2023-07-14 12:51:40 ET
Summary
- Charles Schwab is set to hold an investor call on July 18th to discuss its Q2 2023 financial results, with analysts predicting a 9.5% YoY decline in revenue to $4.61 billion.
- The company's total value of interest-earning assets has decreased, while its debt has significantly increased, potentially impacting its net interest income.
- Despite its challenges, the company has seen growth in client assets and brokerage accounts, leading the author to maintain a 'strong buy' rating for the long term.
Before the market opens on July 18th, the management team at Charles Schwab ( SCHW ) is going to be holding an investor call to provide financial results covering the second quarter of the company's 2023 fiscal year. As we approach that date, investors would be wise to make a list of a few important metrics to pay attention to for when the company does report. These metrics will go a long way toward determining how the company performs fundamentally for the foreseeable future. Although I fully expect there to be some negative developments that could weigh on the business to some extent, I believe that the overall picture for the enterprise still looks very attractive.
An important disclosure
After seeing shares of Charles Schwab take a beating in response to the banking crisis that began earlier this year, I could not help but to dive in. While the company is the smallest holding in my portfolio, accounting for only 3.8% of it in all, it is one that I believe offers attractive upside. So far, I have generated a return of about 12.5% on the stake since acquiring my units, and along the way I have chronicled by journey with the business. The most recent article I published on it came out when management provided their monthly activity report for May, and I would encourage you to take a deeper look into its findings here .
What to expect
As with any company that reports financial results, the first thing that the investment community will center on will be the headline news items. At the very top of the list, we have revenue. In this particular case, we are talking about net revenue, which strips out interest expense that the company pays on its deposits. The current expectation set out by analysts is for the company to report revenue of $4.61 billion. If this turns out to be accurate, it would translate to a year-over-year decline of 9.5% compared to the $5.09 billion the company reported one year earlier.
This might seem odd to some. After all, during the first quarter of the year , the company generated revenue of $5.12 billion. That was up nicely compared to the $4.67 billion reported one year earlier. But there are some issues that the company is contending with that could prove problematic. For starters, the total value of interest earning assets for the company continues to decline. For the first quarter of the 2022 fiscal year, for instance, this number came in at $632.38 billion. By the first quarter of 2023, the average for the timeframe covered was $504.60 billion. Even though the company has seen a surge in assets associated with its money market activities, bank account deposits have continued to fall because of the high interest rate environment that we are dealing with. Frankly, depositors are seeking attractive yields elsewhere, which has created an outflow of capital for a part of the company that has historically been quite profitable.
By the month of May, which is the most recent month for which data is available, average interest earning assets for the company had fallen to $483.44 billion. This is down from the $620.16 billion that the company had one year earlier. Lower assets translates to less investment income, all else being equal. In the first quarter of this year, this was more than offset by a greater amount of net interest income due to growth in the company's net interest margin. That margin expanded from 1.38% in the first quarter of 2022 to 2.19% in the first quarter of this year. That rise was driven by the company’s ability to benefit from higher interest rates more than the extent to which it was hurt by having to pay out more because of said higher rates.
What could come back to bite the company for the second quarter is the fact that the firm has seen a rather significant increase in its debt. At the end of 2022, Charles Schwab had total borrowings of $37.88 billion. This number expanded to $72.69 billion in the first quarter of 2023. Most of that increase came from borrowings associated with the Federal Home Loan Bank program, aimed at supporting financial institutions during these difficult times. Borrowings there shot up from $12.40 billion to $45.60 billion. But average borrowings during the quarter came in at only $24.46 billion. These have a rather lofty interest rate of 5.05% per annum. Or at least that's what the rate was during the first quarter. If the company saw its borrowings remain flat at the end of quarter amount I mentioned, and if interest rates remained unchanged, and no other changes occurred on the company's balance sheet, the change from the average balance in the first quarter to the balance for the second quarter would cause 45.5% of the growth in net interest income between the first quarter of last year and the first quarter of this year to vanish. Naturally, investors should be paying attention to the net interest margin of the company, as well as both debt and interest earning assets.
There could be other problems on the revenue front. For instance, the reduction in bank account balances that the company has seen and will likely continue to see in the near term could very well cause fees associated with the deposits to dry up. In the first quarter of 2023, these fees totaled $151 million. That was only a little more than half the $294 million reported one year earlier. On top of this, trading fees are also likely to continue declining. From the first quarter of 2022 to the first quarter of 2021, these dropped from $963 million to $892 million. Even though the company enjoyed an increase in the average revenue per trade from $2.36 to $2.44, a change in investor behavior resulted in average daily transactions dropping from 6.58 million to 5.90 million. If this continues, the company could see further contraction on this front.
Naturally, all of this could have major implications for the firm's bottom line. Analysts don't seem to be terribly optimistic. Right now, they anticipate earnings per share of $0.63, with adjusted earnings per share of $0.71. By comparison, earnings per share during the second quarter of 2022 came in at $0.87, with the adjusted figure totaling $0.97. Total net profits during the second quarter of last year were $1.65 billion. If management achieves what analysts anticipate, this would drop to $1.16 billion, with the adjusted figure at $1.31 billion.
At this point, some investors may wonder why I have a ‘strong buy’ rating on the company. The expectations so far for the second quarter are not looking particularly pleasant. However, there is a slew of other data that I believe investors will enjoy. Even though bank account deposits have been on the decline, overall client assets for the company have only grown. In May of 2022, for instance, the company had $7.30 trillion of client assets. By May of this year, which is the most recent month for which we have data, that number had grown to $7.65 trillion.
Some of this upside can be driven by the fact that money market funds have exploded in popularity. Last May, the company had $158 billion dedicated to money market funds. That number has more than doubled to $384.9 billion at the same time this year. Just from April to May alone, the company experienced a net growth of $16.4 billion. The firm may very well generate lower margins associated with these assets. But they are still assets that the company has control over. In the most recent month covered, the firm saw net new assets come in of $24.6 billion. Only one time over the past year has the company actually seen negative net new assets. And in some months, such as March of this year, additions have been as high as $72.9 billion.
More exciting than this, however, is the fact that the company continues to grow its brokerage business. In May alone, the company added $24.6 billion in net new assets, with core net new asset additions totaling $20.7 billion. Even though this is lower than what the company has historically achieved, it does still represent growth. This growth is likely attributable to the fact that the company continues to see additions to the number of brokerage accounts in its ecosystem. In the month of May, the firm added 314,000 brokerage accounts. This is actually within the range of what the company has achieved historically. In the last 13 months covered, Charles Schwab has seen between 278,000 and 386,000 new brokerage accounts added each month. And as of the most recent period covered, the firm had 34.31 million active brokerage accounts.
Takeaway
I understand why some investors may be concerned about Charles Schwab. There are certain aspects of the company that are not looking particularly great. In addition to this, the expectation from analysts is that the second quarter will have been a rather difficult time compared to what the company achieved last year. But when you look at the picture in its totality, you see an enterprise that is continuing to grow its asset base. Its overall ecosystem, in fact, continues to expand. The firm does need to work on paying down debt, and investors need to be prepared for the negative side effects associated with high interest rates to continue in the near term. But in the long run, I have no doubt that the company will make for a solid ‘strong buy’ prospect.
For further details see:
Charles Schwab: A Look At The Good And The Bad That's Right Around The Corner