Per Briefing.com, Charles Schwab (NYSE:SCHW) is scheduled to report their Q1 ’20 financial results before the opening bell on Wednesday morning, April 15th, 2020. Per Street consensus, Schwab is expected to report $0.63 in earnings per share on $2.63 billion in revenue for expected y/y declines of 10% and 4%, respectively.
Schwab is lapping the strong 1st quarter of 2019, when the S&P 500 returned 13.65% in the 3-month period, followed by the 31% in calendar year 2019.
Needless to say, “tough compares” will be the hallmark of 2020.
The real damage for Schwab is the return to zero interest rates, reminiscent of the post-2008 period when it eliminated fees on its money market funds for clients, and at one point, per the spreadsheet, Schwab was “masking” $0.50 – $0.60 in annual EPS from foregone money market fees.
While this is not 2008, this 2nd round of zero interest rates could last for 6-9 months, or even longer.
And that will mean forward EPS estimates will be reduced if money market fees are waived once again.
Trends in EPS and Revenue Revisions
Readers will see the sharp reductions to calendar 2020 and 2021 EPS estimates for Schwab in this table:
Source: internal valuation spreadsheet
The first column of EPS and revenue numbers in both spreadsheets is the Street’s current consensus for annual EPS and revenues for Schwab.
Readers can see the progressions starting from the left and working to the right.
Here is another way to look at the annual EPS and revenue growth:
|EPS||y/y gro||Rev’s (bl’s $)||y/y gro|
|2022 – est||$2.07||0%||$9.9||-6%|
|2021 – est||$1.86||7%||$9.5||4%|
|2020 – est||$2.00||-3%||$9.7||1%|
Source: valuation s/sheet from earnings reports and 10-Qs
Readers can see how the next few years might be a struggle for Schwab, given the current environment and the expected dilution from the Ameritrade deal.
This monthly chart of Schwab shows the brokerage giant has fallen sharply since its $60 peak in May of 2018, presumably as the stock began to discount an increasingingly heated trade war, a slowing US economy, eventually lower interest rates, and the end of commission revenue.
A trade back to the $45 area would break the downtrend line since the May ’18 peak and give some hope back to the bulls.
This YCharts graph calculates the Schwab total return vs. the S&P 500 total return for the decade from 1/1/2020 to 12/31/19.
Readers can see the impact of low rates following the Mortgage Crisis of 2008-2009 and its impact on the stock, and then, improvement in relative performance after Janet Yellen started raising the fed funds rate in December ’15 and through the early part of 2018.
So far, in 2020, Schwab is down about 20% versus the S&P 500’s 14%, so the underperformance continues, which is understandable.
TD Ameritrade Merger
Schwab announced the blockbuster, all-stock acquisition last November ’19, and it is still awaiting Justice Department approval, even though Justice has already given the OK to the Morgan Stanley – ETrade deal.
Morningstar estimates that the combined Schwab – Ameritrade deal will have roughly 40% market share in the “3rd party custodian” market, and TD is expected to add $1.3 trillion in assets under management to Schwab’s $3 trillion base.
From an interest rate perspective, while the zero rates will continue to depress net interest margins, the gross cash balances from TD Ameritrade should boost the net interest margin earnings, so I’m hoping for approval of the deal sometime in the summer of 2020.
Here is what Schwab’s net interest margin looked like through Q4 ’19:
While both Schwab and Ameritrade are talking to “cost synergies”, the deal is dilutive to Schwab for a few years, although the current environment should only accelerate those cost savings if the deal should be approved by the summer.
|Valuation metric||as of 12/31/19|
|3-yr avg “expected” EPS gro||-21%|
|3-yr avg ‘expected” rev gro||-7%|
|3-yr avg PE||18x|
|ROE||14% – 16%|
|ROA||1% – 1.25%|
|Net int margin||2.34%|
|Expected 5-yr avg rev gro (Mstar)||0%|
|Intrinsic value (Mstar)||$43|
Source: valuation spreadsheet and Morningstar
* assumes $35 stock price for valuation metrics
The valuation metric that really jumps out at readers is the 19% free cash flow assuming a $35 stock price, so – assuming the Ameritrade merger gets approved this year, I would think an ASR (accelerated share repurchase) might be in order, even though share repurchase programs have suddenly become unfashionable in the current environment.
Again, the deal is stock-for-stock, so Schwab has an excess of capital currently that could be returned.
Covid-19 and the return to zero fed funds rates returns Schwab to the post-2008 market environment which constrains net revenue. Commission revenue is gone, so Schwab won’t benefit from recent volatility, and Justice is eyeballing the Ameritrade merger hard, given the market share implications.
In the mid-$30s, the stock is probably 20-25% undervalued, so the stock will continue to be held for clients, and re-evaluated once the mid-$40s are achieved and we see what else is happening.
Schwab is a top 3 position within client accounts although the decline from the high $50’s has impacted its overall weighting.
Financials stocks are not typically evaluated on a “free cash flow” basis but rather on “capital adequacy”, but the discount brokers and the exchanges are different from the major and regional banks, so I consider cash flow in the valuation.
Continued improvement in Covid-19 numbers, a move towards the reopening of the US economy, an approval of the Ameritrade merger, a pro-business result for the Presidential election in November ’20 and a steepening yield curve are all pluses for faster EPS and revenue growth. Of course, the opposite of those events will hurt the growth, although some of this is in the current share price.
At current prices, the stock will be given another 3-6 months to see what transpires.
Disclosure: I am/we are long SCHW. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: SCHW reports next week