Schwab cuts trading fees to zero

Hi,

Yesterday Schwab announced that they would eliminate commissions on trades for all US stocks and ETFs. The surprise move sent SCHW shares down 10% and sent ripples across other online trading companies. For Schwab trading revenue has been declining for the past decade. They advertise discount trading to grow assets under management (AUM). They have been the leader in reducing costs and pressuring the competitors to follow.

For Schwab trading revenue is only 6-7% of total revenue which is far less than Ameritrade or IBG both whom collect more than a third of their revenue from trading. Clearly, Schwab is placing a lot of pressure on competitors and some consolidation is expected. Yesterday, Ameritrade’s stock fell by over 20%.

Our thesis for buying Schwab focuses on growth in AUM, not trading revenue. Schwab estimates they could lose $400m in revenue through zero commissions which could be replaced by $20b gain in deposits. Schwab has grown deposits by more than $20b annually over the past 3 years. Deposit growth is driven by AUM growth and the amount of cash held by investors. Cash levels are near market cycle lows, so an increase in market volatility (fear) could raise cash levels and benefit Schwab’s bottom line.

Since we bought Schwab, interest rates have fallen significantly. Considering Schwab’s interest revenue is 73% of total revenue, the effect of a decline in interest rates on net margin is important – much more important than trading revenue. We expect some contraction in net interest margin, but also expect Schwab to manage costs by keeping deposit yields low. Schwab’s strategy to gain assets is to give away trading, while Fidelity has been advertising higher yields on money markets funds.

Schwab reports Q3 on 10/15, which will give us greater insight on AUM growth, deposit growth and net interest margin.

Please let me know if you have any questions.

Thanks,

John

$US.SCHW

[tag Equity Research]

John R. Ingram CFA

Chief Investment Officer

Partner

Direct: 617.226.0021

Fax: 617.523.8118

Crestwood Advisors

One Liberty Square

Suite 500

Boston, MA 02109

www.crestwoodadvisors.com