Business context and reporting period
The Charles Schwab Corporation is a savings and loan holding company providing brokerage, banking, investment management, and related services. This unaudited Form 10-Q covers the quarter and nine months ended September 30, 2010; comparisons are with the same 2009 periods unless noted. Dollar amounts below are in millions except per-share data and where stated.
Financial and operating performance
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Total net revenue | $1,063 (+5%) | $1,011 | $3,121 (-3%) | $3,207 |
| Net interest revenue | $384 (+31%) | $294 | $1,092 (+21%) | $902 |
| Asset management and administration fees | $468 (+4%) | $451 | $1,325 (-8%) | $1,439 |
| Trading revenue | $182 (-24%) | $241 | $624 (-19%) | $772 |
| Expenses excluding interest | $864 (+25%) | $691 | $2,571 (+17%) | $2,197 |
| Income before tax | $199 | $320 | $550 | $1,010 |
| Net income / diluted EPS | $124 / $0.10 | $200 / $0.17 | $335 / $0.28 | $623 / $0.54 |
| Pre-tax profit margin | 18.7% | 31.7% | 17.6% | 31.5% |
| Net interest margin | 1.88% | 1.88% | 1.91% | 2.16% |
- Revenue drivers: Higher average interest-earning balances lifted net interest revenue, partly offset by lower yields. Trading revenue fell amid lower trading activity and lower revenue per trade following online pricing changes. Fee waivers for money market funds were $93 in Q3 and $331 year to date, versus $78 and $114, respectively, in 2009.
- Client activity: Quarter-end client assets were $1.471 trillion, up 8% year over year. Q3 net new client assets were $14.6 billion; daily average trades declined 12% to 352,600. Nine-month net new assets were $0.4 billion, including $51.5 billion of outflows tied to a planned mutual-fund-clearing client deconversion.
- Balance sheet at September 30: Assets were $87.3 billion versus $75.4 billion at December 31, 2009; deposits from banking clients were $48.8 billion versus $38.8 billion; long-term debt was $2.0 billion versus $1.5 billion; and stockholders’ equity was $6.0 billion versus $5.1 billion. Cash and cash equivalents were $5.7 billion, while $20.1 billion of cash and investments were segregated or on deposit for regulatory purposes.
- Cash flow, nine months: Operating activities provided $442 versus $700 in 2009; investing activities used $13.4 billion versus $10.2 billion; financing activities provided $10.4 billion versus $12.2 billion. Cash and cash equivalents declined $2.54 billion, ending at $5.70 billion. The company raised $543 through a January common-stock offering.
- Liquidity and capital: Management reported a 17% loan-to-deposit ratio. Schwab Bank was classified as well capitalized, with Tier 1 capital of 23.6%, total capital of 23.9%, and Tier 1 leverage of 7.6%; its stated target leverage ratio is at least 7.5%. CSC’s Tier 1 leverage ratio was 6.8% against a 6% target. Schwab’s net capital was $1.1 billion, $887 above its minimum required amount. No commercial paper or committed-credit-facility borrowings were outstanding at quarter end.
- Debt: The company issued $700 of 4.45% Senior Notes due 2020 in Q3. Long-term debt was 25% of total financial capital, compared with 23% at year-end 2009; management’s stated long-term target is no more than 30%.
Material changes, outlook, risks and unusual items
- Profit fell despite Q3 revenue growth, principally because Q3 2010 expenses included a $132 charge to cover remaining losses in a money market fund tied to a structured investment vehicle that defaulted in 2008. The quarter also included a $21 charge for ending sponsorship of the Invest First and WorldPoints Visa credit-card programs; a further $9 charge had been recorded in Q1.
- Nine-month 2010 expenses included a $196 reserve, net of $39 in insurance proceeds, for YieldPlus Fund class-action litigation. The proposed settlements totaled $235, without admission of liability. On October 14, 2010, after quarter end, the court interpreted the proposed settlement terms in a way that could leave some class members able to bring further California-law claims; the company was evaluating litigation options, including possible termination of the settlements. The reserve may be higher or lower than ultimate liability.
- Other legal and regulatory matters include auction-rate-securities inquiries and litigation, SEC and FINRA Wells notices, and litigation and regulatory inquiries involving the Total Bond Market Fund. The company says outcomes and potential losses in certain matters cannot currently be estimated. It also reported 68 YieldPlus-related individual arbitration claims seeking $17 in damages.
- Management said persistently low short-term rates constrain net interest revenue and require money-market fee waivers, which could increase. The company recorded $19 of securities impairment losses year to date, mainly related to non-agency mortgage-backed securities; further deterioration in underlying mortgage performance could cause additional charges. Non-agency securities had $298 of unrealized losses at quarter end, concentrated in mortgage-backed securities.
- Credit and concentration exposures include $8.2 billion of banking-client loans, $48 of nonaccrual loans, and $52 of nonperforming assets. Delinquencies were 0.96% of loans, versus 0.87% at year-end 2009. Approximately 41% of residential mortgages and 49% of home-equity balances were secured by California properties; about 70% of first-mortgage balances had interest-only payment terms.
- The Dodd-Frank Act was enacted in July 2010. Management was assessing potential effects, including possible changes to capital, leverage, liquidity, regulation, and FDIC insurance costs. The filing provides no quantified earnings guidance. The company announced a proposed $150 acquisition of Windward Investment Management, expected to close in Q4 2010 subject to customary conditions.
- Interest-rate sensitivity modeling estimated that a gradual 100-basis-point rate increase would raise next-12-month net interest revenue by 16.9%, while a 100-basis-point decrease would reduce it by 7.8%, assuming balance-sheet structure remains unchanged. Management cautioned actual results could differ.
Important facts for investors to verify
- Whether the YieldPlus proposed settlements receive final approval, are modified or terminated, and whether additional litigation or regulatory liabilities arise beyond the $196 reserve.
- Whether money-market fee waivers remain elevated and how persistently low rates affect net interest revenue and profitability.
- Performance and impairment assumptions for non-agency mortgage-backed securities, including the impact of housing conditions and underlying loan delinquencies.
- Trends in client asset flows and trading activity, including the effect of the planned $51.5 billion client deconversion on reported asset gathering.
- The final terms, closing, and integration effects of the Windward acquisition, and the eventual regulatory and cost impact of Dodd-Frank.