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Morningstar | Charles Schwab Increases Capital Returns and Takeaways From Winter Update

Wide-moat Charles Schwab recently increased its dividend, and management had its winter business update with commentary on four items that could be interpreted negatively. After having transferred over $70 billion of client cash from its money market funds into its bank in 2018 and with only about $30 billion left in sweep money market funds, the company increased its quarterly dividend 31% to $0.17 from $0.13 per share. For a couple of years, we had commented that we thought the company would hug close to the lower end of its 20% to 30% dividend payout ratio because it needed to retain equity to capitalize its bank subsidiary to change money market fund balances into bank deposits. With the company's plan to finish up the cash transfers in 2019, we had already forecast a significant increase in the dividend. Even after this dividend raise, we wouldn't be surprised if the company increases its dividend another 20% to 40% in the next couple of years and conducts significant share repurchases with its new $4 billion repurchase authorization.

Four somewhat negative items stood out to us from the winter update. First was the 6% to 7% expense growth guidance that was pretty much set regardless of revenue growth. For the previous couple of years, the company had usually guided to a 2- to 4-percentage-point difference between its revenue and expense growth. Second was that competition in options commissions could increase, whereas historically there was more competition in equity commission pricing. Third was that about $15 billion of the $30 billion left in sweep money market funds couldn't be moved into the bank. Fourth was that there could be more movement by clients into less profitable "investment" cash products from "transactional" cash products. We don't anticipate making a material change to our $53 fair value estimate for Charles Schwab and assess shares as undervalued.

For our recent analysis of deposit costs and net interest margins, please see our December 2018 Financial Services Observer, "The Return of the Bank: Net Interest Margins Reach a Turning Point."