The Charles Schwab Corporation — Q3 2017 Form 10-Q
Business context and reporting period. Schwab provides wealth management, brokerage, banking, asset management, custody, and advisory services through Investor Services and Advisor Services. This unaudited quarterly report covers the three and nine months ended September 30, 2017; comparisons are with the corresponding 2016 periods unless noted. Amounts are in U.S. dollars.
Financial and operating performance
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Net revenues | $2.165 billion | $1.914 billion | $6.376 billion | $5.506 billion |
| Expenses excluding interest | $1.220 billion | $1.120 billion | $3.679 billion | $3.337 billion |
| Income before income taxes | $945 million | $794 million | $2.697 billion | $2.169 billion |
| Net income | $618 million | $503 million | $1.757 billion | $1.367 billion |
| Net income available to common stockholders | $575 million | $470 million | $1.630 billion | $1.268 billion |
| Diluted EPS | $0.42 | $0.35 | $1.21 | $0.95 |
| Pre-tax profit margin | 43.6% | 41.5% | 42.3% | 39.4% |
- Revenue mix: Q3 net interest revenue was $1.082 billion, up 28%; asset management and administration fees were $861 million, up 8%; trading revenue was $151 million, down 21%. For the first nine months, those amounts were $3.135 billion (+30%), $2.529 billion (+12%), and $500 million (-20%), respectively.
- Interest margin: Net interest margin was 2.00% for Q3 and 1.94% for the first nine months, versus 1.72% and 1.73% in 2016. Management attributed growth to higher short-term rates and increased interest-earning assets, including bank deposits.
- Client activity: Q3 net new client assets were $51.6 billion versus $30.0 billion; nine-month core net new assets were $136.7 billion versus $88.6 billion. Quarter-end client assets reached $3.181 trillion, up 17% year over year. Schwab opened 336,000 brokerage accounts in Q3; active accounts totaled 10.565 million.
- Cash flow: For the first nine months, operating cash flow was $1.828 billion, investing cash flow was negative $7.231 billion, and financing cash flow was $6.828 billion. Cash and cash equivalents ended at $12.253 billion, up from $10.828 billion at year-end 2016. The filing does not provide separate Q3 cash-flow totals.
- Balance sheet and funding: At September 30, total assets were $230.714 billion, total liabilities $212.687 billion, and stockholders’ equity $18.027 billion. Bank deposits were $165.263 billion. Short-term borrowings were $5.000 billion and long-term debt was $3.268 billion; long-term debt carried a weighted-average rate of 3.11%.
- Capital and liquidity: The consolidated Tier 1 leverage ratio was 7.7%, compared with 7.1% a year earlier. CSC and Schwab Bank were reported as well capitalized, and the company was compliant with the fully phased-in modified liquidity coverage ratio requirement. Available funding included a $750 million committed credit facility and $14.875 billion of Federal Home Loan Bank secured capacity, among other facilities.
Material changes versus comparable periods
- Q3 revenue grew 13% and nine-month revenue grew 16%; net income increased 23% and 29%, respectively. Expense growth was slower, at 9% and 10%, contributing to higher pre-tax margins.
- Net interest revenue benefited from higher rates, interest-earning asset growth, and migration of uninvested client cash into Schwab Bank. Client cash was 11.1% of client assets at quarter-end, down from 12.5% a year earlier.
- Trading revenue declined following 2017 commission cuts: standard equity, ETF, and option trade commissions fell from $8.95 to $4.95, and the per-contract option fee fell from $0.75 to $0.65. Average revenue per revenue trade declined 31% in Q3.
- Expenses increased with staffing, compensation, technology projects, asset-management-related costs, and FDIC assessments. Average full-time equivalent employees were up 5% for the nine-month period.
- In March 2017, $24.7 billion of securities were transferred from available-for-sale to held-to-maturity, primarily to reduce potential regulatory-capital volatility as consolidated assets approach the $250 billion threshold. Management said the transfer did not affect overall net interest margin.
Outlook, risks, contingencies, and unusual items
- Outlook: The filing provides no numerical earnings or revenue guidance. Management described client growth, multiple revenue sources, and expense discipline as supporting its business model.
- Interest-rate exposure: Modeling estimated that a gradual 100-basis-point rate increase would raise net interest revenue 5.2% over the next 12 months, while a 100-basis-point decrease would reduce it 8.3%. These simulations rely on uncertain assumptions and actual results may differ.
- Credit and concentration risks: The investment portfolio included $10.3 billion of corporate debt securities and commercial paper, 44% issued by financial-services institutions. The mortgage and HELOC portfolio had a 47% California concentration. Bank loans totaled $16.258 billion gross, with a $26 million allowance; nonperforming assets were $29 million.
- Legal matters: The company faces ordinary-course litigation and regulatory proceedings. A pending appeal in the Total Bond Market Fund litigation seeks unspecified damages and other relief; Schwab said it could not reasonably estimate potential liability. Management said it believes it has strong defenses. The filing reported no material changes to the risk factors in the 2016 Form 10-K.
- Accounting and tax items: Adoption of share-based compensation accounting guidance reduced tax expense by approximately $11 million in Q3 and $47 million for the first nine months. The company expected the 2018 revenue-recognition standard to affect timing of contract-acquisition costs and presentation of certain revenues, but did not expect a material financial-statement or EPS impact.
- Subsequent financing: On October 31, 2017, Schwab issued Series F preferred depositary shares and received $492 million net. It announced redemption of all Series B preferred stock on December 1, 2017, to be funded with the offering proceeds.
Most important facts for investors to verify
- Whether net interest revenue and margin growth can continue as rates, client cash balances, deposit costs, and asset mix change.
- How commission reductions affect trading activity, client growth, and revenue per trade over time.
- Whether expense growth remains below revenue growth while staffing and technology investment continue.
- The implications of the $24.7 billion securities reclassification and future crossing of the $250 billion consolidated-asset threshold for regulatory capital and AOCI.
- Updates on the pending Total Bond Market Fund appeal, other legal or regulatory matters, and potential losses not presently estimable.
- Execution and cost effects of the Series F issuance and Series B redemption, and subsequent changes in capital, liquidity, and preferred dividends.