In June, I concluded that the situation appeared to stabilize in the case of The Charles Schwab Corporation (NYSE:SCHW) after shares fell victim to a panicky move when the regional banking sector turmoil hit in March.
Hit hard by deposit migration, pressure on net interest margins and thus earnings, as well as concerns on the future of the business, the situation appeared to be improving in June. Given all this, including a recovery in stock markets and a lagging share price, I started to get more compelled to the situation.
I was looking for more clues about the impact of the crisis in the second quarter results as the crisis arrived late in the first quarter, making it hard to see the real impact of all of this already, yet a reassuring Q2 earnings report has eliminated the immediate appeal by now.
A Quick Recap
Early in March, Schwab was a $75 stock, and following the implosion of SVB Financial Group, shares fell to just $60 in the time frame of just two days, with shares falling further to the $50 mark in the weeks thereafter.
Being both a broker and bank under one roof, questions were asked as Schwab investors voted with their feet, after the company had grown to a balance sheet of more than half a trillion.
For the year 2022, sales were up 12% to $20.8 billion with GAAP earnings reported at $7.2 billion, equal to $3.50 per share, with adjusted earnings coming in at nearly four dollars per share. Most of the assets managed by the firm are not apparent on the balance sheet, as the company held over $7 trillion in client assets in both separated and segregated accounts, after seeing $400 billion inflows for the year. Despite these inflows, it was lower valuations which made that assets under administration were actually down in 2022.
On a $552 billion balance sheet, the company paid a mere 46 basis points on deposits on a $367 billion deposit base in the fourth quarter, leaving the door wide open for deposit migration. 2022 pre-tax profits of $9.4 billion left significant room to hike these deposits, but that would involve the elimination of earnings, as deposit hikes were needed to avoid depositor migration.
Deposits fleeing had to be avoided as otherwise Schwab had to sell assets, with many liquid assets depleted, and available-for-sale securities and held-to maturities assets trading underwater amidst their duration characteristics in a rising interest rate environment, as such sales would spur large capital losses.
First quarter results revealed a 10% increase in revenues to $5.1 billion with GAAP earnings up as much as 14% to $1.6 billion, for earnings of $0.83 per share with adjusted earnings coming in a bit higher. For the quarter the company reported $132 billion in asset inflows to $7.5 trillion, as the company even hiked the dividend by 14% to $0.25 per share while halting the share buyback program.
Net interest income fell from $3.0 billion in the four quarter of 2022 to $2.8 billion in the first quarter of 2023. Total assets fell by $16 billion to $535 billion, with deposits down by $41 billion to $326 billion, with all these comparisons based on a sequential basis. Note that however this was based on average assets for the quarter, not ending assets for the quarter, as the company resorted to expensive borrowings (from among others) Federal Loan Bank, among others.
The company guided for second quarter revenues down in the high single digits, with earnings seen down a third. Ever since there has been quite some good news with the situation in the banking sector stabilizing and equity markets recovering. The company reported another $13.6 billion asset inflows in April and $20.7 billion inflow number for May. Despite this observation, CFO Peter Crawford announced that second quarter sales were seen down 10-11% on a sequential basis, as the original high single-digit decline looked a bit optimistic in my eyes.
With the situation improving, I was hoping for a steady share price development until the second quarter results were announced, before potentially initiating a position.
A Massive Recovery
In June and the earlier part of July, shares have crept up to the high-fifties as shares jumped 12% to $66 per share in the wake of the release of the second quarter results. Second quarter sales came in at $4.66 billion, a 9% decline on an annual basis, with the sequential revenue decline being less bad than previously thought.
The company posted net earnings of $1.29 billion (GAAP) which is down 28% year-over-year with earnings reported at $0.64 per share, and adjusted earnings coming in eleven cents higher. The decline in sales was due to net interest income falling further to $2.3 billion, due to more expensive deposits and borrowings. While interest earning assets advanced to 3.36%, funding costs rose to 1.49%, still leaving a huge gap of 1.87% as the net interest margin (although down substantially).
The company paid an average of 1.11% to bank deposits, which was not enough to halt outflows, but enough to limit the outflow of these towards the end of the quarter. Federal Home Loan Bank borrowings jumped to $46.8 billion, being expensive debt which carries a yield in excess of 5%, higher than the money earned on average assets. The balance sheet shrank further by another $24 billion to $511 billion, mostly due to lower available-for-sale securities, while the deposit base shrank as well, with bank deposits down another $21 billion to $304 billion.
There were many positives as well, as assets under administration surpassed the $8 trillion mark again amidst inflows and higher asset values. Moreover, the company sees continued asset inflows and sees deposit migration ending, as the current profitability remains quite strong, providing Schwab with sufficient earnings power to increase deposit rates (if needed) to halt the outflows altogether. In fact, the company could raise rates by another 2% before breaking even, although that deposit rates would still trail risk-free rates by a wide margin in such a scenario.
What Now?
The reality that the worst seems to be behind, and with earnings power having fallen from a run rate of around $4 per share in 2022 to $3 per share right now, The Charles Schwab Corporation situation looks quite good given the circumstances. The reality is that last year’s earnings power probably never was realistic, as the company paid too little to depositors, so it was essentially borrowing from depositors, its core clients.
With a $3 per share run rate translating into a low twenty multiple, quite frankly I still regard shares of The Charles Schwab Corporation as fair value here after the re-rating in the stock, after I was a bit more upbeat back in June when the shares were ten dollars lower.
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