We have downgraded our long-term recommendation on The Charles Schwab Corporation (SCHW) to Neutral from Outperform. The recommendation change is based on flagging equity markets, declining interest rate yields and legal predicaments.

We anticipate organic growth to be driven primarily by recent acquisitions. A low-cost capital structure will benefit results in the subsequent quarters. However, lower trading activities and relatively low capital intensity as compared to its peers may act as headwinds.

Schwab’s first-quarter 2012 results came in line with the Zacks Consensus Estimate. The improvement in quarterly results was attributable to increased trading revenue and absence of loan loss provisions. However, elevated operating expenses, declining net interest income along with higher asset management and administration fees offset the positives.

Charles Schwab has been expanding mainly through acquisitions. Last year, the company acquired Compliance11 Inc. and optionsXpress Holdings Inc. Through these acquisitions, Schwab is trying to expand the reach of its futures and options market, thereby providing stimulus to the equity-concentrated businesses by intensifying the profitable derivatives trading and fuelling the growth of its registered investment advisor (RIA) business.

Schwab’s efforts towards minimizing its dependence on interest rates are highly credible. It has introduced certain initiatives like the Schwab Index Advantage and Independent Branch Services, which will promote client cross-selling relationship amongst corporate and retail services. Further, independent branch services will allow individual operators to manage company’s franchise in markets where it does not have a physical presence.

Schwab’s reasonable capital position allows it to maintain a healthy dividend policy. The dividend payout ratio has been almost 20-30%, and since the late 1990’s the compounded growth rate for quarterly dividend payment is stable at 24%. This is highly valuable for maintaining investors’ confidence in the stock.

On the flip side, persistent low interest rate environment has been adversely affecting revenue growth due to Schwab’s sensitivity to interest rates. The company has been allowing significant fee waivers to its clients, which has taken a toll on its revenue. Gloomy economic conditions and less possibility of improvement in the near future, both net interest margin as well as revenue growth will be restricted.

Schwab will have to bear the legal charges of optionXpress for its involvement in a fraudulent short-selling scheme before it was acquired. Consequently, the lawsuit might dent its goodwill, profitability as well as client relationships.

The company’s dependence on fee-based revenue also thwarts its growth prospects. However, acquisitions are anticipated to contribute to trading revenues, but the proportion of trading revenues is comparatively too low to boost the overall organic expansion.

Charles Schwab currently retains a Zacks #4 Rank, which translates into a short-term Sell rating. One of its peers KBW Inc. (KBW) retains a Zacks #1 Rank, which translates into a short term Strong Buy rating.

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