The Charles Schwab Corporation — Q3 2016 Form 10-Q
Reporting period: Three and nine months ended September 30, 2016. Financial amounts are in millions of dollars unless noted. Schwab operates Investor Services and Advisor Services, spanning brokerage, banking, asset management, custody, and advisory services.
Financial and operating performance
| Metric | Q3 2016 | Q3 2015 | 9M 2016 | 9M 2015 |
|---|---|---|---|---|
| Net revenue | $1,914 (+20%) | $1,597 | $5,506 (+17%) | $4,689 |
| Net interest revenue | $845 (+33%) | $635 | $2,415 (+32%) | $1,835 |
| Asset management and administration fees | $798 (+20%) | $663 | $2,254 (+14%) | $1,977 |
| Trading revenue | $190 (-17%) | $228 | $623 (-5%) | $658 |
| Expenses excluding interest | $1,120 (+10%) | $1,014 | $3,337 (+9%) | $3,055 |
| Income before tax | $794 (+36%) | $583 | $2,169 (+33%) | $1,634 |
| Net income | $503 (+34%) | $376 | $1,367 (+33%) | $1,031 |
| Net income available to common stockholders | $470 | $365 | $1,268 | $986 |
| Diluted EPS | $0.35 (+25%) | $0.28 | $0.95 (+28%) | $0.74 |
| Pre-tax margin | 41.5% | 36.5% | 39.4% | 34.9% |
| Net interest margin | 1.72% | 1.57% | 1.73% | 1.59% |
- Drivers and client activity: Management attributed revenue gains mainly to growth in client assets and higher short-term interest rates. Quarter-end client assets were $2.73 trillion, up 13% year over year; average client assets rose 7% to $2.70 trillion. Core net new assets were $30.0 billion in Q3 and $88.6 billion for nine months, equivalent to a 5% annualized organic growth rate over year-end 2015 assets. Active brokerage accounts increased 4% to 10.0 million.
- Revenue mix: Net interest revenue benefited from higher interest-earning assets, particularly as bank deposits grew, as well as higher short-term rates. Asset-based fees grew substantially, including money-market fund fees as fee waivers declined. Trading revenue fell as daily average revenue trades and average revenue per trade declined; Q3 daily average revenue trades were down 12% and average revenue per trade down 4%.
- Costs and profitability: Expenses rose with headcount and investment in technology, professional services, and business growth; higher FDIC assessments also contributed. Expenses excluding interest were 0.17% of average client assets annualized versus 0.16% a year earlier. Return on average common equity was 14% in Q3 and 13% for nine months, compared with 13% and 12%, respectively.
- Cash flow and balance sheet: For the first nine months, operating cash flow was $974 million, investing cash outflow was $26.0 billion, and financing cash inflow was $23.5 billion; cash and cash equivalents declined $1.5 billion to $10.4 billion. Total assets were $209.3 billion at quarter-end, up from $183.7 billion at December 31, 2015. Bank deposits increased to $149.6 billion from $129.5 billion, while securities available for sale and held to maturity totaled $141.8 billion.
- Debt, liquidity, and capital: Long-term debt was $2.876 billion. Short-term borrowings were $3.001 billion, principally FHLB funding; $5.9 billion of additional FHLB capacity was available against pledged collateral. A $750 million committed corporate credit facility was undrawn. CSC and Schwab Bank reported Tier 1 leverage ratios of 7.1% and 7.0%, respectively; Schwab Bank was categorized as well capitalized. The company reported compliance with its fully phased-in modified liquidity coverage ratio requirement.
Material changes versus prior comparable periods
- Revenue and net income accelerated, with growth led by interest income and asset-based fees; trading revenue declined in both comparison periods.
- Bank deposits grew about $20.1 billion from year-end 2015, and the balance sheet expanded 14%. Schwab began using its bank sweep feature as the default for uninvested cash in new brokerage accounts in June 2016 and continued planned transfers of client cash to Schwab Bank.
- Q3 2015 included $14 million of net tax benefits, contributing to a lower prior-year quarterly effective tax rate. The 2016 effective tax rate was 36.6% for Q3 and 37.0% for nine months.
- The company issued Series D preferred stock in March 2016, receiving $725 million net proceeds. After quarter-end, it issued Series E preferred depositary shares, receiving $591 million net proceeds.
Outlook, commentary, risks, and unusual items
- Outlook: The filing provides no specific earnings or revenue guidance. Management stated that net interest revenue is expected to rise if short-term rates increase and decline if rates fall; the low-rate environment limits further reductions in funding costs. A 100-basis-point gradual rate increase was modeled to raise next-12-month net interest revenue by 8.1%, while a 100-basis-point decrease was modeled to reduce it by 11.1%, assuming no balance-sheet changes. Actual outcomes may differ.
- Regulatory developments: Schwab Bank must develop a recovery plan under new OCC guidelines by the end of 2017. A proposed minimum net stable funding ratio rule could apply beginning in 2018, but its impact could not yet be assessed. The company said it did not expect the final Department of Labor fiduciary rule or a proposed capital deduction rule to have a material impact, while noting ongoing uncertainty and implementation risks.
- Portfolio and credit risks: Three FFELP asset-backed securities were downgraded below investment grade during Q3, with aggregate fair value of $588 million; further downgrades followed after quarter-end. Management cited federal guarantees and additional credit enhancement and did not consider the securities impaired. The company also reported substantial mortgage-backed and asset-backed securities holdings and concentration in California for 48% of its mortgage and HELOC portfolio. Bank-loan delinquencies were 0.21% of loans, versus 0.25% at year-end 2015; nonaccrual loans were 0.19% at both dates.
- Legal and unusual items: Q3 other revenue included higher litigation proceeds related to the company’s non-agency residential mortgage-backed securities portfolio; management said these proceeds concluded the last pending cases. The SEC’s August 2016 decision in the optionsXpress Regulation SHO proceeding dismissed fraud charges but affirmed other violations and financial sanctions; the matter was concluded. A separate Schwab Total Bond Market Fund lawsuit remained on appeal, and the company could not estimate potential liability for significant pending matters.
- Other: The quarterly common dividend was raised to $0.07 per share in April 2016. The company reported no material changes to its risk factors, no material change in internal controls, and no share repurchases under its program during Q3.
Important facts for investors to verify
- Whether net interest revenue growth persists as client cash migration, deposit growth, and interest-rate changes affect asset yields and funding costs.
- Progress and timing of planned bulk transfers of uninvested brokerage cash to Schwab Bank, and the associated balance-sheet, liquidity, and regulatory-capital effects.
- Subsequent developments in FFELP security ratings, repayment timing, and the company’s impairment assessment.
- Final requirements and effects of proposed banking rules, including the net stable funding ratio, and implementation of the Department of Labor fiduciary rule.
- Outcomes of the pending fund litigation and other legal or regulatory matters for which potential losses were not estimable in the filing.