When it comes to bank stocks, surprises during earnings season are rarely a good thing. Investors expect their banks to be boring, making money by taking deposits and making loans at a relative snail's pace.
But last week, three banks revealed especially impressive fourth-quarter earnings results that resulted in big pops in their share prices. Here's how Charles Schwab (NYSE:SCHW), First Republic Bank (NYSE:FRC), and Bank of America (NYSE:BAC) topped the market's expectations for the fourth quarter.
1. More bank than broker
Charles Schwab may market itself as more of a brokerage than a bank, but there's no denying that it makes the majority of its money from banking activities. In the fourth quarter, nearly 61% of its net revenue came from net interest income, which makes it far more a bank than a broker or asset manager.
Hidden in plain sight, Charles Schwab's banking unit is absolutely massive. With an average of $217.3 billion of client deposits during the fourth quarter, its banking unit is larger than super regional banks like BB&T and M&T Bank, for example. But the amazing thing is that even on a large base of assets, Schwab's bank is still growing at an impressive rate. In the fourth quarter, average deposits increased by 4.1% quarter over quarter and 31.2% year over year. That's extraordinary for a bank of its size.
But fast growth is just one piece of the puzzle. The other important puzzle piece is Schwab's ability to hold down its deposit costs, even in a rising rate environment. Its average deposit cost it the equivalent of 0.38% per year in the fourth quarter, helping it hold down its funding costs to an average of 0.43% per year across its balance sheet.
Low funding costs enable Schwab to earn high returns even though it takes very little risk with its clients' cash, investing the bulk of it in super-safe securities. In all, its securities and loan portfolio generated a yield of about 2.82% annualized in the fourth quarter. As rates have increased, the yields it's earning on its assets are increasing at a faster clip than what it pays on its deposits.
There's plenty of reason for investors to believe that Charles Schwab has a long runway for double-digit deposit growth over time. Its roboadvisory service is designed to funnel client cash allocations to the bank. Meanwhile, the company has made strides in convincing customers to move their cash from money market funds to the bank, where it generates more revenue per dollar of client money. Those two factors alone could set the stage for impressive deposit growth for a long time to come.
2. The bank of customer service
First Republic Bank surprised Wall Street by beating earnings expectations and laying out rosy guidance for 2019. The bank of the ultra wealthy, First Republic competes in major metropolitan areas across the United States, targeting valuable customers who get lost in the bureaucracy of bigger retail institutions.
The crown jewel of First Republic's business model is its sticky and fast-growing deposit base. In the fourth quarter, the bank revealed that total deposits increased 14.7% year over year. Checking accounts, on which the bank pays just 0.05% in annual interest, make up nearly 60% of its deposit base. Those deposits are so cheap they may as well be free.
Management said that competition for deposits is heating up, which will invariably result in higher deposit costs as the bank competes aggressively for customer accounts. But the proof is in the numbers -- its robust deposit growth in the fourth quarter suggests that its customers bank with First Republic for reasons that go beyond getting the highest rate of interest on their accounts. If its customers aren't rate shopping now with short-term interest rates near 2.5%, when will they?
In the last five years, First Republic has grown its deposits at a compounded annual clip of 20% per year. It was easy to dismiss that as a fluke, owed to the fact that interest rates were near zero and thus customers weren't particularly concerned about the rates they earned on their cash. But its fourth quarter surge in deposits largely squashed the fears that First Republic that the bank is a one-trick pony that can only perform when rates are near record lows.
3. A rare big beat by a big bank
Big banks are supposed to be boring, slow-growing businesses, so Bank of America surprised Wall Street when it reported that its loan portfolio grew by about 1.9% in the fourth quarter of 2018. That's an impressive result, considering it compounds to about 7.8% on an annualized basis. It's hard to grow a $900-plus billion loan book much faster than that.
Bank of America is firing on all cylinders. Loan losses remain low, as its net charge-off ratio stood at just 0.39% of loans in the fourth quarter. The bank is winning valuable corporate deposits, as deposits from its largest customers in its global bank increased more than 9% year over year. It doesn't hurt that one of its biggest competitors in retail and commercial banking, Wells Fargo, now expects that regulators won't allow it to grow its balance sheet until after 2019.
The story for Bank of America is the same one that has been playing out for years. The megabank has improved where it counts, delivering year-over-year revenue growth greater than expense growth for 16 consecutive quarters. As expenses have generally fallen and revenue has generally increased, Bank of America has emerged as exceptionally efficient. In 2018, the bank spent 58.5% of net revenue on operating expenses, down from 62.7% in 2017 and 69.4% as recently as 2015.
In short, Bank of America is finally realizing the advantages of being able to scale its expenses across a $2.4 trillion balance sheet, and Wall Street is happy to see that more of its top-line revenue is finally falling further down the income statement.