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The Science of Hitting
The Science of Hitting
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Some Thoughts on Charles Schwab

A look at a leader in the financial services industry

July 08, 2019 | About:

Charles Schwab Corp. (SCHW) is a leader in the financial services industry. The company, which traces its roots to the deregulation of brokerage commissions in the 1970s, is a provider of retail brokerage and banking services for individuals, as well as custodial, trading and support services for roughly 7,500 independent registered investment advisors (RIAs) across the country.

Schwab ended 2018 with more than 10 million active brokerage accounts (with an average value of roughly $300,000), a level that has been reached through years of steady growth:

Growth in active brokerage accounts, along with the tailwind of higher equity markets, has led Schwab to be an asset-gathering machine over the past decade:

Despite their solid track record, with total client assets of $3.5 trillion, management estimates that they still have less than 10% of the addressable market (management estimates that total investable wealth in the U.S. is north of $45 trillion). As shown below, much of Schwab’s net new asset growth has been organic (i.e., not driven by higher market prices):

But while client assets have roughly tripled over the past 10 years, revenues have only doubled (from $5.1 billion to $10.1 billion). The company’s revenues come from three sources: net interest revenue (roughly 60% of total), asset management and administration fees (roughly 30% of total) and trading revenue (roughly 10% of total). Net interest revenue is the difference between what Schwab earns on interest-earning assets and what it pays on funding sources (primarily client cash balances). Asset management and admin fees are generated through proprietary and third-party mutual fund offerings, as well as fee-based advisory solutions. Finally, trading revenue are commissions earned from executing trades for clients (twenty years ago, trading accounted for the majority of Schwab’s revenues).

As noted in the 2018 annual report, serving RIAs is an important part of Schwab’s business:

“Our position as the largest provider of custodial services for independent investment advisors has been an important driver of our overall growth. The revenue and earnings derived from serving independent advisors make up about 30% of our overall results.”

This is one example of how Schwab is benefiting from structural change (in this case, RIAs takings share from traditional wirehouses). Based on company disclosures, Schwab has also been taking a larger share of the RIA pie: The company held roughly 30% of RIA industry assets in 2017, compared to a low-20s share of the market 10 to 15 years ago.

Schwab is also a leader in the robo-advice business, with Intelligent Portfolios accounting for more than $30 billion in assets under management (AUM). That is one way Schwab is increasing its value add to end clients that are seeking ongoing advice (in addition to generating higher fees for themselves), which is a growing mix of their business: At year-end 2018, assets receiving ongoing advice totaled $1.7 trillion, an increase of roughly $600 billion from year-end 2013.

In summary, Schwab has done a great job increasing its share of investable assets in the U.S. Based on the significant investments it has made to ensure it has best-in-class product offerings, I see no reason why that growth will not continue in the years ahead.

As shown below, Schwab has consistently maintained a spread of 10 to 15 basis points between revenues and expenses (as a percentage of average client assets) over the long run:

As CFO Peter Crawford noted in his 2018 shareholder letter, Schwab’s expense on client assets (EOCA), a key efficiency measure and an indicator of one of its core competitive advantages, was just 16 basis points in 2018 – an all-time low for the company and the best among public investment services firms (tits closest peer, TD Ameritrade (AMTD), was at 27 basis points in 2018).

I’m comfortable assuming that the conditions that led to these results over the past 10 years are sustainable. Said differently, I think Schwab will continue to attract client assets.

The next question is what that means for Schwab’s profitability. As I noted earlier, there has been a lag between growth in client assets and the company’s financials. As Crawford noted in his 2018 shareholder letter, the “coiled spring” for Schwab started to release when the Fed started raising rates in December 2015 (they’ve raised rates nine times since).

Money market fund fee waivers, which reached three-quarters of a billion dollars at their peak, have essentially been eliminated. In addition, Schwab’s net interest margin has expanded by roughly 80 basis points (to 2.4%), along with a material increase in interest-earning assets. This has led to significant earnings per share growth over the past four years:

Now that the Fed has signaled an end to rate hikes – and the potential for the first rate cut since 2008 – it will impact Schwab’s profitability. It will impact the company through both net interest margin (NIM) compression and fee waivers. As noted in the 10-K, management estimates that a gradual 100 basis point decrease in market interest rates would reduce net interest revenues by 5%, or $300 million (equal to 7% of the company’s 2018 pre-tax income). If you are considering an investment in Schwab, do so with the understanding that you are in some ways making a bet on the future path of interest rates. (You could frame that another way: If you believe rates will eventually return to more “normal” levels, this could be an interesting opportunity. For what it’s worth, management previously said the normalized NIM could get back to 3.5%-4.0%).

Over the long run, mid-single-digit organic asset growth and market appreciation provide support for high-single-digit growth in client assets (and revenues). If management can hit their objective of low-to-mid-single digit expense growth (“we are convinced we can continue to bend our cost curve in the future as our investments focus on driving both growth and efficiency”), that would result in annual pre-tax income growth in excess of 10%. Finally, assuming some help from share repurchases (which Schwab resumed in 2018 for the first time in a decade), earnings per share can grow at a low double-digits annualized rate. That’s a financial formula that could create a lot of value for shareholders (the company also pays a dividend, with a target payout ratio of 20-30%).

All-in, this is a high-quality financial services firm with a best-in-class CEO that is benefiting from a number of structural tailwinds that will support long-term earnings per share growth. And I think the opportunity exists because market participants (somewhat correctly) are hyper-focused on the short-term direction of interest rates (which is not helping Schwab’s profitability).

Conclusion

In his 2018 shareholder letter, CEO Walt Bettinger wrote the following:


“I have never been more confident about our future. Our position in the marketplace has never been stronger. Our client metrics have never been stronger. And our financials, both revenue and earnings, have never been stronger.”

I wouldn’t place much weight on those words if they were uttered by the average CEO. But over time I’ve come to believe Bettinger is a best-in-class leader (and for what it’s worth, he has beneficial ownership of shares worth $60 million). He is focused on what matters – decisions that please clients and create long-term value for Schwab’s owners. And over his 11-year tenure as CEO, the company has clearly delivered on both of these fronts. With him at the helm, I’m confident that Schwab will continue to be run with a focus on long-term value creation.

Disclosure: None.

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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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