Schwab Has 40% Upside: Bernstein

NEW YORK ( TheStreet) -- Short-term rates must rise eventually, which will mean a feast of fees for money market fund managers like Charles Schwab ( SCHW).

Bernstein Research analyst Brad Hintz on Monday said in a report that Schwab could "generate ~$2 per share in normalized earnings, considerably more than the $0.74/share we expect the company to earn in 2013," once interest rates begin to rise.

The Federal Reserve has the kept short-term federal funds rate in a range of between zero and 0.25% since late 2008. This is not only squeezing net interest margins for banks, it is forcing money market fund managers like Schwab to waive management fees, in order to keep the money fund rates from dropping below zero.

Hintz on Monday upgraded Schwab to an "outperform" rating, while raising his price target for the shares to $23 from $15. The new price target implies 40% upside from the stock's closing price of $16.40 on Friday.

Schwab earned $928 million, or 69 cents a share, in 2012, compared to $864 million, or 70 cents a share, in 2011. Money market fee waivers lowered the company's revenue by $587 million in 2012, after lowering revenue by $568 million the previous year. Net interest revenue for 2012 was $1.764 billion, increasing from $1.725 billion in 2011.

Net interest revenue grew, despite a decline in average yield to 1.62% in 2012 from 1.81% in 2011, because average interest-earning assets grew 14% year over year, to $108.6 billion in 2012. The average yield for the fourth quarter was just 1.49%.

When detailing his estimate for roughly $2 a year in "normalized earnings," Hintz wrote that "revenue upside is driven by net interest margin expansion and the reinstatement of money market fees, along with an increase in trading volumes and asset management fees when the retail investor returns to the market." The analyst added that "the firm should be able to translate 75-80% of incremental revenues to pre-tax income due to the operating leverage inherent in its business model."

Hintz called Schwab an "early cycle interest rate play," saying that "net interest margin expansion presents the largest earnings power normalization opportunity as the company should be able to re-price its interest earning assets faster and to a greater extent than its interest bearing liabilities when rates rise." The analyst estimates that over the long term, Schwab's net interest margin could climb to 3.5% net interest margin, "resulting in an incremental $2.6bn of revenues."

The waiver of money market fees could disappear completely with an increase in the federal funds rate of just 100 basis points, according to Hintz.

"Future revenues should also get a boost from the typical late cycle rebound in retail activity" among investors, Hintz said. "Our analysis of prior recoveries indicates that trading volumes and asset management fees should rebound, leading to a ~$190mm/year increase in revenues."

Bernstein's rating of an aggressive price target for Schwab obviously represents a long-term stock play, and there is no way to predict when the Fed will begin to increase short-term rates. But it will happen. They can't go any lower.

Hintz also pointed out that Schwab's "client assets are up 77% while the stock price has only increased 2%" since 2008. The analyst expects Schwab to continue adding client assets, "between 4% - 6% per year (including the reinvestment of dividends and interest income) through the end of the decade."

Schwab's shares were up 1.13% in early trading on Monday, to $16.58

SCHW Chart SCHW data by YCharts

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-- Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for TheStreet.com Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.