2023-04-12 08:40:37 ET
Summary
- Recent rate hikes have further fueled the previous trend of customers transferring their assets from low-yielding The Charles Schwab Corporation sweep accounts to higher-paying ones.
- The bank deposit account balances could fall below $100 billion by the end of the first quarter from $126.6 billion at the end of December 2022.
- Charles Schwab faced several difficulties in the first quarter: negative sentiment among investors, increasing interest rates, and the disruption experienced by regional banking sectors.
- Those investors who are in SCHW for long-term growth could lock in a 2% dividend yield with an attractive valuation.
- What do you expect to see in the first quarter results?
Investment thesis
The Charles Schwab Corporation ( SCHW ) will report its first-quarter earnings on April 17 before the market opens. Investors are keen on seeing the numbers in these difficult times to assess the exact impact of the deposit account shifts and its consequences on net interest margin and profitability for the upcoming quarters. I do not expect big outflows of client funds but massive asset restructuring within client accounts which will hurt the company’s profit margins and bottom line. The aggressive rate hikes have made capital very expensive which will also have a negative impact on its earnings. However, I see a stable long-term picture with steady growth after the external trends move in favor of the company from the third or fourth quarter of the year.
Charles Schwab Q1 Earnings preview
At the end of 2022, The Charles Schwab Corporation saw remarkable results in terms of growth with $128 billion of net new assets collected in the fourth quarter. This translates to an impressive annualized organic growth rate of around 8%. The next couple of quarters is likely not to be so great. Revenue for the fourth quarter was reported to be $5.50 billion, which was less than the $5.55 billion estimate, but remaining stable compared to the previous quarter. The interest-earning assets have been on the decline since the aggressive rate hikes, in December 2022 the average interest-earning assets amounted to $520 billion, which was a 14% decrease on a Y-o-Y basis. I expect this trend to continue throughout the year, especially in the first and second quarters. Charles Schwab sweeps excess cash from customers into its bank accounts and pays them minimal interest. However, the brokerage firm makes a considerable profit from this approach.
Recent rate hikes have changed the course of this trend and customers transferring their assets from low-yielding Schwab sweep accounts to higher-paying ones. This will have a significant impact on the company’s earnings because it generates two-thirds of its income from NII on deposits. Capital has become much more expensive than a year ago and its cost is continuing to rise. I expect the capital cost to peak in the third quarter of 2023 based on the current Fed rate hike projections . The increased cost of capital caused interest rates on loans to go up, as well as on deposits hurting SCHW’s net interest margin. Charles Schwab has to pay approximately 7.5-8.5x more for deposits since the Fed began increasing interest rates. Schwab relies heavily on the net interest income it receives from deposits, therefore any difficulties faced in the process of cash sorting could have a detrimental effect on its profit margin. Investors will see the exact impact in just a couple of days in the earnings report.
SCHW illustrative net yield (aboutschwab.com/cfo-commentary)
The bank experienced some outflows in January and February, but the majority of the cash movement was mainly inside transfers from bank deposit accounts to money market accounts. The good news is that client deposits are not leaving the firm. The bad news is that SCHW earns significantly less on money market accounts than on deposit accounts.
During March, at the height of the banking crisis, the company made several statements that highlighted that their position is stable and more than 97% of their deposit account are insured accounts to calm investors. They also stated that they experienced an enormous influx of core net new client assets totaling over $53 billion , which is the second-highest March results in the company’s history. It means to me and most investors that SCHW’s position is stable and will remain stable. Despite the short-term turmoil due to high-interest rates and its direct impact on funding costs and declining profits, the long-term picture looks secure. As the cost of funding start to decrease possibly around the third or fourth quarter of the year, SCHW business’ natural growth will flourish and should result in a steady rise in profits in the long term.
However, the short-term picture and the first quarter earnings look rather turbulent than stable. Schwab was one of the many financial firms that suffered losses (share price) due to its significant amounts of long-term bond investments. A month ago investors were worried that SCHW may be forced to liquidate its assets earlier than anticipated, leading to significant losses just like SVB but it was not the case. SCHW has a completely different business model and in addition, they have adequate liquidity and a low loan-to-deposit ratio. The management did not have to liquidate held-to-maturity securities to honor deposit withdrawals. We do not know the exact deposit outflow numbers just yet for the first quarter but I estimate that it was minimal and the future risk of significant outflows is insignificant. The client assets rather moved between accounts rather than direct outflows from the firm.
Q1 Earnings Estimates
In recent weeks, quite a few analysts slashed the price target for The Charles Schwab Corporation due to the same reasons I highlighted above. A Citi analyst lowered his target price to $65 from $75, and a Morgan Stanley analyst cut his target price to $68 from $99. The EPS estimates are also down from previous projections, the current EPS estimate for the first quarter is around 0.91-0.93. A decrease in deposits in the company’s highly profitable sweep accounts is very likely. At the end of the fourth quarter, these deposits amounted to $367 billion which was a 17% decline Y-o-Y and a 7% drop Q-o-Q. In my opinion, the bank deposit account balances could fall below $100 billion by the end of the first quarter from $126.6 billion at the end of December 2022 which would mean a 26.6% decline.
I believe, and the figures show this so far, that most of the client asset movements could have happened between accounts rather than direct outflows from the firm. Due to this, I anticipate that the outflows from the bank deposit account moved to money market funds possibly reaching more than $355 billion by the end of the first quarter meaning it will likely be up by 25.9% Q-o-Q. The total money market funds will likely take up 40-42% of cash balances in Q1, which is 10% higher than in Q4 and 24% higher on a Y-o-Y basis. I also expect this trend to continue until the third quarter of 2023. By then the money market funds could reach $400-420 billion while the bank deposit account balances could decline below $75 billion. These customers’ cash movements out of sweep accounts into money market funds means that Schwab earns less from monetizing cash, which will hurt earnings on top of higher funding costs both in the first and second quarters of 2023.
SCHW Stock Valuation
As we can see the upcoming quarters for SCHW are far from great but the long-term picture seems stable and secure. The question is: should investors buy now or wait until the second half of 2023 when the macro trends move in favor of SCHW? I am a bit pessimistic over the short term, I do not believe that SCHW is a great choice because there are too many risks, tightening profit margins, and fewer assets to earn money on. Even though at the height of the banking turmoil billionaire investor Ron Baron and SCHW’s CEO both purchased SCHW shares. However, they are not in for a quick buck, but for the long-term rebound of the company with which I agree. Looking at a DFC valuation SCHW’s intrinsic value is around $100 per share. I calculated a 7% discount rate and a terminal growth of 3% for 5 years.
In addition, long-term investors could buy SCHW with a record dividend yield due to 2 reasons. The management increased the dividend at the end of January by 13.6% and the stock price has plummeted to $50 from its $75-80 territory. However, its ttm yield seems only 1.7% the forward dividend yield is almost 2%. It is one of the rare occasions this happened so investors can lock in a good deal. For investors who already had SCHW before the crash, it seems it will need a minimum of a year but rather 5-6 quarters to recover to its $75-80 territory in my opinion due to short-term fundamental difficulties.
Final thoughts
Despite the difficult first quarter, and very likely a difficult second quarter as well, with negative sentiment among investors, increasing interest rates, and the disruption experienced by regional banking sectors, The Charles Schwab Corporation's customer-oriented growth strategy is still stable and is delivering good results. The short-term issues will likely solve themselves as the tide turns, interest rates start to come down and the macroeconomic environment changes in favor of the company. Short-term traders and investors should be cautious in the next 4-5 months with The Charles Schwab Corporation. For those with long-term investment objectives, the current levels could be an attractive entry point.
For further details see:
Charles Schwab Earnings Preview: Short-Term Pain, Long-Term Gain