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Morningstar | Net Interest Income Propels Earnings Growth Despite Pricing and Market Concerns at Schwab

Net interest income and operating expansion continue to drive wide-moat Charles Schwab to record earnings; however, pricing pressures and market uncertainty may be weighing on the stock. The company reported record quarterly net income to common shareholders of $885 million, or $0.65 per diluted share, on $2.6 billion of net revenue in the third quarter. Net revenue increased $414 million, or 19%, with net interest income growing $445 million from the previous year. Operating margins expanded to 47.3% from 43.6%. We don't expect to make a material change to our $57 fair value estimate and believe that the shares are moderately undervalued.

The interest-rate environment continues to evolve in Charles Schwab's favor. At the end of September, the Federal Reserve increased the target federal-funds rate 25 basis points to 2%-2.25%, and the 10-year U.S. Treasury has recently climbed above 3.15% compared with 2.5% at the beginning of the year. While the stock market has taken a step back from recent highs, Schwab derives approximately 60% of net revenue from net interest income compared with 30% from asset-management fees. This means that a market correction, as long as it isn't accompanied by a recession and accommodative monetary policy that lowers interest rates, won't significantly affect the company's medium-term earnings growth.

Pricing competition chatter also increased in the third quarter, with Fidelity introducing its ZERO line of index funds, Vanguard announcing the expansion of its no-transaction-fee platform to nearly 1,800 exchange-traded funds, and JPMorgan having a free trading promotion. Fees will continue to decline across the industry, but Schwab already offers a low trading fee of $4.95 per online trade and has its own commission-free offerings. In fact, about 45% of trades at Schwab are done without a commission, and only 7% of net revenue is from trading. Even if commissions go to $0, Schwab has a wide moat and should remain highly profitable.

On the zero-fee front, Schwab itself has been disruptive with its 0% advisory fee. In its robo-advisor, Schwab Intelligent Portfolios, it charges a 0% advisory fee while many robo-advisors charge 0.25% or more. Schwab has been able to do this by having a low cost of customer acquisition and monetizing assets in its robo-advisor through other methods, such as using proprietary products and using its own bank for the cash portion of the portfolio. While many firms have announced a zero-fee offering, nothing is truly free, and there are myriad strategies for companies to profit. For our analysis of the various ways robo-advisors monetize client assets, please see our June special report, "Robo-Advisor Upgrade! Installing a Program for Profitability."