The Charles Schwab Corporation — Q3 2012 Form 10-Q
Business and period: Schwab is a savings and loan holding company providing brokerage, banking, investment management and related services. This unaudited filing covers the quarter and nine months ended September 30, 2012; comparisons are with the corresponding 2011 periods unless noted. Dollar amounts are in millions except per-share data.
Financial performance
| Metric | Q3 2012 | Q3 2011 | Nine months 2012 | Nine months 2011 |
|---|---|---|---|---|
| Total net revenues | $1,196 | $1,181 | $3,668 | $3,578 |
| Expenses excluding interest | $835 | $821 | $2,562 | $2,438 |
| Income before tax | $361 | $360 | $1,106 | $1,140 |
| Net income | $247 | $220 | $717 | $701 |
| Net income available to common shareholders | $238 | $220 | $694 | $701 |
| Diluted EPS | $0.19 | $0.18 | $0.54 | $0.57 |
| Pre-tax margin | 30.2% | 30.5% | 30.2% | 31.9% |
| Net interest revenue | $439 | $443 | $1,331 | $1,330 |
| Trading revenue | $204 | $248 | $666 | $694 |
| Asset management and administration fees | $524 | $466 | $1,504 | $1,470 |
- Q3: Revenue rose 1% and net income rose 12%; diluted EPS increased 6%. Fee growth, especially mutual fund and advice-solutions fees, largely offset lower trading revenue. The lower tax expense included a nonrecurring $20 million state tax benefit.
- Nine months: Revenue increased 3%, but pre-tax income declined 3% and diluted EPS fell 5%. Results included a $70 million pre-tax gain from a confidential vendor-dispute resolution in Q2; net impairment losses on securities were $28 million versus $22 million in 2011.
- Daily average trades were 402,400 in Q3, down 15%; daily average revenue trades were down 19%. Quarter-end client assets were a record $1.89 trillion, up 20% year over year. Q3 net new client assets were $20.4 billion, including $1.3 billion of outflows related to optionsXpress subsidiary closures or sales; excluding significant one-time flows, net new assets were $21.7 billion.
Financial position, cash flow and capital
- At September 30, 2012, total assets were $117.7 billion, up from $108.6 billion at year-end 2011; stockholders’ equity was $9.5 billion, including $864 million carrying value of preferred stock. Cash and cash equivalents were $8.5 billion.
- Banking-client deposits increased to $68.8 billion from $60.9 billion; long-term debt declined to $1.8 billion from $2.0 billion. The company reported debt at 16% of total financial capital, versus 21% at year-end 2011, and a weighted-average debt rate of 4.73%.
- For the first nine months, operating cash flow was $373 million, compared with $2.0 billion in 2011; investing cash outflow was $8.8 billion and financing cash inflow was $8.3 billion. Cash decreased $156 million. Cash-flow movements were substantially affected by investment purchases and changes in regulatory-segregated balances, client receivables/payables and bank deposits.
- Schwab Bank was classified as well capitalized: Tier 1 risk-based capital ratio 21.7%, total risk-based ratio 21.9%, and Tier 1 leverage ratio 7.5%. CSC’s Tier 1 leverage ratio was 6.9%, against its stated target of at least 6%.
- Liquidity included an unused $800 million committed CSC credit facility, $2.8 billion available through the Federal Reserve discount window and $4.9 billion available through the Federal Home Loan Bank facility. The filing states that client-regulatory segregated funds are not available for general liquidity.
Material changes and unusual items
- Fee revenue increased 12% in Q3, while trading revenue declined 18%; net interest revenue was broadly flat as larger earning-asset balances offset lower spreads in the low-rate environment.
- Expenses rose 2% in Q3 and 5% for the first nine months, partly reflecting optionsXpress. Depreciation and amortization increased 28% in Q3 and 36% year to date, mainly from acquired intangible assets.
- CSC issued Series A and Series B perpetual preferred stock in January and June, receiving net proceeds of $394 million and $469 million, respectively. Preferred dividends reduced income available to common shareholders by $9 million in Q3 and $23 million year to date.
- In August, CSC exchanged $256 million principal amount of 4.950% notes due 2014 for 3.225% notes due 2022 and paid $19 million cash consideration. It also redeemed trust preferred securities and associated junior subordinated notes for $207 million.
- Capital expenditures were $98 million for the first nine months. Management expected full-year 2012 capital expenditures to be approximately 20% below 2011, revising its earlier expectation of a 30% reduction because of higher software and technology spending.
Outlook, risks and contingencies
- The filing gives no specific earnings or revenue guidance. Management said a prolonged low-rate environment could continue to constrain net interest revenue and money-market-fund fees; Schwab continued waiving some fund management fees where yields were at or below fees.
- A gradual 100-basis-point rate increase was modeled to raise 12-month net interest revenue by 20.7%; a 100-basis-point decrease was modeled to reduce it by 9.7%. These are simulations, not forecasts, and depend on assumptions including unchanged balance-sheet structure.
- Non-agency mortgage-backed securities remain exposed to underlying mortgage deterioration. Schwab recorded $3 million of Q3 and $28 million of year-to-date net impairment losses and cautioned that further deterioration could cause additional charges. Management said it did not intend, and was not likely required, to sell the securities before expected recovery.
- Bank lending exposure included $6.0 billion of residential mortgages and $3.3 billion of HELOCs. About 78% of HELOC balances were second lien; 44% of mortgage balances and 50% of HELOC balances were secured by California properties. Delinquencies were 0.90% of loans, versus 0.81% at year-end; nonaccrual loans were $46 million.
- Material matters disclosed include the New York Attorney General’s appeal in the auction-rate securities case; an appeal in the Total Bond Market Fund litigation; and two SEC administrative proceedings involving optionsXpress. A contingent liability for the optionsXpress matters was recorded but was not material at quarter-end. The filing says potential losses in certain matters cannot yet be reasonably estimated.
- Proposed Federal Reserve capital rules implementing Dodd-Frank and aligning rules with Basel III were under evaluation; management did not expect a material impact, while noting the proposals remained subject to change. The filing reported no material change to previously disclosed risk factors.
Important facts for investors to verify
- Whether client-asset growth and fee revenue can offset persistently weak trading activity and low interest-rate spreads.
- The sustainability of earnings after excluding the $70 million vendor-settlement gain and $20 million state tax benefit, and accounting for preferred dividends.
- Mortgage-backed securities impairment assumptions, including projected defaults and recoveries, and any subsequent changes in credit performance.
- Loan-credit trends, especially California and second-lien HELOC exposure, delinquency rates and future HELOC conversion to amortizing repayment.
- Developments in the disclosed litigation and optionsXpress regulatory proceedings, as well as the final effect of new capital rules and 2012 capital spending.