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Morningstar | Schwab's 'No Trade-Off' Proposition for Clients Hasn't Traded Off Profitability for the Firm

Wide-moat Charles Schwab's record 45.5% pretax operating margin in the second quarter demonstrates the profitability of net interest income and that the company can maintain high profitability while effectively competing with peers. The company reported net income of $813 million, or $0.60 per diluted share, on $2.5 billion of net revenue. Net revenue grew 16.7%, driven by net interest income that contributed $354 million of the $356 million increase. We don't anticipate making a material change to our $57 fair value estimate for Charles Schwab and believe that shares are fairly valued to slightly undervalued.

We continue to expect that net interest income will be the primary driver of earnings. The Fed Funds rate increased another 0.25-percentage points in June to a target range of 1.75% to 2%. Given the positive trajectory of the U.S. economy, we expect the Federal Reserve to continue with its gradual increasing of the Fed Funds rate. While a flat yield curve isn't as beneficial to financials, much of the proceeds from interest yielding securities on Schwab's balance sheet that are maturing over the next couple of years will be invested at higher rates, even if the long-end of the yield curve doesn't move.

Another positive for net interest income is the growth in the company's balance sheet. This quarter was a milestone in that the balance sheet surpassed $250 billion, which is a key regulatory threshold for banks in the United States. Now that Schwab's total assets are past $250 billion, it should be able to accelerate balance sheet growth to be largely in line with retained earnings growth.

It's worth remembering that the company's record operating margin comes despite reducing prices on multiple products over the past couple of years. Commission pricing, proprietary ETF management fees, and money market fund fees have all been recently lowered. The company's "no trade-offs" philosophy for clients hasn't traded off profitability for the company.

Charles Schwab's digital advice assets grew to $33.3 billion by the end of the quarter, and the company says it is collecting approximately $1 billion of additional digital advice assets per month. Based on our recent analysis of robo-advisors, we assess that Schwab Intelligent Portfolios is a net positive to the firm, even if 65% or more of assets going into the digital portfolios are from existing Schwab clients. We believe that the revenue from retaining clients, adding new clients, and transitioning buy & hold clients to Intelligent Portfolios more than outweigh any potential cannibalization from clients that are using another Schwab managed product that has a higher revenue yield.

For our recent analysis of robo-advisors, please see our June 2018 special report, "Robo-Advisor Upgrade! Installing a Program for Profitability."