Schwab-TD Ameritrade Merger Can Create Value in Face of Low Rates

The primary topic for investors looking at Charles Schwab SCHW is the pending merger with TD Ameritrade AMTD. The two companies announced the deal in November 2019 and hope to complete it in the second half of 2020. We believe the merger is more likely than not to occur and currently incorporate a 75% probability of its going through in our valuation model. We don’t see much antitrust concern regarding combining the two companies’ retail online brokerage businesses, as there are many online brokerage companies and the space is very competitive. However, the combined registered investment advisor businesses of the combined companies will likely have upward of 40% market share by assets. There are many types of wealth management firms, though, and we estimate that the combined companies’ market share of wealth management assets is probably only a mid- to high-single-digit percentage.

We recently tempered our near- to medium-term outlook for Schwab’s earnings on a stand-alone basis. The largest driver of the company’s earnings is net interest income, which in recent quarters has made up around 60% of net revenue. The positive outlook for interest rates in the United States reversed in late 2018, and rates gradually declined in 2019. However, in March 2020, the federal-funds rate was dramatically cut to 0%-0.25% to deal with the economic downturn caused by the coronavirus. The 10-year U.S. Treasury yield has also fallen below 1%--a level that wasn’t even breached during the “zero interest rate policy” period after the 2008 financial crisis. Net interest income is likely to remain constrained at Schwab for a couple of years.

Client asset growth is the other major revenue lever for Schwab. Approximately 30% of the company’s net revenue is directly from asset management and administration fees. The company has been building out its investment management service offerings, such as its exchange-traded fund, separately managed account, and robo-advisor offerings. However, as in the rest of the investment management industry, these offerings have experienced pressures on pricing.

Scale-Driven Cost Advantage Results in Wide Moat Given its massive scale and industry-leading cost efficiency, we believe Schwab can sustain severe competitive pressures, such as trading revenue dropping to $0, and still earn above its cost of capital. After the commission pricing cut in 2019, we still forecast returns on capital in the low to mid-teens, well above the company's cost of capital, which we estimate in the high single digits. We also estimate that around 25% of client assets are in either a Schwab proprietary or a controlled product, which allows the company to extract more profits on client assets than other brokerages, where clients use primarily third-party products.

Retail brokerages’ 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 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 who 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 brings a cost advantage that few can match. Currently, Schwab supports over $3 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.

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 $200 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 the company’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.

Our moat trend rating for Charles Schwab is stable. The company is already one of the low-cost leaders in its industry. While it will continue to increase in size and its costs will scale downward, we don’t believe the gap between the company and its peers will materially widen. For example, Schwab has over $3 trillion in client assets compared with TD Ameritrade with over $1 trillion, whereas full-service wealth managers, such as Morgan Stanley, have more than $2 trillion. A certain amount of switching costs may be developing at Schwab from the increasing usage of proprietary products and advice solutions among its clients, but we don’t view them as sufficiently material to affect the overall level of the company’s already strong competitive position. Schwab’s small proportion of trading revenue--less than 5% of net revenue after the 2019 pricing cut--means that the trend toward ever-lower trading fees at brokers won’t significantly affect profits or lead to a competitive disadvantage.

Interest Rates and Fee Pressures Are Major Risks Interest rates will be the key driver of Schwab's earnings over the next several years. Because of the staggered reinvestment of the company's portfolio, interest rates have to remain at a high level for the company's investment portfolio to fully reprice at higher rates. In a recession with accommodative monetary policy, portions of the company's investment portfolio could be stuck at a lower rate. Even if the recession is short-lived, long-term interest rates have drastically declined over the previous year, with the 10-year Treasury recently below 1%. Low long-term interest rates will affect Schwab's reinvestment opportunities for much of its banking portfolio, while short-term interest rates, such as the federal-funds rate, will affect the company's floating-rate securities. 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. Retail brokerages’ cuts in trading prices in 2017 caused their stocks to fall by mid-single-digit percentages, while the cuts in 2019 led to double-digit declines at many of the retail brokerages. 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.

Given the competitive dynamics in the investment services industry, the future path of monetary policy, and potential for a bear market, we have a high fair value uncertainty rating for Charles Schwab.

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

Schwab increased its quarterly dividend to $0.18 per share from $0.17 in January 2020. The company targets a dividend payout ratio of 20%-30%. The payout ratio had been sticking closer to 20% as the company retained earnings to capitalize its growing bank. Given the economic downturn and capital needed to support increases in its balance sheet from acquiring USAA’s brokerage business and TD Ameritrade, Schwab is likely to significantly reduce share repurchases until it returns to its target Tier 1 leverage ratio range of 6.75%-7%. As the bank grows, we believe the company will periodically issue preferred stock to supplement its regulatory bank capital ratios.

Stewardship Is Exemplary Schwab has consistently been an industry trendsetter by innovating and disrupting the status quo or by being a fast follower and propagating a formerly niche product or idea. 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. In terms of capital allocation, we had seen the slow growth of the company's dividend as prudent, because the strategic retention of capital should translate into accelerated economic return growth at Charles Schwab Bank. We also agreed with the subsequent increase in the dividend and share-repurchase program, now that the hypergrowth phase of the bank from the movement of money market fund balances is done. Generally, we think management has successfully transformed the company into a modern investment services company from a discount brokerage during a period of substantial industry structure changes.

We see Charles Schwab’s merger with TD Ameritrade as sound. Not only does it create an industry leader in retail brokerage, but it creates a leader in the overall financial sector. The merger cements Schwab’s position as one of the key players in the financial sector as the lines between industries such as traditional banks, wealth management, and retail brokerages are blurring.