Charles Schwab (SCHW, Financial) reported strong first-quarter 2023 earnings results a few weeks ago, highlighting the successful execution of its client-centric strategy and diversified business model. Furthermore, rising interest rates and benefits from the Federal Reserve's tightening program expanded its net interest margin and grew net interest revenue. I believe Schwab's ongoing focus on managing liquidity in the banking crisis and effectively navigating during the Fed's quantitative tightening, coupled with the continuous enhancement of its product offerings and fees, positions it to navigate potential challenges and capitalize on the recovery of the U.S. economy.
Recent earnings results
For the quarter, Schwab's net income rose 14% to $1.6 billion year over year, driven by the inflow of new assets, record Advisor Services net flows of $71 billion and the opening of over 1 million new brokerage accounts. Schwab's sustained business momentum was also supported by rising interest rates and benefits from the Federal Reserve's tightening program, which expanded its net interest margin by 81 basis points and grew net interest revenue by 27% to $2.8 billion. Schwab's latest earnings update paints a stable picture, with no signs of stress on the balance sheet or client retention.
Source: Bloomberg
Schwab reported net income to common shareholders of $1.5 billion, translating to $0.83 per diluted share, and net revenue of $5.1 billion. While net revenue increased by 9.5% from the year-ago quarter, it sequentially declined by 7%, primarily due to higher funding costs that impacted net interest income. In addition, clients had moved their transactional deposits into money market funds and fixed-income securities, which forced Schwab to use higher-cost certificates of deposits and FHLBank borrowings to fill the gap.
In the future, the company expects earnings to follow a checkmark pattern with quarterly declines through 2023 or even mid-year 2024, with the deterioration initially caused by higher funding costs and later by Federal Reserve rate cuts. Since the second quarter of 2022, deposits have decreased each quarter, indicating clients are moving their money into higher-interest-yielding products.
Notably, Schwab's funding of the quarterly difference with other sources, such as FHLBank loans at a 5% interest rate, is higher than the revenue yield on interest-earning assets. The company's commitment to enhancing its clients' experiences was also evident in its announcement of several enhancements to Schwab Personalized IndexingTM, including new tools that expand personalization options and streamline onboarding. Moreover, acquiring The Family Wealth Alliance will bring additional resources and technology to enable the company to serve ultra-high-net-worth individuals' needs.
Further, completing the Ameritrade integration should unlock significant opportunities, supporting the company's scale and efficiency, win-win monetization and segmentation strategies. The successful conversion of the initial client transition group in February validated the company's roadmap for the remaining client transition groups.
Looking ahead, I believe Schwab's strong financial foundation and unwavering long-term orientation position it to navigate through potential challenges and capitalize on future opportunities. The company's ongoing focus on client needs and evolving industry trends, coupled with the continuous enhancement of its platform, should help it stay ahead of the curve.
However, there are potential risks, including the impact of market volatility on the company's earnings, competition from emerging fintech companies and regulatory changes. In addition, the evolving regulatory landscape, including possible tax policy changes, could impact investors' behavior and the company's bottom line.
Banking failures
The recent decline in deposits (down 30% year over year) at Schwab highlights the growing competition for deposits in a challenging market environment. With customers seeking better returns elsewhere, banks are pressured to offer competitive interest rates to retain and attract deposits. However, this comes when the industry is already grappling with the fallout from the biggest crisis in over a decade.
As interest rates rise, customers move their funds to higher-yielding investments like savings accounts or money market funds. This trend, known as client cash sorting, has led to a steady outflow of deposits at many financial institutions. As a result, while large banks have seen their deposits rise above pre-crisis levels, small banks are still short of their previous levels.
In this environment, financial institutions must differentiate themselves by offering value-added services, such as financial planning and investment advice, to retain and attract customers. For example, Schwab, which managed declining deposits in the first quarter, has a more diverse deposit base and offers a range of services beyond traditional banking, including wealth management, brokerage, asset management and financial advisory services. By providing a one-stop shop for clients' financial needs, Schwab is better positioned to weather the current market challenges over traditional banks.
Looking ahead, Schwab may face several challenges, including the economic impacts of the Fed's quantitative tightening, which has fueled uncertainty already, and growing competition from non-traditional players like Apple (AAPL, Financial), which recently announced that its Apple Card users might earn up to 4.15% on savings. Financial institutions must continue to adapt to changing market conditions by offering innovative products and services that perfectly address the evolving needs of their customers.
Brokerage battlefield
Schwab's inclination on its banking operation is to drive profits after slashing trading commissions to zero in 2019, a move quickly adopted to compete with Robinhood (HOOD, Financial). For a while, the strategy worked, with the company benefiting from inflows to its banking operations as interest rates remained low. However, the recent collapse of three large U.S. banks has turned that wager on its head. With the rapid surge in interest rates, deposits have declined, and unrealized losses on Treasuries have swelled. As a result, investors are now looking for signs of Schwab's longer-term prognosis. Notably, Wall Street has sharply reduced its profit estimates for the company in recent weeks.
Source: Bloomberg
The company generates most of its money from customer funds in low-yielding accounts that it "sweeps" into its bank arm, where it invests in securities backed by the U.S. government. However, the risk was that interest rates could rise, leaving the investments underwater. Although Schwab won't have to book a loss unless forced to sell them, the situation is cause for concern.
Furthermore, Schwab's strategy to increase profitability in the coming years hinges on several assumptions, particularly that deposit flight will ebb. The leaders estimated that interest-earning assets had an additional 8% to 12% to fall from year-end levels. However, this could be challenging as independent advisers buttress Schwab's business and are increasingly focused on getting the best returns for clients' cash. For example, Schwab's sweep accounts offer 0.45%, while Fidelity Investments offers some sweep accounts that earn more than 4% with no extra effort required.
Schwab's long-term prognosis will depend on several factors, including whether the remaining deposits stay put and how the company adapts to changing circumstances. In the short term, the company may need to adjust its strategy by finding new revenue streams, such as offering higher-yielding sweep accounts, to prevent further deposit flights. It may also need to diversify its investments to avoid further losses from its banking operations. Schwab's ability to navigate these challenges will be critical to its future success.
Bullish catalysts and risks
I believe Schwab has a considerable opportunity in the financial sector based on several bullish catalysts. Higher interest rates will likely continue to lift net interest income. Interest income may continue to sustain if the rates move around the current levels. Moreover, Schwab collects management fees from a massive crowd of investors that own mutual and exchange-traded funds, generating fee income regardless of their performance. During the first quarter of 2023, it collected nearly $1.12 billion in management fees, up 5% year over year.
Source: Q1 2023 results
Further, Schwab still has massive liquidity to counter decay in deposits. While its total asset base has contracted since the end of last year, it still has $156 billion in highly marketable available-for-sale securities. In addition, its held-to-maturity securities offer rapid liquidity if necessary. In the aftermath of Silicon Valley Bank's collapse, the company may enhance its safety measures and diversify its asset portfolio.
However, the stock market remains volatile and has various risks, such as the potential for another wave of the banking crisis and economic uncertainties. These risks can negatively affect Schwab's investment performance and may decrease investors' appetite for financial stocks.
Another potential risk for Schwab is the possibility of increased competition. Fintech companies like Robinhood have been disrupting traditional financial services and gaining market share. As a result, Schwab must stay innovative and continue improving its offerings to compete effectively with these new players.
Finally, Schwab's revenue is sensitive to market volatility, negatively impacting its trading volumes and revenue. If there is a prolonged bear market, Schwab's asset management and administration fees may decline due to lower investment returns, potentially leading to reduced profitability.
