We have downgraded our long-term recommendation on
The Charles Schwab Corporation
) to Neutral from Outperform. The recommendation change is based on
flagging equity markets, declining interest rate yields and legal
We anticipate organic growth to be driven primarily by recent
acquisitions. A low-cost capital structure will benefit results in
the subsequent quarters. However, lower trading activities and
relatively low capital intensity as compared to its peers may act
Schwab's first-quarter 2012 results came in line with the Zacks
Consensus Estimate. The improvement in quarterly results was
attributable to increased trading revenue and absence of loan loss
provisions. However, elevated operating expenses, declining net
interest income along with higher asset management and
administration fees offset the positives.
Charles Schwab has been expanding mainly through acquisitions.
Last year, the company acquired Compliance11 Inc. and optionsXpress
Holdings Inc. Through these acquisitions, Schwab is trying to
expand the reach of its futures and options market, thereby
providing stimulus to the equity-concentrated businesses by
intensifying the profitable derivatives trading and fuelling the
growth of its registered investment advisor (RIA) business.
Schwab's efforts towards minimizing its dependence on interest
rates are highly credible. It has introduced certain initiatives
like the Schwab Index Advantage and Independent Branch Services,
which will promote client cross-selling relationship amongst
corporate and retail services. Further, independent branch services
will allow individual operators to manage company's franchise in
markets where it does not have a physical presence.
Schwab's reasonable capital position allows it to maintain a
healthy dividend policy. The dividend payout ratio has been almost
20-30%, and since the late 1990's the compounded growth rate for
quarterly dividend payment is stable at 24%. This is highly
valuable for maintaining investors' confidence in the stock.
On the flip side, persistent low interest rate environment has
been adversely affecting revenue growth due to Schwab's sensitivity
to interest rates. The company has been allowing significant fee
waivers to its clients, which has taken a toll on its revenue.
Gloomy economic conditions and less possibility of improvement in
the near future, both net interest margin as well as revenue growth
will be restricted.
Schwab will have to bear the legal charges of optionXpress for
its involvement in a fraudulent short-selling scheme before it was
acquired. Consequently, the lawsuit might dent its goodwill,
profitability as well as client relationships.
The company's dependence on fee-based revenue also thwarts its
growth prospects. However, acquisitions are anticipated to
contribute to trading revenues, but the proportion of trading
revenues is comparatively too low to boost the overall organic
Charles Schwab currently retains a Zacks #4 Rank, which
translates into a short-term Sell rating. One of its peers
) retains a Zacks #1 Rank, which translates into a short term
Strong Buy rating.
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