Schwab’s zero-fee trading kicked off a price war and could pay off with the deal of a lifetime

Market Insider

A pedestrian walks past a Charles Schwab office in New York, U.S., on April 12, 2013.

Scott Eells | Bloomberg | Getty Images

Charles Schwab’s decision to give investors zero commission online trades turned his industry upside down but looks like it could work out well for the firm that bears his name.

The move was a shrewd manuever. Schwab’s action pressured his rivals to quickly match no fee commissions, their stocks fell, and now a source tells CNBC that Charles Schwab is close to announcing a deal to buy key rival TD Ameritrade. The combined firm would have $5 trillion in assets, and the Financial Times says the deal could value Ameritrade at $25 billion.

“The pricing cut to zero is absolutely the catalyst here for consolidation. If you’re Schwab, and you’re thinking about consolidation, you wouldn’t pay for revenues that you knew were going to decline, if you were going to lead that decline,” said Devin Ryan, financial analyst at JMP Securities.

Ryan said the combined Schwab and Ameritrade would have strong synergies. They both have a similar client base, but Schwab clients also are larger, but trade less frequently and are more “advice-centric.” Ameritrade has a strong active trader business and a superior options business. The combined firm would also have about a third of the assets in the growing custodial business for registered investment advisers.

“For RIA financial advisers that are fee based, fiduciary advisers, Schwab and Ameritrade provide the custodial platfroms for those advisers. They hold the assets. They custody the accounts… It’s where the puck is going,” said Ryan. He said Schwab is number one in the business with about 25% of the assets, followed by Fidelity, Ameritrade and Pershing.

Free trading fallout

Schwab founded low cost broker Charles Schwab in 1971, and as the father of low cost brokers, he said he led the charge to end commissions as a final solution for removing costs for investors. When his firm first announced on Oct. 1 that commissions would go from $4.95 for online trading of stocks and ETFs to zero, the company said it was taking the action in conjunction with the release of Schwab’s book, Invested.

The low cost brokerage industry, which was basically founded by Schwab, morphed as electronic trading came into vogue and it continued to eat away at the high cost structures of the bigger more traditional Wall Street rivals. It also faced new competition as more players came into the field including upstart Robinhood, which has its own no fee trading.

The stocks of Schwab and its rivals were hit hard after Schwab and the others chopped commissions. In the days that followed, Schwab stock was down as much as 17.3% but recovered by Nov. 4 and has since risen by 38%. Its rivals Ameritrade and E-Trade were hit harder.

Ameritrade fell as much as 30% to $32.69 and only recovered those losses Thursday, as news of the takeover surfaced. Ameritrade was up 19% at $48.86. ETrade fell about 20% and its stock, which has been surrounded by takeover speculation, recovered its losses by Nov. 15. On Thursday, it lost 8.4% on disappointment that it was not the company being acquired.

“There was a lot of smoke over the industry even before the Schwab thing. You could tell in the summer these companies were acting very weird,” said Don Bilson, head of events driven research at Gordon Haskett. “Interest rates were falling and these are interest rate sensitive companies.”

‘Wounded ducks’

Bilson said it was unusual that just after Ameritrade CEO Tim Hockey said in July that he would be leaving, E-Trade replaced its CEO. Then not long after, Schwab unveiled its no fee structure.

Schwab took aim at the industry and is about to carry off one of the “wounded ducks,” he said.

“You basically pulled the rug out from under your competitors and then swooped in to pick up your healthiest competitor. It’s bigger than ETrade. They were looking for a CEO so this solves the issue. There was a succession issue at Ameritrade,” Bilson said. Schwab CEO Walter Bettinger has been designated to run the combined company, sources said.

Last week, Schwab reported it had a big surge in new client accounts in the month it dropped commissions. Online trades had no fees starting Oct. 7 and in the month of October, Schwab added 142,000 new brokerage accounts, a gain of 31% from September and 7% more than last October. The new accounts brought Schwab’s client assets to a record $3.85 trillion.

“The frictional costs of finance are declining. That’s not likely to change in our lifetimes, and Schwab has been a key driver of that change in Wealth since launching as a low cost broker in the 1970s,” wrote Mike Mayo, senior analyst at Wells Fargo.

Mayo said the new firm would be far more efficient than big Wall Street rivals like Morgan Stanley and Bank of America, which have margins in their wealth businesses of about 30%. Pretax margins for the combined company would be about 45 to 50% before merger savings, and it would also have a greater budget to spend on technology and innovation.

Analysts said the merger of the two makes perfect sense for a number of reasons. “You’re essentially combining two of the leading platforms, and there should be synergies on the expense side and the revenue side as well,” said Ryan.

“Consolidation makes sense…There’s a lot of expense savings. Ameritrade has a great platform so you’re probably not going to cut too much of their platform but there’s still going to be an opportunity in marketing and possible employee head count as well,” said Ryan.

Ryan said Schwab could lead the combined firm in pricing, on such things as options trades, margin expenses and even customer cash. Options trades currently cost $0.65.

“In Schwab fashion, to the extent they create significant synergy with the transaction, it would be logical that they could look to reinvest some of that back into the business and pricing is a way to invest,” said Ryan.

CNBC’s Chris Hayes and Michael Bloom contributed to this story

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