Nervous people tend to overreact. – Toba Beta
When Charles Schwab (SCHW) announced that it was going commission-free last month, it was the inevitable next step in a years-long trend in the “race to zero”. Robinhood has offered commission-free trading for years. Vanguard decided to offer no-fee trading on virtually all ETFs on its platform earlier this year. Fidelity debuted its first zero expense ratio mutual funds just recently. The day in which trading commissions were eliminated too was always coming eventually, yet it still managed to catch the street a little off-guard.
All of the major online brokers saw their share prices plunge as traders correctly expected that they would be getting rid of commissions too. Over the course of three days, Schwab’s stock dropped more than 16% but E*Trade (ETFC) and TD Ameritrade (AMTD), which derive much more of their revenue from trading commissions and shortly after followed suit in eliminating commissions as well, saw even larger drops.
The thing that caught my attention most following this announcement was the statement put out by Schwab CEO Peter Crawford. In it, he notes that the decision to eliminate trading commissions will cost the company around $90-100 million quarterly, which amounts to about 3-4% of total revenue. Schwab’s impact is obviously less than some of the more pure online brokers because it also offers a thriving money management and ETF business.
But consider the revenue impacts of Schwab’s competitors and how their stock prices reacted.
The stock prices of E*Trade and TD Ameritrade fell roughly in line with their revenue impacts, 18% and 25% respectively. Schwab, on the other hand, fell more than 16% on a much more modest financial impact. Granted, this is a relatively simplistic example and there are several moving parts here but on the surface the drop in Schwab stock feels like an overreaction.
The main reason I think it’s an overreaction is because Schwab’s core business is a cash cow. Schwab has grown their ETF lineup immensely and has become the 5th largest ETF provider in the industry with assets of more than $110 billion. Schwab has accomplished that mostly through low-cost leadership. The asset-weighted average expense ratio for its cap-weighted ETF lineup is just 0.05%. That’s not going to make the ETF business a huge revenue generator for Schwab but the assets it’s bringing in can be cross-sold to other more lucrative products and services.
One of the big differentiators, in my opinion, is Schwab’s OneSource platform. Fund providers pay Schwab a hefty amount to host products on its platform. It can range from next to nothing to a lot. For example, Schwab makes about 500 ETFs available to its customers. According to Schwab, the typical asset-based fee for these holdings is about 0.04% annually but can get to as high as 0.15%. In other words, it’s not a huge revenue generator. On transaction fee and load mutual funds, the percentages are still relatively low, somewhere between 0.10% and 0.25% on average. It’s the NTF funds that are the money makers.
The take for Schwab on NTF funds is around 0.4% to 0.45% on average. That can vary on a case-by-case basis but can also rise to as high as 1.1% in rare cases. With mutual funds accounting for more than ⅓ of Schwab’s total client assets, that’s no small change.
The big revenue generator for Schwab, however, remains net interest income, which includes things like customer cash balances. That figure rose by 14% compared to the same quarter one year ago and has been steadily rising.
Schwab’s decision to eliminate trading commissions was certainly a headline grabber but it wasn’t the monumental event that some made it out to be. In reality, commission revenue accounts for relatively little of Schwab’s top line and the remainder of its business model remains healthy. Net interest income continues to rise steadily and its OneSource platform is raking in fat fees on NTF fund holdings.
A drop in Schwab’s share price was justified but not to the extent that the market beat down its shares. At a P/E of under 14, Schwab represents a strong value and buy-the-dip opportunity.
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