Charles Schwab may be best known for its brokerage platform, but it’s the company’s bank that’s once again giving investors headaches.
Shares fell 10.2% after second-quarter earnings missed key metrics. Bank deposits fell and additional borrowing rose in the second quarter, dashing hopes of investors looking for confirmation that Schwab had turned the page on the cash management problems that plagued it last year.
“Liquidity stabilization is at the heart of the story,” said Jeff Schmitt, an analyst at William Blair. Barron’s“To get a big EPS rebound, short-term funding needs to be taken off the books. This quarter, it was the opposite.”
Additionally, CEO Walt Bettinger has indicated that Schwab will adjust its strategy and shrink the size of its bank. While not much will change in the short term (Bettinger stressed that the changes will happen over several years, not months), this is of great interest to shareholders given that about half of Schwab’s revenue comes from net interest income (the difference between what the bank earns in interest and what it pays in interest).
Sorting cash. Schwab is shifting clients’ uninvested money into low-yielding bank accounts. Last year, clients moved billions of dollars of deposits from transfer accounts to higher-yielding options such as money market funds in a process known as cash sorting. The money may not have left Schwab’s platform, but it put pressure on profits because Schwab had to increase its short-term borrowings when deposit outflows outpaced available cash. That impacted net interest income.
Some skeptics have argued that Schwab doesn’t deserve the large valuation premium it’s long been given as a retail brokerage or fintech company because it looks like a bank. The stock has averaged about 20 times earnings over the past five years, about double the valuation of banks. Even with Tuesday’s selloff, Schwab trades at 21 times projected 2024 earnings, or $3.20 per share, and 16 times estimated 2025 earnings, or $4.30 per share. That’s a premium to banks like Bank of America
,
JPMorgan and Wells Fargo
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which are trading at between 12 and 13 times this year’s estimated earnings.
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But analysts have been generally upbeat about Schwab this year because of signs that the pace of deposit outflows is slowing; some analysts have said that most customers who were going to transfer money have already done so. Investors have been scanning the financial results for signs that Schwab is repaying its loans.
“A stabilization of client cash balances and deposits is needed for Schwab to see more consistent earnings growth,” Morningstar analyst Michael Wong wrote Tuesday. “Some of the decline in deposits is related to tax payments, but there is still some ‘cash sorting’ going on, as evidenced by the more than $20 billion increase in money market balances.”
Wong did not change his estimate of the $76-per-share fair value of Schwab, whose shares closed Tuesday at $67.43. He believes the shares are fairly valued or somewhat undervalued.
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If the Fed starts cutting interest rates later this year, that could ease the pressure on Schwab to find money. And with TD Ameritrade fully integrated, the company should be able to increase its asset intake, analysts said. Core net new assets rose 17% year over year to $61.2 billion for the quarter, the company said. Schwab reported record total client assets of $9.41 trillion, split between retail investors and registered investment advisors.
But it was questions about Schwab’s banking strategy that were at the heart of the call with analysts. Bettinger said Schwab has been “reviewing” its approach to banking and will make adjustments in the coming years. For example, he said Schwab would place more emphasis on attracting transactional bank deposits, such as checking balances. “This would serve to increase liquidity and further stabilize our overall deposit base,” he said.
Schwab is also considering using more third-party banks to provide expanded FDIC insurance to its clients and improve its liquidity. The company has one such agreement with TD Bank. Bettinger didn’t provide details, but said “these various measures should result over time in a somewhat smaller bank than we’ve had in recent years, while maintaining the ability to meet the banking needs of our clients, reduce our capital intensity and, most importantly, protect the earnings we’re able to generate from owning a bank.”
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Schwab appears to be saying the bank has grown too big, far beyond what it needed to provide lending services to customers, and has introduced too much volatility and risk. Analysts were disappointed in the quarter by the continued high level of costly additional borrowing, a continued outflow from core deposits and a less clear outlook for improved net interest income, which was expected to fuel Schwab’s profits through 2025 after what the company called a transition year in 2024.
For investors, it’s hard to imagine what Schwab’s bank will look like in the years ahead. But it will certainly look different than it does today. Schwab’s profits may depend more on the company’s other revenue streams, such as its robust wealth management offerings.
“This strategic shift by management makes us increasingly less confident in the upside potential of net interest income (NII),” Piper Sandler senior analyst Patrick Moley wrote Tuesday. “We plan to further analyze the implications of this change in the coming days and weeks.”
With the unexpected surge in additional borrowing delaying the implementation of his bullish thesis, Moley lowered his 2024 and 2025 target price and earnings estimates to $3.05 and $4.47 from $4.63 and $4.47, respectively.
Write to Andrew Welsch at andrew.welsch@barrons.com and Andrew Bary at andrew.bary@barrons.com