SBNY - The SVB Financial Group Debacle And Schwab: Time To Buy May Be Nigh

2023-03-13 17:20:34 ET

Summary

• The Charles Schwab Corporation dropped the third-most in the 67-member S&P 500 Financials Index on Thursday. Only SVB Financial Group and First Republic Bank were down by more.
• The cause of Silicon Valley Bank’s implosion reveals much regarding an investment in Schwab.
• Most analysts view the fall in the Schwab share price as a buying opportunity.

The collapse of SVB Financial Group (SIVB) and Signature Bank (SBNY) roiled the markets. Shares of financial stocks plunged, and the fear of anything financial spread like a contagion. The Charles Schwab Corporation ( SCHW ) stock price dropped over 22% last week and initially fell nearly 20% this morning alone.

This follows a hit the shares took last month following a remark by Schwab’s CFO regarding client cash sorting, a process whereby clients move cash into higher-paying money market funds from lower-yielding bank deposits.

That, coupled with tepid Q4 results , had the stock on the decline before the news of SVB and Signature hit the markets.

However, amid the stock’s fall, an analyst at Morgan Stanley listed Schwab near the top of a list of stocks that have been “high-quality companies that have been unfairly punished by the market.”

A few weeks later, that was followed by analyst Michael Cyprys' observation that the:

"sharp sell-off presents a compelling entry point for a high quality franchise that should be able to better navigate liquidity risks than the market prices in, given significant financial strength/ flexibility, liquidity profile and significant earnings/capital generation."

However, Bank of America’s assessment aligns with the current market. SCHW was downgraded there on concerns that client cash sorting, combined with lessened revenues from rising short-term interest rates, will result in deteriorating profits for the company.

The Collapse OF SVB And How It Relates To Schwab

SVB Financial Group was favored by venture capitalists who raised huge funds and invested in startups. Therein lies its Achilles’ heel. As 2022 came to a close, the bank had 37,466 deposit customers with an excess of $250,000 in each account. The quarter-million number is of pivotal importance, as that is the limit for deposit insurance.

One could also argue that the figure 37,466 also holds some weight. That reflects a relatively small number of people with a rather large collective sum in the bank. All in all, those folks had $157 billion in deposits, of which less than $10 billion was insured by the FDIC.

The bank’s deposit base is far from the norm for your average bank. SVB also had 106,420 customers that are fully insured, but their accounts total only $4.8 billion. Therein lies half of the story regarding why there was a run on the bank: customers with accounts that are not insured by the FDIC feared they would lose their deposits.

However, there is another factor that played into the SVB’s demise. Government largess resulted in deposits in U.S. banks increasing by $5.4 trillion from the end of 2019 through the first quarter of 2022. Loan demand was weak, so banks invested part of that treasure trove in securities. Funds devoted to security portfolios surged from just under $4 trillion at the end of 2019 to $6.26 trillion.

There are two categories of securities purchased by banks. One is referred to as “held-to-maturity” ((HTM)), the other as “available-for-sale” ((AFS)). Unlike HTM’s, securities designated as AFS are marked-to-market. SVB’s holdings in HTMs extended to 6.2 years.

Since they pay a fixed rate, when interest rates rise, the value of the securities falls. As rates went up, the value of the HTM securities plunged in value. The unrealized losses in SVB's securities portfolio in December had grown to more than $17 billion.

The following chart gives a picture of the size of the bond portfolio held by SVB.

SVB held an inordinate share of the bank’s deposits in securities, and the bulk of those investments were held in HTMs. By the end of September, with $15.9 billion in HTM market-to-market losses, Silicon Valley Bank was technically insolvent. Silicon Valley Bank was faced with $42 billion in withdrawals on Thursday alone.

This stands in stark contrast to the manner in which Schwab operates. Schwab held $27.9 billion in unrealized losses across its HTM and AFS bond portfolio as of the firm’s last 10-K filing. The company had $150 billion in AFS and $159 billion in HTM holdings with weighted yields of 2.13% and 1.74%, respectively.

Analysts for Morgan Stanley estimate that in a worst-case scenario, Schwab has $275 billion in immediate liquidity available and $375 billion over a 12-month period. Considering the firm has $366.7 billion in the deposit base, that would mean Schwab’s potential liabilities are more than well covered.

Furthermore, in sharp contrast to SVB, 80% of Schwab’s total bank deposits are FDIC insured. Securities and cash in brokerage accounts are also insured by SIPC for up to $500,000.

The Morgan Stanley analysts provided the following assessment:

Notably, in a worst case scenario, if Schwab were to fund customer withdrawals via liquidating their $148 billion available for sale securities portfolio and crystallize $12 billion of unrealized securities losses, their Tier 1 leverage ratio would be largely unchanged.

Schwab also has a CET1 ratio of 21.9% and tier 1 leverage ratio of 7.2%. The latter metric is above management’s target and the regulatory minimum of 4%.

So that leaves investors with the following question: Has the run on financial stocks presented a buying opportunity?

A Glance At Schwab’s Q4 Earnings

Schwab reported Q4 2022 results on the 18th of January. Revenue and earnings both missed consensus. Adjusted EPS of $1.07 fell two cents shy of expectations and was also short of the $1.10 recorded in Q3. However, it was well above the $0.86 year over year mark.

Revenue of $5.50 billion missed the $5.55 billion forecast by analysts. That figure was flat in relation to Q3 but well ahead of the $4.71 billion in Q4 of 2021.

Revenue from net interest of $3.03 billion was up from $2.93 billion in Q3 and the $2.14 billion year over year figure.

Asset management and administration fees were $1.05 billion, down from $1.11 billion a year ago and flat from the prior quarter.

Trading revenue took a substantial hit. At $895 million, it fell shy of the $930 million in the prior quarter and well below the $1.02 billion in Q4 2021. Daily average trading volume also fell to 5.45 million from 5.5 million in Q3.

However, total client assets were $7.05 trillion, representing significant growth from the $6.6 trillion held as of September 30, 2022.

Schwab also added 4 million new brokerage accounts in 2022 for a total of 34 million.

The firm’s retail channel notched record core inflows during 6 separate months of 2022, and adjusted net income rose 21% to $2.2 billion.

Average interest-earning assets fell to $533.32B from $588.13B a year earlier, and bank deposits fell from nearly $410 billion in the year-ago quarter to just under $375 billion.

FY 2022 saw revenues jump 12% to $20.8 billion and adjusted EPS increased 20% to $3.90 from $3.25.

Schwab raised the dividend to $0.25 a quarter, an increase of 13.6%.

Understanding Schwab

Schwab is the largest self-directed brokerage in the U.S. As of January 31, 2023, the firm held $7.48 trillion in client assets, along with 33.9 million brokerage accounts, 2.4 million corporate retirement plan participants, and 1.7 million banking accounts.

Schwab is the industry leader by a wide margin in terms of active brokerage accounts.

Interest related revenue accounts for over 50% of the firm’s net revenue. Asset management and administration fees bring in 19% and trading fees generate around 16% of revenues.

The firm’s banking business holds $375 billion in deposits that fuel revenue in net interest income as the Fed raises interest rates.

SCHW holds an 11% share of the $70 trillion in U.S. investable wealth, providing the company with a long growth runway.

The banking business, with around $375 billion in deposits, should benefit from the rise in interest rates. Furthermore, the nature of Schwab’s business means the banking arm does not have the expenses associated with a physical branch presence.

Schwab also ranks among the top-ten companies for exchange traded funds.

Dividend And Valuation

SCHW currently yields 1.86%. The payout ratio is 21.48%, and the 5-year dividend growth rate is 21.22%.

Following the authorization of a $15 billion buyback program in July, Schwab repurchased an aggregate 47 million shares for $3.4 billion in 2022.

Schwab now trades for $53.33 a share. The average one year price target of the 16 analysts that follow the stock is $90.12. The average price target of the 7 analysts that rated the stock following the most recent earnings report is $85.50.

The forward P/E is 13.4x, well below the stock's 5-year average P/E of 19.28x. The 5-year PEG is 0.78x, well below the average PEG over the last 5 years of 1.40x.

Is SCHW A Buy, Sell, Or Hold?

On Thursday, of the 67 stocks that constitute the S&P 500 Financials Index, The Charles Schwab Corporation suffered the third largest percentage share loss. As I write these words, the stock is down over 8% this Monday alone.

My investigation has convinced me that Schwab is well prepared for even a worst case scenario. Furthermore, I rank SCHW among the top tier of prospective investments.

Over the first three quarters of FY 2022, Schwab reported 39%, 31% and 24% earnings growth on a year-over-year basis.

While it is true that the company is subject to risks related to changing interest rates and trends in the global equity and fixed-income markets, as well as the possibility that cash-sorting could result in funds flowing out of customers' Schwab accounts, the long-term outlook for the stock is quite favorable.

I’m not tethered to others' opinions, but I’ll note that analysts covering the stock seemed to provide a rather nonchalant collective shrug following the decline in the Schwab’s share price.

In the turmoil created by the SVB debacle, Piper Sandler analyst Richard Repetto views the drop in Schwab’s share price as a buying opportunity, Citi states the recent pullback "creates a compelling entry point," as does Michael Cyprys, analyst for Morgan Stanley, and JPMorgan Chase analyst Kenneth Worthington.

The same holds true for Morningstar analyst Michael Wong, who advised he is keeping his fair value estimate of SCHW at $87.

I cannot recall four analysts characterizing a steep sell off in a stock as a compelling entry point in this short of a time span.

Management guides for revenue growth of approximately 10% from the year-ago period, while the average analyst estimate is for 14.6% growth.

I rate SCHW as a Buy.

I held a small stake in The Charles Schwab Corporation prior to recent events. I’ve added markedly to that position today. I’ll readily admit that this investment may be poorly timed over the short run; however, as a largely buy and hold investor, I welcome an opportunity to invest in Schwab at the current share price.

Should The Charles Schwab Corporation stock move lower, I will gladly add to my position.

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