Charles Schwab: Losing Ground To Robinhood

 

 

Investment Thesis

Recent outages at US brokerage firm Charles Schwab (NYSE:SCHW) have revealed what I believe to be a critical vulnerability in their reliability of both digital banking and trading platforms for US retail investors. These incidents include inaccessibility of client accounts for several hours, which has highlighted a growing concern among some of their users on the stability of their online financial portals​​​​.

Since downtimes can lead to disruptions and potential financial losses, it's not surprising why some of their clients have considered alternative services that appear to offer more reliable access or better customer service during such crises. At the same time, (but not necessarily in response to these disruptions), Robinhood has rolled out an aggressive rewards program aimed at retaining their customer base and attracting clients from competitors (such as Charles Schwab) who are frustrated with service outages and want the potential 3% match Robinhood is offering for some client accounts.

Beyond these recent outages, Charles Schwab has faced significant headwinds over the past year, culminating in a series of financial and operational setbacks. In 2023, the financial services company reported a 48% decline in net new assets and a nearly 50% drop in net income during Q4 2023. Bank deposits also dropped 21% to $290 billion​​.

Adding to their challenges, in August of last year, they announced a major restructuring plan, including lay-offs and downsizing of their corporate office space to save approximately $500 million annually.

Charles Schwab's CEO, during an earnings call, described 2023 as the most challenging year since the dot-com bubble burst in 2000, as they are trapped in a financial climate that has seen many similar institutions scrambling to stabilize their operations amid fluctuating market conditions​​.

Given these factors—the technical outages, cost-cutting measures due to restructuring, and customer service issues post-acquisition—investors might view these actions with caution when choosing where to place their investments. I believe these operational challenges and strategic errors lead to my recommendation that Charles Schwab's stock is a sell. The company is losing to Robinhood in my opinion.

Background of TD Merger

In 2019, Charles Schwab announced their acquisition of TD Ameritrade for $26 billion, and completed during COVID in 2020. Charles Schwab's acquisition was largely driven by declining commission revenues for TD Ameritrade that rendered their business model unsustainable​​. As trading commissions form a considerable part of revenue for brokerage firms, eliminating such fees pressured many in the industry to consolidate to maintain profitability. These commissions originally started to decline quickly in 2019 in response to Robinhood's no commission fee model.

While the drop in commissions hurt their business model, TD Ameritrade was particularly popular among users for their trading platform, with features that included advanced charting tools and a user-friendly interface that appealed to both novice and experienced traders alike. The Thinkorswim platform, in particular, offered trading tools that were reportedly well-received by the trading community​​.

However, the merger's completion resulted in Charles Schwab deciding to close or rebrand all of TD Ameritrade's platforms. This decision was met with largely negative reactions from TD Ameritrade's loyal user base. Many appreciated the unique features of their platform, which were not initially replicated on Charles Schwab's offerings​​. The consolidation was part of Charles Schwab's goal to integrate TD Ameritrade's technology into their platform and align the technological infrastructure and trading tools of both companies.

Charles Schwab's approach was aimed to ensure that former TD Ameritrade clients would continue to have access to familiar trading tools within Charles Schwab's broader service offering. This meant investing in refurbishing the platform that included adopting TD Ameritrade's core order management systems to improve trade execution speeds.

The ambitious transition brought a share of challenges, particularly the dissatisfaction among users long accustomed to TD Ameritrade's interface. Charles Schwab had to retain the loyalty of these new clients while attempting to streamline the platforms they had to do maintenance on (both the original Schwab platform and the TD platform).

Despite these efforts, the move inevitably led some users to explore other options in the market. It reflected the inherent risks associated with such large-scale integrations in the financial services industry.

Post TD Struggles

TD Ameritrade's platforms were phased out earlier this year​​. Charles Schwab's focus post-merger has been on integrating TD Ameritrade's trading platform, Thinkorswim, into their services. Thinkorswim was highly favored by TD Ameritrade's clients for their complete trading tools and features​​.

However, the transition to Charles Schwab has been anything but smooth for many of their users. Many users have expressed frustration over the changes, especially those related to the platform's usability and functionality, such as trading interfaces. Clients have lamented the loss of a familiar and efficient trading environment, which was replaced by Charles Schwab's system that some find less intuitive and flexible​.

Adding to this, recent technical issues have also compounded the dissatisfaction. Account outages and the display of inaccurate stock data have sparked widespread complaints, with some users reporting significant difficulties accessing real-time financial information​​. I think such a reaction is inevitable, especially for TD Ameritrade clients who were forced to transition to a platform that they feel was imposed on them without adequate consideration of their needs and financial preferences (as evidenced in Reddit users' frustrations).

Charles Schwab's management has recognized the gravity of these issues, with executives admitting to the challenges faced during the integration process and promising enhancements that aim to better serve the combined client base​. The company has laid out a growth strategy that they claim will expand their service offerings, including introducing former TD Ameritrade clients to Charles Schwab's broader range of services, such as wealth management and advisory services. Charles Schwab projects that the integration could potentially bring an additional $500 billion in assets from the existing TD Ameritrade client base​​. Charles Schwab is also capitalizing on the opportunity to increase revenue through bank lending products and other financial services.

Robinhood Grabbing Accounts

Robinhood (HOOD)'s customer acquisition trend was in full swing following the transition of TD Ameritrade clients to Charles Schwab's platform. With the complaints about the complexity and usability of their interface, Robinhood reported a considerable influx of new accounts during this period. Robinhood is known for an easy-to-use interface.

Robinhood's aggressive marketing strategy aimed at wealthier clients has also paid dividends. The company rolled out a series of enticing offers to attract these clients, including a 1% match on transferred brokerage accounts to bolster the group's assets under management. This was highly successful, according to the company, as it made approximately $1.1 billion in account transfers from the start of the promotion in October up through December of 2023 alone. Robinhood saw more than 150 account transfers that topped $1 million each, reflecting the shift of wealthier clients to their platform.

The company also improved their retirement account services by temporarily offering a 3% match on IRA transfers and 401(k) rollovers for Robinhood Gold subscribers until April 30th. It was designed to attract clients looking to consolidate their retirement savings into Robinhood's platform. The 3% match applies to any amounts transferred or rolled over to a Robinhood IRA, with the condition that these funds must be maintained in the account for at least five years to retain the full match value. This was a good marketing move to attract competitors' customers, in my opinion, and assets grew to accompany it. I wrote more about the Robinhood Gold plan last month.

In essence, Robinhood is starting to nibble away at Schwab's struggles post TD merger. This is all the more reason why I do not think their valuation makes sense.

Valuation

Charles Schwab's forward price-to-earnings (P/E) ratio stands at 22.27 (a “D-” sector relative grade), which is significantly higher than the sector median of 10.16, marking a 119.29% difference. This elevated P/E ratio, which far exceeds both the sector median and Charles Schwab's historical average, suggests that the stock is currently overvalued relative to their earnings capacity compared to their peers​​.

Despite the P/E premium, the company's revenue growth trajectory shows that while revenue will theoretically return to growth over the next 12 months, but the growth will still be a 43.13% discount to sector median over the next year (this is not a GARP play in my opinion).

Over the last 12 months, the company saw a year-over-year revenue contraction of -12.98%, a stark contrast to the sector's median growth of 4.51%. This decline is mainly attributed to decreasing net interest revenue, which according to the company: “…[was] down 19% from the prior year's first quarter due primarily to greater use of supplemental funding and lower average interest-earning assets” (10Q). These assets have been under pressure due to the broader economic environment affecting financial institutions​​. While client assets as a whole may be increasing due to rising stock market valuations, losing any client accounts to Robinhood doesn't help either, as this is one less client they can benefit from in the future.

Looking forward, although analysts project some improvement in earnings per share (EPS), with a forecasted growth of 3.64% in the short term and an optimistic long-term growth rate (3-5 year CAGR) of 25.81%, these expectations are anchored on robust net interest revenue and the company's capability to retain client assets amid competitive pressures​​. I think this future growth may be overly optimistic given the current economic pressures and competitive landscape.

Competitive threats, particularly from emerging fintech platforms like Robinhood, pose significant risks, in my opinion. As I've mentioned above, Robinhood has been aggressively capturing market share by offering lower fees and innovative products aimed at both novice and seasoned investors. This competition is likely to intensify in the coming years.

If Charles Schwab's forward P/E were to align with the sector median, which, I believe, is a plausible scenario given the competitive and operational challenges it faces, this would represent significant downside potential. Specifically, aligning the forward P/E of 22.27 to the sector median of 10.21 indicates a potential price drop of approximately 54%, assuming other factors remain constant.

Bull Thesis

While Charles Schwab's significant asset accumulation and market presence provide a strong foundation, the current valuation and the pressures from decreasing net interest revenue and increasing competition pose significant downside risks. In May 2024 alone, the firm reported net new assets totaling $31.1 billion, marking it as one of their best Mays historically. In addition, total client assets reached a staggering $9.21 trillion, up by 20% from the previous year​. Keep in mind the US stock market is up well over 20% over the last year, so total assets going up is not necessarily indicative of them attracting new assets.

Despite positive asset inflows, I am concerned regarding the company's valuation and future growth trajectory. As I mentioned above, I believe the company's earnings potential relative to their peers​​ is overestimated. Furthermore, the growth that the company is witnessing in client assets and their market position might not be enough to mitigate the risks of declining net interest revenue, which is crucial for their profitability. The expected decrease in Q2 2024 revenue by 1% to 2% relative to the prior quarter will have an anticipated impact, such as lower transactional sweep cash and expected trading volumes.

I think that the growth they are seeing is not enough, and they have downside risks that need to be addressed as soon as possible. Robinhood's competitive edge will only make this more difficult.

Takeaway

Given the current market, and internal challenges within Schwab, I think the stock appears overvalued. I believe that the company's stock is a sell because of the current overvaluation as well as the fundamental and operational risks at play, together with tough competition from platforms like Robinhood, the outlook for Charles Schwab is cautious at best. I think there is a real risk of the 54% downside coming to fruition.