| 21 January 2010

The Charles Schwab Corporation (SCHW) reported fourth quarter and full year results Tuesday afternoon. We take a look at Q4, which is of course a much more current indicator of performance. Schwab's fourth quarter net revenue declined 23% year-over-year. A good chunk of that decline came thanks to a 36% decline in trading revenue.

Interest revenue dropped, as we would expect, but only 13% or about one-third as dramatic as the drop in trading revenue. "As we’ve been discussing for some time," said CFO Joe Martinetto, "with declining investment yields and essentially no room left to reduce liability costs, the resulting drop in our net interest spread has outweighed balance sheet growth."

Fourth quarter expenses for the firm remained roughly the same, leading to an overall drop in quarterly net income of 47%. That's a 47% drop in net income during a quarter in which the markets rebounded quite nicely. DARTs for the firm decreased 26% vs Q4 2008.

What continues to amaze us is the fact that Q4 2008 was a dismal time for the markets while 2009 saw healthy gains*. Online brokers' performance has, in the past, generally tracked the performance of the markets. We can now confirm that past performance is not an indication of future performance.

We think that, going forward, a better indicator of industry potential is a combination of unemployment rates and market performance. Until unemployment drops significantly below the 9% mark we suspect overall growth in the industry will continue to slow. (Weekly initial unemployment claims came out today and, in a surprise, shot back up.)

We also suspect there are changes taking place under the hood that have had more significant impacts on these businesses than they let on. We commented on one possibility surfaced by a new pricing plan announced by OptionsHouse.

When we look at annual figures for Schwab the trend remains the same. Net income for the year dropped 35% to $787 million. Total client assets increased to $1.42 trillion, a 25% increase over 2008 figures. But that growth slowed significantly. Schwab added $8.1 billion in new assets in Q4 2008 but only $3.1 billion in Q4 2009.

The real heavy lifting was done in adviser services and corporate and retirement services -- the latter adding 363% more assets in 2009 than in 2008. In fact, the company has nearly doubled the number of client banking accounts to 722,000 which probably explains why they decided to raise upwards of $480 million in a public offering announced on Wednesday specifically to drive new banking account activity.

On the retail side, total accounts increase just 3% to 5.4 million at year's end, with the pace slowing dramatically at year's end. Net new accounts for the quarter totaled approximately 36,000, down 30% year-over-year. Most of the reatail growth was concentrated in Schwab’s fee-based advice offerings. New enrollments increased 37,000, up a whopping 61% from 2008.

Despite what it may sound like, we like Schwab and think they're doing a fine job in a tough environment, especially compared with other brokers. In particular, they are well positioned and (will be) well capitalized to take advantage of the big changes to come.

We'll let Walt Bettinger, Schwab's CEO, point out the positives: "I believe our continued success in balancing priorities is reflected in the strength of both our client and financial metrics for 2009. Client loyalty scores reached new highs, new brokerage accounts exceeded 750,000 for the third consecutive year, net new assets reached $87 billion, down from 2008 but still far ahead of the pace reported by any other firm, and total client assets rose by 25% to $1.42 trillion... We remain committed to achieving disciplined, profitable growth across all market cycles, and we know that growth is only made possible by keeping client needs front and center at all times." (Emphasis ours.)

The business is changing rapidly and the firms that stand to benefit the most from these changes are the firms that change quickly to meet customer demand. In Schwab's case, as Bettinger points out, "Important client-oriented actions taken during the year include a new high yield savings account, temporary fee waivers on certain advisory services, significant reductions in the expense ratios on our proprietary equity index funds, and the launch of an innovative proprietary ETF offering with extremely competitive management fees and commission-free trading."

We saw similar results from TD Ameritrade (AMTD), whose net dropped 26% in Q4. Fred Tomczyk, president and CEO of AMTD, also commented on the changes their firm is making to face a rocky future. "We have taken a number of steps over the last year to mitigate the impact of the near-zero interest rate environment," he said . "Everything we did this quarter, from investing in client account and asset acquisition to improving the flexibility of our capital structure, was done with a view towards our long-term growth."

We'll hear from optionsXpress (OXPS) next week and we look forward to seeing how David Fisher's comments fit in with those of Messrs. Bettinger and Tomczyk.




* In Q4 of 2008 we saw an 22% drop in the S&P 500 versus an 8% gain in Q4 of 2009, for those of you keeping score.