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I wrote this up three years ago, but I think it’s timely for an update given the significant changes that have occurred since then with no change in the share price.  Giving credit for the TD deal synergies, run-rate earnings are up around 30% from the original write up despite NIM declining by ~100bps (reducing earnings by ~$2/share) and equity trading commissions being reduced to zero.  Schwab is priced at ~14x earnings after giving full credit for the TD synergy targets (which will take a couple years) but assuming no change in NIM.  If the Fed Funds Rate simply returns to 1.25-1.5%, it would be ~10x earnings at this price.  I think the right multiple is at least double that given Schwab’s ability to grow earnings by low double digits annually for the foreseeable future.

What has changed since the original post?

(1)  NIM has declined from ~ 2.5% to 1.4-1.5%, which if unwound would increase earnings by ~$4 billion;

(2)  Equity trading commissions were reduced to zero;

(3)  Schwab acquired one of its largest competitors, TD Ameritrade, & USAA;

(4)  MMT went mainstream.

The pace of asset gathering has continued as expected since the original write up, and the TD deal was a hugely accretive surprise; but like most, I didn’t foresee the pandemic and the return to 0% rates which offset most of the benefits of the TD deal. 

Schwab is the largest publicly traded brokerage with ~$7 trillion in client assets.  Their scale allows them to have the lowest costs in the industry per dollar of client assets, which allows them to provide the best combination of service and price for retail investors while still earning 46% margins and 21% returns on equity (even with zero rates).  Their brand and high-quality offering lead to consistent 5-7% net new asset inflows, which adds to the scale advantages which they partially pass on to customer in a better offering (like reducing equity commissions to zero).  The scale economies shared model has been working for them for decades. The TD Ameritrade acquisition provides clear evidence of the scale advantages in the business.  TD had $1.3 trillion in assets, by no means “small”, and Schwab will strip out nearly two thirds of TD’s stand-alone cost structure (~$1.8-2 billion) by combining the entities.  

Besides validating the moat, the acquisition was incredibly timely and on very reasonable terms. It was timely because TD had a much higher % of revenue coming from trading (options, foreign equities, and payment for order flow) right when NIM cratered and the retail trading frenzy began.  Schwab also increased its share of RIA assets custodied from ~33% to ~44% through the deal.  They also purchased the USAA brokerage and referral relationship, Motif (thematic investing), and Wasmer Schroeder (fixed income management).  Thematic investing, direct indexing, fixed income, and advice are areas where Schwab can continue to innovate and undercut third-party offerings, for the benefit of the client, while still earning more for itself on those assets to help mitigate the effects of fee compression.

Despite the scale of the business doubling, Schwab has grown 7%/year each of the last three years from net new client asset inflows, the high-end of its long-term 5-7% range.  To be clear, that doesn’t include market appreciation for existing assets.  At 13% of U.S. investable wealth, there is still plenty of room to grow.  A decade of net new client asset growth of 6%/year would still leave them with only ~20% market share in 2031.

In Q4 (includes TD merger from 6 days into the Q) Schwab’s run-rate earnings were $5.5B.  Giving credit for the synergyies management expects from the deal, that would be $7.3B.  Admittedly, this is 2-3 years out, but I think these are very low risk targets so you can model them over a few years if you want, but I think this is a case where napkin math is all you need.  Assuming the Fed Funds Rate returns to 1.25-1.5%, earnings giving credit for the TD synergies would be $10.5-11B.  So, choose your multiple, it either trades at 19.1x, 14.4x, or 9.8x earnings for the “no synergies and no change in rates”, “$1.8B synergies and no change in rates”, or “$1.8B synergies and rates rise modestly” scenarios.  I think even the 19x is too low, especially since that presupposes rates stay low forever (and mgmt extracts no synergies from the TD deal).  If rates stay low forever, why should a business with exceptional management that can organically grow earnings double digits annually for many years trade at a 5%+ earnings yield?  If they grow revenue at 9%/year (6% from net new assets + 3% from market appreciation) and grow expenses at 5%/year for the next decade, with no change in interest rates earnings would compound at 12.5%/year.  They’d need to retain no more than 40% of earnings to grow at that rate and stay within their 6.75-7% Tier 1 Leverage Ratio target, leaving enough available for distribution to return 3-3.5% annually via dividends and buybacks for a mid-teens IRR.  That’s without any change in rates.  There may be some fee compression that reduces that a bit and they will surely pass on some of the margin improvement to customers, so the returns will probably be a bit lower than that; but, underwriting a low-teens IRR on this for a decade without any change in rates isn’t that hard to do.

Nobody knows what rates will look like in 3-5 years, but it wouldn’t surprise me if unprecedented COVID stimulus (25% of GDP) + a huge infrastructure deal + pent-up demand + $15 minimum wage in many states leads to meaningfully higher rates than currently anticipated by the market.  I think that’s a risk to equity multiples in general and to the extent you think it’s worth hedging that, Schwab is a great option since it’ll do well even if rates don’t change, but will do incredibly well if they do... and the option on rates rising never expires.  While we wait (possibly forever) for inflation, Schwab will keep collecting assets and the spring will keep coiling. 

Note: Rates don’t need to go crazy for the leverage to kick in.  Schwab’s securities portfolio duration is only 2 years.  Every 25bps on the Fed Funds Rate is $650-850 million dropping to the bottom line.  My “rates go up” scenario is really just saying the Fed Funds Rate goes up to 1.25-1.5%.

Catalyst

Fed Funds Rate increases.

Time.