Record Earnings Year Expected for Schwab
We think the wide-moat firm has buffers to its earnings in the event of a market correction.
Wide-moat-rated Charles Schwab (SCHW) reported record net income for the first quarter, and its earnings should prove resilient even in a market correction. Operating income grew 19% from the previous year to $1.4 billion, and diluted earnings per share grew 41% to $0.55. The high EPS growth can be attributed to two factors: operating leverage and tax reform. Of the $317 million increase in net revenue, $174 million, on an adjusted basis excluding margin loan losses, fell to the operating income line. This translates to a 55% incremental margin. Additionally, Schwab's effective tax rate was 22% during the quarter compared with 33% a year ago, which alone increased net income by about 17%. Given our belief that U.S. interest rates will continue to gradually rise and that corporate tax reform is settled for the foreseeable future, we expect Schwab to have a record year of earnings in 2018. We are maintaining our $57 fair value estimate.
Schwab’s earnings have two buffers in the event of a market correction. The first is the company’s net new asset growth rate. Excluding the effect of outflows from a mutual fund clearing client in the first quarter, Schwab had annualized net new asset growth of 7.8%. In the past three years, average net new assets increased over 5% on average. In our view, net new asset growth should serve to balance out much of a decrease in assets and revenue during a normal market correction. The second buffer the company has right now is growth in net interest income. Even if interest rates remain at current levels, we forecast that Schwab is likely to increase its balance sheet upward of $30 billion through the end of the year. Assuming a 2% net interest spread, this would be roughly equivalent to the revenue yield on an additional $200 billion of client assets. Combining these two buffers, Schwab could see an 11% decrease in client assets and still keep earnings relatively flat, in our view.
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Michael Wong does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.