2023-04-18 11:49:43 ET
Summary
- The in-line 1Q23 financial performance shows fundamentals not as bad as feared as net revenues, pre-tax profit margin and EPS grew.
- Based on their models, management expects the pace of client cash realignment activity was stabilizing and expects it to end sometime in 2023.
- The outlook for the second quarter implies mid to single digit percentage declines in revenue as a result of the temporary higher cost of funding.
- Management assured investors that it had more than ample liquidity, a diversified and safe client cash balance and a conservative and consistent asset portfolio.
- I think that Charles Schwab remains compelling from a risk/reward perspective. My 1-year price target for Charles Schwab is $89.15, implying 69% upside from current levels.
Charles Schwab ( SCHW ) just reported its first quarter 2023 results and I have looked through the earnings results and listened in to the details in the management call. This article summarizes my view on how Charles Schwab did in the first quarter and where it will head in the next year.
For members of Outperforming the Market, I published an earlier article detailing why I thought that there was an excellent contrarian opportunity with Charles Schwab at the current attractive risk/reward level.
In-line 1Q23 financial performance shows fundamentals not as bad as feared
Even in a difficult environment due to the banking industry turmoil, Charles Schwab posted results that were in-line with expectations.
Net revenues in the first quarter of 2023 was up 10% to $5.1 billion, while adjusted net income was up 12% to $1.8 billion. Pre-tax profit margin in the first quarter reached 45.8%, up 1 percentage point from the prior year and adjusted EPS grew 21% to $0.93.
Charles Schwab Financial Performance 1Q23 (Author generated)
The question is then what resulted in the net interest revenue increase.
The answer lies in the higher net interest margin as a result of the higher yield received on its interest earning assets while controlling the interest cost on its interest bearing liabilities. The yield on interest bearing assets increased from 1.38% in 1Q22 to 3.09% in 1Q23. This helped to offset the 20% decline in the total interest earning assets declined to $504 billion.
Net interest revenue breakdown for Charles Schwab (Charles Schwab IR)
On the balance sheet front, as a result of client cash realignment trends, the bank deposits were down 11% year on year. The pace of average daily bank sweep flows in March has slowed considerably compared to the start of the year, as I will explain further below based on management commentary. What this means is that management expects that the client cash realignment trend to stabilize in the next quarter or two. In addition, management had to increase FHLB and short-term borrowings that had a higher cost of funding as a temporary measure as a result of the unprecedented and unanticipated pace at which clients were reallocating their cash.
Lastly, the tier 1 leverage ratio at the end of the quarter was at 7.1% and above the company's own operating objective of between 6.5% to 6.75%. This is also well above the current regulatory minimum and if capital requirements were to become tougher, the company expects that it can build incremental capital from its regular operations due to its highly profitable growth model. Management expects that at a non-GAAP pre-tax margin of 40% or more, it would take 10 consecutive quarters for the company to meet the stricter capital requirement.
Record core Net New Assets in 1Q23 evidence of strong trust in Charles Schwab in volatile times
In the first quarter of 2023, despite the banking turmoil and volatility, Charles Schwab actually grew core net new assets by $132 billion. The other important thing to note is that the pace at which net new assets grew accelerated from January's $32 billion to $54 billion in March.
Core Net Assets and Money Market Funds Net Buy (Author generated, quarterly reports)
Furthermore, when looking at the organic core NNA growth rate, in the first quarter, the growth rate reached 7.6%, which implies that the organic core net new assets growth rate was at one of the highest points since 2009.
Organic core NNA growth rates (Charles Schwab IR)
In the earnings call, management also gave commentaries on the daily Schwab cash movements. In February, that figure was less than in January. In March, that figure was also less than in February. And as of the first half of April, the figure for April is also expected to be measurably lower than in March.
Significant liquidity available to the company from different sources
The main point here is that with all the liquidity available to the company, it does not foresee a scenario where it needs to sell a single security for liquidity needs.
The company currently has about $100 billion in organic liquidity from its cash on hand, principal and interest payments from its investment portfolio and net new assets expected to come in over the next year.
The company has long been planning for periods where it would require more liquidity and thus have been reserving its CD and FHLB capacity.
In any case, retail CDs, DHLB advances and other short-term borrowings will provide Charles Schwab with the necessary capital needed temporarily. As these funds have a higher cost of funding, this is typically seen as a supplemental and temporary source of funding.
Lastly, while management does not see a scenario where the company might need it, Charles Schwab has access to more than $300 billion in additional liquidity from the Federal Home Loan Bank ("FHLB") and the Bank Term Funding Program.
Client cash balances
Charles Schwab's client cash balances are also safe and diversified. 86% of the company's bank deposits are within FDIC insurance limits. On top of that, client bank deposits come from Charles Schwab's large and diverse brokerage client base. There are more than 34 million accounts today which includes individual investors and advisors.
Charles Schwab's management mentioned with confidence in the call multiple times that they see that based on their models and forecast and what they are seeing on the daily basis, there are early signs that cash realignment is moderating and could end sometime in 2023. As noted below, transactional cash per account reached $10.4k in March 2023, below levels seen in March 2004 and management is using transactional cash balance trends to predict how much downside there is left in terms of cash realignment.
Transactional Cash Balance Trends (Charles Schwab IR)
Unrealized losses on securities
The message that management was trying to get across was clear: Charles Schwab has been managed the same way it has been for more than two decade, by managing assets conservatively and consistently.
It has focused on its strategy of deploying its cash balances beyond that required for client demand into liquid, high quality investment securities.
There is minimal credit risk on its balance sheet and it has maintained the same duration policy for years. Management stated that it did not extend duration during the pandemic by taking on additional duration risk as it stayed within its own normal duration limit of between 2.75 years to 4 years.
When interest rates started to rise aggressively, Charles Schwab's investment securities portfolio had a duration of about 3.5 years.
As they saw that the tightening cycle was beginning, the company started to increase its cash on bank by more than $60 billion.
Its current loan to deposit ratio is 12%, while its realized loan losses were less than 0.25% and its portfolio is made up of 85% to 90% securities that are backed by the US government or agency.
With better transparency into Charles Schwab's portfolio and what exactly happened in the past year, I am more confident in the quality of the Charles Schwab's securities portfolio. While there were some things that could have been done better in hindsight like lowering duration to the lower end of its duration limit and increasing more cash on hand as the tightening cycle started, hindsight is 20/20 and what management has done is to ensure consistency and conservatism in its asset portfolio.
How has the outlook changed?
As a result of the unprecedented and unanticipated pace at which clients realigned their cash allocations, Charles Schwab had to increase the use of higher cost of funding sources like retail CDs and FHLB advances.
Management emphasized that the use of these higher cost funding sources will be temporary and that most of it are expected to be repaid by the end of 2024. These higher cost liabilities have less than nine months in weighted tenor.
This leads to the expectation that Charles Schwab's second quarter 2023 revenue to decline mid to high single digit percentage points relative to the second quarter of 2022.
Arguably, I think that this expected decline in the second quarter 2023 revenue is actually less than I had initially feared.
In fact, management also emphasized that the near-term headwinds are not expected to change their long-term margins expectations as they expect that the net interest margin will steadily improve through 2023 and expected to reach 3% by the end of 2025.
While listening in on the earnings call, management did sound confident that the near-term headwinds does not affect the long-term business and that these near-term headwinds should dissipate over the subsequent seven quarters.
On the cost end, management remained disciplined to controlling expenses while balancing its need to reinvest for future growth. In 2024, from the integration of the Ameritrade transaction, management expects to be able to reap in excess of $500 million in cost synergies from the transaction, with the total cost synergies from the acquisition of TD Ameritrade expected to be $1.8 billion to $2 billion. The completion of the integration is expected to be on track, finishing in the first half of 2024.
Valuation
I think that Charles Schwab remains compelling from a risk/reward perspective.
At the 12x 2024F P/E that Charles Schwab is currently trading at, it is trading at a 50% discount to its average 5-year P/E of 24x. Rerating in its current P/E towards its longer-term average can already bring a 100% return.
At the same time, Charles Schwab is expected to grow at a CAGR of at least 10% in the next 5-year period.
Adding the EPS upside and the P/E rerating upside, there is almost a three bagger opportunity here in a 5-year time frame.
As highlighted before, the trough P/E during the 5-year period from 2018 to 2022 was 10.6x P/E in 2020 and in the Great Financial Crisis, the trough P/E was around 10.1x.
Thus, I do think that the company is trading close to its trough P/E with relatively limited downside while strong upside potential.
To derive my 1-year price target for Charles Schwab, I used a cost of equity of 10% and terminal 2026 P/E of 24x. I used the 24x P/E as the terminal P/E because that is the average 5-year P/E for Charles Schwab and it is reasonable for the company to revert back to it when the sentiment improves.
My 1-year price target for Charles Schwab is $89.15, implying 69% upside from current levels.
Risks
Challenging economic backdrop
If the economy were to slowdown, this will affect account growth and asset levels. There is downside risk if the macroenvironment were to worsen, driving higher than expected losses
Regulatory headwinds
As a result of the regional banking turmoil, there has been increased scrutiny on the more relaxed regulatory environment for smaller banks. As a result, there may be near-term regulatory headwinds that could result in near-term revenue or costs headwinds.
Capital market activity
If there is a dramatic slowing in capital market activity levels or weaker trading volume, this could lead to lower trading revenues. Trading revenues make up around 17% of Charles Schwab's total net revenues so a slowdown in capital market activity could bring further pressure to the stock.
Conclusion
After reviewing the 1Q23 results and listening in closely to what management had to say about the fundamentals and the outlook of Charles Schwab, I have actually increased my conviction on the contrarian investment thesis on the company.
The fact that the first quarter 2023 results were in-line with expectations showed that the company was in a better shape than initially feared. Charles Schwab continued to see strong core net new assets in 1Q23 of $132 billion. Furthermore, the core net new assets growth was one of the strongest over the past decade and the core net new assets steadily increased from January 2023 to March 2023.
Management did a good job conveying confidence to the capital markets as it assured investors that it had more than ample liquidity, a diversified and safe client cash balance and a conservative and consistent asset portfolio.
Management's outlook suggests single to mid-single digit percentage point decline in revenues while net interest margin is expected to steadily improve through 2024. While there are near-term headwinds in the form of higher cost of funding, management is confident that this will dissipate by the end of 2024 and management looks to remain disciplined on the cost front as well.
My 1-year price target for Charles Schwab is $89.15, implying 69% upside from current levels.
For further details see:
Charles Schwab: Increasing Conviction In The Contrarian Investment Thesis