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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 June 30, 2004 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 by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
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.
1,366,488,547 shares of $.01 par value Common Stock
Outstanding on July 30, 2004
THE CHARLES SCHWAB CORPORATION
Quarterly Report on Form 10-Q
For the Quarter Ended June 30, 2004
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 - 12
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 13 - 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, Use of Proceeds and Issuer Purchases
of Equity Securities 30
Item 3. Defaults Upon Senior Securities 30
Item 4. Submission of Matters to a Vote of Security Holders 30
Item 5. Other Information 30
Item 6. Exhibits and Reports on Form 8-K 31
Signature 32
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 Six Months Ended
June 30, June 30,
2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 514 $ 445 $1,019 $ 873
Commissions 286 313 676 553
Interest revenue 276 244 539 483
Interest expense (52) (64) (105) (128)
------- ------- ------- -------
Net interest revenue 224 180 434 355
Principal transactions 40 43 92 76
Other 48 37 81 61
- ------------------------------------------------------------------------------------------------------------------------------------
Total 1,112 1,018 2,302 1,918
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 533 449 1,061 866
Occupancy and equipment 104 111 210 222
Depreciation and amortization 55 71 114 147
Communications 61 58 126 118
Professional services 63 44 123 81
Advertising and market development 47 21 109 69
Commissions, clearance and floor brokerage 21 20 44 33
Restructuring charges 2 24 2 24
Impairment charges - - - 5
Other 47 38 87 74
- ------------------------------------------------------------------------------------------------------------------------------------
Total 933 836 1,876 1,639
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before taxes on income 179 182 426 279
Taxes on income (66) (56) (152) (79)
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations 113 126 274 200
Loss from discontinued operations, net of tax - - - (3)
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income $ 113 $ 126 $ 274 $ 197
====================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,373 1,360 1,374 1,358
- ------------------------------------------------------------------------------------------------------------------------------------
Earnings Per Share - Basic
Income from continuing operations $ .08 $ .10 $ .20 $ .15
Loss from discontinued operations, net of tax - - - -
Net income $ .08 $ .10 $ .20 $ .15
Earnings Per Share - Diluted
Income from continuing operations $ .08 $ .09 $ .20 $ .14
Loss from discontinued operations, net of tax - - - -
Net income $ .08 $ .09 $ .20 $ .14
- ------------------------------------------------------------------------------------------------------------------------------------
Dividends Declared Per Common Share $ .020 $ .011 $ .034 $ .022
- ------------------------------------------------------------------------------------------------------------------------------------
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)
June 30, December 31,
2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 2,547 $ 2,832
Cash and investments segregated and on deposit for federal or other
regulatory purposes(1) (including resale agreements of $14,820 in 2004
and $16,824 in 2003) 20,475 21,343
Securities owned - at market value (including securities pledged of $3
in 2004 and $131 in 2003) 4,808 4,023
Receivables from brokers, dealers and clearing organizations 366 556
Receivables from brokerage clients - net 9,257 8,581
Loans to banking clients - net 6,778 5,736
Loans held for sale 35 29
Equipment, office facilities and property - net 942 956
Goodwill - net 1,029 835
Intangible assets - net 172 144
Other assets 912 831
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 47,321 $ 45,866
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 10,045 $ 8,308
Drafts payable 331 154
Payables to brokers, dealers and clearing organizations 2,763 2,661
Payables to brokerage clients 26,878 27,184
Accrued expenses and other liabilities 1,248 1,330
Short-term borrowings 679 996
Long-term debt 645 772
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 42,589 41,405
- ------------------------------------------------------------------------------------------------------------------------------------
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;
1,392,091,544 shares issued 14 14
Additional paid-in capital 1,759 1,749
Retained earnings 3,334 3,125
Treasury stock - 26,414,570 and 34,452,710 shares in 2004 and 2003,
respectively, at cost (235) (319)
Unamortized stock-based compensation (110) (95)
Accumulated other comprehensive loss (30) (13)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,732 4,461
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 47,321 $ 45,866
====================================================================================================================================
(1) Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes were $20,570 million at June 30, 2004, excluding $200 million of intercompany repurchase agreements,
and $21,005 million at December 31, 2003. On July 2, and January 5, 2004, the Company deposited $496 million and $221 million,
respectively, into its segregated reserve bank accounts.
See Notes to Condensed Consolidated Financial Statements.
- 2 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Cash Flows
(In millions)
(Unaudited)
Six Months Ended
June 30,
2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 274 $ 197
Adjustments to reconcile net income to net cash used for operating activities:
Depreciation and amortization 114 147
Impairment charges - 5
Tax benefit from, and amortization of, stock-based awards 32 9
Deferred income taxes 51 16
Other (9) 2
Originations of loans held for sale (530) (183)
Proceeds from sales of loans held for sale 526 83
Net change in:
Cash and investments segregated and on deposit for federal or other
regulatory purposes 868 (2,356)
Securities owned (excluding securities available for sale) 56 (197)
Receivables from brokers, dealers and clearing organizations 194 (98)
Receivables from brokerage clients (676) (182)
Other assets (82) (15)
Drafts payable 177 89
Payables to brokers, dealers and clearing organizations 102 1,210
Payables to brokerage clients (306) 501
Accrued expenses and other liabilities (144) (91)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) operating activities 647 (863)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (1,697) (868)
Proceeds from sales of securities available for sale 137 159
Proceeds from maturities, calls and mandatory redemptions of securities
available for sale 771 308
Net increase in loans to banking clients (1,043) (413)
Purchase of equipment, office facilities and property - net (88) (65)
Cash payments for business combinations and investments, net of cash acquired (290) (8)
Proceeds from sales of subsidiaries - 53
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (2,210) (834)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net change in deposits from banking clients 1,736 (2)
Net change in short-term borrowings (317) 806
Proceeds from long-term debt 136 -
Repayment of long-term debt (255) (73)
Dividends paid (46) (30)
Purchase of treasury stock - (32)
Proceeds from stock options exercised and other 24 13
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 1,278 682
- ------------------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (285) (1,015)
Cash and Cash Equivalents at Beginning of Period 2,832 3,114
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 2,547 $ 2,099
====================================================================================================================================
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, and with its majority-owned
subsidiaries collectively referred to as the Company) is a financial holding
company engaged, through its subsidiaries, in securities brokerage, banking, and
related financial services. Charles Schwab & Co., Inc. (Schwab) is a securities
broker-dealer with 336 domestic branch offices in 48 states, as well as a branch
in the Commonwealth of Puerto Rico. See note "17 - Subsequent Events" for
further discussion on branch offices. 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 38 offices in 15 states. Other subsidiaries include
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, exchange-listed, and other securities providing trade execution services
primarily to broker-dealers and institutional clients, CyberTrader, Inc., an
electronic trading technology and brokerage firm providing services to highly
active, online traders, and Charles Schwab Bank, N.A. (Schwab Bank), a retail
bank which commenced operations in the second quarter of 2003.
On January 31, 2003, the Company sold its United Kingdom (U.K.) brokerage
subsidiary, Charles Schwab Europe (CSE), to Barclays PLC. The results of the
operations of CSE, net of income taxes, have been presented as discontinued
operations on the Condensed Consolidated Statement of Income.
The accompanying unaudited condensed consolidated financial statements
include CSC and its majority-owned subsidiaries. These financial statements have
been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission (SEC) 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
generally accepted accounting principles in the U.S. (GAAP). All adjustments
were of a normal recurring nature. Certain items in prior periods' financial
statements have been reclassified to conform to the 2004 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 2003 Annual
Report to Stockholders, which is filed as Exhibit 13.1 to the Company's
Form 10-K for the year ended December 31, 2003, and the Company's Quarterly
Report on Form 10-Q for the period ended March 31, 2004. The Company's results
for any interim period are not necessarily indicative of results for a full year
or any other interim period.
2. New Accounting Standards
SEC Staff Accounting Bulletin (SAB) No. 105 "Application of Accounting
Principles to Loan Commitments" was released in March 2004. This release
summarizes the SEC staff position regarding the application of GAAP to loan
commitments accounted for as derivative instruments. The Company accounts for
interest rate lock commitments issued on mortgage loans that will be held for
sale as derivative instruments. Consistent with SAB No. 105, the Company
considers the fair value of these commitments to be zero at the commitment date,
with subsequent changes in fair value determined solely on changes in market
interest rates. As of June 30, 2004, the Company had interest rate lock
commitments on mortgage loans to be held for sale with principal balances
totaling approximately $150 million, the fair value of which was immaterial.
Emerging Issues Task Force Issue (EITF) No. 03-01 "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments" was
ratified by the Financial Accounting Standards Board in March 2004. This EITF
addresses how to determine the meaning of other-than-temporary impairment and
its application to investments classified as either available-for-sale or
held-to-maturity under Statement of Financial Accounting Standards
(SFAS) No. 115 - Accounting for Certain Investments in Debt and Equity
Securities (including individual securities and investments in mutual funds),
and investments accounted for under the cost method or the equity method. The
new guidance for evaluating whether an investment is other-than-temporarily
impaired is effective for the third quarter of 2004. The Company's investments
classified as available for sale are primarily comprised of U.S. government
sponsored agency and private mortgage-backed securities and collateralized
mortgage obligations. At June 30, 2004, the gross unrealized loss on these
investments, caused by recent interest rate increases, was $40 million. Because
the decline in market value is attributable to changes in interest rates and not
credit quality and because the Company generally has the ability and intent to
hold these investments until a recovery of fair value (up to or beyond the cost
basis), which may be maturity, the Company does not consider these investments
to be other-than-temporarily impaired. Management is continuing to evaluate the
potential impact of this new guidance.
- 4 -
3. Stock Incentive Plans
The Company's stock incentive plans provide for granting options to
employees, officers, and directors. Options are granted for the purchase of
shares of CSC's common stock at an exercise price not less than the market value
on the date of grant, and expire within ten years from the date of grant.
Options generally vest over a four-year period from the date of grant.
A summary of option activity follows:
- --------------------------------------------------------------------------------
2004 2003
---------------- ----------------
Weighted- Weighted-
Number Average Number Average
of Exercise of Exercise
Options Price Options Price
- --------------------------------------------------------------------------------
Outstanding at
beginning of year 136 $15.25 156 $15.38
Granted:
Quarter ended March 31 1 $13.73 -(1) $ 9.26
Quarter ended June 30 -(1) $10.21 2 $ 8.93
- --------------------------------------------------------------------------------
Total granted 1 $12.94 2 $ 8.99
Exercised (5) $ 5.28 (2) $ 5.65
Canceled (5) $19.30 (10) $18.48
- --------------------------------------------------------------------------------
Outstanding
at June 30 127 $15.43 146 $15.25
================================================================================
Exercisable
at June 30 88 $15.78 80 $14.14
- --------------------------------------------------------------------------------
Available for future
grant at June 30 46 40
- --------------------------------------------------------------------------------
Weighted-average fair
value of options granted:
Quarter ended March 31 $ 3.95 $ 4.34
Quarter ended June 30 $ 3.52 $ 3.96
- --------------------------------------------------------------------------------
(1) Less than 500,000 options were granted.
The Company changed its option pricing model from the Black-Scholes model
to a binomial model for all options granted on or after January 1, 2004. The
fair values of stock options granted prior to January 1, 2004 were determined
using the Black-Scholes model. The Company believes that the binomial model
offers greater flexibility in reflecting the characteristics of employee stock
options. The binomial model takes into account similar inputs to a Black-Scholes
model such as volatility, dividend yield rate, and risk-free interest rate. In
addition to these assumptions, the binomial model considers the contractual term
of the option, the probability that the option will be exercised prior to the
end of its contractual life, and the probability of termination or retirement of
the option holder in computing the value of the option. The Company determines
these probabilities generally based on analysis of historical trends of such
events. The assumptions used in the respective option pricing models were as
follows:
- --------------------------------------------------------------------------------
Three Months Ended
March 31, June 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Expected dividend yield .48% .30% .48% .30%
Expected volatility 36% 52% 36% 49%
Risk-free interest rate 4.0% 2.9% 4.6% 2.6%
Expected life (in years) 4 5 4 5
- --------------------------------------------------------------------------------
The Company applies Accounting Principles Board Opinion No. 25 - Accounting
for Stock Issued to Employees, and related interpretations, for its stock-based
employee compensation plans. Because the Company grants stock option awards with
an exercise price not less than the market value of CSC's common stock on the
date of grant, there is no compensation expense recorded, except for
restructuring-related expense for modifications of officers' stock options.
- 5 -
Had compensation expense for the Company's stock option awards been
determined based on the Black-Scholes or binomial fair value, as described
above, at the grant dates for awards under those plans consistent with the fair
value method of SFAS No. 123 - Accounting for Stock-Based Compensation, the
Company would have recorded additional compensation expense and its net income
and earnings per share (EPS) would have been reduced to the pro forma amounts
presented in the following table:
- --------------------------------------------------------------------------------
Three Six
Months Ended Months Ended
June 30, June 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Compensation expense for stock
options (after-tax):
As reported $ - $ - $ - $ -
Pro forma (1) $ 20 $ 29 $ 44 $ 58
- --------------------------------------------------------------------------------
Net income:
As reported $113 $126 $274 $197
Pro forma $ 93 $ 97 $230 $139
- --------------------------------------------------------------------------------
Basic EPS:
As reported $.08 $.10 $.20 $.15
Pro forma $.07 $.07 $.17 $.10
Diluted EPS:
As reported $.08 $.09 $.20 $.14
Pro forma $.07 $.07 $.17 $.10
- --------------------------------------------------------------------------------
(1) Includes pro forma compensation expense related to stock options granted in
both current and prior periods. Pro forma stock option compensation is
amortized on a straight-line basis over the vesting period beginning with
the month in which the option was granted.
4. Restructuring
In the second quarter of 2004, the Company announced a firm-wide cost
reduction effort designed to mitigate the financial impact of its recent pricing
changes and to strengthen its productivity and efficiency. This effort will
consist of two phases, with phase one focusing on the elimination of work that
is not essential to meeting client service standards or the Company's ongoing
operating needs. During the second quarter, the Company implemented the first
element of phase one - the reallocation of certain client service functions from
its Orlando regional telephone service center to other centers. Phase two of the
cost reduction effort will focus on reengineering work processes to maximize
productivity, minimizing organizational complexity through functional
streamlining, and addressing business unit performance across the firm.
The Company recorded pre-tax restructuring charges of $4 million in the
second quarter of 2004, reflecting severance costs for approximately 250
employees, including the workforce reduction in Orlando. For further discussion
on the cost reduction effort, see note "17 - Subsequent Events."
The Company's 2003, 2002, and 2001 restructuring initiatives included
workforce reductions, reductions in operating facilities, the removal of certain
systems hardware, software, and equipment from service, and the withdrawal from
certain international operations. These initiatives reduced operating expenses
and adjusted the Company's organizational structure to improve productivity,
enhance efficiency, and increase profitability. The Company recorded a pre-tax
restructuring credit of $2 million in the second quarter of 2004 and pre-tax
restructuring charges of $24 million in the second quarter of 2003 related to
these restructuring initiatives, both primarily due to changes in estimates of
sublease income associated with previously announced efforts to sublease excess
facilities.
A summary of the activity in the restructuring reserve for the second
quarter and first half of 2004 is as follows:
- --------------------------------------------------------------------------------
Three months ended Workforce Facilities
June 30, 2004 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at March 31, 2004 $ 12 $ 188 $ 200
Restructuring charges 4 (2) 2
Cash payments (4) (21) (25)
Other (1) - 1 1
- --------------------------------------------------------------------------------
Balance at June 30, 2004 $ 12 (2) $ 166 (3) $ 178
================================================================================
- --------------------------------------------------------------------------------
Six months ended Workforce Facilities
June 30, 2004 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at December 31, 2003 $ 23 $ 201 $ 224
Restructuring charges 4 (2) 2
Cash payments (14) (37) (51)
Non-cash charges (4) (1) - (1)
Other (1) - 4 4
- --------------------------------------------------------------------------------
Balance at June 30, 2004 $ 12 (2) $ 166 (3) $ 178
================================================================================
(1) Primarily includes the accretion of facilities restructuring reserves,
which are initially recorded at net present value. Accretion expense is
recorded in occupancy and equipment expense on the Condensed Consolidated
Statement of Income.
(2) Includes $4 million related to the Company's 2004 cost reduction effort, as
well as $6 million, $1 million, and $1 million related to the Company's
2003, 2002, and 2001 restructuring initiatives, respectively. The Company
expects to substantially utilize the remaining workforce reduction reserve
through cash payments for severance pay and benefits over the respective
severance periods through 2005.
(3) Includes $6 million, $66 million, and $94 million related to the Company's
2003, 2002, and 2001 restructuring initiatives, respectively. The Company
expects to substantially utilize the remaining facilities reduction reserve
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. Business Acquisitions and Divestiture
In January 2004, the Company completed its acquisition of SoundView
Technology Group, Inc. (SoundView), a research-driven securities firm providing
institutional investors with fundamental research on companies in selected
industries, for approximately $340 million, or $289 million net of SoundView's
cash and cash equivalents acquired. Additionally, the Company recorded
securities owned of $93 million related to this acquisition. As a result of a
preliminary purchase price allocation, the Company recorded goodwill of $194
million, subject to management's final evaluation of pre-acquisition legal
contingencies, and intangible assets of $21 million related to this acquisition.
In October 2003, U.S. Trust acquired State Street Corporation's Private
Asset Management group, a provider of wealth management services to clients in
the New England area, for $365 million.
In June 2003, the Company sold its investment in Aitken Campbell, a
market-making joint venture in the U.K., to the Company's joint venture partner,
TD Waterhouse Group, Inc. In the first quarter of 2003, the Company recorded an
impairment charge of $5 million pre-tax to reduce the carrying value of its
investment and a deferred income tax benefit of $16 million. The Company's share
of Aitken Campbell's historical earnings, which was accounted for under the
equity method, was not material to the Company's results of operations, EPS, or
cash flows.
6. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Residential real estate mortgages $5,535 $4,624
Consumer loans 803 735
Other 468 404
- --------------------------------------------------------------------------------
Total loans 6,806 5,763
Less: allowance for credit losses (28) (27)
- --------------------------------------------------------------------------------
Loans to banking clients - net $6,778 $5,736
================================================================================
Included in the loan portfolio are nonaccrual loans totaling $1 million at
both June 30, 2004 and December 31, 2003. Nonaccrual loans are considered
impaired by the Company, and represent all of the Company's nonperforming assets
at both June 30, 2004 and December 31, 2003. For each of the second quarters and
first halves of 2004 and 2003, the impact of interest revenue which would have
been earned on nonaccrual loans versus interest revenue recognized on these
loans was not material to the Company's results of operations.
The amount of loans accruing interest that were contractually 90 days or
more past due was immaterial at both June 30, 2004 and December 31, 2003.
Recoveries and charge-offs related to the allowance for credit losses on
the loan portfolio were not material for each of the second quarters and first
halves of 2004 and 2003.
7. Deposits from Banking Clients
Deposits from banking clients consist of money market and other savings
deposits, certificates of deposit, and noninterest-bearing deposits. Deposits
from banking clients are as follows:
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Interest-bearing deposits $ 9,431 $ 7,585
Noninterest-bearing deposits 614 723
- --------------------------------------------------------------------------------
Total $10,045 $ 8,308
================================================================================
The average rate paid by the Company on its interest-bearing deposits from
banking clients was 1.04% and 1.97% for the second quarters of 2004 and 2003,
respectively, and 1.17% and 2.01% for the first halves of 2004 and 2003,
respectively.
8. Long-term Debt
Long-term debt consists of the following:
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Senior Medium-Term Notes, Series A $ 446 $ 466
Lease financing liability 136 -
Note payable - 235
8.41% Trust Preferred Capital Securities 52 52
Fair value adjustment (1) 11 19
- --------------------------------------------------------------------------------
Total $ 645 $ 772
================================================================================
(1) Represents the fair value adjustment related to hedged Medium-Term Notes.
Upon adoption of Financial Accounting Standards Board Interpretation
(FIN) No. 46 - Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51 - Consolidated Financial Statements, in the
first quarter of 2003, the Company consolidated a special purpose trust (Trust)
and recorded a note payable of $235 million. This Trust was formed in 2000 to
finance the acquisition and renovation of an office building and land.
- 7 -
In June 2004, the Company exercised its option to purchase this property
from the Trust and repaid $99 million of the note payable. Simultaneously, the
Company completed a transaction on this property with American Financial Realty
Trust, a publicly-traded real estate investment trust, resulting in proceeds of
$136 million, which was used to repay the remainder of the note payable, and a
20-year lease. This transaction was accounted for as a financing. The lease
financing liability of $136 million will be reduced by a portion of the lease
payments over the 20-year term.
Annual maturities on long-term debt outstanding at June 30, 2004 are as
follows:
- --------------------------------------------------------------------------------
2004 $ 63
2005 60
2006 72
2007 43
2008 20
Thereafter 376
- --------------------------------------------------------------------------------
Total maturities 634
Fair value adjustment 11
- -------------------------------------------------------------------------------
Total $ 645
================================================================================
9. Pension and Other Postretirement Benefits
U.S. Trust maintains a trustee managed, noncontributory, qualified defined
benefit pension plan, the U.S. Trust Corporation Employees' Retirement Plan (the
Pension Plan), for the benefit of eligible U.S. Trust employees. U.S. Trust also
provides certain health care and life insurance benefits for active employees
and certain qualifying retired employees and their dependents.
The following table summarizes the components of the net periodic benefit
expense related to the Pension Plan and health care and life insurance benefits:
- --------------------------------------------------------------------------------
2004 2003
---------------- ----------------
Three months ended Pension Health & Pension Health &
June 30, Plan Life Plan Life
- --------------------------------------------------------------------------------
Service cost and expenses $ 2 $ - $ 4 $ -
Interest cost 4 1 4 1
Expected return on
plan assets (5) - (6) -
Amortization of
prior service cost (1) - - -
Amortization of
net loss 2 - - -
- --------------------------------------------------------------------------------
Net periodic benefit expense $ 2 $ 1 $ 2 $ 1
================================================================================
- --------------------------------------------------------------------------------
2004 2003
---------------- ----------------
Six months ended Pension Health & Pension Health &
June 30, Plan Life Plan Life
- --------------------------------------------------------------------------------
Service cost and expenses $ 5 $ - $ 7 $ -
Interest cost 8 1 9 1
Expected return on
plan assets (10) - (12) -
Amortization of
prior service cost (2) - - -
Amortization of
net loss 3 - - -
- --------------------------------------------------------------------------------
Net periodic benefit expense $ 4 $ 1 $ 4 $ 1
================================================================================
10. 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 Six
Months Ended Months Ended
June 30, June 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Net income $ 113 $ 126 $ 274 $ 197
Other comprehensive income (loss):
Net gain on cash flow
hedging instruments 5 3 9 6
Change in net unrealized gain
on securities available for sale (41) (1) (26) (2)
Foreign currency translation
adjustment - - - 5
- --------------------------------------------------------------------------------
Total comprehensive income,
net of tax $ 77 $ 128 $ 257 $ 206
================================================================================
- 8 -
11. 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 Six
Months Ended Months Ended
June 30, June 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Net income $ 113 $ 126 $ 274 $ 197
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - basic 1,352 1,340 1,350 1,341
Common stock equivalent shares
related to stock incentive plans 21 20 24 17
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,373 1,360 1,374 1,358
================================================================================
Basic EPS:
Income from continuing operations $ .08 $ .10 $ .20 $ .15
Loss from discontinued operations,
net of tax - - - -
Net income $ .08 $ .10 $ .20 $ .15
- --------------------------------------------------------------------------------
Diluted EPS:
Income from continuing operations $ .08 $ .09 $ .20 $ .14
Loss from discontinued operations,
net of tax - - - -
Net income $ .08 $ .09 $ .20 $ .14
- --------------------------------------------------------------------------------
The computation of diluted EPS excludes outstanding stock options to
purchase 91 million and 110 million shares for the second quarters of 2004 and
2003, respectively, and 91 million and 114 million shares for the first halves
of 2004 and 2003, 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.
12. 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. The regulatory capital and
ratios of the Company, U.S. Trust, United States Trust Company of New York
(U.S. Trust NY), U.S. Trust Company, National Association (U.S. Trust NA), and
Schwab Bank are presented in the following table:
- --------------------------------------------------------------------------------
2004 2003
----------------- -----------------
June 30, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,626 19.6% $ 3,648 24.8%
U.S. Trust $ 675 14.5% $ 627 16.3%
U.S. Trust NY $ 359 10.1% $ 358 11.2%
U.S. Trust NA(2) $ 268 26.6% $ 243 39.5%
Schwab Bank $ 337 27.5% $ 273 123.9%
Total Capital:
Company $ 3,656 19.7% $ 3,676 25.0%
U.S. Trust $ 702 15.1% $ 652 16.9%
U.S. Trust NY $ 383 10.8% $ 380 11.9%
U.S. Trust NA(2) $ 271 26.9% $ 246 40.0%
Schwab Bank $ 338 27.6% $ 273 123.9%
Tier 1 Leverage:
Company $ 3,626 8.0% $ 3,648 9.1%
U.S. Trust $ 675 7.9% $ 627 8.9%
U.S. Trust NY $ 359 5.6% $ 358 6.3%
U.S. Trust NA(2) $ 268 10.7% $ 243 16.0%
Schwab Bank $ 337 9.2% $ 273 61.0%
- --------------------------------------------------------------------------------
(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.
Additionally, Schwab Bank is subject to a minimum tier 1 leverage ratio of
8% for its first three years of operations. 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.
(2) During 2003, U.S. Trust consolidated its regional subsidiary banks located
outside of New York and New Jersey into U.S. Trust NA, a single
nationally-chartered banking entity. Amounts and ratios for June 30, 2003
have been calculated based on this consolidation.
Based on their respective regulatory capital ratios at June 30, 2004 and
2003, the Company, U.S. Trust, U.S. Trust NY, U.S. Trust NA, and Schwab Bank are
considered well capitalized (the highest category) pursuant to Federal Reserve
Board guidelines. There are no conditions or events that management believes
have changed the Company's,
- 9 -
U.S. Trust's, U.S. Trust NY's, U.S. Trust NA's, or Schwab Bank'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 this 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 June 30, 2004, Schwab's net capital was $1.3 billion (13% of
aggregate debit balances), which was $1.1 billion in excess of its minimum
required net capital and $801 million in excess of 5% of aggregate debit
balances. At June 30, 2004, SCM's net capital was $45 million, which was
$44 million in excess of its minimum required net capital.
13. Commitments and Contingent Liabilities
Guarantees: The Company provides certain indemnifications (i.e., protection
against damage or loss) to counterparties in connection with the disposition of
certain of its assets. Such indemnifications typically relate to title to the
assets transferred, ownership of intellectual property rights (e.g., patents),
accuracy of financial statements, compliance with laws and regulations, failure
to pay, satisfy or discharge any liability, or to defend claims, as well as
errors, omissions, and misrepresentations. These indemnification agreements have
various expiration dates and the Company's liability under these agreements is
generally limited to certain maximum amounts. At June 30, 2004, the Company's
maximum potential liability under these indemnification agreements is limited to
approximately $100 million. Additionally, the Company has guaranteed certain
payments in the event of a termination of certain mutual fund sub-advisor
agreements, related to the adoption of AXA Rosenberg LLC's U.S. family of mutual
funds, known as the Laudus Funds. The maximum aggregate guarantee is $75 million
through 2011, and $50 million thereafter. The Company does not believe that any
material loss related to such indemnifications is likely and therefore the
liabilities recorded for these guarantees are immaterial.
The Company has clients that sell (i.e., write) listed option contracts
that are cleared by various clearing houses. The clearing houses establish
margin requirements on these transactions. The Company satisfies the margin
requirements by arranging standby letters of credit (LOCs), in favor of the
clearing houses, that are guaranteed by multiple banks. At June 30, 2004, the
outstanding value of these LOCs totaled $630 million. No funds were drawn under
these LOCs at June 30, 2004.
The Company also provides guarantees to securities clearing houses and
exchanges under their standard membership agreement, which requires members to
guarantee the performance of other members. Under the agreement, if another
member becomes unable to satisfy its obligations to the clearing houses and
exchanges, other members would be required to meet shortfalls. The Company's
liability under these arrangements is not quantifiable and may exceed the cash
and securities it has posted as collateral. However, the potential requirement
for the Company to make payments under these arrangements is remote.
Accordingly, no liability has been recognized for these transactions.
Legal contingencies: 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 these
existing claims and proceedings will not have a material adverse impact on the
financial condition, results of operations, or cash flows of the Company.
14. Financial Instruments Subject to Market Risk
Interest rate swaps: As part of its consolidated asset and liability
management process, the Company utilizes interest rate swap agreements (Swaps)
to manage interest rate risk.
U.S. Trust uses LIBOR-based Swaps to hedge the interest rate risk
associated with its variable rate deposits from banking clients. The Swaps are
structured for U.S. Trust to receive a variable rate of interest and pay a fixed
rate of interest.
- 10 -
Information on these Swaps is summarized in the following table:
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Notional principal amount (in millions) $ 450 $ 705
Weighted-average variable interest rate 1.32% 1.17%
Weighted-average fixed interest rate 6.80% 6.41%
Weighted-average maturity (in years) .9 1.0
- --------------------------------------------------------------------------------
At June 30, 2004, Swaps with a combined notional amount of $125 million
were designated as cash flow hedges under SFAS No. 133 - Accounting for
Derivative Instruments and Hedging Activities with changes in their fair values
primarily recorded in other comprehensive income (loss), a component of
stockholders' equity.
Due to a divergence between LIBOR rates and the variable rate paid on
banking client deposits, the remaining Swaps with a combined notional amount of
$325 million were de-designated as cash flow hedges for accounting purposes in
the second quarter of 2004. Changes in fair value of these Swaps, which were
immaterial for the second quarter of 2004, are recorded in interest expense.
These Swaps mature over the remainder of 2004 and will not have a material
impact on the Company's financial position, results of operations, EPS, or cash
flows.
At June 30, 2004 and December 31, 2003, U.S. Trust recorded a derivative
liability of $16 million and $33 million, respectively, for all U.S. Trust
Swaps. Based on current interest rate assumptions and assuming no additional
Swap agreements are entered into, U.S. Trust expects to reclassify approximately
$13 million, or $8 million after tax, from other comprehensive loss to interest
expense over the next twelve months.
CSC uses Swaps to effectively convert the interest rate characteristics of
a portion of its Medium-Term Notes from fixed to variable. These Swaps are
structured for CSC to receive a fixed rate of interest and pay a variable rate
of interest based on the three-month LIBOR rate. The variable interest rates
reset every three months.
Information on these Swaps is summarized in the following table:
- --------------------------------------------------------------------------------
June 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Notional principal amount (in millions) $ 293 $ 293
Weighted-average variable interest rate 3.76% 3.62%
Weighted-average fixed interest rate 7.57% 7.57%
Weighted-average maturity (in years) 4.8 5.3
- --------------------------------------------------------------------------------
These Swaps have been designated as fair value hedges under SFAS No. 133,
and are recorded on the Condensed Consolidated Balance Sheet. Changes in the
fair value of the Swaps are completely offset by changes in fair value of the
hedged Medium-Term Notes. Therefore, there is no effect on net income. At
June 30, 2004 and December 31, 2003, CSC recorded a derivative asset of
$11 million and $19 million, respectively, for these Swaps. Concurrently, the
carrying value of the Medium-Term Notes was increased by $11 million and
$19 million, at June 30, 2004 and December 31, 2003, respectively.
15. 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.
In the first quarter of 2004, the Company changed its methodology for the
computation of its segment information. The new methodology utilizes an
activity-based costing model to allocate traditional income statement line item
expenses (e.g., compensation and benefits, depreciation, and professional
services) to the business activities driving segment expenses (e.g., client
service, opening new accounts, or business development). Previously-reported
segment information has been revised to reflect this new methodology.
Previously, except for the U.S. Trust segment, for which expenses were directly
incurred, technology, corporate, and general administrative expenses were
allocated to the remaining segments generally in proportion to either their
respective revenues or average full-time equivalent employees.
The Company periodically reallocates certain revenues and expenses among
the segments to align them with 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 (a non-GAAP income measure), which excludes items such as
restructuring charges, acquisition- and merger-related charges, impairment
charges, discontinued operations, and extraordinary items. Intersegment revenues
are not material and are therefore not disclosed. Total revenues, income from
continuing operations before taxes on income, and net income are equal to the
amounts as reported on the Condensed Consolidated Statement of Income.
- 11 -
Financial information for the Company's reportable segments is presented in
the following table:
- --------------------------------------------------------------------------------
Three Six
Months Ended Months Ended
June 30, June 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Revenues:
Individual Investor $ 609 $ 591 $1,287 $1,106
Institutional Investor 223 203 454 393
Capital Markets 75 55 164 91
U.S. Trust 194 153 375 302
Unallocated 11 16 22 26
- --------------------------------------------------------------------------------
Total $1,112 $1,018 $2,302 $1,918
================================================================================
Adjusted operating income
before taxes:
Individual Investor $ 98 $ 116 $ 263 $ 155
Institutional Investor 66 77 137 145
Capital Markets 1 2 3 (8)
U.S. Trust (1) 11 5 17 19
Unallocated 5 6 8 (3)
- --------------------------------------------------------------------------------
Adjusted operating income
before taxes 181 206 428 308
Excluded items (2) (2) (24) (2) (29)
- --------------------------------------------------------------------------------
Income from continuing
operations before taxes on
income 179 182 426 279
Taxes on income (66) (56) (152) (79)
Loss from discontinued operations,
net of tax (3) - - - (3)
- --------------------------------------------------------------------------------
Net Income $ 113 $ 126 $ 274 $ 197
================================================================================
(1) In accordance with the Company's new cost allocation methodology, amounts
include costs ($14 million and $18 million in the second quarter of 2004
and 2003, respectively, and $29 million and $30 million in the first half
of 2004 and 2003, respectively) allocated to U.S. Trust.
(2) Includes restructuring charges of $2 million for the second quarter and
first half of 2004, and $24 million for the second quarter and first half
of 2003. Also includes an impairment charge of $5 million related to the
Company's investment in its U.K. market-making operation for the first half
of 2003 (see note "5 - Business Acquisitions and Divestiture").
(3) Represents the impact of the Company's sale of its U.K. brokerage
subsidiary, which was previously included in the Individual Investor
segment (see note "1 - Basis of Presentation").
16. Supplemental Cash Flow Information
Certain information affecting the cash flows of the Company is presented in
the following table:
- --------------------------------------------------------------------------------
Six
Months Ended
June 30,
2004 2003
- --------------------------------------------------------------------------------
Income taxes paid $ 137 $ 93
- --------------------------------------------------------------------------------
Interest paid:
Deposits from banking clients $ 52 $ 44
Brokerage client cash balances 30 48
Long-term debt 16 20
Short-term borrowings 2 8
Other 5 9
- --------------------------------------------------------------------------------
Total interest paid $ 105 $ 129
================================================================================
Non-cash investing and financing activities:
Consolidation of special purpose trust: (1)
Building and land - $ 229
Note payable and other liabilities - $ 228
Common stock and options issued
for purchase of businesses $ 3 $ 4
- --------------------------------------------------------------------------------
(1) Upon adoption of FIN No. 46 in the first quarter of 2003, the Company
consolidated a special purpose trust (see note "8 - Long-term Debt").
17. Subsequent Events
In July 2004, as part of phase one of the cost reduction effort, the
Company initiated the consolidation of 38 branch offices into nearby locations,
the closure of 15 additional offices, and the streamlining of its technology
organization. The Company expects to record a restructuring charge in the third
quarter of 2004 to reflect these actions.
During the last week of July 2004, CSC repurchased and recorded as treasury
stock a total of 3 million shares of its common stock for $26 million. As of
July 30, 2004, authorization granted by CSC's Board of Directors allows for
future repurchases of up to $292 million.
- 12 -
THE CHARLES SCHWAB CORPORATION
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Description of Business
Overview: Mixed securities market returns, continuing geopolitical
uncertainties, and concerns about rising interest rates all weighed on client
engagement during much of the second quarter of 2004. Client daily average
revenue trades declined by 20% from the first quarter of 2004, and were
comparable to the year-ago level. The sharp downturn in trading activity was the
primary cause of the 26% decline in the Company's trading revenues from the
first quarter of 2004. Although client trading activity decreased, the Company's
non-trading revenues - asset management and administration fees, net interest
revenue, and other revenues - reached a record level in the second quarter of
2004, as the Company continued its focus on building stronger client
relationships and diversifying its sources of revenues. Net new client assets of
$6.7 billion for the second quarter of 2004 were comparable to the year-ago
level, despite a $6.0 billion outflow in June relating to a mutual fund clearing
client. Additionally, assets in client accounts were $998.3 billion at June 30,
2004, an increase of $153.6 billion, or 18%, from a year ago.
The Charles Schwab Corporation (CSC) and its subsidiaries (collectively
referred to as the Company) provide securities brokerage, banking, and related
financial services for 7.5 million active client accounts(a). Charles Schwab &
Co., Inc. (Schwab) is a securities broker-dealer with 336 domestic branch
offices in 48 states, as well as a branch in the Commonwealth of Puerto Rico.
For further discussion on the branch offices, see Description of Business -
Restructuring. 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 38 offices in 15 states. Other subsidiaries include 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,
exchange-listed, and other securities providing trade execution services
primarily to broker-dealers and institutional clients, CyberTrader, Inc., an
electronic trading technology and brokerage firm providing services to highly
active, online traders, and Charles Schwab Bank, N.A. (Schwab Bank), a retail
bank which commenced operations in the second quarter of 2003.
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 retail brokerage and banking operations. The
Institutional Investor segment provides custodial, trading and support services
to independent investment advisors (IAs), serves company 401(k) plan sponsors
and third-party administrators, and supports company stock option plans. 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,
wealth management, custody, fiduciary, and private banking services to
individual and institutional clients.
Management of the Company focuses on several key financial and
non-financial metrics (as shown in the following table) in evaluating the
Company's financial position and operating performance:
- --------------------------------------------------------------------------------
Three Months Six Months
Ended Ended
June 30, June 30,
Key Metrics 2004 2003 2004 2003
- --------------------------------------------------------------------------------
Client Activity Metrics:
Net new client assets (in billions) (1) $ 6.7 $ 6.5 $ 20.5 $ 20.7
Percent change 3% (1%)
Client assets
(in billions, at period end) $998.3 $844.7
Percent change 18%
Daily average revenue trades
(in thousands) 142.2 141.0 160.1 128.0
Percent change 1% 25%
Company Financial Metrics:
Revenue growth (decline) from
prior year's period 9% (2%) 20% (8%)
After-tax profit margin 10.2% 12.3% 11.9% 10.2%
Return on stockholders' equity 10% 12% 12% 10%
Net income growth (decline) from
prior year's period (10%) 29% 39% 3%
Revenue per average full-time
equivalent employee
(annualized, in thousands) $ 263 $ 250 $ 274 $ 233
Percent change 5% 18%
- --------------------------------------------------------------------------------
(1) Includes an individual outflow of $6.0 billion in the second quarter and
first half of 2004 related to a mutual fund clearing client.
Management continues to believe that the key to sustaining and improving
the Company's competitive position will be its ability to combine people and
technology in ways that provide investors with the access, information,
guidance, advice and control they expect - as well as high-quality service - all
at a lower cost than traditional providers of financial services.
- -------------------------------
(a) Accounts with balances or activity within the preceding eight months.
- 13 -
Business Strategy: The Company's primary strategy is to meet the financial
services needs of individual investors and independent IAs. To sustain and
advance this core franchise, the Company remains focused on improving service
for these clients and building stronger relationships with them. The Company
provides investors and IAs with products and services that are tailored to (a)
support a full spectrum of investment styles and life stages, and (b) utilize
its scale in trading, operations, distribution and marketing.
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 2003
Annual Report to Stockholders, which is filed as Exhibit 13.1 to the Company's
Form 10-K for the year ended December 31, 2003. See also Item 1 - Business -
Narrative Description of Business - Business Strategy in the Company's Form 10-K
for the year ended December 31, 2003. Significant recent developments relating
to the Company's main avenues for growth include:
Product Expansion: During the second quarter of 2004, the Company launched the
PortfolioCenter Relationship Manager(TM), a contact management and office
workflow automation system designed to assist IAs in strengthening client and
prospect relationships.
For clients interested in fixed income securities, the Company introduced
Standard & Poor's Ratings Xpress(TM), a tool designed to provide in-depth
information on a bond's credit rating, including credit profiles of bond
issuers, the rationale behind upgrades and downgrades, analysts' outlooks, and
recent news reports.
Service/Offer Expansion: In the second quarter of 2004, the Company lowered
online equity trade commissions for many clients, including both individual
investors and clients of IAs. Among the changes for individual investors, the
Company introduced a flat $14.95 commission rate for clients who make at least
30 equity or option trades in a quarter, and a flat $9.95 commission rate for
online equity trades made by clients who have more than $1 million in assets at
Schwab. For most clients of IAs, the Company introduced $19.95 pricing for
online equity trades, and it also extended the flat $9.95 commission rate to
clients of IAs who have more than $1 million in assets custodied at Schwab.
Restructuring: In the second quarter of 2004, the Company announced a
firm-wide cost reduction effort designed to mitigate the financial impact of its
recent pricing changes and to strengthen its productivity and efficiency. This
effort will consist of two phases, with phase one focusing on the elimination of
work that is not essential to meeting client service standards or the Company's
ongoing operating needs. The Company currently estimates that phase one will
result in the identification and implementation of approximately $175 million to
$225 million in annualized cost savings by the end of 2004, with the full
benefit of these savings realized in 2005.
During the second quarter of 2004, the Company implemented the first
element of phase one - the reallocation of certain client service functions from
its Orlando regional telephone service center to other centers. In addition,
during July the Company initiated the consolidation of 38 branch offices into
nearby locations, the closure of 15 additional offices, and the streamlining of
its technology organization. All together, these actions will result in a total
of approximately 500 mandatory staff reductions. The Company expects that its
phase one efforts will result in an additional 400 to 600 mandatory staff
reductions by the end of 2004, and that its headcount will decline further
through ongoing attrition and reduced usage of temporary staff and contractors.
Phase two of the cost reduction effort will focus on reengineering work
processes to maximize productivity, minimizing organizational complexity through
functional streamlining, and addressing business unit performance across the
Company. Management estimates that this phase will extend through the remainder
of 2004 and into 2005 - targeted expense savings and timing have not yet been
established.
The Company recorded pre-tax restructuring charges of $4 million in the
second quarter of 2004, reflecting severance costs for approximately 250
employees, including the workforce reduction in Orlando. Although the workforce
decisions for the Orlando center were made and communicated during the second
quarter, the accounting treatment of these decisions will continue into the
third quarter, with a charge of approximately $6 million. Additionally, charges
associated with the branch actions and the streamlining of the technology
organization will be approximately $25 million. Total restructuring charges
associated with the remainder of phase one have not yet been determined as the
Company continues to identify and refine its plans and estimates.
The Company's 2003, 2002, and 2001 restructuring initiatives included
workforce reductions, reductions in operating facilities, the removal of certain
systems hardware, software, and equipment from service, and the withdrawal from
certain international operations. Related to these restructuring initiatives,
the Company recorded a pre-tax restructuring credit of $2 million in the second
quarter and first half of 2004 and pre-tax restructuring charges of $24 million
in the second quarter and first half of 2003, both primarily due to changes in
estimates of sublease income associated with previously announced efforts to
sublease excess facilities.
As of June 30, 2004, the remaining facilities restructuring reserve of $166
million is net of estimated future sublease income of approximately $300
million. This estimated future sublease income amount is determined
- 14 -
based upon a number of factors, including current and expected commercial real
estate lease rates in the respective properties' real estate markets, and
estimated vacancy periods prior to execution of tenant subleases. At June 30,
2004, approximately 90% of the total square footage targeted for sublease under
the restructuring initiatives has been subleased, up from approximately 65% at
December 31, 2003. The increase in subleased square footage is primarily due to
the subleasing of certain property in New Jersey to a real estate investment
trust in the second quarter of 2004.
For further information on the Company's restructuring initiatives, see
note "4 - Restructuring" in the Notes to Condensed Consolidated Financial
Statements.
Regulatory Developments: As disclosed previously, the Company has been
responding to inquiries and subpoenas from federal and state authorities
relating to circumstances in which a small number of parties were permitted to
engage in short-term trading of certain Excelsior(R) Funds through U.S. Trust.
In addition, the Company has responded to regulatory inquiries focusing on a
small percentage of trades through Schwab's Mutual Fund MarketPlace(R) service
that were received from the client prior to market close, but were modified
shortly after market close, in each case after employees contacted the client
when Schwab's computer systems rejected the trades as originally submitted. The
Company's internal review found no evidence of any intention on the part of
Schwab employees to circumvent rules or policies, no evidence of arrangements
with Schwab clients to permit late trading or market timing through the Mutual
Fund MarketPlace, and no evidence of trading activity by clients or employees to
take advantage of post-market close information.
Although the Company is unable to predict the ultimate outcome of these
matters, any enforcement actions instituted as a result of the investigations
may subject the Company to fines, penalties or other administrative remedies.
The Company is cooperating with regulators, and has taken steps to enhance its
existing policies and procedures to further discourage, detect, and prevent
market timing and late trading.
Lawsuits have been filed against the Company and U.S. Trust and affiliates
alleging breaches of duties and violations of law with respect to these matters.
See Part II - Other Information, Item 1 - Legal Proceedings.
Subsequent Event
Effective July 20, 2004, the Company's Board of Directors appointed Charles
R. Schwab as Chief Executive Officer, replacing David S. Pottruck. Mr. Schwab
will continue to serve as Chairman of the Board of Directors.
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 2003 Annual Report to
Stockholders, which is filed as Exhibit 13.1 to the Company's Form 10-K for the
year ended December 31, 2003. 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 continually evaluates and considers a wide array of potential
strategic transactions, including business combinations, acquisitions and
dispositions of businesses, services, and other assets. Any such transaction
could have a material impact on the Company's financial position, results of
operations, earnings per share (EPS), or cash flows. Currently, the Company is
considering strategic alternatives (e.g., retention, full or partial
divestiture, outsourcing, etc.) for its Schwab SoundView Capital Markets
operations. No decisions have been made at this time.
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," "anticipate," "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
- 15 -
ability to pursue its business strategy and the Company's ability to sustain and
improve its competitive position (see Description of Business - Business
Strategy); the impact of the firm-wide cost reduction effort on the Company's
results of operations (see Description of Business - Restructuring); the outcome
of pending regulatory investigations (see Description of Business - Regulatory
Developments); the potential impact of future strategic transactions (see Risk
Management); the impact of commission pricing reductions on the Company's
results of operations (see Revenues - Commissions); sources of liquidity and
capital (see Liquidity and Capital Resources - Liquidity); the Company's cash
position and cash flows (see Liquidity and Capital Resources - Cash and Capital
Resources); and contingent liabilities (see Part II - Other Information, Item 1
- - Legal Proceedings). 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 this Form 10-Q or, in the case of documents incorporated by
reference, as of the date of those documents.
Important factors that may cause such differences are noted in this interim
report and include, but are not limited to: the Company's success in building
fee-based relationships with its clients; 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 Company's ability to recognize the
expected benefits of acquisitions or dispositions; geopolitical developments
affecting the securities markets, the economy, and investor sentiment; 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
and changing industry practices adversely affecting the Company; adverse results
of litigation or regulatory matters; 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 2003 Annual Report to Stockholders, which is filed as
Exhibit 13.1 to the Company's Form 10-K for the year ended December 31, 2003.
There have been no material changes to these critical accounting policies during
the first half of 2004.
Three Months Ended June 30, 2004 Compared To Three
Months Ended June 30, 2003
All references to EPS information in this report reflect diluted EPS unless
otherwise noted.
FINANCIAL OVERVIEW
Total revenues for the second quarter of 2004 were $1.1 billion, up
$94 million, or 9%, from the second quarter of 2003. The Company's 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, increased 19% in the second quarter of 2004, compared to the year-ago
level. The increase in non-trading revenues was largely due to increases in
asset management and administration fees, resulting primarily from higher levels
of client assets and higher asset-based fees from certain client relationships,
and net interest revenue, resulting primarily from higher levels of
interest-earning assets. The Company's trading revenues, which include
commissions and principal transaction revenues, decreased 8% from the second
quarter of 2003, primarily due to lower average revenue earned per revenue
trade.
Total expenses excluding interest during the second quarter of 2004 were
$933 million, up 12% from the second quarter of 2003. This increase was
primarily due to higher compensation and benefits expense, as well as increases
in professional services and advertising and market development expense.
Income from continuing operations before taxes on income was $179 million
for the second quarter of 2004, down 2% from the second quarter of 2003. This
decrease was primarily due to the combination of factors discussed separately
above. Net income for the second quarter of 2004 was $113 million, or $.08 per
share, down 10% from the second quarter of 2003. The decrease in net income was
primarily due to a tax benefit in 2003 related to the Company's merger with
U.S. Trust, as well as lower income from continuing operations before taxes on
income as
- 16 -
discussed above. The Company's after-tax profit margin for the second quarter of
2004 was 10.2%, down from 12.3% for the second quarter of 2003. The annualized
return on stockholders' equity for the second quarter of 2004 was 10%, down from
12% for the second quarter of 2003.
Segment Information: In evaluating the Company's financial performance,
management uses adjusted operating income, a non-generally accepted accounting
principles (non-GAAP) income measure which excludes items described in the
following paragraph. Management believes that adjusted operating income is a
useful indicator of the ongoing financial performance of the Company's segments,
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 items, non-operating revenues,
restructuring charges, impairment charges, acquisition- and merger-related
charges, and discontinued operations).
In the second quarter of 2004, net income of $113 million included
$1 million of after-tax restructuring charges. In the second quarter of 2003,
net income of $126 million included the following items which in total had the
effect of decreasing after-tax income by $4 million: $15 million of after-tax
restructuring charges and an $11 million tax benefit associated with the
Company's merger with U.S. Trust.
As detailed in note "15 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements, adjusted operating income before taxes was
$181 million for the second quarter of 2004, down $25 million, or 12%, from the
second quarter of 2003 primarily due to decreases of $18 million, or 16%, in the
Individual Investor segment and $11 million, or 14%, in the Institutional
Investor segment, partially offset by an increase of $6 million, or 120%, in the
U.S. Trust segment. The decrease in the Individual Investor segment was due to
growth in expenses outpacing growth in revenues primarily as a result of lower
average revenue earned per revenue trade. The decrease in the Institutional
Investor segment was due to growth in expenses outpacing growth in revenues
primarily as a result of higher client acquisition and servicing costs. The
increase in the U.S. Trust segment was due to revenue growth outpacing expense
growth primarily related to the integration of State Street Corporation's
Private Asset Management group (PAM) acquisition.
Discontinued Operations: On January 31, 2003, the Company sold its U.K.
brokerage subsidiary, Charles Schwab Europe (CSE), to Barclays PLC. The results
of CSE's operations have been summarized as loss from discontinued operations,
net of tax, on the Condensed Consolidated Statement of Income.
REVENUES
The Company categorizes its revenues as either non-trading or trading. As
shown in the following table (in millions), non-trading and total revenues
increased, while trading revenues decreased, in the second quarter of 2004 from
the second quarter of 2003.
- --------------------------------------------------------------------------------
Three Months
Ended
June 30, Percent
Composition of Revenues 2004 2003 Change
- --------------------------------------------------------------------------------
Non-trading revenues:
Asset management and
administration fees $ 514 $ 445 16%
Net interest revenue 224 180 24
Other 48 37 30
- --------------------------------------------------------------------------------
Total non-trading revenues 786 662 19
- --------------------------------------------------------------------------------
Trading revenues:
Commissions 286 313 (9)
Principal transactions 40 43 (7)
- --------------------------------------------------------------------------------
Total trading revenues 326 356 (8)
- --------------------------------------------------------------------------------
Total $1,112 $1,018 9%
================================================================================
Percentage of total revenues:
Non-trading revenues 71% 65%
Trading revenues 29% 35%
- --------------------------------------------------------------------------------
While the Individual Investor and Institutional Investor segments generate
both non-trading and trading revenues, the Capital Markets segment generates
primarily trading revenues and the U.S. Trust segment generates primarily
non-trading revenues. Revenues by segment are as shown in the following table
(in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
June 30, Percent
Revenues by Segment 2004 2003 Change
- --------------------------------------------------------------------------------
Individual Investor $ 609 $ 591 3%
Institutional Investor 223 203 10
Capital Markets 75 55 36
U.S. Trust 194 153 27
Unallocated 11 16 (31)
- --------------------------------------------------------------------------------
Total revenues $1,112 $1,018 9%
================================================================================
The increases in revenues in the Individual and Institutional Investor
segments from the second quarter of 2003 were primarily due to higher levels of
client assets. The increase in revenues in the Capital Markets segment was
primarily due to growth in the Company's institutional trading business. The
increase in the U.S. Trust segment was primarily due to the acquisition of PAM
and higher levels of client assets. See note "15 - Segment Information" in the
Notes to Condensed Consolidated Financial Statements for financial information
by segment.
- 17 -
Asset Management and Administration Fees
Asset management and administration fees, as shown in the table below (in
millions), include mutual fund service fees, as well as fees for other
asset-based financial services provided to individual and institutional clients.
- --------------------------------------------------------------------------------
Three Months
Ended
June 30, Percent
Asset Management and Administration Fees 2004 2003 Change
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds (SchwabFunds(R),
Excelsior(R), and other) $ 216 $ 223 (3%)
Mutual Fund OneSource(R) 93 65 43
Other 15 13 15
Asset management and related services 190 144 32
- --------------------------------------------------------------------------------
Total $ 514 $ 445 16%
================================================================================
The increase in asset management and administration fees from the second
quarter of 2003 was primarily due to higher levels of client assets and higher
asset-based fees from certain client relationships, including increases in
average assets in and service fees earned on Schwab's Mutual Fund OneSource
service.
Commissions
The Company earns commission revenues, as shown in the following table (in
millions), by executing client trades.
- --------------------------------------------------------------------------------
Three Months
Ended
June 30, Percent
Commissions 2004 2003 Change
- --------------------------------------------------------------------------------
Equity and other securities $ 234 $ 262 (11%)
Mutual funds 29 27 7
Options 23 24 (4)
- --------------------------------------------------------------------------------
Total $ 286 $ 313 (9%)
================================================================================
The decrease in commission revenues from the second quarter of 2003 was
primarily due to lower average revenue earned per revenue trade as discussed
below.
In the second quarter of 2004, the Company significantly reduced commission
pricing for online equity trades and lowered commissions for a wide range of
additional clients. The Company estimates that these pricing changes will reduce
commission revenues by approximately $150 million, depending on actual client
trading patterns, over the twelve months beginning July 2004. Concurrent with
these pricing changes, the Company announced a firm-wide cost reduction effort
designed to mitigate the financial impact of these pricing changes and to
strengthen the Company's productivity and efficiency. See Financial Overview -
Restructuring.
Commission revenues include $44 million in the second quarter of 2004 and
$27 million in the second quarter of 2003 related to Schwab's institutional
trading business. This $17 million, or 63%, increase in revenues was primarily
due to the Company's expanded institutional equities trading business.
Additionally, commission revenues include $16 million in the second quarter of
2004 and $18 million in the second quarter of 2003 related to certain securities
serviced by Schwab's fixed income division, including exchange-traded unit
investment trusts, real estate investment trusts, and corporate debt. Schwab's
fixed income division also generates principal transaction revenues.
As shown in the following table, average revenue earned per revenue trade
decreased 8% while daily average revenue trades executed by the Company
increased 1% in the second quarter of 2004.
- --------------------------------------------------------------------------------
Three Months
Ended
June 30, Percent
Trading Activity 2004 2003 Change
- --------------------------------------------------------------------------------
Daily average revenue trades
(in thousands) (1) 142.2 141.0 1%
Accounts that traded (in thousands) 1,233 1,222 1
Average revenue trades
per account that traded 7.2 7.3 (1)
Trading frequency proxy (2) 3.3 3.9 (15)
Number of trading days (3) 62.0 63.0 (2)
Average revenue earned
per revenue trade $34.87 $37.73 (8)
Online trades as a percentage of
total trades 89% 87%
- --------------------------------------------------------------------------------
(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 total client assets.
(3) Effective in the third quarter of 2003, the Company considers reduced
exchange trading sessions as half days.
The Company continually monitors its pricing in relation to competitors and
periodically adjusts prices to enhance its competitive position, as well as to
attract and retain clients. The Company continues to actively evaluate
commission rates and fee structures for certain clients.
- 18 -
Net Interest Revenue
Net interest revenue, as shown in the following table (in millions), is the
difference between interest earned on certain assets (mainly margin loans to
clients, investments of segregated client cash balances, loans to banking
clients, and securities available for sale) and interest paid on supporting
liabilities (mainly deposits from banking clients and brokerage client cash
balances). 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.
- --------------------------------------------------------------------------------
Three Months
Ended
June 30, Percent
2004 2003 Change
- --------------------------------------------------------------------------------
Interest Revenue:
Margin loans to clients $ 107 $ 84 27%
Investments, client-related 62 76 (18)
Loans to banking clients 66 56 18
Securities available for sale 33 19 74
Other 8 9 (11)
- --------------------------------------------------------------------------------
Total 276 244 13
- --------------------------------------------------------------------------------
Interest Expense:
Deposits from banking clients 23 22 5
Brokerage client cash balances 15 24 (38)
Long-term debt 8 9 (11)
Short-term borrowings 3 4 (25)
Other 3 5 (40)
- --------------------------------------------------------------------------------
Total 52 64 (19)
- --------------------------------------------------------------------------------
Net interest revenue $ 224 $ 180 24%
================================================================================
Client-related daily average balances, interest rates, and average net
interest spread for the second quarters of 2004 and 2003 are summarized in the
following table (in millions):
-------------------------------------------------------------------------------
Three Months
Ended
June 30,
2004 2003
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $20,567 $22,108
Average interest rate 1.20% 1.38%
Margin loans to clients:
Average balance outstanding $ 9,177 $ 6,581
Average interest rate 4.70% 5.11%
Loans to banking clients:
Average balance outstanding $ 6,335 $ 4,746
Average interest rate 4.14% 4.75%
Securities available for sale:
Average balance outstanding $ 4,000 $ 1,694
Average interest rate 3.36% 4.40%
Average yield on interest-earning assets 2.73% 2.68%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $23,980 $23,039
Average interest rate .25% .40%
Interest-bearing banking deposits:
Average balance outstanding $ 8,858 $ 4,630
Average interest rate 1.04% 1.97%
Other interest-bearing sources:
Average balance outstanding $ 2,874 $ 2,668
Average interest rate .97% 1.17%
Average noninterest-bearing portion $ 4,367 $ 4,792
Average interest rate on funding sources .45% .61%
Summary:
Average yield on interest-earning assets 2.73% 2.68%
Average interest rate on funding sources .45% .61%
- -----------------------------------------------------------------------