Charles Schwab: Buy The Discount Broker/Asset Manager On Improving Business Trends

| About: The Charles (SCHW)
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Charles Schwab Corporation (NYSE:SCHW) operates as one of the largest discount brokers in the U.S. The company posted better than expected results for the second quarter of the current year, and the latest business trends are encouraging. The company has recently announced the closure of its trading wing in Europe, which will reduce the uncertainty stemming from the debt-stricken continent. Therefore, we recommend our readers to long the stock.

Company Overview:

Engaged in banking, brokerage and related financial services, Charles Schwab Corporation operates as a savings and loan holding company. For the purpose of reporting, the operations of the company are classified into two segments; Investor Services and Institutional Services. While Investor Services provides banking and retail brokerage services to individual investors, Institutional Services, as the name suggests, provides trading, custodial, retirement, brokerage and mutual fund clearing services to institutional clients. During the most recent quarter, 68% of revenues came from Investor Services; therefore, the company relies heavily on this business segment. Among the sources of revenues for the company are revenues from asset management and administration fees, net interest revenues, and trading revenues. Around 42% of revenues come from asset management and administration fees, followed by net interest revenues at 38%.

Surprise History:

The table above shows that the company has been meeting consensus expectations over the past five quarters. Both revenues and earnings remained in line with expectations, with only a 2.1%, and a minor 0.2% average positive surprise over each of the past five quarters.

Third Quarter Earnings Preview:

The company is scheduled to post the performance of the third quarter of the current year on October 15, 2012. Analysts expect EPS of $0.17 on revenues of $1.2 billion. The earnings per share estimate has not been revised since 90 days.

Even though the company is less dependent on revenues from trading activities than its peers in the discount brokers industry, revenues from asset management and administration fees will be hit in the third quarter due to the low interest rates. The prolonged interest rate environment could also cause headwinds for the coming quarter's net interest margin, as a majority (approximately 70%) of the assets portfolio that the company owns is composed of agency residential mortgage-backed securities.

Latest Business Trends:

The company's August business trends were healthy as compared to June. Clients' assets totaled $1.86 trillion at the end of August, 2% above the June level. During the same month, the company's retail clients moved out of the equity funds and into the money market products and fixed income funds. While equity funds witnessed an outflow of $350 million, fixed income funds and money market products received inflows of $3.6 billion and $1.3 billion.

Besides, the company was able to open up 72,000 new brokerage accounts during the same month. This is compared to 62,000 accounts in the month of July.

Most Recent Quarter's Performance:

Compared to the second quarter of the previous year, revenues from asset management and administration fees plunged 1.2%. Revenues from trading and net interest revenues for the second quarter of the current year increased 6.8% and 1.55%, respectively.

Revenues accruing from asset management and administration fees declined from $496 million in the same quarter of the previous year to $502 million in the second quarter of the current year. Much of the decline in revenues from asset management and administration fees were associated with the decline of 8% in mutual fund services fees. The prolonged low interest rate environment was largely to be blamed for lower yields on fund assets. This was partially offset by a 6% YoY increase in revenues from advice solutions.

Interest revenues remained largely flat at $497 million, when compared to the second quarter of the previous year. However, interest expense declined from $45 million to $39 million (13% decline) over the same period. Despite a 15.5% increase in the average interest yielding asset, interest revenues remained largely flat when compared to the second quarter of the previous year. The prolonged low interest rate and the flattening of the yield curve as a result of several actions by the Fed led to a decline in asset yields from 2.17% to 1.88% over the same period. The impact of the decline in asset yields was offset by a decline in interest expense from 0.2% to 0.14% over the same period. Here the company seems to have benefited from the record low interest rate environment by decreasing the cost of its funds.

Trading revenues increased from $205 million to $219 million, from a year ago to the second quarter of the current year. This is a YoY surge of about 7%. Much of this surge was associated with higher daily average revenues trades.

Expense for the second quarter of the current year surged 6% over the previous year. Compensation and benefits being the single largest expense surged 4% over the previous year. Depreciation and amortization surged a significant 45% over the same period.

As a result of the above, the bottom line of $275 million surged 16% YoY, from $238 million.

Capital Position:

Against the minimum Tier 1 capital ratio requirement of 4%, the company had a Tier 1 capital ratio of 22.1% at the end of the second quarter of the current year. This reflects the company's strong and robust capital position.

European Exposure:

Due to the prolonged crisis in the debt stricken European continent, the company has decided to suspend its trading business. From the end of November of the current year, the company has decided to close the European arm of its derivatives trading unit and has advised its clients to transfer their accounts to another company. This will help reduce the risk and uncertainty stemming from the continent.


The stock currently trades at a price to book value multiple of 2 times against the book value multiples of 0.51 times and 0.85 times for E*TRADE Financial Corp (NASDAQ:ETFC) and JPMorgan Chase & Co (NYSE:JPM).

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

Business relationship disclosure: The article has been written by Qineqt's Financials Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.