Morgan Stanley analyst Scott Patrick sent a note to clients arguing that the merger speculation around Schwab (ticker: SCH) has over-extended its stock price. Excerpts:
SCH chart below.
Charles Schwab: Merger Speculation Creates Near-Term Valuation Risk
Quick Comment: Having risen 10.8% over the past two trading sessions on merger speculation, shares of Schwab have become a bit overheated, in our view. Schwab shares advanced 4.7% on Wednesday and reached a 52-week high of $13.80 on Thursday (up 15.2% from the prior day's close), driven primarily by widely published rumors that HSBC Holdings (902 GBp, UW) would acquire Schwab. Though these rumors were squashed by a Schwab statement during the trading day on Thursday that it is not interested in a sale of the company, the stock found renewed strength from further speculation that Schwab would emerge as a buyer, maintaining a two-day gain of 10.8%. Indeed, according to a report by CNBC today, Schwab has held talks with several online brokers, including E*Trade.
As such, Schwab shares now trade at 23.9x 2005E EPS, compared with a P/E of 23.4x for Ameritrade shares.
And Schwab has indicated that it is not interested in buying another online-trading firm. Indeed, from a strategic standpoint, Schwab has been increasingly diversifying its business away from trading toward asset-based revenue streams. In 1Q05, for example, trading revenues represented just 19.5% of Schwab's total revenues, down from 32.6% a year earlier and 59.8% in 1Q00. Moreover, we believe that management remains intently focused on its ongoing efforts to rationalize the company's cost structure and reconnect with its retail clients. As such, though we cannot be sure, we view the probability of Schwab participating in online brokerage industry consolidation in the near term as somewhat limited.
That said, from a longer-term perspective, Schwab may still need to consider its options in a consolidating industry. First, combining two online brokerage platforms can yield significant scale economies and synergies, driving greater profitability and the ability to subsidize higher cost operations, like an advice platform. Second, the recent announcement of an agreement for Ameritrade to acquire TD Waterhouse USA creates a more formidable competitor in the online brokerage industry, which we think raises the imperative to build scale.
Full disclosure: at the time of publishing this excerpt, the editor of The Internet Stock Blog (David Jackson) is short SCH.
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