it's possible to earn big bucks from a standalone brokerage and research operation.

As the firm strives to do that, it's finding some unexpected allies among the regulators. On May 21, Merrill reached a $100 million settlement with New York Attorney General Eliot Spitzer, who charged that its analysts issued misleading research to win banking business from Internet companies. Merrill also agreed to change its research standards and even the way that its analysts are paid. Other firms will likely follow suit. Spitzer is also investigating Salomon Smith Barney, Morgan Stanley, and at least three other firms. Meantime, the Securities & Exchange Commission hinted that Spitzer may not have the final word. "While this settlement is an important milestone for investor protection, it is not the finish line, and will not preclude our own efforts on behalf of the investing public," says SEC Director of Enforcement Stephen M. Cutler. The SEC has also launched a probe into the practices at 10 firms. And plaintiffs' lawyers are filing a flurry of class actions against Wall Street firms.

All the same, Schwab may find that it isn't alone in bragging about having no conflicts for very long. Merrill immediately tried to turn the May 21 settlement to its advantage, saying that it was setting a "new industry standard" for research--a boast that will be backed by an ad campaign. "Merrill Lynch can consider this a victory because they won a significant competitive advantage over their rivals," says John Coffee, professor of securities law at Columbia University. "They not only escaped crucifixion but they are blessed with holier analysts than the rest of their competitors." The same day, Goldman, Sachs & Co. appointed an investment research ombudsman and expanded its audit committee's responsibilities to include monitoring the integrity of its research. And on May 22, Salomon said it would adopt the same changes as Merrill.

While most of Wall Street quietly dismissed Schwab's offensive as a marketing ploy, Merrill pointed out a potential Achilles' heel. On May 16, it said in a rare statement that Schwab's attempt to recast itself as a source of advice simply reflected the woes of its discount-brokerage business. "They will be hard-pressed to deliver on that promise for the majority of their clients," it said.

Merrill may well be right. Schwab's culture is being severely tested. Employees hired mainly as order-takers are finding that they're underqualified as Schwab strives to upgrade its branch staff with more experienced--and more expensive--financial advisers. Meanwhile, there has been turmoil at the top. Steven L. Scheid, who headed the retail business, abruptly left in February because he wanted more "autonomy," according to the company. Scheid declined to comment. Pottruck is filling in for him while the company looks inside for a replacement.

The company's relationship with 5,000 independent advisers has been fraying ever since 2000, when Schwab bought U.S. Trust Corp., a 149-year-old advisory firm catering to multimillionaires. As Schwab pushes deeper into the advice business, many are feeling much more threatened and blame the firm for eating in to their business. "We feel Schwab's competing with us," says Christiane Delessert, an adviser in Newton, Mass., who keeps about $150 million in client assets at Schwab. "They are angering a lot of people." Schwab has tried to mollify the elite group of 330 outside advisers who form Schwab's Advisor Network. It has set up an incentive for branches to refer clients to them as they're supposed to--but the advisers have to turn over a small cut of the fees they earn from clients.

However risky the strategy might be, Schwab and Pottruck have little alternative but to bet big. The firm is still reeling from the financial aftershocks of Nasdaq's nosedive in 2000. Pummeled by a 34% drop in daily average trades, revenue dropped 25% last year, to $4.35 billion, while net income plunged 72%, to $199 million. With little prospect of quick improvement, Pottruck moved to slash costs: Apart from the layoffs, he also dumped millions of dollars' worth of computer equipment to save the costs of running and maintaining it. "Obviously, we weren't going to succeed based on online trades," says Pottruck. Trading levels are "not going to go back to where they were in 2000, ever."

That realization also put the advice strategy on the front burner. Schwab had been quietly putting it in place well before the tech bust. By then, Schwab had already announced plans to acquire U.S. Trust. That move was designed to help Schwab retain customers who were leaving because it didn't provide trust and estate services. But Schwab still needed a service to offer to the legions of people with $500,000 or more in assets who want to keep control of their own accounts but need an adviser to give them ideas.

Launched on May 16, Schwab Private Client is Schwab's play for this market. For a fee of 0.6% of assets--or a minimum of $1,500--per year, customers meet face-to-face with an adviser to work out an investment plan and return to the same consultant for further advice. The adviser might call the client to discuss market or industry developments and their impact on the portfolio. What clients don't get: legal, tax, and estate-planning advice. Nor do Schwab's private-client advisers actually manage the client's money or decide what to buy and sell. That's still the client's job.

The service, which is by appointment only, will be available in most Schwab branches. But Schwab has also opened nine separate, plusher offices in upmarket neighborhoods for customers wanting to avoid the hoi polloi at regular branches. The discreet fourth-floor office in Santa Clara, Calif., in the heart of Silicon Valley, is furnished with dark wood furniture, flowers, and a conference room where customers can bring their tax advisers, estate planners, and attorneys for powwows with the Schwab adviser. "It feels like a private-client atmosphere," says John Molskness, who heads the office. "It's not designed for the walk-in client."

Pottruck credits U.S. Trust staffers for helping Schwab figure out how to structure its new service. They warned, for instance, that unlike Schwab's do-it-yourself customers, private clients don't appreciate being told to phone a call center if their adviser isn't available. But in other areas, the relationship hasn't been too fruitful. It quickly became clear that Schwab wouldn't be able to scale down U.S. Trust's high-maintenance hand-holding of clients to accounts as small as $500,000. And U.S. Trust stock analysts balked at putting their own research reports on Schwab's Web site. Pottruck says that was "a little bit of a disappointment," but Schwab realized that the analysts covered too few stocks to make the effort worthwhile. Instead, Schwab is offering Goldman Sachs' research to top-drawer clients.

Now, Schwab faces a reality check as it starts selling advice to a wider public. During a year of testing, the service attracted about 1,000 clients--mostly existing Schwab account holders--and $1.5 billion of assets, of which just $225 million was new money. Chuck Schwab is projecting the private-client business to reach between $3 billion and $4 billion in assets by yearend. Can he succeed? Some observers believe he has a decent shot at making the service work because many customers, burned by the tech meltdown, want advice. "Customers will want it because customers need it," says Morty Schaja, president of New York-based Baron Funds, which owns 22.3 million Schwab shares. "With the new service, they'll successfully fill in the gap between U.S. Trust and the discount-brokerage online trader. Now they can compete favorably with Merrill Lynch and Morgan Stanley."

Others are far less sanguine because so many other banks and brokers are chasing the same affluent clients. "They're going into a very crowded marketplace," says David Thompson, consultant at NFO WorldGroup Inc. Adds Ward Harris of financial-services consulting firm McHenry Consulting Group: "I don't know if Schwab has the history or experience needed to succeed at this." While Schwab's advisers may be able to handle basics such as asset allocation, he says, they may cope less well with more complex issues such as managing options.

In pushing itself as a financial adviser to the affluent, Schwab's biggest hurdle may be finding the right staff. It now faces an urgent need to develop a cadre of qualified advisers for its private-client service. It has only 150 in place, but plans to double that number by yearend. If it can't find them within its existing ranks, it must look outside. That's already happening. Before he came to the then-new Santa Clara office about a year ago, the 34-year-old Molskness worked at the financial-advice operations of Prudential Financial and American Express. All four advisers in Santa Clara have years of experience in giving financial advice. But three of them lack a certified financial planner qualification, although they are currently completing the coursework to receive it.

Even with a qualified staff, Schwab may still be battling what Pottruck calls a "credibility gap" that keeps many potential customers from seeing Schwab as a legitimate source of advice. "We're not yet trusted for our market wisdom or the nature and depth of our client relationships," he says.

As its adviser staff boosts its qualifications, they're sure to demand higher salaries, something Schwab traditionally isn't known for. A former manager who voluntarily left the company in early 2001 notes an inside joke: Schwab is a discount broker that offers a "discount paycheck." Says Erick F. Maronak, head of research at Newbridge Partners LLC, which in early May sold about 6 million Schwab shares: "Where it cuts back on order-takers, it's got to replace with advice givers, and they cost more. If they want to compete with Merrill Lynch, it will require a lot of capital." Daniel O. Leemon, Schwab's chief strategy officer, counters that expected increased revenue and efficiency will offset rising payroll costs in the future.

Schwab also faces a real danger that customers will view its private-client advice as a one-size-fits-all product. Private-client advisers make heavy use of in-house computerized systems to develop investment plans for clients. Without them, serving each client would take so much time that Schwab's costs would spin out of control. "You run the risk of [getting into] a slippery slope where before you know it, you've reinvented the cost structure of your most expensive competitors," says Pottruck. "The key for Schwab is our ability to use technology and automation to keep the cost structure down."

Using a consistent computerized system to analyze client needs also protects clients from the whims or offbeat personal preferences of the adviser, Schwab executives say. But it's a small step from consistent to cookie-cutter. That's a perception Schwab has been aware of and wants to avoid. "None of us is so naive to think there's a model that works for everyone all the time," says Jeremiah H. Chafkin, an executive vice-president who is overseeing the advice service. "No one wants a relationship with a computer." The new ads try to counter any such perception, insisting that advisers "take the time to study your financial needs" and "listen to you and your goals."

That may produce hollow laughter from Schwab's traditional clients. Schwab no longer pays postage on envelopes customers can use to mail in checks. Since last fall, households with less than $50,000 in their accounts have to pay $30 a quarter, unless they trade eight times a year. And starting on June 1, the company will raise its minimum fee for broker-assisted trades by 41% and automated-phone trades by 65%. It also plans to start charging a $60 fee for all customers when they want to close an account. "It obviously wants to chase smaller customers out of there," sniffs Muriel Siebert, chairwoman of Muriel Siebert & Co., a rival discount broker that hasn't changed its fees. "Schwab could lose a lot of goodwill." Adds Baron Capital's Schaja: "The risk is that the customer that isn't profitable today might be a profitable customer in five years."

Pottruck clearly has to execute a delicate balancing act. The company's ambitious financial targets for this year don't leave him much room to maneuver--requiring him both to cuts costs and bag significant new revenues. Schwab is targeting operating profit margins of 12% to 14% by yearend and aiming to boost revenue per employee to $300,000 in 2003, up from $190,000 in 2001. In addition, it hopes to garner $125 billion in net new assets, a considerable jump from the $74 billion added in 2001--all the while nurturing the new private-client service.

In the past, Schwab has had its snafus. In 1999, it set up Epoch Partners Inc. along with TD Waterhouse, Ameritrade, and three venture-capital firms, to underwrite initial public offerings of technology companies to sell to clients, a market that froze after the tech bust. In June of last year, it sold its stake to Goldman Sachs, which acquired all of Epoch. Other ill-timed initiatives have included PocketBroker, a wireless trading service for handheld gadgets that Schwab acknowledges hasn't taken off, and CyberTrader, a service for active online traders that it is still trying to expand.

But it would be dangerous for Wall Street to assume that Schwab's private-client service will fall flat. Time and again, Chuck Schwab's rivals have pooh-poohed his ideas as impractical or unnecessary; time and again, his ideas have wrought major changes in the way Wall Street operates. If Schwab can show that a large-scale advice business can work profitably without being inextricably wed to an investment bank, he'll blow the Street's current business model out of the water--probably to the cheers of millions of disgruntled investors.

By Louise Lee in San Francisco, with Emily Thornton in New York

— With assistance by Emily Thornton

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