Charles Schwab is considered a best of breed financial service company with $7.38 trillion in client assets. Following the collapse of Silicon Valley Bank (SVB) and the perceived weakness in the banking system stemming from rising interest rates, Charles Schwab stock fell more than 30% on fears that it too faced potential solvency issues as deposits fled the bank. Since then, the stock has found a base around $50 per share as fears surrounding the worst outcomes have somewhat abated following Q1 results and positive rhetoric from management. Still, a series of analyst downgrades have highlighted the very real possibility that Schwab’s earnings could deteriorate as depositors seek higher yields on cash held in sweep accounts.
Since then, Schwab has become one of the company’s I have received the most questions about. As I dug into the company to uncover the severity of these threats, I learned that there is a lot to learn, some of which is mired in complexities. In the article below, I have attempted to break down some of the nuances to not only understand the issues the Schwab faces, but gauge whether the pullback offers an opportunity for investors. To do this, I will answer a series of questions to tell Schwab’s story and then attempt to determine a fair value for Schwab’s shares.
Is Schwab’s Financial Position Stable?
Let’s begin by taking a look at Schwab’s financial position. One of the main differentiators between Schwab and the banks that have collapsed recently including SVB, Signature Bank and First Republic is the fact that Schwab is a more diversified business that makes billions of dollars off of brokerage services in addition to its banking services. Schwab’s management has gone to great lengths to justify the strength of the bank’s position and shore up confidence including buying shares of the company. Further, they have assured investors and clients that should the situation deteriorate, the company has more than enough liquidity and sources of capital to offset their deposit base.
Assuring investors that capital is accessible is an important element of this story. Schwab needs to maintain confidence in its deposit base to avoid potential solvency issues. Here is why.
Schwab has $325.7 billion in deposits, down 30% from Q1 2022. The way banks make money is by offering interest on deposits, then lending those deposits at higher rates. The difference between the two rates is called the net interest margin (NIM) and Schwab reports revenue earned on the NIM as “Net Interest Revenue”.
Like the collapsed banks, Schwab took a large portion of their deposits and invested them in longer dated securities that now have below market yields. These securities are categorized on Schwab’s balance sheet as “Available For Sale” (AFS) securities and “Held to Maturity” (HTM) securities. As of Q1 2023, the AFS securities totaled $141 billion and HTM securities totaled $170 billion. Schwab’s HTM securities ballooned as a result of a significant transfer from AFS to HTM as interest rates rose in 2022. Schwab did this to minimize the impact of its unrealized AFS losses on its capital position. This is because unrealized AFS losses are recognized as “Accumulated Other Comprehensive Income” (AOCI) which are included in shareholder’s equity, while unrealized HTM losses are amortized (a method to write off losses over time) meaning that the entire loss is not recognized at once.
This is important because as of December 2022, Schwab has seen over $12 billion in unrealized losses on AFS securities and $15.580 billion on HTM securities, and recognized over $22 billion AOCI impact on shareholder’s equity. Schwab does not want to have to recognize these losses, particularly the HTM losses because of the impact it would have on the company’s capital position. The good news is the company shouldn’t have to unless they continue to lose deposits, or there are regulatory changes.
As a result, each of these are worth exploring.
What is the regulatory risk?
Schwab is taking actions to protect its capital position as demonstrated by the transfer of funds from AFS to HTM. The threat persists, though, if we take a closer look at Schwab’s capital position. Banks are bound by federal regulators to have certain capital requirements, one of which is called CET1 capital ratio. Without getting too nuanced, this ratio compares a bank’s risk assets to its equity, and there is a minimum threshold of 4.5%. Schwab’s CET1 ratio is 7.2%.
In their calculation of this ratio seen in the table above, we can see that Schwab adds back the AOCI loss to its capital position. If Schwab were forced to recognize these losses either because of persistent or rapid outflows, or because of changes to capital requirements particularly as they relate to mark-to-market rules, it could have significant impacts on Schwab’s tier 1 capital.
On the regulatory front, Schwab will need to remain nimble if changes are introduced. This also epitomizes the need for Schwab’s management to control the narrative to induce confidence in the bank. So far, Schwab’s management has made some important points that plausibly explain the deposit outflows; for example, management has called deposit outflows typical of the higher interest rate environment. They have also stated that they have the liquidity to offset deposits which would buy Schwab the time to allow its AFS and HTM securities to mature effectively allowing them to redeem them at par value.
Will deposit outflows continue?
As mentioned earlier, Schwab’s deposits are declining. In Q1 2023, Schwab’s bank deposits declined 11% during the quarter and 30% year over year. While bank deposits may not be leaving Schwab as the company saw $132 billion of core net new assets, and as demonstrated by 150% year over year increase in money market funds, this does set the stage for revenues to decline.
It seems entirely possible that as long as interest rates remain high deposit outflows will continue. Here’s why.
Schwab’s average interest rate on bank deposits was 0.73% in Q1 2023. Investors now have safe alternatives including money market accounts, US Treasuries and certificates of deposit that pay 3-5%. As long as interest rates remain elevated, money will continue to seek higher interest rates. The good news is that Schwab’s deposit outflows have decelerated to about $1 billion in April.
Will this impact earnings?
As mentioned, analysts have begun downgrading Schwab as a result of the impact these deposit outflows will have on earnings. This seems inevitable as a lower deposit base will mean fewer deposits to loan and earn interest on as long as outflows persist. As a result, net interest revenue was down over 8% quarter over quarter in Q1, decreasing the benefits of higher net interest margins (NIM).
While Schwab is classified as a discount broker, 51% of Schwab’s revenue comes from net interest revenue. As deposits leave the bank, Schwab has fewer deposits to loan and earn interest on.
The value of bank deposits for Schwab is derived from the very low interest rate Schwab was able to pay its depositors. In 2022, the average yield for bank deposits was 0.17%.
So, if interest rates continue to rise or plateau at these levels, Schwab will have to make tough decisions – raise the yield offered on bank deposits which would negatively impact NIM, or continue to offer very low rates and risk more deposit outflows. Schwab has already begun to do the former. The average interest rate on deposits in Q1 increased to 0.73% and this will most likely continue to rise.
Despite this, Schwab saw its NIM increase to 2.19% from 1.38% a year earlier. As interest rates rose, Schwab was able to earn higher rates of return on all of its interest bearing assets. The table below shows the average yield Schwab receives on its interest bearing assets. Between 2022 and 2023, the average interest rate earned on all interest earning assets rose from 1.47% in 2022 to 3.19% in 2023 more than offsetting the increase in rates paid by Schwab. This should continue particularly for AFS securities that are currently invested at low interest rates. As they mature, they can be reinvested at higher rates effectively creating a tailwind for Schwab’s NIM.
Again, the problem is that the higher NIM will be earned on a lower deposit base that should net to declines in revenue. This has already begun to play out in Q1 earnings. Total revenues declined nearly 7% sequentially to $5.116 billion led by lower net interest revenues. It will be imperative to watch the trends in deposit rates and the flow of funds at Schwab.
VALUATION
If we briefly recap the takeaways thus far, Schwab does appear to have threats that remain to its capital position that can be exposed by rapid deposit outflows and/or certain regulatory changes. At the moment, deposit outflows, though persistent, appear normal and manageable making the likelihood of a really bad outcome for Schwab unlikely. While regulatory changes appear likely, the rumor is that an increase to capital requirements is possible which Schwab should be able to handle. That said, the interest rate environment appears to set the stage for continued deposit outflows that should have a near term impact on net interest revenues which will negatively impact earnings.
As of this writing, Schwab stock price is down over 30% YTD which appears to price in some of the risks that Schwab faces. We can evaluate Schwab’s current valuation in two ways, using relative valuation and the dividend discount model.
Relative Valuation
In terms of a relative analysis, we will look at Schwab compared to peers using the P/E ratio and book value per share, but we can also consider the company relative to itself historically. Schwab’s 5 year average P/E and book value per share are around 22x earnings and 3.5x, respectively. Today, the company is trading at around 15x TTM earnings and traded as low as 12x during the height of the banking turmoil while book value has fallen below 3x. Schwab’s multiple contraction appears to be factoring in a considerable decline in earnings which we have outlined as a likely outcome, however, the decline in book value per share can be explained by a decline in Schwab’s stock price while its equity remained relatively constant. We have discussed above the quality of the assets that make up this equity which appear to be moving to lower margin assets.
If we broaden out the analysis to consider Schwab relative to its peers, we can get an idea of where similar companies are trading. The peers chosen include those that are financial service companies (Morgan Stanely, Goldman Sachs and Interactive Brokers) and banks with financial service offerings (Bank of America and JP Morgan).
The relative metrics that we want to use to evaluate Schwab versus its peers are the P/E ratio and price to book value (P/BV). At first glance, it appears that Schwab is more expensive than its peers with higher than average P/E and P/BV. In an effort to justify the premium, we can include comparative metrics including return on equity, payout ratio and net profit margin. For each of these metrics over the trailing twelve months, Schwab has demonstrated superiority over its peers, potentially justifying its higher valuation. It is worth noting that we should expect a financial service firm to trade at premiums to banks not only because of the prospects for growth, but also as a result of the diversification of revenue streams as well as the regulatory environment that banks face. As mentioned, a major portion of Schwab’s revenue is exposed to these regulatory risks.
While we do expect near term deterioration in the metrics outlined above, the conclusion we can draw from this analysis is that on an earnings basis, Scwhab is trading in line with its peers while its P/BV is trading well above its peers. We can assume this is because investors are using earnings to value Schwab as the company grows. If Schwab is able to maintain or return to its profitability, paying a premium for its shares in excess of its current P/E multiple and closer to its historic multiple will be justified; however, should these metrics moderate, Schwab may face a re-rating based on its equity similar to other financials.
Dividend Discount Model
Another way to determine the value of Schwab is to use the dividend discount model. Schwab has a reasonable history of paying its dividend with some inconsistency increasing the dividend. Schwab has also had an inconsistent history of share buybacks and as of Q1 suspended its $15 billion share buyback program as a result of the uncertainty related to the current environment.
To create the model, we will make use of relatively conservative inputs. Let’s assume that EPS falls by 15% in 2023 and then returns to growth at a rate of 10% for the next 5 years. The difficulty is this growth rate will be greatly impacted by the state of the economy and the Federal Reserve’s decision surrounding interest rates. This also assumes that any further banking turmoil does not impact Schwab to any greater degree. That said, we expect that the company will continue to take on new client assets which should bode well for earnings long-term.
To build in a margin of safety, we are assuming that return on equity falls as a result of regulatory changes which we will assume include a 20% increase in the capital requirements. This will effectively create a one year dividend freeze before returning to dividend growth. We will also factor in share buybacks, and assume that Schwab does not buy back shares until 2025 at which point it will resume share buybacks at an average rate of $2 billion per year. If we discount these assumptions at 9.6% we are returned a price of $54.53. Using these assumptions and omitting share buybacks, Schwab’s value based on the model would be around $40 per share.
It is worth reiterating that these assumptions are quite conservative particularly compared to analyst expectations. As a result, I think it is fair to suggest that Schwab can be purchased between $40-$55 per share with $40 per share offering a reasonable margin of safety.
FINAL THOUGHTS
While Schwab faces some challenges in the current economic environment, the movement of deposits within the company should provide some solace to investors given Schwab’s capital position. The company remains a leading player in the financial services industry, and has positioned itself to attract new business as a result of the banking turmoil which should bode well for the company’s longer term prospects. It will be important to monitor Schwab’s performance in the coming months including the impact of persistent deposit outflows and the management of their capital position. Taking all of this into consideration, it appears that many of these risks are priced into Schwab’s stock price with the exception of a run on deposits and specific changes to banking regulations. For these reasons, Schwab may not be for the faint of heart or for those with shorter time horizons. For those willing to bear these risks and the near term headwinds on earnings, Schwab may offer a compelling opportunity to investors.
Disclosure: I have currently have small long position in Charles Schwab.
