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Morningstar | Schwab Reports Strong 4Q Earnings; a Share Price in the $40s Compensates Investors for a Recession

Despite the increased uncertainty regarding the economic environment in 2019 and beyond, wide-moat-rated Charles Schwab posted strong fourth-quarter earnings, and we believe that shares are moderately undervalued. Schwab reported $885 million of net income to common shareholders, or $0.65 per diluted share, on $2.67 billion of net revenue for the December quarter. Compared with the year-ago period, net revenue grew 19%, operating income grew 27%, and net income grew 61%. The large increase in net income was due to tax reform, but the strong revenue and operating income growth were due to positive trends in the company's business model and expense discipline. That said, we anticipate that our current $57 per share fair value estimate for Schwab will decrease $1 to $2 as we incorporate a longer time horizon to reach a normalized level of interest rates, as well as to adjust for the decline in equity markets in the fourth quarter. Even so, we still believe the shares are undervalued, estimating that a share price in the low $40s would adequately compensate long-term investors for a near-term recession and a dip in interest rates. We should also note that the firm is likely to significantly increase its dividend in the coming year.

Changes in interest rates continue to be primary drivers of Schwab's earnings, so with the outlook for interest-rate increases becoming more uncertain of late it becomes more difficult to project earnings growth. As we saw last year, when $544 million in net interest income more than made up for a $108 million decline in asset management revenue, rising rates have been a net positive for Schwab. During 2018, interest earning assets increased 20% to $268 billion and Schwab's net interest margin expanding to 2.39% from 2.03% during the year ago period. Interest-earning asset growth was primarily driven by an increase in bank deposits, aided by the company's movement of money market fund balances into its bank.

While it would have been great if Schwab's asset management fees increased year over year, the primary reason for the decrease was the company's shifting of money market fund assets (where it earns 0.4%) into its own bank (where it can earn a net interest margin upwards of 2%). Money market fund fee balances decreased $24 billion during the year from $162 billion at the end of 2017. Schwab also made changes to its money market fund pricing, with its overall revenue yield hitting 0.34% in the quarter (compared with 0.49% in the year-ago period). In total, money market fund fee revenue was just 4% of Schwab's net revenue during the fourth quarter. Mutual Fund OneSource balances (which decreased $28 billion to $192 billion during the year) have struggled due to changing investor preferences, but any drag from this platform should be manageable. Despite total client assets increasing to $3.25 trillion from $2.56 at the beginning of 2016, Mutual Fund OneSource balances have hovered around $200 billion as investors have increasingly allocated capital to passive investment products, like exchange-traded funds. With Mutual Fund OneSource revenue accounting for just 6% of total revenue in the fourth quarter, further decreases in this line wouldn't be overly significant for the company, especially as there are likely to be some offsets if the outflows end up in Charles Schwab's own ETFs.

While the interest-rate outlook is increasingly uncertain, share prices in the $40s includes quite a bit of bearishness for this particular earnings driver, and the current environment, in our view, remains constructive for earnings. During 2019, Schwab will benefit from the additional 25-basis-point increase in the federal-funds rate in December of last year that has yet to flow through to earnings. That said, we may not be able to count on additional Fed rate hikes in 2019. Currently, CME Group futures are pricing in an over 50% probability that the Fed doesn't raise interest rates in 2019. Compare this with an over 50% chance of one or more hikes that was implied in the futures just a quarter or two ago, and the Fed's own dot plot in December 2018 that was still baking in two rate hikes. With approximately 40% of Schwab's bank portfolio floating rate in nature, it is largely influenced by the federal-funds rate. With the remaining 60% of the firm's bank portfolio being more fixed in nature (with a duration of 4 to 4.5 years), we have to keep an eye on the 10-year Treasury, which has fallen to around 2.7% of late from 3.25% during the fourth quarter of 2018. A portion of this portfolio matures each year and is then reinvested at the longer end of the interest-rate yield curve. While the recent decrease in the 10-year Treasury was disappointing from a reinvestment perspective, at 2.7% we feel that Schwab can still probably modestly increase the yield on the fixed portion of its portfolio.

On the interest expense side, we expect to be keeping a closer eye on competition from the online brokerages and banks to determine Schwab's full exposure. Deposit betas, or the increase in the cost of deposit funding compared with the rise in interest rates, increased in 2018. Interest expense on deposits was 0.38% in the fourth quarter of 2018 compared with 0.12% a year ago. If competition for deposits increases at the online brokerages and banks absent any increases in the fed-funds rate, net interest income growth could be challenging for Schwab in the back half of 2019.

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."