Schwab Expects Costs to Rise

Last week, Charles Schwab Corp. (SCHW - Analyst Report) announced its expectation for capital spending on client-related initiatives to increase approximately 40% in 2011 over 2010.

The company increased its earlier projection of 35% increment mentioned in 2010 annual report filed at the end of February 2011 to 40%, driven by anticipated increase in spending on software, equipment related to computer systems and leasehold improvements.

Specifically, Schwab’s spending plan includes significant improvement in service areas like fixed-income, global investing, mobile and tablet solutions, and advisor-focused technology, coupled with advancement of index-and-ETF-based 401(k) and Independent Branch Services initiatives.

In 2010, Schwab's capital expenditures were $127 million, or 3% of net revenue. Based on current assumptions, spending is expected to climb by more than $50 million to $178 million in 2011.

According to Schwab, if low-interest rate environment persists, constrained growth in net interest revenue with the erosion of asset management fees will be recorded in the forthcoming quarters.

The company’s initiatives to enhance growth through investments in the coming years will help it sustaining the better revenue over the long term with a strong client network.

As a part of growth initiative, in March 2011, Schwab had announced an all-stock deal to acquire optionsXpress Holdings Inc. (OXPS) for $1.0 billion. Under the agreement, the company will offer 1.02 shares for each share of optionsXpress.

The deal is valued at $17.91 per share or 17% premium to the closing price of optionsXpress’ stock as of March 18. The company anticipates the deal to be modestly accretive and expect synergies worth $80 million in the first full year of combined operations.

Earnings Recap

Schwab’s first-quarter 2011 earnings came in at 20 cents per share, a penny ahead of the Zacks Consensus Estimate of 19 cents. This also compares favorably with the year-ago quarter’s earnings of 11 cents. The results benefited from improved revenue and increase in interest-earning assets. Additionally, fall in non-interest expenses was also a positive for the company.

Our Take

While focus on lower-cost capital structure will sustain better results in the upcoming quarters, Schwab’s financials will continue to be impacted by lower trading activity and volatile interest rates. However, after the completion of the optionsXpress, the company’s top line will benefit from increased trading in derivatives and capital spending initiatives will augment further revenue growth.

CharlesSchwab currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Moreover, considering the fundamentals, we maintain our long-term Neutral recommendation on the stock.