Company Reports

There were clear signs of Charles Schwab’s positive, medium-term earnings narrative in its first-quarter results. The firm reported net income to common shareholders of $1.25 billion, or $0.68 per diluted share, on $4.7 billion of net revenue. Excluding acquisition-related and restructuring costs, adjusted diluted EPS was $0.74. Net revenue was 7% lower than a year ago, but more importantly, net revenue increased 6% sequentially. This was the company’s first sequential increase in net revenue since the third quarter of 2022. There was broad strength across revenue lines with trading increasing 7%, asset management increasing 9%, and net interest revenue increasing 5%. Adjusted expenses were little changed from a year ago at $2.8 billion. We don’t anticipate making a material change to our $73 fair value estimate for wide-moat Charles Schwab and assess shares are currently fairly valued.

We're adjusting our fair value estimate for wide moat-rated Charles Schwab to $73 per share. Our fair value estimate implies a price/2025 earnings multiple of about 22.5 times and price/book multiple of about 3.7 times. We made many adjustments to our prior model, with the most impactful change being in our long-run forecast operating margin.

We assess that Charles Schwab is fine from a liquidity and capital standpoint, but that it could take more than a year before earnings are on a tenable upward trajectory. While Charles Schwab is best known for its retail investor and Registered Investment Advisor platforms, Charles Schwab Corporation is a savings and loan holding company that had around $300 billion of deposits at the end of 2023 and generates about half of its revenue from net interest income.

Revenue growth for Charles Schwab in 2024 is less certain due to expectations for falling interest rates, but the company's business model and longer-term trends still paint a bright picture. During 2023, Schwab reported net income to common shareholders of $4.6 billion, or $2.54 per diluted share, on $18.8 billion of net revenue. On an adjusted basis, which excludes nearly $1.5 billion of restructuring and acquisition-related costs, earnings per share was $3.13. Net revenue decreased 9%, primarily due to a nearly $2 billion decline in net interest income and bank deposit account fees.

In the medium to long term, Charles Schwab should see significant growth in earnings, and third-quarter results show stabilization in revenue that has recently been trending downward. Charles Schwab reported net income to common shareholders of $1.02 billion, or $0.56 per diluted share, on $4.61 billion of net revenue. Net income was affected by $279 million of restructuring charges in the quarter, and adjusted EPS that excludes restructuring, acquisition, and certain amortization costs was $0.77. Net revenue decreased 16% from the prior year's record revenue quarter, mostly due to a nearly $700 million decline in net interest income as funding costs have increased. Net revenue declined only 1% from the previous quarter, which is a significant deceleration of the revenue declines of 7% to 9% the prior two quarters. We don't anticipate making a material change to our $80 fair value estimate for wide-moat Charles Schwab and assess shares are undervalued.

There are both environmental and company-specific issues that will negatively affect Charles Schwab's third-quarter results, but we continue to believe that the market is overreacting and that shares are undervalued after the recent selloff. Two major drivers of earnings for investment service companies are asset prices and interest rates. Both equity and bond prices have recently taken a hit, with the Morningstar US Market Index down over 7% and Morningstar US Core Bond Index down 4% since the end of July, which means lower client assets.

Charles Schwab released August metrics, and while there were areas showing some weakness, there was nothing alarming. The three areas that caught our attention were net new client assets, proprietary money market fund balances, and the certificate of deposit balances. Net new client assets in August were $8.1 billion, a decrease of 81% from a year ago and 37% from the previous month. The main reason for the lower net new assets is that Charles Schwab did a $1.3 trillion movement of TD Ameritrade assets onto its platform over the Labor Day weekend. The movement to the Schwab platform was a catalyst for clients to move their assets elsewhere, such as for registered investment advisors who didn’t want to concentrate all of their assets at Schwab, and for Schwab to end some client relationships that didn’t meet its criteria.

Charles Schwab’s stock may be feeling some pressure from recently announced one-time charges related to its $500 million expected cost-savings initiative and the 10-year Treasury rate that has made new highs. The company said that it expects to incur $400 million to $500 million of costs over the remainder of 2023 and in 2024 related to reducing headcount and its real estate footprint as part of its plan for $500 million of cost savings. The $500 million of expected cost savings is much more important and beneficial than the $400 million to $500 million of one-time charges, so this is a net positive to shareholders.

We are increasing our fair value estimate for wide-moat-rated Charles Schwab to $80 from $70, as we have gained more comfort with the trajectory of the company’s earnings after the effects of client cash sorting. At the end of the second quarter of 2023, deposits from banking clients stood at $304 billion compared to a peak of $466 billion at the end of the first quarter of 2022. Clients have sorted their cash from low interest-yielding sweep deposits into higher yielding products, such as money market funds. The outflows of deposits caused Charles Schwab to rely on higher cost funding sources, such as certificates of deposits and Federal Home Loan Bank system loans, to manage its bank balance sheet. The higher cost funding led to net interest income declines over the previous two quarters.

We assess that Charles Schwab is fine from a liquidity and capital standpoint, but that it could take a couple of years before earnings are on a tenable upward trajectory. While Charles Schwab is best known for its retail investor and Registered Investment Advisor platforms, Charles Schwab Corporation is a savings and loan holding company that had over $300 billion of deposits at the end of 2022 and generates about half of its revenue from net interest income. The company has access to the Federal Reserve’s Bank Term Funding Program and the Federal Home Loan Bank system, which can provide the firm upward of $200 billion of cash to deal with any potential deposit withdrawals from clients.

As expected, wide moat-rated Charles Schwab’s revenue and earnings are under pressure, but more clarity on additional expense savings and signs that the company may be past the peak of high-cost funding usage is positive news. Schwab reported net income to common shareholders of $1.17 billion, or $0.64 per diluted share, on $4.66 billion of net revenue for the second quarter. Net revenue was about 9% lower from the previous year and the previous quarter as the company tapped high-cost funding sources such as certificates of deposit and Federal Home Loan Bank borrowings. We don’t anticipate making a significant change to our $70 fair value estimate and assess the shares as fairly valued to modestly undervalued.

The Federal Reserve has released the results of its annual stress tests for the banks. Similar to the 2022 stress test, Charles Schwab did exceptionally well. Schwab was one of the four banks whose minimum common equity tier 1, or CET1, capital ratio during the stress period increased amid an increase to 22.8% from 21.9% for the firm from its fourth-quarter ratio of 2022. Schwab often references an internal target for its Tier 1 leverage ratio of 6.5%-6.75%, and its projected minimum in the stress test is 7.4%. We are maintaining our $70 per share fair value estimate for wide moat-rated Charles Schwab.

There were no real signs of balance sheet stress or client attrition in Charles Schwab’s first-quarter earnings, but we expect the trajectory of earnings to look like a check mark with a near-term decline and longer-term uptrend. Charles Schwab reported net income to common shareholders of $1.5 billion, or $0.83 per diluted share, on $5.1 billion of net revenue. Net revenue increased 9.5% from the previous year but sequentially declined 7%. Most of the net revenue decline was from higher funding costs that affected net interest income, as clients shift their transactional deposits into money market funds and fixed income securities and Schwab has to substitute for the deposits with higher-cost certificates of deposits and FHLBank borrowings. While net revenue and earnings sequentially declined, the company still reported a strong annualized return on equity of 23% and operating margin of 41%. We plan to maintain our $70 fair value estimate for wide-moat-rated Charles Schwab and assess shares as undervalued.

For Charles Schwab's upcoming first quarter of 2023 earnings, we expect to see some signs of accelerated "cash sorting," with low-cost sweep deposits being moved into higher-yielding fixed-income securities and money market funds. The low-cost deposit funding is also being replaced by higher-cost funding sources. When Schwab released its annual report in late February, it had already borrowed an additional $13 billion from the FHLBank system, which more than doubled its FHLBank loan balance of $12.4 billion at the end of 2022. The FHLBank loans carry an interest rate around 5% compared with Schwab's average funding costs from bank deposits of 0.46% in the fourth quarter of 2022. Schwab has also likely incorporated more retail certificates of deposit on its funding base, which also have an interest rate around 5%.

We're reducing our fair value estimate for Charles Schwab to $70 per share from $87. Our fair value estimate implies a price/2024 earnings multiple of about 20 times and price/book multiple of about 5 times. $70 is currently our best assessment of the company's long-term intrinsic value. That said, new data regarding how the financial sector and Charles Schwab were affected by the events surrounding Silicon Valley Bank could materially change our valuation in the following months. We made many adjustments to our prior model with the most impactful changes being a large increase in usage of high-cost, short-term debt in the near term and more client cash being held in lower revenue-yielding money market funds instead of more profitable banking deposits.

We assess that Charles Schwab has enough access to cash and capital that it can weather the storm in the financial sector that was unleashed after the collapse of Silicon Valley Bank. While Charles Schwab is best known for its retail investor and registered investment advisor platforms, Charles Schwab Corporation is a savings and loan holding company that had over $300 billion of deposits at the end of 2022. The company has access to the Federal Reserve’s Bank Term Funding Program that can provide the firm upwards of $200 billion of cash to deal with any potential deposit withdrawals from clients. It also had about $40 billion of cash on its balance sheet at the end of 2022, over $50 million of cash inflows projected in 2023 according to our calculations, and other sources of liquidity, such as commercial paper and inflows from certificates of deposits.

Charles Schwab has always had multiple levers to increase its liquidity, and the Federal Reserve’s newly announced Bank Term Funding Program, or BTFP, should provide additional confidence in Charles Schwab and U.S. banking institutions. The BTFP will offer loans of up to one year to eligible depository institutions that pledge U.S. Treasuries, agency debt and mortgage-backed securities, and other qualifying assets as collateral. At the end of 2022, Schwab had about $300 billion of close to credit-risk-free U.S. Treasuries and agency mortgage-backed securities at amortized cost (around $275 billion at fair value). This $300 billion of assets that can be used as collateral plus the $40 billion that the company has on its balance sheet compares with $367 billion of deposits, so wide-moat Charles Schwab should be fine from a liquidity perspective.

Charles Schwab's stock price decreased 12.77% on March 9, as concerns rippled across a large swath of the financial sector due to an announcement from Silicon Valley Bank. Silicon Valley Bank announced that it sold substantially all of its available-for-sale securities portfolio, was booking a $1.8 billion after-tax loss related to the sale, and that it was raising equity capital. Many banks and companies with related banking entities, such as Charles Schwab, also have a material amount of fixed income securities on their balance sheet with unrealized losses, as recently rising interest rates have decreased the value of fixed income securities. Based on our initial analysis, we don't have concerns over wide-moat Charles Schwab's liquidity or capital levels, don't plan to make a material change to our $87 fair value estimate, and assess shares are undervalued.

Charles Schwab’s net revenue was sequentially flat in the fourth quarter, but we believe the company’s revenue and earnings will still experience a substantial uptrend over the near and long term. The company reported net income to common shareholders of $1.8 billion, or $0.97 per diluted share, on $5.5 billion of net revenue for the fourth quarter of 2022. Net revenue grew $789 million, or 17% from a year ago, but decreased $3 million from the previous quarter, while net income grew $372 million, or 26%, from the previous year, but decreased $63 million, or 3%, sequentially. The roughly flat sequential revenue and slight decrease in earnings was a bit disappointing given that net revenue grew at a high-single-digit percentage and net income grew a double-digit percentage in each of the previous two quarters. We continue to believe that wide-moat Charles Schwab will have stronger earnings growth in both the near and long term, so we are maintaining our $87 fair value estimate and assess shares are fairly valued to slightly undervalued.

We assess that a combined Charles Schwab-TD Ameritrade is a financial sector powerhouse that will be able to compete in an environment where traditional industry lines have increasingly blurred. The combined firm had over $6.5 trillion of client assets as of the end of September 2022, which compares favorably with the largest wealth managers, asset managers, and banks. In addition to its pure scale and efficient business model, both companies have a history of adapting to new sector trends, so we are confident that together they will be a key financial sector player over the next decade. With expense synergies to be realized over the next two years and much of the revenue synergies tied to the gradual movement of client cash from Toronto-Dominion Bank to Charles Schwab, the combined firm should experience a prolonged earnings tailwind.