Charles Schwab: Hard Power is Undeniable, But More Effort is Needed to Stimulate Growth

$Charles Schwab(SCHW.US) The third-quarter performance was reasonably good as expected, with highlights in interest and trading income, mainly reflecting the increased activity in the capital markets under the expectation of interest rate cuts, and the company's effective cash management and cost optimization under economies of scale as a leading player.

Key Points:

1. Two Key Metrics—NNA, NIM: Currently, if we simplify Schwab's business, the core is to look at the net increase in user assets and the net interest margin. One reflects long-term endogenous growth (scale-driven business logic), and the other reflects the ability to monetize assets (net interest is still the main monetization channel).

(1) Net New Assets (NNA): Q3 NNA was $134 billion, with an annualized growth rate of 4.9%, as expected by the market, gradually approaching the lower end of the long-term guidance range of 5%-7%. Whether it can continue to return to the median level of 6% or above is key to driving intrinsic value enhancement.

(2) Net Interest Margin (NIM): Q3 was 2.87%, exceeding market expectations. Although in a rate-cutting cycle, the first rate cut of 25 basis points was only announced in September, with limited impact on Q3. Additionally, the active capital market in Q3 significantly increased high-interest margin trading, causing the income-side interest rate to continue rising. Meanwhile, Schwab's short-term debt decreased by $2.7 billion quarter-on-quarter, reducing interest expenses, thus further expanding the net interest margin.

2. Trading Business: Q3 saw a 25% year-on-year growth, mainly driven by DARTs (up 30% year-on-year). The activity in DARTs is closely linked to the stable 6% growth in account numbers and a 10% increase in per capita asset size, along with market conditions boosting turnover rates.

DARTs slightly declined quarter-on-quarter, but the penetration rate of derivative trades in Q3 reached 22%, up 2 percentage points from the previous quarter. This increased average revenue per trade quarter-on-quarter, and with two more trading days in Q3, trading income was significantly higher than in Q2.

3. Net Interest Business: Q3 saw a 37% year-on-year growth, accelerating compared to the previous quarter, primarily driven by the aforementioned increase in NIM, with interest-earning asset size remaining flat year-on-year.

4. Wealth Management Business: Q3 saw a 13% year-on-year growth, mainly driven by scale expansion, as both 1P fund management fees and 3P fund commissions saw a comprehensive fee rate decline. Due to the expectation of interest rate cuts, users invested more idle funds into money market or mutual funds, and funds from users receiving advisory services also increased significantly in Q3, driving the rise in wealth management scale.

5. Profitability: Changes in Q3 expenses were mainly reflected in increased employee costs, while marketing and basic operating expenses remained restrained, resulting in an operating profit of $3 billion. Despite a higher base, a 64% growth rate was achieved. The profit margin was 49.2%, up more than 1 point quarter-on-quarter and 11 percentage points year-on-year.

6. Shareholder Returns: Q3 saw the repurchase of 28.9 million common shares, costing $2.7 billion, an increase of $900 million from the previous quarter. If annualized at the Q3 level, the return yield is 6%, which is a decent return rate in a low-interest environment. The total shares at the end of the period were 1.811 billion (including potential dilution), a decrease of 11 million quarter-on-quarter, boosting EPS by 0.6%.

7. Key Metrics Overview:

Dolphin Research's View

The third-quarter performance was decent, slightly exceeding expectations, and overall is in a trend of gradually recovering endogenous growth. However, compared to peers, growth still lags behind emerging platforms like Robinhood.

But Schwab's valuation is not high, currently at a forward 1-year valuation of 18x P/E, which is below the central level of 20x P/E under normal operations before the 2023 squeeze crisis, indirectly indicating that some negative drag from future rate cuts has already been priced in.

Compared to the industry average,Schwab's current premium level is at its lowest in the past 10 years, directly showing the business difficulties Schwab faced at the time and the competitive threat from new forces. But the flip side of the coin is that it leaves room for Schwab to catch up and for valuation recovery (+10%-20%)

As repeatedly mentioned in Dolphin Research's initial coverage, the future drivers for Schwab's valuation recovery mainly come from:

(1) Improvement in the net new asset rate (NNA) (from the current growth rate below 5% back to the management's long-term guidance—5% to 7% growth median or even the upper end of the range);

(2) Accelerating the repayment of short-term debt to reduce funding costs, offsetting the impact of rate cuts on the net interest margin;

(3) Effective cash management: by automatically transferring idle client funds from Schwab Bank to external partner banks (TD Bank), effectively moving client deposits off-balance sheet to achieve light asset operations, reducing potential operational risks and cost drags.

(4) Cost optimization under economies of scale, especially whether the integration of Ameritrade can further improve operational efficiency.

Of course, from a long-term perspective, the core driver is still the first point, namelythe improvement of NNA is the most critical. Secondly, it is about the changes in cost optimization, cash management, and shareholder returns driven by economies of scale for Schwab. The following chart shows Dolphin Research's breakdown of Schwab's long-term growth drivers:

If the annualized growth rate of NNA can return to the company's guidance median of 6%, then combined with the regular industry value-added income of 3%, unchanged capital monetization efficiency (income/asset size), and an annual growth rate of 6% in operating expenses (3 points lower than income growth), it can bring about a 12% CAGR growth in operating profit. Finally, with an additional 2-3 points from buyback dividends, there is a total long-term growth outlook of about 15% in earnings per share.

The growth rate of NNA, although partially influenced by market performance, still requires Schwab's own competitiveness to achieve alpha growth. Currently, this mainly refers to the work that Schwab still needs to complete or make up for during the "lost three years"—"Ameritrade user integration" and "product innovation iteration".

(1) Although the acquisition of TD Ameritrade was announced at the end of 2020, Schwab has been integrating the users of the two ecosystems over the past few years. Providing original Schwab users with a more convenient "thinkorswim" platform for trading, and offering Ameritrade users a richer range of financial products and advisory services.

The company revealed last quarter that the net asset size (NAA) of Ameritrade users grew by 100% year-on-year over the past year, exceeding the growth rate of the entire group's net new assets (46%), indicating that the synergistic integration effect of 1+1>2 is playing a positive role. This expansion of user service coverage should be a factor driving NAA growth over a longer cycle.

(2) Over the past three years, due to being deeply involved in the squeeze crisis, the company's team has spent most of its energy and resources, causing Schwab to lag behind industry newcomers like Robinhood in product innovation. Especially in the layout of cryptocurrency-related product services, Schwab currently only has the cryptocurrency ETFs (BTC & ETH) theme fund launched in 2022, with a cryptocurrency spot trading platform to be launched next year. However, regulatory compliance issues may also be a reason for Schwab's hesitation in cryptocurrency deployment.

Therefore, closely monitoring Schwab's product innovation progress (short-term focus: expanding the range of investable derivatives, advancing cryptocurrency spot trading, issuing stablecoins) is expected to be a forward-looking signal for further valuation recovery.

However, Schwab had no particularly significant moves in new products in Q3, mainly focusing on alternative investment platforms, employee equity incentive management plans, etc. In addition, it is adding branches and teams (16 added, with plans to expand 25 more, and 400 employees recruited) to penetrate more regions. Schwab's management will elaborate on business outlooks during the conference call, which investors are advised to focus on. Dolphin Research will also publish updates in the community and chat groups as soon as possible.

Detailed Analysis Below

I. Overview of Schwab's Business Structure

Charles Schwab can be said to be one of the preferred platforms for most American families for financial management. On Schwab:

(1) ToC (Investor service): Retail users can achieve a complete wealth management plan from trading stocks and bonds to purchasing funds, seeking investment advice, and handling deposits, loans, trusts, etc.

(2) ToB (Advisor service): Schwab also provides a series of support services such as trading, custody, and financing to external independent advisory consultants (RIA).

The two businesses are not isolated but complement each other. For Schwab, outsourcing RIA services allows it to enhance its wealth management business line in a "light asset" manner and even reach more quality clients through RIA. Similarly, RIA can achieve its independent business goals by leveraging Schwab's reputation (safe and reliable fund custody, a wide range of trading varieties, etc.).

In the trend of reducing trading and fund commission fees, Schwab relies on interest income from deposit-loan spreads and investment in fixed-income financial assets to fill the gap in trading income. From the overall group perspective, the business model is gradually taking shape—attracting customers through commission-free securities trading, low channel fees, zero transaction fees for fund subscriptions and redemptions, low advisory fees for intelligent investment, and no promotion fees for independent RIA custody services, expanding the overall client asset size (AUM), and ultimately generating revenue mainly through asset interest (deposit, loan interest/investment income).

II. Core Growth: On the Path to Healthy Recovery

In Q3, Schwab's ecosystem was in stable expansion, with several user metrics:

(1) Brokerage accounts saw a gross increase of 1.14 million, with 660,000 inactive accounts removed, resulting in a net increase of 490,000. On an annualized basis, this equates to a 12% gross increase, 7% attrition, and a final 5% net increase. Looking at the past year's cycle, it is relatively stable.

Maintaining such growth, Schwab's marketing expenses are also relatively stable. The comprehensive calculation shows a customer acquisition cost of $207 per person, fluctuating around the central level of $200 per person. This indicates that despite increasing external competition, Schwab's brand awareness remains relatively solid among its core user base.

(2) In Q3, client scale reached $11.6 trillion, with the average account asset size further growing to $300,000. Overall, the newly added over $800 billion in assets came from $138 billion in new deposits, a one-time withdrawal of $30 billion, and $702 billion in asset appreciation.

From the final annualized growth rate perspective, it is "5% new deposits + 7% market fluctuations" bringing a total asset scale endogenous growth rate of 12%. However, market fluctuations are uncontrollable, so the growth rate of new deposits is key to endogenous growth, which is why Dolphin Research has always emphasized the net new asset scale (NNA).

Management guides the long-term growth rate of NNA to be in the 5%-7% range, but it has not yet returned to this range. In a rate-cutting environment, NNA is expected to naturally return to the above range, but to maintain long-term stability or even exceed the range, product innovation needs to be accelerated, especially compared to new force platforms with strong current product development capabilities, Schwab still needs to further enhance product competitiveness.

III. Trading: Mainly Driven by Market Conditions

The market conditions in Q3 were favorable, with the S&P 500 up 7%, and cryptocurrencies also gaining traction, with Bitcoin reaching a new high of $123,000 in Q3 from $108,000 at the end of Q2.

During this period, user trading sentiment gradually recovered from the shadow of April's tariffs, with Schwab's STAR index rising month by month since May, indicating an increase in investor risk exposure on the platform. Throughout the industry, options and margin trading activities were also relatively active, with a significant increase in scale compared to the previous quarter.

In such an external environment, Schwab's trading income grew 25% year-on-year in Q3, further accelerating from 22% in Q2. The average daily trading volume was 7.42 million, up 30% year-on-year. Annualizing the Q3 situation, each account traded 49.3 times a year on average, up 24% year-on-year.

However, trading frequency slightly declined quarter-on-quarter, related to the superior market performance in Q2. The S&P 500 rose 7.6% in Q2, higher than the 6.5% in Q3. But notably, the proportion of derivative trades in Q3 increased by 2 percentage points quarter-on-quarter.

Enriching the range of investable derivatives to activate more trades and penetrate more users is one of Schwab's important initiatives for driving growth in the future. This can not only attract high-frequency trading users that Schwab currently lacks but also improve the monetization efficiency of trading income through higher trading fees and PFOF rates.

IV. Net Interest: NIM Exceeds Expectations

Net interest income grew 37% year-on-year, further accelerating compared to the previous quarter. This was mainly due to the increase in high-interest margin trading and the rapid repayment of high-cost short-term debt.

From the perspective of net interest margin and scale breakdown, the interest-earning asset scale remained flat year-on-year, while the net interest margin (NIM) increased by 2 percentage points year-on-year and 0.17 percentage points quarter-on-quarter, exceeding market expectations. The rate cut in September had a relatively limited impact on Q3.

Last quarter, the company raised its net interest margin target for the year from 2.65% to 2.75%. Currently, the average for Q1-Q3 has already reached 2.75%. Given the current cash management capabilities, achieving a net interest margin higher than 2.75% in Q4 is not impossible. Attention should be paid to the conference call to see if management raises the net interest margin target again.

V. Wealth Management: Fee Rates Decline, Scale Drives Growth

Asset management business income grew 13% year-on-year in Q3, mainly driven by scale expansion, while comprehensive fee rates declined. Due to the expectation of interest rate cuts, users invested more funds in stocks, and idle funds during trading gaps were more inclined to be invested in money market or mutual funds, with the proportion of pure cash, including bank deposits, further declining. Meanwhile, the scale of funds from users receiving advisory services also increased significantly in Q3.

VI. Operating Leverage Continues to Optimize

As a mature financial platform, the expenditure side generally remains stable. Total operating expenses in Q3 grew 3% year-on-year, mainly increasing in employee costs and expert consultant fees, while marketing expenses, communication operations, and other expenses remained restrained, flat year-on-year, with depreciation and amortization expenses slightly declining.

Ultimately, operating profit was $3.02 billion, up 64% year-on-year, with a profit margin of 49%, up 11 percentage points year-on-year and 1.2 percentage points quarter-on-quarter, with the scale effect of the financial leader continuing to play a positive role.