Charles Schwab’s Brokerage Expansion Plan Survives COVID-19

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Charles Schwab (NYSE: $SCHW) adopting strategies amidst the COVID-19 pandemic leading to an increase in their Q3 earnings.

It’s been a tough year for the financial sector. Ever since the COVID-19 pandemic hit, the financial sector has found itself in volatile waters, down 15% compared to last year while the banking industry fell by 30%.

Here’s a rundown of the situation:

According to the Dow Jones U.S. Banks Index, the YTD returns have declined with 32.75%.

In March, the banking industry got pummeled as the markets sold off and interest rates hit zero. Unlike the rest of the market, banks stocks haven’t recovered yet. The main reasons are high unemployment rates increasing non-performing assets and defaults, along with the capping of interest rates which was announced in March by FOMC.

Also in March, the Federal Reserve Board released the result of the 2020 stress test for banks. In the report, the Common Equity Tier 1 Capital Ratio (calculated by comparing Tier 1 capital to Total Risk-Weighted Assets) informs banks minimum solvency requirements during different crisis situations.

It is the core measure of a bank’s financial strength from a regulator’s point of view.

The test result showed that under severely adverse scenario all banks can pass, but under the W-shaped scenario banks’ CET1 capital ratio moves very close to the minimum requirement level of 4.5% which could put them on the verge of failure (see figure 8 below).

At the same time, the average loan loss rates from the report indicated that the loan losses at banks would get worse under U-shaped. It is projected that the weighted average nine-quarter loan loss rate under severely adverse conditions could be about $430 billion, which is $700 billion less than U-shaped (see figure 8 below).

The Federal Reserve made restrictions on Banks’s capital distribution that required 34 major banks to suspend share buybacks and limit dividend payouts in the third quarter of this year.

The banks are way better prepared this time around, compared to the ’08 GFC.

Overall most banks are reasonably well-capitalized, and the gain can be expected, especially for long-term investors.

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Brokers on the other hand, have seen a different scenario unfold – a retail investor rush – similar to the one in early 2000’s, but different. Technology has enabled easier accessibility while competition has brought down the affordability.

A handful of companies like Charles Schwab, Robinhood, eToro etc. have positioned themselves to seize this opportunity to grab their share of the new retail investors.

 

How Charles Schwab (NYSE: SCHW) positioned itself to benefit from this unfolding:

  1. Schwab completed acquisition of TD Ameritrade in Oct.

As a result of this roughly $22 billion deal, we are now looking at a behemoth wealth management company with more than $6 trillion in client assets, and 28 million brokerage accounts.

According to Bank of America (BOA) analysts, it is estimated that “Schwab could control over 40% of the Registered Investment Advisor (RIA) custodian market”.

Furthermore, BOA believes these activities positions SCHW as a long-term investment opportunity, and the average Wall Street price target of SCHW is at $39.64 based on current news.

  1. Schwab completed acquisition of Wasmer, Schroeder & Company, LLC in July.

This acquisition enables Schwab to expand its fixed income capabilities, and to meet its clients’ needs for retirement preparation.

  1. Schwab completed acquisition of Motif’s Technology and Intellectual Property in June.

“We intend to leverage Motif’s platform to build on Schwab’s existing capabilities and help accelerate our development of thematic and direct indexing solutions for Schwab’s retail investors and RIA clients” said Neesha Hathi, EVP and Chief Digital Officer at Schwab. This acquisition would be supporting the company’s RIA development, and boost new accounts opening.

  1. Schwab completed acquisition of the assets of United Services Automobile Association (USAA) in March.

According to a company presentation, this acquisition would help Schwab increase the company’s earnings per share, and could probably save operation costs.

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According to the Schwab Q3 2020 earnings report, its net income for this quarter was $698 million that is 4% more than Q2 2020. Above is the company’s Q3 distribution of revenue, “Net Interest Revenue” still is the heart of the Schwab.

Its Net Interest Revenue decreased 18% on a Year-over-Year basis and decreased 3% on a Month-over-Month basis. Within its Q3 net interest revenue, bank loans only occupied 6% which was the same as Schwab’s receivables from brokerage clients – leaving only available for sale securities for revenue generation.

The company has had a significant rise in new accounts since it announced offering commission-free trading in 2019. A move betting on up- and cross-selling of other products, while cashing in by selling user-data to hedge funds and third parties.

With the series of acquisitions, Schwab brings over its competitive advantage on low-cost and high-value analysis tools to the market.

As a result, Schwab’s earnings beat consensus, and its stock price closed 5.8% at higher.

Based on the Projected FCF model, as of today Schwab’s intrinsic value is $48.01, fitting well with SCHW’s 52-week high is $51,64.

Compared with its closing price of $38.15, there is an 24.84% growth opportunity waiting for a long-term play.

 

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Shiying Yang

Shiying Yang, a junior equity research analyst who thrives to be a quantitative analyst. She graduated from Drexel University with a dual degree in Finance and Business Analytic. Shiying has found a passion for seeking algorithms and rules behind the various transactions in the capital market. She believes that innovation is the key to economic growth. Shiying is a patient investor who manages a personal portfolio of common stocks, with a heavy weight on technology companies.

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