Our article on Charles Schwab SCHW 0.00 on Sunday morning was 3,400 words long. It could have been 13,400 words. Many angles we couldn't cover simply due to time and space constraints. Another we missed while trying to navigate a complex story in a relatively short amount of time.

Engagement on the piece has been high, and a number of subscribers have joined me in going long the stock

The angle we missed was not better covering the downside risk to SCHW assuming insolvency is not a material possibility. The argument from bears is that, even as a going concern, the balance sheet is ugly, which is true. For instance, Schwab has $159 billion (fair value) in securities that mature more than a decade from now. In other words, just because Schwab isn’t going the same way as SVB doesn’t automatically make it a buy.

source: Finviz.com

But it’s worth reiterating a point from Sunday, perhaps more succinctly. It’s an important point not just for SCHW, but all of the stocks being impacted by the SVB bank run and the Signature failure: as far as the balance sheets go, nothing that has come out is new information.

Investors and analysts in the space knew about the impact of unrealized losses on the earnings of regional banks, Schwab, and others. Clearly, they did not forecast a run on SVB, but the simple math of adjusting tangible equity for unrealized bond losses is, you know, simple.

Analysts knew about the long-dated side of the portfolio when modeling years of double-digit EPS growth going forward (driven in large part by older assets rolling off and being replaced by higher-yield instruments). Schwab knew about it when it modeled net interest margin roughly doubling between 2021 and 2025. It’s possible Schwab and those covering it were wrong, certainly, but that risk seems mitigated by a 26% decline since Wednesday’s close. More broadly, it’s not that hard to model some upside in NIM and profits given the upper bound created by the zero-rate environment in a year like 2021 (when adjusted EPS when $3.25).

What’s Changed?

So to quantify the downside, what we’re really looking for (for SCHW and other impacted names) is what has changed since Wednesday. To be fair, there are some possibilities.

One is an acceleration of “cash sorting”, in which Schwab customers move cash to get better yield, if only because of the latest publicity surrounding yields and duration. This in turn requires Schwab to either liquidate its near-term portfolio — or potentially borrow more, which isn’t cheap. In 2022, for instance, borrowings from the Federal Home Loan Bank carried a weighted average interest rate of 4.88%.

In a worst-case scenario, Schwab might be forced to raise capital. Scuttleblurb, an excellent and experienced analyst, dove into this possibility on Sunday, and concluded the odds were relatively thin

Scuttleblurb floated the idea (as did we) that a simple preferred stock issuance to Berkshire Hathaway could probably fix any concerns. Such an issuance wouldn't be ideal, but it's worth remembering that the raised capital would itself bring in some profit, since Schwab could invest the proceeds in Treasuries (which have a 0% risk weighting).

The second change is that Treasury yields have plunged, bringing down the forward curve. That in turn reduces the improvement in NIM that Schwab was modeling less than two months ago.

That said, the move isn’t that severe; the curve actually had moved in Schwab’s favor until last week. Since the time of the model (Jan. 3), the 2-year Treasury yield is down 20 basis points and the 3-year 13 bps. Again, we’re talking a 28% decline here. That aside, lower Treasury yields actually help the balance sheet in terms of unrealized losses and the price that would be achieved if Schwab had to liquidate bonds with shorter maturities to meet withdrawals. Net/net, the impact here seems relatively muted.

Third, Schwab’s credibility has simply been dinged. It made the same mistake as SVB, taking on duration risk long term in exchange for higher near-term profits. Schwab CEO Walt Bettinger had an interview on CNBC on Tuesday, and over on Twitter, Siyu Li raised some questions about what Bettinger had to say.

Siyu Li @siyul

interview w/ $SCHW ceo He: ❌makes untrue claim: “That’s why we don’t go out a long way in terms of duration..." (see table👇) ❌ plays victim game: "investors confused FDIC with SPIC/confused our biz with reg banks". No, e.g. $IBKR wasn't down cnbc.com/2023/03/14/cha…

8:50 PM ∙ Mar 14, 2023

He’s not wrong in doing so. Bettinger appears to have been talking to his customers more than his shareholders. He did disclose a large insider buy but it’s fair to wonder if part of our argument (that investors are getting a wonderful business at this lower price) is dented by concerns around Schwab’s management over the past few quarters.

These concerns are real, but still seem acceptable in the context of valuation and the mid-term opportunity for margin improvement when and if the environment improves.

At Tuesday’s close of $57, Schwab EPS probably needs to dip below ~$2 for investors to get hurt. (In the right market, even that might not be low enough; investors might reasonably apply a mid- to high-20s multiple, believing that NIM expansion has simply been delayed.)

EPS below $2 requires a combination of all these factors: a lower forward curve, higher funding costs, maybe some dilution, perhaps another management misstep. Again, we’re talking earnings down ~40% from 2021, when NIM was less than half what it was in the normalized rate environment of the 2000s. And, again, there are some internal hedges within those factors (lower near-term yields lower the incentive for cash sorting, for instance).

It’s possible those factors converge, earnings decline, and investor confidence plunges. It’s possible near-term volatility continues, and that we’re right but early. We (and I) remain comfortable with those risks. Schwab’s update on Monday morning provides more confidence. Though it appears results were disappointing relative to Street expectations, Schwab expects Q1 revenue to increase roughly 10% year-over-year. The midpoint of profit margin guidance suggests earnings per share should climb about 13%. Barring a sea change, the profit trajectory still looks attractive given current valuation. As a result, we continue to believe Schwab is a good long term bet.

Closing Harley-Davidson

In other news... I closed my short of Harley-Davidson HOG 0.00 on Tuesday and we will close it in our performance sheet as well. The trade was more a single than a home run: HOG is down 4.5% since publication, eight points better than a long position in the S&P 500 and a modest outperformance relative to a short of the index.

In this market, there’s nothing wrong with singles. And at this point HOG probably suffers primarily from the “better opportunities elsewhere” argument.

Longer-term, we still think the short case has merit. The Harley brand has likely peaked. The company no doubt was a pandemic winner, as were most manufacturers of big-ticket, outdoor items. (Recreational vehicle and boat sales of course soared as well.) Financing profits are coming down, and the LiveWire LVWR 0.00 spin-off seems likely to be a bust.

But, like peers in boats and RVs, to this point results have held up well. Harley posted a strong Q4, with results that crushed analyst expectations. The company guided for revenue growth in 2023 and improved operating margin, leading HOG stock sharply higher. LVWR, though down 33% from its merger price, has also held up better than we expected. (There would be a case for shorting the spin-off, but cost to borrow is about 140%.)

With shares crashing in recent weeks, we’ll cover and take the small win for now, while acknowledging the possibility that Harley’s reckoning has simply been delayed, not avoided.

As of this writing, Vince Martin is long shares of Charles Schwab.

Disclaimer: The information in this newsletter is not and should not be construed as investment advice. Overlooked Alpha is for information, entertainment purposes only. Contributors are not registered financial advisors and do not purport to tell or recommend which securities customers should buy or sell for themselves. We strive to provide accurate analysis but mistakes and errors do occur. No warranty is made to the accuracy, completeness or correctness of the information provided. The information in the publication may become outdated and there is no obligation to update any such information. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Contributors may hold or acquire securities covered in this publication, and may purchase or sell such securities at any time, including security positions that are inconsistent or contrary to positions mentioned in this publication, all without prior notice to any of the subscribers to this publication. Investors should make their own decisions regarding the prospects of any company discussed herein based on such investors’ own review of publicly available information and should not rely on the information contained herein.