Does Renewed Interest in Schwab Make it a Buy?

Financial pros began dumping shares of Charles Schwab (SCHW) en masse back in March during the regional banking crisis.

Since then, it’s been one misstep after another.

The company acquired TD Ameritrade and then transitioned customers off TD’s Think or Swim platform.

So many customers complained Schwab was forced to rerelease the app a month later.

In August, TD clients pulled a net $23.2 billion out, while all other customers added a net $28.1 billion. Most of the outflows came from registered investment advisors the company kicked out because they ‘didn’t meet our criteria.’

A recent surge in search volume by financial pros comes after the company announced dismal earnings in October and laid off 2,000 employees in early November.

As we looked through our Trackstar Data for clues to what financial pros were thinking, it became clear that despite the huge drop in share price, they’re still hesitant to invest in Schwab.

Here’s why.

Schwab’s Business

Charles Schwab won over retail traders and investors with excellent customer service and education, growing to the second-largest brokerage in the U.S. with $8.02 trillion under management and over 32 million clients.

Charles Schwab segments its business into the following areas:

• Investor Services (70% of total revenues) – Focuses on retail brokerage and banking, retirement plan services, and corporate brokerage to individual investors and businesses.
• Advisor Services (30% of total revenues) – Delivers custodial, trading, retirement, and support services to independent investment and retirement advisors, along with record keepers.

Although quarterly revenues climbed by 16.8%, a 33.3% drop in net income ensued from escalating operating costs and taxes.

The real challenge lies in holding onto customer deposits.

Schwab, like banks, makes money on net interest margin (the rate at which it pays depositors and the rate it invests). 

Interest expenses soared, primarily due to a spike in depositor yields from 0.23% to 1.24% and an additional $477 million from Federal Home Loan Bank borrowings.

The company borrowed $36.2 billion from the FHLB to shore up its balance sheet during the regional banking crisis at a rate of 5.18%. However, that’s down from $46.8 billion from last quarter. Yet, that coincides with a drop in assets, which isn’t ideal.

At the current rate, Schwab will repay the entire balance within a year, reducing one of its largest interest costs.

Financials

Source: Stock Analysis

Revenues jumped in 2021 with the acquisition of TD Ameritrade in late 2020.

Since then, Schwab’s attempted to hold the line in the face of the fleeing depositors.

In the last two years, profit and free cash flow margins have declined as interest costs skyrocketed.

Right now, Schwab is doing what it can to reduce its investment interest rate exposure, hold onto deposits, and reduce costs. Not an easy task.

Valuation

Source: Seeking Alpha

A the moment, Schwab trades at a premium relative to its peers.

Its 18.6x P/E ratio is higher than every other competitor. Even its price to book ratio is 3.6x, which is excessive for a broker or bank.

However, Schwab may be priced under the assumption its FHLB costs will disappear.

Yet, the forward P/E is still high, especially when you can buy Goldman Sachs (GS) for 14.0x next year’s earnings.

Growth

Source: Seeking Alpha

While Goldman and Morgan Stanely (MS) forecast revenue declines next year, other brokers see slight growth, with Interactive Broker (IBKR) predicting +20% gains.

In fact, they, along with Raymond James, expect double-digit EPS growth next year as well.

Schwab’s revenue growth looks great, but that’s largely from their acquisition of TD Ameritrade.

Profitability

Source: Seeking Alpha

Schwab’s profitability appears unusually high relative to its competitors. Yet, it’s roughly the same as it was in 2018.

However, it’s not truly indicative of the decline in performance the way as the return on assets, which is a paltry 1.59%.

Our Opinion 3/10

We cannot recommend Schwab any more than we would a below-average regional bank.

Management failed to hedge interest rate risk and now faces a flight of deposits that its bungled transition from TD Ameritrade exacerbated.

While the company may turn around, we believe there are many other and better opportunities in similar businesses.