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Morningstar | Charles Schwab's Streak of Sequential Net Revenue Growth Broken As Interest Rates Fall

Net interest income remains the key driver of wide-moat Charles Schwab's earnings, and the fall in market interest rates, as well as changes in client cash balances, caused net revenue to decline 2% to $2.68 billion during the second quarter, breaking what had been a streak of sequential net revenue increases for the company since the first quarter of 2015. In perspective, the $2.68 billion of net revenue reported for the second quarter was still a great number, as it was down just 2% from the first quarter of 2019 (which was a quarterly net revenue record). We are maintaining our $47.50 fair value estimate for the firm and assess shares as modestly undervalued right now.

Charles Schwab's interest earning asset balances and net interest margin both declined sequentially, leading to a $72 million decrease in net interest income. Yields across all interest earning assets declined except for available for sale securities, causing the average yield on interest-earning assets to decline sequentially to 2.88% from 2.92%. Total funding costs also increased 2 basis points sequentially, causing the net interest margin to contract to 2.40% from 2.46%.

Given that the company has finished moving as much of its client asset balances from money market funds to banking deposits as possible, the company's net interest income is now largely dependent on factors not under its control, such as market interest rates. As the 10-year treasury averaged about 2.35% in the second quarter compared with 2.65% in the first quarter, and the one-month treasury averaged 2.35% compared with 2.43%, there was bound to be pressure on asset yields.

The 10-year treasury is currently at about 2.10% and the one-month is around 2.15% with many expecting the Federal Reserve to cut the federal-funds rate in 2019, so further declines in earning asset yields is likely.

Despite some likely revenue headwinds, Charles Schwab appears committed to investing in its platform with full-time equivalent employees up 1,000 since the end of the year to 20,500 and up nearly 3,000 since the end of 2017. Capital expenditures for the quarter also were $173 million compared with a quarterly average of $144 million in 2018 and $103 million in 2017.

Real GDP growth in the United States in the first quarter was 3.2% annualized, an improvement from the 2.2% rate during fourth-quarter 2018. Recent economic data indicates somewhat lower growth in the second quarter, with the Federal Reserve Bank of Atlanta forecast model estimating GDP growth of 1.4%. The consumer price index increased at an annual rate of 0.7% in June, declining from the near 1% rate seen during May. And, the core level of inflation, which excludes food and energy, posted a 3.5% annualized rate in June, breaking a streak of four consecutive months below the Fed's 2% target.

The ISM purchasing managers' manufacturing index, generally the first data release following month-end, fell to 51.7 in June, its lowest level since October 2016. Similarly, the ISM non-manufacturing index, at 55.1 for June, also fell to a multiyear low. An index level over 50 represents continued expansion, and the ISM metrics indicate a potential slowdown, rather than imminent recession. The IMF projects GDP growth of 2.3% for the U.S. economy in 2019, with forecast growth declining to 1.9% in 2020. The IMF is also forecasting 2% inflation for the year, with prices expected to rise at a 2.7% clip in 2020.

The Federal Reserve maintained the target range for interest rates at 2.25%-2.50% following its June meeting, holding benchmark rates stable since the last increase in December. In contrast to previous meetings, the vote to maintain rates was not unanimous, with one member voting to lower rates. The Fed has made clear it will "act as appropriate to sustain the (economic) expansion" and Chairman Jerome Powell has indicated that rate cuts are on the table with intensifying economic and geopolitical risks.

Any near-term rate cuts would likely be more to prevent a significant slowdown in the U.S. economy than an indication that we’ve entered into a recession. The futures market is anticipating a rate cut at the next Fed meeting in late July, and it appears a dovish shift in Fed monetary policy is on the horizon.