Sector

Asset Management

Background

Andrew Hollingworth is the founder and portfolio manager of Holland Advisors. We cover how Charles Schwab built a behemoth out of a newsletter, why it pivoted to an asset-heavy model, and what it shares in common with Amazon.

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Date

July 20, 2022

Episode Number

66

Charles Schwab Business Breakdown

Background / Overview

Charles Schwab, founded in the late 1960s by Charles Schwab himself, began as an investment newsletter and evolved into a financial powerhouse with over $8 trillion in assets under management (AUM) and a market capitalization of approximately $120 billion. The company’s origins lie in Schwab’s frustration with the high costs and exclusivity of traditional brokerage services, leading to a mission to democratize investing. Following the deregulation of the stock exchange in the mid-1970s, Schwab capitalized on the opportunity to offer low-cost trading, establishing the company as a pioneer in the discount brokerage model. Over decades, Schwab has transformed from a traditional brokerage into a hybrid model that operates as both a brokerage platform and a bank, with a significant pivot toward banking activities driving its profitability. Headquartered in the U.S., Schwab serves a mix of retail investors (about 35% of income) and registered investment advisors (RIAs, about 65% of AUM but one-third of income), employing thousands of staff across its branch network and digital platforms.

Ownership / Fundraising / Recent Valuation

Schwab is publicly traded, with no specific details in the transcript about recent private equity ownership or fundraising events. The company’s market cap of $120 billion implies a significant enterprise value (EV), though exact EV multiples or transaction details are not provided. The TD Ameritrade acquisition, completed around 2020, was a pivotal event, with Schwab acquiring its competitor at a share price reflecting TD Ameritrade’s pre-zero-commission trading valuation, approved unanimously by TD Ameritrade’s board. The transcript notes Schwab’s stock trading at $62 per share recently, up from $40-something, with normalized earnings suggesting a price-to-earnings (P/E) ratio of approximately 12x based on a $5 look-through earnings estimate for 2019-like interest rate conditions.

Key Products / Services / Value Proposition

Schwab offers a comprehensive suite of financial services, including:

1. Brokerage Services: Commission-free trading of securities, custody services, and access to mutual funds and ETFs. The value proposition is low-to-no fees, making it attractive for cost-conscious investors.
2. Banking Services: Interest-earning deposit accounts, margin loans, and other lending products. Schwab earns a net interest margin (NIM) on customer cash deposits, which constitute about 10% of client assets.
3. RIA Platform: Back-office support and technology for independent RIAs, allowing them to manage client portfolios at lower costs (saving clients 15-20 basis points compared to traditional wealth managers like Merrill Lynch).
4. Ancillary Services: Tax advice, inheritance planning, and branch-based customer support, enhancing stickiness by offering a full-service experience.

The unique value proposition is Schwab’s ability to provide high-quality services at minimal cost to clients, funded primarily through NIM on cash deposits rather than direct fees. This “win-win monetization” model ensures clients perceive exceptional value, akin to Amazon’s low-price, high-service approach.

Segments and Revenue Model

Schwab operates two primary economic segments:

1. Brokerage and RIA Platform: This segment serves retail investors and RIAs, generating revenue through custody fees, asset management fees, and order flow. It accounts for roughly 30% of revenue, with RIAs contributing about one-third of income despite managing 65% of AUM, indicating lower margins compared to banking.
2. Banking: The dominant segment, contributing 60-75% of revenue through NIM on customer cash deposits (approximately 10% of AUM, or $580 billion). Schwab sweeps client cash onto its balance sheet, earning a spread between the low interest paid to clients (e.g., 0.1%) and the higher rates it earns on investments (e.g., 1.5-2.4% NIM).

The revenue model is unique in its reliance on NIM, which allows Schwab to offer free or low-cost brokerage services, undercutting competitors reliant on trading or custody fees. This model resembles an insurance float or Amazon’s scale-economy-shared approach, where low customer-facing costs are subsidized by high-margin, less visible revenue streams.

Splits and Mix

• Customer Mix: Approximately 65% of AUM comes from RIAs, with the remainder from retail investors, including ultra-high-net-worth individuals (8-10% of clients) attracted by low costs. Retail clients are more buy-and-hold (e.g., 401k holders), while TD Ameritrade’s acquired clients were more trading-oriented.
• Revenue Mix: 60-75% from NIM, 25-40% from fees (custody, lending, asset management, order flow). RIA income is less profitable, contributing one-third of income despite higher AUMwatermark AUM.
• Geographic Mix: Primarily U.S.-focused, with no significant international revenue details provided.
• Channel Mix: Combination of digital platforms, branch networks, and RIA partnerships. The go-to-market (GTM) strategy emphasizes low-cost, high-service offerings, with branches and ancillary services reducing churn.
• End-Market Mix: Serves retail investors (individuals, 401k holders) and RIAs, with no specific end-market revenue splits provided.
• Historical Mix Shifts: Post-TD Ameritrade acquisition, Schwab increased its market share from 6% (2018) to 12% (post-2020), with a shift toward more trading-oriented clients. Deposit growth (30% CAGR from 2007-2020) outpaced customer growth (5-7% annually), increasing NIM reliance.

KPIs

• Organic AUM Growth: 5-7% annually (2007-2022), reflecting steady customer acquisition.
• Deposit Growth: 30% CAGR (2007-2020), now stabilizing at 7-8% annually, indicating a maturing balance sheet.
• Market Share: Increased from 6% (2018) to 12% (post-2020), showing competitive dominance.
• NIM: 1.5% (2021) to 2.4% (2019), sensitive to interest rates, driving profitability swings.
• Pre-Tax Margin: 45%, with potential for expansion through client segmentation and upselling.
• Payout Ratio: Historically low (30% until 2020) due to capital retention, expected to rise to 40-60% post-integration.

The business shows acceleration in market share and deposit growth, with stabilization in deposit growth signaling a shift toward higher cash flow generation in 2-3 years.

Headline Financials

• Revenue Trajectory: Driven by 5-7% organic AUM growth, supplemented by market movements and upselling. The TD Ameritrade acquisition boosted AUM and market share, but revenue details are absent.
• EBITDA Trajectory: 45% pre-tax margin, with mid-teens growth driven by NIM expansion (1.5% to 2.4%), client segmentation, and operating leverage. Margin expansion is expected as integration costs subside.
• FCF: Limited by high capital retention (90-130% of net income from 2014-2016), with a shift to 40-60% payout expected in 2-3 years, enhancing FCF margins.
• Long-Term Trends: Revenue and EBITDA grow in tandem with AUM (5-7%), with margins stable at 45% but poised for expansion. FCF is suppressed by capital needs but will rise post-integration.

Value Chain Position

Schwab operates midstream in the financial services value chain, bridging investors (upstream) and investment opportunities (downstream). Its primary activities include:

• Inbound Logistics: Customer deposits and AUM onboarding via digital platforms and branches.
• Operations: Trade execution, custody, deposit sweeping, and RIA platform support.
• Outbound Logistics: Delivery of investment products, tax advice, and customer service.
• Marketing/Sales: Low-cost, high-service branding, leveraging scale to attract cost-sensitive clients.
• Service: Branch network, digital tools, and ancillary services to enhance stickiness.

Schwab’s competitive advantage lies in its scale and banking integration, allowing it to capture NIM on deposits, a profit pool unavailable to asset-light competitors. The GTM strategy combines digital accessibility, branch presence, and RIA partnerships, targeting both retail and high-net-worth clients with a low-cost, full-service offering.

Customers and Suppliers

• Customers: Retail investors (401k holders, traders, ultra-high-net-worth individuals) and RIAs. Customers are sticky due to low costs, comprehensive services, and high switching costs (e.g., tax implications of moving 401ks).
• Suppliers: Limited supplier power, as Schwab relies on market infrastructure (e.g., stock exchanges) and technology vendors. For deposits, Schwab competes with banks but holds leverage due to its $580 billion deposit base.

Pricing

• Contract Structure: No long-term contracts for clients; services are usage-based with no trading commissions. RIA contracts are fee-based, with flexible terms.
• Pricing Drivers:
• Industry Fundamentals: Fee compression in brokerage (zero commissions) shifts pricing power to NIM.
• Branding/Reputation: Schwab’s low-cost, high-service brand commands loyalty.
• Differentiation: Comprehensive services at low cost create consumer surplus.
• Mission-Criticality: High for 401k and RIA clients, reducing price sensitivity.
• Blended Price: Low due to zero commissions and minimal custody fees, offset by NIM.

Bottoms-Up Drivers

Revenue Model & Drivers

Schwab generates revenue through:

1. NIM (Banking): 60-75% of revenue from a 1.5-2.4% spread on $580 billion in deposits. Drivers include:
• Volume: Deposit growth (30% CAGR 2007-2020, now 7-8%) and client cash balances (10% of AUM).
• Price: NIM fluctuates with interest rates (1.5% in 2021, 2.4% in 2019, up to 4% pre-2008).
• Stickiness: High due to low leakage from savings accounts (clients rarely withdraw).
2. Fees (Brokerage/RIA): 25-40% of revenue from custody, lending, asset management, and order flow. Drivers include:
• Volume: 5-7% AUM growth, boosted by TD Ameritrade.
• Price: Low fees (15-20 basis points savings vs. traditional wealth managers).
• Stickiness: High due to comprehensive services and switching costs.

• Aftermarket Revenue: Minimal, as Schwab focuses on primary services rather than recurring maintenance contracts.
• Absolute Revenue: Driven by AUM growth and NIM expansion, with mid-teens EPS growth expected.
• Mix: Shifting toward NIM reliance (60-75%) and away from fees due to zero commissions.
• Organic Growth: 5-7% AUM growth, with inorganic growth from TD Ameritrade.

Cost Structure & Drivers

• Variable Costs: Include transaction processing, technology maintenance, and client servicing. Estimated at 20-30% of revenue, driven by:
• Economies of Scale: Large AUM reduces per-unit costs.
• Technology: Investments in digital platforms lower marginal costs.
• Fixed Costs: Include branch network, regulatory compliance, and technology infrastructure. Estimated at 25-35% of revenue, driving operating leverage:
• Operating Leverage: High, as fixed costs are spread over growing AUM and deposits.
• Regulatory Capital: Significant, with 90-130% of net income retained (2014-2016) to support $580 billion in deposits.
• Contribution Margin: High for NIM (near 100% after minimal interest paid), moderate for fees due to servicing costs.
• Gross Profit Margin: ~55% (100% - 20-30% variable - 15-25% allocated fixed).
• EBITDA Margin: 45% pre-tax, with potential expansion via cost control and upselling.
• Cost Trends: Fixed costs decline as a % of revenue with scale, while variable costs remain stable.

FCF Drivers

• Net Income: Driven by 45% pre-tax margins and mid-teens EPS growth.
• Capex: Moderate, focused on technology and branch maintenance. Estimated at 5-10% of revenue, with minimal growth capex.
• NWC: Stable, with short cash conversion cycles due to real-time transaction processing.
• Capital Intensity: High due to regulatory capital requirements (6.1% tier-one equity ratio vs. 4% required).
• FCF Margin: Suppressed by capital retention (30% payout until 2020), expected to rise to 40-60% post-integration.

Capital Deployment

• M&A: TD Ameritrade acquisition added $4 trillion in AUM and doubled market share. Synergies include cost reductions and deposit sweeping, with no near-term M&A planned.
• Share Buybacks/Dividends: Historically low (30% payout), expected to rise to 40-60% in 2-3 years, boosting FCF.
• Organic Growth: 5-7% AUM growth, funded by retained earnings.
• Acquisition Synergies: TD Ameritrade integration enhances NIM by sweeping deposits onto Schwab’s balance sheet, reducing reliance on third-party banks.

Market, Competitive Landscape, Strategy

Market Size and Growth

• Size: U.S. brokerage and wealth management market is estimated at $50-60 trillion in AUM, with Schwab holding $8 trillion (12% share).
• Growth: 5-7% annually, driven by population growth, wealth accumulation, and market returns.
• Price/Volume: Volume grows with AUM (5-7%), while pricing faces compression (zero commissions).
• Industry Growth Stack: Driven by GDP growth (2-3%), inflation (2-3%), and wealth creation (2-3%).

Market Structure

• Competitors: Fragmented, with key players including Fidelity, Interactive Brokers, E-Trade, and Morgan Stanley. Schwab leads in scale.
• MES: High, requiring large AUM and regulatory capital, limiting competitors to a few large players.
• Cycle: Moderately cyclical, with cash balances rising in downturns (boosting NIM) but AUM growth slowing.
• Traits: Heavily regulated, sensitive to interest rates and market volatility.

Competitive Positioning

Schwab positions as a low-cost, full-service provider, targeting cost-sensitive retail and RIA clients. Its banking integration and scale provide a moat, unlike asset-light competitors (e.g., Hargreaves Lansdown) reliant on fees.

Market Share & Relative Growth

• Market Share: 12% (post-TD Ameritrade), up from 6% (2018).
• Relative Growth: 5-7% organic AUM growth matches or exceeds market growth, with inorganic boosts from M&A.

Competitive Forces (Hamilton’s 7 Powers)

1. Economies of Scale: Schwab’s $8 trillion AUM and $580 billion deposits reduce per-unit costs, enabling zero commissions and low fees. Competitors like TD Ameritrade lack scale to match.
2. Network Effects: Limited, but RIA platform creates a flywheel where more advisors attract more clients.
3. Branding: Strong, with a reputation for low costs and reliability, akin to Amazon’s customer-centric model.
4. Counter-Positioning: Banking integration allows Schwab to subsidize free trading, a model competitors cannot replicate without significant capital investment.
5. Cornered Resource: Access to $580 billion in sticky deposits, unavailable to asset-light peers.
6. Process Power: Advanced technology and operational efficiency support low-cost services.
7. Switching Costs: High for 401k and RIA clients due to tax implications and operational complexity.

• New Entrants: High barriers (capital, regulation, scale) deter new players.
• Substitutes: Limited, as traditional wealth managers charge higher fees, and neobanks lack Schwab’s scale.
• Supplier Power: Low, as Schwab controls its deposit base and technology stack.
• Buyer Power: Moderate, with clients price-sensitive but loyal due to low costs and stickiness.
• Rivalry: Intense, with fee compression forcing competitors to consolidate (e.g., TD Ameritrade acquisition).

Strategic Logic

• Capex Bets: Defensive, with investments in technology and regulatory capital to maintain leadership.
• Vertical Integration: Sweeping deposits onto its balance sheet integrates banking and brokerage, capturing NIM.
• Horizontal Integration: TD Ameritrade acquisition expands AUM and client base.
• MES: Schwab operates at optimal scale, avoiding diseconomies (e.g., bureaucracy) by focusing on core services.
• M&A: Creates value by enhancing NIM and market share, with synergies outweighing integration costs.

Valuation

Schwab’s valuation reflects its hybrid model and growth potential:

• P/E: 12x normalized EPS ($5-$5.50), based on 2019 NIM (2.4%). At $62 per share, this is attractive for mid-teens EPS growth.
• ROE: Stable despite capital retention, as growing deposits and profits offset equity base expansion.
• Margin of Safety: Provided by secular growth (5-7% AUM), interest rate tailwinds (NIM potential >2.4%), and scale advantages.
• Risks: Interest rate volatility, market downturns (reducing AUM), and integration challenges.
• Comps: Asset-light peers (e.g., Hargreaves Lansdown) trade at higher multiples (20x+) due to lower capital intensity, but lack Schwab’s NIM-driven growth.

Key Dynamics and Uniqueness

Schwab’s business model is unique due to its hybrid brokerage-bank structure, enabling it to:

1. Subsidize Free Services: NIM (60-75% of revenue) funds zero-commission trading and low fees, creating a “win-win” for clients.
2. Leverage Sticky Deposits: 10% of AUM in cash ($580 billion) is highly sticky, with low leakage compared to traditional bank accounts, ensuring stable NIM.
3. Exploit Scale: $8 trillion AUM and a $580 billion balance sheet create unmatched economies of scale, deterring competitors.
4. Strategic Aggressiveness: The TD Ameritrade acquisition and zero-commission move demonstrate Schwab’s “gorilla” tactics, using its balance sheet to crush fee-reliant competitors.
5. Capital Intensity Trade-Off: Retaining 90-130% of net income builds a moat but delays FCF, a long-term bet akin to Amazon’s reinvestment strategy.

The interviewee emphasizes Schwab’s customer-centric ethos, akin to Amazon, where low costs and high service drive loyalty. The pivot to an asset-heavy model, initiated 25 years ago, was a bold move that competitors cannot replicate without decades of capital investment. The TD Ameritrade acquisition highlights Schwab’s power to reshape industry economics, forcing competitors to consolidate or exit.

Conclusion

Schwab’s business model combines the best of brokerage and banking, using NIM to fund low-cost services and capture a growing share of a $50-60 trillion market. Its scale, sticky deposits, and strategic acquisitions create a formidable moat, with mid-teens EPS growth and rising FCF potential in 2-3 years. While complex and capital-intensive, Schwab’s Amazon-like focus on customers and long-term reinvestment positions it as a dominant, “uncatchable” player in financial services.