Charles Schwab Goes on Sale Amid Bank Selloff
As the fallout from the collapse of SVB Financial Goup's Silicon Valley Bank (SIVB) continues to slam stocks, one casualty that caught some investors by surprise was Charles Schwab (NYSE:SCHW).
The financial services giant, which offers everything from brokerage to banking, advisory services and more, has seen its shares drop 30% since March 8, which was when the Silicon Valley Bank crisis started. The last time the stock was this cheap, its earnings were half of what they were for the fourth quarter of 2022.
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Silicon Valley Bank brought the spotlight to some issues that had mostly been overlooked before. For one, most of the Treasury bonds that banks purchased at near-zero interest rates are now worth less money thanks to rising interest rates, so if banks are forced to sell these bonds, it would be at a loss. Another issue is deposit outflows, which could negatively impact net interest income and, in a worst-case scenario, result in capital issues.
While these factors are likely to hurt Charles Schwabs earnings as the economy weakens further, the company has rushed to reassure the market that its financial position is strong. Granted it can come out the other side of economic turmoil intact, could Charles Schwab be a bargain after the recent selloff? Lets take a look.
Stable financial position
Part of the recent panic surrounding Charles Schwab is likely due to the companys February 2023 monthly activity report released on Monday, which revealed it had experienced a 28% decline in margin balances and a 4% decline in total client assets compared to the same month of 2022.
In light of the Silicon Valley Bank situation, Charles Schwab took the initiative on its February report to allay investors fears, noting these developments were well within its expectations of client cash realignment decisions. Moreover, the company said, we still believe client cash realignment decisions will largely abate during 2023. Since client cash realignment trends would only be likely to change if the Federal Reserve were to stop hiking interest rates or lower them again, we can surmise Charles Schwab is betting on rate hikes being done with by the time 2024 rolls around, though of course that is all speculation for now.
Is it a possibility the company could run out of cash? It seems unlikely. Charles Schwab reassured investors it has access to significant liquidity, which includes approximately $100 billion from cash on hand, portfolio-related cash flows and estimated net new assets for the next 12 months, as well as $8 billion per month in retail CD issuances and $300 billion in short-term loan capacity. Total client assets were $7.38 trillion as of the end of February, though the vast majority of these assets were in investments of various types, so in the case of a sale, their expenses would be covered by the buyers.
"More than 80% of our total bank deposits fall within the (Federal Deposit Insurance Corporation) insurance limits," said the company in a statement, which is in stark contrast to Silicon Valley Bank, where most deposits fell well outside the FDIC range. Thus, there is no need for most of Charles Schwabs customers to panic, drastically reducing the likelihood of a run on deposits.
How low could earnings go?
Historically, Charles Schwab derived most of its revenue from the brokerage business through things like direct commissions, transaction fees and payment for order flow. This business is negatively impacted by declines in stock market activity, as less stock market activity means less order flow.
With the exception of payment for order flow, these revenue streams have declined due to the advent of zero-fee transactions. Payment for order flow has had to pick up the slack, though it is a small price to pay for remaining competitive. Rather than selling order flow to the highest bidder, Charles Schwab has a policy of setting the same price across the board and routing trades to the market maker that offers each client the best execution, which has helped it gain popularity.
In recent years, Charles Schwab has been diversifying more of its revenue through banking, and in its latest fourth-quarter earnings report, the company noted that approximately $10.7 billion of its total annual revenue for 2022 was net interest revenue. Net interest revenue is the difference between interest earned on bonds and loans and interest paid out to funding sources.
Net interest revenue reached $10.7 billion, an increase of 33% versus the prior year, as higher interest rates more than offset the impact of balance sheet contraction due to client cash sorting, the company said in its fourth-quarter earnings report.
As interest rates rise, loans can garner more revenue, but investors tend to be less willing to let cash sit in their accounts as there are more attractive low-risk or even risk-free assets available such as U.S. Treasury bonds. No asset is truly risk-free, but the U.S. government has never defaulted on its debt before as of this writing, so its debt is broadly considered to be risk-free. Cash balances built up in recent years as near-zero interest rates were followed by a stock market crash, but that landscape is changing now that interest rates are rising again.
In summary, there are two main dangers facing Charles Schwabs earnings in the near term: declines in trading volume and further balance sheet contraction as clients move funds to higher-yielding assets. Advisor services (which made up about 25% of 2022 revenue) could also take a hit due to lower trading volume. How much this could impact the companys earnings per share is anyones guess as it depends on the markets behavior, but we do know that after the March 2020 market crash, earnings per share dropped as low as 48 cents per share, driven by lower stock market trading volume and near-zero interest rates.
Valuation in perspective
As of March 13, the GF Value chart rated Charles Schwab as significantly undervalued based on a combination of historical returns, past valuation multiples and estimates of future business performance:
Thus, as long as the company keeps up its growth trajectory in the long term, it could be considered undervalued at the moment.
According to the discounted cash flow calculator, the company would only need to grow its earnings per share by about 8% per year on average for the next decade in order to be fairly valued at current levels, which is much lower than the past 10-year growth rate of 18% or even the past five-year growth rate of 12.40%.
As with most stocks, there is still plenty of downside potential left if the economy enters a full-blown recession or the stock market crashes. However, Charles Schwab is positioning itself well for long-term growth with a client-focused strategy that could help it continue winning more market share.
Charles Shwabs stock has gone on sale following the Silicon Valley Bank failure, but with a solid balance sheet and 80% of cash deposits being fully covered by FDIC insurance, it seems highly unlikely that the brokerage giant will go belly-up.
The question for investors then becomes whether the stock is undervalued compared to its long-term potential. While there is no doubt room for further downside potential in the short term, especially with the possibility of a recession factored in, Charles Schwabs focus on providing clients the best services should help it gain market share in the long term, and its earnings should naturally recover along with the market as well.
This article first appeared on GuruFocus.