Charles Schwab Corporation — Q2 2013 Form 10-Q
Reporting period: Three and six months ended June 30, 2013; comparisons are with the corresponding 2012 periods unless noted. Amounts are in USD millions except per-share data and where otherwise indicated. The filing is unaudited.
Business context and reporting period
Schwab provides securities brokerage, banking, money management, and financial advisory services through its Investor Services and Advisor Services segments. In Q1 2013, the company realigned its reporting segments; prior-period segment data was recast.
At quarter-end, client assets were $2.051 trillion, up 14% year over year. The company added 243,000 brokerage accounts in Q2, up 10%, and had 8.962 million active brokerage accounts, up 3%.
Key financial metrics
| Metric | Q2 2013 | Q2 2012 | First half 2013 | First half 2012 |
|---|---|---|---|---|
| Total net revenues | $1,337 | $1,283 | $2,627 | $2,472 |
| Net interest revenue | $473 | $458 | $942 | $892 |
| Income before taxes | $412 | $432 | $743 | $745 |
| Net income | $256 | $275 | $462 | $470 |
| Net income available to common stockholders | $233 | $261 | $431 | $456 |
| Diluted EPS | $0.18 | $0.20 | $0.33 | $0.36 |
| Pre-tax profit margin | 30.8% | 33.7% | 28.3% | 30.1% |
Q2 revenue grew 4%, while expenses excluding interest rose 9% to $925; first-half revenue grew 6% and expenses rose 9% to $1,884. Compensation and benefits increased 11% in Q2 and 13% in the first half, driven by incentive compensation, salary increases, and benefit-plan changes. Q2 effective tax rate was 37.9%; first-half rate was 37.8%.
Six-month operating cash flow was $164, versus cash used of $232 in 2012. Investing activities used $11,152, mainly reflecting securities purchases and loan growth; financing provided $4,559, including a $4,968 increase in bank deposits. Cash and cash equivalents fell $6,429 during the half to $6,234. The filing notes that cash flows are affected by investment activity and client balance movements.
At June 30, total assets were $135,907 and stockholders’ equity was $9,720. Cash and investments segregated for regulatory purposes were $27,011. Banking-client deposits were $84,345, up from $79,377 at year-end; long-term debt was $1,630, little changed from $1,632. Long-term debt was 14% of total financial capital. Schwab Bank was well capitalized, with a 6.6% Tier 1 leverage ratio and 18.8% total risk-based capital ratio. CSC’s Tier 1 leverage ratio was 6.3%.
Q2 other comprehensive loss was $297 after tax, principally reflecting a $477 pre-tax decline in unrealized gains on available-for-sale securities. Accumulated other comprehensive income fell to $3 from $298 at year-end. Held-to-maturity securities had $714 of gross unrealized losses at June 30.
Material changes versus the prior comparable period
- Asset management and administration fees increased 15% in both Q2 and the first half, mainly on growth in mutual fund service and advice-solution fees.
- Net interest revenue rose 3% in Q2 and 6% in the first half as higher interest-earning asset balances outweighed lower short-term rates.
- Trading revenue increased 7% in Q2 on higher daily average revenue trades, but declined 1% in the first half as trading activity remained muted.
- Other revenue fell 51% in Q2 and 31% in the first half. Comparisons were affected by a $70 pre-tax vendor-dispute resolution gain recorded in Q2 2012.
- Common earnings declined faster than revenue as operating expenses rose; Q2 net income was down 7%, common income down 11%, and diluted EPS down 10%.
- Reported Q2 net new client assets were negative $21.7 billion, including $44.3 billion of outflows from the planned transfer of a mutual fund clearing-services client. Core net new client assets were positive $22.6 billion, up 41% year over year.
Outlook, management commentary, risks, and unusual items
- Interest rates and fees: Management said persistently low short-term rates constrain net interest revenue. Schwab continued waiving part of its money-market fund management fees to maintain positive client yields; continued low fund yields could pressure asset-management fees.
- Capital spending: Management expected 2013 capital expenditures to be approximately 110% above 2012 levels, versus its prior estimate of about 85%, due mainly to accelerated Colorado campus spending and increased software investment. The campus project was expected to be completed in 2014.
- Rate sensitivity: The company’s 12-month simulation estimated net interest revenue would increase 11.9% with a gradual 100-basis-point rate increase and decrease 5.8% with a 100-basis-point decline, based on June 30 balances and assumptions. Actual results could differ.
- Regulation: Basel III-related capital rules were to phase in beginning in 2015. Management was evaluating their impact and did not expect a material effect. A proposed NSCC rule could require supplemental liquidity funding; the company said it could not yet assess the impact.
- Credit and market exposures: Banking loans were $11.789 billion gross, with a $57 allowance. Nonaccrual loans were $43 million, and no loans were accruing while 90 or more days past due. About 78% of HELOC balances were in second-lien positions; 46% of residential mortgages and 51% of HELOC balances were secured by California properties. Securities valuation, interest-rate movements, and underlying mortgage performance remain risks.
- Legal matters: Schwab was appealing an adverse June 2013 administrative decision involving optionsXpress and Regulation SHO; a separate optionsXpress registration matter remained pending. The related contingent liability was described as immaterial. Other disclosed matters included appeals in auction-rate securities and Total Bond Market Fund litigation; potential losses were not clearly estimable for certain matters.
- Other contingencies: The company disclosed standby letters of credit, including $240 million for options clearing and $32 million for securities-lending clients, with no funds drawn at quarter-end. It also described clearing-house guarantees whose potential liability is not quantifiable but whose payment was considered remote.
- Subsequent financing: On July 25, 2013, CSC issued $275 million of 2.20% fixed-rate senior notes due 2018. This issuance occurred after the quarter-end balance-sheet date.
Most important facts for investors to verify
- Whether core asset gathering, account growth, and client-asset gains continue, while distinguishing reported net flows from the planned client transfer.
- Whether revenue growth can outpace compensation, marketing, and other expense growth, supporting recovery in pre-tax margins and common earnings.
- How low rates, money-market fee waivers, and subsequent rate changes affect net interest revenue and asset-management fees.
- Whether the securities portfolio’s unrealized losses and mortgage-related credit exposures lead to further impairment or valuation pressure.
- Updates on the NSCC liquidity proposal, Basel III implementation, and the optionsXpress and other legal proceedings.
- Actual 2013 capital spending versus management’s revised estimate, and the liquidity and funding effects of securities purchases, deposit flows, and the July debt issuance.