2023-04-19 08:09:07 ET
Summary
- Charles Schwab presented Q1 earnings yesterday.
- The firm's core business is very healthy and continues to attract core net new assets.
- The best reason to buy shares of Charles Schwab right now is the valuation.
Charles Schwab ( SCHW ) submitted its earnings sheet for the first-quarter yesterday and the financial brokerage company beat analysts' Q1'23 EPS expectations on the bottom line while slightly missing on the top line. While Charles Schwab lost $41B in deposits in the first-quarter due to higher interest rates, the financial services firm is overall doing great, posting profits of $1.6B in a quarter of severe stress in the financial system. I believe that Charles Schwab has considerable rebound potential in FY 2023 as fears over a new financial crisis subside and that the risk profile for the brokerage’s shares is extremely attractive.
Long position
I started a long position in Charles Schwab after the sell-off in March, the reasons of which I detailed here: Charles Schwab: This Is A Unique Opportunity To Be Greedy . The key reason for me to buy Charles Schwab was the fundamentally sound business model, strong franchise value and attractive valuation.
Charles Schwab beats earnings and is seeing deposit outflows
Earnings expectations for Charles Schwab have not been high ahead of the earnings release as the market already expected net deposit outflows as investors moved bank deposits into higher-yielding options such as money market funds. At the end of March, Charles Schwab’s total money market funds totaled $360.7B, showing a year over year increase of 132%. Charles Schwab has the Fed to thank for the outflow of deposits as investors sort their cash and ditch traditional bank deposits.
Charles Schwab's attraction of new client assets is a key competitive strength for the financial services company and the financial crisis didn't damage Schwab's ability to grow its asset base. As a matter of fact, Charles Schwab attracted more assets in the first-quarter than in most quarters in the past. Historically, the client asset acquisition growth rate has been around 5-7% whereas in Q1'23 it accelerated to 7.6%.
While Charles Schwab lost $41B in total deposits in the first-quarter, showing a decline of 11% quarter over quarter, the financial services firm still did quite well, all things considered, and beat earnings estimates.
For Q1’23, Charles Schwab reported adjusted earnings of $0.93 per-share which beat the consensus figure of $0.90 per-share by three cents. The firm fell short of top line expectations by reporting revenues of $5.12B, missing the forecast by $10M.
What stands out from Charles Schwab’s Q1’23 earnings sheet is that the firm saw strong and resilient profitability in its core business. Despite a truly tumultuous first-quarter which saw the market panicking about another financial crisis, Charles Schwab’s brokerage business delivered $1.6B in earnings which translates to a huge pre-tax profit margin of 41%. The company’s top line showed 10% year over year growth while adjusted EPS was up a solid 21% year over year.
Source: Charles Schwab
Fundamentally profitable business model
As a brokerage, Charles Schwab benefits from market volatility as it makes money from trading activity and other related services. The key benefit of an investment in Charles Schwab, in my opinion, is that the financial services company is running an extremely profitability franchise that has profit margins of close to 50%. In Q1'23, Charles Schwab's profit margin, on an adjusted level, was 45.8%, showing 1 PP growth year over year. The business as a whole, as I laid out in the prior section, has seen overall robust growth in the first-quarter, despite the broader implications of Silicon Valley Bank's shutdown.
Source: Charles Schwab
Charles Schwab has grown its revenues at a quicker pace after the acquisition of rival broker TD Ameritrade in 2019 and the company has consistently seen high profitability. With revenues in a general up-trend and profit margins approaching 50%, Charles Schwab is a very profitable financial franchise that should not be trading at a 12X earnings multiplier, in my opinion!
Core net new asset trend indicates healthy financial franchise value
The most important take-away from the company's Q1'23 earnings report was that Charles Schwab’s core business is actually in top shape. While some deposits have left the brokerage for higher yielding alternatives in money market funds, the core investment business keeps attracting net new client assets, a development I already pointed to at the beginning of the month in my work “ The Market Is Wrong, I Am Buying More ”. In the first-quarter, Charles Schwab attracted $53.9B in core net new assets to its platform, showing 16% year over year growth. At no point in the last year were core net new asset inflows higher than in March 2023 which is also when the market had to deal with the outbreak of a major deposit crisis at community banks. What this tells us about Charles Schwab is that investors are not the least bit concerned about putting their assets with the financial services company. While investors are generally changing their cash allocations (moving funds from banks into money market funds), Charles Schwab's core business is growing at a healthy rate and should continue to do so in the coming quarters.
Charles Schwab’s valuation
The valuation is what makes Charles Schwab especially attractive as an investment right now and I am looking forward for SCHW to complete a major valuation re-rating by the end of the year. My minimum expectation is for Charles Schwab's valuation to return to the pre-crisis level at around $75 which gives the company's shares approximately 42% upside. The valuation metric, P/E, also shows that Charles Schwab, due to a lack of a rebound, is still undervalued: shares are trading at a P/E ratio of 11.6X while the 1-year average P/E ratio is 15.3X. Right now, investors can still get a 25% discount on the firm's average valuation ratio pre-crisis.
Risks with Charles Schwab
The biggest risk for Charles Schwab is a deterioration of operating conditions in the financial system which could result in massive client asset outflows, but this is so far not the case. The reason why Charles Schwab lost deposits in the first-quarter does not relate, in my opinion, to fear about the solidity of the company’s business, but to higher interest rates which make bank deposits significantly less attractive from a yield point of view. What would change my mind about Charles Schwab is if the financial services company saw a serious decline in core net new client assets and if its profitability metrics were to suffer.
Final thoughts
The Q1'23 earnings report showed that investors have to fear nothing. I already bought the post-crisis drop in Charles Schwab a couple of times and I consider the financial services company to be extremely deep value from an earnings perspective for investors. While it is true that Charles Schwab lost $41B in deposits in the first-quarter, the overall business is healthy, growing and highly profitable. Considering that Charles Schwab has a valuation that is significantly below its 1-year average P/E ratio, I believe investors should buy shares of the financial services company before they are going into a new up-leg. I expect a full re-rating of Charles Schwab by the end of the year and believe that investors could potentially capture a 42% total return here if SCHW returns to its pre-crisis valuation level!
For further details see:
Charles Schwab Q1 Earnings: A Top Recovery Bet For 2023