Charles Schwab

Case 15

Charles Schwab

Charles Hill

Introduction

In 1971, Charles Schwab, who was 32 at the time, set

up his own stock brokerage concern, First Commander.

Later he would change the name to Charles Schwab &

Company, Inc. In 1975, when the Securities and

?Exchange Commission abolished mandatory fixed commissions on stock trades, Schwab moved rapidly into

the discount brokerage business, offering rates that

were as much as 60% below those offered by full commission brokers. Over the next 25 years, the company

experienced strong growth, fueled by a customer centric

focus, savvy investments in information technology, and

a number of product innovations, including a bold move

into online trading in 1996.

By 2000, the company was widely regarded as one

of the great success stories of the era. Revenues had

grown to $7.1 billion and net income to $803 million,

up from $1.1 billion and $124 million respectively in

1993. Online trading had grown to account for 84% of

all stock trades made through Schwab, up from nothing

in 1995. The company¡¯s stock price had appreciated by

more than that of Microsoft over the prior ten years.

In 1999, the market value of Schwab eclipsed that of

Merrill Lynch, the country¡¯s largest full service broker,

despite Schwab¡¯s revenues being more than 60% lower.

The 2000s proved to be a more difficult environment for the company. Between March 2000 and mid

2003 share prices in the U.S. tumbled, with the technology heavy NASDAQ index losing 80% of its value from

peak to trough. The volume of online trading at Schwab

slumped from an average of 204,000 trades a day in 2000

to 112,000 trades a day in 2002. In 2003 Schwab¡¯s revenues and net income fell sharply and the stock price

tumbled from a high of $51.70 a share in 1999 to a

low of $6.30 in early 2003. During this period Schwab

?expanded through acquisition into the asset management

business for high net worth clients with the acquisition

on U.S. Trust, a move that potentially put it in competition with independent investment advisors, many of who

used Schwab accounts for their clients. Schwab also entered the investment banking business with the purchase

of Soundview Technology Bank.

In July 2004 founder and chairman Charles Schwab,

who had relinquished the CEO role to David Pottruck in

1998, fired Pottruck and returned as CEO. Before stepping down in 2008 he refocused the company back on

its discount brokering roots, selling off Soundview and

U.S. Trust. At the same time, he pushed for an expansion

of Schwab¡¯s retail banking business, allowing individual

investors to hold investment accounts and traditional

bank accounts at Schwab. Schwab remains chairman of

the company.

In 2007¨C2009 a serious crisis gripped the financial

services industry. Some major financial institutions went

bankrupt, including Lehman Brothers and Washington

Mutual. The widely watched Dow Industrial Average

Index plunged from over 14,000 in October of 2007 to

6,600 in March 2007. Widespread financial collapse was

only averted when the Government stepped in to support

the sector with a $700 billion loan to troubled companies. Almost alone amongst major financial service firms,

Schwab was able to navigate through the crisis with relative ease, remaining solidly profitable and having no need

to place a call on Government funds. By 2010¨C2013 the

company was once again on a growth path, fueled by

School of Business, University of Washington, Seattle, WA 98105,

June 2013.

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Case 15 Charles Schwab

expanded offerings including the establishment of a market place for Exchange Traded Funds (EFTs). Schwab¡¯s

asset base expanded at around 6% per annum during this

period. The major strategic question going forward was

how to continue to grow profitably in what remained a

challenging environment for financial service firms.

The Securities

Brokerage Industry1

A security refers to financial instruments, such as a stocks,

bonds, commodity contracts, stock option contracts, and

foreign exchange contracts. The securities brokerage industry is concerned with the issuance and trading of financial securities, as well as a number of related activities.

A broker¡¯s clients may be individuals, corporations, or

government bodies. Brokers undertake one or more of the

following functions; assist corporations to raise capital by

offering stocks and bonds, help governments raise capital

through bond issues, give advice to businesses on their

foreign currency needs, assist corporations with mergers

and acquisitions, help individuals plan their financial future and trade financial securities, provide detailed investment research to individuals and institutions so that they

can make more informed investment decisions.

Industry Background

In 2011 there were 4,456 broker-dealers registered in the

United States, down from 9,515 in 1987. The industry is

concentrated with some 200 firms that are members of

the New York Stock Exchange (NYSE) accounting for

87% of the assets of all broker-dealers, and 80% of the

capital. The 10 largest NYSE firms accounted for almost

57.9% of the gross revenue in the industry in 2011, up

from 48% in 1998. The consolidation of the industry has

been driven in part by deregulation, which is discussed

in more detail below.

Broker-dealers make their money in a number of

ways. They earn commissions (or fees) for executing a

customer¡¯s order to buy or sell a given security (stocks,

bonds, option contracts, etc). They earn trading income,

which is the realized and unrealized gains and losses on

securities held and traded by the brokerage firm. They

earn money from underwriting fees, which are the fees

charged to corporate and government clients for managing an issue of stocks or bonds on their behalf. They earn

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asset management fees, which represent income from

the sale of mutual fund securities, from account supervision fees, or from investment advisory or administrative

service fees. They earn margin interest, which is the

interest that customers pay to the brokerage when they

borrow against the value of their securities to finance

purchases. They earn other securities related revenue

comes from private placement fees (i.e. fees from private equity deals) subscription fees for research services,

charges for advisory work on proposed mergers and acquisitions, fees for options done away from an exchange

and so on. Finally, many brokerages earn non-securities

revenue from other financial services, such as credit

card operations or mortgage services.

Exhibit 1 illustrates the breakdown between the various income sources for brokers in 2004, 2007 and 2011.

Of particular note is the surge in ¡°other securities revenue¡± in 2007. This reflects the boom in private equity

deals, derivatives contracts, and associated fees that were

not executed through an exchange, and therefore were

unregulated. The high volume of derivatives, in particular, was a major factor in the 2008 turmoil in global financial markets, since many of the derivatives were tied

to mortgage-backed securities, the value of which collapsed during 2008.

Industry Groups

Brokerage firms can be segmented into five groups. First,

there are national full line firms, which are the largest full service brokers with extensive branch systems.

They provide virtually every financial service and product that a brokerage can offer to both households (retail

customers) and institutions (corporations, governments,

and other nonprofit organizations such as universities).

Examples of such firms include Merrill Lynch, Morgan

Stanley Smith Barney, and A.G. Edwards. Most of these

firms are headquartered in New York. For retail customers, national full line firms provide access to a personal

financial consultant, traditional brokerage services, securities research reports, asset management services,

financial planning advice, and a range of other services

such as margin loans, mortgage loans, and credit cards.

For institutional clients, these firms will also arrange

and underwrite the issuance of financial securities, manage their financial assets, provide advice on mergers and

acquisitions, and provide more detailed research reports

than those normally provided to retail customers, often

for a fee.

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Case 15 Charles Schwab

Exhibit 1

Brokers¡¯ Line of Business, as a Percentage of Revenues, 2004,

2007 and 2011

Item

2004 (%)

2007(%)

2011(%)

Commissions

16.5

8.2

17.4

Trading Gain

10.9

?2.9

1.0

0.9

0.0

10.5

6.6

12.4

Margin Interest

3.9

8.3

3.3

Asset Management Fees

8.8

6.1

17.4

Commodities

0.6

0.2

1.7

37.2

60.4

32.7

10

13.8

Investment Gain

Underwriting

Other Securities Revenue

Other Revenue

1.04

6.8

Source: SIFMA

Large investment banks are a second group. This

group includes Goldman Sachs. These banks have a limited branch network and focus primarily on institutional

clients, although they also may have a retail business

focused on high net worth individuals (typically individuals with more than $1 million to invest). In 2008

Lehman Brothers went bankrupt, a casualty of bad bets

on mortgage backed securities, while the large bank,

JP Morgan, acquired Bear Stearns, leaving Goldman

Sachs as the sole stand alone representative in this class.

A third group are regional brokers, which are full

service brokerage operations with a branch network in

certain regions of the country. Regional brokers typically

focus on retail customers, although some have an institutional presence.

Fourth, there are a number of New York City Based

brokers, who conduct a broad array of financial services,

including brokerage, investment banking, traditional

money management, and so on.

Finally, there are the discounters, who are primarily

involved in the discount brokerage business and focus on

executing orders to buy and sell stocks for retail customers. Commissions are their main source of business revenue. They charge lower commissions than full service

brokers, but do not offer the same infrastructure such

as personal financial consultants and detailed research

84487_case-15_ptg01_hr_C210-C225.indd 212

reports. The discounters provide trading and execution

services at deep discounts online via the Web. Many

discounters, such as Ameritrade and E* Trade, do not

maintain branch offices. Schwab, which was one of the

first discounters, and remains the largest, has a network

of brick and mortar offices, as well as a leading online

presence.

Earnings Trends

Industry revenues and earnings are volatile, being driven

by variations in the volume of trading activity (and

commissions), underwriting, and merger and acquisition activity. All of these tend to be highly correlated

with changes in the value of interest rates and the stock

market. In general, when interest rates fall, the cost of borrowing declines so corporations and governments tend

to issue more securities, which increases underwriting

income. Also, low interest rates tend to stimulate economic growth, which leads to higher corporate profits,

and thus higher stock values. When interest rates decline,

individuals typically move some of their money out of

low interest bearing cash accounts or low yielding bonds,

and into stocks, in an attempt to earn higher returns. This

drives up trading volume and hence commissions. Low

interest rates, by reducing the cost of borrowing, can also

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Case 15 Charles Schwab

increase merger and acquisition activity. Moreover, in a

rising stock market, corporations often use their stock as

currency with which to make acquisitions of other companies. This drives up drives up merger and acquisition

activity, and the fees brokerages earn from such activity.

The 1990s was characterized by one of the strongest

stock market advances in history. This boom was driven

by a favorable economic environment, including falling

interest rates, new information technology, productivity

gains in American industry, and steady economic expansion, all of which translated into growing corporate profits and rising stock prices.

Also feeding the stock market¡¯s advance during the

1990s were favorable demographic trends. During the

1990s American baby boomers started to save for retirement, pumping significant assets into equity funds. In

1989 some 32.5% of U.S. households owned equities.

By 1999 the figure had risen to 50.1% (see Exhibit 2). In

1975, some 45% of the liquid financial assets of American

households were in financial securities, including stocks,

bonds, mutual funds, and money market funds. By 2011

this figure had increased to 72.6%. The total value of

Exhibit 2

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household liquid financial assets increased from $1.7

trillion to $25.6 trillion over the same period.

Adding fuel to the fire, by the late 1990s stock market

mania had taken hold. Stock prices rose to speculative

highs rarely seen before as ¡°irrationally exuberant¡± retail

investors who seemed to believe that stock prices could

only go up made increasingly risky and speculative ¡°investments¡± in richly valued equities.2 The market peaked

in late 2000 as the extent of overvaluation became apparent. It fell significantly over the next two years as the

economy struggled with a recession. This was followed

by a recovery in both the economy and the stock market,

with the S&P 500 returning to its old highs by October

of 2007. However, as the global credit crunch unfolded

in 2008, the market crashed, falling precipitously in the

second half of 2008 to return to levels not seen since the

mid 1990s. Although the market has since recovered, US

households still have less of their liquid financial assets

in stocks and mutual funds than at the peak of the 1990s

boom (see Exhibit 2).

The long stock market boom drove an expansion

of industry revenues, which for brokerages that were

Percentage of US Household Liquid Financial Assets held

in Equities and Mutual Funds 1990¨C2011

80

% of liquid financial assets

70

60

50

40

30

20

10

19

9

19 0

9

19 1

9

19 2

9

19 3

9

19 4

9

19 5

9

19 6

9

19 7

9

19 8

9

20 9

0

20 0

0

20 1

0

20 2

0

20 3

0

20 4

0

20 5

0

20 6

0

20 7

0

20 8

0

20 9

1

20 0

11

0

Equities

84487_case-15_ptg01_hr_C210-C225.indd 213

Mutual Funds

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Case 15 Charles Schwab

members of the NYSE, grew from $54 billion in 1990

to $245 billion in 2000. As the bubble burst and the

stock market slumped in 2001 and 2002, and brokerage

revenues plummeted to $144 billion in 2003, forcing

brokerages to cut expenses. By 2007 revenues had recovered again and were a record $352 billion. In 2008

the financial crisis hit and industry revenues contracted

$178 billion. In that year the industry lost $42.6 billion.

As of 2011 they remained depressed at $147 billion,

while industry profits were $7.7 billion.

The expense structure of the brokerage industry

is dominated by two big items: interest expenses and

compensation expenses (see Exhibit 3). Together these

account for about three quarters of industry expenses.

Interest expenses reflect the interest rate paid on cash

deposits at brokerages, and rise or fall with the size of

deposits and interest rates. As such, they are generally

not regarded as a controllable expense (since the interest rate is ultimately set by the U.S. Federal Reserve

and market forces). Compensation expenses reflect both

employee headcount and bonuses. For some brokerage firms, particularly those dealing with institutional

clients, bonuses can be enormous, with multi million

dollar bonuses being awarded to productive employees.

Compensation expenses and employee headcount tend

to grow during bull markets, only to be rapidly curtailed

once a bear market sets in.

Exhibit 3

As shown in Exhibit 4, which graphs the return

on equity in the brokerage industry between 1990 and

2011. The profitability of the industry is volatile, and

depends critically upon the overall level of stock market

activity. Profits were high during the boom years of the

1990s. The bursting of the stock market bubble in 2000¨C

2001 bought a period of low profitability, and although

profitability improved after 2002, it did not return to the

levels of the 1990s. The financial crisis and stock market crash of 2007¨C2009 clearly impacted profitability

for the industry.

Deregulation

The industry has been progressively deregulated since

May 1st, 1975, when a fixed commission structure on

securities trades was dismantled. This development

allowed for the emergence of discount brokers such

as Charles Schwab. Until the mid 1980s, however, the

financial services industry was highly segmented due to

a 1933 Act of Congress know as the Glass-Steagall Act.

This Act, which was passed in the wake of wide spread

bank failures following the stock market crash of 1929,

erected regulatory barriers between different sectors of

the financial services industry, such as commercial banking, insurance, saving and loans, and investment services

(including brokerages). Most significantly, Section 20

Expense Structure of Brokerages, 2000¨C2011

400,000

350,000

$ billions

300,000

250,000

200,000

150,000

100,000

50,000

Total Compensation

Interest Expense

11

20

10

20

09

20

08

20

07

20

06

20

05

20

04

20

03

02

20

20

01

20

20

00

0

Other Expenses

Source: SIFMA

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