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| SCHW > SEC Filings for SCHW > Form 10-Q on 6-Aug-2009 | All Recent SEC Filings |
6-Aug-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 second quarters and first halves of 2009
and 2008 are shown in the following table:
Three Months Six Months
Ended Ended
June 30, Percent June 30, Percent
2009 2008 Change 2009 2008 Change
Client Activity Metrics:
Net new client assets (in
billions) $ 17.3 $ 26.0 (33 %) $ 42.6 $ 67.3 (37 %)
Client assets (in billions, at
quarter end) $ 1,224.3 $ 1,396.9 (12 %)
Clients' daily average trades (in
thousands) 349.7 299.4 17 % 354.4 312.9 13 %
Company Financial Metrics:
Net revenues $ 1,085 $ 1,308 (17 %) $ 2,196 $ 2,615 (16 %)
Expenses excluding interest 750 794 (6 %) 1,506 1,593 (5 %)
Income from continuing operations
before taxes on income 335 514 (35 %) 690 1,022 (32 %)
Taxes on income (130 ) (201 ) (35 %) (267 ) (404 ) (34 %)
Income from continuing operations 205 313 (35 %) 423 618 (32 %)
Loss from discontinued
operations, net of tax - (18 ) N/M - (18 ) N/M
Net income $ 205 $ 295 (31 %) $ 423 $ 600 (30 %)
Earning per share from continuing
operations - diluted $ .18 $ .27 (33 %) $ .36 $ .53 (32 %)
Earnings per share - diluted $ .18 $ .26 (31 %) $ .36 $ .52 (31 %)
Net revenue (decline) growth from
prior year (17 %) 9 % (16 %) 11 %
Pre-tax profit margin from
continuing operations 30.9 % 39.3 % 31.4 % 39.1 %
Return on stockholders' equity
(annualized) 18 % 32 % 20 % 31 %
Annualized net revenue per
average full-time equivalent
employee (in thousands) $ 356 $ 390 (9 %) $ 351 $ 391 (10 %)
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N/M Not meaningful.
Economic and market conditions remained challenging in the second quarter of 2009, marked by tight credit markets, continued liquidity concerns, increases in home foreclosures and delinquencies, and unsettled equity markets. Although the Nasdaq Composite Index, the Standard and Poor's 500 Index, and the Dow Jones Industrial Average increased 20%, 15%, and 11%, respectively, during the second quarter, these indices ended the quarter down 20%, 28%, and 26%, respectively, from the second quarter of 2008. In addition, the depressed interest rate environment continued in the second quarter as the federal funds rate remained unchanged at a range of zero to 0.25% and the three-month LIBOR decreased by 65 basis points from 1.27% in March 2009 to 0.62% in June 2009.
During the second quarter of 2009, clients remained actively engaged with the Company. Clients' daily average trades increased 17% on a year-over-year basis to 349,700 in the second quarter of 2009. Net new client assets totaled $17.3 billion in the second quarter of 2009, down 33% from the second quarter of 2008. Lower equity valuations affected total client assets, which ended the second quarter of 2009 at $1.22 trillion, down 12% from the prior year.
Net revenues decreased by 17% and 16% in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, primarily due to the decreases in asset management and administration fees and net interest revenue, which resulted from lower equity valuations and the low interest rate environment. The decrease in net revenues was partially offset by the increase in trading revenue. For the first half of 2009, 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 in the first quarter of 2009.
Management's Discussion and Analysis of Financial Condition and Results of Operations
Net revenues were also negatively impacted by net impairment charges of $13 million and $27 million in the second quarter and first half of 2009, respectively, relating to certain residential mortgage-backed securities available for sale.
Expenses excluding interest decreased by 6% and 5% in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, due to decreases in compensation and benefits expense, professional services expense, and advertising and market development expense, partially offset by increases in occupancy and equipment expense and other expense. Expenses excluding interest in the second quarter and first half of 2009 include total facilities and severance charges of $40 million and $99 million, respectively, relating to the Company's cost reduction measures. Additionally, the Company incurred a $16 million Federal Deposit Insurance Corporation (FDIC) special industry assessment in the second quarter. Expenses excluding interest in the second quarter and first half of 2009 were reduced by a net credit of $2 million and $13 million, respectively, 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 30.9% and return on stockholders' equity of 18% in the second quarter of 2009. Annualized net revenue per average full-time equivalent employee decreased 9% and 10% in the second quarter and first half of 2009 due to lower net revenues, partially offset by the decrease in average full-time equivalent employees.
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. If reduced equity valuations continue in 2009, asset management and administration fees will be negatively impacted on a year-over-year basis. Additionally, mutual fund service fees may be further reduced if the current interest rate environment persists. The overall yields on certain money market mutual funds have fallen to levels 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. Continuation of the current interest rate environment through 2009 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. Although the average balance of margin loans for the second quarter of 2009 increased $168 million, or 3%, from the first quarter of 2009, the average balance decreased by $5.4 billion, or 47%, from the second quarter of 2008. The average yield earned on margin loans decreased to 5.25% for the second quarter of 2009 from 5.52% for the first quarter of 2009 and from 5.77% for the second quarter of 2008. The average balance of margin loans decreased in the first half of 2009 by $5.3 billion, or 46%, from the first half of 2008 and the average yield earned on margin loans decreased to 5.39% from 6.13% for the same periods.
The Company recorded net impairment charges of $13 million and $27 million related to certain non-agency residential mortgage-backed securities in the second quarter and first half of 2009, respectively, due to credit deterioration of the securities' underlying collateral. Further deterioration in the performance of the underlying loans in the Company's residential 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 second quarter and first half of 2009 compared to the same periods in 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 second quarter and first half of 2009 compared to the same
periods in 2008.
Three Months Ended June 30, 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®) (15 %) $ 269 25 % $ 315 24 %
Mutual Fund OneSource® (32 %) 105 10 % 155 12 %
Clearing and other (24 %) 22 2 % 29 2 %
Investment management and trust fees (31 %) 64 6 % 93 7 %
Other - 26 2 % 26 2 %
Asset management and administration fees (21 %) 486 45 % 618 47 %
Net interest revenue
Interest revenue (24 %) 361 33 % 478 37 %
Interest expense 16 % (59 ) (5 %) (51 ) (4 %)
Net interest revenue (29 %) 302 28 % 427 33 %
Trading revenue
Commissions 17 % 233 21 % 199 16 %
Principal transactions 26 % 39 4 % 31 2 %
Trading revenue 18 % 272 25 % 230 18 %
Other 15 % 38 3 % 33 2 %
Net impairment losses on securities N/M (13 ) (1 %) - -
Total net revenues (17 %) $ 1,085 100 % $ 1,308 100 %
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N/M Not meaningful.
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial Condition and Results of
Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Six Months Ended June 30, 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®) (10 %) $ 573 26 % $ 637 24 %
Mutual Fund OneSource® (36 %) 195 9 % 303 12 %
Clearing and other (26 %) 43 2 % 58 2 %
Investment management and trust fees (30 %) 129 6 % 183 7 %
Other (4 %) 48 2 % 50 2 %
Asset management and administration
fees (20 %) 988 45 % 1,231 47 %
Net interest revenue
Interest revenue (28 %) 707 32 % 988 38 %
Interest expense (30 %) (99 ) (4 %) (142 ) (6 %)
Net interest revenue (28 %) 608 28 % 846 32 %
Trading revenue
Commissions 12 % 462 21 % 412 15 %
Principal transactions 8 % 69 3 % 64 3 %
Trading revenue 12 % 531 24 % 476 18 %
Other 55 % 96 4 % 62 3 %
Net impairment losses on securities N/M (27 ) (1 %) - -
Total net revenues (16 %) $ 2,196 100 % $ 2,615 100 %
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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 client activity. 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 $132 million, or 21%, and $243 million, or 20%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, primarily due to decreases in mutual fund service fees and investment management and trust fees, which resulted from lower equity valuations of client assets and an increase in money market mutual fund waivers due to the low interest rate environment.
Mutual fund service fees decreased by $103 million, or 21%, and $187 million, or 19%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively. The decrease was primarily due to a 24% decrease in the Company's Mutual Fund OneSource client asset balances, a 22% decrease in mutual fund clearing services client asset balances, and a 4% decrease in the Company's proprietary funds client asset balances. Given the low interest rate environment in the second quarter and first half of 2009, the overall yields on certain of the Company's money market mutual funds have fallen to levels at or below the management fees on those funds. As a result, the Company waived a
Management's Discussion and Analysis of Financial Condition and Results of Operations
portion of its fees which totaled $30 million and $36 million in the second quarter and first half of 2009, respectively, in order to provide some return to clients.
Investment management and trust fees decreased by $29 million, or 31%, and $54 million, or 30%, in the second quarter and first half of 2009 compared to the same periods in 2008, respectively, primarily due to lower client asset balances participating in advisory and managed account services programs, as well as temporary fee waivers relating to these programs which totaled $14 million and $18 million in the second quarter and first half of 2009, respectively.
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). When interest rates fall, the Company attempts 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. Additionally, balances in Schwab Bank's investor checking and investor savings deposit accounts have grown significantly since the products were introduced in 2005 and the beginning of 2009, respectively. Average interest-bearing deposits from banking clients increased $10.9 billion, or 59%, in the second quarter of 2009 and $10.4 billion, or 63%, in the first half of 2009, compared to the same periods in 2008. The average balance of securities available for sale increased $6.2 billion, or 57%, in the second quarter of 2009 and $6.8 billion, or 72%, in the first half of 2009, while the average balance of loans to banking clients increased $1.9 billion, or 43%, and $2.2 billion, or 54%, in the same periods.
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 June 30, 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 $ 8,462 $ 10 0.47 % $ 4,935 $ 32 2.61 %
Cash and investments segregated 16,287 22 0.54 % 10,247 68 2.67 %
Broker-related receivables (1) 329 - 0.17 % 510 2 1.58 %
Receivables from brokerage clients 6,262 82 5.25 % 11,709 168 5.77 %
Securities available for sale (2) 17,056 128 3.01 % 10,860 116 4.30 %
Securities held to maturity 986 10 4.07 % - - -
Loans to banking clients 6,470 59 3.66 % 4,535 54 4.79 %
Loans held for sale 148 2 5.42 % 89 1 4.52 %
Total interest-earning assets 56,000 313 2.24 % 42,885 441 4.14 %
Other interest revenue 48 37
Total interest-earning assets $ 56,000 $ 361 2.58 % $ 42,885 $ 478 4.48 %
Funding sources:
Deposits from banking clients $ 29,423 $ 26 0.35 % $ 18,507 $ 21 0.46 %
Payables to brokerage clients 17,459 1 0.02 % 15,031 9 0.24 %
Short-term borrowings (3) - - - 95 - 2.17 %
Long-term debt 1,028 15 5.85 % 894 15 6.75 %
Total interest-bearing liabilities 47,910 42 0.35 % 34,527 45 0.52 %
Non-interest-bearing funding sources 8,090 8,358
Provision for credit losses 17 4
Other interest expense - 2
Total funding sources $ 56,000 $ 59 0.42 % $ 42,885 $ 51 0.48 %
Net interest revenue $ 302 2.16 % $ 427 4.00 %
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(1) Includes receivables from brokers, dealers, and clearing organizations. Interest revenue on broker-related receivables was less than $500,000 in the second quarter of 2009.
(2) Amounts have been calculated based on amortized cost.
(3) Interest expense on short-term borrowings was less than $500,000 in the second quarter of 2008.
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:
Six Months Ended June 30, 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 $ 6,996 $ 20 0.58 % $ 5,048 $ 81 3.23 %
Cash and investments segregated 15,424 51 0.67 % 10,271 167 3.27 %
. . .
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