Description

Recommendation: Buy a ‘dream business’ trading at 13.3x 2024E P/E and 6.0x 2024E EBIT combining high ROE and free cash flow generation capabilities with a competitive moat and potential for capital allocation-driven re-rate. 

Executive Summary: The Charles Schwab Corporation, Inc., (“Schwab,” “SCHW,” or “the Company”) is a high-quality, defensive online brokerage with nearly $7T in customer assets. SCHW retains strong economics on client cash deposits, generating as much as 70% of its profitability from 10% of client assets on its balance sheet, and generates higher profitability in a rising rate environment. SCHW’s ability to generate significant profits on a fraction of customer assets improves customer retention, as SCHW can offer best-in-class customer service and products at very little or no cost. SCHW trades at reasonable valuations of 13.3x 2024E P/E, 6.0x 2024E EBIT, and 5.4x 2024E EBITDA when considering the Company’s consistent, profitable growth since 2009 which shows no signs of moderating. Further, SCHW is approaching a critical inflection point in its 20yr evolution from an asset-lite to asset-heavy business model and is poised to return a significant amount of cash to equity holders.

Company Overview

The Charles Schwab Corporation, Inc. is a savings and loan holding company engaging in wealth management, securities brokerage, banking, asset management, custody, and financial advisory services. As of Q2 2022, SCHW had $6.83T in client assets, 33.9mm active brokerage accounts, 2.3mm corporate retirement plan participants, and 1.7mm banking accounts. Founder Charles “Chuck” Schwab started the business in 1982, growing it from a monthly newsletter into a financial behemoth dedicated to providing Americans with a better investing experience at a highly competitive cost. Management estimates that investable wealth in the United States currently exceeds $70T, which based on client assets on the balance sheet today SCHW has penetrated just 12%.

Charles Schwab offers wealth management, securities brokerage, banking, and related financial services to both individual and institutional clients. SCHW reports two business segments, i) Investor Services and ii) Advisor Services. Investor Services offers individual investors access to a broad set of products, tools, education, trading and advisory solutions, along with award-winning and 24/7 service to all clients, regardless of asset levels, via online, mobile, telephone, and branch support. According to SCHW management, the Company maintains Net Promoter Scores in the mid-to-high 60s and 83% of SCHW clients rate the Company’s phone-based service experience a perfect 7 out of 7. Advisor Services span a broad range of discretionary and non-discretionary products and strategies, with minimum investments starting as low as $5,000. Schwab Private Client features a personal advice relationship with a designated Private Client Advisor, supported by a team of investment professionals who provide individualized service, a customized investment strategy developed in collaboration with the client, and ongoing guidance and execution. SCHW also offers referrals to an independent RIA in the Schwab Advisor Network to provide personalized portfolio management, financial planning, and wealth management solutions. SCHW also offers clients diversified mutual fund and ETF strategies, including fixed income, ESG, and crypto.

Variant View: Wall Street analysts treat SCHW like a bank, focusing on metrics such as Net Interest Margin (“NIM”) and balance sheet deposits to inform profit forecasts. However, this analysis misses the crux of the SCHW thesis. Over the past 20 years, SCHW has evolved into a version of Warren Buffett’s ‘Dream Business,’ transitioning from an ‘asset-lite’ brokerage into an asset-heavy, complex, highly regulated institution. SCHW’s ‘no trade-offs’ customer-first strategic approach and consistent reinvestment into both its service offerings and its balance sheet have built an incredibly resilient and powerful franchise that is not well understood by the market. SCHW is loved by its diversified customer base of Registered Investment Advisors (“RIAs”) and retail investors who are receiving great service at a very small or no cost. SCHW can provide this high level of service effectively for free as the Company earns a substantial amount of its profits on just 10% of its customer deposits, which the customer is not even aware is taking place. SCHW is in a unique situation where the vast majority of its profitability is derived from something that its customer doesn't value that much. SCHW is reinvesting in a growing customer flywheel, where repeat business is generated because of the service SCHW provides. Further, SCHW’s competitive moat is only widening as its large pool of assets and complex, highly regulated business model have made it extremely difficult for new entrants to unseat its market positioning. The anticipated catalyst to a re-rating is SCHW returning significant amounts of capital to its shareholders in the form of dividends or share buybacks. While SCHW bulls believe this may not occur for another 2 – 3 years, recent messaging from SCHW management around Tier I equity ratios, a 10% dividend increase, and a $15bn share repurchase authorization suggests capital returns might come sooner than the market thinks

Comparables

Valuation, Historical & Projected Performance

On FactSet consensus estimates, SCHW trades at 

• 5.8x 2023E EV/EBITDA and 5.4x 2024E EV / EBITDA

• 6.6x 2023E EV/EBIT and 6.0x 2024E EV/EBIT

• 14.4x 2023E P/E and 13.3x 2024E P/E

• 8.3x 2023E Cash Flow from Operations (“CFO”) and 7.2x 2024E CFO

Chart 1: FactSet Estimates

How Schwab Makes Money

According to its filings, Schwab’s largest sources of revenue are i) net interest revenue, ii) asset management and administration fees, iii) trading revenue, and iv) bank deposit account fees. 

• Net interest revenue is defined as the difference between interest generated on interest-earning assets (uninvested client cash balances held on Schwab balance sheet) and interest paid on funding sources (high-quality fixed income securities, margin loans, and bank loans). 

• Asset management and administration fees are earned from proprietary and third-party money market funds, mutual funds, ETFs, and fee-based advisory solutions. 

• Trading revenue includes commissions earned for executing trades for clients in equities, options, futures, fixed income securities, and certain third-party mutual funds and ETFs; order flow revenue; and principal transaction revenue earned primarily from actions to support client trading in fixed income securities, margin loans, and bank loans.

• Bank deposit account fees are primarily recognized under Schwab’s Insured Deposit Account (“IDA”) agreement with Toronto-Dominion Bank, as well as sweep agreements with other third-party depository institutions. Under these agreements, uninvested cash within eligible brokerage client accounts is swept off-balance sheet to deposit accounts at the TD Depository Institutions and other third-party depository institutions. 

In FY 2021, Schwab generated $8bn in net interest revenue, which Morgan Stanley projects will rise to $17.9bn by FY 2026 at a 17.3% CAGR. According to Colossus’ Business Breakdowns podcast, Schwab’s net interest revenue represents extremely high margin dollars. Holland Advisors estimates that Schwab earns roughly 60 – 75% of the Company’s Net Income from the 10% of customer assets sitting in cash within their current/deposit accounts. Schwab customers are paid 0.1% interest on these cash assets, which they elect to sweep to Schwab via push notification or landing page prompt. Assuming interest rates are
2% – 3%, Schwab earns the difference in margin. The remaining 25 – 30% of Schwab’s Net Income comes from a combination of asset management and administration fees, bank deposit account fees, and a small amount of trading fees.

Chart 2: Schwab Net Interest Margin & Revenue Return on Client Cash Balances

Why Schwab’s Net Interest Revenue Matters

The vast majority of Schwab’s profitability is derived from an action Schwab’s customer doesn’t value that much, or in some cases may not even realize. Schwab customers pay little to no fees to invest through Schwab’s platform. Schwab’s customers believe they are getting a lot of services without any fees – customers are simply foregoing a small interest rate benefit for the convenience of the Schwab platform. Schwab is anticipated to generate $20.9bn of revenue and $11.2bn of EBITDA in FY 2022E, which is a significant amount of value being captured on deposits that its core customer doesn’t value all that much. 

Chart 3: SCHW Net Interest Revenue & Net Interest Margin Earned vs. 10yr UST Yield

Understanding Schwab’s Competitive Moat

The scale of Schwab’s net interest revenue is impressive and a testament to a 20-year strategic vision that Schwab has been diligently building toward over the years. Over the past 20 years, Schwab’s competitive moat has widened as the Company scaled assets and regulatory complexity, evolving from an asset-lite business model into an asset-heavy, intensely regulated entity. Schwab’s large pool of assets provides it with scale advantages that afford the Company a unique ability to make a significant profit on a relatively small portion of the customer’s deposits which the customer is indifferent towards. Asset-lite brokerages such as Interactive Brokers and Hargraves London make almost all their revenue on trading fees, margin loans, and custody. While these asset-lite brokerages make a small amount of net interest revenue, without a regulated bank balance sheet, the money on deposit with these brokerages is required to sit off these brokerage’s balance sheets at a third-party bank to earn bank deposit account fees. Asset-lite brokerages earn 10 – 30bps from bank deposit account fees. In comparison, asset-heavy brokerages sweep client deposits onto their wholly-owned banking subsidiaries, which are used to extend loans to clients and purchase investment securities. By sweeping this cash and laddering deposits out in a securities portfolio, Schwab captures a significantly higher net interest margin than the asset-lite brokerages. Per Chart 3, Schwab’s net interest margin was 2.41% in 2019, 1.62% in 2020, and 1.47% in 2021, driving net interest revenue up from $6.5bn in 2019 to $8.0bn in 2021. The key takeaway is that Schwab generates sustainably high net interest margins while growing revenue at a tremendous clip. Understanding the nuances behind how Schwab can accomplish this is the crux of the thesis and illustrates why Schwab’s competitive moat would be extremely difficult to penetrate. New entrants to the brokerage space would be hard-pressed to
i) accumulate the amount of deposits Schwab has under management, and ii) navigate an increasingly more complex regulatory framework to maintain compliance. 

Competitive Moat #1: Size & Scale

Historically, brokerages earned money through trading fees, margin loans, and other ancillary products. In October 2018, Interactive Brokers announced it would offer zero trading commissions to a small subset of its customers. Schwab one-upped Interactive Broker’s maneuver, going across its entire network and cutting the cost of buying and selling USD-listed securities to zero. Schwab’s share price fell 9% on announcement day, but the maneuver was a brilliant long-term strategic play aimed at hamstringing competition such as TD Ameritrade, E-Trade, and Interactive Brokers which were far more reliant on trading fee income as a source of revenue. Most US customers today pay nothing for trading fees on US and Canadian-listed securities and it is unlikely this revenue stream ever returns to historical levels. Schwab was able to lead the transition to zero trading fees without cannibalizing its own business because the Company had accumulated enough capital over time to drive corporate profitability almost entirely on its net interest margins, which Schwab earned by sweeping customer cash onto its balance sheet. New brokerage entrants had historically used trading and margin loan fees to scale their business growth. Schwab’s maneuver ‘pulled up the ladder,’ simultaneously crushing the Company’s existing competition while making the path to scale for any future entrant nearly impossible. A new entrant to the brokerage industry today wanting to achieve a similar scale as Schwab would need to be willing to burn cash through uneconomic client offers and partnerships for 10 – 20 years before it could begin to rival Schwab’s market positioning and $7T of client assets. Such a venture in today’s funding environment would be incredibly risky with a low probability of success. Schwab’s competitive advantage only becomes stronger in volatile bear markets where every dollar of corporate cash burn is being scrutinized.

Similar business case analogies can be found in the credit card industry as well as e-commerce. American Express is one business case study example. Credit card/charge card companies might have been set up to compete with American Express by charging lower merchant fees or offering uneconomic incentives to attempt to steal away customers. However, given the number of customers required to bring merchant fees to a sufficient level of profitability, new entrants would find this path extremely challenging to execute. Amazon is another business case study example, where cutting delivery fees to zero and reinvesting every dollar back into its business hurt competition. Anyone attempting to compete with Amazon’s e-commerce capabilities today would find it extremely challenging to replicate Amazon’s scale and logistics advantage.

Competitive Moat #2: Highly Regulated Industry

Acquiring $7T in assets would be a significant operational challenge for any financial institution on its own. Keeping these assets on balance sheet is arguably just as difficult. Brokerages such as Schwab fall under strict compliance by various governmental agencies, supervisory authorities, and self-regulatory organizations (“SROs”). This includes the Federal Reserve, the Federal Deposit Insurance Corporation (“FDIC”), and the Consumer Financial Protection Bureau (“CFPB”), among others. Schwab is required to undergo an annual Dodd-Frank Act Stress Test, report a quarterly Tier I/II/III liquidity coverage ratio, and prepare a quarterly Basel III disclosure statement. Charles Schwab Corporation (CSC) is required by the Federal Reserve to maintain a Tier 1 Leverage Ratio of at least 4.00%, and the Company has a long-term operating objective of 6.75 – 7.00%. Schwab’s principal banking subsidiary, CSB, is required to maintain a Tier 1 Leverage Ratio of at least 5.00% to be sufficiently capitalized but seeks to maintain a ratio of at least 6.25%. CSB finished 2021 with a Tier 1 Leverage Ratio of 7.1%, while CSC finished at 6.2%. Despite extreme volatility over the past two quarters, SCHW ended Q2 with a consolidated Tier 1 leverage ratio of 6.4%, with the entire entity in a sound capital position today. Schwab’s asset-heavy balance sheet requires the Company to make a significant, recurring financial commitment to maintaining compliance, which builds tremendous complexity and corporate overhead into the business model. It is important to note that for the past 20 years, Schwab has actively pursued this highly regulated model, evolving from an asset-lite brokerage to asset-heavy.

Brokerages can be loosely separated into two groups; i) asset-lite and ii) asset-heavy. Asset-lite competitors such as Interactive Brokers, Hargreaves Lansdown, and E-Trade are not subject to the same level of bank-like regulatory scrutiny and capital controls as the asset-heavy competitors. Effectively serving as a platform for buying and selling securities, asset-lite brokerage revenue is derived mostly from custody, advisory, and margin loan fees. This is a very different revenue model from Schwab. Without the balance sheet scale to keep customer deposits in-house and earn a net interest margin spread, asset-lite brokerages only earn what they can charge their customers for. If a scale competitor such as Schwab undercuts these service fees, the asset-lite model becomes vulnerable.

Schwab’s key strategic insight driving its pivot from asset-lite to asset-heavy was the recognition of the profit pool that can be derived from sticky customer assets. Bank customers at JP Morgan, Bank of America, and Wells Fargo routinely take money out of their checking accounts. However, these same customers are far less likely to take money out of their savings, brokerage, and 401k accounts. Sticky deposits that sit on Schwab’s balance sheet can be repurposed to earn a margin. At the same time, these sticky deposits can fuel a better customer experience, including i) free trading ii) access to other low-fee investment products, iii) very low custody rates, and iv) high-touch customer service. The strategic benefits of the asset-heavy model in creating sticky deposits generating high levels of profitability more than offset the necessary regulatory burden.

Competitive Moat #3: Best-In-Class Customer Service Flywheel

The keystone of Schwab’s asset-heavy model is gathering customer assets and keeping them on the balance sheet. This has driven SCHW’s steady, stable growth over the years (Exhibits 1 & 3). Reinforcing this growth is management’s steadfast commitment to top-tier customer service, a strategy they refer to as “Through Client’s Eyes.” On SCHW’s July 28 Summer Business Update call, CEO Richard Wurster stated that when Schwab sees through its clients’ eyes, its corporate priorities are clear.

“…what we continue to hear from clients is they want the combination of low-cost and high-quality experiences and solutions that deliver great value, the transparency that is the foundation of any trusted relationship, multichannel experiences that meet them where they are, and ease. Clients expect their interactions with us to be easy, and they also want to consolidate as much of their financial lives as possible into one place.

The reason clients continue to turn to Schwab is our consistent no tradeoffs approach…At Schwab, clients don't have to choose between low-cost and stellar service, access to some of the best service professionals in the industry, and the digital and technology platforms and experiences they expect from a modern firm: straightforward, foundational investment offers, and more personalized solutions; tools and capabilities for those who want to take investing into their own hands; and a spectrum of advised offers that help clients get to where they want to go with the help of a professional; proprietary and third-party products that give them the choice they want.

They don't need to make any tradeoffs because Schwab is uniquely positioned to deliver it all here with our strength as a wealth manager, as a bank, and as an asset manager. Our size and our focus uniquely enable us to deliver for clients in a way that sets us apart in the industry. And this focus, which starts with seeing through clients' eyes drives the virtuous cycle. This means we will continue to put clients at the forefront and challenge the status quo to benefit investors. And when we do that, investors will reward us by trusting us with more of their assets. This leads to consistent financial results and outstanding stockholder value, which enables us to continue to invest in our business to serve our client’s needs, and that brings us back to the start of the virtuous cycle.”

Chart 4 depicts the virtuous cycle in visual form. Core Net New Asset growth from investors leads to higher Net Interest Margin, driving revenue and EPS growth. A portion of these earnings are reinvested back into Schwab’s OpEx to “challenge the status quo to benefit investors.” Investors then reward SCHW with more of their assets, and the virtuous cycle continues anew.

Chart 4: Schwab’s Virtuous Circle

Schwab’s commitment to excellent customer service shows up in its Net Promoter Scores and customer surveys. The Company receives Net Promoter Scores in the mid-to-high 60s, with High Net Worth investors with $1 – $10mm of assets (Schwab’s fastest growing client base) giving the highest scores overall. 83% of Schwab’s clients rate their phone-based service experience a perfect 7 out of 7. Schwab is committed to meeting its customers through whichever medium is most valuable to them, whether online, by phone, or in person at a branch. Schwab’s focus on building loyalty with its clients translates to robust organic growth and strong market positioning.

Key Performance Indicators That Matter

There are several GAAP and Non-GAAP metrics investors can track to determine whether the Schwab thesis is working. GAAP Metrics include Schwab One Client Cash Deposits Growth, annualized Return on Equity (“ROE”) and Return on Assets (“ROA”), and Client Assets Growth vs. Brokerage Accounts Growth. Exhibits 8 – 10 graph these various metrics from the early 2000s through Morgan Stanley’s forecasted Base Case FY 2022E. Key Non-GAAP metrics which Schwab discloses within its Annual Report include Revenue on Client Assets (“ROCA”) and Expenses on Client Assets (“EOCA”), found in Exhibit 1. SCHW management tracks ROCA and EOCA as a measure of value delivered to clients and internal operating efficiency. ROCA has declined by a little more than 1/3 since 2004 while the Company has been able to slightly improve profitability. According to management, lower ROCA means SCHW clients are paying less for SCHW services over time even as the products and offerings continue to be enhanced, which results in greater overall delivered value. EOCA has been reduced by more than half since 2004, reflecting both SCHW’s larger scale and high fixed costs, but also management’s disciplined focus on productivity and operating efficiencies. Another important non-GAAP metric is SCHW’s Transfer Of Account Ratio (“TOA Ratio”), which the Company reported at 1.6x as of Q2 2022. Management uses the TOA Ratio as a measure of competitive strength in terms of relative market share. A measure of 1.6x implies SCHW is winning $1.60 from competitors for every $1.00 of client assets they lose. I believe tracking these GAAP and Non-GAAP metrics over time can help investors get comfortable with SCHW’s consistent operating performance.

Capital Allocation

Schwab has paid 131 consecutive quarterly dividends since first issuing a dividend in 1989, increasing the dividend rate 25 times at a 20% CAGR. SCHW targets a common stock cash dividend payout ratio of approximately 20 – 30% of net income. On July 27, SCHW declared a 2 cent, or 10% increase in its quarterly common stock cash dividend to $0.22 / sh. The Board of Directors also replaced the previous $1.8bn of authorized share repurchases with a new $15bn share repurchase plan, targeting either open market or privately negotiated transactions. On August 1, SCHW announced the purchase of approximately 15mm shares of nonvoting common stock directly from TD Bank Group (“TD Bank”) for $1bn. SCHW’s public disclosure when assuming the market’s forward rate expectations as of mid-July indicates that the Company will deliver FY 2022E revenue growth between 11 – 13%. According to SCHW management, revenue growth combined with expense discipline driving “expanded earnings power and increased capital levels unlock[s] the opportunity for additional capital return activity” above and beyond the 10% increase and $15bn repurchase authorization. CFO Peter Crawford characterized the TD repurchase transaction as representing a “bring-forward of activity that might have otherwise occurred later this year” and their opportunistic purchase was “done in the best interest of [SCHW] stockholders.” Mr. Crawford clarified further that this transaction “does not necessarily indicate that we’re ready to begin open market repurchases of our stock” suggesting open market repurchases have not meaningfully begun, but that they might soon. “Looking ahead, while supporting Schwab’s long-term growth and maintaining appropriate regulatory ratios remain our prime objectives, the combination of our expanding earnings power and increasing capital levels has us clearly on a path towards a compelling growth plus capital return story.” 

On Morgan Stanley’s Base Case forecasts, at $69.92, SCHW equity implies a 1.6% 2022E, 1.6% 2023E, and 1.8% 2024E dividend yield and a 23.5% - 28.0% payout ratio based on Operating Core Net Income. In a 2018 Goldman Sachs equity research report, analysts argued that SCHW could achieve 55 – 70% total payout ratios in a bull case scenario. This would imply a 2.3 – 2.5x increase in SCHW’s dividend assuming earnings remain flat. SCHW is expected to grow revenue at an 11.5% CAGR, EBITDA at 16.5% CAGR, and GAAP EPS earnings at a 21.5% CAGR. Assuming 2024E GAAP EPS of roughly $5.00, SCHW would need to grow the dividend 7% annually just to keep payout ratios flat. Morgan Stanley maps average annual net capital return between 2022E and 2026E (combining dividends and buybacks after netting out new shares and option exercises) of $2.9bn on $9.6bn of Operating Core Net Income, roughly 27.7%. SCHW equity benefits from persistently high Adjusted ROE metrics above 20% and a capital return policy with the potential for significant convexity to earnings growth.

Mr. Crawford eloquently summarized the Schwab investment thesis in his closing remarks of the July 28 Business Update Call, reflecting a business that’s executing at an extremely high level while prioritizing shareholder returns.

“[SCHW] is a company built and managed for the long term. So while we're certainly pleased by our current financial performance despite the difficult macro environment, we are much more gratified by our ability to consistently drive a set of behaviors and outcomes that have enabled us to deliver for clients and stockholders for over four decades. [SCHWB is]…[c]ontinuing to be the premier asset gatherer, as indicated by our net new assets, new accounts and TOA ratio, a reflection of our Through Clients' Eyes strategy and formidable competitive position. Building a diversified and resilient business model that converts business growth into revenue growth, producing record revenue in the second quarter. Maintaining discipline in how we manage expenses, reducing operating leverage through the cycle and increasing margins, which have now reached nearly 50% and have an opportunity to continue to climb. And being very efficient in how we deploy the capital that has been entrusted to us, or as we're now poised to do, return excess capital to our stockholders.”

Investment Strengths

Schwab is the brokerage best positioned to navigate the hyper-competitive backdrop given scale, balance sheet strength, and franchise strength.

Schwab is well-managed and highly profitable with a competitive moat that is nearly impossible to replicate. Schwab’s size and scale, heavily regulated asset-heavy business model, and best-in-class customer service create a powerful flywheel. Schwab’s customers extract a significant amount of value from Schwab services for little to no fees, while Schwab generates significant profit from a fraction of its customer’s assets which the customers don’t value. Schwab has a near-perfect alignment with both its customer base and its shareholders. 

'Dream business’ trading at the low end of historical P/E multiple ranges.

SCHW trades near the bottom of its P/E multiple ranges despite strong execution. Schwab’s management provides clear financial targets and goalposts with their long-term financial formula. The formula calls for high-single digit to low-double digit client asset growth, 5 – 7% organic revenue growth, and expanding pre-tax margins through scale and expense discipline which drives low double-digit earnings growth. Factoring in SCHW’s capital return program creates mid-teens EPS growth. Despite strong execution and capital allocation levers to the upside, SCHW is trading near the bottom of its P/E multiple ranges (Exhibits 11 & 12), suggesting there is margin of safety in SCHW equity today.

Emerging capital return story.

Schwab generates mid-20s Return on Equity by capturing spread off-balance sheet client cash. Over the past decade, SCHW has been moving off-balance sheet client cash into its bank subsidiaries. This allows it to capture a greater spread on these balances by laddering them out in a securities portfolio rather than collecting a comparatively lower money market fund fee. This has been an extremely attractive use of capital, which generates mid-20s ROEs after factoring in lost money market fund fees. As this process comes to an end, SCHW's organic capital generation from earnings will outpace its growth, leading to significant excess capital. Street analysts see a significant acceleration in share repurchases as SCHW maintains a ~20 – 30% dividend payout ratio and deploys excess capital generation into share repurchases.

Earnings are positively correlated to higher interest rates.
Schwab’s net interest margin captures greater value as rates rise. Schwab’s ‘all weather’ business model benefits from higher interest rates, as client cash deposits earn higher net interest revenue. Assuming the Fed Funds rate finishes FY 2022 at 3.50% (in line with market consensus DOT plots) SCHW forecasts FY 2022 revenue growth of 11 – 13%. Exhibit 13 contains information regarding SCHW’s securities portfolio which derives this net interest revenue.

Schwab is continuing to drive efficiencies in its business and is taking incremental share from retail brokerage competition.
ROCA, EOCA, and TOA Ratio metrics suggest SCHW management is executing well. Schwab’s management is explicitly clear in how they measure operational performance, giving investors clear metrics and guidance to monitor

Investment Risks

Any reduction in client cash allocations would negatively impact SCHW’s net interest margin captured and total revenue growth.

SCHW depends on a consistent, sticky client cash allocation to generate income. Client cash awaiting investment in client brokerage accounts is swept to its wholly-owned banking subsidiaries, which is used to extend loans to clients and purchase investment securities. SCHW also sweeps a portion of this cash to unconsolidated third-party financial institutions to earn lower margin bank deposit account fees. Changes to this allocation could negatively impact SCHW revenue and earnings.

M1: Client cash as a % of client assets was 10.9% in 2021, down from 12.3% in 2020 and 11.3% in 2019. Exhibit 8 graphs Schwab One client cash deposits over time, plotted against realized net interest margin. Deposits have grown over the projection period, while net interest margin has recently begun to increase as the Fed raises interest rates.

Bears are concerned SCHW’s client cash assets will decline as customers shift capital out of the system.

Cash sorting has been a key topic of conversation on recent calls with SCHW management. Bears believe that in a persistently high interest rate environment, SCHW’s balance sheet could shrink as customers move cash balances to higher yield alternatives such as money funds or off the platform to other brokerage institutions.

M1: On the July 28th Business Update Call, management walked through cash sorting in detail. First, cash sorting dynamics through Q2 2022 have been “very consistent” with management’s expectations. SCHW management estimates that the level of cash sorting won’t be higher than the last rising rate cycle, with the potential to be “somewhat lower” given the fact [the Company] “is not going through the bulk transfer process it was doing in the last rising rate cycle, and that [SCHW] has an influx of smaller accounts who tend to do less sorting.” Further, Schwab’s client base is actively trading much more than they were previously, which tends to improve account cash balances. Management’s tracking of cash sorting across prior periods leads them to be confident that cash “will find its level” so long as the cash remains at Schwab.

M2: Cash sorting driven by rate increases is “just one part of the equation.” According to management, rate increases which can cause higher levels of cash sorting are offset by SCHW’s higher net interest margin on the cash that remains on deposit. To the extent the S&P 500 index finishes FY 2022 down 18%, SCHW management still expects to generate “roughly $500mm more in net interest revenue in Q4 than it did in Q2 despite allowing for some continuation of client cash sorting.”

M3: In the event cash sorting materially increases, there are levers management can pull to offset the impact as Tier I leverage ratios will decrease freeing up capital, which enables SCHW to repurchase higher levels of stock and drive EPS growth. I plan to spend more time diligencing this point along with an update to Exhibit 7.

Bears are also concerned that in the event SCHW’s balance sheet grows over $700bn, the Company’s securities portfolio will lose a regulatory exclusion, putting SCHW behind regulatory requirements and preventing capital returns.

Mark-to-market unrealized losses can negatively impact SCHW’s capital returns if interest rates are high and cash balances are growing. 

M1: Management again provided helpful context on the July 28 Business Update Call, stating these concerns are not factoring into the Company’s capital allocation policies, and that there are several options the Company has to manage these well in advance of them becoming an issue for shareholders. “[M]ark-to-market unrealized losses only matter from a regulatory standpoint if [SCHW] is over $700bn in assets for four consecutive quarters.…we're…going to see this point coming well in advance. The other point is that AOCI goes down with lower rates and it also amortizes steadily over time, about 15% or closer to 20% per year over the next four to five years. So, the only scenario where it poses a ‘problem’ is if rates are high and balances are growing, which, of course, would be a scenario in which we’re producing very, very strong net interest revenue, very, very strong earnings. And…if somehow [SCHW] find ourselves in this situation [the Company can] to utilize [its] Sweep Tower to move some of those balances off [the Company’s] balance sheet into Sweep Money Funds.

Conclusion & Recommendation

Based on my preliminary diligence, Schwab is the rare combination of a Dream Business and Capital Compounder. Schwab’s ‘Dream Business’ of gathering and reinvesting customer deposits affords it a wide competitive moat, massive economies of scale, and sustainably high margins, cash flow generation, and ROEs. On the other hand, Schwab’s banking subsidiaries give it a tremendous ability to compound capital and shareholder returns, without taking credit risk. Further, Schwab has substantial growth prospects as its customers grow assets within their brokerage accounts and are cross-sold investment products and services. A business with these characteristics should arguably trade at a steep premium, yet Schwab trades at the low-end of its historical P/E multiple. SCHW trades at very reasonable valuations of 13.3x 2024E P/E, 6.0x 2024E EBIT, and 5.4x 2024E EBITDA when considering the Company’s consistent, profitable growth. My view is that SCHW is approaching a critical inflection point in a 20-year evolution from an asset-lite to asset-heavy business model and is poised to return a significant amount of cash to equity holders. This action will force a re-rating in SCHW equity.

Exhibit 1: Revenue & Expense as % of Client Assets, 2004 – 2021

Exhibit 2: Wealth & Asset Managers NTM Consensus P/E: 2001 – July 2022

Exhibit 3: Organic Growth Rate vs. Market Index Performance

Exhibit 4: Organic Growth by Customer Segment (Under 40 & Registered Investment Advisors)

Takeaway (Left): Over half of SCHW’s new-to-retail clients are under the age of 40, driving over half of SCHW’s $185bn in Core Net New Assets (“Core NNA”) in 1H 2022. This illustrates that SCHW is not only taking share in the under-40 segment, but winning under-40 investors with substantial investable assets, not simply winning younger investors who have little money with which to invest.

Takeaway (Right): SCHW’s largest share of net new assets in the YTD 2022 period has come from smaller advisors, those who manage less than $500mm.

Exhibit 5: Retail Client Breakdown

Exhibit 6: SCHW’s “No Trade-Offs” Client Approach

Exhibit 7: EPS Sensitivity to Interest Rates & Cash Deposits (November 2018)

Exhibit 8: Schwab One Client Cash Balance vs. Net Interest Margin: 2000A – 2022E

Exhibit 9: EBITDA vs. Return on Equity & Return on Assets

Exhibit 10: Client Assets Growth vs. Brokerage Accounts Growth

Exhibit 11: FactSet NTM P/E Multiples: 30yrs

Exhibit 12: FactSet NTM P/E Multiples: 2006 - Today

Exhibit 13: Schwab Reinvestment Securities Portfolio Summary

Catalyst

Earnings results, share repurchases, dividend increases