Banking on a Change at This Company

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

People used to think of a brokerage as a company that held client's hands, talked them through rough stretches in the market, and gave advice. Today a brokerage can still do all of these things, but many of the most popular companies are not much more than an online platform to execute trades. One company that has tried to keep its old school feel is Charles Schwab (NYSE: SCHW). The company still offers old fashioned advice, but has to compete with much cheaper discount brokers as well. One thing that is just beginning to set Charles Schwab apart is their banking business. Looking at the company's most recent earnings report, the results just met expectations. However, if the company can pull customers from traditional banks, this could be the start of something big.

As I mentioned before, Charles Schwab competes directly with many discount brokerage firms. Companies like E*Trade (NASDAQ: ETFC), TD Ameritrade (NYSE: AMTD), and even the Sharebuilder division of Capital One (NYSE: COF) offer cheap trades online. While some customers gravitate toward a full service brokerage, many investors are perfectly happy going with a discount brokerage to execute their own strategies. With trades as cheap as $4 at Sharebuilder, to $9.99 at the other two, discount brokers do have Schwab beat on price. However, Schwab still has most of its competition beat when it comes to size. Take a look at the following:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Total Brokerage Accounts</strong></p> </td> <td> <p><strong>New Accounts</strong></p> </td> <td> <p><strong>% Change</strong></p> </td> </tr> <tr> <td> <p>Charles Schwab</p> </td> <td> <p>8.7 million</p> </td> <td> <p>198,000</p> </td> <td> <p>2.28%</p> </td> </tr> <tr> <td> <p>E*Trade</p> </td> <td> <p>2.874 million</p> </td> <td> <p><span><span><a href="">46,000</a></span></span></p> </td> <td> <p>1.60%</p> </td> </tr> <tr> <td> <p>TD Ameritrade</p> </td> <td> <p>5.736 million</p> </td> <td> <p><span><span><a href="">171,000</a></span></span></p> </td> <td> <p>2.98%</p> </td> </tr> </tbody> </table>

(Capital One didn't provide a breakdown of brokerage accounts in its last annual report) 

As you can see, Schwab has almost 3 million more brokerage accounts than TD Ameritrade and 5.8 million more than E*Trade. Though TD Ameritrade had slightly higher new account growth, Schwab is the clear leader. The company's current quarter doesn't look that impressive if you just look at revenue and net income growth, but when you go beyond the headline numbers, you can see a big opportunity.

Schwab reported net revenue up just 1% and diluted EPS increased just 6%. The good news for investors is that Schwab continues to attract clients that will stick with the firm over the long haul. The company's CEO Walt Bettinger said: “Our clients...continue to be net purchasers of securities,” indicating that these clients are the long-term investors that every brokerage desires. The company saw significant growth in balances across the board. Net new core assets increased by over $21 billion. When you consider that E*Trade brought in $2.2 billion in new assets, and TD Ameritrade brought in $9.7 billion in new assets, you can see the clear leader again is Schwab.

The company also saw strong growth in both retail advised balances and total client assets, which both registered a 20% increase. Newer initiatives like Schwab Index Advantage for 401k plans are improving client interactions. This Index Advantage service offers 401k plan participants index funds with lower fees as part of their choices. The service has seen a significant increase in advice usage, with participants seeking advice 92% of the time versus 10% previously. The company's financials show both positive results and opportunities for improvement.

On the one hand, Schwab made a move in the right direction by reducing its long-term debt on a year-over-year basis by 10%. The company also redeemed $202 million in notes that were at 7.5% to issue new notes at 4.95%. However, Schwab currently has about $23 billion in cash and investments earning 0.20%, and yet they are still carrying $1.923 billion in long-term debt with an average interest rate of 5.59%. I'm sorry, but simple math tells me this doesn't make a lot of sense. Though, on a relative basis, $1.923 billion isn't excessive, there doesn't seem to be a good reason for the company to carry this debt at all.

One move Schwab could make to improve both their results and their balance sheet would be to redeem the remainder of their long-term debt. This would eliminate this interest cost, and the cost to do so would be minimal. A second way the company could achieve better results is by improving their net interest spread, which currently stands at just 1.6%. This leads us to the biggest opportunity Schwab has, and that is to push harder to gain clients of Charles Schwab Bank.

Charles Schwab Bank added 844,000 new banking accounts in the current quarter. In addition, this division of Schwab saw balance sheet assets jump 28% to over $75 billion. The company also has $9.3 billion in mortgage and home equity loans outstanding, and their delinquency rate is low at 0.90%. The point is, with 8.7 million active brokerage accounts, the company needs to work hard to cross-sell each of these customers a bank account.

Based on the huge number of new accounts, it's obvious that the bank account offers a good value. Customers who already trust Schwab with their investments should feel comfortable trusting the company with their banking business as well. In the past, having a brick and mortar bank was necessary, but not anymore. With the advent of direct deposit, online banking, and fee-free ATM offerings, customers can bank with anyone. This was one of the primary reasons that Capital One made the purchase of ING U.S.A.: to bring in low cost deposits and diversify the company's funding sources.

Schwab's growth in the brokerage industry can continue, but the company needs to cross-sell a bank account with each brokerage account. The company has cost advantages that traditional banks can't match, and 844,000 customers realized this in just this quarter alone. By diversifying its funding sources, and gaining stickier relationships by pushing banking services, Schwab can be a one stop financial shop. Traditional banks beware, Schwab and others have a better relationship with your customers. Once the brokerage realizes the advantage of going after this business with more force, the exodus out of traditional banks could spell big opportunity for brokers. In the future, “Talk To Chuck” could mean talking about checking, savings, mortgages, home equities, as well as brokerage needs. Since many customers distrust banks after all of the turmoil of the last few years, the time for brokerages to act on this opportunity is now.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend TD AMERITRADE Holding. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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