Schwab Pre-Earnings: Net New Assets Likely Lower While Trading Volumes Recover

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Charles Schwab (NYSE:SCHW) is scheduled to release its Q2 2013 earnings report on the July 16. The company’s shares have had a good run this year rising over 50% year-to-date and recently reaching a new 52-week high of $22.38 per share. This rally appears to be due to a general optimism about the U.S. brokerage industry because stocks of rival firms such as TD Ameritrade (NYSE:AMTD) and E*Trade (NASDAQ:ETFC) are also up by the same magnitude since the start of the year.

At an individual company level, Schwab has shown very good asset gathering performance in the recent quarters. It attracted over $43 billion in net new client assets in Q1 2013, making it its best first-quarter performance since the year 2000.

See our full analysis for Charles Schwab

However, Q2 2013 net new asset figures are likely to see a departure from that trend. The company was hit by tax related client cash disbursements and a “pre-planned” exit of a mutual fund clearing client during this period, which could have adversely impacted the net new asset figures. As a result, Schwab was able to add merely $22 million net new assets in April and actually lost around $2 billion in May. The figure for June is unlikely to be any better because the outflow of funds related to the exit of the mutual fund client will continue until all of its $80 billion in assets are transferred. As of mid-June, only $18 billion out of this amount had been transferred, meaning that Schwab will either take a big hit in June or will continue to report depressed net new asset figures in Q3 as well. [1] Apparently, this mutual fund clearing client has developed in-house capabilities that make Schwab’s services unnecessary, prompting it to transfer all of its assets in-house. [2]

While this is a hiccup for Schwab’s asset gathering activity, we believe that the impact on its bottom line will be minimal. Schwab earns only a small portion of its revenue from clearing services and the yield on such assets is very low. Moreover, the client’s $80 billion constitute less than 4% of the Schwab’s total client assets, meaning that the company is unlikely to be impacted in a big way by the loss of these assets. This client’s exit will be written off as a one-time event that is unlikely to impact asset gathering activity in the long term. Another point that makes this client’s exit bearable is the fact that Schwab has not lost this mutual fund client to a competitor. This makes us believe that there is currently no major competitive threat to Schwab’s mutual fund client base other than the fact that some of its clients may follow suit and launch in-house capabilities.

The Stock Market Rally Is Good For Schwab

On the positive side of things, Schwab continues to benefit from the rally in the U.S. capital markets since the value of its clients’ assets currently has climbed along with a surge in the stock markets. The company’s asset base has grown by almost $117 billion through May this year on account of stock market gains. In comparison, the company brought in only $41.5 billion during this period by attracting new clients or by getting more business from existing clients.

We expect stock market gains to continue supporting Schwab’s client asset figures in Q2 because the U.S. stock market was up for the majority of the last three months. The company’s net market gains for April and May were $21.3 billion and $5.5 billion respectively, as reported in its monthly market activity report.

Trading Volumes Also Looking Up

On the trading business front, the company seems to be slowly recovering from the exceptionally low trading volumes of 2012. Trading volumes were up year-over-year for the sixth straight month in May 2013. May was particularly good for the brokerage as the company reported a 17% year-over-year increase in daily average revenue trades that month.

Should volumes continue to increase at this pace in the coming quarters, we believe that the company’s trading commission revenue will be back on growth track much sooner than anticipated. This however is unlikely to cause a large increase in our price estimate for Schwab because trading commissions constitute less than 10% of the value in the company, according to our estimates. Currently we forecast trading volumes to start picking up meaningfully only after 2015. A quicker turnaround will be a welcome change for the brokerage, but it will still be very small in terms of adding more value to the company. (Related article: Rise in Trading Volumes to Give Online Brokers a Boost in 2nd Quarter)

Interest Rate Environment Is A Key Driver

A few weeks ago the Federal Reserve sparked speculation about an early reversal of its quantitative easing (QE) program. This is positive for brokerages like Schwab because an end to QE implies that interest rates would rise sooner than anticipated. If this happens, brokerage firms will benefit from a higher net interest incomes on their growing asset bases. The event would be particularly important for Charles Schwab because the company derives over 44% of its value from net interest income on client assets. An increase in interest rates would also mean a decline in the fee waivers that Schwab has been giving its clients on money market funds, meaning that its net asset management revenue would increase.

We currently forecast interest rates to rise meaningfully only in the second half of this decade. However, if it happens sooner then one can expect a 10%-20% upside in our price estimate for the company, depending on the magnitude of the rise in interest rates. Our current price estimate for Schwab is around $17 per share.

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Notes:
  1. Schwab Reports Monthly Activity Highlights, Charles Schwab, June 14, 2013 []
  2. The Charles Schwab’s CEO Hosts Spring 2013 Business Update Conference, SeekingAlpha, April 25, 2013 []
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