UNITED STATES

SECURITIES  AND  EXCHANGE  COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

 

QUARTERLY  REPORT  PURSUANT  TO  SECTION  13  OR  15(d)
OF  THE  SECURITIES  EXCHANGE  ACT  OF  1934

 

For the quarterly period ended September 30, 2015

 

Commission File Number: 1-9700

 

THE  CHARLES  SCHWAB  CORPORATION

(Exact name of registrant as specified in its charter)

 

 

211 Main Street, San Francisco, CA  94105

(Address of principal executive offices and zip code)

 

Registrant’s telephone number, including area code:  (415) 667-7000

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes ⌧  No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes ⌧   No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ☐ No ⌧

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

1,316,523,363 shares of $.01 par value Common Stock

Outstanding on October 26, 2015

 

 

 

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

INTRODUCTION

 

The Charles Schwab Corporation (CSC) is a savings and loan holding company engaged, through its subsidiaries, in wealth management, securities brokerage, banking, money management, and financial advisory services. Charles Schwab & Co., Inc. (Schwab) is a securities broker-dealer with over 325 domestic branch offices in 45 states, as well as a branch in each of the Commonwealth of Puerto Rico and London, England. In addition, Schwab serves clients in Hong Kong through one of CSC’s subsidiaries. Other subsidiaries include Charles Schwab Bank (Schwab Bank), a federal savings bank, and Charles Schwab Investment Management, Inc. (CSIM), the investment advisor for Schwab’s proprietary mutual funds, which are referred to as the Schwab Funds®, and for Schwab’s exchange-traded funds, which are referred to as the Schwab ETFs™.

 

CSC and its subsidiaries (collectively referred to as the Company) operate through two reportable segments – Investor Services and Advisor Services. The Investor Services segment provides retail brokerage and banking services to individual investors, retirement plan services, and corporate brokerage services. The Advisor Services segment provides custodial, trading, and support services to independent investment advisors, and retirement business services to independent retirement plan advisors and recordkeepers whose plan assets are held at Schwab Bank.

 

 

Forward-Looking Statements

 

In addition to historical information, this Quarterly Report on Form 10-Q contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “could,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements.

 

These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are necessarily estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things:

 

Achievement of the expressed beliefs, objectives, and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of

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this Quarterly Report on Form 10-Q or, in the case of documents incorporated by reference, as of the date of those documents.

 

Important factors that may cause actual results to differ include, but are not limited to:

 

Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in “Part I –Item 1A – Risk Factors” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014, and “Part II – Other Information – Item 1A – Risk Factors.”

 

 

 

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OVERVIEW

 

Management of the Company focuses on several key client activity and financial metrics in evaluating the Company’s financial position and operating performance. Management believes that net revenue growth, pre-tax profit margin, earnings per common share (EPS), and return on average common stockholders’ equity provide broad indicators of the Company’s overall financial health, operating efficiency, and ability to generate acceptable returns. Expenses excluding interest as a percentage of average client assets are considered by management to be a measure of operating efficiency. Results for the third quarters and first nine months of 2015 and 2014 are:

 

 

 

Core net new client assets is defined as net new client assets before significant one-time flows. Management considers this to be a useful metric when comparing period-to-period client asset flows. The following one-time flows were excluded from core net new assets.

 

The Company’s financial results are influenced by market conditions. Asset management and administration fees vary with the changes in the balances of client assets due to market fluctuations. In addition, volatility in the markets can influence client behavior in terms of investment decisions and volume of trading activity. Interest rates have a direct correlation to the Company’s ability to generate net interest revenue as interest-earning assets and funding sources are sensitive to changes in the rate environment.

 

During the third quarter, there was heightened volatility in the equities markets. In the month of August, the S&P 500 dropped 11% in six trading days and the CBOE Volatility Index spiked to 41 on August 24, 2015, after averaging 14 for the prior four weeks. This decline eroded the majority of the equity market gains generated over the past 12 months. The Nasdaq Composite Index finished up 3% at the end of the third quarter of 2015 compared to the same period in 2014 while the Standard & Poor’s 500 Index declined 3% over the same period. Meanwhile, short-term interest rates continued to be constrained as the federal funds target rate remained unchanged at a range of zero to 0.25% and the average 3-month LIBOR yield improved 8 basis points to .31% compared to the third quarter of 2014. Long-term interest rates decreased in the third quarter of 2015 compared to the same period in 2014. The average 10-year yield during the third quarter of 2015 was 2.22% which was 27 basis points lower than the average yield during the third quarter of 2014.

 

Strong client momentum continued as the Company’s innovative, full-service model continued to resonate with clients and drive growth during the third quarter of 2015. Core net new assets totaled $30.8 billion in the third quarter of 2015 compared to $34.7 billion in the same prior year period. Core net new client assets increased $10.4 billion to $102.0 billion for the first nine months of 2015 compared to the same period in 2014. Total client assets ended the third quarter of 2015 at $2.42 trillion, up 1% from the third quarter of 2014, inclusive of the $117.5 billion impact of reduced market valuation on client portfolios over the last 12 months. 

 

The Company added 254,000 new brokerage accounts to its client base during the third quarter of 2015, up 11% compared to the third quarter of 2014. Active brokerage accounts ended the third quarter at 9.7 million, also up 4% on a year-over-year basis. Faced with economic uncertainty and the resulting market volatility, investors increasingly turned to advice offerings throughout the quarter. Approximately 36,000 accounts enrolled in one of the Company’s retail advisory solutions during the third quarter, 57% more than the year-earlier period, and total accounts using these solutions reached 550,000, up 13% year-over-year.

 

For the third quarter of 2015, the Company’s net revenues increased 3% compared to the third quarter of 2014 primarily due to increases in net interest revenue, trading revenue and asset management and administration fees, partially offset by a decrease in other revenue. For the first nine months of 2015, the Company’s net revenues increased 4% compared to the same prior year period primarily due to increases in net interest revenue and asset management and administration fees, partially offset by decreases in other revenue and trading revenue.

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Expenses excluding interest decreased 2% in the third quarter of 2015 compared to the same period in 2014 primarily due to a charge of $68 million in the third quarter of 2014 for estimated future severance benefits resulting from changes in the Company’s geographic footprint. Partially offsetting this charge are increases in compensation and benefits associated with higher headcounts in 2015 and expenses associated with investments in new technology enhancements and new facilities and service centers. Expenses excluding interest increased 4% in the first nine months of 2015 compared to the same period in 2014 primarily due to increases in compensation and benefits, other expense, depreciation and amortization, and occupancy and equipment.

 

The combined effect of the market conditions, strong business growth, and the Company’s overall spending discipline resulted in a pre-tax profit margin of 36.5% and 34.9% in the third quarter and first nine months of 2015, respectively. Included in taxes on income during the third quarter and first nine months of 2015 are $14 million of net tax benefits attributable to changes in estimates for positions taken for tax years 2011 to 2014.

 

Net revenue growth drove the increase in net income of 17%  and 6% in the third quarter and first nine months of 2015, compared to the same periods in 2014. The return on average common stockholders’ equity was 13% and 12% in the third quarter and first nine months of 2015, respectively.

 

 

CURRENT MARKET AND REGULATORY ENVIRONMENT AND OTHER DEVELOPMENTS

 

To the extent short-term interest rates remain at current low levels, the Company’s net interest revenue will continue to be constrained, even as growth in average balances helps to increase such revenue. The low short-term interest rate environment also affects asset management and administration fees. The Company continues to waive a portion of its management fees, as the overall yields on certain Schwab-sponsored money market mutual funds have remained at levels at or below the management fees on those funds. These and certain other Schwab-sponsored money market mutual funds may not be able to replace maturing securities with securities of equal or higher yields. As a result, the yields on such funds may remain at or decline from their current levels and therefore, below the stated management fees on those funds. To the extent this occurs, asset management and administration fees may continue to be negatively affected.

 

In July 2013, the United States (U.S.) banking agencies issued regulatory capital rules that implemented BASEL III and relevant provisions of the “Dodd-Frank Wall Street Reform and Consumer Protection Act” (the Dodd-Frank Act) (Final Regulatory Capital Rules), which are applicable to savings and loan holding companies, such as CSC, and federal savings banks, such as Schwab Bank. The implementation of the rules began on January 1, 2015.

 

The Final Regulatory Capital Rules, among other things:

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The application of the revised risk-weighting of assets resulted in a decrease in the Company’s Common Equity Tier 1 Risk-Based Capital, Tier 1 Risk-Based Capital, and Total Risk-Based Capital ratios of approximately 3.5% in 2015. The required minimum capital conservation buffer will be phased in incrementally, starting at 0.625% on January 1, 2016 and increasing to 1.25% on January 1, 2017, 1.875% on January 1, 2018 and 2.5% on January 1, 2019.

 

The Final Regulatory Capital Rules provide that the failure to maintain the minimum capital conservation buffer will result in restrictions on capital distributions and discretionary cash bonus payments to executive officers.

 

In September 2014, the Board of Governors of the Federal Reserve System (Federal Reserve), in collaboration with the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC), issued a rule implementing a quantitative liquidity requirement generally consistent with the LCR standard established by Basel III. The LCR applies to all internationally active banking organizations. The Federal Reserve also issued a modified LCR that applies to the Company. Under the modified LCR, a depository institution holding company is required to maintain high-quality liquid assets in an amount related to its total estimated net cash outflows over a prospective period. The modified LCR will be phased in beginning on January 1, 2016, with a minimum requirement of 90%, increasing to 100% at January 1, 2017. The Company expects to be compliant with the modified LCR by January 1, 2016 and does not expect a material impact to the Company’s business, financial condition, and results of operations.

 

In October 2015, the FDIC issued a notice of proposed rulemaking that would impose a surcharge on the quarterly assessments of insured depository institutions with total assets of $10 billion or more. The surcharge would equal an annual rate of 4.5 basis points applied to the institution’s assessment base, with certain adjustments. The FDIC expects the proposed surcharge to commence in 2016 and continue through the quarter that the reserve ratio of the Deposit Insurance Fund reaches 1.35%. Under the proposed rule, if by year-end 2018, the reserve ratio has not reached 1.35%, the FDIC would impose a shortfall assessment on the institutions subject to the surcharge. The proposed rule is subject to a comment period which will end 60 days after the proposed rule is published in the Federal Register and is subject to further modification. The Company is currently evaluating the impact of the proposed rule.

 

In April 2015, the Department of Labor published notice of a rule proposal to significantly broaden the definition of “fiduciary” under the Employee Retirement Income Security Act of 1974. If adopted, among other things, the new rule would subject broker-dealers who provide non-discretionary investment advice to retirement plans and accounts to a “best interest” standard, as well as other conditions and requirements. The second comment period for the rule proposal ended on September 24, 2015 and the rule proposal is subject to further modification. The Company will continue to evaluate the impact of the proposed rule.

 

The Company is pursuing lawsuits in state court in San Francisco for rescission and damages against issuers, underwriters, and dealers of individual non-agency residential mortgage-backed securities on which the Company experienced losses. The lawsuits allege that offering documents for the securities contained material untrue and misleading statements about the securities and the underwriting standards and credit quality of the underlying loans. On January 27, 2012, and July 24, 2012, the court denied defendants’ motions to dismiss the claims and discovery is proceeding. As of September 30, 2015, the Company has realized $48 million in net settlement proceeds on such claims, and an initial trial relating to certain of the defendants who remain in the case is set for February 2016.

 

 

 

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Results of Operations

 

The following discussion presents an analysis of the Company’s results of operations for the third quarter and first nine months of 2015 compared to the same periods in 2014.

 

 

N/M Not meaningful.

 

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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 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 these funds. The Company also earns asset management fees for advice solutions, which include advisory and managed account services that are based on the daily balances of client assets subject to the specific fee for service. The fair values of client assets included in proprietary and third-party mutual funds are based on quoted market prices and other observable market data. Other asset management and administration fees include various asset-based fees, such as third-party mutual fund service fees, trust fees, 401(k) recordkeeping fees, and mutual fund clearing and other service fees. Asset management and administration fees vary with changes in the balances of client assets due to market fluctuations and client activity. For a discussion of the impact of current market conditions on asset management and administration fees, see “Current Market and Regulatory Environment and Other Developments.”

 

The following tables present a roll forward of client assets for the Schwab money market funds, Schwab equity and bond funds and Mutual Fund OneSource:

 

 

 

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The following tables present asset management and administration fees, average client assets, and average fee rate:

 

 

N/A Not applicable.

 

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N/A Not applicable.

 

Asset management and administration fees increased by $14 million, or 2%, and $85 million, or 4% in the third quarter and first nine months of 2015 compared to the same periods in 2014, due to the following items.

 

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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.

 

Schwab Bank maintains available for sale and held to maturity investment portfolios for liquidity as well as to earn interest by investing funds from deposits that are in excess of bank loans and liquidity requirements. Schwab Bank lends funds to banking clients primarily in the form of mortgage loans, home equity lines of credit (HELOCs), and personal loans secured by securities. These loans are largely funded by interest-bearing bank deposits.

 

In clearing their clients’ trades, Schwab and optionsXpress, Inc., a securities broker-dealer and wholly-owned subsidiary of optionsXpress Holdings, Inc. (optionsXpress), hold cash balances payable to clients. In most cases, Schwab and optionsXpress, Inc. pay their clients interest on cash balances awaiting investment, and in turn invest these funds and earn interest revenue. Receivables from brokerage clients consist primarily of margin loans to brokerage clients. Margin loans are loans made to clients on a secured basis to purchase securities. Pursuant to applicable 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, which are recorded in cash and investments segregated on the Company’s condensed consolidated balance sheets.

 

The Company’s interest-earning assets are primarily funded through brokerage client cash balances and bank deposits. These interest-bearing liabilities are primarily sensitive to short-term rates, and the Company establishes the rates paid on most of these liabilities. The Company expects that the rate paid on these liabilities will generally adjust at some fraction of the movement in short-term market rates. The rates on the majority of the firm’s investment securities and loans re-price or reset based on short-term market rates. A smaller portion is invested in fixed-rate loans and securities. As such, the Company expects that net interest revenue will increase as short-term market rates increase, and decline as rates fall from current levels. When interest rates fall, the Company may attempt to mitigate some of this negative impact by lowering rates paid to clients on interest-bearing liabilities. The current low interest rate environment limits the extent to which the Company can reduce interest expense on funding sources. The Company may also alter the amount and type of fixed-rate loans and securities that are added to the portfolio. Generally, increases in the percentage of fixed-rate assets relative to total interest-bearing liabilities will reduce the rate at which net interest revenue changes if rates move.

 

Non-interest-bearing funding sources include non-interest-bearing brokerage client cash balances, stockholders’ equity, and proceeds from stock-lending activities. Revenue from stock-lending activities is included in other interest revenue.

 

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The following tables present net interest revenue information corresponding to interest-earning assets and funding sources on the condensed consolidated balance sheet: