Charles Schwab Corp. (SCHW), a leader in the financial services industry, recently reported financial results for the second quarter of fiscal 2020. Revenues in the period declined 9% to $2.45 billion, primarily attributable to a mid-teens decline in net interest revenues. As CFO Peter Crawford noted during the Business Update conference call, “The overall takeaway is that we’re obviously impacted in the near-term by factors outside our control.”
The most significant headwind to Schwab’s business has been the reduction in interest rates across the yield curve. According to the earnings report, "We saw a dramatic reduction in both short-term and long-term rates from early Q1 to the middle of Q2." In the second quarter, a sizable increase in average earning assets (+37% year-over-year to $363 billion) was more than offset by contraction in the company’s net interest margin (NIM), which declined 87 basis points to 1.53%.
In addition, as Crawford noted that it’s likely Schwab’s NIM will continue to decline in the near future, falling below 1.50% by the fourth quarter (assuming flat rates). That implies that the company’s fourth quarter NIM will be down roughly 90 basis points from the 2.34% reported a year ago.
Schwab’s results were also negatively impacted by the pricing actions implemented in October 2019 when the company eliminated commissions for stocks, ETF’s and options listed on U.S. and Canadian exchanges in order to compete with new players, with a 126% increase in daily average trades offset by a 59% decline in revenue per trade. The net result was a 7% decline in trading revenues to $193 million.
The only business segment that reported revenue growth in the second quarter was Asset Management & Administration Fees, which was up 2% to $801 million despite the return of money market fee waivers (another area where Schwab is negatively impacted by low rates). As Crawford noted, this is another headwind for Schwab that will likely grow in the near future: the size of the quarterly money fund fee waivers could triple or quadruple in the coming periods to roughly $50 million, or more than 5% of the segment’s revenues in the year ago quarter.
While revenues declined 9% in the quarter, adjusted expenses increased 2% to $1.47 billion. The net result was a material contraction in Schwab’s pre-tax margins (-650 basis points to 40.0%). For the quarter, Schwab reported adjusted earnings per share (EPS) of $0.54 – down 19% from the second quarter of 2019. Year to date, EPS has declined by 16% to $1.14 per share.
Despite the challenging short-term results on the income statement, the company continues to report solid underlying customer fundamentals that are key to long-term success. Crawford commented:
"This current crisis – and specifically low interest rates across the curve - obviously creates challenges for us. But these challenges are near-term challenges that we believe have little to no bearing on our longer-term success. In fact, if you look at the predictors of long-term success [growth in accounts, assets, etc.], those are all pointing in the right direction.”
For example, the number of net new brokerage accounts in the quarter was up more than 50% year-over-year, adjusted for the accounts acquired from USAA. At quarter's end, Schwab had more than 18 million active brokerage accounts, up 18% year-over-year (excluding USAA, the number of accounts was +9%). In addition, total client assets increased double digits to $4.11 trillion, led by continued mid-single digit growth in core net new assets, as well as a market tailwind (the S&P 500 was up 5% in the trailing twelve months through June). As shown below, the value of client assets at Schwab has increased by roughly 160% since 2010 – a compounded annual growth rate of 10%.
As I’ve noted in the past, I believe the mid-single digit organic net new asset growth that Schwab has consistently delivered points to their strong positioning in the industry. In addition, I think the company has a unique brand voice that will enable it to stand out from its peers and continue taking market share among retail clients. In both cases, I think Schwab’s outsized growth will endure.
Conclusion
In the short-term, Schwab is facing significant pressure on its income statement from low interest rates and a relatively flat yield curve. That said, I still believe that market participants are being asked to pay a reasonable price for this asset, even if they believe that interest rates never return to “normal” (at some point, we may just have to accept that this is the new “normal”).
In addition, as Crawford noted in his closing remarks on the conference call, they are working to mitigate the impact of external factors that are not within their control:
“As I said before, we're certainly not blind to the pressures that we face, but nor we faced by them. As Walt mentioned, we know that interest rates move-in cycles and in this low-rate environment we'll never give away at some point to more normalized rates. But also not just waiting around for that to happen. We're planting a lot of seeds, and these seeds will take time to bear fruit, in some cases months and other cases years. But we're very confident that they will bear fruit, and will help create a company that has better position in the market, that offers an offers an even better value proposition to clients and that has even more resilient in all other business model and a lower-cost business model, company which will reward both stockholders, clients and our employees who put their faith in it. And with that, thank you. We look forward to talking to you again in October.”
I continue to believe that this is a high-quality business with meaningful long-term tailwinds that will enable mid-single digit organic growth off of a large base (more than $5 trillion in client assets once the TD deal closes), with the potential to deliver high-single digit earnings per share growth – or better - over the long run. In addition, I think it has a best-in-class leadership team that will continue investing for the long-term. For those reasons, I’m happy to be a shareholder of Schwab – and I would love the opportunity to increase my position in the company at the right price.
Disclosure: Long SCHW (Charles Schwab)
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