When Charles Schwab Corporation (NYSE:SCHW) announced its second quarter results last year, I warned for a tough third quarter and second half of 2023 coming up, which was not a surprise given the market conditions.
Continued deposit outflows, in the wake of the regional banking crisis, induced by higher risk-free rates, were flattening out a bit. Despite the flattening out, deposit outflows were still seen, which set the company up for a challenging third quarter. While fourth quarter results showed even bigger revenue declines, the earnings report included green shoots, even including positive deposit inflows, the root of all the concerns in 2023.
Schwab was a $75 stock early in March as the regional banking crisis sent shares down to just $60 in the time frame of a couple of days following the implosion of SVB Financial Group, only to fall to the $50 mark in the weeks which followed.
Ahead of this crisis, Schwab posted 2022 results, a year in which revenues rose by 12% to $20.8 billion as GAAP earnings came in at a solid $7.2 billion, equivalent to $3.50 per share, with adjusted earnings coming in at nearly $4 per share.
With the business housing a broker and bank under a single roof, investors sold first and asked questions later when the regional banking turmoil unfolded. The balance sheet is dominated by over $7 trillion in client assets in separated and segregated accounts, while the balance sheet of the company itself totaled $552 billion.
These assets were mostly financed by a $367 billion deposit base, on which Schwab only paid 46 basis points in the fourth quarter of 2022, leaving the door wide open for deposit migration with risk-free rates being a multiple of this amount. Fortunately, pre-tax profits of $9.4 billion left a lot of capacity for Schwab to tackle this, as retaining deposits was key as otherwise Schwab had to sell assets. This is fine in the case of liquid assets, but if available-for-sale and held-to-maturity assets were to be sold (which were massively underwater due to duration risks), real capital losses were to be incurred.
The impact of the regional banking crisis did not yet have a real impact on the first quarter results. In fact, asset inflows totaled $132 billion to $7.5 trillion, yet deposits fell by $41 billion to $326 billion (on average assets).
With the company forced to hike the rates paid on these, to avoid further outflows, to thereby compress net interest margins, second quarter revenues fell by 9% to $4.66 billion, with earnings down 28% to $0.64 per share. This came as funding costs rose to 1.49% overall, with bank deposits being paid 1.11% on average, still a modest number.
Despite such payments, deposits fell another $21 billion to $304 billion. Simply attributing all those outflows to the interest rate situation was a bit too simplistic as well, as the integration of the Ameritrade reportedly caused attrition too, although hard to quantify of course.
With Schwab on the verge of posting third quarter results early in October, I was still a bit cautious at $55, as interest rates at the time were still hovering around their cyclical peak.
Further pain was seen indeed in October, as third quarter sales fell by 16 to $4.6 billion, with GAAP earnings down 43% to $0.56 per share. While deposit migration continued, down another $20 billion to $284 billion, the balance sheet shrank quicker to $475 billion. Trying to manage the deposit outflows, Schwab paid its average deposit payments to an annual 1.24%.
With interest rates seeing a massive move lower in the final quarter of 2023, the fourth quarter results were very interesting, as the net benefit of deposit migration for clients was rapidly coming down (with the gap with risk-free rates closing on both ends).
Fourth quarter results were announced in January, with sales down 19% to $4.5 billion, and GAAP earnings down 47% to $0.51 per share. This made that full year GAAP earnings were reported at $2.54 per share, with adjusted earnings reported at $3.13 per share, with most adjustments relating to acquisition and amortization charges.
The more interesting action took place on the balance sheet, which sequentially grew to $493 billion, supported by a more than $5 billion increase in deposits to $290 billion (still down $77 billion on an annual basis). With rates on deposits paid hiked to 1.37%, the gap with risk-free rates is coming down, supporting the asset inflows as this of course hurt the net interest margins in a huge way.
With the business posting earnings around $3 per share, it is the fourth quarter results and market conditions which confirm normalization in deposit flows and rates, and hence the worst of the margin pressure might be a thing of the past. This made that earnings power around $4 per share in 2022 has come down to about $3 per share, or a bit less, but at least the worst concerns are alleviated now.
On the operational side of the business, Schwab does fine with client assets up from $7.0 trillion by year-end 2022, to $8.5 trillion here, mostly driven by asset gains but also another $66 billion in client inflows in the final quarter.
With the net interest pressure being mostly a thing of the past now, stock markets trading at their highs, inflows continuing and more synergies to be reaped from the Ameritrade deal, prospects for earnings growth in 2024 look solid, at least on a sequential basis. I must say that this report should give investors a lot more comfort, as shares have recovered to the $70 mark in December, but sold off to $62 per share here as the market did not particularly like the fourth quarter report.
Given all of this, I have actually grown more appreciative of Schwab, as most of the immediate tail risks appear to be a thing of the past. Likely, the company will do a better job to prevent a similar situation from having the same impact on the business, driven by better duration management.
Given the Ameritrade deal being responsible for many of the earnings adjustments, I am quite comfortable using adjusted earnings numbers. While shares are not cheap, continued asset inflow and stabilization provide support, as I consider shares to be fair value, with a long term positive view.