Charles Schwab had a challenging second quarter—bank deposits and net income fell—but the company’s earnings were still better than Wall Street expected.
Charles Schwab
(ticker: SCHW) shares opened sharply higher Tuesday, although they are still down about 20% for the year.
“While recent results have been negatively influenced by a number of temporary factors, we remain extremely well-positioned heading into the years to come,” CFO Peter Crawford said.
Schwab’s second-quarter net income declined to $1.3 billion from $1.8 billion for the same period a year ago, a 28% drop. Net revenue fell 9% year over year to $4.66 billion. The company reported adjusted earnings per share of 75 cents. Analysts surveyed by FactSet anticipated non-GAAP earnings per share of 71 cents and revenue of $4.61 billion.
Bank deposits fell again, dropping to $304 billion from $326 billion for the first quarter and $442 billion for the year-ago period. Schwab customers have been moving cash from sweep accounts to higher paying options in a process known as cash sorting. It has put pressure on Schwab’s earnings because when deposit outflows exceed cash on hand, the company has to rely on other and more expensive funding sources, such as CDs and Federal Home Loan Bank loans.
Crawford said that the company’s revenue decline was driven primarily by Charles Schwab’s increased reliance on supplemental funding to compensate for cash sorting.
“While anticipated client cash realignment, along with net equity buying during June, pushed cash levels lower, we observed a continued and substantial deceleration in the daily pace of cash outflows versus prior months,” he said. “The continuation of this trend through the end of the quarter further strengthens our conviction that this realignment activity will inflect before the end of 2023, unlocking growth in client cash held on the balance sheet.”
Charles Schwab’s interest revenue soared to $4.1 billion for the quarter from $2.7 billion for the same period a year ago. But interest expense also skyrocketed, rising to $1.8 billion from $166 million, resulting in lower net interest revenue for the quarter of $2.29 billion, down from $2.54 billion.
Total expenses excluding interest rose modestly to $2.96 billion from $2.8 billion.
The company is in the midst of integrating TD Ameritrade clients and advisors, a herculean task. Schwab, which is the largest custodian for registered investment advisors in the nation, provided an update on its progress: “With approximately 30% of client accounts converted thus far, we are on-track to move nearly all of the remaining Ameritrade clients over before year-end—with the final transition group scheduled for the first half of 2024,” CEO Walt Bettinger said.
This is breaking news. Read a preview of Schwab’s earnings below and check back for more analysis soon.
Analysts expect Schwab to report EPS of 71 cents for the second quarter, down from 97 cents reported a year ago.
Dreamstime
It has been a challenging year for Charles Schwab’s stock. Investors will be looking to the company’s second quarter earnings report for signs that relief is on the horizon.
Over the past year, Schwab customers have been moving cash out of sweep accounts and into higher yielding offerings, which are less profitable for the company. That process, known as cash sorting, has been a headache for Charles Schwab and it will be a key theme in Tuesday’s earnings.
“While we expect a deceleration in sorting, we predict sorting will remain at an elevated level preventing net deposit growth until 2024 given our estimation of $20 billion of organic liquidity generation per quarter,” analysts at Bank of America wrote in a July 11 research note.
Analysts surveyed by FactSet anticipate non-GAAP earnings per share of 71 cents and revenue of $4.61 billion. The same quarter last year, Schwab reported EPS of 97 cents and revenue of $5.1 billion.
Charles Schwab stock, which is down about 30% this year, was trading around $59 a share as of Monday morning. That’s well below the stock’s 52-week high of $86.63. The Bank of America analysts have a price target for Schwab stock of $52.
Funding costs. Although Charles Schwab is best known for its online brokerage platform, the company also operates a sizable bank which generates considerable revenue. Charles Schwab sweeps uninvested client cash into bank accounts that pay as little as 0.48%.
Last year, Schwab generated more than $10 billion of net interest revenue, which is the difference between the interest Schwab earns on bonds and loans and the interest it pays out to its funding sources. Net interest revenue represented about half the company’s total annual revenue last year.
But because interest rates have soared, customers have been moving their uninvested cash into higher paying options, such as CDs and money-market funds. First-quarter client assets in proprietary and third-party purchased money-market funds totaled $343.5 billion, up 179% year-over-year, according to Charles Schwab.
Bank deposits, however, are down. The company had $325.7 billion in deposits at the end of the first quarter, down from $465.8 billion in the same period a year ago.
When deposit outflows exceed Schwab’s cash on hand, the company has to rely on other and more expensive funding sources, such as CDs and Federal Home Loan Bank loans. Charles Schwab reported it had issued $41 billion of CDs as of May, up from $6 billion at the start of the year. “Given that these funding costs are around 5% or more, this is putting pressure on the net interest margin (NIM) and ultimately earnings,” William Blair analyst Jeff Schmitt wrote in a June 14 update.
The Bank of America analysts suggest that Schwab may be able to sell some securities in its available-for-sale securities portfolio in the coming quarters, which would allow it to pay down a portion of its growing external funding pool. “This action would free-up capital, eliminate some pressure on its NIM and speed up the securities reinvestment bull thesis although we don’t believe this catalyst is likely to happen until regional bank stock volatility reaches a low/stable level,” they wrote.
There are signs that cash sorting has been abating. Analysts at UBS point to lower inflows in Schwab money-market funds. “Month-to-date the average daily pace of inflows amounts to $543 million, which is 41% lower than historical average of $927 million,” they wrote in a July 14 research note. “Furthermore, it is 46% lower than the daily average excluding April (low due to tax payments). While money-market fund flows may not provide a perfect indicator of sorting, they do suggest a deceleration in the sorting process.”
Investors will also be looking for updates on Charles Schwab’s efforts to integrate TD Ameritrade customers and advisors. The company bought TD in 2019, but transitioning accounts is a big undertaking that takes time. So far the company has moved about 5.5 million retail client accounts from TD to Schwab. It has said it remains on track to transitioning nearly all remaining TD client accounts over the course of 2023 and early 2024.
Charles Schwab is the largest custodian for registered investment advisors in the nation, providing RIAs with technology, asset management, and other services. The RIA segment is among the fastest growing parts of the wealth management industry.
Charles Schwab, which also operates a sizable online brokerage, has been raking in new assets this year. In May, core net new assets brought to the company by new and existing clients totaled $20.7 billion, according to Charles Schwab. Total client assets were $7.65 trillion as of month-end May, up 5% from May 2022, according to Schwab’s monthly update.
If the cash sorting figures aren’t worse than expected, investors should see positive news in other parts of the company reported Tuesday.
Write to Andrew Welsch at andrew.welsch@barrons.com
