Business Diversification Benefits Muted for Schwab
For this wide-moat firm, we don't anticipate making a material change to our fair value estimate and currently assess shares as modestly undervalued.
While we continue to believe that wide-moat Charles Schwab has one of the strongest business models in the investment services industry, some of the company’s business diversification benefits are muted. For the first quarter of 2020, the company reported net income to common shareholders of $757 million, or $0.58 per diluted share, on $2.6 billion of net revenue. Net revenue declined 4% from the previous year and was flat sequentially, while earnings before taxes declined 17% from the previous year and 6% sequentially. Compared with the fourth quarter of 2019, a 54% increase in trading revenue to $188 million offset modest declines in other revenue lines. We don’t anticipate making a material change to our $43 fair value estimate for Charles Schwab and currently assess shares as modestly undervalued.
Headwinds in the current environment and recent industry developments will more than offset certain revenue lines that usually would have buffered the earnings decline. While daily average trades at Schwab nearly doubled sequentially to 1.5 million that led to trading revenue increasing 54%, trading revenue still only constituted 7% of total revenue. High trading activity from a tough market environment would have actually led to revenue growth in the first quarter if not for the recent cut in trade pricing across the industry.
Higher client cash balances in market downturns are also supposed to hedge earnings for investment service firms, but that’s been counteracted by the low interest rate environment. Client cash sequentially increased about $70 billion and increased as a percentage of total assets to 15.1% from 11.3% the previous quarter, as clients took more defensive positions. The increase in client cash would normally be a great boon to Schwab, as the company earns more net interest income on client cash than fee revenue on non-cash client assets. However, low interest rates mean the company is earning little on the additional client cash.
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