On September 26, Interactive Brokers announced its Interactive Brokers Lite service, offering commission-free trading on all US listed stocks and ETFs. Interactive Brokers (aka IB) is a relatively small online broker with AUM of about $160B vs Schwab’s $3.7T. In the last year alone, Schwab added $200B in net new AUM from customers.

So it surprised the market when, on October 1, the behemoth Schwab (SCHW) announced that it too would eliminate trading commissions for US and Canadian Stocks, ETFs, and Options commissions.

Source: Bloomberg:Online Brokers performance 9/23/19-10/24/19

With that move, Schwab effectively killed the business that birthed it 44 years ago.

IB’s management was taken aback by its impact on the industry a few weeks later during its earnings conference call:

“ we did not expect such a swift reaction in the sense that we thought that we come out with IBKR Lite as an additional offering and that we go on for a while, and will attract some customers and then eventually, other people will start reducing and maybe all go to zero. So this — this very swift reaction was a surprise to us.” – Thomas Peterffy, Founder and Chairman, Interactive Brokers Group (IBKR), 3Q 2019 Earnings Call

Schwab’s price cut was put into effect a week later on October 7, coinciding with the release of its founder and Chairman, Mr. Charles Schwab’s new book Invested. Charles Schwab was one of the key figures fathering and successfully growing the discount brokerage industry after the SEC deregulated trading commissions on May 1, 1975 (aka May Day). He adopted the use of computing technology and operational efficiency to continually drive down the cost, and with it the price, of trading shares.

By offering better value to customers, Schwab (the eponymous company) was able to grow its scale and with scale it improved its efficiency, which allowed it to further invest in technology, service capabilities, and lower prices resulting in further improving value and winning over more customers.

In examining its history, it’s clear that Schwab’s culture has played an important part in the use of technology and efficiency as a force for disruption and commoditization, either as a leader or fast follower (as in the latest incident swiftly following on the heels of IB).

As a result of this, Schwab has earned its customers trust and business, which has enabled it to leverage growing scale to disrupt lower value services (commissions, index funds, vanilla mass financial advisory) while climbing up the value chain of higher value services, thereby broadening its platform and scale. Most recently, that strategy has been embodied in Schwab’s dual mantras of viewing its service delivery “Through Clients’ Eyes” and with “No Trade-offs”, delivering everything the client wants at the lowest effective price in its market.

On the surface this looks like bad business, but delve a little more deeply and it becomes clear that it’s all in the service of scale and efficiency which trumps “price” as a driver for long term competitive advantage in this business.

Source: Charles Schwab, Fall 2019 Business Update

As the most scaled and efficient player in its industry, Schwab has the best expense efficiency on AUM (referred to by Schwab as EOCA = Expenses on Client Assets).

Source: Charles Schwab, Winter 2019 Business Update

The scale and efficiency have allowed Schwab to deliver lower prices to customer over time while increasing profits for shareholders – a win-win scenario we love to see in companies because it represents a non-zero sum relationship between a company and its customers.

Source: Charles Schwab, Fall 2019 Business Update

Despite its relatively small size, IB is a credible player, especially among active traders, to have elicited a response from Schwab (we were not surprised) — the type of aggressive response that had been brewing as the new style of “fintech” players like Robinhood have arisen, leading their value proposition with commission free trading while monetizing client trades via order flow.

IB’s move essentially brought that commission-free/order-flow monetization model into the boundaries of the mainstream discount brokerage business, and Schwab’s aggressive move brought the model from the boundaries into the center, and forced the rest of the industry to follow suit  and leaving them to nurse their now wounded financial models.

The timing may have been surprising, but the end state of commissions was not to anyone who has been paying attention. When computers do all the trading, the marginal cost (and revenue) trend to zero. The trading infrastructure has transformed from expensive people to predominantly cheap computers, and so did the business model.

Source: Vice.com, Ensemble Capital Management

Luckily for Schwab’s investors, its strategy of moving up the value chain (vertical expansion) and creating increasing platform leverage across market participants (horizontal expansion) have rendered its original trading commissions business, the most commoditized segment, of low importance to the whole at just 3.5% of revenue and ~8% of profits. Some modest expense control is all it would take to offset most of loss or ~6% incremental growth in AUM (all other factors being equal).

Source: Ensemble Capital Management

Building the business this way needed healthy doses of both long-term foresight (where does competitive advantage come from today and in the future – i.e. customer value and scale) and near-term opportunism (what should be within the business’ focus area to invest in and what’s not).

TD Ameritrade’s (AMTD) CEO Tim Hockey candidly admitted during its 4Q2019 Earnings Call:  “The best time to have, I think, build out a proprietary product offering was probably 25 years ago. There is a significant price point pressure obviously on active and passive… But as we know, you need absolutely massive scale for an offering and asset management fees base and so we don’t think that makes sense for us.”

In fact, as we’ve discussed in our previous post here, Schwab has increasingly shifted its customer monetization strategy from explicit fees via commissions and AUM based investment fees towards implicit fees based on opportunity cost of cash balances via net interest margins (NIM) at its Bank.

Therefore, Schwab wins over and retains customers with the lowest fees on the ~90% of their investment portfolio, thus accelerating market trends of declining AUM fees which is good for clients and a key decision point for them, while making money on the residual ~10% of their portfolio cash balance that is automatically swept into its Bank.

In its most recent 3Q 2019, proforma operating margins hit nearly 48% and 21% ROE (45.6% and 20% including a $62MM charge in 3Q19). For all of 2019 we expect a nearly 47% proforma operating margin and 20% ROE, while we expect to see only a modest impact to 2020 profitability of less than 5% from the commissions cut due to offsetting expense controls and some incremental AUM growth.

The impact of eliminating trading commissions is asymmetric across the major online brokers, with Schwab most insulated with only about a 3-4% net revenue impact and 8% hit to earnings (before expense adjustments), while TD Ameritrade (AMTD) noted a 15%-16% impact to revenue and E-Trade (ETFC) could see about a 10% impact. Goldman Sachs estimated a much deeper initial impact to earnings for AMTD and ETFC at -32% and -24%, with expense controls likely to mitigate some of the impact.

But there is no doubt the impact of the commission cuts has significantly weakened competitors AMTD and ETFC ability to invest in client service and technology investment going for several quarters to come.

On that note, TD Ameritrade’s management commentary is an interesting contrast to Schwab’s CFO commentary:

“we know that this boost to business alone will not replace all of the lost revenue. Accelerating and diversifying revenue remains a strategic priority – one that will guide continued exploration and efforts to recoup the lost economics over time. Over a year ago, we also started a formal strategic resiliency program to inject more discipline into how we allocate resources. Our work involved identifying our strategic differentiators – the things we can be really good at and win (things we could potentially accelerate) – as well as what we need to do to keep the lights on… Now, we’re tackling what’s left – the non-differentiators and things that don’t drive growth – to slow or stop investments and redeploy them to the things that matter.”

“Charging for help/advice. With the commission reset, we have shifted from the premium price in the market, ensuring that our value to customers justified that price, to an environment where we are providing extraordinary value to our customers. We have received numerous phone calls concerned that zero commissions could result in less insight to customers, fewer interactions with our highly qualified people, etc. We have been exploring a number of potential ways to monetize this value, but fear of cannibalization or being perceived as charging beyond a premium price had held us back. Now, armed with segmented customer data, both on profitability and usage of services and information, we are well positioned to begin to monetize this value. This could take the form of recurring fees for premium services or charging for episodic advice. Where the customer does not attribute value to these services, we can adjust our costs accordingly.” – Management Commentary, 3Q 2019 TD Ameritrade

In contrast, Schwab’s commentary took on a different tone that is reflective of its business’ strategic and financial positioning going into the price cuts:

“Why did we take this step, and why now? [We are] continuing our tradition of challenging the status quo on behalf of individual investors… it’s the right move from a competitive standpoint. There has been a clear pause in the so-called commission wars among the “traditional” e-brokers since the price reductions we made [offensively] in 2017. At the same time, we are seeing new firms trying to enter our market – using zero or low equity commissions as a lever. We’re not feeling competitive pressure from these firms…yet. But we don’t want to fall into the trap that a myriad of other firms in a variety of industries have fallen into and wait too long to respond to new entrants. It has seemed inevitable that commissions would head towards zero, so why wait? We have a business model that doesn’t depend on commission revenue, a long-term orientation and a history of being willing to disrupt ourselves based on client needs and competitive dynamics. That’s exactly what we are doing here – we’re making these pricing changes because we believe they enhance both our value proposition and our competitive positioning, encouraging the consolidation of client assets and trades at Schwab.” – CFO Commentary, Charles Schwab 

“This elimination of commissions is something that we have been anticipating, was inevitable for over a decade. And we’ve been aggressively at work over the last couple of decades executing on strategies that reduced our reliance on commissions from a level of almost half of our revenue down mid-single digits. And while some might have been surprised by the timing of our move, our view is that anyone carefully following our commitment to the virtuous cycle would likely have anticipated it…

Now importantly, price is only one aspect of our commitment to delivering the best combination of value service and capabilities to all investors. Whether it’s our industry-leading client service, our broad range of solutions, our robust research tools and our industry first and still only satisfaction guarantee. We’re committed to serving investors in a manner unmatched by any competitor… in reality the virtuous cycle is not intended for short-term timeframes. It’s designed to be effective over the years, many years, and even over decades…

It begins at 12 o’clock by challenging the status quo on behalf of investors… how that has benefited our clients. Pretty remarkably what clients pay us in total for our services has declined by about 80% over the last 30 years. And as we share the benefits of our scale and efficiency with our clients, they bring us more assets. With assets growing exponentially over the same 30-year time horizon. Our commitment to operating efficiency and technology investments has enabled us to consistently grow our pre-tax margin over the last 30 years, even as our revenue per dollar client assets again has declined by about 80%. And our stockholders have benefited, as our net income and earnings per share have grown dramatically… of course, the virtuous cycle works, because we continue to make a variety of investments that benefit our clients. Sometimes we do so in services, products, capabilities, sometimes in price, as we did a couple of weeks ago.” – Walt Bettinger, President and CEO, Charles Schwab during 3Q19 Business Update Call

We believe Schwab’s business stands to benefit the most because of the relatively small impact to its revenue and income and the broad, efficient set of high quality service it offers to clients. While the commission cuts mean Schwab offers an even more compelling value to its customers for its existing suite of high quality services, a disadvantaged competitor like TD Ameritrade is trying to figure out how to charge for its “premium” services for customers, effectively raising prices for service in other ways and depressing its value proposition.

Decades of experience  indicates the companies offering higher value propositions win more customers. By  continuing to pursue aggressive reinvestment in both client service and technological efficiency, Schwab can continue to leverage its growing scale to further improve upon the value proposition it provides clients while continuing to drive down its expense (efficiency) ratio. We believe the gap in differentiation will only get wider now that the smaller competitors are much weakened financially, which is why it made sense for Schwab to be so aggressive in cutting commissions both in 2017 and again October 2019.

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE

For more information about positions owned by Ensemble Capital on behalf of clients as well as additional disclosure information related to this post, please CLICK HERE.

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