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We are upgrading our recommendation on Charles Schwab Corp. (SCHW - Analyst Report) to Neutral from Underperform based on better results compared to the prior-year quarter and an improvement in client assets.

Charles Schwab’s second quarter 2011 earnings came in at 20 cents per share, in line with the Zacks Consensus Estimate. However, this compared favorably with the year-ago earnings of 17 cents.

Results were aided by improved net interest revenue and lower impairment losses on securities. Improved pre-tax profit margin was also an upside during the quarter. However, weak trading revenue and higher non-interest expenses were the downsides.

Fundamentals remain solid at Charles Schwab, with steady improvement over the last few years. Diversified revenue streams remain the major strength at Charles Schwab. Earnings continue to benefit from management’s aggressive efforts to increase clients in advisory solutions. Client assets enrolled in Schwab’s retail advisory offerings increased 20% year over year to $113 billion at June end.

Despite slower-than-expected economic growth, the company’s cash holdings declined to pre-crisis levels, implying strong involvement of clients. Also, improvement in profitability metrics has been hindered by numerous fee cuts, but we continue to see these moves as important in the long run from a competitive point of view.

In March 2011, Charles Schwab announced the acquisition of optionsXpress Holdings Inc. in an all-stock deal valued at $1 billion. The agreement is expected to close in the third quarter of 2011. The company expects revenue synergies of nearly $60 million and cost synergies of about $20 million in the first full year of combined operation.

As a result of low interest rates and declining trading volumes, the company has been struggling to retain its growth momentum for the past two years. So, the deal will enhance its equities-focused business by expanding into lucrative derivatives trading and fuel the growth of its registered investment advisor (RIA) business.

On the flip side, Charles Schwab is highly sensitive to interest rates. Low rates have been a drag on the company's revenue since the Federal Reserve shrunk its benchmark interest rate to a record low of near zero in December 2008.

Near-zero U.S. interest rates have forced the company to waive fees it charges clients for managing funds. Until the economic recovery gains momentum and interest rates increase significantly (which we do not expect any time soon) the company will continue to feel some pressure on its net interest margin and a decline in its revenues.

Management expects $240–$300 million in incremental spending in 2011 based on the full-year’s impact of its Windward acquisition, additional project spending including independent branches and new 401(k) offerings, and other volume-related costs. Accordingly, client base growth and increased spending on projects and marketing investments will lead to higher operating expenses in the upcoming quarters.

Currently, Charles Schwab retains a Zacks #4 Rank, which translates into a short-term Sell’ rating. However, the company’s competitor, Raymond James Financial Inc. (RJF - Analyst Report) retains a Zacks #3 Rank (a short-term ‘Hold’ rating).

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