Charles Schwab Holds Its Own, But We Prefer Banks Over Brokerage Houses (NYSE:SCHW)

Business Model Resilience Demonstrated

Charles Schwab (NYSE:SCHW) reported Q3 earnings this Monday. We recently reviewed Q3 performance for major US banks (including JPMorgan Chase (JPM), Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC) and gained perspectives on the US economy. As a leading brokerage firm, Charles Schwab can provide clarity into how US investors are viewing the economy. We’ll evaluate Charles Schwab’s financial performance and outlook for investors interested in the stock.

The company beat EPS estimates but met revenue expectations. Revenues declined 16% year-over-year and adjusted diluted EPS dropped 30%, accelerating from H1 2022 declines. The stock rose 5% post-earnings, signaling positive momentum.

We think the market responded favorably primarily due to continued client account growth. Accounts grew 2% year-over-year and 0.7% quarter-over-quarter, reflecting sustained customer trust. Total client assets grew 18% year-over-year and fell 3% sequentially.

In our view, the number of client accounts is the best indicator of Charles Schwab’s long-term fundamentals and business health. Growth in active brokerage accounts signals that customers continue placing trust in Schwab for their investments, despite some slowdown in new account openings in July through September 2023. Schwab’s ability to sustain brokerage account expansion this quarter amid economic uncertainty reinforces the durability of its competitive positioning and brand reputation.

Looking closer, retirement plan participants make up about 7% of Schwab’s accounts and represent a stable source of account growth thanks to labor market resilience. Schwab’s corporate retirement plan participants grew 7% year-over-year and 1% quarter-over-quarter, showing Schwab remains firmly entrenched as a leading 401(k) provider even against fintech competition. The steady expansion of retirement accounts demonstrates Schwab’s success in deepening its customer relationships over time and maintaining trust as individuals progress in their careers. This reliable base of sticky retirement customers helps offset potential slowing in the growth of Schwab’s wider brokerage account base when markets face volatility or economic challenges emerge.

Net Interest Income Compression Weighs on Profits

Charles Schwab faced sharp revenue and earnings declines this quarter due to significant compression in net interest margins, as evidenced by interest expense spiking 310% year-over-year. This aligns with the net interest margin pressure we observed across major US bank earnings.

However, unlike banks that grew earnings by offsetting margin declines with fee revenue increases and flat expense growth, Schwab saw expenses rise 20% while asset management fees failed to compensate for the net interest income hit. Clients rebalancing into index ETFs and fixed income, and away from cash and equities, drove declines in trading activity and thus trading revenue for Schwab.

This divergence makes sense given brokerages typically charge lower fees than banks due to more intense pricing competition. Banks provide stickier services like savings and payments that raise customer switching costs. In contrast, brokerages compete more directly on price and trade commissions, limiting their ability to offset interest margin declines through fee increases.

The significant uptick in compensation expenses also highlights differences in business models. Banks mostly kept costs flat by already operating lean. Meanwhile, Schwab likely needed to increase advisor pay to retain talent being recruited by competitors in a heated wealth management market. Rising wages to limit employee turnover is a cost banks are less exposed to presently.

Business Model Intact Despite Profit Pressures

As expected, the brokerage pricing model faces more pressure than banks, which have stickier services like payments. Continued interest expense escalation led to another pre-tax margin decline to 30%, the lowest in years, compressing ROE to 14% from 25% in 2022.

Despite meaningful short-term earnings impacts squeezing margins, Schwab maintaining a 30% pre-tax margin alongside continued client account growth indicates business model resilience. The 14% ROE still looks healthy to us, above an 11% cost of equity threshold based on a 5% risk-free rate and a 6% equity risk premium. This suggests Schwab remains a relatively safe investment for 2024 assuming high Fed rates persist, compared to stocks with sub-11% ROEs.

Further evidence of balance sheet strength, Schwab grew shareholders’ equity despite unrealized losses on fixed-income holdings. This implies the firm successfully offsets securities write-downs by raising debt and earning asset growth. Ongoing equity expansion demonstrates Schwab still has solid access to capital markets amidst volatility.

Competitive Position Still Solid

Schwab’s assets under management remain nearly 2x competitor Fidelity despite fewer customers, evidencing loyalty and a superior financial profile. Schwab also offers crypto services unlike Fidelity, a potential long-term edge.

Valuation Reflects Short-Term Profit Pressure

We monitor client account trends to gauge the health of Schwab’s business model and evaluate valuation primarily using the price-to-book ratio, as it reflects overall profit generation capability. Schwab’s P/B multiple is currently trading at the median of its historical range.

This seems appropriate given our view that Schwab’s customer account growth shows an intact franchise despite short-term profit struggles. The valuation seems to fully reflect transient earnings challenges rather than signal secular business model risks. Further, with Q4 potentially marking an EPS trough, the current valuation presents a short-term buying opportunity.

Banks Better Positioned for Higher Rates

However, persistent net interest margin pressures likely weigh further on book value ahead. In a higher for longer rate scenario, banks seem better positioned than brokerages given banks’ ability to offset most net interest declines with non-interest revenue growth. Brokerage fee structures provide less insulation.

Similarly, bank valuations based on P/E and P/B multiples sit significantly below brokers, reflecting greater challenges for Schwab’s business mix in coming quarters if rates remain elevated.

Conclusion – Rate Charles Schwab a Hold

Charles Schwab continues demonstrating sector leadership in the brokerage space by maintaining strong 30% pre-tax margins and 14% ROE amidst economic crosswinds. These return metrics exceed our thresholds for consideration as a long-term hold in the expected higher for longer rate environment going into 2024.

However, compared to other rate-sensitive sectors like banks, brokers look relatively challenged. Banks concentrated in consumer lending such as Bank of America appear better positioned than Schwab given large non-interest revenue contributions and pricing power in deposits.

Conversely, Schwab’s brokerage model relies predominantly on net interest income, faces fierce pricing competition, and has limited ability to drive incremental fees. Intensifying competition from banks encroaching into wealth management further clouds Schwab’s outlook.

Amidst the high rate environment in 2024, we rate Charles Schwab a Hold for now and prefer more attractively valued bank stocks.