Reviewing Charles Schwab’s Business, Part 1: Interest Income

Charles Schwab (NYSE:SCHW) reported a decline in trading activity through most of 2012 but was still able to maintain revenue growth, albeit at a lower rate than the historical average. Growth in income through asset management fees and interest revenue helped the company mitigate the effect of a 5% decline in trading revenues through the first nine months of 2012. In this article, we analyze the brokerage’s interest earning assets which account for about 40% of Schwab’s revenues.

Our current price estimate for Schwab is $15, in-line with the market price.

See Our Full Analysis for : Charles Schwab|Ameritrade|E*TRADE Financial

Interest Earning

Charles Schwab invests client’s assets that are awaiting investment to earn interest income and in return pays interest to its clients. The funding sources for Chuck’s interest-earning assets include deposits from banking clients which account for 60% of the net assets.

The company primarily invests in corporate debt securities, U.S. agency notes and residential mortgage-backed securities. The investment strategy is based around interest-rates, which are dependent on external factors and is designed to produce higher interest income as interest rates rise. With the Fed maintaining low interest rates, the company has been forced to extend the maturities of assets in its portfolio and lower rates paid to clients from whom it borrows. The average interest paid on deposits from banking clients has declined from 0.12% at the end of September 2011 to 0.07% at the end of the same month in 2012 as the total yield on total interest-earning assets has dropped from 2% to 1.74%.

The highest yield is earned on margin loans made to brokerage clients to allow them to invest. Receivables from brokerage clients account for about a quarter of the net interest-income.  Schwab reported a 19% year-on-year decline in revenue earning trades at the end of the third quarter of 2012. To revive trading activity, the company has had to reduce the interest charged on margin loans. The average interest rate on client receivables dropped from 4.32% to 4.07% at the end of the September quarter.

We expect a gradual increase in yield as interest rates rise over time, but we expect low interest rates in the short-term based on government policies and tepid economic growth. You can modify the interactive chart below to gauge the effect a change in yield would have on our price estimate.

While the yield on assets has been dropping due to macro-economic factors, the company has been able to attract assets. The net interest-earning assets at the end of the September quarter increased by 10% over the prior year. The biggest increase came in deposits from banking clients which jumped 25%. We expect the company to consolidate interest earning assets to help it maintain revenues at the current level through a low-interest rate period.

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