Schwab expansion plans slowly coming into focus

With brokerage houses swallowing one other amid a wave of rapid consolidation, Wall Street is closely watching discount brokerage king Charles Schwab.

So far, he’s played his cards close to his vest, but in an investor and analyst conference last month, Mr. Schwab and his top lieutenants offered a glimpse into their strategy to further the brokerage’s quest for assets.

One cornerstone of that plan is an effort to bolster the brokerage’s stock order-filling business.

Mr. Schwab and longtime lieutenant and co-chief executive David Pottruck also acknowledged a pressing need to expand Schwab’s fixed-income trading and inventory capabilities to win a bigger share of their customers’ investment holdings.

The firm is also contemplating a bigger push into the high-net-worth money management business.

In addition, some investment house analysts suggest Schwab may want to expand its brokerage presence in Europe by shopping for a firm there.

International business currently makes up just 6% of the company’s revenues, and Schwab executives are committed to expanding that share.

However, Mr. Schwab has said that he plans an Internet-based expansion and that sufficient infrastructure does not yet exist to support such a move.

Great plans

Five years ago, Mr. Schwab set a goal to grow to $1 trillion in assets in a decade – a bold goal considering the San Francisco-based brokerage then oversaw $125 billion in assets.

With assets having surpassed that milestone in August – five years ahead of schedule – Wall Street and Schwab shareholders are wondering where Mr. Schwab will take his namesake firm next.

Over the next month or two, Schwab executives will map out plans for the company’s growth for the next decade.

Mr. Schwab says company executives are now laying out plans to double or triple the asset base.

With an estimated $17 trillion of investible assets in the United States, Schwab currently has almost a 6% share of the market.

“We think it is very realistic for us to garner a larger share of that, and we have a lot of great plans to make that happen,” Mr. Schwab told analysts.

Indeed, Mr. Schwab’s intentions – if not his game plan – have been known for sometime.

Some news organizations reported in September that the brokerage had held informal merger talks with longtime investment banking adviser Goldman Sachs Group.

In late October, Schwab registered 15 million shares of common stock – then worth $461 million – earmarked for future acquisitions.

The move quickly pushed the company’s shares up 14% to over $35. Worries over the swooning Nasdaq Composite Index – where many of Schwab’s retail clients trade – have since pulled the stock down to under $28.

filling in holes

Speculation that Goldman and Schwab are continuing to talk still courses through the industry.

But Goldman brokerage analyst Richard Strauss hasn’t placed Schwab’s stock on his restricted list as he did when the firm advised Schwab on its purchase of U.S. Trust Corp., suggesting that no serious merger discussions have occurred.

During the conference, Mr. Schwab acknowledged the company’s need to bolster its market-making capabilities.

Merrill Lynch and Goldman Sachs have snapped up market makers Herzog Heine Geduld Inc. and Spear Leeds & Kellogg, respectively, and in light of industry consolidation, a similar deal appears to be on Mr. Schwab’s shopping list.

“Would we like to buy another company in that space? Sure we would, if it came at the right price,” he told conference participants.

Schwab’s capital markets and trading unit – including this year’s acquisition of order-routing specialist Cybercorp Inc. – currently has an estimated 10% to 12% of the stock market-making business.

But few independent market makers remain. Jersey City, N.J.-based Knight Trading Group Inc., the biggest remaining independent Nasdaq share dealer, hired Robertson Stephens Inc. in September to advise the company on a possible sale. (See related story on Page 3.)

New York investment houses Morgan Stanley Dean Witter and Citigroup Inc. subsidiary Salomon Smith Barney have been mentioned as potential suitors.

Some analysts think, however, that Knight would be too big for Schwab to comfortably digest so soon after its acquisition of U.S. Trust.

As for its fixed-income trading and inventory capabilities, only about 8% of the brokerage’s $950 billion in customer assets are fixed-income securities.

However, customer surveys have shown that clients typically hold more than 20% of their assets in bonds, suggesting that Schwab has about half of that business.

That shortfall could grow as investors become increasingly cautious in the face of the volatile stock market and move money into more-conservative fixed-income securities outside Schwab.

Part of the brokerage’s undersized bond business reflects Mr. Schwab’s long-standing bias toward equities.

“It’s not a problem getting bonds,” says Brad Jones, senior vice president of Chicago money manager Stein Roe & Farnham Inc.

“But if they don’t have an inventory, it’s more expensive for our clients. I think it’s wise to have it on their list.”

Mr. Schwab now acknowledges that the company can no longer operate that way and is exploring alternative ways to buy bonds directly or establish an inventory, which could mean acquiring a bond-trading firm.

In June, Schwab struck an alliance with online bond trading startup ValuBond in Atlanta so it could offer customers access to new bond offerings, bond trading and portfolio management services.

An agreement with eSpeed Inc. is aimed at improving the brokerage’s access to U.S. Treasury and U.S. agency fixed-income securities.

Trolling for the rich

Some observers also believe that Schwab’s October stock registration is a prelude to a deeper push into the high-end money management business.

At last month’s investor conference, John Philip Coghlan, vice chairman and president of the brokerage’s adviser unit, confirmed that Schwab will continue to back U.S. Trust’s previous efforts to buy regional investment managers that cater to the wealthy.

Though the move reflects Schwab’s heightened efforts to pursue the expanding pool of affluent investors, it is also a response to worries about losing some of its biggest independent financial adviser clients to other industry consolidators