Description

Schwab is one of the largest wealth management firms globally with ~$3.7tn of client assets under custody. The assets break down roughly 50%/50% between (i) the retail business (“Investor Services”) and (ii) the institutional business (“Advisor Services”) which serves as a custody and trading platform for independent financial advisors (RIAs). Despite roughly equal client assets in each segment, the revenue and pre-tax contribution from the retail side is substantially higher than the institutional side (70%/30%) due to the fact retail investors hold higher cash balances (which are invested by SCHW at a spread).

Schwab has three key revenue streams:

• Interest income on its balance sheet (funded by client cash): ~60% of total

• Asset management revenues: ~30% of total

• Trading commissions/payment for order flow: ~10% of total

Long ago, the e-brokers were good businesses. They generated attractive ROEs due to significant fee income from trading and asset management, and earned interest income from cash balances. Today however, the entire e-broker business model is under siege. Like all financial services, this is a commodity business and is beset by competitive pressure from start-ups and incumbents alike. Free trading/$0 commission trades are being used as an effective customer acquisition tool for new players like Robinhood, JPMorgan (You Invest) and more recently, Interactive Brokers (IBKR Lite). Mutual funds, once the dominant asset management wrapper in the US, are cutting fees and bleeding market share to much cheaper, or even free ETFs. And even interest income isn’t what it used to be with the “lower for longer” backdrop and inverted yield curve. I go through each of these in more detail below:

Trading

The trading commissions business is a revenue stream that will effectively go to zero over time. While Schwab is the least exposed to commissions among the big e-brokers, they still derive nearly 10% of their revenue from a business that is living on borrowed time. SCHW management foolishly accelerated this race to zero in early 2017 by cutting commission rates from $9 per trade to $7, then four weeks later lowered it again to $5 after Fidelity reduced their rate in response to the first cut. This revenue is 100% incremental margin, so the price reduction cut deeply into SCHW’s incremental margins in 2017. While I do not know when commissions will go to zero, I believe SCHW will be forced at some point to make a painful decision between showing growth (especially among millennials) or keeping this revenue stream. The recent news out of Interactive Brokers about their IBKR Lite platform offering commission free, unlimited trades on US exchanges and ETFs is just the most recent example of where the industry is going longer-term.  If you assume just half of the commission revenues disappear in the next 3 years, that alone represents a ~2% annual earnings headwind (and if it were to disappear entirely, a 4% annual headwind).

Asset management

The asset management revenue stream has also been under pressure for a number of years due to the move toward passive management and ETFs. This mix shift erodes revenue from Schwab’s profitable mutual fund marketplace called Mutual Fund OneSource (which allows clients to buy/sell mutual funds with no fee). Schwab receives an asset-based fee from the mutual fund manufacturer (~35bps) which had proven to be a stable source of revenue historically. While Schwab has created an ETF OneSource marketplace, the “take rate” on that is substantially below the mutual fund take rate (~5-10bps vs. the 35bps for mutual funds). Note that since 2016, the Mutual Fund OneSource assets have actually declined ~5% to ~$190bn despite the market being up over 30% during that time. Meanwhile, ETF OneSource assets are up over 70% in the same period.  Money market funds are another big category in the asset management bucket, and the fee rate on that product has declined from ~60bps in Q1’17 to ~30bps today. The only silver lining is the Advisor Solutions business (~35-40% of total) that is growing balances MSD%+, but the fee rate is coming down on that too. For example, Advisor Solutions revenue only grew 4% y/y in Q2’19 (against ~8% balance growth), as the blended fee rate continues to decline.

Interest income

This leaves us with Schwab’s largest revenue stream: interest income. Clients typically leave ~10-12% of their assets in cash, and SCHW will pay them a skinny interest rate akin to the checking account rate you’d get at JPMorgan, and then invests that money into a portfolio of fixed income securities (~70% fixed, ~30% floating). The e-broker business model has gradually evolved to effectively become a deposit gathering vehicle. Unfortunately, this revenue stream is far less predictable than the other revenue streams, and it’s also capital intensive. Given the secular challenges confronting the other two legs of the SCHW’s revenue stool, the company is looking increasingly like a bank, or more accurately, a mortgage REIT, since the vast majority of their portfolio is Fannie/Freddie mortgages.  This doesn’t screen to me as a high multiple business – whether on P/TBV or P/E.

Why it’s a short

Despite the fact we're at peak earnings, SCHW trades at a massive premium to other similar financial services companies (~16x NTM P/E and ~3x P/TBV vs ~10x P/E and ~2x P/TBV for similar "high quality" financials like JPM or RJF) . While there probably isn’t massive downside if the US never goes into another recession and the Fed never cuts rates back to zero, I think that rosy macro outcome is pretty remote (and at the very least, SCHW can be a nice portfolio hedge).

When/if the US enters recession and rates head back to zero, not only does SCHW’s net interest income decline, but their asset management fees also decline as balances shrink and at the zero-lower-bound they waive the fees on money market funds. In 2015 for example, while the headline MMF fee rate was 60bps, they were only able to charge 17bps. In this recession scenario, SCHW will likely trade down significantly from its current ~2.8x P/TBV today to

I think it’s important to recognize that historically SCHW’s valuation was buttressed by the “optionality” of bringing the money market AUM on balance sheet via bulk transfers (because SCHW could earn a net interest margin of $2.00+ for every $100 of cash, vs. only ~$0.30 in a money market fund). The problem though is that they waited too long to do this. If they did the bulk transfers when Fed Funds was at 0.50%, clients probably would not have noticed. But given they were moving people out of money market funds generating 2.0% and putting them into a deposit account yielding 0.20%, clients noticed and reacted. Hence, a significant portion of the bulk transfers (at least 50%) have not stuck and those balances just moved back into purchase money market funds.  Now that the bulk transfers are complete, there are no more magical ways of engineering balance sheet growth and revenue. Schwab’s revenue trajectory from here will be based on the growth of cash balances, asset management AUM, and fee pressure across all lines of their business. That hardly sounds exciting, especially when you consider the downside macro scenario of zero lower bound rates.

To sum this up, I think SCHW is a mediocre or even low-quality cyclical business that’s trading at ~16x 2020 earnings of ~$2.65 (which I’m modeling as “through-cycle” (1.25-1.50% Fed Funds). In a recession case, however, I think SCHW would earn closer to ~$1.90 (meaning the stock is trading at 22x trough earnings). This all is assuming that commission revenues are sustainable. If you cut commissions in half, that would reduce EPS another ~0.15-0.20.

I think if one were to use a similar framework as other financials, SCHW would be worth closer to ~$32 today (12x through-cycle earnings) which would triangulate to a more reasonable 2.2x for a company that’s doing a high teens ROTE (e.g. JPM trades at 11x 2020 and 2.0x P/TBV for the same ROTE).

In a recession, I think SCHW will trade down to ~1.5-2.0x TBV (if the company is expected to do that recession number of ~$1.90), which would triangulate to $22.50-30.00 (or ~30-45% downside).

The views expressed herein are my opinion. I do not hold a financial interest in the issuer, nor do I hold a non-financial position, such as employment, directorship, or consultancy.

Catalyst

-Recession, Fed cuts, or lower long-term rates