Charles Schwab Corp (NYSE:SCHW) is an attractive investment opportunity given its significant earnings leverage to rising interest rates as well as a solid runway for core business growth.
Based in San Francisco, California, Charles Schwab provides a full range of securities brokerage, banking, money management and financial advisory services to individual investors and independent investment advisors.
The latest Fed decision to taper its bond buying program represents a significant step in the right direction toward net interest margin (NIM) improvement.
BMO Capital Markets analyst David Chiaverini views the announcement with measured enthusiasm for the short to intermediate term given that Schwab is still disproportionately leveraged to changes at the short end of the curve where rates are expected to remain low well past the end of the bond buying program
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NIM is expected to remain steady through 2015 before turning into a material tailwind. For core business growth, Schwab will continue to benefit from strong net, new asset growth as it refines its advice offering and increases awareness of its capabilities in the marketplace.
With 17 percent of its investor services clients now in an ongoing advice offering, the company still has a large opportunity to improve utilization in its existing retail client base, which would pay off through consistent long-term growth in recurring revenue streams.
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Chiaverini said trading activity remains at the low-end of historical levels as clients remain generally risk adverse and are doing most of their trading around account rebalancing. Management continues to believe trading activity will remain fairly stable, meaning daily average revenue trades (DARTs) will grow in line with account growth.
According to data captured in Charles Schwab's most recent Trading Services Sentiment Survey, only 10 percent of traders say they have a bearish outlook for the next three to six months – the lowest level seen since the survey's inception in February 2008, and a notable drop from September 2013 when 15 percent of traders surveyed had a negative short-term outlook.
While the general outlook is more positive, Schwab hasn't seen bullish sentiment translate into changes in trading behavior yet. Despite lower trading activity, retail engagement remains solid as clients are more interested in fee-based programs than ever before. Schwab will do more financial consultations with clients this year (about 100,000) than any other year in the firm's history. The breakaway broker trend remains healthy and steady as Schwab will roughly add the same number of teams this year as last year.
In the bank, management is excited about new pledged asset line products offered to retail and advisor clients. The company has $1 billion in balances now and expects that to grow and build momentum. For advisors, the lending product can help it pay off loans needed before breaking away from their current employer and going independent. For a retail client, it can be a liquidity strategy that is more stable than a margin loan.
Chiaverini, however, noted that the retail channel (investor services) is still lagging advisor services in asset growth. The company believes retail will be strengthened as unemployment continues to decline and clients have more discretionary income to invest.
In addition, asset growth should accelerate as the spread between money market rates and bank deposits shrinks over time. With banks paying a much higher rate on deposits than Schwab is able to pay on sweep deposits, clients do not have much incentive to move unencumbered money from their banks to a brokerage account.
Roughly 40-50 percent of Schwab clients have direct deposit set up with the company, meaning Schwab bank serves as these clients' primary bank.
Schwab's improved earnings are helping to grow capital and Schwab bank paid a dividend to the parent for four consecutive quarters now. As its consolidated tier-1 leverage ratio builds back toward 6.75-7.00 percent (6.3 percent as of the third quarter 2013) the company will look at capital options including buybacks and increased dividends. The company targets a payout ratio in a range of 20-30 percent of cash flow.
Chiaverini noted that the independent branch strategy is progressing well with a "couple dozen" branches currently operating and asset gathering trending above initial expectations. He expects roughly 10-15 branch openings to continue over the next couple years.
Net new asset (NNA) growth has been trending in the mid-single digits, and in a normalized environment the company is targeting 8-10 percent NNA growth, driven by a more favorable operating backdrop and execution of its growth initiatives.
As such, under a normalized environment, it would not be unreasonable to expect the company to report low-double-digit revenue growth, a 200 basis point (bp) differential between revenue growth and expense growth, leading to earnings growth in the mid-teens. Following capital management initiatives including potential buybacks, EPS should further increase.
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