2023-06-19 10:59:25 ET
Summary
- Charles Schwab's Monthly Activity Report for May 2023 shows a slowdown in cash inflows and increased reliance on expensive short-term funding sources.
- Analysts have revised Schwab's FY 2024 earnings estimates to $3.9 per share, down 35% since the start of the year, suggesting a forward P/E of around 14x.
- Schwab's stock appears overvalued compared to industry peers such as J.P. Morgan, UBS, and Morgan Stanley.
Charles Schwab ( SCHW ) recently published its Monthly Activity Report for May 2023, giving investors a peek into key financial indicators regarding client activity and asset levels. While cash sorting continues to decelerate, the report also highlighted a persistent slowdown in cash inflows. To manage the liquidity headwinds, Schwab is relying on more expensive short-term funding sources to compensate for declining deposit levels, which is exerting pressure on the company's earnings. Notably, SCHW consensus estimates for FY 2024 earnings are now at ~$3.9/ share, down approximately 35% since the start of the year, and suggesting a FWD P/E of close to 14x. Accounting for the earnings pressure, paired with duration-related balance sheet risk, I see SCHW stock as slightly overvalued versus quality peers such as JPMorgan (JPM), UBS (UBS), or Morgan Stanley (MS).
For reference, Charles Schwab stock has strongly underperformed the broad market since early 2023 - SCHW stock is down about 34% YTD, versus a gain of 15% for the S&P 500 (SP500).
Key Insights - Monthly Activity Report for May
For May, SCHW communicated growth in core net new assets, reporting a total of $20.7 billion inflow brought in by new and existing clients, and $24.5 billion excluding mutual fund clearing. Investors should consider, however, that the asset growth for May 2023 was below the $30 billion average inflow that Schwab has received during the past three years. At the end of May 2023, Schwab's total client assets amounted to $7.65 trillion, up 5% YoY versus May 2022; but, also below the 3-year historical average growth of 7-10%.
Perhaps the most important May metric related to cash balancing by clients. Although the "cash sorting" activity decelerated in May, the percentage of client cash as a proportion of assets nevertheless fell, to 11.5% at the end of May, versus 12% in May 2022. The number suggests that the average daily outflows of cash were about $0.3 billion (as compared to $1.2 billion/ day in April).
Cash Sorting Activity, Schwab YTD 2023
Funding Pressure & Earnings Headwinds
As Schwab clients are drawing down their cash balances, the company is pressured to access more expensive funding costs, including borrowing from the Federal Home Loan Bank ((FHLB)) and issuing retail certificates of deposit (CDs).
In May, Schwab issued about $5 billion worth of CDs, bringing the total to $41 billion (as compared to $6 billion at the beginning of the year). Needless to say, accessing these short-term funding sources applies pressure on earnings, with SCHW CD rates not trending well above 5% across 1-18 months tenures. (See below chart from UBS' Brennan Hawken, CPA, et al., published in the WM Rate Monitor dated 9th June)
In May, Schwab also announced the issuance of $1.3 billion worth of fixed-to-floating rate senior notes due in 2034 with an interest rate of 5.853%, and a $1.2 billion of fixed-to-floating rate senior notes due in 2029 with an interest rate of 5.643%.
Reflecting on the higher funding costs, SCHW management anticipates a 35 basis points headwind to Q2 net interest margin, likely resulting in a ~11% revenue decline versus Q1. With that frame of reference, analysts (based on consensus estimates) expect a sharp drop in Schwab's earnings power, with FY 2024 earnings estimates now at ~$3.9/ share, as compared to $5.9/share estimated 6 months ago - and revisions are still trending down.
Balance Sheet Duration Risk
Speaking about Schwab's fundamentals, I would also like to quickly point investors' attention to the company's balance sheet duration risk, which also connects to the funding pressure. In 2022, Schwab made a decision to transfer $189 billion of agency mortgage-backed securities from the "available-for-sale" category to the "held-to-maturity" category on its balance sheet. The purpose behind this move was to safeguard stockholders from potential unrealized "paper" losses. However, this decision doesn't reverse the asset duration exposure. As a result of the transfer, Schwab now holds more than $150 billion worth of debt assets with a weighted-average yield to maturity of 1.74%, which is significantly lower than the current benchmark 10-year Treasury yield of approximately 3.8%. Accounting for opportunity costs, Schwab's forgone income as a consequence of the duration exposure is a real loss to shareholders.
Valuation - Downside Risk
With Schwab's FY 2024 EPS anchored at around $3.9, SCHW stock is currently priced at a one-year FWD P/E of around 14x. Accordingly, Schwab is valued at a ~60% premium versus the comparable P/E median for the financial service industry. And if investors reference SCHW's valuation as compared to JPMorgan , which is in my opinion the most high-quality asset in the Financials group, Schwab is priced at a ~50% premium respectively.
While I acknowledge that JPM's and SCHW's businesses are different -- qualitatively reflecting on MOAT, growth outlook, and profitability -- I don't think a SCHW valuation premium versus JPM is justified. And I wouldn't be surprised if SCHW stock trades down to ~10x P/E to close the valuation gap.
Conclusion
Charles Schwab recently released its Monthly Activity Report for May 2023, revealing key financial indicators related to client activity and asset levels. While cash sorting has been slowing down, the report also highlighted a persistent decline in cash inflows. To address liquidity challenges, Schwab has been relying on costlier short-term funding sources to compensate for decreasing deposit levels, which is affecting the company's near-term earnings. Analysts have revised their estimates for Schwab's FY 2024 earnings, with consensus now at approximately $3.9 per share, reflecting a 35% decrease since the beginning of the year. This suggests a forward price-to-earnings (P/E) ratio of around 14x, indicating an overvaluation compared to the industry and quality leader, JPMorgan.
Schwab's Monthly Activity Report for May 2023 shows a slowdown in cash inflows and increased reliance on expensive short-term funding sources. Analysts have revised Schwab's FY 2024 earnings estimates to $3.9 per share, down 35% since the start of the year, suggesting a forward P/E of around x14. Schwab's stock appears overvalued compared to industry peers such as J.P. Morgan, UBS, and Morgan Stanley.
I believe the current valuation premium of SCHW is unwarranted and unlikely to be maintained. Accordingly, I see a decline in SCHW's P/E ratio to around ~10x as likely.
For further details see:
Charles Schwab: With Earnings Power Down, Stock Will Likely Follow