Charles Schwab: Buy, Sell or Hold?

Charles Schwab (NYSE: SCHW) has been under pressure for the past few years as years of high interest rates weighed on the company. The financial services company, which relied heavily on cheap deposits to fund its operations, has struggled with a decline in bank deposits and has been forced to rethink its business model.

During the second-quarter earnings call, CEO Walt Bettinger said the bank will reduce the size of its bank over the next few years. Here’s why and what that means for the business going forward.

Charles Schwab relied on cheap financing

According to Bettinger, Charles Schwab would send excess deposits to third-party banks, which should help reduce his bank’s “capital intensity.” The move would also improve the company’s liquidity, which has been struggling with deposit outflows since the Federal Reserve began aggressively raising interest rates.

The move is probably Schwab’s best. The financial services company relied heavily on cheap deposits in the 2010s, which helped it achieve a superior return on equity (ROE) compared with its competitors. Its cheap business model worked well because interest rates remained low for several years after the Great Recession.

But this low-cost deposit model has run into trouble when interest rates rise. In 2017, the Federal Reserve began gradually raising its benchmark federal funds rate. While those rate hikes weren’t as aggressive as the central bank’s moves in recent years, Charles Schwab has run into a deposit outflow problem known as “customer cash sorting.”

Customers have decided that instead of keeping their deposits in low-interest bank accounts, they will use high-interest savings accounts, certificates of deposit, or other relatively safe assets with decent yields.

Sorting of consumer cash accelerates amid Fed’s aggressive interest rate policy

Schwab’s problem sorting through customer cash was just a blip on the radar in 2017. But when the Federal Reserve started raising interest rates in 2022, the problem became much more serious. In a little over a year, the federal funds rate went from nearly zero to 5%, and suddenly high-yield savings accounts and other interest-bearing products became incredibly attractive to investors.

The worst was from August 2022 to April 2023, when average deposit balances in Schwab’s bank accounts fell by $49.8 billion. That was a 33% decline since the Fed’s rate-hiking cycle began. While deposit outflows have slowed significantly, they are still flowing out of Schwab. This year alone, deposits in Schwab’s bank accounts have fallen by another $10.3 billion, to $85.1 billion.

The story continues

Falling deposits have forced Schwab to rely on more expensive funding sources, such as retail certificates of deposit and Federal Home Loan Bank advances, to ensure it has enough liquidity if customers continue to move funds out of their bank accounts. As a result, these higher costs have eroded Schwab’s net interest margin, weighing on the company over the past few quarters.

Here’s What’s Next for Schwab

Charles Schwab’s move to shrink the bank is likely to take years as the company tries to execute its plan through the entire interest rate cycle. As a result, many analysts have lowered their estimates for Schwab’s earnings and net interest income over the next few years. Analysts at The Fly reported Bank of America noted that the move “represents a 180-degree turn” in Schwab’s bank-focused strategy.

Schwab’s move will impact the company’s growth and earnings over the next few years. But I believe it’s the right decision for the company over the long term. There are long-term risks that inflation and interest rates will remain higher.

Massive structural changes have been underway for several years. The shift away from globalization and toward more protectionist policies, rising fiscal obligations and government deficits, and rising geopolitical tensions could all maintain upward pressure on inflation. If they do, inflation and interest rates are unlikely to return to the low levels seen in the 2010s.

Buy, sell or hold Charles Schwab stocks?

Charles Schwab could see more volatility and lower returns over the next few years as it retools its business. The stock is trading right around its 10-year average price-to-earnings and price-to-book values, so it’s not cheap. If you’re an investor, hold on, but I don’t see any need for investors to rush out and buy the stock now.

It’s good for Schwab that management recognizes that what worked before may not work in the future and is taking much-needed steps to mitigate that risk going forward. It will take time and may change some aspects of the business that you’ll want to pay close attention to over the next few quarters.

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Charles Schwab is an advertising partner of The Ascent, a Motley Fool company. Courtney Carlsen has no positions in any of the stocks mentioned. The Motley Fool has a position in and recommends Charles Schwab. The Motley Fool recommends the following options: short September 2024 call options at $77.50 on Charles Schwab. The Motley Fool has a disclosure policy.

Charles Schwab: Buy, Sell, or Hold? was originally published by The Motley Fool