This content is from: Wealth Management

The World Schwab Thrived in Disappeared on Sunday

The Fed cut interest rates close to zero. What will happen to the company with 60% of revenue tied to interest rates?

After Charles Schwab’s winter business update in February, equity researchers at Barclays published a note forecasting revenue at the financial services company would be up slightly more than they thought in 2020, to more than $10.8 billion. They also cautioned investors: “The narrative can change quickly.”

In the weeks leading up to Schwab’s guidance, expectations for the Federal Reserve’s benchmark rate in 2020 shifted. The market moved from 90% confidence that rates would remain stable, to forecasting there would be one mid-year rate cut. In addition, observers believed there was a 50% chance of a second cut later in the year, the analysts wrote.

That’s a meaningful change at a company like Schwab, where about 60% of total revenue was tied to interest rates at the end of 2019, according to Morningstar. Short-term rates moving up or down 25 basis points represent a revenue delta of $75 million to $175 million for Schwab, according to Barclays.

But analysts also worried the change in sentiment toward the Fed wasn’t only about an economic slowdown. “The move could be transitory and coronavirus related,” the Barclays analysts wrote in the February note.

Now, barely a month later, fears of the coronavirus impacting life and markets have become a grim reality, including for Schwab.

The coronavirus has spread into a pandemic. As of Monday afternoon, at least 173,800 people had been diagnosed with the disease and 7,281 have died, according to a New York Times database tracking global confirmed cases. Half the cases and deaths have occurred outside mainland China.

Countries have declared states of emergency, closed their borders, ordered business to cease operations, and asked residents to remain indoors. In response to the escalating efforts to slow the spread of the outbreak, markets have been as volatile as they were during the global financial crisis in 2008 and plummeted into the fastest-ever bear market.

On Friday, Peter Crawford, chief financial officer at Schwab, published commentary about the company’s health. Through the first two months of the year, Schwab took in $45.3 billion in net new client assets — “the strongest start to any year in our history.”  In February, it averaged well over one million trades per day, up 53% year-over-year, and volatility and markets drove clients to increase allocations to cash “reinforcing the resilience of our all-weather business model,” according to Crawford.

“Stronger levels of trading-related and net interest revenue generated by these client actions should help soften the impacts of lower rates and equity market valuations, enabling us to deliver linked-period top-line growth for the first quarter of 2020,” he said.

Schwab’s stock surged 19% on the news, more than double the S&P 500’s 9% gain. 

But over the weekend, ahead of its scheduled meeting this week, the Federal Open Market Committee met and voted to lower the target federal-funds rate to between zero and 25 basis points. The range at the start of 2020 was 1.5% to 1.75%. The Fed also said it would restart quantitative easing and buy $700 billion in Treasury and mortgage-backed securities.

Schwab, along with other discount brokerages, are going to suffer as a result, according to analysts. “Material declines in revenue and earnings” will move management teams to lower their guidance, according to Michael Wong, a sector director at Morningstar, said in a report published Monday.

“With both short- and long-term interest rates having significantly fallen, there’s no maneuvering that the firms can undertake to prevent a material decline in interest-rate related revenue,” Wong wrote.

Morningstar estimates Schwab’s 2020 revenue will fall by $1 billion, or 9.2% year-over-year, to just over $9.7 billion. It estimates adjusted net income will fall 28% year-over-year to $3.8 billion. The research firm lowered its fair value estimate for Schwab 12% to $43 from $49, and its estimate for TD Ameritrade to $46 from $53, as of March 14.

Schwab agreed to acquire TD Ameritrade in November for $26 billion and Morningstar incorporated a 75% probability in its valuations that the deal will be approved.

KBW Research also published a report Monday detailing how it thinks Schwab and other discount brokerages would respond in a negative rate environment. In the potential scenario, where rates fall to negative 1% and gradually return positive, earnings per share at Schwab, TD Ameritrade, E*Trade, and Interactive Brokers, could fall by between roughly 30% to 60%.

Analysts at KBW, however, estimate that discount brokerages could cut expenses by 10% and make other changes to better the businesses. The researchers suggested the companies could make material changes to balance sheets by expanding investable securities or “essentially taking on increased credit risk in their securities portfolios to pick up incremental spread” and potentially grow their loan portfolios. The balance sheets of the companies currently have “high-quality” assets and haven’t taken any material credit risk.

Should the rate environment go negative and become “the new norm,” the companies might need to make material changes to their business strategy, including their overall pricing models.

On Monday, Schwab tumbled 9.7%, compared to a 12% loss for the S&P 500.

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