Charles Schwab may be best known for its securities platform, but it's its bank that's once again giving investors headaches.
The stock fell 10% after second-quarter profit missed a key indicator and was down another 5% by Wednesday morning. The second quarter saw a drop in bank deposits and a rise in additional borrowing, dashing investors' hopes for assurances that the company was out of the cash-consolidation quagmire that plagued Schwab last year.
“The stabilization of the cash sweep is at the heart of the story,” said Jeff Schmidt, an analyst at William Blair & Co. Barons“Any meaningful recovery in EPS requires removing short-term capital from the books. This quarter, the opposite was true.”
Additionally, CEO Walt Bettinger suggested that Schwab will adjust its strategy and reduce the size of the bank. While this won't change much in the short term (Bettinger emphasized that the change will happen over years, not months), it will be of great interest to shareholders, given that roughly half of Schwab's revenue comes from net interest income (the difference between what the bank earns in interest and what it pays out).
Sorting cash. Schwab has been sweeping clients' uninvested cash into lower-yielding bank accounts. Last year, clients moved billions of dollars in deposits from sweep accounts into higher-yielding options like money market funds, a process known as cash sorting. While the money may not have left Schwab's platform, it has hurt earnings by forcing Schwab to increase short-term borrowing as deposit outflows outpaced its cash reserves. That has hit net interest income.
Some Schwab skeptics argue that because it's more like a bank, it doesn't deserve the big valuation premium it's long been given as a retail brokerage and financial technology company. Its shares have averaged about 20 times earnings over the past five years, roughly double the valuations of banks. Even after Tuesday's offering, Schwab's shares traded at 21 times projected earnings of $3.20 in 2024 and 16 times projected earnings of $4.30 in 2025 — a premium for a bank such as Bank of America.
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JP Morgan and Wells Fargo
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It is trading at 12 to 13 times this year's expected earnings.
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But analysts have been generally bullish on Schwab this year because of signs that the pace of deposit outflows is slowing. Some analysts said most of the clients who had planned to move their money have already done so. Investors have been scrutinizing the results for signs that Schwab is paying down its debt.
“For Schwab to achieve more consistent profit growth, it needs stabilization in client cash balances and deposits,” Morningstar analyst Michael Wong wrote on Tuesday. “While some of the deposit declines are related to tax payments, there is still 'cash sorting' going on, as evidenced by the more than $20 billion increase in money market balances.”
Wong left his fair value estimate for Schwab at $76 a share, which closed at $67.43 on Tuesday, unchanged. He calls Schwab's shares fairly valued or slightly undervalued.
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If the Federal Reserve starts to cut interest rates later this year, that could ease pressure on Schwab to sift through cash. And with the merger with TD Ameritrade now complete, the firm should be able to beef up asset collection, analysts said. Core net new assets rose 17% year-over-year to $61.2 billion in the quarter, the firm said. Schwab said total client assets, including individual investors and registered investment advisers, hit a record $9.41 trillion.
But one hot topic on the call with analysts was a question about Schwab's banking strategy. Bettinger said Schwab is “studying” how it approaches banking services and will make adjustments over the next few years. For example, he said Schwab will focus on attracting transactional bank deposits, such as checking accounts. “This will be a way to increase liquidity and further stabilize our overall deposit base,” he said.
In addition, Schwab envisions tapping more third-party banks to provide extended FDIC insurance to clients and improve Schwab's liquidity. The company has such an arrangement with TD Bank. “Over time, these various measures will return us to a somewhat smaller bank than we have been in recent years, while preserving our ability to meet our clients' banking needs, reducing our capital intensity, and, importantly, protecting the economies that we can generate by owning a bank,” Bettinger said, without going into details.
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Schwab seems to be saying the bank has gotten too big, far beyond its need to service loans to customers, and that it has become too volatile and risky. Analysts were disappointed in the fourth quarter by continued high incremental borrowing, continued outflows of core deposits and a murky outlook for improvement in net interest income, which was expected to drive Schwab's earnings through 2024, which the company calls a transitional period, and into 2025.
It may be hard for investors to predict what Schwab Bank will look like in the next few years, but it will certainly be different than it is today. Schwab's revenues may become more dependent on the company's other revenue streams, such as its robust wealth management services.
“This strategic shift by management has gradually eroded confidence in NII’s profit potential. [net interest income] “This change is driving the earnings recovery,” Patrick Morey, senior research analyst at Piper Sandler, wrote Tuesday. “We will further analyze the impact of this change in the coming days and weeks.”
With the unexpected increase in additional borrowings delaying the timing of the bullish thesis, Morey lowered his earnings forecast targets for 2024 and 2025 to $3.05 and $4.47 from $4.63 and $4.47, respectively.
Please contact Andrew Welsch at andrew.welsch@barrons.com and Andrew Bary at andrew.bary@barrons.com.
