Schwab Earnings Preview: Is Schwab's 'Core EPS' $2 Per Share?

| About: The Charles (SCHW)


Rising stock prices and an interested retail investing base has reinvigorated the stock.

The money-market fee waiver is masking about $0.50 in EPS.

The dividend and share repo is has been dormant for years - time to return more capital?

Charles Schwab (NYSE:SCHW) or "Chuck" as it has become more humorously known the last few years, is scheduled to report their q2 '14 earnings before the opening bell on Tuesday, July 15th, 2014.

Analyst consensus is expecting $0.23 in earnings per share (NYSEARCA:EPS) on $1.48 billion in revenue for expected year-over-year growth of 28% and 11% respectively.

SCHW was up 81% in 2013, in terms of capital gain (return does not include dividend) as the 32% return on the SP 500 last year, comforted individual investors.

However the biggest change in SCHW's business model from the $50 peak stock price in early 1999, is that the company has morphed from a retail trading and discount brokerage firm to an asset management juggernaut, and SCHW was well out in front of any number of firms now doing so.

The latest convert to the asset-gathering world is Morgan Stanley (NYSE:MS), who is morphing from the investment banking and proprietary trading model to the asset-gathering model, which is a much lower-risk business in terms of the balance sheet and capital requirements, not to mention the asset accumulation model will allow for a far more consistent and stable earnings and revenue stream.

And "Chuck" has had a 14 year head-start on the rest of the Street.

As a Schwab-centric advisor (as an RIA, I do not custody assets here at the firm) but instead use a 3rd-party custodian such as Schwab to custody the assets and generate statements. This is in clients' best interests since it insures separate statement generation, and keeps an independent 3rd party between the advisor and the client, which is how most major client scams (i.e. Bernie Madoff and most Ponzi schemes) get perpetrated. Although there are mostly honest and ethical advisors, anytime an investment advisor custodies client assets and thus generates monthly client statements, there would seem to me to be the opportunity for statement "manipulation" and fraud.

Anyway, back to the financials and Schwab's valuation:

The biggest drag to Schwab's earnings since 2008, has been the quarterly fee waiver of the money market management fee, since money market yields are so low.

  12/31/2014 9/30/2014 6/30/2014 3/31/2014 12/31/2013 9/30/2013 6/30/2013 3/31/2013 12/31/2012 9/30/2012 6/30/2012 3/31/2012 12/31/2011 9/30/2011 6/30/2011 3/31/2011 12/31/2010 9/30/2010
Money mkt fee waivers ($'s ml's) n/a n/a n/a $185 $182 $180 $157 $155 $142 $136 $146 $163 $168 $160 $128 $120 $112 $104
per share n/a n/a n/a $0.141 $0.140 $0.139 $0.122 $0.121 $0.111 $0.107 $0.115 $0.128 $0.132 $0.130 $0.106 $0.099 $0.09 $0.09
4q trailing n/a n/a n/a $0.542 $0.521 $0.493 $0.461 $0.453 $0.460 $0.481 $0.505 $0.496 $0.467 $0.428 $0.385 n/a n/a n/a
Click to enlarge

* Source: internal spreadsheet

We've been tracking the money market management fee waiver since late, 2010 and as the reader can quickly see from scanning the numbers, the absolute dollar value of the waiver hit a peak in the March '14 quarter. I think as investors and RIA's take duration off the table in the bond portfolio's, they are not necessarily allocating that money to equities, but rather letting the proceeds sit in Schwab money markets as the Fed's Tapering program continues, the economic data gets stronger, and the stock market continues to rise. This is causing the fee waiver to increase as more money is kept in money markets. (This is strictly an educated guess on my part, but I have some portion of client's bond money in the money market currently, and have had for a while.)

Again, as the reader can quickly see, if short-term rates rise only 100 bp's to 1%, Schwab has the ability to start to raise their money market management fee and start to replace this lost revenue.

By our calculations, Schwab is masking between $0.50 and $0.55 per share in "normalized EPS" just from the fee waiver.

Here is another interesting aspect of the forward earnings data:

n/a     est actual actual                
n/a 12/31/2014 9/30/2014 6/30/2014 3/31/2014 12/31/2013                
2016 eps - estimated n/a n/a $1.67 $1.64 $1.49                
  n/a n/a n/a $0.44                  
  n/a n/a n/a $0.43                  
  n/a n/a n/a $0.42                  
  n/a n/a n/a $0.40                  
  n/a n/a n/a 9 5                
2015 eps - estimated n/a n/a $1.16 $1.18 $1.15 $1.10 $1.10 $1.06 $1.04 $1.25      
  n/a n/a n/a $0.33 $0.30 $0.30 $0.23 $0.28 $0.25 $0.22      
  n/a n/a n/a $0.32 $0.30 $0.29 $0.23 $0.27 $0.25 $0.21      
  n/a n/a n/a $0.28 $0.28 $0.26 $0.23 $0.26 $0.25 $0.21      
  n/a n/a n/a $0.27 $0.26 $0.24 $0.22 $0.26 $0.24 $0.19      
  n/a n/a n/a 20 20 12 12 10 6 1      
2014 eps - estimated n/a n/a $0.96 $0.97 $0.95 $0.90 $0.88 $0.86 $0.86 $0.87 $0.95 $1.09 $1.08
  n/a n/a n/a $0.25 $0.25 $0.24 $0.22 $0.23 $0.22 $0.22 $0.22 $0.27  
  n/a n/a n/a $0.25 $0.26 $0.24 $0.23 $0.23 $0.23 $0.21 $0.21 $0.25  
  n/a n/a n/a $0.23 $0.23 $0.22 $0.21 $0.21 $0.21 $0.21 $0.21 $0.26  
q1 '14 eps - actual $0.24 $0.24 $0.24 $0.24 $0.21 $0.20 $0.19 $0.20 $0.20 $0.19 $0.20 $0.23  
  21 21 21 21 21 20 20 32 18 10 9 10 7
Click to enlarge

* Source: internal spreadsheet from Thomson Reuters estimate detail

This could get confusing for readers, but the current 2014, 2015 and 2016 EPS consensus from Thomson as of this weekend is $0.96, $1.16 and $1.67 per share for expected EPS growth the next 3 years of 23%, 21%, and 44% respectively.

If you want some numerical expectation of when the Fed will tighten, rather than trying to interpret Yellen and Fed-speak, note the trends in earnings estimates for the last 2 quarters of 2015 and then the full year 2016 EPS estimate.

When the market starts to factor in Fed tightening, one of the places that expectation should show up first is in Schwab's EPS estimates, other than the short-term Treasury market yields.

Valuation: Schwab at $27 per share is currently trading at 28(x) the expected '14 EPS estimate of $0.96, for expected y/y growth this year and next of 23% and 21%.

However, using that waiver, I do think SCHW's "normalized" or core EPS is probably closer to $2 per share, so at 20(x) $2, a $40 fair value wouldn't be too unrealistic in our opinion.

Currently our intrinsic value model puts an estimated intrinsic value on Schwab of $27, while Morningstar places an estimated perceived intrinsic value model on SCHW of $23.

The longer the Fed maintains ZIRP and the longer those money market fees have to be waived, the more improbable the $2 in "core EPS" and the $40 intrinsic value estimate becomes.

This is one reason I think our entire financial system could benefit from some inflation and higher short-term rates.

Schwab's valuation isn't impacted entirely by short-term rates. As long as the SP 500 and the US stock markets remain reasonably-valued, the $2.5 trillion Schwab now has under management, with the RIA assets being the fastest growing segment of the business, should continue to add to fee-based revenues as stock market values increase.

One final potential positive for the stock is that SCHW has had about $600 million remaining on a share repurchase authorization since early, 2008. In addition, they have been paying a quarterly dividend of $0.06 a share or $0.24 a year since June of 2009, or 5 solid years, with no increase in the dividend and no repurchase of stock.

Granted Dodd-Frank, and the SIFI (strategically important financial institution) initiative has played havoc with the financial sector, but Schwab is generating a lot of free-cash-flow currently, and the asset management business has the ability to leverage nicely over a fixed-cost or fixed expense base.

One metric we follow from the 10-Q and 10-K is "fixed-charge coverage" which is risen from 2(x) a few years ago to 9(x) as of the March '14 quarter. The rating agencies could be as spooked as the various financial sector management's seem to be, as to what the Fed, Dodd-Frank, the Justice Department and the various charged-up regulators will concoct next in terms of capital constraints, so this could very well be the reason SCHW hasn't increased the dividend or repo'ed shares. (The fixed charge coverage is used as credit rating indicator, so the better the credit of Schwab, pari passu, the greater the ability of the management team to return capital to shareholders.)

Maybe SCHW is waiting to see what happens to interest rates, before deciding to return capital to shareholders. Given SCHW's PE ratio, I would think they would take action on the dividend first, before buying back shares.

However the share repo could be used to offset some of the insider selling: since March, 2010, SCHW's fully diluted shares outstanding have risen 10% from 1.188 billion to 1.311 billion as of 3/31/14, which is a 10% increase, in 16 quarters or 4 years. (There must be a reason they have not bought back ANY stock in the last 6 years, although I haven't seen that reason anywhere, either in Street research or management comments.)

Year-to-date, 2014, SCHW's stock is up about 3.5%-4%, or about half the SP 500's return. We think the stock benefits from a.) a rising stock market, b.) greater assets under management both from net new assets coming under the Schwab umbrella, as well as rising asset values, c.) rising DART's (daily average revenue trades) from the portfolio re-positioning, but the biggest catalyst, if and when it arrives, will be the short-term rate hike by the Fed, which will allow money market management fees to be re-instituted.

The return of record stock market levels has been a huge positive for SCHW and yet valuations are still reasonable.

We think the stock has more upside. We currently have a 3% position in the stock within client accounts, and think the Goldman / Morgan banking / trading model is the wrong model for today's post 2008 financial institution environment, while SCHW has the right model.

Rumor has it Goldman is looking for a discount broker to acquire. It could be a good move on their part given the volatility of the traditional white-shoe, investment banking and trading firm model.

We think SCHW is well-positioned for the future.

Here are our earlier articles on SCHW, this one in January, '13, and this one later in '13. The theme has been consistent. The question remains core earnings power and valuation.

Disclosure: The author is long SCHW. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.