2023-05-16 15:24:43 ET
Summary
- The Charles Schwab Corporation has had a rough start to 2023, but many investors thought its Q1 was positive.
- However, each of Schwab's main businesses has struggled upon further inspection.
- We believe Schwab is entering a period of high uncertainty.
Background
When we last wrote about The Charles Schwab Corporation ( SCHW ), the company was in full meltdown (you may read the article here ). The first wave of the regional banking crisis was moving at full steam, and investors were becoming aware of two previously innocuous classifications of fixed income securities: available for sale assets which companies actively mark to their market prices, and held to maturity securities which companies expect to hold until maturity, and as such record on their balance sheets at the purchase price rather than the current market price.
It was in this context that Schwab burst into the limelight, with the stock falling by 30% over three days.
Since then, the stock has ground slowly downward as investors digest each bit of information that comes out regarding banking deposit levels and the subsequent erosion of general trust that bank management teams have properly matched--or at least hedged--deposit liabilities with corresponding interest-bearing securities.
Bank deposit outflows and the corresponding inflows to higher-yielding money market funds have been a second narrative of the banking crisis, with obvious negative effects on banks since deposits are the largest funding source for commercial banks.
It's against this backdrop that we revisit Schwab. Let's dive in.
A Solid Quarter?
Schwab reported its first quarter results on April 17th, and on the surface, things appeared to be steady, if not positive. The company reported net revenue of $5.1 billion, a 10% increase versus the prior year's first quarter income of $4.6 billion, and a 24% increase in GAAP EPS from $0.67 to $0.83 per share in Q1.
The stock moved up 5% over the next few days on this news before resuming its movement downward. As of this writing, the stock is down roughly 4% since its Q1 earnings.
The reason for this, we believe, has a lot to do with the fact that a lot of items between the top and bottom lines of the quarterly income statement were weaker than they initially appeared. We'll start by reviewing the various ways in which Schwab makes its money.
Interest-Earning Assets
First up are the assets which generate income and the associated costs with those streams of income.
Total interest-earning assets fell from $632 billion in March 2022 to $504 billion in March 2023, while total revenue rose from $2.3 billion to $4 billion due to the average yield earned on those holdings rising from 1.47% to 3.19%, a 172 basis point increase. Among interest-earning assets, only held to maturity securities and bank loans increased in average balance value, while all other balances fell. Moreover, the majority of the increase in interest bearing revenue came from idle cash in the form of higher yields.
Corresponding funding sources fell year-over-year, from $632 billion to $504 billion. Bank deposits fell by 24% year-over-year, and funding costs increased by 96 basis points.
Of course, one would be tempted to point out that earnings are rising faster than costs (largely because the average Schwab bank deposit costs the company a mere 73 basis points), but we point out that this is only one aspect of the overall picture--one that can distract investors from seeing that the margin on Schwab's interest bearing assets is rapidly eroding.
In 2022, Schwab's interest earnings assets were almost a money printing machine with a 94% gross margin. In 2023, however, that margin fell to 69%. Given that net interest revenue has typically represented about half of Schwab's overall revenue, we think this is a not insignificant.
Asset Management & Administration Fees
Schwab's asset management and admin fee business (which comprises its advisor network and the fees associated with the mutual funds and exchange-traded funds, or ETFs, the company manages or administers) makes up around 22% of overall revenues, and it faced similar pressures in Q1.
Total mutual fund, ETF, and CTF (collective trust fund) revenue grew $96 million year-over-year, while advice solutions revenue fell by $43 million year-over-year, making the total year-over-year gain of $50 million for the segment a near wash.
What we point out, however, is that the margin compression observed in the company's interest-earning assets continues here. With the exception of Mutual Fund OneSource, every other line item's average fee fell year-over-year.
In the advice solutions business, this is no surprise: margin compression has been squeezing advisors for a long time, after all, as clients press for financial advice at ever cheaper costs. Where it is perhaps unexpected, however, is in the company's money market and other funds business.
Lastly, average client assets in both categories fell on a year-over-year basis.
Trading Revenue
The last large business segment for Schwab is trading revenue, which also took a hit year-over-year and represents a little less than 20% of overall revenue.
It was a bit surprising to us to see that trading revenue is down at the firm, given that Schwab's trading base is largely retail and retail investors have reportedly reached new highs in terms of trading volume to start 2023 .
However, the decline in Schwab's trading volume could speak to something a bit more troubling: Schwab could be losing its retail market share to other firms and upstarts such as Robinhood Markets, Inc. ( HOOD ). To this end, Schwab posted a 13% decline in new brokerage accounts opened year over year for Q1. Total brokerage accounts, meanwhile, have stayed relatively flat, rising 2% overall year over year. Robinhood (which has its own problems), meanwhile, posted an acceleration of new funded accounts year over year for its first quarter.
Looking Ahead
We want to emphasize that we believe there is no reason to suspect that The Charles Schwab Corporation may be in any sort of material trouble--the business has ample liquidity and access to liquidity if needed. Rather, we believe our analysis shows that Schwab's business is deteriorating on multiple fronts and no longer possesses the same myriad advantages that it once did, save for sheer scale.
Going forward, we see little reason to believe that the interest income margin will meaningfully improve. Depositors, after all, are being conditioned to look for higher yields on their deposits after multiple years of near-zero interest rates, and money market funds (for decades a sleepy backwater of finance) are suddenly front and center in investor's minds as a better place to find yield. We also point out that even if Schwab were to continue to pull in assets to its own money market funds, its overall margin profile would continue to deteriorate as its cost of funds would rise overall.
The Bottom Line
We firmly believe that The Charles Schwab Corporation isn't going anywhere. The company has a strong brand and reputation, and enormous scale. However, the company seems to have been caught unprepared for a rising interest rate environment, which has squeezed margins. Further, the company's legacy advice and trading businesses are also under pressure, both from cost and competitors who may be more nimble than the old Goliath.
While we are glad to see that The Charles Schwab Corporation is taking some action (management began--finally!--hedging its interest rate risk in 2023), we believe that the business remains in a state of flux, which could increase volatility risk in the near to mid-term. In short, the high degree of uncertainty around where the business will settle going forward keeps us away from The Charles Schwab Corporation for now.
For further details see:
Schwab Isn't Going Anywhere, But That Doesn't Mean It's A Buy