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AMM Dividend Letter #40: Charles Schwab
Schwab Kills Commissions to Feed its Flywheel of Scale
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Welcome to the 8th episode of the AMM Dividend Growth podcast. I’m Glenn Busch a portfolio manager with American Money Management.
If this is your first time listening this podcast it’s all about our dividend growth strategy, what we’re investing in, how we’re managing a concentrated portfolio, and any major updates to our investment thesis in a current holding.
Today’s episode is another update episode. I’ll talk about recent events with eBay and Charles Schwab.
But first the disclaimer.
[disclaimer]
eBay was the subject of our second podcast episode and the subject of the 39th issue of the AMM Dividend Letter. I’ll put a link in the description.
Our investment thesis in eBay was built around activist shareholders getting eBay to spin-off or sale some its non-core assets like StubHub and eBay’s online Classifieds business. The true value for both these assets are being overshadowed by the parent company.
eBay just announced that it is selling StubHub for $4 billion to Viagogo, a European ticket reseller.
I placed StubHub’s value at $4.75 billion. It looks like I slightly overvalued the company. It doesn’t really change our sum of the parts eBay valuation. But I’m going to go ahead and blame the Endowment Effect for the difference in value.
The endowment effect is when you value something you own far more than what the market will pay. I didn’t assign an appropriate discount to StubHub’s price to account for the fact a strategic buyer wants to pay as low a price as possible. If I’m expecting 5 billion and they come in with 3 then we’ll most likely meet in the middle at 4.
Regardless, this is an extra $4 billion – not accounting for any taxes owed – for eBay that it will probably return to shareholders through a large share buyback.
The next asset on the block is eBay’s online classifieds business. Personally, I would like eBay to spin off this business. Online classifieds are extremely profitable and I would expect a standalone classifieds business to pay a dividend since they need very little capital to maintain and grow their operations.
The more likely event is a company Schibsted stepping up and buying this business. eBay’s online classified business would be a great addition to Schibsted’s portfolio. But we’ll just have to wait and see.
The second update comes from Charles Schwab.
Schwab has made a lot of noise since I profiled our position back in episode 3. I even had to make an update episode when they dropped trading commissions down to zero.
Now Schwab is buying TD Ameritrade in an all stock deal valued at 26 billion dollars.
Talk about a savage business move.
Schwab cuts commissions to zero forcing everyone else to drop their commissions to zero too.
Commissions were about 8 percent of Schwab’s revenue but they’re around 30% for TD Ameritrade. Commissions were a big chunk of TD’s revenue and profits. TD’s share price dropped 25% on the zero commission news.
Kill your competitors and then buy them at a cheap price.
Once the deal closes, Schwab will have over 5 trillion dollars in client assets.
Schwab is the leading custodial platform for RIAs, one of the fastest growing financial services sector as measured by asset growth.
Buying TD Ameritrade adds another 7,000 RIAs to the Schwab platform. Now there is some overlap. Our primary custodian is Schwab but we also use TD Ameritrade for a small portion of our business. Those assets will come over to Schwab now but it’s not like a completely new, never used Schwab before RIA is joining up. I would guess a lot of RIAs on the TD platform also use Schwab too.
I would also expect some RIAs on TD’s platform to not come over to Schwab. They joined TD and not Schwab for a specific reason. Another reason for some attrition is repapering accounts.
If you’re a financial advisor then you know how much of a hassle it is to repaper your clients’ accounts and get them set-up at a new custodian. If this deal forces RIAs to repaper their accounts, it gives RIAs a chance to look around for another option. If they’re going to have to repaper their accounts anyways, why not look around for the best fit? Now, this shouldn’t be a large number of RIAs and the overwhelming majority of the assets will move over to the Schwab platform. Some of the estimates I’ve seen in models for revenue attrition is 4 to 7 percent.
More assets and more RIAs gives Schwab more scale and a big opportunity to lower costs and generate some big synergy gains. Schwab is guiding towards 3 billion in annual cost synergies.
This should lead to excess capital being returned to shareholders through increased dividends and share buybacks. Since Schwab is more like a bank now, it will have to raise some additional capital to keep its required capital ratio levels in compliance. And I’m sure the excess capital earned from the cost synergies will go to rebuilding Schwab’s capital ratios first. Schwab will also most likely have to raise some capital through a stock or preferred stock offering. But once Schwab meets its capital ratios, the excess capital from the cost synergies will fuel more share buybacks and dividends.
One of our main investment themes for Charles Schwab is the long-term secular growth of the RIA. As costs have come down for trading and servicing accounts, the total addressable market for people seeking or using financial advice has expanded. Schwab was already a leader in the RIA space and this acquisition of TD makes it even stronger.
More RIAs feeds into Schwab’s vertical integration. It has its own bank to generate net interest margin off client cash, it has more order flow giving it larger bargaining power with wholesalers, Schwab has its own low cost ETFs that advisers will use, it has its own robo-advisor offering that advisors can white label and use as their own which further feeds into Schwab’s ETFs and cash sweep program.
I like to think of Schwab as a platform company for RIAs. The total value of the businesses built on Schwab’s custodial platform will exceed Schwab’s value but Schwab will be there every step of the way earning economic rent off the long-term secular growth of the RIA business.
And if the custodial platforms need to switch to asset based pricing or a subscription based pricing for access to their platforms, Schwab’s increased scale gives it great leverage with RIAs to d so.
I think this deal is good for both shareholders. The big hurdle that remains is any anti-trust review. The argument against consolidation is less competition hurts the consumer. But it’s tough to argue the consumer is being hurt when their commissions and the major costs they pay attention to are zero.
Yes, the real cost is how little they are being paid on their cash but people don’t really pay attention to that. It’s out of sight out of mind. Regulators are people too and I think they’ll pay more attention to the headline costs than the indirect costs from Schwab’s cash sweep program.
If this deal closes Schwab will have between 50-70% market share of the RIA custodial space. Which is the stat t gives me pause about the deal. But the RIA space is one small channel for the consumer. Consumers can go with their bank, both the regional and really large banks, they have regional brokers and advisers like Raymond James and Edward Jones. They have the large wire houses like Merrill Lynch and Morgan Stanley. And a bunch more options.
If the deal is looked through the eyes of the average consumer and the effects on them, I don’t see much trouble with this merger.
The big hang up is the RIA channel.
The other thing is so far under the Trump administration financial mergers have not received a whole lot of scrutiny. So we’ll see if that remains the case.
While I think this deal is great for Schwab and its “flywheel of scale”, to borrow a term from Ensemble Capital, It will take a long time to complete. We need shareholder approval, regulatory approval, then the two companies need to merge operations, Schwab needs to rebuild capital ratios. It’ll be a few years until the big benefits from the cost synergies and increased size and scale really payoff for Schwab’s shareholders.
It’s a time arbitrage play.
That’s it for this brief portfolio update episode. Again, thank you for listening and if you enjoyed this episode please leave a rating and subscribe to get all our future episodes. If you’re an individual investor or a financial advisor that uses separately managed accounts and you want to learn more about the AMM Dividend Growth Strategy, give me a call at 888-999-1395. And don’t forget to use the link in the description to sign up for our email newsletter to get notified when we issue a new dividend letter, podcast episode, or video.
Until next time.
