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| SCHW > SEC Filings for SCHW > Form 10-Q on 7-May-2009 | All Recent SEC Filings |
7-May-2009
Quarterly Report
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
Management of The Charles Schwab Corporation (CSC) and its subsidiaries (collectively referred to as the Company) focuses on several key financial and non-financial metrics in evaluating the Company's financial position and operating performance. Results for the first quarters of 2009 and 2008 are shown in the following table:
Three Months
Ended
March 31, Percent
2009 2008 Change
Client Activity Metrics:
Net new client assets (in billions) $ 25.3 $ 41.3 (39 %)
Client assets (in billions, at quarter end) $ 1,099.7 $ 1,393.0 (21 %)
Clients' daily average trades (in thousands) 359.4 327.2 10 %
Company Financial Metrics:
Net revenues $ 1,111 $ 1,307 (15 %)
Expenses excluding interest 756 799 (5 %)
Income before taxes on income 355 508 (30 %)
Taxes on income (137 ) (203 ) (33 %)
Net income $ 218 $ 305 (29 %)
Earnings per share - diluted $ .19 $ .26
Net revenue growth from prior year (15 %) 13 %
Pre-tax profit margin 32.0 % 38.9 %
Return on stockholders' equity (annualized) 21 % 33 %
Annualized net revenue per average full-time
equivalent employee (in thousands) $ 350 $ 391 (10 %)
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Difficult market conditions persisted in the first quarter of 2009, including continued downward pressure on home prices, tight credit markets, liquidity concerns, significant volatility and declines in the equity markets. The Dow Jones Industrial Average, Standard and Poor's 500 Index, and the Nasdaq Composite Index ended the quarter down 13%, 12%, and 3%, respectively, after declining by 20% or more earlier in the quarter. In addition, the depressed interest rate environment continued in the first quarter as the federal funds rate remained unchanged at a range of zero to 0.25%.
During the first quarter of 2009, clients remained actively engaged with the Company in managing their investments and made heavy use of all of the Company's service channels - branch, phone and internet. Clients' daily average trades increased 10% on a year-over-year basis to 359,400 in the first quarter of 2009. Net new client assets totaled $25.3 billion in the first quarter of 2009, down 39% from the first quarter of 2008, reflecting continued deterioration in the equity markets. Lower valuations also affected total client assets, which ended the first quarter of 2009 at $1.10 trillion, down 21% from the prior year.
Net revenues decreased by 15% in the first quarter of 2009 compared to the same period in 2008 primarily due to the decrease in asset management and administration fees and net interest revenue, which in turn resulted from lower equity valuations and the low interest rate environment, respectively. The decrease in net revenues was partially offset by the recognition of a $26 million gain on the repurchase of a portion of the Company's long-term debt. Net revenues in the first quarter of 2009 were also negatively impacted by net impairment charges of $14 million relating to certain mortgage-backed securities available for sale. Expenses excluding interest decreased by 5% in the first quarter of 2009 from the first quarter of 2008 primarily due to decreases in professional services expense, advertising and market development expense, and compensation and benefits expense, partially offset by an increase in occupancy and equipment expense. During the first quarter of 2009, expenses excluding interest included severance and facilities charges of $59 million relating to the Company's cost reduction measures. Expenses excluding interest in the first quarter of 2009 were reduced by a net credit of
Management's Discussion and Analysis of Financial Condition and Results of Operations
$11 million relating to insurance recoveries of certain charges for individual client complaints and arbitration claims relating to Schwab YieldPlus Fund investments. As a result of the Company's cost reduction measures and ongoing expense discipline, the Company achieved a pre-tax profit margin of 32.0% and return on stockholders' equity of 21% in the first quarter of 2009. Annualized net revenue per average full-time equivalent employee was $350,000 in the first quarter of 2009, down 10% from the first quarter of 2008 due to lower net revenue in the current quarter.
CURRENT MARKET ENVIRONMENT
The market conditions discussed above continue to negatively impact the Company's revenues.
The Company earns mutual fund service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue earned by the Company. Continued depressed equity valuations in 2009 will negatively impact asset management and administration fees on a year-over-year basis. Additionally, mutual fund service fees may be further reduced if the current interest rate environment persists. The overall yield on certain money market mutual funds has fallen to a level at or below the management fees on those funds, and the Company is waiving a portion of its fees in order to continue providing some return to clients. To the extent these and other money market mutual funds find it necessary to replace maturing securities with lower yielding securities on an ongoing basis, the amount of fees waived may increase.
Given the low interest rate environment, the Company's revenue from interest-earning assets, such as securities held and loans to clients, has been declining more than the rates that the Company pays on funding sources, such as customer deposits. The Company's ability to reduce those rates has been limited as short term rates have approached zero. If the current interest rate environment persists through 2009, it will negatively impact net interest revenue on a year-over-year basis.
The level at which clients utilize margin loans will also impact net interest revenue. The average balance of margin loans for the first quarter of 2009 was $6.1 billion, down $1.0 billion, or 14%, from $7.1 billion for the fourth quarter of 2008. The average yield earned on margin loans decreased to 5.52% for the first quarter of 2009 from 5.83% for the fourth quarter of 2008.
The Company recorded net impairment charges of $14 million related to certain non-agency residential mortgage-backed securities in the first quarter of 2009 due to credit deterioration of the securities' underlying collateral. Further deterioration in the performance of the underlying loans in the Company's mortgage-backed securities portfolio could result in the recognition of additional future impairment charges.
Management's Discussion and Analysis of Financial Condition and Results of Operations
RESULTS OF OPERATIONS
The following discussion presents an analysis of the Company's results of operations for the first quarters of 2009 and 2008.
Net Revenues
The Company's major sources of net revenues are asset management and administration fees, net interest revenue, and trading revenue. Asset management and administration fees and net interest revenue decreased while trading revenue increased in the first quarter of 2009 from the first quarter of 2008.
Three Months Ended March 31, 2009 2008
% of % of
Percent Total Net Total Net
Change Amount Revenues Amount Revenues
Asset management and administration
fees
Mutual fund service fees:
Proprietary funds (Schwab Funds
® and Laudus Funds®) (6 %) $ 304 27 % $ 322 25 %
Mutual Fund OneSource® (39 %) 90 8 % 148 11 %
Clearing and other (28 %) 21 2 % 29 2 %
Investment management and trust fees (28 %) 65 6 % 90 7 %
Other (8 %) 22 2 % 24 2 %
Asset management and administration
fees (18 %) 502 45 % 613 47 %
Net interest revenue
Interest revenue (32 %) 346 31 % 510 39 %
Interest expense (56 %) (40 ) (3 %) (91 ) (7 %)
Net interest revenue (27 %) 306 28 % 419 32 %
Trading revenue
Commissions 8 % 229 21 % 213 16 %
Principal transactions (9 %) 30 2 % 33 3 %
Trading revenue 5 % 259 23 % 246 19 %
Other 100 % 58 5 % 29 2 %
Net impairment losses on securities N/M (14 ) (1 %) - -
Total net revenues (15 %) $ 1,111 100 % $ 1,307 100 %
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N/M Not meaningful.
Asset Management and Administration Fees
Asset management and administration fees include mutual fund service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund service fees for transfer agent services, shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. These fees are based upon the daily balances of client assets invested in third-party funds and the Company's proprietary funds. The Company also earns asset management fees for advisory and managed account services, which are based on the daily balances of client assets subject to the specific fee for service. The fair values of client assets, which include proprietary and third-party mutual funds, are based on quoted market prices and other observable market data. Asset management and administration fees may vary with changes in the balances of client assets due to market fluctuations and levels of net new client assets. For discussion of the impact of current market conditions on asset management and administration fees, see "Current Market Environment".
Asset management and administration fees decreased by $111 million, or 18%, in the first quarter of 2009 from the first quarter of 2008 due to lower mutual fund service fees and investment management and trust fees, which resulted from lower equity valuations. Mutual fund service fees decreased by $84 million, or 17%, primarily due to a 37% decrease in the
Management's Discussion and Analysis of Financial Condition and Results of Operations
Company's Mutual Fund OneSource asset balances, and a 4% decrease in the Company's proprietary funds. Investment management and trust fees decreased by $25 million, or 28%, primarily due to lower client asset balances participating in advisory and managed account services programs.
Net Interest Revenue
Net interest revenue is the difference between interest earned on interest-earning assets and interest paid on funding sources. Net interest revenue is affected by changes in the volume and mix of these assets and liabilities, as well as by fluctuations in interest rates and portfolio management strategies. The Company is positioned so that the consolidated balance sheet produces an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall (i.e., interest-earning assets generally reprice more quickly than interest-bearing liabilities). In the event of falling interest rates, the Company might attempt to mitigate some of this negative impact by extending the maturities of assets in investment portfolios to lock-in asset yields as well as by lowering rates paid to clients on interest-bearing liabilities. Since the Company establishes the rates paid on certain brokerage client cash balances and deposits from banking clients, as well as the rates charged on receivables from brokerage clients, and also controls the composition of its investment securities, it has some ability to manage its net interest spread. However, the spread is influenced by external factors such as the interest rate environment and competition. For discussion of the impact of current market conditions on net interest revenue, see "Current Market Environment."
In clearing its clients' trades, Charles Schwab & Co., Inc. (Schwab) holds cash balances payable to clients. In most cases, Schwab pays its clients interest on cash balances awaiting investment, and may invest these funds and earn interest revenue. Receivables from brokerage clients consist primarily of margin loans to brokerage clients. Margin loans are loans made by Schwab to clients on a secured basis to purchase securities. Pursuant to Securities and Exchange Commission (SEC) regulations, client cash balances that are not used for margin lending are generally segregated into investment accounts that are maintained for the exclusive benefit of clients.
The Company's interest-earning assets are financed primarily by brokerage client cash balances and deposits from banking clients. Other funding sources include non-interest-bearing brokerage client cash balances and proceeds from stock-lending activities, as well as stockholders' equity.
The amount of excess cash held in certain Schwab brokerage client accounts that is swept into deposit accounts at Charles Schwab Bank (Schwab Bank) has increased significantly since the program's inception in 2003. Average interest-bearing deposits from banking clients increased $9.9 billion, or 68%, to $24.5 billion in the first quarter of 2009 from the first quarter of 2008. The average balance of securities available for sale increased $7.5 billion, or 91%, to $15.7 billion in the first quarter of 2009, while the average balance of loans to banking clients increased $2.5 billion, or 68%, to $6.2 billion in the same period.
Management's Discussion and Analysis of Financial Condition and Results of Operations
The following table presents net interest revenue information corresponding to interest-earning assets and funding sources on the condensed consolidated balance sheet:
Three Months Ended March 31, 2009 2008
Interest Average Interest Average
Average Revenue/ Yield/ Average Revenue/ Yield/
Balance Expense Rate Balance Expense Rate
Interest-earning assets:
Cash and cash equivalents $ 5,515 $ 10 0.74 % $ 5,160 $ 49 3.82 %
Cash and investments segregated 14,552 29 0.81 % 10,294 99 3.87 %
Broker-related receivables (1, 2) 354 - 0.37 % 558 4 2.88 %
Receivables from brokerage clients 6,094 83 5.52 % 11,204 181 6.50 %
Securities available for sale (3) 15,673 134 3.47 % 8,213 99 4.85 %
Securities held to maturity 442 5 4.34 % - - -
Loans to banking clients 6,220 57 3.72 % 3,697 48 5.22 %
Total interest-earning assets 48,850 318 2.64 % 39,126 480 4.93 %
Other interest revenue 28 30
Total interest-earning assets $ 48,850 $ 346 2.87 % $ 39,126 $ 510 5.24 %
Funding sources:
Deposits from banking clients $ 24,538 $ 15 0.25 % $ 14,634 $ 36 0.99 %
Payables to brokerage clients 16,220 1 0.03 % 15,317 35 0.92 %
Long-term debt 834 14 6.81 % 901 15 6.70 %
Total interest-bearing liabilities 41,592 30 0.29 % 30,852 86 1.12 %
Non-interest-bearing funding sources 7,258 8,274
Provision for credit losses 9 2
Other interest expense 1 3
Total funding sources $ 48,850 $ 40 0.33 % $ 39,126 $ 91 0.93 %
Net interest revenue $ 306 2.54 % $ 419 4.31 %
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(1) Includes receivables from brokers, dealers, and clearing organizations.
(2) Interest revenue on broker-related receivables was less than $500,000 in the first quarter of 2009.
(3) Amounts have been calculated based on amortized cost.
Net interest revenue decreased in the first quarter of 2009 from the first quarter of 2008 due to the impact of a decrease in the average net interest yield from 4.31% in the first quarter of 2008 to 2.54% in the first quarter of 2009. As a result of the low interest rate environment in the first quarter of 2009, the Company experienced declines in the yields of all interest-earning assets compared to the first quarter of 2008. The average rates on deposits to banking clients and payables to brokerage clients were reduced in the first quarter of 2009 compared to the first quarter of 2008.
Trading Revenue
Trading revenue includes commission and principal transaction revenues. Commission revenues are affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenues are primarily comprised of revenues from client fixed income securities trading activity. Factors that influence principal transaction revenues include the volume of client trades, market price volatility, and competitive pressures.
Trading revenue increased by $13 million, or 5%, in the first quarter of 2009 from the first quarter in 2008 due to higher daily average revenue trades, offset by lower investment gains and lower average revenue earned per revenue trade.
Management's Discussion and Analysis of Financial Condition and Results of Operations
As shown in the following table, daily average revenue trades executed by the Company increased 10% in the first quarter of 2009. The increase in daily average revenue trades was due to higher volumes of equity, mutual fund, and principal transaction trades, offset by lower volume of option trades. Average revenue earned per revenue trade decreased 3% in the first quarter of 2009 primarily due to lower average revenue earned per revenue trade for mutual funds.
Three Months
Ended
March 31, Percent
2009 2008 Change
Daily average revenue trades (in thousands) (1) 302.9 274.6 10 %
Number of trading days 61.0 61.0 -
Average revenue earned per revenue trade $ 14.06 $ 14.47 (3 %)
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(1) Includes all client trades that generate trading revenue (i.e., commission revenue or revenue from fixed income securities trading).
Other Revenue
Other revenue includes gains and losses on sales of loans held for sale, service fees, and software maintenance fees. Other revenue increased by $29 million, or 100%, in the first quarter of 2009 from the first quarter of 2008 primarily due to the recognition of a gain on the repurchase of a portion of the Company's long-term debt in the first quarter of 2009. The Company repurchased $64 million of trust preferred securities related to its junior subordinated notes for a cash payment of $38 million in the first quarter of 2009. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the junior subordinated notes and resulted in a gain of $26 million.
Net Impairment Losses on Securities
The Company recorded net impairment charges of $14 million related to certain non-agency residential mortgage-backed securities in the first quarter of 2009 due to credit deterioration of the securities' underlying collateral. See note "3 - Securities Available for Sale and Securities Held to Maturity" for further discussion.
Expenses Excluding Interest
As shown in the table below, expenses excluding interest decreased in the first quarter of 2009 from the first quarter of 2008, primarily due to decreases in professional services expense, advertising and market development expense, and compensation and benefits expense, partially offset by an increase in occupancy and equipment expense.
Three Months
Ended
March 31, Percent
2009 2008 Change
Compensation and benefits $ 425 $ 437 (3 %)
Professional services 60 84 (29 %)
Occupancy and equipment 81 74 9 %
Advertising and market development 58 76 (24 %)
Communications 53 52 2 %
Depreciation and amortization 42 38 11 %
Other 37 38 (3 %)
Total expenses excluding interest $ 756 $ 799 (5 %)
Expenses as a percentage of total net revenues:
Total expenses excluding interest 68 % 61 %
Advertising and market development 5 % 6 %
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Management's Discussion and Analysis of Financial Condition and Results of Operations
Compensation and Benefits
Compensation and benefits expense includes salaries and wages, incentive compensation, and related employee benefits and taxes. Incentive compensation is based on the achievement of specified performance objectives, including revenue growth and profit margin, and therefore will fluctuate with these measures.
Compensation and benefits expense decreased by $12 million, or 3%, in the first quarter of 2009 from the first quarter of 2008 due to decreases in incentive compensation and employee benefits and other expense, offset by an increase in salaries and wages expense. The following table shows a comparison of certain compensation and benefits components and employee data:
Three Months
Ended
March 31, Percent
2009 2008 Change
Salaries and wages $ 273 $ 250 9 %
Incentive compensation (1) 85 116 (27 %)
Employee benefits and other 67 71 (6 %)
Total compensation and benefits expense $ 425 $ 437 (3 %)
Compensation and benefits expense as a percentage of
total net revenues:
Salaries and wages 25 % 19 %
Incentive compensation 8 % 9 %
Employee benefits and other 5 % 5 %
Total compensation and benefits expense 38 % 33 %
Full-time equivalent employees (in thousands) (2)
. . .
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