Business context and reporting period
The Charles Schwab Corporation’s Form 10-K covers the fiscal year ended December 31, 2011. Schwab provides brokerage, banking, investment-advisory, retirement-plan, and related services through Investor Services and Institutional Services. At year-end, it reported $1.68 trillion in client assets, 8.6 million active brokerage accounts, and 780,000 banking accounts.
The filing also reports fourth-quarter 2011 results. Amounts below are in U.S. dollars; financial statement amounts are generally in millions unless noted.
Financial performance and condition
| Metric | 2011 | 2010 |
|---|---|---|
| Net revenues | $4.691 billion | $4.248 billion |
| Income before taxes | $1.392 billion | $779 million |
| Net income | $864 million | $454 million |
| Diluted EPS | $0.70 | $0.38 |
| Pre-tax profit margin | 29.7% | 18.3% |
| Operating cash flow | $2.464 billion | $(9) million |
| Capital expenditures | $190 million | $127 million |
| Year-end total assets | $108.553 billion | $92.568 billion |
| Year-end stockholders’ equity | $7.714 billion | $6.226 billion |
| Year-end long-term debt | $2.001 billion | $2.006 billion |
- Revenue mix in 2011: asset-management and administration fees $1.928 billion; net interest revenue $1.725 billion; trading revenue $927 million; and other revenue $160 million. Money-market fund fee waivers reduced fees by $568 million, versus $433 million in 2010.
- Annual net interest margin, as reported through net interest revenue divided by average interest-earning assets and funding structure, was 1.81%, compared with 1.93% in 2010. Net interest revenue rose 13% as average interest-earning assets grew, but low rates and mortgage-security premium amortization constrained results.
- Year-end cash and cash equivalents were $8.679 billion. Banking-client deposits were $60.854 billion, up from $50.590 billion; brokerage-client payables were $35.489 billion. Much of the cash and investments reported as segregated is held for clients and is not freely available for general corporate use.
- Long-term debt was 21% of total financial capital, below management’s stated long-term target ceiling of 30%. Schwab Bank was classified as well capitalized; CSC’s Tier 1 leverage ratio was 6.3%.
- Fourth-quarter revenue was $1.113 billion, net income $163 million, and diluted EPS $0.13, versus $1.127 billion, $119 million, and $0.10, respectively, in Q4 2010.
Changes versus the prior comparable period
- Revenue increased 10% and net income increased 90% year over year. All major revenue sources rose: fees increased 6%, net interest revenue 13%, and trading revenue 12%.
- Expenses excluding interest fell 5% to $3.299 billion. The comparison benefited from $482 million of significant 2010 charges, including YieldPlus litigation and regulatory reserves, money-market-fund losses, and the credit-card program termination. Meanwhile, compensation and benefits rose 10%, and professional-services expense rose 13%.
- Client assets increased 7% to $1.678 trillion. Net new client assets were $145.9 billion, including $56.1 billion from a mutual-fund-clearing client and $7.5 billion from optionsXpress; core net new assets, excluding significant one-time flows, were $82.3 billion versus $78.1 billion in 2010. Daily average client trades increased 13% to 451,100.
- The September 2011 optionsXpress acquisition cost $714 million, principally paid in Schwab shares. It contributed $68 million of revenue after acquisition through year-end; its net loss for that period was not material. The acquisition added $507 million of preliminary goodwill.
- Operating cash flow improved from $(9) million to $2.464 billion, while financing cash flow was $9.951 billion and investing cash flow was $(8.667) billion. Cash flows reflect substantial client-balance, deposit, and securities activity and should not be read like those of a nonfinancial company.
Outlook, commentary, risks, and unusual items
- Management described 2011 as a challenging market year, with volatility, lower valuations, and further declines in interest rates. It warned that persistently low rates could constrain net interest revenue and require continued or increased money-market fee waivers.
- Management expected 2012 capital expenditures to be approximately 30% below 2011’s $190 million, subject to change with business conditions. It targeted common dividends at approximately 20%–30% of net income; the Board retains discretion over dividend payments.
- On January 26, 2012, Schwab issued $400 million of Series A perpetual preferred stock and received $394 million net proceeds. The stock pays a 7% fixed dividend through 2022, then a floating rate; the proceeds are for general corporate purposes. Preferred-dividend terms can restrict common dividends and repurchases if the preferred dividend is not paid or set aside.
- Non-agency residential mortgage-backed securities continued to deteriorate. Schwab recorded $31 million of 2011 impairment losses, and further underlying-loan deterioration could cause additional charges. The company was pursuing lawsuits concerning 51 such securities; in January 2012, the court allowed claims concerning all but four to proceed to discovery.
- Other legal matters include the appeal of dismissal of the New York Attorney General’s auction-rate securities complaint; an appeal in the Schwab Total Bond Market Fund litigation, whose remaining claims had been dismissed with prejudice; and optionsXpress regulatory matters under discussion with regulators. The optionsXpress contingent liability was reported as not material at year-end. The YieldPlus settlement received final approval in 2011; the company recorded $199 million of 2010 charges net of insurance proceeds.
- Regulatory risks include new capital and leverage requirements under Dodd-Frank and CSC’s new Federal Reserve oversight. Principal business risks also include interest-rate and market movements, client cash outflows, credit and mortgage exposure, litigation, pricing competition, technology or vendor failures, and the possibility of support to sponsored funds.
Important facts for investors to verify
- Whether the strong 2011 earnings comparison persists after excluding the unusually large 2010 charges, and how recurring costs and acquisition integration affect margins.
- The trajectory of money-market fee waivers, net interest revenue, interest-rate spreads, and mortgage-security premium amortization.
- OptionsXpress integration, realized cost or revenue synergies, and final purchase-price allocation and goodwill.
- Credit performance and concentration in non-agency mortgage securities, California mortgage and HELOC exposures, and the adequacy of impairment and loan-loss assumptions.
- Potential outcomes and reserves for securities-related litigation and optionsXpress regulatory matters, plus the impact of evolving Dodd-Frank capital rules.
- Availability of parent-company liquidity after accounting for client-segregated funds, subsidiary regulatory restrictions, debt maturities, and the preferred stock’s dividend terms.