After month in COVID-19 hell, Charles Schwab spends $27 million to placate staff, RIAs and investors -- an amount dwarfed by $37 million spent to keep three M&A deals chugging ahead

The San Francisco broker coughed up cash to quell rare internal strife in March as workers faced battle conditions -- and couldn't all shelter in place -- as trading exploded, retail calls spiked 16% and many workers shared desks in cramped cubicles.

The Charles Schwab Corp. survived, perhaps, the biggest 30-day stress test in its history by balancing shareholders, regulators, retail investors, RIAs and its own staff while it scrambled to safeguard workers from the COVID-19 virus, it revealed in its Thursday earnings release.

But Schwab did not apparently trim its operating budget for feverishly wiring the three acquisitions -- valued at signing at a combined $28 billion -- that it plans to close this year to leapfrog the scale and footprint of its competition in 2021.

The San Francisco broker, custodian and bank made clear in its latest earnings call that it is now -- finally --  safeguarding nearly all of its own staff while choosing to err on the side of keeping investors well-served in the downturn -- and put the price tag for making home offices industrial strength and compensating staff for upending their work lives at $27 million.

"Every company has had to make adjustments in order to meet clients’ needs during this turbulent time, and while there are some challenges to be met, we are pleased with how our people have risen to the occasion," Schwab CEO Walt Bettinger said in the company's quarterly earning release Wednesday (Apr. 15).

Bettinger updated investors with the news that now 95% of Schwab's staff are home, up from 90% as of the previous report. That represents about 900 more people.

That said, Schwab spent much more in the 90 days ended March 30 -- $37 million on  matters "relating to our pending acquisitions," its release states. Schwab currently has three deals under agreement, including USAA's broker-dealer for $1.8 billion, Wasmer, Schroeder & Co. and TD Ameritrade. See: Schwab's merger with TD Ameritrade was sterling until the Covid-19 pandemic and financial collapse took some of the shine off the deal

Not all Schwab's investment in staff got reflected in those numbers. Schwab has also promised to guarantee the jobs of all current employees until the COVID-19 all-clear is sounded.

These moves have all but stopped, for now, the drumbeat of staff complaints to RIABiz inboxes and comment sections about ignoring community sheltering safeguards and providing poorly functioning home technology.  

"We’ve been up and running day-after-day, without significant disruption," Bettinger crowed.

Righting the ship

When the COVID-19 pandemic exploded, most of Schwab's 19,000 employees were ordered, Mar. 16, to report to work, even while competitors, like Fidelity, were sending workers home in droves.

Within 12 hours of a Mar. 12 decision to go remote, 70% of Fidelity staff were working at home, said human resources head Bill Ackerman in an Apr. 10 LinkedIn post.

Schwab's famously quiet, loyal and largely contented workforce was roiled by the decision. A number of workers blew the whistle, mostly through anonymous emails and comments to RIABiz, which broke the story, Mar. 16.  See: As COVID-19 crisis grows, Schwab charts own course, orders office workers to stay put, while Fidelity, other firms urge employees to work from home.

To quell the uproar, Schwab on Mar. 18 said it would give a $1,000 "spot bonus" to any employees below the officer level to help them deal with the fallout of COVID-19, as well as pick up extra expenses like office food. See: Under withering staff pressure, Walt Bettinger course corrects to shut all Schwab branches and to let Charles Schwab Corp. non-branch employees work from home.

By Mar. 19, staff pressures prompted Schwab's to allow 35% of its employees to work remotely. 

To make matters worse, retail call volumes spiked 16% at the same time, reaching the highest levels measured since 2003. Mobile logins were up an estimated 35% from a year ago.

But better late than never, Schwab got the ship righted -- without materially affecting service to RIAs or investors. 

"I know they did struggle initially, but overall they seem have sorted it out," says Joel Bruckenstein, founder of the T3 Conferences, via email.

Schwab has gotten a handle on things, says one employee, who asked to remain anonymous. "Things are going well ... there'll be a cultural shift allowing employees to work from home [in future] ... we've been told no layoffs will occur this year."

"They do deserve credit for what they’ve done to support their advisor network," agrees Will Trout, senior analyst at Boston consultancy, Celent, via email.

Once bitten

But it took some doing to get there. A senior advisor at one RIA that uses Schwab as its custodian said via email that things were farcical at times.

"[We] placed Market orders in our block-trading account only to see them showing as still open. A call to trading was necessary more than once to find out if orders were executed. [But] it’s gotten a bit better ... [and] calls to our service team haven't suffered."

Bernie Clark, executive vice president and head of Schwab Advisor Services, said via email that the adverse events should ensure better future service delivery.

"The extreme market volatility we all experienced impacted our whole industry, and we are working hard to ensure that we are prepared for future events and to deliver the service our clients have come to expect from us."

"I have been very proud to see the incredible teamwork across the organization to manage the unprecedented volumes we’ve seen the past month," he adds.

In fact, Schwab can make hay from the difficulties its recently faced with staff, says Peter Giza, chief product officer of Layton, Utah-based rebalancing vendor AdvisorPeak, via email. See: Why Charles Schwab staffers are still waving COVID-19 red flags even after Walt Bettinger capitulated to allow most of them to work at home.

"[Schwab] have a chance of taking the twin black eyes they received a month ago and turning that into a crown."

Holding the line

It's not like Schwab has cash flow issues that would prevent it from pouring capital into upgrades.

Schwab's assets under management (AUM) fell only 2% to $3.5 trillion over the quarter, and it brought in $73.2 billion in net new assets -- a 42% increase year-over-year, according to its latest financials. 

On the retail side, investors also opened a record 609,000 new brokerage accounts -- partly because of the company's bet on zero-commission trades.

Indeed, if Schwab hadn't started a price-war last year it would be sitting pretty, writes Michael Wong, director for financial services equity research at Chicago research firm and software vendor, Morningstar, in an Apr. 15 note.

"High trading activity from a tough market environment would have actually led to revenue growth in the first quarter if not for the recent cut in trade pricing."

The broker-dealer’s bottom line was saved by the company's embrace of the payment-for-order-flow model, which limited potential trading losses into a trickle.

Trading up 

In fact, first-quarter trading revenues fell just 13% to $188 million, owing to a huge increase in transaction numbers and payment from wholesale market makers.  Twenty of the highest 30 days in Schwab's trading history occurred in March.

Order flow payments involve firms, like Citadel Securities or Virtu Financial, that pay for first dibs in executing stock orders on behalf of retail clients. In turn, these firms profit on the spread between a retail bid and a sale offer, part of which they keep and part of which they return to the broker-dealer.

To go zero-commission and take only a 13% hit in 'trading" revenues, shows just how much Schwab has profited by using this Robinhood model of discount brokerage, says Baldwin. See: After Vanguard instigated commission war in June, Charles 'Chuck' Schwab steps up to challenge in brilliant counterstroke that paints bull's eye on custody rivals in zero-sum showdown

"For only $24 million in revenue, Schwab now gets to say they’re free, all while generating an entirely new revenue stream," he explains. "[It also] bolsters the chances of the acquisition [of TD Ameritrade] being approved by maintaining significant trading revenue and net interest revenue."

Indeed Bettinger, and chief financial officer Peter Crawford both struck a bullish note in the earnings report.

"Schwab is financially strong and growing -- with a business model positioned to weather circumstances like this pandemic-related storm," Bettinger said. "I have every confidence that we’ll emerge from this successfully."

We will, Crawford added. "We’re facing the storm from a position of strength and expect to remain on offense."

Falling numbers

But Schwab's April report also contains plenty of grim detail about the shellacking it's taken over the last few months. Industry observers note that the second quarter will likely bring even harsher news.

Schwab beat analyst expectations on revenues, bringing in $2.62 billion in Q1, largely as a result of surging cash levels that buttressed losses, despite the low-interest environment. The Fed made two emergency cuts in March, sending the benchmark rate to 0.0.% to 0.25%.

But net income slid by 18% to $795 million, or $0.58 per share, missing analysts' estimates. Analysts tracking the stock were expecting a consensus $2.61 billion in revenue and a net profit of $0.62 per share.

A full $0.02 of the $0.04 earnings-per-share miss is a direct result of a $27 million pandemic splurge. "[This included the cost] for the employee award and other compensation and business continuity expenses relating to our pandemic response," Crawford explains. See: COVID-19 throws a curve ball at RIA M&A market, gut-punching valuations and causing fence-sitters to resolve to get the hell out, but Q1 prices hold their own.

The shopping list was likely a long one, says Bruckenstein.

"It's not just the trading volume [increases that needed fresh support]. It's also calls to call centers, website visits, etc. If 95% of staff are working from home, Schwab may have needed to provide them with tools and licenses for additional software, additional tech support and cybersecurity."

But if you break that expenditure down per-employee level, it's a pittance, meaning Schwab has missed a trick, says Giza.

"The cost to properly establish a home office is probably closer to $3,000 to $4,000," he points out.

Adding expenses (mostly) related to buying TD Ameritrade, Schwab's earnings decline totalled $64 million.  See: Schwab's merger with TD Ameritrade was sterling until the Covid-19 pandemic and financial collapse took some of the shine off the deal

Schwab's share price dipped 3.7% from $36.19 to $34.85 on market opening. By mid-day Apr. 16, it dropped a further 3% to $33.80. It has since rallied to $35.79.

Much of the sour sentiment is related to interest rates, something Schwab is managing well enough, says Frank Bonanno, managing director of NYC cash-broker StoneCastle Partners, via email.

"Competition has made the model more difficult, but it looks like Schwab is picking up a lot of operating leverage as a market leader," he says. "Cash will eventually be reinvested along the yield curve improving the margins to some extent."

Debt foray 

The Dodd-Frank Act, 2010, requires that all major US financial institutions, Schwab included, conduct annual stress tests to assess their ability to ride out major financial shocks through nine quarters of adverse economic conditions.

As yet, economists remain uncertain about how long the Covid-19 induced recession will last. That said,, the downturn has been widely predicted, including by the IMF, to be the worst since the Great Depression.

One of the core requirements of a stress test is a firm's tier one capital ratio. It must be higher than 6%, so that it can withstand significant financial distress. This ratio balances a firm's equity, capital and disclosed reserves against total risk-weighted assets.

For Schwab, the one up-shot of the low-rate environment is that it allowed the firm to quickly tap the markets for cheap debt to bolster its cash reserves closer to its operational ideal of 7%.

In March, the firm issued a number of five- and 10-year senior notes totaling $1.1 billion.

"It was smart balance sheet management," Schwab spokeswoman, Mayura Hooper explains, via email.

Very wise, says John Merante, chief economist at Wayzata, Minn.-based RIA lender SkyView Partners, via email.

"Schwab wanted to borrow when they could, rather than when they'd have to ... [and] with Q2 GDP projected to crash anywhere from 14% to 30% -- quarter-on-quarter-annualized -- prudent risk management [is] to strengthen liquidity."

Tough bird

Falling interest revenues, however, expose Schwab's increased dependence on earnings accrued on the spread between the interest it receives and the interest it pays out through its proprietary bank. 

In 2014, such earnings accounted for 38% of the firm's revenues; today this figure stands at roughly 60%, according to Morningstar data.

"[Schwab], like all their peers, face challenges on both interest rates and asset volatility ... but they've built a strong foundation," says Scott Smith, director of advice relationships at Boston-based consultancy Cerulli Associates, via email.

Nor is Schwab alone in depending heavily on interest-backed revenues. TD Ameritrade -- soon to be acquired by Schwab if the deal passes Department of Justice antitrust muster -- is just as reliant on spread-based earnings, according to Morningstar. See: TD Ameritrade hedges its bets that Schwab can swallow it whole as DOJ letter lands, LINC 2021 gets planned and TD pledges it'll go 'full tilt'.

Privately-owned Fidelity does not disclose how much it earns on interest spreads, but BNY Mellon, parent of number four RIA custodian Pershing, derives just 19% of its revenue from spread-based income.

Bleak house

It's only going to get worse for Schwab, however, because interest-backed revenues will fall further, says Matt Crow, president of Mercer Capital in Memphis, Tenn., via email.

"Net interest revenue ... was supposed to make up for cutting trading revenue [last year]. If trading activity declines in Q2 and rates stay roughly where they are, Schwab’s aggregate revenues will trend down further. I don’t think they can avoid it."

Moreover, surging Q1 client cash balances counterbalanced depressed rates, insulating Schwab from the full force of a hit to revenues. Plus, the Fed cuts came midway through the last month of the quarter. 

"With first quarter market volatility driving a significant influx of client cash, our balance sheet expanded by $77 billion ... to $371 billion at March 31st," Crawford explains.

The downside to such support is that when markets start to stabilize, Schwab could face one last interest hit, says Baldwin.

"Right now, Schwab may be making a third of what they previously made off interest before the rate drop ... [but] Q3 income will significantly drop as cash balances decline from clients putting their money back to work in the market."

That said Schwab's reliance on interest-backed revenues isn't solely dependent on Fed rates, because the broker-dealer owns a proprietary bank.

Even in the current low-rate environment, Schwab can still make far in excess of the current difference of roughly 0.24% between the 0.01% it pays out on cash and standing Fed rates. As a result, although the near-zero rate is a sizeable blow, Schwab can handle it, says Bonanno.

Bettinger shares Bonanno's positive outlook.

"With the COVID-19 pandemic continuing, daily life as we’ve known it has been upended ... this is uncharted territory for us all," the Schwab CEO writes.

"We don’t know how events will unfold from here; we do know that we’ll emerge from this successfully."

Clarification, apology and correction: In a previous version of this story, Peter Giza was paraphrased saying that Schwab was penny wise and pound foolish in not previously equipping employees with home offices and that it endangered employees. In fact he never mentioned endangering employees. He stated that companies could spend as little as $3,000 per staffer to set them up with a good home office and that companies are wise not to "cheap out" on making that outlay --and that "Charles Schwab should very seriously take this opportunity to invest in their operations future." We are sorry for the errors.

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