WAL - Charles Schwab: Warren Buffett Has A Warning For Bank Investors

2023-05-08 07:45:00 ET

Summary

• Warren Buffett warned bank investors over the weekend that he doesn't "know where the shareholders of banks are heading."
• Schwab's balance sheet remains under pressure as clients search for higher yields.
• The company must demonstrate its ability to continue attracting and holding on to client assets as it navigates a subsequent earnings recovery.
• The recent banking crisis worsened last week as speculators bet on the next bank to collapse.
• Investors looking to add more exposure must pay close attention to the rapidly-changing dynamics.

The Charles Schwab Corporation ( SCHW ) has continued to engage its investors after its April earnings call , assuring them that " client outflows have decelerated for the third consecutive month."

CFO Peter Crawford presented an update on May 5 that outflows slowed to $1B in April 2023, down from $1.19B in March. It also included the impact of " seasonal tax payments ," suggesting that Schwab could have performed better.

As such, the wide moat integrated finance company has strengthened the thesis of its April update, increasing its confidence that the outflow could abate this year, leading to a " resumption in the growth of client cash on the balance sheet."

However, the recent events in the regional banking sector over the past week suggest that holders must be prepared for more volatility, as it came under attack from short-sellers and speculators.

The crisis threatened to engulf PacWest Bancorp ( PACW ) and Western Alliance Bancorporation ( WAL ), as speculators assessed that both banks could be next to collapse.

However, the massive short-covering on Friday (May 5) saw PACW and WAL recover more than 80% and nearly 50%, respectively. As such, it's incredibly challenging for investors to time an entry in banking stocks right now, particularly the regional banks.

We also reminded members of our service that it might be more prudent to consider a regional banks ETF ( IAT ) ( KRE ) as a bet on the sector recovery than individual banks. We wouldn't know where the "cockroaches" are hiding until it's too late.

Schwab investors saw SCHW nearly crumbling to take out the lows it formed in March. We reassessed the buying sentiments last week and believe that SCHW's March lows continue to hold remarkably well, despite the collapse in the regional banks.

Accordingly, the KRE and IAT have fallen to lows last seen in 2020, as the fallout threatened to engulf the entire sector.

Therefore, the company's timely update on Friday could have soothed some lingering fears about Schwab's ability to hold on to its deposits, critical to underpinning a recovery in 2024.

As such, SCHW holders likely saw a dip-buying opportunity over the week, defending a critical support zone to prevent it from crashing toward its 2020 lows.

Berkshire Hathaway ( BRK.A ) ( BRK.B ) CEO Warren Buffett sounded a word of caution for bank stock investors at the company's annual meeting yesterday (May 6).

The Oracle of Omaha stressed that he doesn't " know where the shareholders of banks are heading." While he suggested he's not worried about his personal deposits above the $250K insured limit with his "local bank," he cautioned that "in terms of owning banks, events will determine their future." He reminded bank investors that "every event starts creating a different dynamic."

Schwab's assurance of its operating model (including its decision not to de-bank ) as CEO Walter Bettinger accentuated that "Schwab's franchise strength and financial model remain intact."

As such, Bettinger doesn't see a need to reconfigure its "multi-decade approach to conservatively managing its bank balance sheet." As such, while Schwab sees a short-term impact on earnings due to the current dynamics, it should not have a long-term material impact on its business model.

Moreover, Bettinger reminded investors, "Schwab's bank is unique as it serves as a bank for investors."

In an interesting column last week, Bloomberg's Matt Levine highlighted why " nobody trusts the banks now." He reminded readers that the current banking crisis had unveiled a critical flaw that relied on the intangible assets of "relationships" to help mitigate the asset-liability mismatch risks that banks face. Levine added:

Relationship businesses in general are on the decline. In a world of electronic communication and global supply chains and work-from-home and the gig economy, business relationships are less sticky. - Bloomberg

Therefore, we assessed Schwab must demonstrate that it can maintain its strong relationship with its customers. In addition, Morningstar reminded investors that Schwab's "low costs and large client base give it the flexibility to create products offering a value proposition."

Notably, Schwab assured investors its focus has not deviated even as rates surged, helping the bank to retain client assets even as they searched for higher yields.

Accordingly, Schwab "responded by introducing new products with higher yields to attract client cash." The company has also continued "exploring other options to help clients earn higher returns on their cash."

Notably, its ability to attract $132B in core net new assets in the past quarter is a testament to Schwab's customer-centric focus.

Therefore, management remains confident that "its model is working well and is attracting new clients to the firm." Despite that, investors must remain alert to the rapidly-changing dynamics in the current banking crisis, which could continue to hurt its deposit outflow, as it fell to $326B in FQ1.

Seeking Alpha Quant suggests that SCHW's valuation grade of "D" is not attractive, even though it has improved from its "F" grade over the past six months.

Schwab's ability to improve Wall Street analysts' confidence about its earnings growth prospects will be critical toward a better revisions grade moving ahead.

Analysts have penciled in further net revenue decline through the quarter ending December 2023, reflecting a further hit to its net interest revenue, which accounted for more than 54% of its net revenue in FQ1.

As such, investors should expect Schwab's adjusted EPS to fall further through 2023 before a possible recovery in 2024.

We assessed that analysts' estimates seem to align with management's commentary about an earnings growth inflection in 2024. However, given the current dynamics, we believe it's too early to tell.

Hence, investors assessing a buying opportunity must have high conviction in Schwab's franchise and business model, allowing the firm to chart a subsequent earnings recovery.

Rating: Buy (Reiterated).

Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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