The Business Of

Banking | Charles Schwab | Hargreaves Lansdown Face-Off

Morning All!

TGIF! The weekend is so close! But before we get there, we’ve got one final newsletter to round off The Business Of Charles Schwab. Let’s have a quick recap of some of the fun, surprising things we’ve learnt about the US brokerage giant this week…

• Interest Hero - Charles Schwab makes ~$4bn from trading revenue. ~$4bn from asset management fees. But a whopping ~$11bn from net interest income!

• Margin Hero - Yes, Schwab got slightly upstaged by Hargreaves’ 55% margin yesterday, but let’s not forget… Schwab’s 45% margin is still ludicrously high!

  Dividend Slacker - For all Schwab’s brilliance, the company has historically only paid out 26% of profits as dividends vs Hargreaves’ 86%…

… and we’re about to find out why! I am SUPER excited for today’s newsletter because not only are we going to solve the dividend mystery. We’ll look at why Hargreaves has such a ridiculous margin. And we’ll investigate why the shares of Schwab and Hargreaves have taken such a pounding recently. So, without further ado, let’s get stuck in!

Platform Fees… That’s New!

Okay, so let’s kick off by taking a look at Hargreaves’ revenues. And as we’ll see, there’s a few key differences between how Hargreaves (HL) makes their money vs Schwab…

1. Net interest income - okay, so this is very similar to what happens at Schwab. HL takes the uninvested cash in their customers’ accounts and invests it.

2. Commissions - this is different. As we saw earlier this week, payment for order flow (PFOF) is banned in the UK and so unlike Schwab, HL charges users a fee (usually £11.95) every time they buy and sell shares.

3. Platform fees - this is very different! Not only do HL take commissions every time a person trades. HL charges an annual fee of 0.45% just for having your money invested on their platform! Let’s say I invest £20k in a J.P Morgan fund, Hargreaves would pocket £90 (0.45%) for themselves at the end of the year!

And as we can see below, platform fees have been super lucrative for HL - being the highest income generator for the company over the last 5 years!

Now, I just want to make a quick comment here on net interest income which we’ll come back to later. You know the idle cash that’s uninvested across Hargreaves’ accounts - where is it actually kept? Well, Hargreaves does what most brokers do - they take this uninvested cash and put it in external banks – like Barclays, Lloyd’s, etc.

However, Charles Schwab takes this money and puts it in their own bank – Charles Schwab Bank. Now, this may not seem a big deal. But as we’ll see in a moment – this is actually a pretty huge deal!

Commission-Free Stocks… AND Options!

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Alrighty, let’s get back to it!

Investment Bankers And Equity Analysts Are Expensive!

Okay, so we’ve looked at Hargreaves’ revenues. Now, let’s look at margins. We saw yesterday that Hargreaves had a crazy-high EBT margin of 55% in 2022. But has it always been like this? Well, the chart below gives us the answer.

It is a resounding yes! Not only has Hargreaves pretty much always had an EBT margin above 50%… in 2017, the company had a scarcely believable margin of 69%!

But here’s a question - what is it that allows Hargreaves to have such higher margins. Margins that are much higher than even Charles Schwab? Well, one of the main reasons is employees.

On Wednesday, we saw that whilst Goldman spent 32% of their revenue on employees’ salaries and bonuses in 2022. And Barclays spent 37%. Schwab spent only 29%. And this helped their margin. But as the chart below shows, at Hargreaves it’s an even more incredible number! In 2022, the company spent only 24% of their revenues on employee salaries and bonuses!

But what’s behind this 24% number? Well, it’s not because they’re hiring less people. Given their size, Hargreaves has a similar revenue/employee ratio as the other financial firms we’ve covered. But the key difference is how much they can afford to pay their employees! In 2022, the average compensation per employee at Hargreaves was ~£80k. This is miles less than what we saw at the other financial firms! At Ninety One it was ~£231k, Goldman ~$312k, Barclays ~£106k and Charles Schwab ~$168k.

And this is key. When your biggest cost is employees. But you can afford to pay your employees far less than investment banks and asset managers, you’re going to have insanely higher margins! By the way, in 2017 when Hargreaves had that monster 69% margin, their employee costs were only 18% of revenues - incredible!

Remember Peter Schwab… With Great Power Comes Great Responsibility

Alrighty, here we go. This is the moment we’ve been all waiting for. Time to answer the question we left unanswered yesterday – what is going on with the dividend payouts at both these wonderful companies? We saw that Hargreaves paid out ~86% of their profits as dividends. But Schwab only paid out a measly 26%!

Well, to really understand this, we need to go back to something we mentioned earlier. Charles Schwab and Hargreaves both take idle cash in the customers’ accounts and invest that cash to make interest income. But there’s a key difference in how these companies do this.

When Hargreaves take their customers’ cash, they put that cash in external banks – like Barclays, Lloyd’s, HSBC, etc. These banks are the ones who actually invest that cash and make the interest income. They then pass SOME of that interest income onto Hargreaves. Not all of it! So whilst Hargreaves do make interest income, they have to give their banks a cut because the banks are the ones who are taking on the risk. Hargreaves aren’t really responsible for that cash!

And by the way, this is how pretty much all brokers make interest income on idle cash. They use external banks to make the interest for them. BUT, that is not how Charles Schwab do things! When Schwab take their customers’ cash, they put that cash in their OWN bank – Charles Schwab Bank. And this means that Schwab have complete control. They have much more freedom in how they invest this cash! The main benefit to this is that Schwab can invest in slightly higher earning assets and make a higher net interest margin. As the chart below shows, Schwab’s net interest margin has consistently been above Hargreaves’ over the last decade!

Okay, that makes sense, but what has all of this got to do with dividends? Well, whilst Schwab has more control over this idle cash by having it in their own bank. It means they also have more responsibility. What do I mean?

Well, I don’t want to get too technical and complicate things here. But basically, regulations for banks are super strict. And because Charles Schwab acts as a bank with this idle cash, it needs to have protection (Tier 1 capital) against these customer deposits. For those interested, you can get a rundown of what Tier 1 capital is here. But to keep it simple-ish, one of the components of Tier 1 capital is ‘retained earnings’ – which measures how much of a company’s profits are kept on the balance sheet. And Schwab - like any bank - is required to increase their retained earnings (and hence not distribute all their profits) when they take on more customers deposits (idle cash).

And so, what this means is that in return for having more control of their customers’ idle cash, Schwab needs to take more of their net income and just not do anything with it! Let is pile up on the balance sheet. And what does that mean? It means less profits can be distributed as dividends!

Whereas for Hargreaves, they’re not a bank. They don’t need to have lots of capital on their balance sheet because they’re not responsible for their clients’ cash in the same way. Their idle cash is off their balance sheet, at the external banks. And so that’s why they can pay the high dividends they do, whilst Schwab can’t! Mystery solved!

Acquisition + Regulatory Scrutiny = Share Price Struggles!

Okay, so we finally got there! I hope that all makes a certain amount of sense. Don’t worry if it’s not 100% clear – it’s quite a complicated topic. But it’s good we went through all of that because now we can properly look at what’s been happening to the stock prices of these two companies!

Below we can see the stock price charts of both Hargreaves and Schwab. And it makes for some pretty interesting reading. Hargreaves is down 71% from its peak. Schwab was down ~50% a few months ago from its peak . So, what’s going on? I’ll be brief here because this newsletter’s getting on the longer side!

Well, let’s start with Schwab. And the reason for their stock drop was kind of to do with what we just talked about. In 2018, Schwab’s CEO said that Schwab had built enough (Tier 1) capital on their balance sheet and that they didn’t need to keep stockpiling cash. And what does less cash stockpiling mean… more dividends! Finally! But then, something happened…

… Schwab made the massive acquisition of TD Ameritrade - one of their main competitors! And what did this acquisition do? It meant Schwab took on all of TD Ameritrade’s client accounts. More client accounts = more idle cash uninvested. More cash uninvested = more cash for Schwab to deposit into their own bank. More clients’ cash in their own bank = higher need for capital. Higher need for capital = less ability to pay out dividends. Less dividends = shareholders upset! Shareholders upset = shares get sold! This FT article gives us a brilliant explanation of all of this!

Okay, let’s quickly look at Hargreaves. What’s been dampening their stock price? Well, it’s kind of two things. One, competition has got more intense. Brokers like Freetrade, (and maybe Investa soon!) have been taking more market share because of their commission-free offers. And so Hargreaves’ client account growth has slowed.

But the second thing that’s hurt their stock more recently is regulatory risk. The FCA is basically targeting net interest income. They don’t enjoy the fact that brokers like Hargreaves, Interactive Investors, AJ Bell, etc. make all that net interest margin that they do. And they want Hargreaves and co. to pass on all the interest they make on their customers’ idle cash to their customers! We don’t have time to get into all the details now, but this article gives us a nice, simple explanation of the risks!

24th Nov 2023

Nigel Jacob CFA