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Morningstar | Charles Schwab Reports Fairly Strong 1Q Results, but Earnings Drivers Likely to Slow

Charles Schwab had fairly strong results in the first quarter of 2019, but earnings drivers are likely to slow. The company reported record quarterly net income to common shareholders of $925 million, or $0.69 per diluted share, on record net revenue of $2.72 billion. Most of the 14%, or $325 million, increase in net revenue from the previous year was from net interest income. Asset-management fees decreased 13%, or $96 million, from a lower fee rate on money market fund balances and lower balances in Schwab Mutual Fund OneSource. Expenses grew about 5% from the previous year to $1.46 billion, and pretax operating margins expanded to 46.4% from 41.8%. We are maintaining our $53 fair value estimate for wide-moat Charles Schwab and assess that the shares are modestly undervalued.

Net interest income remains a key focus, as it's over 60% of net revenue and its earnings drivers are in a state of flux. Client cash balances ticked down to 11.3% of client assets from 12.8% in the fourth quarter. However, there was a spike in cash in the fourth quarter as clients took shelter in cash as markets fell. The 11.3% is still higher than the 10.7% average from the fourth quarter of 2017 through the third quarter of 2018, so clients still seem a bit wary. The shift to relatively less profitable money market funds (0.31% revenue yield) from bank deposits (about 2.46% net interest margin) continued, with average money market fund balances increasing $20.7 billion while deposits only increased $2.7 billion.

Overall, we're not forecasting increases in the federal-funds rate in 2019, and the company is about done with shifting client money market fund balances into its bank--in fact, clients may increasingly choose to move their cash deposits into money market funds--so the previous net interest income drivers of high growth in deposits and higher short-term rates have played out. That said, we still see some benefit from repricing of longer-dated securities.

Charles Schwab's asset-management and administration fees have been under pressure from industry shifts. Average Schwab Mutual Fund OneSource assets decreased a material 16%, or $35 billion, from the previous year. Based on period-end assets, it only looks marginally better with a 12%, or $30 billion, decline. This revenue line is being negatively affected by the shift to passive investment products, which should be considered a long-term headwind.

Schwab ETF OneSource has limited ability to offset the decline in Schwab Mutual Fund OneSource. Balances spiked in the first quarter to $82.5 billion from $30.6 billion in the fourth quarter, as the company doubled the exchange-traded funds in the program to over 500 in February 2019. However, Schwab's revenue yield on third-party mutual funds and ETFs is 0.07%-0.09% compared with Mutual Fund OneSource at 0.32%. Mutual Fund OneSource also had $187 billion of assets in the first quarter compared with $82.5 billion in ETF OneSource.

In addition to the expansion of Schwab ETF OneSource, the company made two other interesting announcements in the first quarter regarding capital returns and its digital advice service. As the company has nearly finished transferring client cash into its bank subsidiary with its related need of capitalizing the bank subsidiary, Charles Schwab increased its dividend 31%, to $0.17 per share from $0.13, and announced a $4 billion share-repurchase authorization. We had been expecting that the company would increase its capital returns this year and believe that the dividend could increase another 20%-40% over the next several years.

Schwab is changing its Schwab Intelligent Advisory, which had a 0.28% advice fee for access to a financial planner, to Schwab Intelligent Portfolios Premium, which has a one-time $300 fee for planning and a $30 per month ongoing fee. We see this as an interesting evolution of both the digital advice business model and wealth-management business model. Robo-advisory firms are increasingly recognizing the need to take a hybrid approach by allowing clients access to human advisors, while the wealth-management industry has been shifting its value proposition toward financial planning and from investment management. These two trends seem likely to continue, while an overall move to a flat fee schedule from a percentage of assets under management or commissions to pay for advice is an emerging trend, and we don't yet know if it will have wide adoption.

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." For our analysis of the various ways robo-advisors monetize client assets, please see our June 2018 special report, "Robo-Advisor Upgrade! Installing a Program for Profitability."