Description

Accelerating business momentum and capital return, heavy insider buying and extremely cheap stock.

Based in Westlake, Texas, The Charles Schwab Corporation (“Schwab”) is a financial services firm that serves retail customers directly through its online brokerage business and registered investment advisors through its institutional services platform.  The company manages over $7 trillion in total client assets, 33 million brokerage accounts, 2.2 million corporate retirement plan participants and 1.6 million bank accounts.  

My Schwab investment thesis is driven by three primary factors:

*Asset gathering tailwinds for electronic brokerage firms.  Schwab, owing to its prominent reputation and consumer preferences for online brokerage and registered investment advisors, has been a magnet for new accounts and new assets.  The company consistently attracts net new client assets of $20-60 billion each month.  Further, the company added 3.5 million active brokerage accounts in 2021, representing double digit growth.  

*Benefits from inflation and higher interest rates.  Schwab is highly sensitive to changes in interest rates, was hurt significantly by zero interest rate policy, and is poised to benefit tremendously from expected Federal Reserve rate increases.  This dynamic results from Schwab’s sweeping of clients’ excess cash into its bank, which invests the cash conservatively in government securities.  In the company’s Summer Business Update (slides), management noted that it expects NIM could exceed 2.0% in Q4, while NIR could reach $3 billion by Q4, “even if ongoing organic growth and sorting net to modest additional balance sheet contraction during 2H22.”  This is an extremely well-positioned business.

*Tremendous synergies from the TD Ameritrade acquisition.  In September 2019, the landscape of the electronic brokerage industry changed dramatically in a period of days.  Initially, Interactive Brokers announced “IBKR Lite” as a zero-commission option for its clients.  Immediately, Schwab and Fidelity followed by cutting their commissions to zero.  Then, in November, Schwab announced its landmark acquisition of TD Ameritrade in a $26 billion all-stock deal.  Interactive Brokers Chairman Thomas Peterffy spoke about the series of events in June 2020, noting how positive the transaction would be for both Schwab and his own firm:

“I did not expect that our introduction of IBKR Lite would have such a large reaction or at least not so suddenly. Looking at Schwab's numbers, the small amount of commissions they generated relative to their peers, it was clear that they have a huge number of advisers, they had relatively few frequently trading accounts. So I said to myself, if I were Schwab, what would I do? I would go to zero commissions and try to get as many of the frequent trading accounts as I could. So if they are going to do that anyway, why don't we go first? And we did just that. We did just that and did expect that Schwab would follow us, but not quite so fast. So we're hoping to be the only one at zero commission - only one of the zero commission brokers among the traditional online firms for quite a while, and we're hoping to pick up a large number of accounts until they would follow us. Well, as you know, they all followed very, very quickly within days. This move cut the stock prices of Ameritrade and E*Trade drastically, giving Schwab and Morgan Stanley both the opportunity to buy them. As it later turned out, the repercussion of coronavirus from the Fed was to cut rates to zero. And since both Ameritrade and E*Trade have very long maturity of government and agency portfolios they invest their customers’ funds in, they have a huge windfall, which you would see -- everybody would see that if they had to mark-to-market their portfolio. So basically, the purchasers are mostly buying these firms with their own monies.”

Because Ameritrade did not operate its own bank, but rather sent customer deposits to TD Bank in exchange for a fee, it historically had been unable to monetize fully its customer relationships.  Following the acquisition, Schwab is set to realize the full revenue benefit from Ameritrade’s clients over time through a recapture agreement.  Additionally, in the first year of its ownership of Ameritrade, Schwab has realized approximately 40% of the $2 billion estimated expense synergies, faster than its initial expectation.  Recently, Schwab management raised its target for total revenue and cost synergies from the transaction by $800 million to $4.3-4.8 billion, a massive recurring benefit for Schwab on its $26 billion purchase. 

Schwab shares, which briefly rose to over $90 in January due to the prospect of increased short-term interest rates and record trading volumes, have since fallen to the $60s due primarily to investor concerns regarding the future path of short term interest rates and client cash “sorting,” the dynamic by which some clients choose to optimize the interest earned on their excess cash by moving low-yielding (but high net interest margin for Schwab) bank deposits to higher-yielding (but less profitable to Schwab) money market funds, CDs or Treasuries.  Additionally, investors have been concerned about a shareholders’ equity decline due to unrealized, mark-to-market value reductions on the fixed-income government securities that the company holds and classifies as “available for sale.”  However, this rate-driven mark-to-market dynamic does not impact the company’s income statement as it flows through “accumulated other comprehensive income” in shareholders’ equity on the balance sheet, and fully reverses when the securities are held to maturity.  The company has clearly explained this, including at the company’s Spring Business Update in April, concluding that “either way, we see this as something quite manageable” due to the offsetting dynamics of rising/falling rates, mark-to-market value fluctuations and client cash sorting dynamics.

In a terrific vote of confidence the week after the Spring Business Update call, Schwab’s CEO (and now Co-Chairman) Walt Bettinger, by all accounts a thoughtful, disciplined executive, personally purchased $9.5 million of the company’s shares in the open market over five days (April 25th, April 26th, April 27th, April 28th and April 29th) at prices ranging from $67.22 to $69.49 per share.  His previous transaction in the company’s stock was in October 2021, when he simultaneously exercised options at $30 and sold shares at $81 that netted him $12.5 million of pre-tax proceeds (perhaps $8 million after-tax).  Bettinger’s April purchases notably exceeded his 2021 after-tax sale proceeds, and since October he has increased his direct holdings from 219,174 to 444,329 shares, excluding options and restricted stock.

This week, Schwab announced a 10% dividend increase and a $15 billion share repurchase authorization.  The company is accelerating capital returns, one of few companies in this enviable position, and has signaled that business is likely to continue improving from here.  This type of “second derivative improvement” is often a driver of large stock returns, and I think that could be the case here.

Schwab shares trade cheaply at only 13x consensus 2024 net income, while the forward year P/E metric has typically fluctuated between 15x and 25x over the last ten years.  I think the shares could fairly easily trade to 20x a 2024 diluted EPS of ~$5.50, or $110 per share, representing a ~60% return from the current price, while the business continues to grow and become more profitable.

Disclaimer:  The author of this idea presently has a long position in securities of this issuer and may trade in and out of these positions without notice.  The data contained herein are prepared by the author from publicly available sources and the author's research, opinions and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein.  Please do your own research.

Catalyst

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