2023-07-28 13:30:00 ET
Summary
- Charles Schwab's Q2 FY23 results have compelled me to do a 180-degree turn in my stance on the stock; from a 'sell' to a 'strong buy'.
- Cash sorting issues are no more as there has been a sharp reduction in net new purchased money market fund flows.
- There are multiple levers for margin expansion. Reduction in high cost short-term borrowings is expected to boost NIMs, and expense reduction is another margin lever.
- Valuations are attractive as the stock trades at a 12.2% discount to its long-term PE.
Thesis change
I had a sell rating on Charles Schwab ( SCHW ) as of my latest article last month. Q2 FY23 results have proved me wrong and compelled me to do a 180-degree switch in my positioning on the stock. This resulted in a negative alpha of 19.5% on the stock (SCHW return of 23.39% vs S&P 500 ( SPY ) ( SPX ) ( VOO )'s return of 3.89% since my last update).
A core piece of my earlier view was that the consensus view on revenues was set for disappointment; management had guided for a 10-11% YoY revenue decline, but consensus was only building in a smaller 7.8% YoY decline.
Before the Q2 earnings release, the Street had downgraded their expectations as consensus had pegged $4.6 billion in revenues, which corresponded to a 9.5% decline. However, Charles Schwab beat both its earlier guidance and consensus expectations as it posted an 8.4% YoY decline in Q2 revenues:
My new thesis rests on 3 legs:
- Cash sorting issues are no more
- There are multiple levers for margin expansion
- Valuations support the bullish momentum
Cash sorting issues are no more
Net new purchased money market fund flows (which represents flows away from higher interest-earning bank deposits into the lower interest-earning money market funds) posted a sharp decrease to $10 billion in June. This is much lower than the $16-17 billion that I had estimated based on mid-June data. Management also noted that this reduction would have been larger if not for net equity purchase inflows in June:
And the reduction [in deposit flows] would have been even more significant or not for a large reversal in client equity allocations from sales in May to net purchases in June.
- CFO Peter Crawford in the Q2 FY23 earnings call
I believe this puts a clear nail in the coffin for cash-sorting headwinds. And this clears the way for net interest margin ((NIM)) expansion to roll forward:
There are multiple levers for margin expansion
To fund higher interest payments caused by cash sorting movements, Charles Schwab has had to draw more upon more short-term borrowings, which are a higher cost of funding:
Over the past 2 quarters, an increase in short-term borrowings has been a key contributor to NIM contraction from 217bps to 175bps:
However, the company is set for strong NIM expansion going forward, driven by a peak in short-term borrowings reliance. In the Q2 FY23 earnings call, the CFO told investors that there have been no new short-term borrowings since May 2023. Importantly, the decline in shorter-term, supplemental funding is expected to continue over the quarters ahead:
And as client cash realignment continues to slow and eventually reverses, we'd expect those supplemental funding balances to continue to decline over the next 18 months and be mostly paid off by the end of 2024. And this means that they should not really be a factor in our earnings picture in 2025 and beyond.
- CFO Peter Crawford in the Q2 FY23 earnings call
Due to this tailwind, I believe there is a strong case for NIM expansion ahead. As an added bonus, Charles Schwab is also expected to realize an additional $500 million in future expense savings. For a sense of magnitude, this corresponds to 2.2% of the total expenses over the last twelve months (LTM).
Valuations support the bullish momentum
To support the constructive margin expansion story, the valuations also seem attractive:
Charles Schwab is currently trading at a 1-yr fwd PE of 19.1x, which corresponds to a 12.2% discount to the long-term average PE of 21.8x. The combination of my expectations of bullish margin expansion and a discount valuation compel me to change my stance to a 'strong buy'.
Key risks and monitorable
My core thesis on Charles Schwab relies on margin expansion tailwinds playing out. Key monthly metrics showing flows of funds will be a key monitorable as they are leading indicators of net margin expansion components; interest revenue and interest expense. Hawkish rates over the longer term may also be a risk if that means Charles Schwab renews its investments at lower rates, thus undermining NIMS. This is something the company management is banking on, and hence if the Fed plays spoilsport here, that can instigate a review of the thesis:
... investing new money and reinvesting principal and interest from our existing securities portfolio at rates
- CFO Peter Crawford in the Q2 FY23 earnings call
Changing my mind
I was wrong-sided in my stance on Charles Schwab. I thought the street was being too optimistic after the company's revenue downgrade for Q2 FY23. However, what I missed was that the consensus revised their expectations downwards later on. And Charles Schwab comfortably beat both its guidance and consensus views.
One of the key drivers of this sharp improvement was a material reduction in cash sorting movements. June's net new purchased money market fund flows of $10 billion number came in much lower than the $16-17 billion I was expecting based on the mid-June run-rate. Even better is management's admission that the reduction in deposit flows would have been even lower if not for net equity purchases in June. This made it clear that the cash sorting issues that have plagued the stock since February this year is officially over.
And that has opened the way for strong net interest margin ((NIM)) expansion to take place, driven by a reduced reliance in more costly short-term borrowings. I believe this, combined with an additional $500 million in opex cost savings positions the company well for multiple quarters of margin expansion.
The stock still trades at a 12.2% discount to the long-term average PE multiples. Hence, I change my stance to a 'Strong Buy'.
For further details see:
Charles Schwab: Get Ready For Multiple Quarters Of Margin Expansion (Rating Upgrade)