Description

Schwab is the largest publicly traded brokerage with ~$3.4 trillion in client assets.  It has averaged a ~20% return on equity over 30 years by providing the industry’s best value proposition to retail investors, which has led to consistent net inflows of client assets, which has led to lower costs per dollar of client assets and better profitability, which has led to even more investments in the value proposition. This virtuous cycle has led to core net new asset growth (i.e., new to firm client assets net of withdrawals) averaging 6% over the last decade, never falling below 5% in any one year. Existing client assets also grow organically over time from investment gains; roughly 60% of the S&P 500 performance is a good proxy for growth of existing client assets.  This leads to a consistent high single digit revenue growth rate, assuming constant interest rates, and lower costs per dollar of client assets as the business benefits from economies of scale. The following chart illustrates the moat:

For years Schwab has intentionally deemphasized trading revenue (< 7% of revenue last quarter) and instead focused on better monetizing its clients’ yield insensitive cash. With three clicks, any of Schwab’s clients can purchase a competitively priced money market fund, yet still its clients leave $243 billion idle, earning roughly 12 basis points through their deposit sweep program.  This is clear evidence that most of Schwab’s customers don’t care about the yield on their cash. They come to Schwab for a safe and convenient place to invest their life-savings with low trading costs and low fee ETFs, not for the yield on their cash. This enables Schwab to earn an attractive ROE while maintaining a highly liquid, low risk balance sheet. This yield insensitivity also means Schwab has significant leverage to rising rates.

Because the deposit base is invested in short duration securities, Schwab’s earnings have been depressed since the financial crisis. As a result, it hasn’t been able to retain enough capital to sweep all of the yield insensitive cash gathered through client asset growth over the last decade onto the bank balance sheet. Roughly $70 billion of yield insensitive cash has built up in money market funds.  This allows Schwab to earn ~30 bps of fee income with no capital investment, but by sweeping this to the balance sheet, Schwab can earn an incremental ~220 basis points on the cash (or an incremental $1.2 billion in after tax earnings) but would need to reinvest ~$4.7 billion in the business to maintain its 6.75-7.00% target leverage ratio. The incremental upside grows as rates rise.

Schwab has finally hit the inflection point where earnings are more than sufficient to cover all capital needs to grow the business, even with low interest rates, and they can begin sweeping this $70 billion onto the balance sheet. Schwab is also currently running above its target leverage ratio (7.6% at year-end), due to temporary factors, providing more capacity to sweep cash onto the balance sheet. Once it crosses the $250 billion threshold, it becomes subject to a different regulatory status.  In order to avoid crossing that threshold in 2017, management intentionally deferred moving some client cash onto the balance sheet last year but continued to retain earnings. I expect this to normalize in 2018 and 2019 through large cash transfers to the balance sheet.

Schwab ended 2017 with $17.4B in Tier 1 capital; if they add $2.7B from earnings (Q4 2017 run-rate) they would end this year with $20.1B in capital.  If we assume they sweep enough cash onto the balance sheet to be at the mid-point of their target leverage range, they would have $292B in assets at year end, compared to Q4 2017 average earning assets of $224B (end of period was $243B).

Schwab’s net interest margin (NIM) in the most recent quarter was 2.03%.  40% of the balance sheet is invested in securities with a 3-month duration.  3-month Libor averaged 1.46% during Q4 and is currently at 2.05%. So 40% of the balance sheet should already have a 60bps higher yield than reflected in the Q4 2017 NIM.  The other 60% of the balance sheet has a 4-4.5 year duration. The 5-year treasury averaged 2.06% during Q4 2017 and is currently at 2.64% today. So the remaining 60% of balance sheet should already have a 57bps higher yield than reflected in the Q4 2017 NIM.  So the average return on earning assets should be 58bps higher. If we assume a 20% deposit beta (consistent with recent past and management statements), the cost of funds should increase by 12bps, bringing NIM to 2.49%. A $292B asset base @ 2.49% NIM = $1.818B quarterly run-rate net interest income, compared to Q4 2017 at $1.147B.

NOTE: This only assumes todays interest rates, no further increases, and is higher than managements recent guidance of a 2.1-2.2% 2018 NIM.  Rates have gone up ~20bps since management issued that guidance, and I think they were sandbagging to begin with; their guidance assumed only one rate hike this year.  I also believe they sandbagged the balance sheet guidance with a growth target of “at least 15% in 2018.”

Assuming money market fund revenue is cut in half (Schwab recently lowered fees by ~40%) and other asset management revenue stays flat, Schwab would produce an incremental $571MM of revenue compared to Q4 2017.  If all expenses increase 10% YoY that would be a $129MM hit. So end of 2018 run-rate pre-tax earnings should be $442MM higher than Q4 2017 of $953MM. That gets us $1,395MM. Tax it at 23.5% and deduct $47MM in preferred dividends and we get $4.08B run-rate earnings power at the end of 2018.  Divided by 1.358B dso = $3/share. Note, this is an end-of-year run-rate, so would be higher than 2018 EPS and lower than 2019 EPS. Schwab won’t exhaust the money market sweep opportunity in 2018; they will still have another ~$45 billion to sweep in 2019, which would increase earnings by ~$0.55/share.  Consensus is $2.40/share in 2018 and $2.85 in 2019.

Also note that a 100 bps parallel shift in the yield curve would increase earnings by another $0.75-$1.00/share depending on how much of the benefit Schwab reinvests in its value proposition.

Paying ~18.5x forward earnings (15.5x if we give full credit for the sweep opportunity) for a quality business that is a major beneficiary of rising rates and has a long runway to grow earnings at more than double the index rate is very reasonable.  As a reference, pre-financial crisis, when the inflation hedge had limited value, Schwab’s forward multiple was 21-25x.

Risks:

Irrational Competition – TD Ameritrade and Etrade are at such a cost disadvantage because of their size that they really can’t afford to compete on price.  But Schwab competes on a more level playing field with Fidelity. If Fidelity took any aggressive pricing actions, Schwab would have to match which would materially reduce the value of the business.  With that said, Schwab has clearly signaled its intent to be rational and Fidelity has no incentive to compete on price. At the last investor day, Schwab’s CEO stated “So long as we sit here today in an environment where price in our view is no longer a barrier to coming to Schwab, we don’t necessarily see reasons for us to be taking pricing actions.  But I would state with great confidence that if we found ourselves ever in a situation where key competition felt they were going to price underneath us, that would not be a situation that would be tenable to us.”

Disrupters – Without understanding Schwab’s business, a “free” Robin Hood type service seems like it could be disruptive.  But Schwab already offers free trading on pretty much any ETF that a retail investor should be investing in. 47% of Schwab’s trades were free last year.  On top of that, they are the exclusive home to Schwab’s proprietary ETFs which have the lowest fees in the industry. So for the typical buy and hold investor who is buying ETFs and holding cash, Robin Hood is actually more expensive and a far more dangerous home for your wealth.  I wouldn’t want my broker to have a client base full of millennial day traders on margin. A valuable active trader that may be attracted by Robin Hood’s “free” trading would likely already be an Interactive Brokers customer anyways. Interactive Brokers has always been the better option for that clientele.  54% of Schwab’s clients also have some kind of an advisory relationship, whether that’s directly with a Schwab adviser or through an RIA. These clients want some hand holding for a reasonable fee, something not available through Robin Hood. Also, I expect Schwab to stop accepting payment for order flow in the near future, which would allow them to attack one of the major revenue sources of the “free” trading services.  Eliminating this practice would only reduce revenue by ~1%.

Market Sensitivity – 29% of Schwab’s revenue is market-sensitive balance-based fee revenue.  To the extent markets sell off broadly, this revenue would decline. However, to the extent a sell-off is a result of a faster than expected pace of rate increases, Schwab would be a net beneficiary (NIM expansion would much more than offset lower fee revenue).  Absent a meaningful increase in rates, markets seem more or less fairly priced to me, so any sell-off unrelated to rates increasing would likely be a temporary set-back, not a permanent step-down in earnings.

Catalyst

1) Time, 2) Balance Sheet Normalization, 3)Interest Rate Increases