Scale Gives Schwab a Wide Moat

We project that over the next five years, operating income will more than double from the effect of higher interest rates, growth of the company’s bank, recent strong growth in client assets, and the effect of a lower corporate tax rate. Net interest income is highly profitable, with management aiming for a majority of interest-rate-related revenue to fall to the bottom line. This mix shift to more net interest income will expand operating margins.

There are three legs to the net interest income story. The first is the effect of higher short-term rates on the company’s floating-rate portfolio, which Schwab targets at 40%.

The second is the repricing of the other portion of the company's fixed-rate bank portfolio, which has a duration of around four years. Only a fraction of this portfolio reprices annually, so a steeper yield curve has always been an earnings driver that would play out slowly over years.

The third leg is management's intention to continue shifting client cash balances from money market funds to its bank. Even with money market fund fee waivers reversed, the company has only around a 50-basis-point revenue yield from its money market funds, while it can potentially earn more than 200 basis points at the bank. To support the bank growth, Schwab will have to retain earnings to bolster its regulatory capital, so we don’t expect a significant increase in dividends or share repurchases in the next two to four years.

Schwab Intelligent Portfolios is an interesting opportunity that is illustrative of the company's wide moat. Charles Schwab is one of the only companies that can make online advisory for the masses profitable, because of its scale-driven operational cost advantage, distribution platform, and proprietary products. Whatever developments occur in the retail brokerage and wealth management industry, Charles Schwab has the resources and capabilities to adapt to them.

Cost Advantage From Massive Scale Our economic moat rating for Charles Schwab is wide. Given its massive scale and industry-leading cost efficiency, we believe the company can sustain severe competitive pressures, such as trading revenue dropping to $0, and still earn above its cost of capital. We also estimate that around 25% of client assets are in either a Charles Schwab proprietary or controlled product, which allows the company to extract more profits on client assets than other brokerages where their clients use primarily third-party products.

Retail brokerage moats are primarily built on cost advantages. Their scalable infrastructure allows them to process additional trades at low costs, which produces high incremental operating margins. Many retail brokerages also have banking subsidiaries that rank well compared with traditional banks in terms of having low funding costs, credit costs, and operating expenses. Their strong banking subsidiary profitability--recent operating margins have been in excess of 60%--comes from not having to support a physical branch presence, brokerage clients that are less sensitive to interest rates than traditional banking customers, and catering to generally higher-net-worth clientele with collateralized lending products.

We think the company’s massive scale gives it a cost advantage that few can match. Currently, Schwab supports over $2.5 trillion of client assets, making it one of the largest U.S.-based companies focused on securities trading and wealth management. Its cost advantage can easily be seen with its industry-leading sub-20 basis points of expenses per dollar of client assets.

Charles Schwab’s low costs and large client base also give it the flexibility to create products offering a value proposition that is comparable or superior to that of peers and that can ramp quickly. While a relative latecomer to creating its own exchange-traded product line, it is now among the top 10 largest exchange-traded fund companies. The company’s new online advisory platform will also benefit from its low cost and client reach, which will enable Schwab to be more profitable than existing players and leapfrog them in assets.

Charles Schwab Bank is one of the largest banks in the U.S., with more than $100 billion in deposits. It has low operating costs because of its synergy with the company’s brokerage business. Credit costs are also low, as much of the bank’s portfolio is in low-risk agency mortgage-backed securities and loans are primarily made to the company’s relatively affluent clients.

The company has a strong intangible asset in its brand and arguably possesses some network effect between its large client base and investment product manufacturers, but we view the cost advantage from its scale as being the primary source of its moat. We estimate that a double-digit percentage of Charles Schwab’s client assets are in a Schwab-branded proprietary product or advice solution. Proprietary products are more profitable than third-party products, but revenue from these sources isn't as material as other revenue lines, such as net interest income. Because Schwab’s commission-free trading product platform is valuable to both clients and product manufacturers, the company is able to extract value from operating it. Additionally, its large independent wealth management client base gives Schwab a singular ability to offer benchmarking and process improvement benefits to affiliated companies.

Interest Rates Will Dictate Growth Major risks to Schwab include the future of interest rates and fee pressures. Interest rates are the key driver of the company's earnings over the next several years, so a long period, three years or more, of low interest rates would materially affect the company's revenue growth and ability to expand operating margins. With negative interest rates in some countries, projected slower global growth, an arguable savings glut in some countries, and currently low inflation, a case can be made for low interest rates for longer. While we currently believe that nominal, long-term interest rates will eventually track back to about 4.5%, structural changes in the economies of developed countries may have permanently reset long-term interest rates lower along with the profitability of Schwab's banking business.

Pricing competition in the retail brokerage is a headline risk. Cuts in trading prices in 2017 among the retail brokerages caused their stocks to fall mid-single-digit percentage points. We think that any further decrease in trading prices will also be met with only mid-single-digit percentage declines, as we forecast trading revenue will be less than 10% of net revenue this year and decrease to less than 5% over the next five years. Asset-management revenue could also come under pressure, but it's likely to be more from an asset mix shift to passive investment products from the company's proprietary and Mutual Fund OneSource products, which have higher revenue yields.

We have no significant concerns about Schwab's financial health. We are comfortable with Schwab's ability to shoulder its debt load, cover its interest obligation, and make its common and preferred dividend payments. Management's stated target is for a long-term debt/financial capital ratio of no more than 30%.

We Like Schwab's Strategic Retention of Capital Schwab recently increased its quarterly dividend to $0.08 per share from $0.07. While the company targets a dividend payout ratio of 20%-30%, we don't foresee significant repurchases, and we expect the payout ratio will stay closer to 20% for the next several years, as we believe management will retain earnings to capitalize its growing bank. As the bank grows, we believe the company will periodically issue preferred stock to supplement its regulatory bank capital ratios.

Schwab is increasingly an industry trendsetter. Over the past several years, the company has been an early mover into asset-based fee products, expanding its bank, exchange-traded funds, digital advice, and physical franchise presence. We see the slow growth of the company's dividend as prudent, because the strategic retention of capital should translate into accelerated economic return growth at the company’s bank. Generally, we think management has successfully transformed Schwab into a modern investment services firm from a discount brokerage during a period of substantial industry structure changes.