Schwab: Competitive Advantage

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About: The Charles Schwab Corporation (SCHW), Includes: AMTD, BAC, BLK, ETFC, IVZ, MS, STT, WETF
by: Eric Sprague
Summary

Interest-earning assets have grown dramatically over the last 10 years.

The company has a scale advantage against Ameritrade and E*Trade.

Legacy competitors are at a cost disadvantage.

Introduction

My thesis is that Schwab (SCHW) has competitive advantages that enable them to grow overall client assets and the crucial interest-earning assets at a low cost. In 10 years Schwab has grown client assets from $1.4 trillion in 3Q07 to $3.2 trillion in 3Q17 and interest-earning assets from $36 billion to $214 billion.

Since the discount broker days the brand has been famous for keeping costs low but in recent years Schwab has also become known as a first-rate asset custodian. This reputation allows the company to gather assets without having to pay exorbitant fees to sales executives.

We use 9M17 when referring to the first 9 months or the first 3 quarters of 2017 and these numbers come from the Third Quarter 2017 Press Release and Tables. Note that we show 3 months ended September 30, 2017 in some places and 9 months ended in other places. For example, the average balance of total interest-earning assets for the single 3Q17 quarter is $214 billion whereas it is $216 billion for 9M17.

Competitive Landscape

The company has a scale advantage over E*Trade (ETFC) and Ameritrade (AMTD). The company gathers assets more efficiently than legacy competitors like Morgan Stanley (MS) and Bank of America Merrill Lynch (BAC).

Slide 19 of the 2017 Spring Business Update shows that Schwab has the lowest expense to average client assets as of 1Q17: Charles Schwab: 18 bps; TD Ameritrade: 27 bps; E*Trade: 43 bps; Bank of America Global Wealth & Investment Management: 53 bps; Morgan Stanley Wealth Management: 58 bps.

Net Interest Revenue

Net interest revenue made up 49% or $3,135 million of the total $6,376 million net revenue for 9M17.

The total 9 month interest-earning assets for this group come to $216 billion. Within this group the "Held to maturity securities" interest-earning asset revenue line is the most sizable. Bank deposits are by far the largest part of this funding source group at $163 billion. iBanknet shows that Schwab Bank has $176 billion in assets as of 07/27/2017. The FDIC insured cash sweep for newer Schwab accounts makes up a considerable percentage of these bank deposits.

The sweep program is a required part of the growing online robo advisor program and it benefits Schwab Bank. The December 2016 disclosure brochure says the cash allocation for Schwab Intelligent Portfolios [SIP] is generally 6% to 30% and this is swept to deposit accounts at Schwab Bank.

Asset Management and Fee Revenue

From $1,446 million in 9 month client assets, this group brought in $2,529 million in 9M17 revenue which was about 40% of the total net revenue.

Fee-based advice solutions

Bringing in $765 million of revenue in 9M17 from $199 billion in 9 month client assets, the fee-based advice solutions segment is the largest contributor to asset management and fee revenue group.

The Schwab Private Client ADV shows over $74 billion in assets enrolled as of December 31, 2016. The 3Q17 Press Release and Tables show that client assets managed by Intelligent Portfolios total $23 billion, client assets managed by ThomasPartners total $13.4 billion and client assets managed by Windhaven total $8 billion.

Schwab money market funds

Generating $665 million in 9M17 revenue from $160 billion in 9 month client assets, Schwab money market fund revenue has grown dramatically over the last few years as fee waivers have been reduced. The fee waivers since 2014 are as follows: 2014 FY: $751 million; 2015 FY: $672 million; 2016 FY: $224 million; 2017 9M: $10 million. The reduction of these punishing waivers as we exited the ultra-low short-term rate environment had a huge impact on the top and bottom line. Obviously the top and bottom line growth from these waiver reductions is non recurring as the waivers are now relatively close to zero.

Investors looking for a better return than the FDIC insured cash sweep account can look at funds in this group like SWVXX. Morningstar shows that SWVXX has a Net Expense Ratio of 0.35% on the 04/28/2017 prospectus. Newer accounts sweep cash into Schwab bank but some legacy accounts still sweep cash into this segment.

Mutual Fund OneSource

The OneSource platform gives investors access to no-load, no transaction fee mutual funds. 9M17 revenue for this segment was $528 million from $214 billion in 9 month client assets. Revenue from this segment has decreased over the last few years as assets flow out of actively managed mutual funds.

Other Asset Management and Fee Revenue

The remaining segments in the Asset Management and Fee Revenue group generated 9M17 revenue as follows: Other balance-based fees: $192 million; Other third-party mutual funds and ETFs: $182 million; Schwab equity and bond funds and ETFs: $163 million; Other: $34 million.

BlackRock (BLK) iShares, Vanguard and State Street (STT) SPDR are the top 3 U.S. ETF sponsors and they are in a class of their own. PowerShares sponsor Invesco (IVZ) and Schwab are the fourth and fifth largest U.S. ETF sponsors. Schwab Proprietary ETF assets have grown substantially from $53.9 billion in 3Q16 to $87.8 billion in 3Q17 but just $20.8 billion are off platform. Unlike other ETF sponsors like WisdomTree (WETF), proprietary ETF fees are not a big factor for the top and bottom lines at Schwab.

Trading and Other Revenue

As a percentage of total net revenue, trading revenue has dropped over the years to 8% in 9M17 where it was $500 million out of $6,376 million. Competitors like Ameritrade and E*Trade are much more dependent on revenue from this segment than Schwab. Schwab is in a very nice position with respect to trading fees. If they want to take assets from Ameritrade and E*Trade they can lower trading fees below $4.95.

Rounding out the 9M17 revenue, $212 million is classified as other.

Assets Driving Revenue

Again, the above shows that a fraction of client assets drive the bulk of revenue. The table on page 9 of the 3Q17 Press Release and Tables shows average 3Q17 assets:

$195.0 billion Schwab One [generates net interest revenue]

$221.2 billion Mutual Fund OneSource

$159.2 billion Money market funds

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$575.4 billion of $3,181.2 billion client assets

*Note that these average 3Q17 asset totals don't match exactly with the average 9M17 assets we showed earlier. Fee-based advice solution assets drive a considerable amount of revenue but these assets are difficult to separate in the above table.

Valuation

Typically I use enterprise value to free cash flow when valuing a company. This doesn't make sense for banks and financial services companies so we look at price to earnings.

Price per share as of 10/27/2017: $44.91

Earnings Per Share Trailing Twelve Months [TTM]

= 9M17 + FY16 - 9M16

= $1.21 + $1.31 - $0.95

= $1.57

P/E = $44.91/$1.57 = 29

Looking through the P/E lens alone, this investment seems underwhelming.

I tend to look at Schwab's valuation through more than one lens including the interest-earning assets lens. Despite having $3.2 trillion in client assets, we've seen that Schwab made 49% of its revenue over the last 9 months from just $216 billion in average interest-earning assets. This is up from 40% of the revenue in 2015. These interest-earning assets have been growing at a high rate and I think the growth will continue:

period

Interest earning

assets

avg net

yield

common

market cap

mcap/iea

2006

$34.3 Bn

4.18%

$24.0 Bn

0.70

2007

$35.7 Bn

4.61%

$25.8 Bn

0.72

2008

$43.8 Bn

3.80%

$15.7 Bn

0.36

2009

$58.6 Bn

2.06%

$21.8 Bn

0.37

2010

$78.9 Bn

1.93%

$21.7 Bn

0.28

2011

$95.4 Bn

1.81%

$14.8 Bn

0.16

2012

$108.9 Bn

1.62%

$21.1 Bn

0.19

2013

$130.3 Bn

1.52%

$32.2 Bn

0.25

2014

$138.9 Bn

1.64%

$34.1 Bn

0.25

2015

$158.0 Bn

1.60%

$33.7 Bn

0.21

2016

$191.6 Bn

1.73%

$55.1 Bn

0.29

9M17

$215.6 Bn

1.94%

$60.8 Bn

0.28

*The "mcap/iea" column heading is short for common market cap divided by interest-earning assets. Apart from 9M17, the above numbers are from 10-K filings and the '06/'07 interest-earning assets are from the '08 filing which is the first filing that uses the current tabular form. Common market cap is the number of shares times the share price from late January or early February of the following year except 9M17 where the price is from 10/27/17.

Per Value Line, book value per share has grown from $3.51 in 2008 to an estimated $13.50 for 2017. Return on equity is in the low double digits.

In the 2016 annual report management says that net revenue growth, pre-tax profit margin, EPS, and ROE are broad indicators. Revenue grew nicely from 2015 to 2016 and the other 3 metrics all improved as well. The same type of developments continued from FY16 to 9M17 as well. CFO Peter Crawford took over for Joe Martinetto as planned earlier in 2017 and the focus on the above metrics as well as the company's ethos seem to remain intact.

In May of 2016 I attended the annual meeting. Two long-term shareholders stood up at separate times to thank management for "making them rich" over the years and this left a lasting impression on me. I have no idea what will happen to the share price over the next year but I think it will do well for folks holding it 5 years or more.

Closing Thoughts

We see that Schwab acts as a bank in many ways. The company knows there will always be investors keeping some of their assets in cash directly. There are also investors indirectly keeping cash in Schwab Bank through the robo advisor program. Investors seeking FDIC insured cash accounts are an excellent source of revenue because Schwab bank gets an interest spread of around 2% at today's short-term rates (we know the spread was higher in 2007 and 2008). When investors want a better return on cash and they're willing to give up FDIC insurance, Schwab is able to generate revenue from money market assets. Combined we see that interest revenue and money market revenue make up over half of Schwab's total net revenue.

In the 1970s Schwab was somewhat limited to parsimonious investors seeking low fees with a do-it-yourself mindset. Today the low fee aspect remains but the customer base is much broader such that customers/investors seeking help and advice are a big part of the picture. In a 2010 CNN article, Charles Schwab says the key to the company's growth and to becoming the low cost finance brand is to get people to think of Schwab as the best place to go for investment advice.

Special thanks to Brian and Steph.

Disclosure: I am/we are long SCHW, VOO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Any material in this article should not be relied on as a formal investment recommendation.