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Morningstar | Charles Schwab Is Showing Flexibility With Expenses and Capital in Subdued Environment

Wide-moat Charles Schwab is taking actions to adapt to the more subdued macroeconomic environment, and its capital flexibility may become a highlight over the next couple of years. The company acknowledged in its recent summer business update that the interest-rate environment has evolved differently than it had anticipated at the beginning of the year. Previously, the company thought we would have one federal-funds rate increase this year. However, most market analysts are now predicting that the Federal Reserve will reduce the fed-funds rate one to three times this year. Additionally, the company had based its 2019 outlook on the 10-year Treasury averaging 2.8% for the year, whereas it's currently near 2.05%. With this lower interest-rate environment, Charles Schwab thinks its net interest margin will be 2.35%-2.4% compared with the first quarter's 2.46%. Offsetting lower net interest margins, is the company reduced its 2019 expense growth forecast to 5% to 6% from 6% to 7%. With the company's contemplated economic scenario, revenue would grow 5% to 7%, expenses would grow 5% to 6%, and operating margins would be about in line with the previous year at 45%. We believe this scenario is reasonable and don't anticipate making a material change to our $47.50 fair value estimate for Charles Schwab and believe shares are fairly valued.

With earnings growth likely slowing, Charles Schwab's use of capital will become more prominent. If the market environment stabilizes, we believe the company could increase its dividend upwards of 20%. However, if the environment deteriorates and the share price falls, management could increase share repurchases. At the end of the second quarter, the company still had $2.8 billion of repurchase authorization outstanding. Acquisitions to build up capabilities also remain an option.

In the second quarter, the company repurchased $1.2 billion of shares, indicating a definite intention to repurchase shares if the company sees them as undervalued. With a Tier 1 leverage ratio of 7.3% compared with a capital target of 6.75% to 7% and possibility to issue more than $1 billion of preferred stock to supplement its capital ratios, the company has flexibility for repurchases or acquisitions.