2023-07-10 11:50:20 ET
Summary
- Charles Schwab is expected to report earnings for Q2'23 and investor expectations may be too bearish.
- Charles Schwab just passed the Federal Reserve's stress test with flying colors, which should give investors confidence.
- The company's shares are currently trading at a significant discount to its pre-crisis valuation, offering potential for a return to its pre-crisis P/E ratio.
- Despite potential risks such as interest rate increases and net interest margin pressure, Charles Schwab's risk profile remains favorable.
Charles Schwab (SCHW) is set to report earnings for its second-quarter of FY 2023 on 07/18/2023, before the market opens, and I believe the financial brokerage company is a strong buy ahead of the earnings release. This is because earnings expectations for Charles Schwab’s second-quarter report are quite low after the company warned of a 10-11% decline in Q2 revenues. Additionally, the financial brokerage passed the Fed's stress test with flying colors and investors can have confidence in the firm's capital position, even if a severe recession were to strike. Because Charles Schwab has not yet recovered from the March sell-off, I believe investors are looking at 32% upside revaluation potential over the next year!
Charles Schwab got good news from the Federal Reserve
The Federal Reserve in June concluded its annual stress test, during which it probes the capital positions of major financial institutions and challenges whether or not banks’ capital levels are sufficient to withstand a severe economic recession.
Under the severe stress test assumption, Charles Schwab is expected to see an increase, not a decrease, in its common equity Tier 1 capital ratio to 22.8%, up from 21.9% at the end of Q4’22. The bank’s capital position is also significantly better than the regulatory minimum capital ratio of 4.5%.
Compared to most other financial institutions, Charles Schwab did extremely well: the brokerage had by far the best common equity Tier 1 capital ratio of all financial institutions that were subjected to the stress test. In other words, Charles Schwab is the most well-capitalized financial institutions in the group of 23 banks -- top tier and regional -- that were tested by the Fed which, I believe, should ultimately clear the path for a higher valuation.
Second-quarter earnings expectations are too low
As higher interest rates continue to bite, Charles Schwab's CFO said in June that he expects the company to experience a 10-11% decline in its revenues for the second-quarter. The decline in revenues is expected due to a pressured net interest margin, softer trading volumes and a smaller interest-earning deposit base (because depositors are still shuffling cash over to higher-yielding money market funds). However, Charles Schwab continued to see robust net new core asset inflows in the second-quarter and the business is not only in good shape from a capital perspective, but also financially.
Charles Schwab is a deeply profitable financial services franchise with net profit margins in excess of 30% and positive operating cash flow. The firm made a profit of $1.6B profit during the challenged first-quarter and I expect that Charles Schwab could post Q2'23 earnings in the amount of $1,370-1,425M.
However, analysts appear overly bearish at the moment, with EPS downside revisions outnumbering upside revisions by a ratio of 15:1. The current expectation is for Charles Schwab to report $0.73 per-share in adjusted earnings, showing a potential 25% year-over-year decrease.
24% discount to pre-crisis valuation
Charles Schwab’s shares are trading at a significant discount to the brokerage’s pre-crisis valuation, and recent EPS down-grades have likely prevented a stronger rebound reaction. Shares of Charles Schwab are trading at a P/E ratio of 13.9X and the EPS trend has been very negative since March, potentially indicating that earnings predictions have become too bearish at this point. Currently, shares of Charles Schwab trade 24% below the company's pre-crisis valuation -- SCHW traded at $75 just before the collapse of Silicon Valley Bank -- and at a 26% discount to the brokerage's 1-year average P/E ratio of 18.9X. A return to a $75 share price implies 32% upside potential!
Risks with Charles Schwab
There is a strong possibility that last week’s strong ADP employment report will result in additional interest rate increases, meaning investors' cash sorting efforts may not yet be completed. Over the last year, depositors have shuffled more funds into high-yielding money market funds in a bid to earn higher returns. There is also the very real risk of continual net interest margin pressure, as higher deposit costs result in a lower spread for financial institutions. Despite those risks, I believe the risk profile remains very favorable.
Closing thoughts
Charles Schwab is a strong buy ahead of the release of its second-quarter earnings, which are scheduled for 07/18/2023, before the market opens. Although the financial brokerage has guided for a decline in its net interest margin due to higher interest rates and a 10-11% drop in revenues, the market is more than fully pricing these trends into the company's valuation, in my opinion.
I believe that earnings expectations are very low heading into the earnings release and that Charles Schwab has surprise potential when it releases Q2 earnings, in part because the company has continued to see net new asset inflows throughout the second-quarter. That the financial brokerage recently passed the Fed’s stress test with flying colors is also a strong reason to consider Charles Schwab’s shares. With a P/E ratio of 14X -- which is below Charles Schwab’s pre-crisis P/E ratio of 19X -- I believe the risk profile remains much more favorable than investors want to acknowledge!
For further details see:
Charles Schwab: The Fed Cleared The Path For A Higher Valuation