The Charles Schwab Corporation — Q2 2011 Form 10-Q
Business context and reporting period
Schwab is a savings and loan holding company operating securities brokerage, banking and related financial services businesses through its Investor Services and Institutional Services segments. This unaudited report covers the quarter and six months ended June 30, 2011; financial amounts below are in millions of dollars unless noted.
Financial performance and position
| Metric | Q2 2011 | Q2 2010 | Six months 2011 | Six months 2010 |
|---|---|---|---|---|
| Net revenue | $1,190 | $1,080 | $2,397 | $2,058 |
| Income before taxes | $386 | $338 | $780 | $351 |
| Net income | $238 | $205 | $481 | $211 |
| Diluted EPS | $0.20 | $0.17 | $0.40 | $0.18 |
| Pre-tax profit margin | 32.4% | 31.3% | 32.5% | 17.1% |
- Q2 net interest revenue rose 18% to $451; asset management and administration fees increased 15% to $502. Trading revenue fell 12% to $205, primarily on lower daily average revenue trades.
- For the first half, net interest revenue increased 23% to $887 and asset management and administration fees rose 17% to $1,004; trading revenue was broadly flat at $446.
- Expenses excluding interest were $804 in Q2, up 8%; first-half expenses declined 5% to $1,617, largely because the 2010 period included a $196 YieldPlus class-action reserve. Q2 compensation and benefits rose 9% to $430.
- At June 30, total assets were $97.6 billion, total liabilities $90.8 billion and stockholders’ equity $6.7 billion. Cash and cash equivalents were $6.5 billion; long-term debt was $2.0 billion, 23% of total financial capital. Banking-client deposits were $52.3 billion.
- First-half operating cash flow was $1.918 billion, investing cash outflow $2.067 billion and financing cash inflow $1.684 billion. Cash and cash equivalents increased $1.535 billion to $6.466 billion.
- Client assets were $1.656 trillion at quarter-end, up 22% year over year. Q2 net new client assets were $15.4 billion; daily average trades were 397,100, down 9% year over year.
Changes versus comparable periods
- Q2 revenue growth of 10% and net income growth of 16% reflected higher net interest revenue and asset-based fees, partly offset by lower trading revenue. First-half revenue rose 16% and net income increased 128% year over year.
- First-half expenses fell despite higher compensation and professional-services costs, primarily because the prior-year period contained the $196 million YieldPlus reserve. In Q2 2011, Schwab recorded a separate $7 million class-action litigation and regulatory reserve.
- Compared with December 31, 2010, total assets increased to $97.6 billion from $92.6 billion; loans to banking clients, net, rose to $9.5 billion from $8.7 billion; and stockholders’ equity rose to $6.7 billion from $6.2 billion. Long-term debt was little changed.
Outlook, risks and unusual items
- Management said historically low interest rates constrained net interest revenue and required waivers of money-market fund fees, which could increase if fund yields remain below management fees. Fee waivers were $128 million in Q2 and $240 million in the first half of 2011.
- Management’s interest-rate simulation estimated that a gradual 100-basis-point rate increase would raise next-12-month net interest revenue by 15.3%, while a 100-basis-point decrease would reduce it by 4.3%. These are model estimates, not forecasts, and actual results may differ.
- Management anticipated full-year 2011 capital expenditures approximately 60% above 2010 levels, versus its earlier expectation of 35% growth, due to greater software and technology-system spending.
- Schwab agreed to acquire optionsXpress in a stock transaction at 1.02 Schwab shares per optionsXpress share. Closing was expected in Q3 2011, subject to shareholder and regulatory approvals and other conditions. The filing also describes merger litigation and a settlement subject to court approval and completion of the transaction.
- Credit risks include continued deterioration in certain non-agency mortgage-backed securities. The company recorded $2 million of impairment in Q2 and $9 million in the first half; further deterioration could cause additional charges. Securities available for sale had $201 million of gross unrealized losses, concentrated in non-agency residential mortgage-backed securities.
- Other material contingencies include regulatory inquiries and litigation involving auction-rate securities and the Schwab Total Bond Market Fund. The YieldPlus settlement received final court approval in April 2011. Management said potential losses in certain matters could not yet be reasonably estimated.
- Schwab Bank was well capitalized at quarter-end; its Tier 1 risk-based capital ratio was 23.4% and Tier 1 core capital ratio 7.6%. The Federal Reserve became the parent company’s primary regulator and the OCC Schwab Bank’s primary regulator effective July 21, 2011, following the elimination of the OTS.
- The filing warns that market and economic conditions, interest rates, asset valuations, money-market fund yields, litigation, regulation, acquisition approvals, client balances and financing availability could affect results. Management reported effective disclosure controls and no material change in internal control over financial reporting during the quarter.
Important facts for investors to verify
- Whether growth in client assets and average balances can sustain fee revenue and net interest revenue amid low rates and money-market fee waivers.
- Progress and final terms of the optionsXpress acquisition, including approvals, closing, share issuance and merger-litigation settlement.
- Credit performance and impairment exposure in non-agency mortgage-backed securities, especially Alt-A holdings, and in the residential mortgage and HELOC portfolios.
- Whether the $7 million Q2 litigation and regulatory reserve or other legal matters lead to additional material charges or settlements.
- Execution of the higher 2011 capital-spending plan and the company’s liquidity, capital ratios and debt position as business and client balances change.