Current Investment Analysis, GenVest Quick Takes

SCHW Selloff-An Opportunity to Get Greedy?

April 12, 2023

Key Points

Charles Schwab is a market leader in investment services for both financial professionals and retail investors. The recent merger with TD Ameritrade will help to solidify this position and generate additional revenue and cost savings in the coming years.
They have a vertically integrated business model that gives them cost advantages in their core business and allows them to grow their wealth advisory, banking, asset custody, and proprietary product businesses.
A strong balance sheet and is well capitalized. They will be supported in times of stress due to their systemic importance and $40 billion in cash on their balance sheet.
Fallout from SVB(Silicon Valley Bank) issues could have an impact on SCHW (although far less than regional banks). This will likely lead to the need to invest in shorter term, lower yielding debt with consumer deposits and squeeze net interest margins.

Why Did SCHW’s Stock Price Decline? How are they different from SVB?

The collapse of SVB brought to light some issues that had been largely overlooked before. For one, many of the Treasury bonds that banks purchased at near-zero interest rates that are held in their investment portfolios are now worth less money due to rising interest rates.

Remember, investors and depositors will seek these higher interest rates which will end up decreasing the value(price) of the lower interest rate bonds.

This was one of the main reasons why SVB got into trouble. Their deposit base was mostly concentrated in commercial(companies) who are quicker to seek higher returns for their cash by withdrawing in comparison to retail depositors(everyday people). A bank does not actually have all the cash on hand to meet depositors’ demands all at once.

If banks are forced to sell these bonds, they would lose money and this is correlated to the phrase of an “unrealized loss”. Another issue is deposit outflows, which could negatively impact net interest income and, in a worst-case scenario, lead to capital problems.

Risk management 101 was non-existent at SVB, and higher quality banks such as J.P. Morgan Chase were the beneficiaries of new deposit inflows in search of a more robust stable bank.

SCHW was brought into the mix as investors became concerned if they might have to deal with the same issues as SVB leading to a severe drop in their stock price. The issue with SCHW, while worth looking at, does not warrant the same level of concern in most analyst opinions and we share the same viewpoint here at GenVest.

Here are a few possible reasons as to WHY Investors should NOT Panic with SCHW.

* Charles Schwab has access to the Federal Reserve’s Bank Term Funding Program, which can provide the firm upward of $200 billion of cash.

* Charles Schwab also had about $40 billion of cash on its balance sheet at the end of 2022.

* This means that Charles Schwab has enough access to cash and capital to weather the storm in the financial sector that was unleashed after the collapse of SVB.

* The company can use this cash to deal with potential deposit withdrawals from clients meaning they will not have to sell assets at losses like SVB.

Is There A Positive Investment Thesis for SCHW?

SCHW is cementing its position as an industry leader with the recent merger with TD Ameritrade. The company is poised to expand into other financial services and reap the benefits of material revenue and expense synergies in the next couple of years.

Their scalable and vertically integrated business model will enable it to convert an increasing percentage of revenue into earnings.

Charles Schwab has built a strong moat in retail brokerages by leveraging cost advantages through its scalable infrastructure, leading to high incremental operating margins.

The banking subsidiaries of many retail brokerages rank well compared with traditional banks, and Charles Schwab’s banking subsidiary profitability is particularly noteworthy. This is achieved through catering to generally higher-net-worth clientele with collateralized lending products and not having to support a physical branch presence.

Charles Schwab’s massive scale, supporting over $7 trillion of client assets by the end of 2022, gives the company a significant cost advantage that few can match. As one of the largest U.S.-based companies focused on securities trading and wealth management, Charles Schwab is well-positioned to continue providing high-quality services to its clients. Their focus on technology continues to separate them from competitors.

Despite being a late entrant in creating its own exchange-traded product line, Charles Schwab is now among the top 10 largest exchange-traded fund(ETF) companies. Additionally, its new online advisory platform is poised to benefit from its low cost and extensive client reach, which positions Schwab to surpass existing players in profitability and assets under management.

SCHW Impressive Financial Metrics

SCHW is one of the very few Financial Services Companies showing an ability to grow top line revenue(sales) on a Year over Year(YOY) basis.

SCHW has shown an impressive ability to operate with higher margins in comparison to other Financial Services Companies. While it is always possible for margins to contract, SCHW should continue to operate more efficiently in comparison to peers and remain ahead of the competition.

**Operating margin is a financial metric that indicates the profitability of a company’s core business operations by measuring the percentage of revenue that remains after deducting operating expenses. A high operating margin suggests that the company is efficiently generating profits from its primary business activities, while a low operating margin indicates that the company may be struggling to control costs.

One of the most important financial performance metrics when it comes to analyzing bank stocks is ROE(Return on Equity). Thanks to their impressive operating margins, SCHW is also able to boast itself as an industry leader when it comes to ROE.

**Return on Equity (ROE) is a financial metric that measures a company’s profitability in relation to the amount of shareholder equity. It is calculated by dividing net income by shareholder equity.

***Shareholder equity*** is the portion of a company’s total assets that is owned by its shareholders after all of its liabilities have been subtracted. Shareholder equity can be calculated by subtracting a company’s total liabilities from its total assets.

ROE is an important metric for investors as it provides insight into how effectively a company is using shareholder equity to generate profits. A higher ROE indicates that a company is generating more profits per dollar of equity invested, which is a positive signal for investors.

Reasons for Concern with SCHW

The future of interest rates. Schwab’s net interest margin, which is the difference between the interest it earns on loans and the interest it pays on deposits, is sensitive to changes in interest rates.

If interest rates rise, Schwab’s net interest margin will widen, which could boost its earnings. However, if interest rates fall, Schwab’s net interest margin will narrow, which could hurt its earnings. Conversely if Schwab needs to pay higher rates of interest on deposits, that will eat into the margin as well.

Decrease in deposits. Schwab’s deposits are a key source of funding for its loans and other activities. If deposits decline, Schwab may have to raise money from other sources, such as issuing debt, which could be more expensive. Additionally, a decline in deposits could reduce Schwab’s ability to lend money, which could hurt its earnings. Lack of investor enthusiasm could stunt growth in deposits as well.

Fallout from SVB/banking issues. The collapse of Silicon Valley Bank (SVB) has raised concerns about the stability of the banking sector. If other banks fail, it could lead to a loss of confidence in the financial system, which could hurt Schwab’s business.

Additionally, the fallout from SVB’s collapse could lead to increased regulation of the banking sector, which could raise costs for Schwab.

Increasing competition. The industry continues to grow with existing competitors as well as new entrants. Some smaller tech focused firms such as Robinhood and others threaten to take market share from Schwab.

GenVest QuickTake

In conclusion, SCHW’s market leadership in investment services for both financial professionals and retail investors has been strengthened by its recent merger with TD Ameritrade. This strategic move is expected to generate additional revenue and cost savings in the years to come.

The company’s vertically integrated business model has provided them with cost advantages in their core business, allowing them to expand their wealth advisory, banking, asset custody, and proprietary product businesses. Overall, Charles Schwab is well-positioned to continue its success in the investment services industry.

While SCHW might face short-term headwinds resulting in further price declines, the GenVest Team sees these as opportunistic moments to scoop up shares in a leading financial services company with growth potential for the long-haul. Our analysis concludes that shares are attractively priced and further price declines back down into the mid $40 range will create an even more attractive opportunity for investors.