At the end of the third quarter of 2012, Charles Schwab’s (NYSE:SCHW) revenue generating daily average trades, also known as DARTs, were down 19% compared to the prior year. Despite this decline, the online brokerage firm reported a 3% year-on-year increase in total net revenues primarily due to the diversification of operations. Chuck earns only about 20% of its revenues from trading commissions, which places it in a better position when trading is weak than peers like Ameritrade (NYSE:AMTD), which earns about 40% of revenues through trade commissions.
Our current price estimate for Schwab is $14, in-line with the market price.
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What Is This Diversification?
Charles Schwab’s primary source of income is asset management fees that it charges clients who invest in the company’s proprietary funds, Schwab Fund and Laudus Fund, or who use the Charles Schwab OneSource Mutual Fund Services to invest in third party mutual funds. Asset management and administration fees account for about 40% of Chuck’s revenues, whereas the remaining 40% are earned through interest on client assets by investing in money market instruments.
Given these figures, it is easy to see that attracting client assets is more important to Schwab than trading activity. The company has done a good job in this aspect, ending November with $.192 trillion in client assets, up 15% from the prior year. Net new assets brought to the company in November were $16.2 billion, up 170% from the same month in 2011. These included a $5.4 billion inflow from an undisclosed mutual fund clearing services client. Excluding this, core new assets of $11.7 billion were the highest for the company in a single month since January 2009. We expect Charles Schwab to maintain the momentum and continue to attract client assets at a healthy rate in the coming years.
Trading Shows Signs Of Recovery
The company’s trading activity declined steadily through the first three quarters of 2012. September, however, brought signs of recovery as DARTs increased by 17% over August. At the end of November, client daily average trades were actually in line with the figure for last year. In addition, active brokerage accounts are up 2% from 2011. More brokerage accounts means that trading volume can increase even if the number trades per account remain low. Trading activity will also be influenced by the Federal Reserve’s measures to stimulate the U.S. economy, but the effect might only be visible in the coming years. 
We expect a gradual improvement in trading activity going forward; however, our model shows that even if the annual number of trades per account continues to drop to below 6 (from about 9 at the end of 2011), the company’s valuation will not be greatly affected. You can modify the interactive chart below to gauge the effect a change in forecast will have on our price estimate.
So Is The Stock Undervalued?
Chuck’s biggest problem is its margins. EBITDA margin dropped from 42% in 2008 to 32% in 2011. In contrast, Ameritrade has managed to keep margins above 40%. Schwab’s primary expenditures are on compensation and benefits, which is almost 40% of the company’s net revenues. Advertising expenses have also increased in the last few years due to the “Talk To Chuck” campaign. The company’s latest guidance shows that expenses in the fourth quarter will actually be 1% higher than the prior year. We believe that the company will have to manage its expenditure in order to increase valuation.Notes:
- Fed Links Rates to Joblessness, Expands Bond Purchases, Bloomberg, 13th December, 2012 [↩]