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Schwab (SCHW) Ratings Affirmed by Moody's, Outlook Positive

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The Charles Schwab Corporation’s (SCHW - Free Report) ratings have been affirmed by Moody’s Investors Service, the rating arm of Moody’s Corporation (MCO - Free Report) . The outlook for the company has been upgraded to positive from stable.

Schwab’s senior unsecured debt rating has been affirmed at A2 and its commercial paper rating is P-1. However, the outlook for Schwab’s senior unsecured and preferred stock instrument ratings have been withdrawn by Moody's for business reasons.

Schwab’s initiatives to strengthen trading income position it well for the future. The company has a consistent long-term business strategy and has been successful in maintaining a stable leverage position over the past several years. These positives, along with the firm’s adherence to conservative financial policies, were the main reasons behind the rating affirmation.

Schwab has a diversified revenue stream, which benefits from management’s aggressive efforts to increase client base in advisory solutions. Despite increasing competition within the investment management industry, Schwab’s pre-tax margin  improved significantly over the past two years. This was primarily driven by rising equity market values, significant net inflows of client assets, higher net interest revenues as a result of increasing rates and significant increase in the amount of client cash balances swept into deposits at Schwab's bank subsidiaries.

Moody’s upgraded the outlook to positive as it believes that Schwab's stronger profitability, as well as its recent market share gains, could result in higher ratings if sustained over the outlook period.

Notably, Schwab does not rely much on transaction fees for revenues. Hence, according to Moody’s, any significant decline in asset management revenues, which is highly possible in the current competitive scenario as demand for passive products is increasing, will pose a greater credit threat to Schwab than reductions in commission.

Further, Schwab remains focused on a low-cost capital structure and targets to maintain a long-term debt-to-total financial capital ratio of less than 30%. Given the favorable capital position, management was able to continuously pay dividends. While the company was able to retain a significant proportion of its earnings to support balance sheet growth over the past few years, this increase might slow down in the next year as the deposit sweep program reaches full potential.

Moody’s stated that Schwab will be subjected to the Federal Reserve's enhanced prudential standards for the first time next year, because of its larger balance sheet. Per Moody’s, this enhanced supervision will likely be a positive for Schwab’s credit profile in the long run.

What Can Drive the Ratings Up?

Per Moody’s, Schwab’s ratings can be upgraded if the company’s pre-tax margin is sustained at over 42%, its debt to EBITDA on an adjusted basis remains below 1.7x and its retained cash flow less capex is above 30% of adjusted debt. Additionally, rating upgrade is possible if Schwab successfully maintains a conservative asset risk appetite, sustains the recent market share gains and complies with the Federal Reserve's enhanced prudential standards.

Reasons That Could Lead to a Downgrade

Schwab’s ratings could be downgraded if the company’s pre-tax margin or debt service capacity declines significantly, if there is a significant deviation from the firm's conservative financial policy or its long-term business strategy, if the asset risk appetite increases or if the franchise value deteriorates significantly.

Schwab’s shares have gained 16.3% over the past year, outperforming the industry’s growth of 6.3%.

Currently, Schwab carries a Zacks Rank #3 (Hold).

Stocks to Consider

A couple of better-ranked stocks from the finance space are First Mid-Illinois Bancshares, Inc. (FMBH - Free Report) and Horizon Bancorp, Inc. (HBNC - Free Report) .

Over the past 60 days, First Mid-Illinois Bancshares witnessed an upward earnings estimate revision of 3.7% for the current year. Its share price increased 7% in the last 12 months. The stock currently sports a Zacks Rank #1 (Strong Buy). You can see the complete list of today’s Zacks #1 Rank stocks here.

Horizon Bancorp presently carries a Zacks Rank #2 (Buy). Over the past 60 days, the company’s Zacks Consensus Estimate for the current year was revised 2.1% upward. Its share price increased 2.8% in the past year.

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