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Bets on Schwab, TD Ameritrade aren’t paying off

Investors who have been pouring money into discount-brokerage stocks on expectations that the companies would get a lift from interest-rate hikes are in for further disappointment, according to a new report from Sanford C. Bernstein & Co. Inc.

Investors who have been pouring money into discount-brokerage stocks on expectations that the companies would get a lift from interest-rate hikes are in for further disappointment, according to a new report from Sanford C. Bernstein & Co. Inc.
Not only have interest rates remained at record lows, but anticipated heavy retail trading volume tied to market volatility has failed to surface and is unlikely to do so because of traditionally slow summer trading, Bernstein analysts write.
“Unfortunately none of the trends that drive a retail revenue rise are imminent,” lead brokerage firm analyst Brad Hintz wrote in the report released today. “Indeed, for the second time in two years a financial crisis is frightening retail investors in North America. Moreover, the disruption of the Euro sovereign-bond market has threatened a U.S. economic recovery and delayed a rise in interest rates. This means that money market fee rebates will have to continue as short rates hover near zero.”
Discount brokers such as Charles Schwab Corp. and TD Ameritrade Holding Corp., which execute much of the trading business for clients of registered investment advisers, are extremely sensitive to interest rates. The near-zero levels at which rates have idled for more than a year have flattened net-interest margins, leveled margin account revenue and have forced the big discount brokers to waive hundreds of millions of dollars of fees on their money-market fund complexes.
Shares of Schwab and TD Ameritrade underperformed the S&P 500 index in May (Schwab by 6 percentage points and TD Ameritrade by 2), and investors who expect commission-generating trading revenue to offset the interest rate pressure are likely to be disappointed, the analysts said. Schwab’s stock also underperformed an index of brokerage stocks in which it is included by 4 percentage points last month, while shares of TD Ameritrade were flat with the index.
The retail brokerage stocks benefited early this year as investors rotated out of large-cap institutional brokerages that appeared to face tough earnings comparisons with 2009, the analysts wrote.
Schwab and TD Ameritrade have both outlined how their earnings would be affected by escalating rates. An initial 1% hike in the federal funds rate could add 60 basis points to Schwab’s net interest margin and allow it to eliminate its money-fund waivers, which Bernstein analysts estimate will total $270 million for the rest of this year.
TD Ameritrade has said that a 25-basis-point rise in the Fed’s target rate will add 7 cents of annual earning per share.
But the bet on rates will likely have to wait, since “the market is currently assuming that an interest rate hike by year-end 2010 is unlikely,” the analysts wrote. And while stock market volatility usually generates high volume from active traders, it’s unlikely to offset the broader trend of retail investors to withdraw from the market in summer.
“We believe the impact of seasonality, even during crisis levels of volatility, could curb this opportunity,” the Bernstein analysts wrote. Daily average trading volume at Schwab was down 4% through the end of April, and other indicators of revenue and expenses are all “below the bear case” that Schwab executives outlined for analysts last month, they wrote.
Bernstein rates both Schwab and Ameritrade “market perform,” which is equivalent to a neutral recommendation. The firms are solid companies with good management teams, they conclude, but there are “no near-term catalysts to provide earnings growth and multiple expansion.”