Charles Schwab Corporation — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Schwab provides brokerage, banking, asset management, custody, and advisory services through Investor Services and Advisor Services. Financial amounts below are in U.S. dollars; dollar figures are in millions unless noted.
Financial performance and position
| Metric | Q3 2018 | Prior-year comparison | Nine months 2018 | Prior-year comparison |
|---|---|---|---|---|
| Total net revenue | $2,579 | Up 19% | $7,463 | Up 17% |
| Net interest revenue | $1,527 | Up 41% | $4,197 | Up 34% |
| Expenses excluding interest | $1,360 | Up 11% | $4,111 | Up 12% |
| Income before taxes | $1,219 | Up 29% | $3,352 | Up 24% |
| Net income | $923 | Up 49% | $2,572 | Up 46% |
| Diluted EPS | $0.65 | Up 55% | $1.79 | Up 48% |
| Pre-tax profit margin | 47.3% | 43.6% | 44.9% | 42.3% |
- Revenue mix and drivers: Net interest revenue was the main growth engine, benefiting from higher interest rates and growth in interest-earning assets. Net interest margin rose to 2.33% for Q3 and 2.25% year to date, from 2.00% and 1.94%, respectively. Asset management and administration fees declined 6% in Q3 and 2% year to date, mainly due to transfers from money-market funds to bank sweep deposits, client allocation choices, and prior fee reductions. Trading revenue increased 17% in Q3 and 11% year to date as higher trade volumes more than offset lower commission pricing.
- Client activity: Quarter-end client assets were $3.56 trillion, up 12%; active brokerage accounts were 11.4 million, up 8%. Q3 core net new assets were $53.5 billion, up 4%, and new brokerage accounts totaled 369,000. Nine-month reported net new assets were $78.6 billion; core net new assets were $172.5 billion, including the exclusion of $93.9 billion of outflows from certain mutual-fund clearing clients.
- Cash flow: For the first nine months, operating activities provided $4,655; investing activities used $26,020; and financing activities provided $29,299. Financing included a $43,752 increase in bank deposits, offset in part by repayment of $15,000 in short-term borrowings and $579 of dividends paid. Cash, cash equivalents, and restricted cash at period end totaled $27,094; balance-sheet cash and cash equivalents were $21,830.
- Balance sheet and debt: Total assets were $272.1 billion, up from $243.3 billion at December 31, 2017. Bank deposits rose to $213.4 billion from $169.7 billion. Long-term debt was $5.79 billion, compared with $4.75 billion at year-end; short-term borrowings were zero, versus $15.0 billion at year-end. The company reported a 7.5% consolidated Tier 1 leverage ratio and stated that CSC and its bank subsidiary met applicable capital requirements and were well capitalized.
- Liquidity: Schwab reported no outstanding borrowings under its listed external facilities at quarter end, including a $750 million committed credit facility and $30.0 billion of FHLB secured borrowing capacity. The company was compliant with the modified liquidity coverage ratio rule.
Material changes versus comparable periods
- Growth in net interest revenue and lower income taxes drove earnings growth; expenses also increased to support client growth and technology and infrastructure investment.
- The effective tax rate fell to 24.3% for Q3 and 23.3% for the first nine months, versus 34.6% and 34.9% in 2017, primarily reflecting the Tax Act’s reduction in the federal corporate tax rate to 21%.
- Client cash declined to 10.3% of client assets from 11.1% a year earlier. Schwab transferred $23 billion from sweep money-market funds to bank sweep during Q3 and $68 billion during 2018 through quarter end.
- Q3 daily average revenue trades increased 22%, while average revenue per revenue trade declined 6%. Nine-month trade volumes rose 30%, while revenue per revenue trade declined 15%.
- Available-for-sale and held-to-maturity securities grew from year-end. At September 30, the portfolio had $3.9 billion of aggregate unrealized losses, including $3.6 billion on held-to-maturity securities; management reported no other-than-temporary impairment recognized in 2018 or 2017.
Outlook, management commentary, risks, and unusual items
- Management expected 2018 capital expenditures to be approximately 6–7% of total net revenue; spending was $417 million for the first nine months. Management also expected consolidated assets to remain above $250 billion in 2018, which would subject Schwab to the full liquidity coverage ratio rule in 2019.
- Management said the investment strategy is designed to benefit net interest revenue when rates rise and to be adversely affected when rates fall. Static simulations estimated a 4.1% increase or 4.7% decrease in next-12-month net interest revenue under a gradual 100-basis-point increase or decrease, respectively; actual results may differ.
- Risks highlighted include market and interest-rate conditions, client asset and cash levels, competitive pricing and deposit rates, client growth and retention, expense management, regulatory requirements, operational risks, and litigation or regulatory matters.
- A $15 million charge was recorded in Q1 2018 for unsecured client margin losses in volatility-related products. The Tax Act reduced the effective tax rate; the filing also describes a $46 million one-time non-cash tax charge recognized in Q4 2017.
- Schwab disclosed pending litigation, including a class action concerning order routing and litigation relating to the Schwab Total Bond Market Fund. It said it could not reasonably estimate potential liability for the described matters at their current stages. It also disclosed guarantees and indemnities, including clearinghouse arrangements for which potential liability is not quantifiable but payment was considered remote.
- After quarter end, the board authorized up to $1.0 billion of common-stock repurchases. On October 31, 2018, Schwab issued $1.1 billion of senior notes: $500 million due 2024 at 3.550% and $600 million due 2029 at 4.000%. The Federal Reserve and other agencies also proposed revised enhanced-prudential standards; Schwab expected to fall into Category III and was evaluating the proposals.
Important facts for investors to verify
- Whether higher rates and bank-sweep growth can continue to support net interest revenue as deposit costs rise and clients shift cash between products.
- Whether client asset gathering, account growth, and trading activity remain strong, and how client cash and clearing-client flows affect reported net new assets.
- Whether expense growth, planned capital spending, and the 2019 full liquidity coverage ratio requirements affect margins, liquidity, or capital.
- The potential effects of unrealized securities losses, credit-loss accounting adoption, and the proposed enhanced-prudential rules on capital and reported results.
- Developments and any financial exposure from the disclosed litigation, regulatory matters, and off-balance-sheet guarantees.
- Execution and funding of the new repurchase authorization and the post-quarter-end debt issuance.