Charles Schwab: Elevated Funding Risk Weighs On The Risk/Reward

Summary

• Schwab may have missed consensus in 1Q20, but the underlying numbers were largely in line.
• More worrying though is the expanding balance sheet amid a low-yield environment.
• With Schwab's tier-1 leverage ratio set to move below its "operating objective," funding risk is a key concern.

On balance, Charles Schwab's (NYSE:SCHW) recent earnings miss was not particularly surprising given the challenging 1Q20 backdrop. There were some notable positives, though, as expense control improved, along with growth in accounts and net new assets, as well as continued balance sheet expansion. Net-net, I think SCHW's earnings power is challenged in a low-yield environment, and I would be particularly cautious about the near-term outlook as the funding risk appears to be elevated. In particular, the asset base is increasing amid a low yield environment, and thus SCHW's capital ratios could come under pressure, driving the need for a capital raise. At ~19x fwd earnings, I do not view the risk/reward as favorable.

Headline Miss But In Line on a Normalized Basis

At a 1Q20 GAAP EPS of $0.58, SCHW missed consensus estimates of $0.63, though core EPS power was likely closer to ~$0.62, excluding ~$37m of acquisition-related expenses and $27m of one-off expenses ($49m net of tax) related to the pandemic.

	1Q20
Income from continuing operations	795
(+) Extraordinary items, net of tax	49
= Recurring Net Income	843
(-) Preferred share dividends	38
= Recurring Net Income available to common shareholders	805
(/) Diluted shares outstanding	1,294
= Operating EPS	$0.62

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Source: Author's Est, Company Filings

Trading revenue came in at $188m (-13% YoY), with 1Q20 representing the first full quarter after the October pricing cuts. Total average daily trading volumes reached 1.5m, up from the 0.8m posted a year ago, as volatility and pricing cuts boosted volumes. I'd also note that Schwab recently included payment for order flow (PFOF) in trading revenue, suggesting an ~18% (implied $135m) of PFOF contribution in FY19.

Source: Company Filings

Net interest income (NII) came in at $1.6bn (-6% YoY), while asset management & trading revenues reached $827m (+10% YoY). While other revenue fell ~57% YoY, the headline number incorporated ~$25m of irregular items, including ~$10m of loan-loss provisions and ~$15m of lower mark-to-market mortgage accruals.

Source: Form 8-K

Elevated Operating Expenses Weigh on Margins

Yet, operating expenses rose $1.6bn (+8% YoY), primarily driven by higher compensation expenses at ~$897m (including additional one-off expenses related to COVID-19 of ~$21m). Adjusted for one-offs such as the $27m COVID-related compensation expense and ~$37m in merger-related expenses, expenses, however, were roughly in line with consensus. Thus, while SCHW's headline pre-tax margin of 40.0% was ~6.4%pts below 1Q19's pre-tax margin of 46.4%, adjusted for ~$64m of one-off expenses, SCHW's pre-tax margin was closer to 42.4%.

Excess Cash and a Lower for Longer Yield Environment Weighs on NIMs

SCHW also posted a rather underwhelming net interest margin (NIM) of 214 bps for the quarter, but if we were to adjust this for the ~$40 billion of increased cash reserves at the Fed (rather than being deployed to AFS), the remaining portfolio likely earned closer to ~225 bps, assuming the cash reserve yield was in line with the Fed funds rate for March.

Meanwhile, cash and cash & investment yields fell by 61 bps and 29 bps QoQ, respectively, as securities AFS also fell by 13 bps QoQ. The net effect was a decline in the overall asset yield by 28 bps QoQ to ~234 bps. Deposit rates on sweep deposits also fell ~6 bps QoQ, and rates on cash payables fell by 6 bps as overall liability costs fell 6 bps QoQ to 19 bps. 2Q20 should see further pressure on NIMs, as the full impact of the 150 bps rate cut and lower reinvestment rates flow through to the P&L. Thus, expect the NIM to contract further in the coming quarters until we near the zero lower bound. Going forward, management has guided toward NIMs settling in the mid-150s range by 4Q.

Source: Business Update Presentation

Balance Sheet Expands Amid Lower Yields

Average interest-earning assets reached $292bn for the quarter, up 8.4% YoY as risk-off sentiment drove flows into FDIC insured deposits. As of end-1Q, however, Schwab's interest-earning assets stood at $355bn, a substantially higher figure than its historical Q1 average. 2Q should see a further rise in cash balances as a result of the delay in the annual tax payments to July. The total balance sheet totaled $371bn at quarter-end, up significantly from the $294bn end-FY19 figure, of which client cash allocation as a % of total assets contributed ~15%.

Source: Business Update Presentation

Worryingly, management disclosed ~$58.7bn of excess reserves were held at the Fed - an increase from the $18.8bn at end-FY19, at a time when short-term rates are in the 0-0.25% range.

Source: Business Update Presentation

Funding Risk is Reason for Caution

Schwab's capital position is a concern - though SCHW reassured investors of its 6.9% tier-1 leverage ratio in 1Q20, this is based on an average basis and thus has not fully accounted for the recent increase in cash balances. Once the full impact of the 1Q20 increase filters through, the tier-1 ratio will likely move closer toward ~6.2-6.3% range - much lower than management's "operating objective" of 6.75-7%.

Source: Company Filings

With the elevated funding risk likely to push SCHW into issuing additional capital down the line, I would be cautious about buying into shares at current levels. Management has outlined its preference for a preferred issuance to manage capital demands, with the issuance likely to be sizeable to make up the ~70bps shortfall. Buybacks are on hold and will likely remain so as the focus turns to managing the business' capital needs. At ~19x fwd earnings, I would avoid the stock.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.