Business context and reporting period
The Charles Schwab Corporation (CSC), a savings and loan holding company, provides brokerage, banking, asset-management, and related services through its subsidiaries. This unaudited Form 10-Q covers the quarter and six months ended June 30, 2012; comparisons are with the corresponding 2011 periods unless noted. Amounts are in millions of dollars except per-share data and ratios.
Financial and operating performance
| Metric | Q2 2012 | Q2 2011 | Six months 2012 | Six months 2011 |
|---|---|---|---|---|
| Net revenues | $1,283 | $1,190 | $2,472 | $2,397 |
| Expenses excluding interest | $851 | $804 | $1,727 | $1,617 |
| Income before taxes | $432 | $386 | $745 | $780 |
| Net income | $275 | $238 | $470 | $481 |
| Net income available to common stockholders | $261 | $238 | $456 | $481 |
| Diluted EPS | $0.20 | $0.20 | $0.36 | $0.40 |
| Pre-tax profit margin | 33.7% | 32.4% | 30.1% | 32.5% |
- Quarterly revenue rose 8% and net income rose 16%; first-half revenue rose 3%, while net income fell 2% and diluted EPS fell 10%. First-half income before taxes declined 4%.
- Q2 net interest revenue was $458 million, up 2%; first-half net interest revenue was $892 million, up 1%. Net interest margin was 1.74% in Q2 versus 1.97%, and 1.70% for the half versus 1.96%.
- Trading revenue increased 7% in Q2 and 4% for the half, primarily reflecting higher options and futures trading, including optionsXpress. Asset-management and administration fees fell 1% for the quarter and 2% for the half, with lower mutual-fund fees partly offset by other fee growth.
- Reported expenses increased 6% in Q2 and 7% for the half, mainly reflecting optionsXpress, including higher compensation, advertising, and amortization. Expenses were 66% of revenue in Q2 versus 68%; for the first half, 70% versus 67%.
- Net interest revenue held roughly flat despite higher average interest-earning asset balances because low rates compressed spreads. Money-market fund fee waivers increased to $146 million in Q2 from $128 million and to $309 million for the half from $240 million.
Balance sheet, cash flow, debt, and capital
- At June 30, 2012, total assets were $111.8 billion, up from $108.6 billion at year-end 2011. Cash and cash equivalents were $8.1 billion; regulatory-segregated cash and investments were $22.7 billion. Client and bank deposits were $66.3 billion and long-term debt was $2.0 billion.
- Stockholders’ equity was $9.1 billion, including $863 million carrying value of preferred stock issued in 2012. Total financial capital was $11.1 billion; debt represented 18% of financial capital, down from 21% at year-end. The company’s long-term debt target is no more than 30% of financial capital.
- For the first half, operating cash flow was negative $232 million, versus positive $1.918 billion in 2011; investing cash outflow was $6.488 billion, versus $2.067 billion. Financing cash inflow was $6.130 billion, including $864 million net preferred-stock proceeds and $5.403 billion of increased bank deposits. Cash and cash equivalents decreased $590 million during the half.
- CSC reported a 7.1% Tier 1 leverage ratio against its stated minimum target of 6%. Schwab Bank was well capitalized, with a 7.6% Tier 1 leverage ratio and 22.1% Tier 1 risk-based capital ratio. Management later lowered Schwab Bank’s internal Tier 1 leverage target from 7.5% to 6.25% in Q3 2012.
- Liquidity facilities included an unused $800 million committed CSC facility, an unused $930 million of Schwab uncommitted bank lines at quarter-end, and Schwab Bank borrowing availability of $1.9 billion at the Federal Reserve discount window and $5.2 billion through the Federal Home Loan Bank. Availability is subject to applicable terms and collateral.
Changes, outlook, risks, and unusual items
- The $70 million pre-tax gain from a confidential vendor-dispute resolution materially benefited Q2 and first-half other revenue; management reported an after-tax effect of $44 million. The filing does not provide enough detail to assess whether this item will recur.
- The 2011 comparison is affected by optionsXpress, acquired in September 2011. It contributed $49 million of Q2 2012 revenue and $6 million of net income; first-half contributions were $101 million and $8 million, respectively.
- Management cited strong client engagement despite market volatility and low long-term rates. Q2 client assets were $1.802 trillion, up 9% year over year; net new client assets were $16.0 billion. First-half net new assets were $54.9 billion, including a $12.0 billion first-quarter inflow from one mutual-fund-clearing client. Daily average client trades rose 10% in Q2 to 435,600.
- No specific earnings or revenue guidance is provided. Management expected full-year 2012 capital expenditures to be about 20% below 2011, revising its earlier expectation of a 30% decline, principally because of increased software and IT spending.
- Low interest rates constrain net interest revenue and money-market fund fees; the company continued fee waivers where fund yields were at or below management fees. Its simulations estimated that a gradual 100-basis-point rate increase would raise next-12-month net interest revenue 16.6%, while a 100-basis-point decline would reduce it 8.4%; actual results may differ.
- Credit deterioration in non-agency mortgage-backed securities led to impairment charges of $7 million in Q2 and $25 million for the half. Unrealized losses on available-for-sale securities totaled $164 million, primarily non-agency residential mortgage-backed securities. Further deterioration could cause additional impairment.
- Legal and regulatory matters include an appeal by New York’s Attorney General of the dismissal of its auction-rate securities complaint; an appeal in the Schwab Total Bond Market Fund litigation; and two SEC administrative proceedings against optionsXpress entities, which the company contests. The related optionsXpress contingent liability was not material at June 30. The filing says potential losses in certain matters cannot yet be reasonably estimated.
- Other exposures include $5.485 billion of European non-sovereign financial-institution holdings, with no direct European sovereign exposure; mortgage concentration in California (44% of residential mortgages and 50% of HELOCs); and contingent clearinghouse guarantees for which potential payments are not quantifiable, though management considered payment remote.
- Subsequent developments: CSC announced a private exchange offer for certain 4.950% Senior Notes due 2014, for new notes due 2022 and cash. It also announced redemption of $300 million of trust preferred securities, with an August 31, 2012 redemption date.
Most important facts for investors to verify
- How much of reported growth and earnings reflects the one-time $70 million vendor settlement and the acquired optionsXpress business.
- Whether client-asset inflows remain broad-based, given the $12 billion single-client contribution to first-half net new assets.
- Changes in money-market fee waivers, interest-rate spreads, and net interest margin under persistently low rates.
- Performance and valuation of non-agency mortgage securities, future impairment exposure, and the California concentration in bank loans.
- Developments in pending litigation and optionsXpress regulatory proceedings, including any changes to estimated liabilities.
- Capital and liquidity implications of the preferred-stock terms, proposed regulatory capital rules, debt exchange offer, and trust-preferred redemption.