Charles Schwab: Q3 Earnings Will Have Warts, and the Firm Must Reassure Investors

There are both environmental and company-specific issues that will negatively affect Charles Schwab’s SCHW third-quarter results. Still, we continue to believe the market is overreacting, and that the firm’s shares are undervalued after its 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 more than 7% and the Morningstar US Core Bond Index down 4% since the end of July, which means lower client assets.

While the effective federal-funds rate has only moved from an average of 5.08% in June to an average of 5.33% in September, the 10-year U.S. Treasury yield moved from 3.81% at the end of June to over 4.7% in recent days. Schwab, along with many banks, should report a significant increase in unrealized losses on its fixed-income securities due to interest-rate risk in its bank portfolio. Thankfully, Schwab’s fixed-income portfolio is primarily composed of U.S. Treasuries and agency mortgage-backed securities that have virtually no credit risk, so the losses won’t be realized as long as the company holds the securities to maturity.

Schwab should also be able to hold the securities to maturity because of the Federal Reserve’s Bank Term Funding Program and other sources of liquidity. Additionally, regulatory capital ratios should be fine, as unrealized losses aren’t currently included in the company’s capital calculation. We do imagine the market will feel uneasy about the company’s low tangible common equity balance on a GAAP basis, and believe management should spend some time reassuring investors about access to liquidity and its capital position. We are maintaining our $80 fair value estimate for the company, and assess that shares are materially undervalued.