To help markets in mid-March, as the novel coronavirus continued to spread and fuel a vicious downturn, the Federal Reserve enacted an emergency rate cut, lowering the federal funds rate by a full percentage point, to near zero. The dramatic reduction, the central bank’s largest since 2008, bruised the discount brokerages that lean on interest income to generate revenue, and the notes from equity analysts that followed reflected that.
Those same companies, collectively, also serve as custodians to the vast majority of RIA assets, which are valued in the trillions of dollars.
At Charles Schwab, 60% of total revenue was tied to interest rates at the end of 2019 and Morningstar estimated Schwab’s 2020 revenue would fall by $1 billion, or 9.2% year-over-year, to just over $9.7 billion. It also estimates adjusted net income will fall 28% year-over-year to $3.8 billion, according to a March 16 note. Revenues at others were also expected to suffer.
But mid-March feels like ages ago; much has changed. The number of Covid-19 cases in the U.S. has risen sharply to over 429,000 and more than 14,000 people have died, according to a New York Times database tracking global confirmed cases. Despite grim headlines, the number of new cases has shown signs of moderating. Not surprisingly, the forward-looking stock market has recently rebounded amid continued volatility.
“Investors can start to dust off their playbook for early-cycle investing,” JMP Securities analysts wrote in a note published Thursday, and Schwab has suddenly fallen back into favor.
As an expected recession begins, so has a shift in focus from rate risk to credit risk, which favors discount brokers. Among those, analysts at Morgan Stanley Research wrote April 1 they are “overweight” and “prefer” one over the others: Schwab.
Relative to peers, the discount brokerage can achieve better organic growth, has more expense levers to pull and will benefit from synergies from its merger with TD Ameritrade, researchers say. Schwab agreed to acquire TD Ameritrade in November for $26 billion. The deal is expected to close this fall (Morningstar says there is a 75% probability the deal will be approved).
Schwab is “best positioned to navigate the volatile and uncertain backdrop given their scale, ability to take share and win new customers in a flight to quality, drive greater expense efficiency and deliver significant earnings accretion from their upcoming USAA acquisition and AMTD merger,” wrote Michael Cyprys, an equity analyst at Morgan Stanley. On April 1, he raised his 12-month price-target on Schwab to $47, which implies almost 30% upside from current levels.
Schwab also “proved defensive” during the global financial crisis, outperforming the S&P 500 by 6% from December 2007 to June 2009, Morgan Stanley Research pointed out.
Analysts at Compass Point Research and Trading also published a note April 1 about Schwab, giving it a “buy” rating and setting a similar price target of $45. “The near-term outlook will clearly be challenging given rate/asset level dynamics, but we continue to like the long-term story here,” Chris Allen and Michael Anagnostakis said.
Piper Sandler Research is also “overweight” Schwab. In addition to recognizing the same themes as other researchers (interest income headwind and synergies with TD Ameritrade), analysts also estimate that record trading volume in the first quarter of 2020 will translate into related revenue of $110 million, up 37% quarter-over-quarter due to increased payment for order flow (PFOF).
But another discount brokerage also piqued the interest of equity analysts.
Last fall, Interactive Brokers Group (ticker: IBKR) launched IBKR Lite — a commission-free trading platform — and Schwab upstaged it by slashing its own commissions a week later and triggering rapid fee eliminating at other brokerages. It still charges transaction fees on its IBKR Pro platform but that in fact helped the company, as investors traded like mad in the first quarter, and the business continues to grow, to the liking of analysts.
Like Schwab, Interactive Brokers benefitted from the recent boost in trade volume. Unlike the competitor, it was charging investors for more of its transactions. About 37% of its revenue comes from trading commissions and only 43% of revenues are truly rate sensitive, according to Compass Point.
It also doesn’t have any asset-sensitive revenues dependent on the ebb and flow or the market, unlike others, a “rock solid” balance sheet absent any debt, and “best-in-class account growth (up 25% YOY in 2020 to-date, although we expect some moderation ahead),” according to Compass Point.
The research firm said Interactive Brokers had the “best model in the current environment.”
“We expect this resiliency to continue to stand out in what is likely to remain a volatile environment near-term. And longer-term, IBKR is well positioned to drive strong growth given its competitive advantages internationally and the impact of technical issues from recent start-ups/impact of mergers at larger players.”
In a note Wednesday, KBW analysts said they were “tactically negative” on Interactive Brokers’ stock going into the second quarter due to the recent Fed rate cuts and resulting headwind that was “more material than expected.” However, their long-term outlook is positive.
“Account growth has accelerated materially over the past quarter, as accounts grew 10% in 1Q20 (or 40% annualized). This is obviously a positive signal for organic growth, and we think this account acceleration could have squeezed some shorts out of the stock,” KBW analysts wrote.
As grim as things might have seemed in mid-March, the narrative of discount brokerages has changed.
“Bottomline, valuations for the eBrokers have remained somewhat flat despite the pullback of the stocks,” Piper Sandler Research wrote.
