Published: January 20, 2010

If you're swimming upriver while the tide is going out, you'll expend a lot of energy just to stay in place. You get little credit for holding your own while others have been washed far downstream. But when the tide shifts, you'll be far ahead of the pack.

So it goes with the operating environment for The Charles Schwab Corp. (Nasdaq: SCHW). Full-service retail brokerages such as Citigroup Inc. (NYSE: C) and Bank of America Corp.’s (NYSE: BAC) Merrill Lynch are seeing their client bases shrink as key brokers move to set up their own shops.

Those accounts must end up somewhere, and these days, it looks as if Charles Schwab is a clear beneficiary. The company’s broad suite of back-office services enables brokers to quickly and seamlessly set up shop. An increasing number of brokers realize that they can provide the same level of service to their clients with Schwab’s platform, and keep more profits that previously had to be remitted to their employer.

Schwab has been picking up new clients at a steady clip, regardless of whether the market has zigged or zagged. The company picked up roughly 350,000 net new client accounts in 2008, and another 300,000 in 2009. The economic downturn did not suddenly create a wave of new investors. Instead, we’re simply seeing Schwab take accounts from rivals.

Yet it’s fair to wonder why shares have simply treaded water while the rest of the market zoomed ahead in 2009. (Schwab's shares rose roughly +10% last year while the XBD Securities Broker/Dealer Index rose by more than +50%). Simply put, low interest rates are crimping profits, as the company now earns far less on the money-market funds it offers clients. As reported after the close of trading Tuesday, Schwab's profit for the full year 2009 fell -35% to $787 million, or $0.68 per share.

We’ve seen this story before. Shares fell -45% in 2001 and another -30% in 2002, before the company saw a rebound in operating trends. At the time, the company saw net income, which had surpassed $700 million in 2000, fall to around $100 million in 2002. By 2007, net income had surged all the way to $2.4 billion. Although it took a while for shares to respond, they finally rose more than +20% in 2005, more than +30% in 2006, and more than +40% in 2007.

Since then, the stock's chart has been an eyesore once again. But the most important metric still marches forward at an impressive clip: New client accounts, which yield rising assets under management. A steady inflow of new clients has boosted assets by roughly $20 billion for each of the last six quarters. That’s down from the $40-60 billion quarterly figures posted a few years ago, but still impressive when you consider that traditional brokerage firms have been seeing their client bases – and assets – steadily shrink. (As an example, UBS (NYSE: UBS) and Smith Barney/Morgan Stanley (NYSE: MS) have each seen their client asset base shrink by about $50 billion in the first nine months of 2009). Sure, Schwab is making less money on their growing client base right now, but the stage is being set for a powerful sales and profit spurt when interest rate trends reverse course.

To help retain all those client accounts, Schwab continues to make a big push into exchange traded funds (ETFs): the company now controls 11% of all ETF trading activity, and roughly 25% of ETF trades among retail investors, according to management. As market share in this hot segment continues to build, and as interest income starts to rebound, Schwab’s profits look set to perk back up.

If the market and the economy struggle anew, Schwab will be seen as a safe port in the storm. And if the economy continues to strengthen in 2010 and 2011, then Schwab will be seen as a high-growth high-return play, as was the case in the middle part of the decade.

-- David Sterman
Contributor
StreetAuthority

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