BW: Schwab's Challenge: Keep Climbing

BusinessWeek: The discount brokerage is better positioned to ride a market rebound than its scandal-tainted rivals. Just don't expect it to happen soon

No matter how hard discount-brokerage king Charles Schwab has tried to broaden its business model in recent years, until recently, its shares just couldn't seem to get any lift. Tracking the market's downward lurch over the past three years has spelled disaster for Schwab investors, as the stock, which traded around $50 in the late '90s, has plummeted along with exchange volume.

Finally, the market has rallied over the last two months, giving Schwab (SCH ) a boost -- and then some. Its shares now trade at a relatively healthy level of around $8.80, as of May 21, up from the 52-week low of $6.25 reached in mid-March.

Schwab got additional juice with its May 9 report that client trading increased 5% in April over March. Even better, by mid-May trading had jumped a further 18% over April. Also driving the two-month 40% stock-price gain was Schwab's first-quarter earnings report, which was on target with Wall Street expectations (after a bitter earnings disappointment in the fourth quarter), and included the sharp expense reductions for which analysts had long been clamoring.

NO CALL FOR BUBBLY. As welcome as the recent gains are, however, many investors continue to view Schwab stock as a risky proposition, even though the broker-for-regular-folks has done a good job differentiating itself from scandal-tainted full-service brokerages. Investor psychology remains fragile as the economy struggles, corporate scandals persist, and terrorism risks remain.

And while six weeks of improved trading volume is encouraging, analysts are reluctant to break out the champagne. In a May 9 report, Lauren Smith, an analyst with Keefe, Bruyette & Woods, estimated that it would take another year to 18 months for investors to really return to the markets given "a very weak economy, corporate malfeasance, terrorism, and war" -- plus the loss of wealth most investors have experienced in the three-year bear market.

Richard Repetto, an analyst with Putnam Lovell NBF Securities, characterizes the climb in retail trading numbers as showing only "some slight signs of life." He thinks seasonal factors will crimp growth in volume in the latter half of May and this summer, even if the economy holds steady. "Summer could be slow and put a damper on the online brokerage stocks," he says. "And if the market were to move down meaningfully, the stock would follow."

PRICEY BRAND. Even David Pottruck, who took over as Schwab's sole CEO in May after sharing the post with Chairman Charles Schwab for years, signaled caution in reporting first-quarter results on Apr. 22. "Significant economic uncertainties continue, and there seems to be no consensus as to their severity or their duration," he said in a statement. "The resulting broad-based investor uncertainty continues to keep clients from reengaging with their financial affairs."

As cheap as Schwab's stock may look relative to its $50 high from mid-1999, it still trades at a substantial premium -- not only to the market and other brokerage stocks but also to other top brand-name companies like Coca-Cola (KO ), Dell Computer (DELL ), and General Electric (GE ), Smith finds.

Smith resumed coverage of Schwab on May 9 with an underperform rating, noting a "huge disconnect" between the company's meager growth prospects and its lofty valuation. Citing a price-earnings (p-e) ratio of 36, based on her 2003 estimate of 25 cents a share (she expects earnings of 35 cents in 2004), Smith asks, "How much should investors be willing to pay for a growth story that isn't growing?" The answer can be found in her price target of just $6.35.

MOVING OUT. Many other analysts are equally pessimistic. Encouraged that Schwab seems finally "to be finding expense religion," Jefferies analyst Justin Hughes made the bold step on Apr. 23 of raising his price target to $7 from $6. He kept it there in a May 15 report titled "April Activity Below Peers" that he issued when the stock had leaped to $9.35 on news of the climb in trading activity. And he pointed out in the report that competitors Ameritrade (AMTD ) and T.D. Waterhouse had scored larger April jumps in trading activity.

Putnam's Repetto, who rates Schwab sector-perform, is a little more sanguine. He thinks if the market upturn continues, the shares will keep moving higher -- no matter how expensive they seem on a price-earnings basis now.

Over the long term, Schwab's shifts in business strategy could bear fruit -- if its moves outside of discount brokerage into other financial services like banking, mortgage lending, and estate planning lead to consistent earnings growth, and if its pitch to provide advice and independent research resonates with its customers and generates more revenues.

Near-term investors should have their eyes glued to trading volume, however. And while April and May have seen it jump, the coming summer months plus the still-fragile state of investor psychology means Schwab's improved share price still has plenty of risk.

By Amey Stone

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