CHICAGO--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings of Charles Schwab Corporation (Schwab) at 'A/F1'. The Rating Outlook is Stable. A complete list of ratings is included at the end of this press release.
KEY RATING DRIVERS - IDR and Senior Debt:
The rating affirmation reflects Schwab's leading market position in the retail brokerage space, increasing earnings diversity, strong operating leverage and margins associated with its business model, and appropriate cash flow and balance sheet leverage metrics. Rating constraints include the cyclicality of the business model and the potential for competition and/or operational risks.
Over the past several years, Schwab has continued to evolve its business model away from pure trading commissions and more toward a full service financial firm catering to the needs of the mass affluent and mass market retail investors. This includes a strong focus on asset/wealth management products and banking products and away from traditional trading products.
Fitch believes this has enhanced Schwab's overall franchise by improving wallet share with customers. It has helped to create sticky, profitable and long-term relationships with its clients that now afford Schwab increased opportunities to capture incremental revenue through cross-selling.
Schwab's key value proposition to its clients is one of offering a myriad of low cost products to its client base with good customer service. Schwab seeks to achieve this through significant investments in technology to streamline operations and improve customer interfaces. Fitch views this approach very positively from a credit perspective, and notes that the strength of Schwab's franchise support's today's
rating action and is a key differentiator in its ratings compared to peers.
Over the last year, Schwab has benefited from continued growth in asset management and other fee revenue, which constituted 48% of the company's revenue at year-end 2014. Similarly, despite the low short-term interest rate environment, Schwab has utilized deposit growth at Schwab Bank to boost net interest income (NII) over the last year. NII accounted for 38% of the company's revenue at year-end 2014.
Additionally, given higher markets in 2014, trading revenue remained good, but Schwab continues to use discounted trading as a subsidized marketing tool to help gather new assets. Lastly, Fitch continues to believe there is more earnings upside for Schwab given its positive sensitivity to higher short-term interest rates. This is due to relatively short duration investments which should reprice more quickly than deposits in a higher short-term interest rate environment. At certain points in the interest rate cycle, this could drive NII to as much as 55% of overall revenue and also significantly boost the company's profit margin and ROE, although this would be viewed as a cyclical dynamic rather than a structural one.
Schwab's revenue growth as well as a continued focus on managing growth in expenses led to higher net income of $1.3 billion in 2014 which translated to a 12% return on average common equity (ROE), a 100 basis point improvement relative to the prior year.
This has also led to an improvement in leverage metrics. At the end of 2014, Schwab's adjusted debt to earnings before interest, depreciation and amortization (EBITDA) declined 0.76x from 0.91x in 2013, which compares favorably to similarly rated entities. Including Schwab's recent $1 billion senior unsecured issuance, whose proceeds will largely be held in high quality liquid assets (HQLA) comprised of treasury securities, Schwab's Fitch calculated pro forma adjusted debt-to-EBITDA metric of 1.16x is still compares well to other similarly rated entities. Fitch also views positively that Schwab's Tier 1 Leverage ratio increased to 6.9% as of YE2014, up from 6.4% at YE2013.
RATING SENSITIVITIES - IDRs and Senior Debt:
As Schwab's business model continues to evolve away from pure trading to a mix of net interest income, asset management earnings, and trading earnings, there could be some modest upside to ratings should Fitch observe greater revenue stability through various market cycles, combined with sustained capital and liquidity levels.
Fitch believes the most significant rating risk is a large operational loss specific to Schwab that causes clients to flee the firm. Operational losses are inherently difficult to predict and measure and do serve as an upwards rating limitation. With the expanding lending platform, underwriting discipline and asset quality are also increasingly important rating drivers. An additional risk that could impact ratings over time is the growth of Schwab Bank. Should the company begin to reach for yield in its investment portfolio such that it increases the credit or interest rate risk profile of the balance sheet, ratings or the Rating Outlook could come under pressure.
Finally, Schwab does derive some revenue from payment for order flow, which is akin to receiving rebates from directing client trades to a certain market makers. While this may provide more efficient execution for clients, given current industry scrutiny that may lead to regulatory changes. Fitch believes it is possible that Schwab could have to adjust its routing practices..
Fitch believes that to the extent there is any potential outsize monetary or reputational implications from this industry scrutiny described above it could adversely affect the ratings.
KEY RATING DRIVERS - Support Ratings and Support Floor Ratings:
Schwab has a support rating of '5' and a support floor rating of 'NF' indicating that support is unlikely.
RATING SENSITIVITIES - Support Ratings and Support Floor Ratings:
To the extent that Fitch's views on the perceived likelihood of extraordinary support being extended to Schwab change, there could be a change in the support and support floor ratings. At this juncture it is not anticipated.
KEY RATING DRIVERS - Subordinated Debt and Other Hybrid Securities:
Schwab has a preferred stock rating of 'BB+', which is five notches below its IDR given its position in the capital structure and potential for non-performance compared with other issuances. This includes two notches for non-performance and three notches for loss absorbing capacity.
RATING SENSITIVITIES - Subordinated Debt and Other Hybrid Securities:
Ratings for Schwab's preferred stock are notched five notches from the IDR based on Fitch's treatment of preferreds in bank capital as this source of capital for Schwab has historically been down streamed to support its banking operations. As such, changes in ratings on the preferred stock are primarily sensitive to any change in the IDR, where the existing notching would be maintained in conjunction with any change in the IDR, at least for so long as the IDR is investment grade.
Fitch has affirmed the following ratings:
Charles Schwab Corporation:
--Long-term IDR at 'A'; Outlook Stable.
--Short-term IDR at 'F1';
--Senior unsecured notes at 'A';
--Short-term debt at 'F1';
--Preferred stock at 'BB+';
--Support at '5';
--Support floor at 'NF'.
Additional information is available at www.fitchratings.com.
Applicable Criteria and Related Research:
--'Global Financial Institutions Rating Criteria' (Jan. 31, 2014);
--'Securities Firms Criteria' (Jan. 31, 2014);
--'Assessing and Rating Bank Subordinated and Hybrid Securities' (Jan. 31, 2014);
--'Rating FI Subsidiaries and Holding Companies' (Aug. 10, 2012);
--'The Evolving Dynamics of Support for Banks' (Sept. 11, 2013);
--'Bank Support: Likely Rating Paths' (Sept. 11, 2013);
--'Sovereign Support for Banks: Update On Position Outlined In 3Q13' (Dec. 10, 2013);
--'U.S. Bank HoldCos & OpCos: Evolving Risk Profiles' (March 2014).