CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings of Scottrade Financial Services, Inc. (Scottrade) at 'BBB-' and revised the Rating Outlook to Positive from Stable.
KEY RATING DRIVERS - IDR and Senior Debt:
The affirmation of Scottrade's ratings reflects its established position in the retail brokerage space, improved operating performance as well as cash flow leverage, which remains adequate for its rating category.
Fitch-calculated adjusted debt to EBITDA at 1.6x at 3Q'14.
The revision of Scottrade's Rating Outlook to Positive reflects two key factors that Fitch believes have the potential to enhance the credit profile of the company over the next 12-24 months.
First, Scottrade recently entered into a bank sweep program with a highly rated third party bank to absorb much of Scottrade's growing and excess deposit base. Fitch believes this program will help moderate growth in Scottrade Bank, as a growing proportion of overall deposits can now be, in effect, transferred to a third party bank. Previously, Fitch had been concerned about the growth of Scottrade Bank impacting overall performance metrics and potentially requiring the company to issue additional debt to support growth.
Secondly, Scottrade has recently improved its liquidity position at the holding company. Cash and liquid securities amounted to over $100mn at 3Q'14, and could increase further. Fitch views this additional liquidity positively from a credit perspective as it provides more financial flexibility at the parent. Additionally, Fitch would note that this additional liquidity offsets some of Scottrade's outstanding debt, thereby reducing its net debt position, which is a positive for creditors.
Scottrade's business model is reliant on fee revenues from retail trading activity and net interest income from investing retained deposits in low-risk securities. Scottrade, like much of the retail brokerage industry, is seeking to diversify its revenue base. Scottrade is also trying to move away from its focus on transactional trading revenues, which are volatile and instead transition to an investment management, sales and customer relationship model like other retail brokers have done.
To that end, Scottrade recently formed Scottrade Investment Management, Inc. (SIM). SIM is a subsidiary of Scottrade Financial Services which will seek to provide guidance and investment management for customer accounts. Fitch expects that SIM will not be a meaningful contributor of revenue until distribution channels for Scottrade are improved. Currently SIM is run out of Scottrade's headquarters in St. Louis. Fitch believes that Scottrade's branch network will be an important distribution channel for SIM in the future.
Earnings improved in 2014, primarily from an increase in net interest income and stabilized trading revenues. Through Sept. 30, 2014 net interest income accounted for 52% of revenues compared to 34% for trading revenues. Fitch believes earnings can improve further once short-term interest rates rise. Although improving revenues are a credit positive for Scottrade, Fitch views the growth of stable fee revenues from managed accounts as a more important rating factor over the long term since it would help reduce the inherent volatility in earnings generated from trading.
RATING SENSITIVITIES - IDRs and Senior Debt:
Fitch believes there is the potential for modest positive rating momentum as signified by the Outlook revision to Negative. The rating could be upgraded if Scottrade is able to demonstrate moderated bank growth and improved holding company liquidity over the next 12-24 months, while maintaining current operating performance and strong cash flow leverage metrics. Until and unless Scottrade is able to achieve meaningful traction on its investment management initiative which leads to a more diversified and stable earnings profile, ratings are likely limited to the 'BBB' rating category.
The Rating Outlook could be revised back to Stable if bank growth does not abate or if holding company levels do not increase as expected.
Fitch believes the most significant downside rating risk is a large operational loss specific to Scottrade that causes clients to flee the firm. Operational losses are inherently difficult to predict and measure and do serve as an upwards rating limitation. Fitch would review the impact of any large operational loss on the firm's clients and franchise to determine if a negative rating action is appropriate.
Other potential negative rating drivers would include an increase in double leverage, defined as equity investments in subsidiaries divided by parent company equity capital beyond 120% (calculated to be 116% at 3Q'14), or if the company began to reach for yield in its investment portfolio such that it materially increased the credit or interest rate risk profile of the balance sheet.
Fitch has affirmed the following ratings:
Scottrade Financial Services
--Long-term IDR at 'BBB-';
--Senior unsecured notes at 'BBB-'.
The Rating Outlook has been revised to Positive from Stable.
Additional information is available at www.fitchratings.com.
In addition to the source(s) of information identified in Fitch's Master Criteria, these actions were additionally informed by information provided by the companies.
Applicable Criteria and Related Research
--'Global Financial Institutions Rating Criteria' (Jan. 31, 2014);
--'Securities Firms Criteria' (Jan. 31, 2014);
--'Rating FI Subsidiaries and Holding Companies' (Aug. 10, 2012);
--'The Evolving Dynamics of Support for Banks' (Sept. 11, 2013);
--'Bank Support: Likely Rating Paths' (Sept. 11, 2013);
--'Sovereign Support for Banks: Update On Position Outlined In 3Q13' (Dec. 10, 2013);
--'U.S. Bank HoldCos & OpCos: Evolving Risk Profiles' (March 2014).