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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, 2002 Commission file number 1-9700
THE CHARLES SCHWAB CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 94-3025021
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
120 Kearny Street, San Francisco, CA 94108
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (415) 627-7000
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 x No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
1,343,647,397 shares of $.01 par value Common Stock
Outstanding on October 31, 2002
THE CHARLES SCHWAB CORPORATION
Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 2002
Index
Page
----
Part I - Financial Information
Item 1. Condensed Consolidated Financial Statements:
Statement of Income 1
Balance Sheet 2
Statement of Cash Flows 3
Notes 4 - 10
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 11 - 27
Item 3. Quantitative and Qualitative Disclosures About Market Risk 27 - 29
Item 4. Controls and Procedures 29
Part II - Other Information
Item 1. Legal Proceedings 29 - 30
Item 2. Changes in Securities and Use of Proceeds 30
Item 3. Defaults Upon Senior Securities 30
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 5. Other Information 31
Item 6. Exhibits and Reports on Form 8-K 31
Signature 32
Certifications 33 - 35
Part I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Income
(In millions, except per share amounts)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
-----------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 434 $ 420 $1,325 $1,239
Commissions 309 276 906 1,025
Interest revenue 295 431 920 1,509
Interest expense (86) (201) (272) (790)
------- ------- ------- -------
Net interest revenue 209 230 648 719
Principal transactions 47 42 147 192
Other 32 55 113 119
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Total 1,031 1,023 3,139 3,294
-----------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 472 461 1,413 1,433
Other compensation - merger retention programs 14 22 44
Occupancy and equipment 113 127 349 372
Communications 63 79 200 264
Depreciation and amortization 79 85 243 252
Advertising and market development 51 41 156 185
Professional services 42 38 138 144
Commissions, clearance and floor brokerage 20 20 55 71
Goodwill amortization 17 49
Restructuring and other charges 160 99 190 244
Other 36 16 92 72
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Total 1,036 997 2,858 3,130
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Income (loss) before taxes on income (loss) and extraordinary gain (5) 26 281 164
Tax expense (benefit) on income (loss) (1) 13 105 73
-----------------------------------------------------------------------------------------------------------------------------------
Income (loss) before extraordinary gain (4) 13 176 91
Extraordinary gain on sale of corporate trust business, net of tax 12 121
-----------------------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $ (4) $ 13 $ 188 $ 212
===================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,358 1,395 1,382 1,403
===================================================================================================================================
Earnings Per Share - Basic
Income (loss) before extraordinary gain $ .00 $ .01 $ .13 $ .07
Extraordinary gain, net of tax $ .01 $ .08
Net income (loss) $ .00 $ .01 $ .14 $ .15
Earnings Per Share - Diluted
Income (loss) before extraordinary gain $ .00 $ .01 $ .13 $ .07
Extraordinary gain, net of tax $ .01 $ .08
Net income (loss) $ .00 $ .01 $ .14 $ .15
===================================================================================================================================
Dividends Declared Per Common Share $.0110 $.0110 $.0330 $.0330
===================================================================================================================================
See Notes to Condensed Consolidated Financial Statements.
- 1 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Balance Sheet
(In millions, except share and per share amounts)
(Unaudited)
September 30, December 31,
2002 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 2,502 $ 4,407
Cash and investments segregated and on deposit for federal or other
regulatory purposes(1) (including resale agreements of $15,163 in 2002
and $14,811 in 2001) 19,216 17,741
Securities owned - at market value (including securities pledged of $406
in 2002 and $185 in 2001) 1,883 1,700
Receivables from brokers, dealers and clearing organizations 197 446
Receivables from brokerage clients - net 7,051 9,620
Loans to banking clients - net 4,334 4,046
Equipment, office facilities and property - net 917 1,058
Goodwill - net 627 628
Other assets 841 818
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 37,568 $ 40,464
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 4,700 $ 5,448
Drafts payable 218 396
Payables to brokers, dealers and clearing organizations 1,101 833
Payables to brokerage clients 24,776 26,989
Accrued expenses and other liabilities 1,218 1,327
Short-term borrowings 760 578
Long-term debt 652 730
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 33,425 36,301
- ------------------------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940,000 shares authorized; $.01 par value per share;
none issued
Common stock - 3 billion shares authorized; $.01 par value per share;
1,391,990,776 and 1,391,673,494 shares issued in 2002 and 2001, respectively 14 14
Additional paid-in capital 1,737 1,726
Retained earnings 2,882 2,794
Treasury stock - 41,531,809 and 23,110,972 shares in 2002 and 2001,
respectively, at cost (431) (295)
Unamortized stock-based compensation (37) (39)
Accumulated other comprehensive loss (22) (37)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,143 4,163
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 37,568 $ 40,464
====================================================================================================================================
(1) Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes were $19,151 million and $18,261 million at September 30, 2002 and December 31, 2001, respectively.
On October 2, 2002, the Company deposited an additional $309 million into its segregated cash portfolio. As of January 3, 2002,
the Company had deposited $710 million to meet its segregated cash requirement.
See Notes to Condensed Consolidated Financial Statements.
- 2 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Cash Flows
(In millions)
(Unaudited)
Nine Months Ended
September 30,
2002 2001
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 188 $ 212
Adjustments to reconcile net income to net cash used for operating activities:
Depreciation and amortization 243 252
Goodwill amortization 49
Compensation payable in common stock 19 25
Deferred income taxes 44 (25)
Tax benefits from stock options exercised and other stock-based compensation 3 27
Non-cash restructuring and other charges 17 49
Net gain on sale of an investment (26)
Extraordinary gain on sale of corporate trust business, net of tax (12) (121)
Other (4) 7
Net change in:
Cash and investments segregated and on deposit for federal or other
regulatory purposes (1,531) (6,231)
Securities owned (excluding securities available for sale) 42 36
Receivables from brokers, dealers and clearing organizations 245 7
Receivables from brokerage clients 2,540 7,000
Other assets (61) (11)
Drafts payable (177) (264)
Payables to brokers, dealers and clearing organizations 269 (263)
Payables to brokerage clients (2,134) (1,314)
Accrued expenses and other liabilities (69) (162)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for operating activities (378) (753)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (1,085) (871)
Proceeds from sales of securities available for sale 578 399
Proceeds from maturities, calls and mandatory redemptions of securities
available for sale 275 377
Net increase in loans to banking clients (483) (657)
Proceeds from sale of banking client loans 196
Purchase of equipment, office facilities and property - net (114) (266)
Cash payments for business combinations and investments, net of cash received (24)
Proceeds from sales of investments 49
Proceeds from sale of Canadian operations 26
Proceeds from sale of corporate trust business 273
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (607) (720)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net change in deposits from banking clients (748) 64
Net increase in short-term borrowings 182 668
Proceeds from long-term debt 100
Repayment of long-term debt (203) (35)
Dividends paid (45) (46)
Purchase of treasury stock (230) (315)
Proceeds from stock options exercised 23 21
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities (921) 357
- ------------------------------------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash and cash equivalents 1 1
- ------------------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (1,905) (1,115)
Cash and Cash Equivalents at Beginning of Period 4,407 4,876
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 2,502 $ 3,761
====================================================================================================================================
See Notes to Condensed Consolidated Financial Statements.
- 3 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Amounts and Ratios)
(Unaudited)
1. Basis of Presentation
The Charles Schwab Corporation (CSC) is a financial holding company
engaged, through its subsidiaries, in securities brokerage and related financial
services. Charles Schwab & Co., Inc. (Schwab) is a securities broker-dealer with
394 domestic branch offices in 48 states, as well as a branch in the
Commonwealth of Puerto Rico. U.S. Trust Corporation (USTC, and with its
subsidiaries collectively referred to as U.S. Trust) is a wealth management firm
that through its subsidiaries also provides fiduciary services and private
banking services with 34 offices in 12 states. Other subsidiaries include
Charles Schwab Europe, a retail securities brokerage firm located in the United
Kingdom, Charles Schwab Investment Management, Inc., the investment advisor for
Schwab's proprietary mutual funds, Schwab Capital Markets L.P. (SCM), a market
maker in Nasdaq and other securities providing trade execution services
primarily to broker-dealers and institutional clients, and CyberTrader, Inc.
(CyberTrader), an electronic trading technology and brokerage firm providing
services to highly active, online investors.
The accompanying unaudited condensed consolidated financial statements
include CSC and its majority-owned subsidiaries (collectively referred to as the
Company). These financial statements have been prepared pursuant to the rules
and regulations of the Securities and Exchange Commission and, in the opinion of
management, reflect all adjustments necessary to present fairly the financial
position, results of operations, and cash flows for the periods presented in
conformity with accounting principles generally accepted in the U.S. All
adjustments were of a normal recurring nature, except as discussed in Note "2 -
Accounting Change." Certain items in prior periods' financial statements have
been reclassified to conform to the 2002 presentation. All material intercompany
balances and transactions have been eliminated. These financial statements
should be read in conjunction with the consolidated financial statements and
notes thereto included in the Company's 2001 Annual Report to Stockholders on
Form 10-K and the Company's Quarterly Report on Form 10-Q for the periods ended
March 31, 2002 and June 30, 2002. The Company's results for any interim period
are not necessarily indicative of results for a full year or any other interim
period.
2. Accounting Change
Statement of Financial Accounting Standards (SFAS) No. 142 - Goodwill and
Other Intangible Assets, was issued in June 2001. Under the provisions of SFAS
No. 142, companies are no longer permitted to amortize goodwill and certain
intangible assets with an indefinite useful life. Instead, these assets must be
reviewed at least annually for possible impairment under new criteria. The
Company adopted SFAS No. 142 and accordingly discontinued the amortization of
goodwill as of January 1, 2002. During the second quarter of 2002, the Company
completed the transitional goodwill impairment test as required and did not
record any impairment charges. Except for the cessation of goodwill
amortization, the adoption of SFAS No. 142 did not have a material impact on the
Company's financial position, results of operations, earnings per share (EPS),
or cash flows.
The decrease in goodwill during the first nine months of 2002 was primarily
due to the sale of the Company's Canadian operations, partially offset by the
effects of foreign currency translation adjustments. The carrying amount of
goodwill, net of accumulated amortization, attributable to each of the Company's
reportable segments is presented in the following table:
- --------------------------------------------------------------------------------
September 30, December 31,
2002 2001
- --------------------------------------------------------------------------------
Individual Investor $ 438 $ 440
Institutional Investor 5 5
Capital Markets 25 25
U.S. Trust 159 158
- --------------------------------------------------------------------------------
Total $ 627 $ 628
================================================================================
The following table compares net income and EPS for the three and nine
months ended September 30, 2002, which excludes goodwill amortization, with net
income and EPS for the three and nine months ended September 30, 2001, which has
been adjusted to exclude goodwill amortization.
- 4 -
- --------------------------------------------------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
2002 2001 2002 2001
(Reported) (Adjusted)(Reported)(Adjusted)
- --------------------------------------------------------------------------------
Net income:
Reported income (loss)
before extraordinary gain $ (4) $ 13 $ 176 $ 91
Add: Goodwill amortization,
net of tax 17 49
- --------------------------------------------------------------------------------
Reported/adjusted
income (loss) before
extraordinary gain (4) 30 176 140
Extraordinary gain, net of tax 12 121
- --------------------------------------------------------------------------------
Reported/adjusted
net income (loss) $ (4) $ 30 $ 188 $ 261
================================================================================
Basic and diluted EPS:
Reported EPS before
extraordinary gain $ .00 $ .01 $ .13 $ .07
Add: Goodwill amortization .01 .03
- --------------------------------------------------------------------------------
Reported/adjusted EPS before
extraordinary gain .00 .02 .13 .10
Extraordinary gain, net of tax .01 .08
- --------------------------------------------------------------------------------
Reported/adjusted EPS $ .00 $ .02 $ .14 $ .18
================================================================================
3. New Accounting Standards
Long-Lived Assets: SFAS No.144 - Accounting for the Impairment or Disposal
of Long-Lived Assets was issued in August 2001 and addresses the financial
accounting and reporting for the impairment or disposal of long-lived assets
(e.g., equipment and office facilities). This statement supersedes SFAS No. 121
- - Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of, and certain accounting and reporting provisions of Accounting
Principles Board Opinion No. 30 - Reporting the Results of Operations. The
Company adopted this statement on January 1, 2002. The adoption of SFAS No. 144
did not have a material impact on the Company's financial position, results of
operations, EPS, or cash flows.
SFAS No. 146 - Accounting for Costs Associated with Exit or Disposal
Activities was issued in June 2002 and addresses accounting for restructuring
and similar costs. SFAS No. 146 supersedes previous accounting guidance,
principally Emerging Issues Task Force Issue No. 94-3 - Liability Recognition
for Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including Certain Costs Incurred in a Restructuring). SFAS No. 146 may affect
the timing of recognizing future restructuring costs, as well as the amounts
recognized. The Company is required to adopt this statement for exit or disposal
activities initiated after December 31, 2002.
4. Restructuring
The Company recorded pre-tax restructuring charges for the third quarter of
2002 and the nine months ended September 30, 2002 as follows:
- --------------------------------------------------------------------------------
Three Nine
Period ended September 30, 2002 Months Months
- --------------------------------------------------------------------------------
2002 Initiatives $ 94 $ 94
2001 Initiatives 66 96
- --------------------------------------------------------------------------------
Total restructuring charges $ 160 $ 190
================================================================================
2002 Initiatives
In the third quarter of 2002, the Company commenced additional
restructuring initiatives due to continued difficult market conditions. These
initiatives are intended to reduce operating expenses and adjust the Company's
organizational structure to improve productivity, enhance efficiency, and
increase profitability. The restructuring initiatives include further reductions
in workforce and facilities. The Company recorded pre-tax restructuring charges
of $94 million in the third quarter of 2002 related to these restructuring
initiatives. The Company expects to recognize additional restructuring charges
during the fourth quarter of 2002 as it completes these restructuring
initiatives. The actual costs of these restructuring initiatives could differ
from the estimated costs, depending primarily on the Company's ability to
sublease properties.
Workforce: During the third quarter of 2002, the Company closed its telephone
service center in Austin, Texas, eliminating 300 jobs, and also eliminated 70
support and administrative positions across its four other service centers
located in Denver, Indianapolis, Orlando, and Phoenix. The Company recorded
charges of $12 million related to these workforce reductions in the third
quarter of 2002. Additionally, the Company expects that reductions in full-time
equivalent employees in the fourth quarter of 2002 will total approximately
1,900, including approximately 1,750 through mandatory staff reductions and
approximately 150 related to a reduction in contractors. The workforce reduction
encompasses employees from all of the Company's segments. In the third quarter
of 2002, the Company recorded charges of $32 million related to the 60-day
notice period provided to these impacted employees (excluding contractors). The
remaining severance pay and benefits, which become contractual obligations only
when the impacted employee signs a severance agreement, will be recorded in the
fourth quarter of 2002.
- 5 -
Facilities: The restructuring charges recognized in the third quarter of 2002
include facility exit costs which are net of estimated sublease income. The
restructuring charges also include write-downs of leasehold improvements,
telecommunications infrastructure, and fixed assets removed from service at
these facilities.
A summary of pre-tax restructuring charges related to the Company's 2002
restructuring initiatives for the third quarter of 2002 and the nine months
ended September 30, 2002 is as follows:
- --------------------------------------------------------------------------------
Three and nine months ended September 30, 2002
- --------------------------------------------------------------------------------
Workforce reduction:
Severance pay and benefits $ 43
Non-cash compensation expense for officers' stock options 1
- --------------------------------------------------------------------------------
Total workforce reduction 44
- --------------------------------------------------------------------------------
Facilities reduction:
Non-cancelable lease costs, net of estimated sublease income 37
Write-downs of leasehold improvements, telecommunications
infrastructure, and fixed assets removed from service 13
- --------------------------------------------------------------------------------
Total facilities reduction 50
- --------------------------------------------------------------------------------
Total restructuring charges $ 94
================================================================================
A summary of the activity in the restructuring liability related to the
Company's 2002 restructuring initiatives for the third quarter of 2002 and the
nine months ended September 30, 2002 is as follows:
- --------------------------------------------------------------------------------
Three and nine months Workforce Facilities
ended September 30, 2002 Reduction Reduction Total
- --------------------------------------------------------------------------------
Restructuring charges $ 44 $ 50 $ 94
Utilization:
Cash payments (8) (8)
Non-cash charges (1) (1) (13) (14)
- --------------------------------------------------------------------------------
Balance at September 30, 2002 $ 35 (2) $ 37 (3) $ 72
================================================================================
(1) Primarily includes charges for write-downs of leasehold improvements,
telecommunications infrastructure, and fixed assets removed from service,
as well as officers' stock-based compensation.
(2) The Company expects to substantially utilize the remaining workforce
reduction liability through cash payments for severance pay and benefits
over the respective severance periods through 2003.
(3) The Company expects to substantially utilize the remaining facilities
reduction liability through cash payments for the net lease expense over
the respective lease terms through 2013.
2001 Initiatives
In the second quarter of 2001, the Company initiated a restructuring plan
to reduce operating expenses. The restructuring plan included a workforce
reduction, a reduction in operating facilities, and the removal of certain
systems hardware, software, and equipment from service. Included in these
initiatives are costs associated with the withdrawal from certain international
operations. In the third quarter of 2002, the Company recorded pre-tax
restructuring charges related to its 2001 restructuring initiatives of $66
million, virtually all of which resulted from changes in estimates of sublease
income due to a continued deterioration of the commercial real estate market.
Total pre-tax restructuring charges related to the Company's 2001 restructuring
initiatives for the first nine months of 2002 were $96 million. The actual costs
of these initiatives could differ from the estimated costs, depending primarily
on the Company's ability to sublease properties.
A summary of the activity in the restructuring liability related to the
Company's 2001 restructuring initiatives for the third quarter of 2002 and the
nine months ended September 30, 2002 is as follows:
- --------------------------------------------------------------------------------
Three months ended Workforce Facilities Systems
September 30, 2002 Reduction Reduction Removal Total
- --------------------------------------------------------------------------------
Balance at
June 30, 2002 $ 31 $ 79 $ 1 $ 111
Restructuring charges 1 65 (1) 66
Utilization:
Cash payments (14) (9) (1) (24)
- --------------------------------------------------------------------------------
Balance at
September 30, 2002 $ 18 (2) $ 135 (3) $ 153
================================================================================
- --------------------------------------------------------------------------------
Nine months ended Workforce Facilities Systems
September 30, 2002 Reduction Reduction Removal Total
- --------------------------------------------------------------------------------
Balance at
December 31, 2001 $ 74 $ 97 $ 4 $ 175
Restructuring charges 19 76 (1) 1 96
Utilization:
Cash payments (72) (38) (5) (115)
Non-cash charges (4) (3) (3)
- --------------------------------------------------------------------------------
Balance at
September 30, 2002 $ 18 (2) $ 135 (3) $ 153
================================================================================
(1) Includes $65 million primarily due to changes in estimates of sublease
income resulting from a continued deterioration of the commercial real
estate market.
(2) The Company expects to substantially utilize the remaining workforce
reduction liability through cash payments for severance pay and benefits
over the respective severance periods through 2003.
(3) The Company expects to substantially utilize the remaining facilities
reduction liability through cash payments for the net lease expense over
the respective lease terms through 2017.
(4) Primarily includes charges for officers' stock-based compensation.
- 6 -
5. Sale of Corporate Trust Business
In June 2001, U.S. Trust sold its Corporate Trust business to The Bank of
New York Company, Inc. The Company recorded an extraordinary gain of $221
million, or $121 million after tax, on this sale in the second quarter of 2001.
During the first quarter of 2002, the Company recorded an extraordinary gain of
$22 million, or $12 million after tax, which represented the remaining proceeds
from this sale that were realized upon satisfaction of certain client retention
requirements.
6. Allowance for Credit Losses on Banking Loans and Nonperforming Assets
Loans to banking clients of $4.3 billion at September 30, 2002 and $4.0
billion at December 31, 2001 are presented net of the related allowance for
credit losses. The allowance for credit losses on banking loans was $23 million
at September 30, 2002 and $21 million at December 31, 2001. Recoveries and
charge-offs were not material for each of the three- and nine-month periods
ended September 30, 2002 and 2001.
Nonperforming assets consisted of non-accrual loans of $1 million at
September 30, 2002 and $5 million at December 31, 2001.
7. Loan Securitization
During the second quarter of 2002, U.S. Trust securitized and sold
residential mortgage loans originated through its private banking business. This
transaction was accounted for as a sale under the requirements of SFAS No. 140 -
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities. U.S. Trust received $196 million in proceeds from the sale and
recognized a gain of $1 million. The senior mortgage pass-through certificates
that were created by the securitization process were sold to third parties. U.S.
Trust retained all other securities created by the process, primarily comprised
of subordinated securities with total par value of $5 million. Any credit losses
on the securitized loans will be assigned to U.S. Trust, as holder of the
subordinated securities, up to the $5 million par value. The estimated fair
value of the retained securities was $6 million at September 30, 2002 and was
included in securities owned on the Company's condensed consolidated balance
sheet. U.S. Trust has not guaranteed the mortgage loans as this transaction was
structured without recourse to U.S. Trust or the Company.
8. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is presented in the following table:
- --------------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
2002 2001 2002 2001
- --------------------------------------------------------------------------------
Net income (loss) $ (4) $ 13 $ 188 $ 212
Other comprehensive income (loss):
Cumulative effect of accounting
change for adoption of
SFAS No. 133 (12)
Net loss on cash flow
hedging instruments (8) (17) (10) (24)
Foreign currency translation
adjustment 2 1 8 (5)
Change in net unrealized gain
on securities available for sale 10 13 17 16
- --------------------------------------------------------------------------------
Total comprehensive income,
net of tax $ 10 $ 203 $ 187
================================================================================
- 7 -
9. Earnings Per Share
Basic EPS excludes dilution and is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted EPS
reflects the potential reduction in EPS that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
EPS under the basic and diluted computations are presented in the following
table:
- --------------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
2002 2001 2002 2001
- --------------------------------------------------------------------------------
Net income (loss) $ (4) $ 13 $188 $212
================================================================================
Weighted-average common
shares outstanding - basic 1,358 1,373 1,364 1,376
Common stock equivalent shares
related to stock incentive plans 22 18 27
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,358 1,395 1,382 1,403
================================================================================
Basic EPS:
Income (loss) before
extraordinary gain $.00 $.01 $.13 $.07
Extraordinary gain, net of tax $.01 $.08
Net income (loss) $.00 $.01 $.14 $.15
================================================================================
Diluted EPS:
Income (loss) before
extraordinary gain (1) $.00 $.01 $.13 $.07
Extraordinary gain, net of tax $.01 $.08
Net income (loss) $.00 $.01 $.14 $.15
================================================================================
(1) For the three months ended September 30, 2002 this computation excludes
common stock equivalent shares related to stock incentive plans of 14
million because inclusion of such shares would be antidilutive.
The computation of diluted EPS for the nine months ended September 30, 2002
and 2001, respectively, excludes outstanding stock options to purchase 114
million and 84 million shares, respectively, because the exercise prices for
those options were greater than the average market price of the common shares,
and therefore the effect would be antidilutive.
10. Regulatory Requirements
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Board of Governors of the Federal
Reserve System (the Federal Reserve Board) under the Bank Holding Company Act of
1956, as amended (the Act).
Under the Act, the Federal Reserve Board has established consolidated
capital requirements for bank holding companies. CSC is subject to those
requirements. The regulatory capital and ratios of the Company, U.S. Trust, and
United States Trust Company of New York (U.S. Trust NY) are presented in the
following table:
- 8 -
- --------------------------------------------------------------------------------
2002 2001
-------------- --------------
September 30, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,574 23.5% $ 3,662 20.5%
U.S. Trust $ 618 17.5% $ 572 16.9%
U.S. Trust NY $ 381 13.4% $ 333 12.5%
Total Capital:
Company $ 3,601 23.7% $ 3,689 20.6%
U.S. Trust $ 641 18.2% $ 593 17.6%
U.S. Trust NY $ 401 14.1% $ 351 13.2%
Tier 1 Leverage:
Company $ 3,574 9.6% $ 3,662 10.2%
U.S. Trust $ 618 9.5% $ 572 9.6%
U.S. Trust NY $ 381 7.3% $ 333 7.2%
- --------------------------------------------------------------------------------
(1) Minimum tier 1 capital, total capital, and tier 1 leverage ratios are 4%,
8%, and 3%-5%, respectively, for bank holding companies and banks.
Well-capitalized tier 1 capital, total capital, and tier 1 leverage ratios
are 6%, 10%, and 5%, respectively. Each of CSC's other depository
institution subsidiaries exceed the well-capitalized standards set forth by
the banking regulatory authorities.
Based on their respective regulatory capital ratios at September 30, 2002
and 2001, the Company, U.S. Trust, and U.S. Trust NY are considered well
capitalized (the highest category). There are no conditions or events that
management believes have changed the Company's, U.S. Trust's, or U.S. Trust NY's
well-capitalized status.
Schwab and SCM are subject to the Uniform Net Capital Rule under the
Securities Exchange Act of 1934 (the Rule). Schwab and SCM compute net capital
under the alternative method permitted by the Rule. This method requires the
maintenance of minimum net capital, as defined, of the greater of 2% of
aggregate debit balances arising from client transactions or a minimum dollar
requirement, which is based on the type of business conducted by the
broker-dealer. The minimum dollar requirement for both Schwab and SCM is $1
million. Under the alternative method, a broker-dealer may not repay
subordinated borrowings, pay cash dividends, or make any unsecured advances or
loans to its parent or employees if such payment would result in net capital of
less than 5% of aggregate debit balances or less than 120% of its minimum dollar
requirement. At September 30, 2002, Schwab's net capital was $1.2 billion (17%
of aggregate debit balances), which was $1.0 billion in excess of its minimum
required net capital and $825 million in excess of 5% of aggregate debit
balances. At September 30, 2002, SCM's net capital was $67 million,
- 8 -
which was $66 million in excess of its minimum required net capital.
11. Commitments and Contingent Liabilities
During 2001, the Company began occupying and making lease payments on a
newly renovated office building. The lease for the building was arranged by
working with a bank to create an unconsolidated special purpose trust (Trust).
The Trust, through an agent, raised the $245 million needed to acquire and
renovate the building by issuing long-term debt ($235 million) and raising
equity capital ($10 million). The Company's lease payments to the Trust vary
with fluctuations in interest rates and are structured to cover the interest on
the debt obligations and a specified return on the equity (defined in the Trust
Agreement as 1.75% above the one-month LIBOR rate). This financing arrangement
is known as a synthetic lease. Upon the expiration of the lease in June 2005,
the Company may renew the lease for an additional five years subject to certain
approvals and conditions, or arrange a sale of the office building to a third
party. The Company also has an option to purchase the office building for $245
million at any time after June 18, 2003. The Company has provided the Trust with
a residual value guarantee, which means that if the building is sold to a third
party the Company is responsible for making up any shortfall between the actual
sales price and the $245 million funded by the Trust, up to a maximum of $202
million. In March 2002, the Company secured an appraisal of the estimated fair
value of the building at the end of the initial lease term in June 2005. On the
basis of this appraisal, the Company determined that it was probable that the
value of the property at the end of the lease term would be less than the
residual value guaranteed by approximately $45 million. This deficiency of $45
million is being amortized as rent expense on a straight-line basis over the
period from January 2002 to June 2005. Adjustments to this amortization will be
made on a prospective basis if it is determined that the estimate of the
probable deficiency has changed.
The nature of the Company's business subjects it to claims, lawsuits,
regulatory examinations, and other proceedings in the ordinary course of
business. The results of these matters cannot be predicted with certainty. There
can be no assurance that these matters will not have a material adverse effect
on the Company's results of operations in any future period, depending partly on
the results for that period, and a substantial judgment could have a material
adverse impact on the Company's financial condition, results of operations, and
cash flows. However, it is the opinion of management, after consultation with
legal counsel, that the ultimate outcome of existing claims and proceedings will
not have a material adverse impact on the financial condition, results of
operations, or cash flows of the Company. For further discussion of legal
proceedings, see Part II - Other Information, Item 1 - Legal Proceedings.
12. Segment Information
The Company structures its segments according to its various types of
clients and the services provided to those clients. These segments have been
aggregated, based on similarities in economic characteristics, types of clients,
services provided, distribution channels, and regulatory environment, into four
reportable segments - Individual Investor, Institutional Investor, Capital
Markets, and U.S. Trust.
Financial information for the Company's reportable segments is presented in
the following table. The Company periodically reallocates certain revenues and
expenses among the segments to align them with the changes in the Company's
organizational structure. Previously-reported segment information has been
revised to reflect changes during the year in the Company's internal
organization. The Company evaluates the performance of its segments based on
adjusted operating income before taxes, which excludes restructuring and other
charges, merger- and acquisition-related charges, and extraordinary gains.
Intersegment revenues are not material and are therefore not disclosed. Total
revenues, income before taxes on income and extraordinary gain, and net income
are equal to the Company's consolidated amounts as reported in the condensed
consolidated statement of income.
- 9 -
- --------------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
2002 2001 2002 2001
- -------------------------------------------------------------------------------
Revenues:
Individual Investor $ 593 $ 576 $1,804 $1,893
Institutional Investor 214 200 638 616
Capital Markets 64 58 194 264
U.S. Trust 160 163 503 495
- --------------------------------------------------------------------------------
Operating revenues 1,031 997 3,139 3,268
Non-operating revenues (1) 26 26
- --------------------------------------------------------------------------------
Total $1,031 $1,023 $3,139 $3,294
================================================================================
Operating income before taxes:
Individual Investor $ 64 $ 35 $ 193 $ 147
Institutional Investor 61 64 182 203
Capital Markets (1) (2) 12 28
U.S. Trust (2) 31 33 111 95
- --------------------------------------------------------------------------------
Operating income before taxes 155 130 498 473
Non-operating revenues (1) 26 26
Restructuring and other charges (3) (160) (99) (190) (244)
Merger- and acquisition-related
charges (4) (31) (27) (91)
- --------------------------------------------------------------------------------
Income (loss) before taxes on income
(loss) and extraordinary gain (5) 26 281 164
Tax expense (benefit) on income (1) 13 105 73
Extraordinary gain on sale of
corporate trust business, net of tax 12 121
- --------------------------------------------------------------------------------
Net Income (Loss) $ (4) $ 13 $ 188 $ 212
================================================================================
(1) Primarily consists of a gain on the sale of an investment.
(2) Excludes an extraordinary pre-tax gain of $22 million for the nine months
ended September 30, 2002 and $221 million for the nine months ended
September 30, 2001.
(3) Restructuring charges include costs relating to workforce, facilities,
systems hardware, software, and equipment reductions. In 2001, other
charges include a regulatory fine, professional service fees for
operational and risk management remediation, and the write-off of certain
software development costs.
(4) Includes retention program compensation related to the merger with USTC,
and intangible asset amortization and retention program compensation
related to the acquisition of CyberTrader. The retention programs related
to the acquisition of CyberTrader and the merger with USTC ended in March
2002 and May 2002, respectively. For 2001, amount also includes goodwill
amortization, which ceased on January 1, 2002 upon the adoption of SFAS No.
142 (see note "2 - Accounting Change").
13. Supplemental Cash Flow Information
Certain information affecting the cash flows of the Company is presented in
the following table:
- --------------------------------------------------------------------------------
Nine
Months Ended
September 30,
2002 2001
- --------------------------------------------------------------------------------
Income taxes paid $ 81 $ 84
================================================================================
Interest paid:
Brokerage client cash balances $ 143 $ 614
Deposits from banking clients 65 104
Long-term debt 51 56
Stock-lending activities 3 19
Short-term borrowings 19 15
Other 5
- --------------------------------------------------------------------------------
Total interest paid $ 281 $ 813
================================================================================
Non-cash investing and financing activities:
Common stock and options issued
for purchase of businesses $ 4 $ 36
================================================================================
- 10 -
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
Description of Business
The Company: The Charles Schwab Corporation (CSC) and its subsidiaries
(collectively referred to as the Company) provide securities brokerage and
related financial services for 8.0 million active client accounts(a). Client
assets in these accounts totaled $726.8 billion at September 30, 2002. Charles
Schwab & Co., Inc. (Schwab) is a securities broker-dealer with 394 domestic
branch offices in 48 states, as well as a branch in the Commonwealth of Puerto
Rico. U.S. Trust Corporation (USTC, and with its subsidiaries collectively
referred to as U.S. Trust) is a wealth management firm that through its
subsidiaries also provides fiduciary services and private banking services with
34 offices in 12 states. Other subsidiaries include Charles Schwab Europe, a
retail securities brokerage firm located in the United Kingdom, Charles Schwab
Investment Management, Inc., the investment advisor for Schwab's proprietary
mutual funds, Schwab Capital Markets L.P. (SCM), a market maker in Nasdaq and
other securities providing trade execution services primarily to broker-dealers
and institutional clients, and CyberTrader, Inc. (CyberTrader), an electronic
trading technology and brokerage firm providing services to highly active,
online investors.
The Company provides financial services to individuals, institutional
clients, and broker-dealers through four segments - Individual Investor,
Institutional Investor, Capital Markets, and U.S. Trust. The Individual Investor
segment includes the Company's domestic and international retail operations. The
Institutional Investor segment provides custodial, trading, and support services
to independent financial advisors, serves company 401(k) plan sponsors and
third-party administrators, and supports company stock option plans and stock
purchase programs. The Capital Markets segment provides trade execution services
in Nasdaq, exchange-listed, and other securities primarily to broker-dealers,
including Schwab, and institutional clients. The U.S. Trust segment provides
investment and wealth management, fiduciary services, and private banking
services to individual and institutional clients.
Business Strategy: The Company's infrastructure and resources are focused
on pursuing six strategic priorities:
- - providing the spectrum of affluent investors with the advice,
relationships, and choices that support their desired investment outcomes;
- - delivering the information, technology, service, and pricing needed to
remain a leader in serving active traders;
- - continuing to provide high quality service to clients with smaller
investment portfolios;
- - providing individual investing services through employers, including
retirement and option plans as well as personal brokerage accounts;
- - offering selected banking services and developing investment products that
give clients greater control and understanding of their finances; and
- - retaining a strong capital markets business to address investors' financial
product and trade execution needs.
For further discussion of the Company's business strategy, see
"Management's Discussion and Analysis of Results of Operations and Financial
Condition - Description of Business - Business Strategy" in the Company's 2001
Annual Report to Stockholders, which is filed as Exhibit 13.1 to the Company's
Form 10-K for the year ended December 31, 2001. See also Item 1 - Business -
Narrative Description of Business - "Products, Services, and Advice Offerings"
in the Company's Form 10-K for the year ended December 31, 2001. Significant
recent developments relating to certain of these strategic priorities, as well
as other significant developments, follows:
Services for Affluent Investors: Schwab Private Client is a fee-based
service designed to help clients who want access to an ongoing, one-on-one
advice relationship with a designated Schwab consultant while retaining control
over their investment decisions. Schwab Private Client was expanded nationwide
in May 2002. In the third quarter of 2002, 3,000 clients signed up for this
service, bringing the total number of participants to over 5,000 as of September
30, 2002. The Schwab Private Client service includes over 150 designated Schwab
consultants and their support teams, serving 360 branch offices nationwide, at
September 30, 2002.
For self-directed affluent investors, the Company introduced Schwab
Signature Platinum(R), the successor to the Schwab Signature Services(TM)
program. Schwab Signature Platinum enables Schwab to provide a select group of
its larger clients with a tailored set of benefits and services, including
priority access, an enhanced suite of investing resources, and preferred
pricing.
The Schwab Advisor Network(TM) is the successor to the Schwab
AdvisorSource(R) referral program, with over 330 participating independent,
fee-based investment advisors (IAs) at September 30, 2002. These IAs provide
customized and personalized portfolio management and financial planning services
to investors who prefer to delegate their financial management responsibilities
to an independent
- --------
(a) Accounts with balances or activity within the preceding eight months.
- 11 -
professional. During the third quarter of 2002, Schwab conducted advisor
education workshops on operational, trading, and technology solutions to help
IAs grow their businesses efficiently. These workshops were held in 18 cities
and attracted 1,100 attendees.
Services for Active Traders: The Company made several technological,
pricing, and service improvements to its offerings for actively trading
investors in the third quarter of 2002. The Company enhanced its CyberTrader(R)
Web Trading platform to include real-time market data, direct access technology,
intelligent order routing, options trading, and premium stock research. The
Company also reduced pricing across all of CyberTrader's platforms; prices now
range from $9.95 for trades executed through the CyberTrader Web site to $12.95
for trades executed through the CyberX2(TM) platform. Additionally, the
CyberTrader offering was expanded to include a broader client base - the
enhanced pricing and technology are available to clients who trade as few as ten
times per month. To support representatives' conversations with actively trading
clients, the Company introduced Active Trader Street, an internal Web site that
provides Schwab representatives with a comprehensive suite of investing
perspectives, trading strategies, and educational tools.
Corporate Services: In the third quarter of 2002, the Company introduced a
monthly online report that allows retirement plan sponsors to monitor activity
and investment performance in their plans against customized criteria and
benchmarks. If a fund deviates from the pre-established criteria, plan sponsors
receive an email alert automatically. The report also provides plan asset
allocations and trend data, market commentary, industry data, fund summaries and
the most recent mutual fund Schwab Focus List(TM), which is specifically
designed for retirement plan sponsors.
Banking and Other Financial Products: In the second quarter of 2002, the
Company filed applications with the Office of the Comptroller of the Currency
and the Federal Deposit Insurance Corporation to establish a national bank and
to obtain deposit insurance for the bank. The Company is awaiting preliminary
approval from the Comptroller of the Currency in order to file applications with
the Board of Governors of the Federal Reserve System (Federal Reserve Board).
Subject to regulatory approvals, the Company expects to commence banking
operations in early 2003.
Capital Markets: The Company expanded its Schwab BondSource(TM) platform in
the third quarter of 2002 to provide additional information, new analytical
tools, and enhanced fixed income securities price quotes to support more
efficient client service. Client assets in fixed income securities were a record
$117.5 billion at September 30, 2002, an increase of $19.3 billion, or 20%, from
a year ago.
Other Significant Developments: The Company continued to combine people and
technology through several important technology-based initiatives during the
third quarter of 2002. Representatives from the Schwab Center for Investment
Research(R), Schwab Equity Research, and Schwab Investment Center hosted a
Webcast designed to help investors navigate the current markets. Along with
advice on investment objectives, diversification, and risk management, the
representatives shared their perspectives on the current downturn and possible
investment opportunities. Also, Schwab added a feature to its Web site to guide
prospective clients to selected service offerings, based on their individual
investing behavior and needs.
In the third quarter of 2002, Schwab expanded its proprietary funds
offering by introducing the Schwab Hedged Equity Fund(TM), which invests in both
long and short positions and is designed to provide investors with long-term
capital appreciation with less volatility than the broad market. This fund,
along with the Schwab Core Equity Fund(TM) introduced in the second quarter of
2002, combines the equity selection capabilities of Schwab Equity Ratings(TM)
with the diversification and convenience of a mutual fund.
Restructuring: The Company recorded pre-tax restructuring charges for the
third quarter of 2002 and the nine months ended September 30, 2002 as follows
(in millions):
- --------------------------------------------------------------------------------
Three Nine
Period ended September 30, 2002 Months Months
- --------------------------------------------------------------------------------
2002 Initiatives:
Workforce reduction $ 44 $ 44
Facilities reduction 50 50
- --------------------------------------------------------------------------------
Total 2002 Initiatives 94 94
- --------------------------------------------------------------------------------
2001 Initiatives:
Workforce reduction 1 19
Facilities reduction 65 76
Systems removal 1
- --------------------------------------------------------------------------------
Total 2001 Initiatives 66 96
- --------------------------------------------------------------------------------
Total restructuring charges $ 160 $ 190
================================================================================
2002 Initiatives
In the third quarter of 2002, the Company commenced additional
restructuring initiatives due to continued difficult market conditions. These
initiatives are intended to reduce operating expenses and adjust the Company's
organizational structure to improve productivity, enhance efficiency, and
increase profitability. The restructuring initiatives include further reductions
in workforce and facilities. The Company recorded pre-tax restructuring charges
of $94 million in the third quarter of 2002 related to these restructuring
initiatives. This amount includes
- 12 -
$12 million for workforce reductions related to the closure of the Company's
telephone service center in Austin, Texas, in the third quarter of 2002, and a
reduction of phone-based client support staff at the remaining four service
centers. Additionally, the Company expects that reductions in full-time
equivalent employees in the fourth quarter of 2002 will total approximately
1,900, including approximately 1,750 through mandatory staff reductions and
approximately 150 related to a reduction in contractors. In the third quarter of
2002, the Company recorded charges of $32 million related to the 60-day notice
period provided to these impacted employees (excluding contractors). The
remaining severance pay and benefits, which become contractual obligations only
when the impacted employee signs a severance agreement, will be recorded in the
fourth quarter of 2002. The Company expects to recognize additional pre-tax
restructuring charges in the fourth quarter of 2002 of approximately $90 million
for workforce reductions. As the Company works toward completing these
restructuring initiatives and assesses the impact of its workforce reductions,
additional charges for further reductions in operating facilities are possible.
The Company estimates that its 2002 restructuring initiatives will reduce
pre-tax operating expenses for full-year 2003 by approximately $250 million
compared to annualized second quarter 2002 operating expenses. Expected
reductions include approximately $150 million in compensation and benefits for
mandatory staff reductions, approximately $50 million in professional services
and other expenses, and approximately $50 million in spending for development
projects and advertising. A portion of these reductions in operating expenses,
however, will likely be used to enhance employee bonuses.
2001 Initiatives
In addition, the Company recorded pre-tax restructuring charges related to
the Company's 2001 restructuring initiatives of $66 million in the third quarter
of 2002, virtually all of which resulted from changes in estimates of sublease
income due to a continued deterioration of the commercial real estate market.
For further information on the Company's restructuring initiatives, see
note "4 - Restructuring" in the Notes to Condensed Consolidated Financial
Statements.
Risk Management
For discussion on the Company's principal risks and some of the policies
and procedures for risk identification, assessment, and mitigation, see
"Management's Discussion and Analysis of Results of Operations and Financial
Condition - Risk Management" in the Company's 2001 Annual Report to
Stockholders, which is filed as Exhibit 13.1 to the Company's Form 10-K for the
year ended December 31, 2001. See Liquidity and Capital Resources of this report
for a discussion on liquidity risk; and see Item 3 - Quantitative and
Qualitative Disclosures About Market Risk for additional information relating to
market risk.
The Company entered into a number of new insurance policies during the
quarter ended September 30, 2002 to replace and renew policies that were
expiring. Given the current state of the insurance market, the Company was
confronted with higher levels of rates and deductibles for coverages similar to
those which were replaced. These rates and deductibles were comparable to those
available to other participants in the insurance market. The increases in
deductibles could have a material adverse effect on the Company's results of
operations in any future period, depending partly on the results for that
period.
Given the nature of the Company's revenues, expenses, and risk profile, the
Company's earnings and CSC's common stock price have been and may continue to be
subject to significant volatility from period to period. The Company's results
for any interim period are not necessarily indicative of results for a full year
or any other interim period. Risk is inherent in the Company's business.
Consequently, despite the Company's attempts to identify areas of risk, oversee
operational areas involving risk, and implement policies and procedures designed
to mitigate risk, there can be no assurance that the Company will not suffer
unexpected losses due to operating or other risks.
Forward-Looking Statements
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," "expect," "intend," "plan," "will," "may," 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, the Company's
ability to achieve its strategic priorities (see Description of Business -
Business Strategy), the impact of the restructuring plan on the Company's
results of operations (see Description of Business - Restructuring), insurance
coverage (see Description of Business - Risk Management), sources of liquidity
and capital (see Liquidity and Capital Resources - Liquidity and - Commitments),
the Company's cash position, cash flows, capital expenditures, and development
spending (see Liquidity and Capital Resources
- 13 -
- - Cash Flows and Capital Resources), net interest expense under interest rate
swaps (see Item 3 - Quantitative and Qualitative Disclosures About Market Risk -
Financial Instruments Held For Purposes Other Than Trading - Interest Rate
Swaps), and contingent liabilities (see Part II - Other Information, Item 1 -
Legal Proceedings). Achievement of the expressed expectations is subject to
certain risks and uncertainties that could cause actual results to differ
materially from the expressed expectations described in these statements.
Important factors that may cause such differences are noted in this interim
report and include, but are not limited to: the effect of client trading
patterns on Company revenues and earnings; changes in revenues and profit margin
due to cyclical securities markets and fluctuations in interest rates; the level
and continuing volatility of equity prices; a significant downturn in the
securities markets over a short period of time or a sustained decline in
securities prices, trading volumes, and investor confidence; the size and number
of the Company's insurance claims; and a significant decline in the real estate
market, including the Company's ability to sublease certain properties. Other
more general factors that may cause such differences include, but are not
limited to: the Company's inability to attract and retain key personnel; the
timing and impact of changes in the Company's level of investments in personnel,
technology, or advertising; changes in technology; computer system failures and
security breaches; evolving legislation, regulation, accounting pronouncements,
and changing industry practices adversely affecting the Company; adverse results
of litigation; the inability to obtain external financing at acceptable rates;
the effects of competitors' pricing, product, and service decisions; and
intensified industry competition and consolidation.
Critical Accounting Policies
Certain of the Company's accounting policies that involve a higher degree
of judgment and complexity are discussed in "Management's Discussion and
Analysis of Results of Operations and Financial Condition - Critical Accounting
Policies" in the Company's 2001 Annual Report to Stockholders, which is filed as
Exhibit 13.1 to the Company's Form 10-K for the year ended December 31, 2001.
There have been no material changes to these critical accounting policies during
the first nine months of 2002.
Three Months Ended September 30, 2002 Compared To
Three Months Ended September 30, 2001
All references to earnings per share information in this report reflect
diluted earnings per share unless otherwise noted.
FINANCIAL OVERVIEW
The Company's financial performance in the third quarter of 2002 was
adversely affected by decreases in client trading activity as investor
confidence continued to be weighed down by persistent securities market
declines, concerns about corporate governance, and geopolitical developments.
Despite the difficult market environment that prevailed during the third quarter
of 2002, the Company's trading revenues increased 12% from the third quarter of
2001. The increase in trading revenues was partially due to a higher number of
trading days in the third quarter of 2002, as well as higher revenue per share
traded (reflected in commission revenues) and higher client fixed income
securities trading activity (reflected in principal transactions revenues).
Non-trading revenues, which include asset management and administration
fees, interest revenue, net of interest expense (referred to as net interest
revenue), and other revenues, decreased 4% in the third quarter of 2002 compared
to the year-ago level. The decrease in non-trading revenues was primarily due to
a 42% decrease in other revenue and a 9% decrease in net interest revenue,
partially offset by a 3% increase in asset management and administration fees.
The decrease in other revenues was primarily due to a gain on the sale of an
investment recorded in the third quarter of 2001. Average margin loans to
clients in the third quarter of 2002 decreased 33% from year-ago levels, which
primarily caused the decline in net interest revenue. The increase in asset
management and administration fees primarily resulted from higher account fees.
Total expenses excluding interest during the third quarter of 2002 were
$1.0 billion, up 4% from the third quarter of 2001. This increase resulted
primarily from higher restructuring charges in the third quarter of 2002,
partially offset by decreases in certain expenses as a result of the Company's
continued expense reduction measures.
In evaluating the Company's financial performance, management uses adjusted
operating income, which excludes non-operating items as detailed in the
following table. Management believes that operating income is a useful indicator
of its ongoing financial performance, and a tool that can provide meaningful
insight into financial performance without the effects of certain material items
that are not expected to be an ongoing part of operations (e.g., extraordinary
gains, restructuring and other charges, and merger- and acquisition-related
charges). In this
- 14 -
manner, operating income assists both management and investors in assessing the
Company's financial performance over extended periods of time. The Company's
after-tax operating income for the third quarter of 2002 was $96 million, up 19%
from the third quarter of 2001, and its after-tax operating profit margin for
the third quarter of 2002 was 9.4%, up from 8.2% for the third quarter of 2001.
A reconciliation of the Company's operating income to net income is shown in the
following table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
2002 2001 Change
- --------------------------------------------------------------------------------
Operating income, after tax $ 96 $ 81 19%
Non-operating items:
Other income (1) 26
Restructuring charges (2) (160) (99) 62
Merger- and acquisition-related charges (3) (31)
- --------------------------------------------------------------------------------
Total non-operating items (160) (104) 54
Tax effect 60 36 67
- --------------------------------------------------------------------------------
Total non-operating items, after tax (100) (68) 47
- --------------------------------------------------------------------------------
Net income (loss) $ (4) $ 13 n/m
================================================================================
(1) Primarily consists of a gain on the sale of an investment.
(2) Restructuring charges include costs relating to workforce, facilities,
systems hardware, software, and equipment reductions.
(3) Includes retention program compensation related to the merger with USTC,
and intangible asset amortization and retention program compensation
related to the acquisition of CyberTrader. The retention programs related
to the acquisition of CyberTrader and the merger with USTC ended in March
2002 and May 2002, respectively. For the three months ended September 30,
2001, amount also includes goodwill amortization, which ceased on January
1, 2002 upon the adoption of Statement of Financial Accounting Standards
No. 142.
n/m Not meaningful
The Company's operating income before taxes for the third quarter of 2002
was $155 million, up $25 million, or 19%, from the third quarter of 2001
primarily due to an increase of $29 million, or 83%, in the Individual Investor
segment, partially offset by a decrease of $3 million, or 5%, in the
Institutional Investor segment. The increase in the Individual Investor segment
was primarily due to lower expenses resulting from the Company's workforce
reduction under its restructuring plan. As certain technology, corporate, and
general administrative expenses are allocated to segments based upon their
full-time equivalent employees, a proportionately larger allocation of expenses
was assigned to the Institutional Investor segment for the third quarter of
2002, which, along with an increase in certain direct costs, resulted in the
operating income decline in that segment.
The Company recognized a net loss of $4 million for the third quarter of
2002, compared to net income of $13 million, or $.01 per share, for the third
quarter of 2001. The Company's after-tax profit margin for the third quarter of
2002 was (.3%), down from 1.3% for the third quarter of 2001.
The annualized return on stockholders' equity for the third quarter of 2002
was 0%, down from 1% for the third quarter of 2001.
REVENUES
Revenues increased by $8 million, or 1%, to $1.0 billion in the third
quarter of 2002 compared to the third quarter of 2001, due to a $33 million, or
12%, increase in commission revenues, a $14 million, or 3%, increase in asset
management and administration fees and a $5 million, or 12%, increase in
principal transaction revenues. These increases were partially offset by a $21
million, or 9%, decrease in net interest revenue and a $23 million, or 42%,
decrease in other revenues. The Company's non-trading revenues represented 65%
of total revenues for the third quarter of 2002, as compared to 69% for the
third quarter of 2001 as shown in the following table:
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,
Composition of Revenues 2002 2001
- --------------------------------------------------------------------------------
Commissions 30% 27%
Principal transactions 5 4
- --------------------------------------------------------------------------------
Total trading revenues 35 31
- --------------------------------------------------------------------------------
Asset management and administration fees 42 41
Net interest revenue 20 22
Other 3 6
- --------------------------------------------------------------------------------
Total non-trading revenues 65 69
- --------------------------------------------------------------------------------
Total 100% 100%
================================================================================
While the Individual Investor and Institutional Investor segments generate
both trading and non-trading revenues, the Capital Markets segment generates
primarily trading revenues and the U.S. Trust segment generates primarily
non-trading revenues. The $8 million increase in revenues from the third quarter
of 2001 was due to increases in operating revenues of $17 million, or 3%, in the
Individual Investor segment, $14 million, or 7%, in the Institutional Investor
segment, and $6 million, or 10%, in the Capital Markets segment, partially
offset by a decrease of $3 million, or 2%, in the U.S. Trust segment.
Additionally, the Company had non-operating revenues of $26 million in the third
quarter of 2001, consisting primarily of a gain on the sale of an investment.
See note "12 - Segment Information" in the Notes to Condensed Consolidated
Financial Statements for financial information by segment.
- 15 -
Asset Management and Administration Fees
Asset management and administration fees include mutual fund service fees,
as well as fees for other asset-based financial services provided to individual
and institutional clients. The Company earns mutual fund service fees for
recordkeeping and shareholder services provided to third-party funds, and for
transfer agent services, shareholder services, administration, and investment
management provided to its proprietary funds. These fees are based upon the
daily balances of client assets invested in third-party funds and upon the
average daily net assets of the Company's proprietary funds. Mutual fund service
fees are earned through the Individual Investor, Institutional Investor, and
U.S. Trust segments. The Company also earns asset management and administration
fees for financial services, including investment management and consulting,
trust and fiduciary services, financial and estate planning, and private banking
services, provided to individual and institutional clients. These fees are
primarily based on the value and composition of assets under management and are
earned through the U.S. Trust, Individual Investor, and Institutional Investor
segments.
Asset management and administration fees were $434 million for the third
quarter of 2002, up $14 million, or 3%, from the third quarter of 2001, as shown
in the following table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
Asset Management September 30, Percent
and Administration Fees 2002 2001 Change
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds
(SchwabFunds(R)and Excelsior(R)) $218 $209 4%
Mutual Fund OneSource(R) 61 69 (12)
Other 10 13 (23)
Asset management and related services 145 129 12
- --------------------------------------------------------------------------------
Total $434 $420 3%
================================================================================
The increase in asset management and administration fees was primarily due
to higher account fees and increases in assets in Schwab's proprietary funds
(collectively referred to as the SchwabFunds), which led to an increase in
service fees, partially offset by a decrease in assets in Schwab's Mutual Fund
OneSource service.
Assets in client accounts were $726.8 billion at September 30, 2002, a
decrease of $41.6 billion, or 5%, from a year ago as shown in the following
table. This decrease from a year ago included net new client assets of $51.0
billion, offset by net market losses of $92.6 billion related to client
accounts.
- --------------------------------------------------------------------------------
Change in Client Assets and Accounts
(In billions, at quarter end, September 30, Percent
except as noted) 2002 2001 Change
- --------------------------------------------------------------------------------
Assets in client accounts
Schwab One(R), other cash
equivalents and deposits
from banking clients $ 29.0 $ 28.1 3%
Proprietary funds (SchwabFunds(R)
and Excelsior(R)):
Money market funds 129.2 130.0 (1)
Equity and bond funds 26.8 27.5 (3)
- --------------------------------------------------------------------------------
Total proprietary funds 156.0 157.5 (1)
- --------------------------------------------------------------------------------
Mutual Fund Marketplace(R)(1):
Mutual Fund OneSource(R) 70.0 76.6 (9)
Mutual fund clearing services 19.8 18.2 9
All other 68.5 66.8 3
- --------------------------------------------------------------------------------
Total Mutual Fund Marketplace 158.3 161.6 (2)
- --------------------------------------------------------------------------------
Total mutual fund assets 314.3 319.1 (2)
- --------------------------------------------------------------------------------
Equity and other securities (1) 272.9 332.0 (18)
Fixed income securities (2) 117.5 98.2 20
Margin loans outstanding (6.9) (9.0) 23
- --------------------------------------------------------------------------------
Total client assets $ 726.8 $ 768.4 (5%)
================================================================================
Net change in assets
in client accounts
(for the quarter ended)
Net new client assets $ 10.6 $ 17.9
Net market losses (80.8) (107.8)
- ------------------------------------------------------------------
Net decline $ (70.2) $ (89.9)
==================================================================
New client accounts
(in thousands, for the
quarter ended) 159.6 184.2 (13%)
Active client accounts
(in millions) (3) 8.0 7.8 3%
- --------------------------------------------------------------------------------
Active online Schwab client
accounts (in millions) (4) 4.1 4.3 (5%)
Online Schwab client assets $ 270.1 $ 306.3 (12%)
- --------------------------------------------------------------------------------
(1) Excludes money market funds and all proprietary money market, equity, and
bond funds.
(2) Includes $15.1 billion and $15.7 billion at September 30, 2002 and 2001,
respectively, of other securities serviced by Schwab's fixed income
division, including exchange-traded unit investment trusts, real estate
investment trusts, preferred debt, and preferred equities.
(3) Active accounts are defined as accounts with balances or activity within
the preceding eight months.
(4) Active online accounts are defined as all accounts within a household that
has had at least one online session within the past twelve months.
- 16 -
Commissions
The Company earns revenues by executing client trades primarily through the
Individual Investor and Institutional Investor segments. These revenues are
affected by the number of accounts that trade, the average number of
revenue-generating trades per account, and the average revenue earned per trade.
Commission revenues for the Company were $309 million for the third quarter of
2002, up $33 million, or 12%, from the third quarter of 2001. This increase was
primarily due to higher revenue per trade and trading days, partially offset by
lower daily average trades.
The Company's client trading activity is shown in the following table (in
thousands):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Daily Average Trades 2002 2001 Change
- --------------------------------------------------------------------------------
Revenue Trades (1)
Online 107.3 109.3 (2%)
TeleBroker(R)and Schwab by PhoneTM 5.4 6.6 (18)
Regional client telephone service
centers, branch offices, and other 16.4 17.9 (8)
- --------------------------------------------------------------------------------
Total 129.1 133.8 (4%)
================================================================================
Mutual Fund OneSource(R) and
Other Asset-Based Trades
Online 47.9 33.3 44%
TeleBroker and Schwab by Phone .3 .4 (25)
Regional client telephone service
centers, branch offices, and other 8.3 20.3 (59)
- --------------------------------------------------------------------------------
Total 56.5 54.0 5%
================================================================================
Total Daily Average Trades
Online 155.2 142.6 9%
TeleBroker and Schwab by Phone 5.7 7.0 (19)
Regional client telephone service
centers, branch offices, and other 24.7 38.2 (35)
- --------------------------------------------------------------------------------
Total 185.6 187.8 (1%)
================================================================================
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
As shown in the following table, the total number of revenue trades
executed by the Company has increased 4% as the client trading activity per
account that traded has increased.
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Trading Activity 2002 2001 Change
- --------------------------------------------------------------------------------
Total revenue trades
(in thousands) (1) 8,263 7,908 4%
Accounts that traded during
the quarter (in thousands) 1,284 1,339 (4)
Average revenue trades
per account that traded 6.4 5.9 8
Trading frequency proxy (2) 3.9 3.8 3
Number of trading days 64 59 8
Average revenue earned
per revenue trade $39.71 $36.35 9
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
(2) Represents annualized revenue trades per $100,000 in client assets.
Net Interest Revenue
Net interest revenue is the difference between interest earned on assets
(mainly margin loans to clients, investments required to be segregated for
clients, private banking loans, and securities available for sale) and interest
paid on liabilities (mainly brokerage client cash balances and banking
deposits). 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
hedging strategies.
Substantially all of the Company's net interest revenue is earned through
the Individual Investor, Institutional Investor, and U.S. Trust segments.
- 17 -
Net interest revenue was $209 million for the third quarter of 2002, down
$21 million, or 9%, from the third quarter of 2001 as shown in the following
table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
2002 2001 Change
- --------------------------------------------------------------------------------
Interest Revenue
Margin loans to clients $ 108 $ 185 (42%)
Investments, client-related 87 128 (32)
Private banking loans 59 61 (3)
Securities available for sale 21 20 5
Other 20 37 (46)
- --------------------------------------------------------------------------------
Total 295 431 (32)
- --------------------------------------------------------------------------------
Interest Expense
Brokerage client cash balances 43 147 (71)
Deposits from banking clients 26 29 (10)
Long-term debt 10 13 (23)
Short-term borrowings 6 8 (25)
Stock-lending activities 1 3 (67)
Other 1 n/m
- --------------------------------------------------------------------------------
Total 86 201 (57)
- --------------------------------------------------------------------------------
Net interest revenue $ 209 $ 230 (9%)
================================================================================
n/m Not meaningful
Client-related and other daily average balances, interest rates, and
average net interest spread for the third quarters of 2002 and 2001 are
summarized in the following table (dollars in millions):
- --------------------------------------------------------------------------------
Three Months Ended
September 30,
2002 2001
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $ 18,973 $ 13,751
Average interest rate 1.83% 3.71%
Margin loans to clients:
Average balance outstanding $ 7,346 $ 10,910
Average interest rate 5.79% 6.73%
Private banking loans:
Average balance outstanding $ 4,139 $ 3,645
Average interest rate 5.69% 6.65%
Securities available for sale:
Average balance outstanding $ 1,568 $ 1,365
Average interest rate 5.29% 5.80%
Average yield on interest-earning assets 3.40% 5.28%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $ 22,917 $ 21,883
Average interest rate .73% 2.66%
Interest-bearing banking deposits:
Average balance outstanding $ 3,908 $ 3,259
Average interest rate 2.62% 3.57%
Other interest-bearing sources:
Average balance outstanding $ 1,021 $ 972
Average interest rate 2.18% 3.57%
Average noninterest-bearing portion $ 4,180 $ 3,557
Average interest rate on funding sources .91% 2.47%
Summary:
Average yield on interest-earning assets 3.40% 5.28%
Average interest rate on funding sources .91% 2.47%
- --------------------------------------------------------------------------------
Average net interest spread 2.49% 2.81%
================================================================================
The decrease in net interest revenue from the third quarter of 2001 was
primarily due to lower levels of, and lower rates received on, margin loans to
clients, as well as lower rates received on client-related investments,
partially offset by lower rates paid on brokerage client cash balances and
higher average balances of client-related investments.
Principal Transactions
Principal transaction revenues are primarily comprised of revenues from
client fixed income securities trading activity, which are included in the
Individual Investor and Institutional Investor segments, and net gains from
market-making activities in Nasdaq and other equity securities, which are
included in the Capital Markets segment. Factors that influence principal
transaction revenues include the volume of client trades, market price
volatility, average
- 18 -
revenue per share traded, and changes in regulations and industry practices.
Principal transaction revenues were $47 million for the third quarter of
2002, up $5 million, or 12%, from the third quarter of 2001, as shown in the
following table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Principal Transactions 2002 2001 Change
- --------------------------------------------------------------------------------
Fixed income securities $ 25 $ 18 39%
Nasdaq and other equity securities 19 22 (14)
Other 3 2 50
- --------------------------------------------------------------------------------
Total $ 47 $ 42 12%
================================================================================
The increase in principal transaction revenues was primarily due to higher
revenues from client fixed income securities trading activity and higher equity
share volume handled by SCM, partially offset by lower average revenue per
equity share traded.
Other Revenues
Other revenues were $32 million for the third quarter of 2002, down $23
million, or 42%, from the third quarter of 2001. This decrease was primarily due
to a gain recorded on the sale of an investment in 2001.
EXPENSES EXCLUDING INTEREST
Total expenses excluding interest for the third quarter of 2002 increased
$39 million, or 4%, from the third quarter of 2001, primarily due to
restructuring charges, partially offset by decreases in certain expenses as a
result of the Company's continued expense reduction measures. The Company
recorded total pre-tax restructuring charges of $160 million in the third
quarter of 2002. In the third quarter of 2001, the Company recorded total
pre-tax restructuring charges of $99 million.
Compensation and benefits expense was $472 million for the third quarter of
2002, up $11 million, or 2%, from the third quarter of 2001 primarily due to the
accrual of discretionary bonuses to employees and higher incentive compensation
and employee benefits, partially offset by a reduction in full-time equivalent
employees in the third quarter of 2002.
The following table shows a comparison of certain compensation and benefits
components and employee data (dollars in millions, except as noted):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
2002 2001 Change
- --------------------------------------------------------------------------------
Compensation and benefits:
Salaries and wages $ 326 $ 345 (6%)
Incentive and variable compensation 73 52 40
Employee benefits and other 73 64 14
- --------------------------------------------------------------------------------
Total compensation and benefits $ 472 $ 461 2%
- --------------------------------------------------------------------------------
Compensation and benefits expense as a
% of total revenues 46% 45%
Incentive and variable compensation as a
% of compensation and benefits expense 15% 11%
Compensation for temporary employees,
contractors and overtime hours as a
% of compensation and benefits expense 6% 6%
Full-time equivalent employees
(at end of quarter, in thousands) (1) 18.8 21.9 (14%)
Revenues per average full-time equivalent
employee (in thousands) $54.5 $46.3 18%
- --------------------------------------------------------------------------------
(1) Includes full-time, part-time, and temporary employees, and persons
employed on a contract basis.
Employee benefits and other expenses increased by $9 million, or 14%, from
the third quarter of 2001 primarily due to an increase in the obligations under
the Company's deferred compensation plan, and higher health insurance costs and
employee claims. Additionally, employee benefits and other expense includes net
pension expense (income) related to U.S. Trust's defined benefit pension plan,
which totaled less than $1 million and ($3) million in the third quarters of
2002 and 2001, respectively. The increase in pension expense from the third
quarter of 2001 was primarily due to a decline in the fair value of pension plan
assets, as well as an increase in the service cost resulting from a greater
number of employees covered under the pension plan, and a lower assumed discount
rate used in the expense calculation.
Goodwill amortization expense for the third quarter of 2001 was $17
million. On January 1, 2002, the Company adopted Statement of Financial
Accounting Standards (SFAS) No. 142 - Goodwill and Other Intangible Assets. Upon
adoption of SFAS No. 142, amortization of the existing goodwill ceased and
therefore there was no such expense in the third quarter of 2002.
The Company's effective income tax benefit rate was 34.2% for the third
quarter of 2002, compared to an effective income tax expense rate of 49.4% for
the third quarter of 2001. The decrease was primarily due to the
- 19 -
cessation of goodwill amortization, which was nondeductible for tax purposes,
upon the adoption of SFAS No. 142 in 2002.
Nine Months Ended September 30, 2002 Compared To
Nine Months Ended September 30, 2001
FINANCIAL OVERVIEW
In the difficult market environment that prevailed during the first nine
months of 2002, daily average revenue trades decreased 18% and average revenue
per equity share traded in the Capital Markets segment decreased 44% from
year-earlier levels. As a result of these two factors, the Company's trading
revenues in the first nine months of 2002 decreased 13% from the first nine
months of 2001 and total revenues decreased 5% for the same period.
Non-trading revenues in the first nine months of 2002 were comparable to
the year-ago level. Asset management and administra