2023-12-28 03:23:46 ET
Summary
- Charles Schwab's mismanagement of its bond portfolio and refinancing pressure may have impacted W&AM's earnings through 2023.
- But recent dovish projections of rate cuts in 2024 and 2025 could ease funding pressure for Schwab and support earnings.
- If the rate cut scenario plays out, pressure on Schwab's deposit migration might ease, potentially allowing the company to keep NII spread at $10 billion annually.
- I'm upgrading SCHW stock to a "Hold" rating, and I adjust my base case target price upwards to $59 per share (compared to $42.39 previously).
In a previous article , I have argued that Charles Schwab has mismanaged the duration in its securities bond portfolio, and refinancing at higher rates to meet client cash sorting demand will likely pressure the company’s earnings through 2025. This thesis was reinforced by the "higher for longer" narrative, suggesting that the Fed may maintain interest rates at elevated levels until 2025.
However, Charles Schwab's luck took a sharp turn in recent weeks: After the FOMC projections released on December 13, market participants have priced up to 175 basis points worth of cuts in 2024, followed by further rate cuts in 2025. If this scenario plays out, the pressure on Schwab's deposit migration might ease, potentially allowing the company to keep net interest earnings spread at approximately $10 billion annually, if not higher. Consequently, I'm upgrading SCHW stock to a "Hold" rating and I adjust my base case target price upwards to $59 per share (compared to $42.39 previously).
For context, Charles Schwab's stock performance has significantly underperformed the broader equities market year-to-date. Since the beginning of the year, SCHW shares are down about 16%, compared to a gain of almost 25% for the S&P 500 ( SP500 ).
Rate Cuts Ease Funding Pressure, Support Earnings
The level of interest rates is a major factor for Schwab's earnings dynamics, as I have previously explained :
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.
Approaching 2024, the outlook for interest rates changed significantly after the FOMC projections from December 13 clashed with the "higher for longer" narrative. Specifically, I point out that FOMC members sharply reduced their end-of-year 2023 inflation estimates compared to the comparable assessment from September: The consensus now anticipates inflation ranging between 2.8-2.9% YoY, a notable drop from the earlier range of 3.2-3.4% YoY. Meanwhile, GDP expansion projections jumped by about 50 basis points, rising from about 2.1% YoY in September to the current estimate of 2.6% YoY.
With a backdrop of expanding economic growth and a downward trajectory in inflation, FOMC participants made notable adjustments to their 2024 rate forecasts. The prevailing consensus now suggests approximately ~75 basis points of cuts over the next year, a significant change from the mere ~25 basis points in cuts projected as recently as September!
FOMC projections 2023 December
Perhaps even more notable than the FOMC pivot is the aggressive repricing of interest rates b< market participants: According to the CME fed funds tracker as of late December 2023, traders are presently foreseeing a notable 150 basis points in cuts by the end of 2024, potentially bringing rates to around 3.75%.
The discussion about rates matters a lot for SCHW investors, as a dovish shift in rates could safeguard the wealth & asset manager's net interest income. This argument anchors on a softened deposit beta and cash sorting/ migration activity. Or in other words, lower rates could substantially counterbalance the challenges from increased short-term funding pressure that has impacted Schwab's earnings narrative throughout 2023. On that note, I point out that Schwab's funding rates - as evidenced by CD rates - have already started to drop over the past 4-5 weeks, with the 10-18 months rate now only about 10 basis points above 5% (compared to about 5.7% in October). Source: UBS research note on US Brokers and Asset Managers, dated 22nd December: WM Rate Monitor.
In my current assessment, I anticipate Schwab's net interest income may stabilize within the range of $9.5-10 billion, which is only about $0.5-1 billion lower than the net interest income achieved over the trailing twelve months ($10.3 billion). Interest income accounts for about 55% of Schwab's total revenue. Lastly, lower interest rates should also be stimulating for Schwab's other businesses, with both transaction Mgmt. revenue (17%) and Asset Mgmt. & Advisory (37%) benefiting from higher capital markets transaction volume as well as an uptick in disposable income on an improving economic backdrop.
Supportive November Metrics
Another argument speaking in Schwab's favor relates to the insights released with the company's monthly metrics for November , with total assets jumping by 6.9% MoM. The net new asset inflows amounted to $19.2 billion, marking a 3.0% annualized growth. Moreover, there was an accelerated growth in net new brokerage accounts in November, with new registrations totaling 101,000, in line with a 3.5% annualized growth (compared to 1.1% in September).
Investors will certainly also appreciate that November metrics indicated an unexpected pivot in transactional cash balances, marking the first monthly increase in cash balances (about $5 billion) since the start of the hiking cycle. A positive MoM delta in transactional cash balances will set the stage for potentially larger paydowns of costly wholesale funding.
Valuation Update: Adjust Target Price To $59
Aligned with the revised forecast for the Fed Funds rate until 2025, I am updating my residual earnings valuation model for Charles Schwab stock: I now expect that SCHW's EPS in FY 2024 will range between $3.3 and $3.5 (vs. 3.5 previously). Similarly, I raise my EPS projection for FY 2025 to $4.2 (vs. 3.6 estimated before). Notably, my estimates are within +/-15% of consensus EPS data as collected by Refinitiv. I maintain a terminal growth rate of 2.25% post-2025, mirroring nominal GDP growth, as well as my cost of equity assumption of 8.75%.
Considering these adjustments in the model's input, my calculations now suggest a fair implied stock price for SCHW stock equal to $59, compared to $42.39 estimated previously.
Analyst Consensus; Company Financials; Author's Calculations
Below is also the updated sensitivity table.
Analyst Consensus; Company Financials; Author's Calculations
Investor Takeaway
Charles Schwab's mismanagement of its bond portfolio and refinancing pressure has impacted W&AM's earnings through 2023. But recent dovish projections of rate cuts in 2024 and 2025 could ease funding pressure for Schwab and support earnings power. If the rate cut scenario plays out, pressure on Schwab's deposit migration might ease, potentially allowing the company to keep NII spread at $10 billion annually. Concluding, I'm upgrading SCHW stock to a "Hold" rating; and I adjust my base case target price upwards to $59 per share (compared to $42.39 previously).
For further details see:
Charles Schwab Is Likely A Major Beneficiary Of 2024 Rate Cuts (Rating Upgrade)