2023-10-23 12:44:23 ET
Summary
- Charles Schwab reported a 44% YoY contraction in EPS for Q3, confirming concerns about earnings pressure.
- The company's stock has underperformed the market and is expected to continue trading lower.
- Schwab's earnings are being impacted by refinancing pressure and client cash sorting activity, leading to liquidity needs on higher interest rates.
- With Q3 insights and NIM visibility, my residual earnings model suggests a base-case target price for Schwab stock of about $42.39 per share.
Oct. 23, 2023 12:44 PM ET
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About: The Charles Schwab Corporation (SCHW)
Long/Short Equity, Growth At A Reasonable Price, Contrarian, Portfolio Strategy
Summary
Charles Schwab reported a 44% YoY contraction in EPS for Q3, confirming concerns about earnings pressure.
The company's stock has underperformed the market and is expected to continue trading lower.
Schwab's earnings are being impacted by refinancing pressure and client cash sorting activity, leading to liquidity needs on higher interest rates.
With Q3 insights and NIM visibility, my residual earnings model suggests a base-case target price for Schwab stock of about $42.39 per share.
previously SP500
Seeking Alpha
After a tumultuous Q2, Schwab reported a disappointing set of Q3 results, missing analyst consensus on both topline and GAAP earnings. During the period spanning June to end of September, Schwab generated about $4.6 billion of revenues, down 16% YoY compared to the same quarter one year earlier, and missing consensus by approximately $10 million (with analyst consensus being already quite bearish following the SVB collapse). For the trailing nine months, revenues are down 6% year over year.
In terms of profitability, Schwab posted $1.1 billion of GAAP net income, almost halved compared to the $2 billion achieved one year earlier (-44%, and even lower than what most – already bearish analysts – expected, missing by about $100 million (-10%). To give some more context about the company’s profitability: pre-tax profit margin dropped 1,860 basis points, to 30% versus 48.7% in Q3 2022; return on tangible common equity dropped 1,600 basis points, respectively, to 58%.
Schwab Q3 2023 reporting
challenging economic and geopolitical backdrop
citing
... a period where the U.S. government narrowly avoided a shutdown, major equity markets posted a quarterly loss, and long-term interest rates touched levels not seen in many years.
While connecting Schwab’s underperformance to a challenging economic backdrop may be convincing to some, I do not see it that way. I would remind investors that market turbulences are usually very volume accretive to trading, while uncertainty is accretive to wealth management, while higher interest rates are accretive to income from margin lending. In that context, Schwab should have been able to capture at least some of the upside. Other giants in the financial services industry such as J.P.Morgan Chase, Citi and Wells Fargo posted very strong results for the September quarter. And e-brokerage competitor Interactive Brokers blew earnings estimates out of the park on a 58% YoY jump in net interest income from margin lending.
On a more positive note, Schwab managed to accumulate $46 billion in core net new assets, with a substantial $27 billion influx occurring in September following the successful Ameritrade client conversion. Year to date, Schwab has now captured an impressive influx of $248 billion in core net new assets, translating into an annualized organic growth rate of over 6% YoY. As of September 30, Schwab’s clients have entrusted the company with a total of $7.82 trillion in assets, distributed across 34.5 million accounts.
Financing Pressure Still The Major Headwind, Albeit Easing
Schwab's earnings are down in Q3 2023 YoY, and this is largely a function of the bank's refinancing and liquidity need connected to client cash sorting activity. As interest rates started to rise, and billions worth of Schwab client deposits started chasing higher-yielding investment opportunities, Schwab was left to meet the liquidity demand financing its balance sheet with CDs and other instruments, reportedly paying well above 5% in interest. Meanwhile, a large share of Schwab's liquid assets is invested in securities whose interest yield carries memory from the low/-zero rate environment leading up to COVID. Needless to say, this dynamic puts pressure on Schwab's earnings.
With the frame of reference above, Deutsche Bank's equity research team led by Brian Bedell, CFA (research note on SCHW dated 16 October) did an excellent job visualizing how Schwab's clients have gradually and consistently drawn down deposits held with the company -- and the outflow still continues, albeit now at a slowing pace. It is also interesting to see how strongly deposit outflows are correlated to money market inflows.
Deutsche Bank Equity Research
Residual Earnings Model
With balance sheet adjustments slowing, and management highlighting a path towards 2025 NIM projections, I feel confident valuing Schwab stock based on a residual earnings model. As per the CFA Institute :
Conceptually, residual income is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company's capital.
With regard to my Charles Schwab stock valuation model, I make the following assumptions:
- To forecast EPS, I anchor on the consensus analyst forecast as available on the Bloomberg Terminal 'till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework. But for 2-3 years, the analyst consensus is usually quite precise.
- To estimate the capital charge, I anchor on Schwab's cost of equity at 8.75%.
- For the terminal growth rate after 2025, I apply 2.25%, which I believe is a reasonable estimate post-2025 (approximately in line with U.S. nominal GDP growth).
- Investors with different assumptions regarding Schwab's cost of capital and terminal growth may take reference from the sensitivity table enclosed.
Given the above assumptions, I calculate a base-case target price for Schwab stock of about $42.39/share, suggesting 15% downside.
Company Financials; Author's EPS Estimates; Author's Calculation
Company Financials; Author's EPS Estimates; Author's Calculation
In my prior analysis of Charles Schwab, I raised concerns about the management of the duration in its securities bond portfolio and the potential earnings pressure resulting from refinancing needs at higher interest rates and client cash sorting activity. After reviewing Schwab's Q3 results, my previous thesis appears to be on track, with the company reporting a 44% YoY contraction in EPS. The earnings pressure continues to be mainly anchored on headwinds from financing, which are expected to remain quite sticky, only gradually fading through 2025. With Q3 insights and NIM visibility, my residual earnings model suggests a base-case target price for Schwab stock of about $42.39 per share, indicating approximately 15% downside. As a consequence, I continue advising to avoid SCHW stock.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
not financial advise
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I have previously argued that Charles Schwab has mismanaged the duration in its securities bond portfolio, and refinancing pressure at higher rates to meet client cash sorting demand will likely pressure the company’s earnings through 2025. Now, after Schwab reported Q3 results, I revisit my thesis; And with Schwab posting a 44% YoY contraction in EPS, I feel broadly confirmed in my assessment that the earnings thesis is playing out as expected. That said, SCHW stock has underperformed the broader market YTD, with the stock down about 37% compared to a gain of 12% for the S&P 500 ( SP500 ). Over the next 12-18 months, I see SCHW stock gradually trading lower still, approaching my newly set target price of $42.39/ share.
Seeking Alpha
Schwab’s Q3 - Review
After a tumultuous Q2, Schwab reported a disappointing set of Q3 results, missing analyst consensus on both topline and GAAP earnings. During the period spanning June to end of September, Schwab generated about $4.6 billion of revenues, down 16% YoY compared to the same quarter one year earlier, and missing consensus by approximately $10 million (with analyst consensus being already quite bearish following the SVB collapse). For the trailing nine months, revenues are down 6% year over year.
In terms of profitability, Schwab posted $1.1 billion of GAAP net income, almost halved compared to the $2 billion achieved one year earlier (-44%, and even lower than what most – already bearish analysts – expected, missing by about $100 million (-10%). To give some more context about the company’s profitability: pre-tax profit margin dropped 1,860 basis points, to 30% versus 48.7% in Q3 2022; return on tangible common equity dropped 1,600 basis points, respectively, to 58%.
Schwab Q3 2023 reporting
Schwab Co-Chairman and CEO Walt Bettinger attributed the muted Q3 results to a
challenging economic and geopolitical backdrop
citing
... a period where the U.S. government narrowly avoided a shutdown, major equity markets posted a quarterly loss, and long-term interest rates touched levels not seen in many years.
While connecting Schwab’s underperformance to a challenging economic backdrop may be convincing to some, I do not see it that way. I would remind investors that market turbulences are usually very volume accretive to trading, while uncertainty is accretive to wealth management, while higher interest rates are accretive to income from margin lending. In that context, Schwab should have been able to capture at least some of the upside. Other giants in the financial services industry such as JPMorgan Chase, Citi and Wells Fargo posted very strong results for the September quarter. And e-brokerage competitor Interactive Brokers blew earnings estimates out of the park on a 58% YoY jump in net interest income from margin lending.
On a more positive note, Schwab managed to accumulate $46 billion in core net new assets, with a substantial $27 billion influx occurring in September following the successful Ameritrade client conversion. Year to date, Schwab has now captured an impressive influx of $248 billion in core net new assets, translating into an annualized organic growth rate of over 6% YoY. As of September 30, Schwab’s clients have entrusted the company with a total of $7.82 trillion in assets, distributed across 34.5 million accounts.
Financing Pressure Still The Major Headwind, Albeit Easing
Schwab's earnings are down in Q3 2023 YoY, and this is largely a function of the bank's refinancing and liquidity need connected to client cash sorting activity. As interest rates started to rise, and billions worth of Schwab client deposits started chasing higher-yielding investment opportunities, Schwab was left to meet the liquidity demand financing its balance sheet with CDs and other instruments, reportedly paying well above 5% in interest. Meanwhile, a large share of Schwab's liquid assets is invested in securities whose interest yield carries memory from the low/-zero rate environment leading up to COVID. Needless to say, this dynamic puts pressure on Schwab's earnings.
With the frame of reference above, Deutsche Bank's equity research team led by Brian Bedell, CFA (research note on SCHW dated 16 October) did an excellent job visualizing how Schwab's clients have gradually and consistently drawn down deposits held with the company -- and the outflow still continues, albeit now at a slowing pace. It is also interesting to see how strongly deposit outflows are correlated to money market inflows.
Deutsche Bank Equity Research
To be fair, following a brief surge in cash sorting activities observed in August, the rate of activity significantly decelerated in September. Client deposits on the balance sheet only saw an approximate $5 billion outflows in September, in contrast to the $16 billion outflow in August. With cash sorting activity also somewhat supported by the gradual maturing of Schwab's securities portfolio, the wealth management and brokerage giant managed to reduce the amount of outstanding supplemental funding. By the end of the third quarter in 2023, the FHLB balance stood at $31.8 billion, reflecting a $9.2 billion decrease from the end of the second quarter. CDs, however, still remained at levels in line with Q2, at roughly $44.5 billion. Thus, overall, Schwab's net interest income remained pressured, with 3Q NIM being reported at only 1.94%. According to management guidance, it will likely take two years of gradual the "temporary borrowing" redemption, and resumption of securities portfolio reinvestments, until the company's NIM strengthens back to (hopefully) 3.00% by the end of 2025.
Residual Earnings Model
With balance sheet adjustments slowing, and management highlighting a path towards 2025 NIM projections, I feel confident valuing Schwab stock based on a residual earnings model. As per the CFA Institute :
Conceptually, residual income is net income less a charge (deduction) for common shareholders' opportunity cost in generating net income. It is the residual or remaining income after considering the costs of all of a company's capital.
With regard to my Charles Schwab stock valuation model, I make the following assumptions:
- To forecast EPS, I anchor on the consensus analyst forecast as available on the Bloomberg Terminal 'till 2025. In my opinion, any estimate beyond 2025 is too speculative to include in a valuation framework. But for 2-3 years, the analyst consensus is usually quite precise.
- To estimate the capital charge, I anchor on Schwab's cost of equity at 8.75%.
- For the terminal growth rate after 2025, I apply 2.25%, which I believe is a reasonable estimate post-2025 (approximately in line with U.S. nominal GDP growth).
- Investors with different assumptions regarding Schwab's cost of capital and terminal growth may take reference from the sensitivity table enclosed.
Given the above assumptions, I calculate a base-case target price for Schwab stock of about $42.39/share, suggesting 15% downside.
Company Financials; Author's EPS Estimates; Author's Calculation
My base case projection for SCHW's target price implies downside. However, it is crucial for investors to evaluate the risk and reward ratio of investing in a company based on a 'scenario' view. To assess different scenarios based on various assumptions, I have created a sensitivity table that analyzes SCHW's cost of equity and terminal growth rate. See below.
Company Financials; Author's EPS Estimates; Author's Calculation
Conclusion
In my prior analysis of Charles Schwab, I raised concerns about the management of the duration in its securities bond portfolio and the potential earnings pressure resulting from refinancing needs at higher interest rates and client cash sorting activity. After reviewing Schwab's Q3 results, my previous thesis appears to be on track, with the company reporting a 44% YoY contraction in EPS. The earnings pressure continues to be mainly anchored on headwinds from financing, which are expected to remain quite sticky, only gradually fading through 2025. With Q3 insights and NIM visibility, my residual earnings model suggests a base-case target price for Schwab stock of about $42.39 per share, indicating approximately 15% downside. As a consequence, I continue advising to avoid SCHW stock.
For further details see:
Charles Schwab: Avoid, As Earnings Pressure Haunts Outlook