Don't 'Discount' This Broker
04/04/2013 7:45 am EST
Its expansion into asset management makes this company much more than a discount broker, says Matthew Coffina of Morningstar StockInvestor.
Charles Schwab (SCHW) has come a long way from its discount brokerage roots.
Only 18% of its revenue came from trading last year, with another 36% from net interest revenue and 42% from asset-management fees. Schwab’s scale and unique operating model give it a low-cost advantage, while customer switching costs make assets relatively sticky.
The company has been very successful at gathering client assets since 2009. While market share gains have enhanced the underlying earnings power, this has been masked by declining interest rates, which hurt both net interest revenue and asset-management fees. When interest rates rise, Schwab’s true earnings power should be revealed.
Schwab’s earnings are highly leveraged to interest rates, and the company has suffered in the current low-rate environment. This is a case where our patience and long-term focus could pay off.
Schwab’s largest revenue lines are asset-management and administration fees and net interest revenue. Combined, these account for more than three-quarters of the company’s total net revenues.
Trading-related revenue remains important at Schwab, but it has declined in relative significance—recently accounting for around 18% of the overall top line, compared with around 31% in 2003.
We generally view asset-linked revenue as more stable over the long term than revenue from trading sources, which can shift quickly with the market’s vicissitudes. In our opinion, the diversification of Schwab’s business has given the company a broader base of services that can be used to attract clients, helping it to add shareholder value in times when trading revenue lags.
Schwab’s net interest revenue—which makes up more than a third of overall revenue—is directly driven by the broad interest-rate picture. As such, the company’s ability to grow this revenue source has been constrained by the low-rate environment. Growth in assets has helped mitigate this decline, but the inescapable fact is that low rates remain a key obstacle to more robust revenue growth.
Given the Federal Reserve’s statement that rates are likely to remain low until conditions such as improved employment set in, we would not expect Schwab’s net interest revenue to benefit significantly from higher rates for some time.
We think Schwab has a narrow economic moat. The company’s expense structure allows it to be a low-cost provider of brokerage and other services. Additionally, it is our view that Schwab’s services pose switching costs for its customers, which helps secure the firm’s revenue base.
These advantages have helped Schwab deliver returns on equity above its estimated cost of equity in most recent years. While low interest rates have limited profitability, the company’s proven ability to keep bringing in new assets speaks to the resilience of its model.
Our fair-value estimate for Schwab is $23 per share. This implies a price multiple of about 36 times estimated 2013 earnings (which are at a depressed level), and an enterprise value of about 14 times projected 2013 EBITDA.
In our view, Schwab could be fairly valued at $31 per share under favorable conditions. This $31 valuation would imply a price multiple of about 44 times estimated 2013 earnings and an enterprise value of around 18 times projected 2013 EBITDA.
Conversely, under our bearish scenario, Schwab’s fair-value estimate could be as low as $10 per share. This valuation implies a price multiple of about 20 times estimated 2013 earnings and enterprise value of around four times projected 2013 EBITDA. Returns on equity rise to no higher than the mid-teens.
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