Schwab Stock: Compelling Opportunity, Regulatory Risks Remain (SCHW) (2024)

Thesis

The Charles Schwab Corporation (NYSE:SCHW) is a well-managed and highly valued business that trades at a premium compared to peers due to its industry-leading brand for retail financial services. Despite near-term headwinds, I view it as a growth company with various initiatives to drive organic growth. The stock has suffered lately due to several risks now surrounding its banking operations, but I believe the risks from cash sorting and bank run are limited and now priced in. The primary risk is from potential regulatory changes that may impact Schwab's earnings and valuation. I maintain a hold rating on SCHW stock, and the regulatory environment becomes more certain.

Risks are Overplayed

Investors are worried about potential risks associated with Schwab's banking operations, which has caused its stock to decline. The risks can be divided into four categories, including bank sorting risk, bank run risk, and bank valuation risk. However, there appears to be limited risk from sorting and virtually no risk from a bank run. The main risk is from potential regulatory changes that could affect Schwab's earnings, which may also impact its valuation. Although uncertainty about the regulatory outlook is likely to continue to weigh on the stock price, the downside risks to earnings and the multiple are already priced in. Therefore, Schwab could be a good investment opportunity at current levels, although it is difficult to have a high degree of confidence given the uncertainty of the regulatory environment.

Cash Sorting is a Risk To Near-Term Earnings

Schwab's stock is under pressure due to concerns about risks related to its banking operations, particularly cash sorting. However, it is worth noting that while cash sorting is a risk, Schwab can also benefit from it. Money market fund flows have increased in recent months as retail bank savers have turned to them to generate higher returns, which can benefit Schwab as investors have easy access to its higher-yielding money market funds. While this process can put pressure on Schwab's near-term earnings, customers are more likely to maintain their assets at Schwab during the sorting process rather than withdrawing them, which differentiates it from traditional banks. While the benefit of this inflow is difficult to quantify at present, it suggests that Schwab's banking operations are not facing an existential threat from cash sorting.

Moreover, market conditions and concerns about the banking sector have driven investors to Schwab, including its government money funds, and this movement of cash to Schwab will take pressure off its net interest margin (NIM) and balance sheet should the slowdown in sorting persist. I believe it is important to look beyond the near-term earnings impact of cash sorting and focus on the potential longer-term benefits that Schwab's banking operations can provide to its business.

Redemption risk

Schwab has experienced a significant increase in weekly flows, indicating that it has benefited from a flight to safety during the current banking crisis. The data for the week ended March 16 showed flows of $16.5 billion, which is about 60% higher than expected in a typical week. This suggests that Schwab clients continue to view the company as a safe haven during times of heightened market risk. This is consistent with previous periods of market stress, such as the early days of the Covid-19 shutdowns in the US in 1Q20, when Schwab saw a surge in deposits.

Bank valuation risk

Schwab is primarily a broker with a bank rather than a traditional bank and, therefore, does not have the credit risk or vulnerability to bank runs that traditional banks do. However, Schwab could be affected by more stringent banking regulations, which could impact its earnings. Despite this, Schwab has historically traded at a premium compared to traditional banks, with an 8x premium over the past five years, which has reduced to a 4x premium today. I expect this premium to partially recover, particularly as the risk associated with cash sorting diminishes.

Valuation

The recent decline in Schwab's stock price has raised concerns about its valuation converging with that of traditional banks. However, my view remains that Schwab is a broker with a bank, which is different from a traditional bank. The bank grows with the broker and takes limited credit risk, and Schwab does not have the run-on-the-bank risks that some smaller and mid-cap-sized banks have. While Schwab has experienced cash sorting, it is fundamentally different from what is seen at banks, as client money leaves banks with sorting, while at Schwab, customer assets are re-bucketed but remain at Schwab. The Schwab brand also reduces the risk of bank runs. Nevertheless, Schwab is subject to bank rules and regulations, and regulatory risk remains a possible headwind for the company.

In terms of valuation, Schwab has historically traded at an 8x premium to large banks over the past five years, but this has reduced to 4x currently. I believe that a healthy premium is justified given the lack of bank-run risk and improving cash sorting metrics. It is important to note that Schwab is under-earning due to a depressed net interest margin driven by cash sorting and short-term borrowing. Therefore, it is expected that earnings will be under pressure, which is another factor to consider in the company's valuation. Overall, while Schwab is not immune to regulatory risk and its earnings are expected to be impacted by cash sorting, it remains a broker with a bank, which is fundamentally different from a traditional bank.

As a result, I expect the stock's valuation to partially recover, but it is important to consider the potential risks and challenges that may impact the company's earnings and valuation. I maintain a Hold rating on the stock for now and do not have a price target until there is more clarity on the regulatory front.

Investors' Takeaway

Schwab's stock price has declined due to concerns about potential risks associated with its banking operations, including cash sorting, bank run, and valuation risks. However, the risks from sorting and bank run are limited, and the main risk is from potential regulatory changes that may impact Schwab's earnings and valuation. Despite the uncertainty of the regulatory outlook, the downside risks to earnings and the multiple are already factored into the current stock price, suggesting a potential investment opportunity in my view. However, the regulatory environment remains uncertain, making it challenging to have much conviction in the investment at the moment. I maintain a hold rating on the stock for now until the regulatory environment becomes more clear.

I utilize a combination of fundamental and technical analysis to identify undervalued and overvalued stocks. I focus my research on growth stocks over a longer-term time horizon.