Business context and reporting period
The Charles Schwab Corporation is a financial services holding company with Investor Services and Advisor Services segments. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2016; comparisons are with the same periods in 2015 unless otherwise noted. Financial amounts are in millions except per-share data and client-asset measures.
Financial and operating performance
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Net revenue | $1,828 | $1,566 | $3,592 | $3,092 |
| Expenses excluding interest | $1,108 | $999 | $2,217 | $2,041 |
| Income before taxes | $720 | $567 | $1,375 | $1,051 |
| Net income | $452 | $353 | $864 | $655 |
| Net income available to common stockholders | $406 | $330 | $798 | $621 |
| Diluted EPS | $0.30 | $0.25 | $0.60 | $0.47 |
| Pre-tax profit margin | 39.4% | 36.2% | 38.3% | 34.0% |
| Net interest revenue | $798 | $612 | $1,570 | $1,200 |
| Net interest margin | 1.73% | 1.60% | 1.73% | 1.60% |
Q2 revenue rose 17%, while expenses rose 11%; first-half revenue increased 16% and expenses 9%. Management attributed growth principally to client growth and the December 2015 Federal Reserve rate increase. Net interest revenue benefited from larger investment-security balances and higher yields. Asset management and administration fees increased 13% in Q2, reflecting higher money-market fund net yields; trading revenue was nearly flat, as more trades were offset by lower average revenue per trade.
Operating indicators included $26.6 billion of net new client assets in Q2 and $58.6 billion for the first half. Client assets reached $2.622 trillion, up 3% year over year; active brokerage accounts rose 4% to 9.977 million. First-half return on average common equity was 13%, versus 11% in 2015. The effective tax rate was 37.2% for Q2 2016, compared with 37.7% in Q2 2015.
Cash flow, balance sheet and capital
For the first half, operating cash flow was $1.523 billion, compared with cash used of $737 million in 2015; investing cash outflow was $13.834 billion, and financing cash inflow was $13.309 billion. Cash and cash equivalents were $12.976 billion at June 30, 2016.
Total assets were $198.052 billion, up from $183.705 billion at year-end 2015. Bank deposits were $137.295 billion, including $116.024 billion swept from brokerage accounts. Total liabilities were $183.062 billion and stockholders’ equity was $14.990 billion. Long-term debt was $2.876 billion; short-term borrowings were $5.0 billion, drawn under Schwab Bank’s Federal Home Loan Bank facility. CSC reported a 7.2% Tier 1 leverage ratio and Schwab Bank 7.1%; Schwab Bank was categorized as well capitalized.
Material changes and management commentary
- Advisor Services revenue increased 31% in both Q2 and the first half, with higher net interest revenue the main driver. Investor Services revenue increased 12% in Q2 and 11% for the first half.
- Higher expenses reflected business investment, increased headcount, technology and outsourced-service costs, occupancy, and advertising. Management said it would retain flexibility to balance near-term profitability with long-term growth as market conditions evolve.
- The default sweep option for uninvested cash in new brokerage accounts became Schwab Bank beginning in June 2016. Management also expected planned bulk transfers of brokerage cash to Schwab Bank later in 2016; the FHLB borrowing was described as temporary support pending those transfers.
- The company issued $725 million net proceeds of Series D preferred stock in March and raised the quarterly common dividend 17%, to $0.07 per share. No share repurchases were made in Q2; approximately $596 million remained authorized.
Outlook, risks and contingencies
No specific earnings or revenue guidance was provided. Management expects net interest revenue generally to benefit from rising short-term rates and to decline if rates fall; its simulation estimated a 9.1% increase in net interest revenue over the next 12 months with a gradual 100-basis-point rate increase, and a 10.7% decrease with a 100-basis-point decline. These are scenario estimates, not forecasts, and assume the balance sheet remains unchanged.
Key exposures include interest-rate and market risk, competition affecting rates and fees, client asset values and cash balances, and the ability to attract clients and manage expenses. The investment portfolio included $88.3 billion of mortgage-backed securities and $21.8 billion of asset-backed securities. Some FFELP asset-backed securities were under rating-agency review for possible downgrade, although management said guarantees and credit enhancement supported its expectation of full payment. About 79% of the $2.582 billion HELOC portfolio was in second-lien positions; 48% of the mortgage and HELOC portfolio was concentrated in California.
The proposed net stable funding ratio rule’s impact was not yet assessable. The company expected the final Department of Labor fiduciary rule not to have a material impact, and anticipated a net FDIC assessment increase of about 2 to 2.5 basis points annually beginning in Q3 2016 through approximately 2018. The filing identifies ongoing litigation and regulatory matters, including the Schwab Total Bond Market Fund litigation on appeal and an optionsXpress Regulation SHO proceeding under appeal; potential material loss estimates for significant matters were generally unavailable. Management reported no material risk-factor changes from the 2015 Form 10-K and no change in critical accounting estimates in the first half.
Important facts for investors to verify
- Whether higher interest rates, client cash-sweep growth, and planned bulk transfers continue to support net interest revenue without materially raising funding costs.
- Whether client asset flows and asset values sustain fee growth, particularly given the Q2 decline in net new assets versus 2015.
- Whether expense growth remains below revenue growth as the company invests in staffing, technology, and growth initiatives.
- Developments in the FFELP securities rating review, mortgage and HELOC credit quality, California concentration, and second-lien exposure.
- Actual costs and implementation effects of the FDIC assessment and other pending regulatory requirements, as well as developments in the disclosed litigation.