Charles Schwab: Riding The Wave Of Interest Rates – Cautious Buy (NYSE:SCHW)

Investment Thesis

Charles Schwab (NYSE:SCHW) recently reported positive first-quarter earnings, exceeding analyst expectations. This continues a trend of the company surpassing estimates for the past two quarters. The company’s net income came in at $1.4 billion or $0.68 per diluted share, on revenue of $4.7 billion. While revenue was down YoY, it showed a positive sequential increase – the first since late 2022. This indicates a potential turnaround and future growth.

During the last earnings call, multiple topics were discussed including positive client engagement, the positive TD Ameritrade integration progress, and optimism for organic growth including potential net interest margin expansion, continued revenue and earnings growth, and the possibility of capital return to shareholders in the form of share buybacks.

So certainly, capital return it remains a very important part of our financial formula. We’ve obviously paused our buyback at the moment to enable us to more quickly grow into what we expect will be our new capital requirements.

Despite a slight decline in total assets, driven in part by the pay down of parent level debt, the company’s capital levels are improving, and it boasts a wide economic moat due to its massive scale and cost efficiency. Analysts forecast an increase in revenue by 4.66% for 2024 and then 14.53% for 2025, fueled by rising client assets and deposits.

While the outlook appears promising, some uncertainties remain. The future path of interest rates and potential loss of deposits are key factors to consider. Additionally, competition from fintech companies offering $0 commission trading and robo-advisors could disrupt the industry. Although, I believe the impact from this disruption will be low as Schwab already competes in this front with their current product and services offering.

Overall, I believe Charles Schwab presents a compelling case for a long-term investment. The company boasts a history if exceeding expectations and maintains strong financial health. Its scalable business model positions it well for continued growth and market share gains, fueled by factors like client engagement and the positive TD Ameritrade integration. Additionally, Schwab’s commitment to capital return through share buybacks and dividend payment makes it an attractive option for a long-term compounder. As you will read later in this article, I find Schwab undervalued, making them a candidate for my value portfolio.

Management Evaluation

Walter W. Bettinger II is the CEO of Charles Schwab since 2008. I found that he has a strong alignment ratio with the company long-term goals due to his significant compensation in company stock, incentivizing him for Schwab’s success. While Schwab’s Glassdoor rating sits around the industry average, Bettinger himself enjoys positive reviews from employees. Prior to his current role, Bettinger served as President and COO, and his career with Schwab began in 1995 when his retirement services company was acquired by the financial giant. With a long history and vested interested in Schwab’s performance, Bettinger appears to me well-positioned to lead the company forward.

Peter Crawford, Schwab’s CFO since 2017, has overseen financial strategy and key functions like treasury and investor relations. He previously held leadership roles in product development and asset management. Under Crawford, Schwab has remained solvent despite an increased in debt used for liquidity and general corporate purposes. This leverage is typical for banks. The all-stock acquisition of TD Ameritrade, I believe also proved a wise decision. The combined entity’s economy of scale likely boosted revenue and profitability, outweighing any dilution effect from issuing new shares.

Overall, Schwab’s leadership team, CEO Bettinger and CFO Crawford, meet expectations. Bettinger long tenure and stock-based pay align his goals with Schwab’s success. Despite increased debt for liquidity, Schwab remains solvent, a common practice in banking. Crawford’s experience across finance and product development positions him well. The strategic TD Ameritrade acquisition and the current management of the interest rate cycle, likely influenced by Crawford, is a win, with economies of scale outweighing dilution. Overall, strong leadership guides Schwab through challenges while maintaining financial health and positioning for future growth.

Corporate Strategy

Charles Schwab navigates the competitive landscape of online brokerage with a well-defined corporate strategy. Their focus is on organic growth, fostering deep client engagement, and delivering long-term value to clients and shareholders. This translates into several key advantages.

First, Schwab is a low-cost leader. Their pioneering commission structure makes them attractive to investors prioritizing affordability. Second, they heavily invest in educational resources, empowering clients to make informed decisions. Excellent customer service has also proven to be another successful hallmark of Schwab, consistently earnings them high satisfaction ratings and fostering client loyalty. Finally, Schwab boasts a strong brand reputation, representing reliability and stability within the financial services industry. The successful integration of TD Ameritrade has significantly bolstered their client base and platform capabilities, further solidifying their position. The company has also integrated vertically and horizontally offering low cost investments like ETFs and Mutual funds, a robo-advisor service, and Schwab Bank creating large economies of scale.

Click to enlarge

Source: From companies’ website, presentations, SeekingAlpha, Financial Statements.

Average Revenue Per User: yearly revenue divided by number of accounts. IBKR does not measure revenue per user instead measures revenue per trade as a key metric.

Comparing Schwab’s strategy to its main competitors reveals its strengths. Fidelity and Vanguard, two private companies, are by far Schwab main competitors and while they also offer a broad product range, Vanguard lacks research tools for more active and sophisticated users as they believe in passive low cost investments, in the case of Fidelity, they have higher expense ratios in some mutual funds compared to Schwab. Further, Robinhood, attracts young investors with commission free trades and user friendly-app, but lack educational resources and depth of customer service offered by Schwab. E*TRADE (MS) position itself similarly to Robinhood emphasizing commission-free trades and attracting less sophisticated audiences, but I believe Schwab’s more comprehensive financial services including bank products options, and focus on long-term investing sets them apart.

Valuation

SCHW currently trades at around $74, slightly higher since its last reported earnings April 15^th. Next earnings are just around the corner and estimated to be presented on July 16^th.

While DCF valuation can be a powerful tool for some of the companies I consider for my growth at reasonable price portfolio, it may not capture the value of financial companies like Charles Schwab. This is due to their focus on consistent profitability rather than growth. Financial institutions are heavily influenced by the strength of their balance sheet and the nature of their core business. Therefore, for SCHW valuation, I will focus on analyzing the compound annual growth rates of their key metrics, particularly those reflected in their balance sheet ratios.

My analysis will prioritize a combination of increasing revenue, Return on Assets (ROA), tangible book value, and net interest margin. These metrics provide a more wholistic and comprehensive picture of SCHW’ financial health, efficiency, and long-term value creation.

While 2023 presented challenges for Charles Schwab, a closer look at key metrics reveals underlying financial resilience. Client cash realignment towards higher-yielding money market funds impacted net interest income and bank deposits, which saw a decline of $175 billion, nearly 40% since its peak. Additionally, trading revenue kept dipping compared to the pandemic-fueled surge in 2020-2021.

However, I find that 2024 has proven to be different and more of a turnaround year as Peter Crawford, the company CFO, mentioned in the earnings call. SCHW maintains a healthy ROA of 1%, indicating efficient utilization of assets to generate profits. The ROE of 12% sits comfortably in healthy territory and suggesting strong profitability. Further, a positive net interest margin demonstrates the company’s ability to generate profit from its core lending and borrowing activities. Finally, Tangible Book value further strengthens my case for SCHW financial health.

Now back in January, Walt and I both said that 2024 is likely to be somewhat of a transitional year from a financial standpoint, but along with steadily improving financial results, the bridge from what proved to be a challenging 2023 to what we believe is a very promising future ahead. One quarter of the way through the year that transition is well on its way, as our core earnings power is becoming less obscured by some of the near-term headwinds and our long-term financial formula that you’re all familiar with growth in the client franchise, driving scale in the business, leading to improving financials and ultimately, capital return re-enters the picture.

Based on all these factors, I believe SCHW is currently fair valued. While lower interest rates could potentially drive further revenue growth, the company’s current financial health suggests a solid foundation for future success.

Technical Analysis

SCHW stock hasn’t moved much from the range where it was trading before the last earnings call. Its RSI is neutral at around 50 and close to its 14-day moving average of 47 and pointing to keep increasing, indicating that the stock might continue to increase in value.

SCHW has formed a support level at around $70 and believe it will trade in the range of $70-80 until there is more news or a surprise from the Fed. I believe the stock will benefit if the Fed cuts interest rates faster than expected. Seeking Alpha has the stock with positive momentum and slightly better earnings revisions, which is very positive.

SCHW should still be able to do well over the long term and that is why I am cautiously optimistic and rating the stock a buy as a longer-term investment on a possible rate cut over the midterm despite some earnings volatility over the near term.

Next earnings are expected July 16th

Takeaway

A closer look at Charles Schwab reveals a compelling long-term investment opportunity despite near-term earnings volatility. Recent positive earnings that exceeded analysts’ expectations suggest a turnaround. Strong financial metrics point to underlying financial strength and its balance sheet figures paint a picture of a fairly valued company. Experienced leadership with strong incentives for Schwab’s success and the company’s economies of scale and competitive advantages like low-cost structure, brand reputation, and excellent client service further solidify the investment case. Additionally, lower interest rates could act as a catalyst for further revenue growth. Overall, Charles Schwab could see a boost in revenue if the next economic cycle brings lower interest rates.