WIRED CASE STUDIES IN RADICAL UPGRADE ATTEMPTS
Charles Schwab & Company
In a conference room at the St. Francis Yacht Club, overlooking San Francisco's breezy waterfront, 10 members of a high-level Charles Schwab & Co. task force debated a plan that everyone agreed would deflate revenues and spark a cultural crisis within the firm. It was July 1997, and Schwab had already established itself as the top Web broker in terms of customers and assets. Yet the company's management regarded complacency as the eighth deadly sin, and Schwab's move online had itself provoked a new challenge.
Since 1995, the San Francisco-based discount brokerage had been allowing its customers to execute trades electronically via e.schwab. A year later, the company drew on its software expertise to launch its Web offering fast. After just two weeks of operation, SchwabNow! managed to snare 10,000 accounts - even though customers had to establish them independently from their offline accounts. The problem: Each service had its own restrictions (e.schwab customers, for example, were allowed only one call per month) and fee schedules. On top of the confusion this caused, some e.schwab customers felt like pariahs, while offline customers felt they were being screwed because they were paying more than twice as much - $80, on average - to make a trade.
"We're patting ourselves on the back because of our great success," said David Pottruck, the company's co-CEO, "but customers on both sides feel we're forcing them to make compromises they don't want to make."
Andrew Salefksy, a Schwab strategist, rose to present the task force's scenario for better managing the online and offline business: Fold all of the electronic services together and call them Schwab.com, and make Schwab.com central to the larger organization. Set a flat rate for every trade made over the Web at $29.95, to drive Schwab's existing phone and in-store customers online. Use the company's bricks-and-mortar branches to support online trading.
"I really believe that the winning combination is the seamless blending of the physical and the digital world," Pottruck said later, explaining the basis for what he now refers to as his "clicks and mortar" strategy. Still, at the time he was worried about how the company would make up the lost revenues from commission-based offline trades. The task force predicted that the pricing move could lose the company as much as $125 million, but it also showed that the lost revenues could be recouped via higher transaction volume.
At the conclusion of the task force meeting, founder Charles Schwab assured Pottruck that if the company dropped the price, everyone in the organization would focus on reducing internal costs.
"It's one of those entrepreneurial things you've got to do," said Schwab. "Let's bite the bullet." Pottruck termed it "management by crisis creation."
Even though they'd committed to the change, everyone around the table at the St. Francis Yacht Club knew the losses would "make the Wall Street analysts nervous," said Suzanne Lyons, Schwab's president for retail client services. So they steeled themselves for a negative reaction on the Street. Meanwhile, they prepared for internal dissent. The decision to integrate would likely make the online troops feel as if their customers were being taken away from them, and employees at Schwab's branch offices and customer-service centers might worry they were being put out of a job.
Sure enough, after the new structure became effective, on January 15, 1998, Schwab's share price tumbled. As the average commission dropped from $63 to $57 (driven down by the Web price), revenue and profit growth slowed. Margins dipped by two-tenths of a percent in the first quarter alone. But the number that the task force cared about - the number of new accounts - grew 30 percent in the same quarter. Eventually, the stock stabilized and started to climb again. And transaction volume kept heading north. By December 1998, Schwab had surpassed Merrill Lynch, its biggest rival and the epitome of the old-line, offline Wall Street brokerage, in market capitalization.
Schwab's $592 billion in assets is still dwarfed today, however, by Merrill's $1.5 trillion, and this December the New York-based financial giant will finally offer online trading to all of its 10 million account holders. "We take them very seriously," Pottruck said just after Merrill's formal announcement in June. "They'll be formidable."
How should Schwab react to Merrill's entry?
The Company
When Charles Schwab founded his brokerage in 1974, he hoped to capitalize on investors' frustration with full-service firms like Merrill Lynch, Smith Barney, and PaineWebber. Trading with Schwab cost less, and its brokers were paid in salary and bonuses - there were no commissions to create conflicts of interest.
Taking full advantage of 1975 changes in SEC regulations that eliminated fixed fees for executing trades, Schwab made a series of groundbreaking moves: creating the OneSource mutual fund supermarket, which made no-load mutual funds available to the masses in the early 1980s; opening the industry's first 24/7 order-entry and quote service; developing seminars and publications to teach people about buying stocks and mutual funds; and launching a marketing campaign that stressed consumers' ability to manage their own investments.
Charles Schwab believed - and still believes - that he was helping lead a revolution that gave the individual investor more power. The company's 13,000 employees all seem to be eager conscripts in his army; ask any one about their objective, and he or she will likely voice the mission statement: "to provide the most useful and ethical financial services in the world."
Schwab's corporate headquarters in San Francisco lacks ostentatious decoration; the only sign that you've arrived on the executive floor, where Schwab and Pottruck have their offices, is a roomier-than-usual reception area and two large black-and-white Sol Lewitt images on the wall.
The company has been an enthusiastic user of information technology since the early days. In 1979, Schwab decided to bring data processing in-house, shelling out more than $500,000 to do so. In 1984, the company introduced online trading with software called Equalizer (and, later, the Windows-based StreetSmart), although the percentage of customers interested in electronic trading at the time was still in the single digits. In 1986, the company debuted Schwabline, a device that downloaded market data over a phone line and printed it out on adding-machine paper.
In 1995, when then-president Pottruck read that the number of personal computers sold in the US had eclipsed the number of televisions sold, he figured that computer-based trading was about to go mainstream. Pottruck bought laptops for all of Schwab's vice presidents and taught himself how to type so he could use the company's email system. He gave himself the username Electric.Dave and developed a reputation for sending out inspirational mass emails to employees at odd hours. The race for the Net was on.
Schwab's early and aggressive embrace of technology has helped the company remain a pacesetter. The company boasts 6.2 million active accounts (2.8 million of which are online), 310 branches in 47 states, and profits that grew 54 percent (to $982 million) from Q2 1998 to Q2 1999. Schwab handles fully one-third of all online trades - no one else comes close to that large a share.
The Management
Co-CEOs Charles Schwab and David Pottruck make a complementary pair. Schwab's the serious uncle who encourages his nieces and nephews to do something wise with their birthday checks. Revered by employees, "Chuck" can come off as slightly stiff in speeches and television appearances. Schwab describes himself as the customer's advocate; CIO Dawn Lepore refers to him as the company's "beta tester in chief." He also serves as the company's public face (see "Power Broker," page 146), while Pottruck focuses on operations. Pottruck, a former wrestler and linebacker at the University of Pennsylvania, is physically intimidating but has the personable charm of a country doctor.
Schwab and Pottruck's combined management style is decisive without being arrogant. Both are willing to admit to missteps, like a proposal last year to impose fees on brokerage accounts with balances below a certain level. That change took effect in June 1998, but the company's field representatives soon reported, "This isn't Schwab-like; this does not feel good," according to Evelyn Dilsaver, Pottruck's chief of staff. So the co-CEOs amended the policy, creating a number of ways to avoid the fees.
"We make some very scary decisions, but here, it's not lonely at the top," Pottruck says. "I have a great partner in Chuck Schwab. We can talk about our worst fears - things you don't want to share with other people, because to them you want to be the confident, sure leader who tells them everything will be great. You need some quiet time to think about how things might not be so great."
The Industry
The booming 1990s have seen Americans' savings migrate from bank accounts to mutual funds and on to individual stocks. With the advent of online trading, an unprecedented bull market, and skyrocketing high tech IPOs, being in the brokerage business, Pottruck observes, "is like selling ice cream in the summer."
Schwab is typically categorized as a discount broker, meaning that the company offers low-priced trades and doesn't give as much advice and guidance as a full-service firm. Of the $15 trillion in individual assets in the United States, about $5 trillion is managed by full-service firms like Merrill, Prudential, and PaineWebber. Discount brokerages lay claim to about $1 trillion, but their asset bases are growing roughly five times faster than the full-service firms'. (The remaining trillions are held by banks, insurance companies, direct-marketed mutual funds, and independent investment managers.)
Just as Amazon.com forced Borders and Barnes & Noble online, the advent of Web-only brokers like Datek Online, E*Trade, and Web Street Securities has forced established players to reckon with the Net - particularly with its ability to offer speed, self-service, and low prices.
The battle for mindshare among brokerages new and old has resulted in a fusillade of marketing - so much so that earlier this year, SEC chair Arthur Levitt criticized some of the ads for making it seem that online stock trading is a simple formula for getting rich quick.
In the second quarter alone, E*Trade spent $82.4 million on sales and marketing. That works out to a per-customer acquisition cost of $250; Schwab, in comparison, spent $130 per customer the same quarter.
The Competition
On the Web, Schwab competes with DLJ Direct, Datek, E*Trade, Waterhouse, and Discover - all of which offer cheaper trades. One site, Brown & Company, will execute market orders for as little as $5. But customers at those firms tend to have fewer assets in their accounts than Schwab customers; E*Trade's asset average, for example, is $30,000, compared with $200,000 at Schwab. Also, many of the online-only brokers, like Datek, don't have the benefit of real-world branches to lure new customers; at Schwab, more than 70 percent of all new accounts are opened in person.
Offline, Schwab's competitors are primarily the full-service brokerage firms. Each of those firms employs an army of brokers (14,800 at Merrill Lynch), who earn commissions from every client trade. That creates reluctance to let clients trade independently online; moreover, the firms' high cost of doing business makes it difficult to offer inexpensive trades on the Net.
Until very recently, these firms have maintained an attitude of "Don't try this at home." One memorable note of caution was sounded by Merrill's vice chair, John "Launny" Steffens, who told an audience at PC Expo in September 1998, "The do-it-yourself model of investing, centered on Internet trading, should be regarded as a serious threat to Americans' financial lives." Merrill spokesperson Susan Thomson says this now infamous quote has been taken out of context. "He was talking about daytrading or hyperactive trading," she says. In any case, Steffens now says that "We're reinventing ourselves in ways our competitors and clients never anticipated. We plan to back [our online] initiative with the full global resources of Merrill Lynch."
"I have the greatest respect for Merrill, but I think theirs will be a subdued kind of offering," counters Schwab. "It's not going to be the core of their business. They just won't be Internet-centric."
The Challenge
The powerful full-service brokerage firms have no intention of ceding their clients to Schwab or the Web upstarts. When Merrill finally rolls out online trading December 1, it will match Schwab's $29.95 transaction pricing, pitting the cachet of the Merrill brand against Schwab's first-mover status. Merrill will also offer a new kind of account: Unlimited Advantage. Customers who choose this package can make any number of trades on the Web, over the phone, or with a broker for an annual flat rate of $1,500, or 1 percent of assets. They also will have access to a human broker who can recommend individual stocks - something Schwab's staffers don't do. And Merrill is certain to play up the value of the equity research its army of analysts produce.
The Response
On a Saturday this spring, Pottruck gathered Schwab employees in 10 locations around the world to talk about how the company could stay a step ahead of competitors like Merrill. It quickly became apparent that the real question was how to reposition Schwab in a world where it faces increasing pressure from both sides: the old-line heavies on the one hand, and the pure Internet companies like E*Trade on the other. The strategy communicated at the Schwab gathering (which cost the company $5 million) was to ensure that Schwab embodies "full service" on the Net in the same way that Merrill embodies full service in the offline world. That means increasing the amount of guidance that Schwab employees offer customers (though they still won't recommend individual stocks, which the co-CEOs say goes against Schwab's DIY ethic) and providing more high-quality research on the Schwab site.
"We've never been an inflexible company," says Pottruck, arguing that clients of this new kind of full-service brokerage want some hand-holding but don't necessarily want to relinquish control. Customers who need more intensive investment advice will be referred by Schwab to an approved money manager.
Significantly, Schwab is also seeking to attract wealthier customers. "Schwab's moving upstream a bit," says Dan Burke, an analyst at Massachusetts-based Gomez Advisors. "They don't want to be known as a cheap, discount broker anymore. Recently, they increased their base account minimum from $2,500 to $5,000." The company also developed a premium level of customer service for clients who carry at least $100,000 in assets and make at least 12 trades a year. Schwab's advertising, in print and on television, stresses the control that users have, rather than the price of a trade.
"They're trying to move out of the do-it-yourself neighborhood, which is our neighborhood," says Ed Nicoll, president and CEO of Datek Online, "and into the validators neighborhood. Those are people who want to listen to their broker's advice but also have their own ideas. It's the huge amount of money in the middle - money that today is at Merrill, PaineWebber, Goldman, and Dean Witter. The validators are the biggest segment; do-it-yourself, where Schwab is now, is the next biggest; and the smallest is delegators - people who want to abdicate all decisions."
Schwab is also exploring ways to let its clients trade using PDAs with wireless connectivity, and developing software that will compare returns against various objective measures. "It'd be nice to see how your portfolio did against relative indices, or other people like you," says Dan Leemon, Schwab's executive VP of business strategy. "That's the fundamental thing the investor wants to know, but old-line brokerages don't want you to know it, because their proprietary stock picks don't do any better than what most informed investors would pick themselves."
In late July, Schwab announced a partnership with Fidelity Investments and Donaldson Lufkin & Jenrette (parent of DLJ Direct) to join marketmaker Spear Leeds & Kellogg in an electronic communications network, or ECN - essentially, a subset of the Nasdaq stock market that will let users trade stocks around the clock. And despite the cost advantages of buying servers rather than real estate, Schwab continues to bolster its storefront presence. Charles Schwab expects to open up another 40 or 50 offices during 1999. "There's always some point in the relationship," he says, "where you need to talk with other human beings."
Additionally, Schwab is exploring several new pricing options, including a version of Merrill's unlimited trading account and a cheap, no-frills trading plan for hyperactive traders. In August, Schwab released new PC-based trading software called Velocity that lets customers get quotes and enter orders more quickly, without waiting for long Web downloads.
"Even before we knew about Merrill's plans," Leemon says, "we saw that all the customers and all the assets are with the full-service brokers, and we said, 'That's where we've got to go.' The whole strategy of help and advice, of segmented offerings for customers with more complex needs, of continuing to build our branch network - it's a concentrated strategy to blur those lines between us and Merrill. This is about reinventing full-service brokerage."
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