Charles Schwab is the leading online broker in the U.S. with about $1.5tn in client assets. Because of the high P/E on current earnings, SCHW doesn't screen as a typical value stock. One has to do the research to recognize this is a high quality, large-cap franchise with a low-cost position and strong secular growth trends who's earnings power is being masked by low interest rates. At the current price of $15, the risk/reward over the next couple years is extremely attractive: downside of $1-2/share and upside of $4-9 share.
Thesis
SCHW is a structural share gainer in the retail brokerage industry. Historically, it has grown net new client assets (excluding market ups and downs) at 5-8% annualized. It is gaining share primarily from the large full service firms (e.g. Merrill Lynch, Morgan Stanley Smith Barney, etc.). In addition to client flows, SCHW's net new assets are also impacted by market increases/decreases (a good rule of thumb is 1% move in equity markets results in a 0.7% move in SCHW's assets).
Although SCHW is the largest online broker in the U.S., less than 20% of revenue comes from client trading commissions. Rather, almost 80% of revenue come from recurring sources charged on the basis of asset values (namely asset management / administration fees and net interest income). The asset management fees come primarily from its mutual fund supermarket whereby mutual fund companies pay SCHW ~30bps annually to distribute their funds to SCHW clients. SCHW also has proprietary mutual funds, which are predominately money market funds. The net interest income is earned as SCHW invests the cash balances that clients keep at the firm. The bulk of these investments are in high quality, short duration securities.
SCHW's current earnings are depressed due to the low level of interest rates, particularly short-end rates. Low short-term rates affect SCHW's earnings in two ways: 1) When rates are extraordinarily low, the company's money market funds have to offer fee waivers to clients. Normally, SCHW's money market funds charge clients ~50bps annually, but when the 3 month LIBOR is just below 30bps (as it is today), it has to waive a large portion of fees so clients don't earn negative money market returns. These fee waivers on money market funds are currently costing SCHW around $440m on an annualized basis, or 23c/share in EPS. 2) SCHW invests client funds held at its bank primarily in short term securities. In a low rate environment, SCHW's net interest margin contracts significantly. In 2007, SCHW's net interest margin was around 4.6% but is around 1.9% in 2010. SCHW estimates that if Fed Funds rise by 100bps, their net interest margin would rise by 60bps, which adds 26c/share in EPS.
The low rate environment has depressed SCHW's earnings over the last couple years, which has caused the stock to lag significantly. Since the recent stock market low on March 10, 2009, SCHW's stock is up +18% vs the S&P +67% and the XLF (benchmark financial ETF) up +107%.
SCHW's earnings power is ultimately driven by the level of client assets, but is being masked today by the low interest rate environment. In 2006-2008, SCHW earned 37-39bps of revenue on average client assets, but in 2010 it will earn about 29bps. Despite the fact that the stock market (e.g. S&P 500) is not back to its 2007 peak levels, SCHW's total client assets are at an all-time high of $1.5tn (due to share gains). Thus, when short-term interest rates rise by just 100bps, SCHW's earnings will "normalize", leading to all-time highs in EPS.
What is the downside?
At 18x 2011 EPS, SCHW does not look like a cheap on most value metrics so I look at downside in three ways: 1) At the depths of the stock market lows in Q1 2009 , SCHW traded below $14/share for only 3 months (Jan - Mar). Given that overall conditions in the economy and stock market are far improved since then, I believe that the stock will have a hard time trading below these levels in the current market environment. 2) One way to look at normalized valuation for SCHW is market capitalization to client assets. On this metric, SCHW is currently trading at ~1.1%, which is the lowest level in the last 10 years. 3) Due to its strong franchise and track record SCHW has historically traded at 20x forward earnings. Even using depressed earnings, SCHW is currently trading at 18x 2011 PE.
Thus, I feel comfortable that SCHW's stock price downside is $13-14/share or $1-2 down from current levels.
What is the upside?
When short term rates start to rise, SCHW's EPS will rebound significantly. For the first 100bps move up in Fed Fund rates, I estimate SCHW's EPS will rebound by ~50c/share. And further rate increases beyond 100bps will also drive SCHW's earnings higher, but at a slower rate. Thus, I view SCHW's normalized EPS as $1.20-1.50. Historically, SCHW has traded at 20x forward PE, which would put the stock at $24-30/share. However, for conservatism I use a 16x forward PE which gets me to $19-24/share target price.
At a $15 price, the risk/reward seems very attractive for a longer-term investment horizon. Downside is $1-2/share and upside is $4-9/share.
The biggest catalyst for the SCHW thesis to work is an increase in short-term interest rates, or at least an expectation that short-term rates will increase.
So when will short-term rates go up? I can't pretend to know this better than anyone else, but I am quite comfortable that they can't go down any more and that the current low level of interest rates is fully in the stock. Thus, this is a highly asymmetrial risk-reward.
Even if Fed Funds rates do not increase at all, I think SCHW should be able to earn 82c in 2011. This is very similar to the consensus 2011 estimate of 84c so I feel comfortable that the sell-side is not expecting interest rate hikes in their estimates.
If rates go up, SCHW's earnings will benefit tremendously and rates don't go up for a while, SCHW won't get hurt much more. Even if I have to wait a couple years for this to happen, the normalized earnings power should keep going up 5-8% per year as SCHW keeps gaining net client assets.