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In search of the best companies on the planet, we at Rule Maker Central are always digging into the financials of industry leaders. My salivary glands have been working overtime to get to Charles Schwab (NYSE: SCH). Last week, I finally found the time. I got out my financial shovel and here is what I discovered.
Before we look at the financial performance of this FOOL 50 company, a little review is order. Since financial companies often deploy greater leverage (i.e., debt) than our Rule Maker criteria allow -- rendering gross margin, Foolish Flow Ratio, and Cash King Margin ratios meaningless -- we established several alternative criteria to evaluate them. Almost a year ago, Matt Richey proposed the following revised quantitative criteria for what he coined "Finance Kings." Phil Weiss jumped into the ring and proposed upping the asset turnover ratio to 0.16 from Matt's original 0.15 because, as he explained, we place "great importance on a company's ability to turn its assets over as frequently as possible." The quantitative criteria are:
- Sales growth > 10%
- "Efficiency margin" (1 minus the efficiency ratio) > 20%
- Net margin > 10% (upped from 7% because we increased our RM net margin hurdle)
- Asset turnover (revenue divided by assets) > 0.16
- Leverage factor (assets divided by equity) < 15
A quarter does not a trend make, so I peeked into the last 10 years for Schwab. Not only does this provide a historical view of how these key ratios have performed, but it shows the drastic improvement Schwab has made over the last decade. I must admit, I was surprised -- and pleasantly so -- by the across-the-board improvement in this Finance King.
Rule Maker companies are not only about financial performance. Schwab's dominant brand, repeat purchase business, convenience, and expanding possibilities are the bricks that lay the foundation of this yellow brick road to financial Oz. That said, today's column will focus on the numbers and I will address the qualitative measures in a later column.
Sales growth > 10%
Before we look at the revenue growth, let's look at the revenue streams. Just like our other financial Rule Makers, American Express (NYSE: AXP) and T. Rowe Price (Nasdaq: TROW), Schwab has two primary sources of revenue: interest income and fee income.
Interest income is actually "net interest income" (defined as interest income minus interest expense) because we only wish to see the "spread income." For the nine months ended Sept. 30, 2000, net interest income was $931.4 million, or 21% of total revenue.
Schwab's fee income is predominately composed of commissions and mutual fund services fees. For the nine-month period, Schwab's commission and mutual fund income provided 41% and 26% to the top line, respectively.
I draw attention to these percentages, because many mistake Schwab as a slave to commissions. Management has not turned a deaf ear to these concerns and has drastically lowered its exposure to this fickle commission revenue by reducing it from 76% in 1992. On the one hand, Schwab benefited from the enormous increase in trading volumes on both the NYSE and the Naz over the last few years, and on the same hand, it diversified its revenue streams. Kind of a cake-and-eat-it-too thing. The point is, Schwab is much more insulated from commission revenue now than a few years ago.
Not only does Schwab ace the revenue growth test with 39% revenue growth ($4,453 million through Q3 2000 versus $3,212 million through Q3 1999) for the nine-month period, but it has a 10-year compound annual growth rate (CAGR) of 27% through 1999. (Note this CAGR does not take into account the acquisition of U.S. Trust, which was accounted for under the pooling method. Historical financials will not be available until after Schwab closes its books for calendar 2000.)
Efficiency margin > 20%
As Phil wrote earlier this year, "This metric is a substitute for the gross margin calculation used for traditional Makers. The efficiency ratio is non-interest expense divided by revenue. Interest expense is excluded from this calculation due to the fact that, for a financial institution, it's an expense that's merely part of the cost of doing business."
Non-interest expense for the nine months was $3,447 million and revenue was $4,453 million. The calculation -- (3,447 / 4,453) - 1 -- yields a 23% efficiency margin, beating the requirement. But, once again, the historical trend tells a better story. Below are the efficiency margins for Schwab over the last 10 years. Consistency with a dab of improvement, just the kind of trend we like to see.
1991 1992 1993 1994 1995 15% 20% 21% 21% 20% 1996 1997 1998 1999 2000* 21% 19% 21% 25% 23% *year-to-date
Net margin > 10%
This traditional Maker measurement requires no adjustment. For the nine months, Schwab had net income of $579 million. Dividing the net income by revenues -- 579 / 4,453 -- reveals a 13.0% net margin, clearing the hurdle rate easily. Just to assure this is not a freakish year, I looked at the last 10 years and Schwab has not posted a net margin less than 10% since 1991 (8.6%).
Asset turnover > 0.16
Similar to our Foolish Flow Ratio, asset turnover is used to measure asset efficiency. The higher the number, the better. The calculation is revenues divided by average total assets. Be sure to annualize the revenue when calculating this measure, otherwise you are understating the numerator. I have decided to annualize the nine-month revenue rather than the third-quarter number, because the mood swings of Wall Street can vary from quarter to quarter and the longer the period used in the measurement, the better. Nine-month revenue of $4,453 million, when annualized, becomes $5,937 million -- (4,453 / 3) x 4 -- and total assets at year-end 1999 and Sept. 30, 2000 were $29,299 million and $35,507 million, respectively. Averaging these total assets yields $32,403 million. Asset turnover is 0.18 -- 5,937 / 32,403 -- surpassing our requirement.
Looking back at historical asset turnovers reveals that Schwab is just now coming into range. Years past show a consistent 0.14 to 0.15 turnover. We will keep an eye on this measure to be sure that 2000 performance is not an anomaly.
Hang in there, only one more calculation. Tap, tap. Class, wake up! Thank you.
Leverage factor < 15
The leverage factor is calculated by dividing average total assets by average equity. We want this number to be as low as possible, because a lower number indicates lower leverage (i.e., debt). Although we prefer this number to be low, we understand that financial companies are built around the principal of other people's money. In other words, it uses leverage (usually with short-term maturity) to enhance performance.
Schwab's equity was $2,274 million at year-end 1999 and was $4,042 million on Sept. 30, 2000. Borrowing the average total assets from above and dividing by the average equity -- 35,507 / 3,158 -- yields a leverage factor of 11.2 comfortably below our target of 15.
So, Schwab stands up to the quantitative tests. Next week, along with the qualitative analysis, I will address how these final three financial measures come together for the "DuPont Analysis," which compartmentalizes the return on equity (ROE) calculation. For a head start, check out this article by Phil Weiss.