The market is off to a pretty terrible start in 2016, but even with this tough start, many companies are thinking 2016 could be their best year yet. The Charles Schwab Corporation (SCHW 0.67%) is one of those companies, and I think it has an excellent chance of doing exactly that.
To me, it boils down to the company's exceptional management, the huge potential of its money market fund business, and the potential for the bank to unleash its lending business.
Schwab's management of the company is exemplary
Schwab makes its money from several independent but related revenue streams. The company is a brokerage, so every time a client buys or sells a stock, Schwab collects a fee. The company also administers managed funds for clients that charge a fee based on the assets under management. Further, Schwabe provides its clients with loans and deposit products similar to a traditional bank, expect that Schwab focuses on margin loans secured by investment accounts and securities.
Within this context, the company will make more money under three conditions: if the stock market is rising and assets under management are increasing; if their clients buy and sell a lot, which is also helped by a rising market; and if interest rates return to the historic norm, which maximizes the yield the company earns on its margin loan business. That is, a rising market = more trading and higher interest rates.
At the beginning of 2015, Schwab's management forecast that interest rates would rise to 0.25%, the S&P 500 would appreciate 6.5%, and their client's average daily trade volume would increase 5%. Based on those underlying fundamentals, management expected to grow revenue by a mid-to-upper single digit percentage.
As 2015 progressed, interest rates did rise, but not until December. The S&P fell by 1% for the year, and the company's trade revenue actually declined 2%. Everything, in other words, was worse than management had hoped.
For most companies, when the economics that drive their business come in so far below expectations, management would be relieved to have such a convenient excuse for underperformance. Not at the Charles Schwab Corporation.
Management at Charles Schwab, in the face of such a challenging environment for their business, still delivered 5% annual revenue growth, setting top line records in both asset management fee income and net interest revenue. The company also hit its profit margin target of 36%, increased net income 10% on the year, and grew core assets 8%. It was an incredible result and a banner year for the company.
This result is not unusual for Schwab. It's management team is among the best in the business. The company fosters a culture that is appropriately conservative and risk aware, yet still aggressive and willing to take the kind of risks that result in consistent outperformance.
$651 million in lost fees could soon be found
One of Schwab's core businesses is administering and managing money market funds for its clients. This business took a major hit when, in response to the financial crisis, the Federal Reserve dropped interest rates to near zero. Schwab and other money market fund managers were faced with a problem. Interest rates were so low that if clients were charged any fee at all, then their returns would turn negative.
Instead of sending their clients into the red, Schwab and other major players elected to waive these fees. The company still incurs all of the expenses related to operating the funds, but currently generates no fee income.
In 2016, most analysts expect this situation to change. The Federal Reserve began raising rates in December, and the consensus among economists is that rates will continue to rise in 2016, albeit slowly. As rates rise, Schwab and others will once again be able to charge fees on their money market funds, which could be a major boost to bottom lines.
For the 2015 calendar year, Schwab waived $651 million in these fees. In 2014, the company waived $740 million. These are big numbers that should have a big impact.
Most observers don't think the Fed will raise rates very quickly, so investors should not necessarily expect all of this lost revenue to return in 2016. However, the money involved here is significant enough that even a small percentage change could have a dramatic and positive effect on the company's profitability.
Doubling (or more) the net revenues from lending
Another repercussion of the low interest rate environment has been lost profits in Schwab's lending business. Much like a traditional bank, Schwab uses some of the customer cash it holds on deposit to invest in higher yielding debt securities and loans. In Schwab's case, these loans are typically margin loans provided to investors interested in buying and selling stock on credit.
In 2008, the difference in Schwab's deposit interest paid and the interest yield it returned, called its "spread," was 3.84%. At the end of 2015, it was just 1.60%.
Schwab averaged nearly $158 billion of client cash on its balance sheet in 2015. Those assets generated $2.5 billion in net interest revenue.
What's incredible about this figure is not its sheer size, which is massive. The incredible part is how much potential there is for this business to grow even large within a higher interest rate environment.
As rates rise, Schwab should be able to increase its yields and interest income faster than its funding costs increase. As that happens, the spread should expand to levels more like what was seen in 2008.
In other words, that $2.5 billion in net interest revenue has the potential to double or more over the next few years as the Fed raises rates.
At the end of the day, Charles Schwab represents a company that has done quite well through a tough business environment thanks to its excellent management. Today, as the Fed begins its work to raise interest rates back to historical levels, the company finds itself sitting on two business lines with the potential to experience serious growth in a higher rate environment.
I'm confident in this company because of its management, but if the stars align and Schwab is able to unleash its money market fee income and spread lending businesses, then 2016 could be this stock's best year yet.
