A closer look: Charles Schwab

Thursday, Jan 19th 2023

Commentary

Holding Name: Charles Schwab (NYSE: SCHW)

Strategy: Flagship

Percent weighting of strategy: ~3.9%


TLDR: For every 50 basis point interest rate hike, Charles Schwab adds ~$750 million to their top line. As the Federal Reserve continues to “use [their] tools forcefully” to attack inflation, Charles Schwab is well positioned to benefit from the rising interest rate environment.

Business overview: Charles Schwab (SCHW) is the largest discount stock broker in the United States, and the largest provider of online brokerage services. With nearly $8 trillion in assets under management and a market cap close to ~$136 billion, Charles Schwab provides a full range of securities, brokerage, banking, money management, and financial advisory services. The company operates in two primary segments: investor services and advisor services.

  • Investor services (23% of revenue): The Investor Services segment provides retail brokerage, investment advisory, banking and trust, retirement plan, and other corporate brokerage services. 

  • Advisor Services (77% of revenue): The Advisor Services segment offers custodial, trading, banking, and support services for independent advisors. This segment provides brokerage accounts with equity and fixed income, margin lending, options, etc. Plus mutual fund trading, clearing services and exchange-traded funds (ETFs). The advisor services segment also offers advice solutions and banking products.

Why we own it: Schwab is an incredibly high-quality business with impressive growth rates from both assets and customers. Schwab has proven to implement disciplined cost management while proving that there is potential for upside optionality for its recent acquisitions and TD Ameritrade synergies. Management expects there could be as much as $2 billion in merger synergies by next year.

Importantly, Schwab remains well positioned to benefit from a higher interest rate environment - management expects the company to generate $750-$950M of incremental revenue from every 50 bps rate hike which should support net interest margin expansion (the difference between what they earn on customer cash deposits vs what they pay to customers) and strong earnings growth. Under our conservative estimates, we believe that earnings per share compounded growth can be well over 20% over the next three years which may enable the company to distribute ~35% of its net income to shareholders via dividends and share buybacks.

What’s the latest: Charles Schwab reported earnings before the market open on Wednesday and the results came in roughly in line with our expectations. Q4 adjusted earnings per share came in at $1.07 vs estimates of $1.09 while revenue came in pretty much in line with expectations. The company hosts a Winter Business Update on January 27th where management has indicated plans to present data around the fact that they're "entering the later innings (though not the last inning) of the cycle and that net sorting activity should abate" - a positive sign for the business.

Bank of America released a downgrade Thursday morning while cutting its price target from $92/share to $75/share which has placed downward pressure on the stock in early hours of trading. BofA mentions continued cash sorting headwinds that we believe are being misinterpreted (more detail below). 

Sign posts moving forward: One of the most important factors for our team is Schwab’s cash sorting trends. Cash sorting represents clients moving funds from cash to money market funds and higher yield products. These products are less profitable for the business and represent a key component to our thesis. Cash sorting trends have decelerated in Q4 and are projected to improve when the Fed pauses interest rate increases which in turn will have a smaller impact on the business.

Net interest margin (a measurement comparing the income Schwab generates from credit products like loans and mortgages, with the outgoing interest it pays holders of savings accounts and certificates of deposit ) is key for our thesis moving forward as well. Management has reiterated the fact that NIM has meaningful upside compared to what they have been guiding and have revised their target higher for second time in Q3. Given that their securities portfolio (55% of book) has ~4 year duration at a yield of ~1.6%, we believe this will eventually roll-off and be reinvested into higher yielding assets. As a result, this trend may lead to higher net interest margin even if the Federal Reserve pauses interest rate hikes.


The content contained in this material is intended for general informational purposes only and is not meant to constitute legal, tax, accounting, solicitation of an offer, or investment advice.

Disclosure

As of this writing, SCHW was a portfolio holding of Titan. This security may cease to be a portfolio holding at some point in the future.

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