Charles Schwab Corporation — Q3 2020 Form 10-Q
Reporting period: Quarter ended September 30, 2020. The unaudited results exclude TD Ameritrade, acquired on October 6, 2020. Unless noted, amounts are in U.S. dollars.
Business context and operating performance
Schwab provides brokerage, banking, asset management, custody, and advisory services through Investor Services and Advisor Services. Despite the COVID-19 pandemic and low interest rates, client activity and asset growth remained strong. At quarter-end, client assets were $4.40 trillion, up 17% year over year; active brokerage accounts totaled 14.4 million, up 19%. Q3 net new client assets were $51.2 billion, including $8.5 billion from the Wasmer acquisition; core net new assets were $42.7 billion.
Financial results and key metrics
| Metric | Q3 2020 | Q3 2019 | Nine months 2020 | Nine months 2019 |
|---|---|---|---|---|
| Total net revenues | $2.448B | $2.711B | $7.515B | $8.115B |
| Net interest revenue | $1.343B | $1.631B | $4.304B | $4.921B |
| Expenses excluding interest | $1.559B | $1.475B | $4.691B | $4.379B |
| Income before taxes | $889M | $1.236B | $2.824B | $3.736B |
| Net income | $698M | $951M | $2.164B | $2.852B |
| Diluted EPS | $0.48 | $0.70 | $1.54 | $2.05 |
| Pre-tax profit margin | 36.3% | 45.6% | 37.6% | 46.0% |
Adjusted diluted EPS, a non-GAAP measure excluding acquisition/integration costs and acquired-intangible amortization and related tax effects, was $0.51 in Q3 and $1.66 year to date, versus $0.70 and $2.07, respectively, in 2019. Adjusted expenses were $1.492 billion for Q3 and $4.488 billion year to date.
- Revenue mix: Q3 asset management and administration fees rose 4% to $860 million, while trading revenue fell 12% to $181 million. Daily average trades more than doubled year over year, but the October 2019 commission cuts reduced revenue per trade.
- Margins and returns: Net interest margin declined to 1.38% in Q3 from 2.43% a year earlier, reflecting rate cuts and faster mortgage-backed-security prepayments. Annualized return on average common equity was 10%, versus 20%.
- Cash flow: Nine-month operating cash flow was negative $6.405 billion, investing cash flow negative $103.445 billion, and financing cash flow positive $102.635 billion. Cash flows reflected substantial investment-security purchases and growth in client-related deposits and balances; they should be interpreted in light of brokerage and banking activity.
- Balance sheet and capital: Total assets were $419.4 billion, up 43% from year-end 2019; total deposits were $320.7 billion. Long-term debt was $7.8 billion. The consolidated Tier 1 leverage ratio was 5.7%, down from 7.3% at year-end 2019 and below the 6.75%–7.00% long-term operating objective, but above the 4.0% regulatory minimum.
- Liquidity: Average Q3 liquidity coverage ratio was 108%, above the 85% applicable requirement. Available external facilities included $45.5 billion of Federal Home Loan Bank capacity, $7.6 billion at the Federal Reserve discount window, and additional corporate credit facilities; none was outstanding at quarter-end.
Material changes and significant events
- Q3 revenue declined 10% and net income declined 27% year over year; for the first nine months, revenue fell 7% and net income fell 24%. Lower net interest revenue was the principal revenue pressure; higher expenses also weighed on earnings.
- Interest-earning assets expanded as client cash balances rose. Schwab invested significant cash in available-for-sale securities; the portfolio’s fair value was $303.8 billion at September 30. Unrealized gains contributed to a $5.686 billion accumulated other comprehensive income balance.
- Schwab completed the $1.6 billion cash acquisition of USAA-IMCO in May, adding approximately $80 billion in client assets and over one million accounts, and acquired Motif technology and Wasmer during 2020.
- On October 6, after quarter-end, Schwab completed the TD Ameritrade acquisition. Provisional purchase price was $21.758 billion, funded principally with approximately 586 million Schwab shares. The combined firms had about $6 trillion in client assets and 29 million brokerage accounts at closing. Provisional goodwill was $10.264 billion and acquired intangible assets were $8.880 billion.
Outlook, risks, and contingencies
- Management expected full-year 2020 capital expenditures of approximately 5%–6% of net revenues. TD Ameritrade integration was expected to take 18–36 months; Schwab anticipated significant bank deposit account fee revenue beginning in Q4 2020 under the amended deposit agreement.
- The amended TD Ameritrade deposit agreement reduced the service fee rate from 25 to 15 basis points. Schwab must maintain at least $50 billion in sweep balances through June 2031, with at least 80% designated fixed-rate through June 2026; specified balances may be migrated subject to contractual limits.
- Management identified COVID-19, persistently low rates, net interest margin compression, client cash allocation, credit conditions, acquisition integration and synergy execution, and operational capacity as key uncertainties. The company warned that elevated cash balances constrain capital returns, including share repurchases, until leverage improves. No shares were repurchased under the authorization in Q3.
- Bank loan credit quality was described as strong, though management noted economic uncertainty and potential for higher mortgage and HELOC delinquencies. Nonaccrual loans were $42 million at quarter-end, compared with $22 million at year-end 2019; the allowance for bank loan credit losses was $30 million.
- Schwab disclosed litigation and regulatory matters, including order-routing cases and claims relating to the TD Ameritrade transaction. The company contests the claims; it said potential losses generally could not be reasonably estimated. It also has ordinary-course guarantees and commitments, including $11.0 billion of commitments to extend credit or purchase first mortgages.
Important facts for investors to verify
- Whether net interest revenue and margin stabilize as interest rates, security prepayments, and client cash balances change.
- Post-acquisition capital ratios, share dilution, provisional purchase accounting, integration costs, and realization of expected cost and revenue benefits.
- The scale, durability, and sensitivity to rates of TD Ameritrade-related bank deposit account fees, including the amended agreement’s sweep-balance requirements.
- Trends in client asset flows, account growth, trading revenue after commission reductions, and money market fund fee waivers.
- COVID-19-related credit, operational, litigation, and regulatory developments, and the effect of capital levels on dividends and future repurchases.