2023-10-23 12:35:48 ET
Summary
- Charles Schwab's Q3 earnings declined by 31% Y/Y due to a shrinking deposit base and falling net interest revenue.
- Despite the decline, Charles Schwab remained highly profitable with double-digit returns on equity and over $1.0B in earnings.
- I believe investors are overreacting again to Charles Schwab's deposit situation.
- I am lowering my fair value estimate from $70 to $60, but long-term investors can nonetheless take advantage of Charles Schwab's share price weakness.
Shares of Charles Schwab ( SCHW ) have given up all gains that accrued between June and July and investors appear to overreact to the financial brokerage company’s third-quarter results. Charles Schwab reported a 31% year over year earnings decline in Q3’23, driven by a shrinking deposit base and falling net interest revenues, but the firm remained highly profitable nonetheless. Given the strength of Charles Schwab's Q3'23 earnings, I believe investors are overreacting to the decline in its deposit base/cash-sorting.
The financial brokerage achieved double-digit returns on equity in the third-quarter, underlying its reputation for being a well-run and profitable brokerage franchise. I am lowering my fair value estimate from $70 to $60 due to net interest revenue and deposit headwinds, but I believe long term investors could take advantage of Charles Schwab’s weak share performance since July!
Previous rating
After Charles Schwab presented Q2’23 results, I down-graded shares to hold and implied that I saw a fair value of approximately $70 . I am adjusting my fair value estimate lower because I now believe that interest rates will stay higher for longer. However, given the demonstrated profitability of the Charles Schwab franchise in the third-quarter (return on equity of 14%) and given that investors likely overreacted to investors' cash-sorting behavior in Q3, I believe investors should see the firm’s share price weakness as a long term buying opportunity. Despite my lowered fair value target, I see 25% upside revaluation potential.
Charles Schwab continues to remain a highly profitable enterprise
Charles Schwab posted better than expected earnings for Q3’23 last week due to higher asset management fee income. Charles Schwab’s third-quarter revenues of $4.61B slightly missed expectations, however. On an adjusted earnings basis, the financial services company generated $0.77 per-share compared against an estimate of $0.74 per-share.
Source: Seeking Alpha
Although the firm's earnings declined 31% year over year due to continual cash-sorting behavior, Charles Schwab posted earnings of $1.1B for the third-quarter which calculates to a solid 14% return on equity.
The decline in earnings has been chiefly driven by a contraction in net interest revenue (higher deposit costs), but offset by higher asset management fees. Charles Schwab’s net interest revenue declined to $2.24B in Q3’23, down 24% Y/Y, due to clients moving money around. Interest expenses grew by $1.36B to $1.79B in the third-quarter. Asset management fees, on the hand, increased 17% year over year to $1.22B, cushioning the blow from cash-sorting.
Source: Charles Schwab
Continual cash-sorting behavior
Charles Schwab’s activity report for the month of September showed that the brokerage’s client base continued to shuffle more funds into higher yielding money market funds, a trend that started more than a year ago when the Fed Reserve moved interest rates up. In September, Charles Schwab’s money market funds included $437.3B, showing an increase of $41.7B compared to the end of June.
Source: Charles Schwab
My personal outlook is that cash-sorting on the part of clients will continue as long as money market funds pay higher yields than regular bank deposits... which means investors should be prepared to see the firm lose more deposits. At the end of the September quarter, Charles Schwab’s deposits were 7% below the Q2’23 level and totaled $284.4B. In the last year, unfortunately, due to higher interest rates, Charles Schwab has lost a massive $111.6B in deposits. As long as interest rates increase, pressure on Charles Schwab's deposit base will likely mount.
Lowering of my fair value estimate
Given the headwinds to Charles Schwab’s deposit base and net interest revenue, I am lowering my fair value estimate from $70 to $60, but still believe that the financial brokerage has considerable revaluation potential. Charles Schwab’s EPS estimates gradually declined in 2023, because of the financial crisis in Q1’23 as well as broader challenges related to cash-sorting on the part of investors.
Analysts estimate, on average, that Charles Schwab could achieve $3.18 per-share in earnings for FY 2023 and $3.89 per-share in FY 2024, implying an increase of 23% year over year. With shares currently trading at $50.87, the market values the Charles Schwab franchise at 13X FY 2024 earnings.
Given the franchise’s strong underlying profitability and potential for earnings/deposit growth in a lower-rate world, however, I believe Charles Schwab could reasonably trade, in the long term, at a P/E ratio of 15-16X, implying a fair value target range of $58-62, and $60. The implied revaluation potential is 18% at midpoint, and 22% in the high-case.
Risks with Charles Schwab
Like any other financial services company, Charles Schwab is facing pressure on its net interest margin in a high-interest world which should result in continual cash sorting behavior on the part of the brokerage firm’s clients in the foreseeable future. However, in the longer term, I expect deposits to return to Charles Schwab and the net interest margin to normalize. The biggest risk for Charles Schwab would likely be a steepening of the yield curve and more aggressive rate increases if inflation sees a reboot in the fourth-quarter.
Final thoughts
Obviously, investors must be prepared to deal with higher for longer interest rates... which will pose continual headwinds to Charles Schwab’s net interest margin and earnings growth. However, investors that can see beyond the current interest rate cycle should consider Charles Schwab’s still enormous profitability… which is to improve once the Federal Reserve lowers its rates. Considering that shares trade at an attractive 13X P/E ratio and that shares have upside of 22% to my high-case fair value estimate, I believe the current share price weakness (despite a lowered FV target) could be exploited by long term investors that are seeking a deep-value play!
For further details see:
Charles Schwab Q3: A Deep Value Opportunity (Rating Upgrade)