Commentary: Charles Schwab Redux

Job One for the newly restored CEO: Focus on the Mass Affluent

Charles R. "Chuck" Schwab always had a knack for bringing revolution to Wall Street. Today it's the brokerage with his name on the door that needs the shake-up. That was the clear message sent by the Charles Schwab Corp. (SCH ) board on July 20, when it ousted Chief Executive David S. Pottruck and asked Schwab to assume that role as well as his chairmanship.

Pottruck, who had been at the firm for 20 years, has said he was surprised by their action. He shouldn't have been. Truth be told, the firm lost its way after the great technology stock bust of 2000 and hasn't found it again. Share trading volumes -- the lifeblood of any brokerage -- tanked. And since then, almost all of the company's efforts to diversify into new financial-service areas to make up for lost trading commissions have been disappointing, whether they involved actively courting millionaires or trying to sell advice to ordinary investors. "Diversification can cut both ways," says Joel K. Gomberg, an analyst at William Blair & Co. "You can lose focus, and resources can be allocated to businesses that aren't profitable enough."

Chuck Schwab, who turns 67 on July 29, needs to refocus the company quickly. That means identifying its true core businesses, focusing on them, and dumping excess baggage. It's not exactly an overnight task, but it's also not one that should take months. After all, as co-CEO and then chairman, Schwab worked with Pottruck, a 20-year veteran, and should know why key decisions were made and where they went awry.

The best chance for Schwab is to home in on its traditional key client group -- the so-called mass affluent, those who have investable assets of $100,000 to $1 million. There are millions of them around, and they're the main target of a slew of banks and brokers. But Schwab has a big advantage over its competitors because it has served those clients well in the past and still has millions of their accounts on its books. To keep them, it must zero in on meeting their needs.

At times, the firm has seemed to take its eyes off that ball. First, it began to race after rich clients with the acquisition of white-shoe wealth manager U.S. Trust, for $3.2 billion in 2000. Meantime, discount brokers such as E*Trade Financial Corp. (ET ) and Ameritrade Inc. started chippin at its client base with cheap trades as low as a third of what Schwab was charging.

Even before Chuck Schwab moved back into the hot seat, the firm began offering cheaper deals to frequent traders and customers with more than $100,000 invested. That's an important first step for the firm in getting back its mojo. To keep the mass affluent loyal -- and paying more -- Schwab needs to deliver higher-caliber service than the discounters. That means striking alliances with other firms to make available a broader range of products to its clients, such as the initial public offerings underwritten by Goldman, Sachs & Co. (GS ) that it sells.

At the other end of the spectrum, Schwab needs to work out what to do with U.S. Trust. Since the get-go it has brought little but headaches. Flaws in the company's technology led to violations of money-laundering rules and ultimately a $10 million fine -- tarnishing Schwab's long-standing reputation for probity. The firm ended up sidelining U.S. Trust's top two executives. The picture isn't much rosier today. U.S. Trust is overshadowed by plenty of other wealth-management firms. And last year, U.S. Trust's revenue fell 4%, to $628 million, the biggest drop among the company's units.

The simplest course might be to sell. Banks such as Northern Trust Corp. WL ) and Wilmington Trust Corp. (NTRS ) that are building up their businesses catering to rich clients might be interested in buying. Alternatively, if Chuck Schwab decides to hold on, he will almost certainly have to keep it entirely separate from Schwab itself. Past efforts to meld the two cultures failed abysmally. One example: When Schwab tried early on to persuade U.S. Trust to share its proprietary research with Schwab's customers, snooty execs simply refused.

Backstabbing Its Partners

Another problem the firm must address is its relationship with the thousands of independent advisers who use Schwab as a back office and park their clients' money there. Starting its own advice services alienated some of those advisers, who saw Schwab as treading on their territory. Some also balk at a few of the fees Schwab charges them for back-office services. At one point, the company was sending these advisers' clients marketing materials promoting Schwab's own advisory services. So fence-mending is clearly on Chuck Schwab's to-do list.

Returning to the firm's roots may also require exiting newly acquired sales-and-trading businesses. Schwab already appears to be shopping around its SoundView Capital Markets business, a trading-and-research outfit. The company paid $321 million for a part of this business in January. That's a good move because its returns have been skimpy. Selling Capital Markets would also underline Schwab's renewed commitment to retail customers. A Schwab spokesman declined to comment.

All this should improve Schwab's numbers. The same day Pottruck was pushed out the door, the company reported second-quarter income of $113 million, down 10% from a year earlier, though revenue rose 9%, to $1.11 billion. To goose earnings, Schwab is embarking on another round of needed cost-cutting and layoffs. The company's costs have long been high compared with other brokers that don't maintain such large branch networks. Analyst Matthew Snowling at Friedman, Billings, Ramsey Group Inc. says the firm is "just too bloated to be competitive."

Will Chuck Schwab fix up his brokerage just for a sale? Most analysts and investment bankers think not -- at least not anytime soon. After all, he owns about 19% of the firm and has repeatedly said it is "well-positioned on its own." Besides, though Schwab's stock price is low, it's still pretty expensive and carries a relatively rich price-earnings ratio. Of course, there's a good deal of cleaning up to be done before he could attract decent offers in any case.

Certainly, many on Wall Street think Chuck Schwab has a good chance of turning his firm around. "Chuck's coming back signals that they're going to start refocusing on what made them successful in the first place, which is going after the mass market," says Snowling. And perhaps he will add a dash of that old revolutionary fervor that served him and his firm so well in the past.

By Louise LeeWith Emily Thornton in New York and Justin Hibbard in San Mateo, Calif.

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