Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 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 Number)
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
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered
------------------- -----------------------------------------
Common Stock - $.01 par value New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. X
---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X No
--- ---
As of June 30, 2004, the aggregate market value of the voting stock held by
nonaffiliates of the registrant was $10,683,699,987. For purposes of this
information, the outstanding shares of Common Stock owned by directors and
executive officers of the registrant, and certain investment companies managed
by Charles Schwab Investment Management, Inc. were deemed to be shares of the
voting stock held by affiliates.
The number of shares of Common Stock outstanding as of February 15, 2005 was
1,319,520,384.
DOCUMENTS INCORPORATED BY REFERENCE
Part III of this Form 10-K incorporates certain information contained in the
registrant's definitive proxy statement for its annual meeting of stockholders
to be held May 19, 2005 by reference to portions of that document.
THE CHARLES SCHWAB CORPORATION
Annual Report On Form 10-K
For Fiscal Year Ended December 31, 2004
-------------------------------------------
TABLE OF CONTENTS
Part I
- ------
Item 1. Business ---------------------------------------------------- 1
General Corporate Overview ------------------------------ 1
Business Strategy and Competitive Environment ----------- 1
Products and Services ----------------------------------- 2
Regulation ---------------------------------------------- 4
Sources of Revenues ------------------------------------- 5
Available Information ----------------------------------- 5
Item 2. Properties -------------------------------------------------- 5
Item 3. Legal Proceedings ------------------------------------------- 5
Item 4. Submission of Matters to a Vote of Security Holders --------- 7
Part II
- -------
Item 5. Market for Registrant's Common Equity, Related Stockholder
Matters and Issuer Purchases of Equity Securities ------- 7
Item 6. Selected Financial Data ------------------------------------- 8
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations ------------------------------- 9
Description of Business --------------------------------- 9
Overview ------------------------------------------- 9
Results of Operations ----------------------------------- 11
Liquidity and Capital Resources ------------------------- 18
Risk Management ----------------------------------------- 22
Critical Accounting Policies ---------------------------- 25
Forward-Looking Statements ------------------------------ 27
Item 7A. Quantitative and Qualitative Disclosures About Market Risk -- 29
Item 8. Financial Statements and Supplementary Data ----------------- 31
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure -------------------------------- 65
Item 9A. Controls and Procedures ------------------------------------- 65
Item 9B. Other Information ------------------------------------------- 65
Part III
- --------
Item 10. Directors and Executive Officers of the Registrant ---------- 65
Item 11. Executive Compensation -------------------------------------- 68
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters --------------- 68
Item 13. Certain Relationships and Related Transactions -------------- 68
Item 14. Principal Accountant Fees and Services ---------------------- 68
Part IV
- -------
Item 15. Exhibits and Financial Statement Schedule ------------------ 68
Exhibit Index ------------------------------------------- 69
Signatures ---------------------------------------------- 75
Index to Financial Statement Schedule ------------------ F-1
THE CHARLES SCHWAB CORPORATION
PART I
Item 1. Business
General Corporate Overview
The Charles Schwab Corporation (CSC), headquartered in San Francisco,
California, and its subsidiaries (collectively referred to as the Company, and
primarily located in San Francisco except as indicated), was incorporated in
1986 and engages, through its subsidiaries, in securities brokerage, banking,
and related financial services. Client assets totaled $1.081 trillion in
7.3 million active client accounts(a) at December 31, 2004. Charles Schwab &
Co., Inc. (Schwab), incorporated in 1971 and entered the discount brokerage
business in 1974, is a securities broker-dealer with 236 domestic branch offices
in 43 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), which was acquired in 2000 and is located in New York City, New
York, is a wealth management firm that through its subsidiaries also provides
fiduciary services and private banking services with 37 offices in 15 states.
Charles Schwab Bank, N.A. (Schwab Bank), is a retail bank located in Reno,
Nevada which commenced operations in April 2003.
Other subsidiaries of CSC include Charles Schwab Investment Management,
Inc. (CSIM), CyberTrader, Inc. (CyberTrader), located in Austin, Texas, and The
Charles Schwab Trust Company (CSTC). CSIM is the investment advisor for Schwab's
proprietary mutual funds. The Company refers to certain funds for which CSIM is
the investment advisor as the SchwabFunds(R). CyberTrader, which was acquired in
2000, is an electronic trading technology and brokerage firm providing services
to highly active, online traders. CSTC serves as trustee for employee benefit
plans, primarily 401(k) plans.
On October 29, 2004, the Company sold its capital markets business,
consisting of the partnership interests of Schwab Capital Markets L.P. and all
of the outstanding capital stock of SoundView Technology Group, Inc.
(collectively referred to as Schwab Soundview Capital Markets, or SSCM). In
2003, the Company substantially exited from its international operations with
the sales of its U.K. brokerage subsidiary, Charles Schwab Europe, and its
investment in Aitken Campbell, a market-making joint venture in the U.K. In
2001, USTC sold its Corporate Trust business. For further information on these
transactions, see "Item 8 - Financial Statements and Supplementary Data - Notes
to Consolidated Financial Statements - 5. Discontinued Operations, 6. Business
Acquisitions and Divestitures, and 4. Sale of Corporate Trust Business."
As of December 31, 2004, the Company had full-time, part-time and temporary
employees, and persons employed on a contract basis that represented the
equivalent of 14,200 full-time employees.
The Company provides financial services to individuals and institutional
clients through three segments - Individual Investor, Institutional Investor,
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 U.S. Trust segment provides investment,
wealth management, custody, fiduciary, and private banking services to
individual and institutional clients. For financial information by segment for
the three years ended December 31, 2004, as well as a discussion of the
previously-reported Capital Markets segment, see "Item 8 - Financial Statements
and Supplementary Data - Notes to Consolidated Financial Statements - 26.
Segment Information."
Business Strategy and Competitive Environment
Consistent with the Company's vision of being the most useful and ethical
provider of financial services in the world, its primary strategy is to meet the
financial services needs of individual investors and the independent IAs who
serve them. In pursuit of this strategy, the Company has refocused on improving
service for these clients and building stronger relationships with them,
simplified its organizational structure and client offers, reduced its
commission rates and fees, and exited the capital markets business.
Another important element of the Company's strategy is its ongoing emphasis
on combining people and technology in ways that facilitate the delivery of a
full range of investment services at great value. People provide the client
focus and personal touch that are essential in serving investors, while
technology helps create services that are scalable and consistent. This
combination helps the Company to deliver useful, relevant, and value-priced
offerings to a broad array of clients - independent investors, individuals
investing through retirement plans, individuals seeking advice, active traders,
and independent IAs - and compete for a large percentage of the trillions of
investable wealth in the U.S. To attract and serve these clients, the Company
offers a broad and growing array of investment, banking and lending products.
The Company's competition in serving independent investors includes a wide
range of brokerage and asset management firms. In serving these investors, the
Company offers branch, telephonic and online service capabilities and
- ---------------------------
(a) Accounts with balances or activity within the preceding eight months.
- 1 -
THE CHARLES SCHWAB CORPORATION
an extensive product line. Schwab's network of branches and regional telephone
service centers is staffed with trained and experienced financial consultants
focused on building and sustaining client relationships. In addition, the
Company offers the ability to meet client trading and/or advice needs through a
single ongoing relationship, even as those needs change over time, and it also
provides access to automated online and telephonic channels to provide quick and
efficient access to an extensive array of information, research, tools, trade
execution, and administrative services. Individuals investing for retirement
through 401(k) plans can take advantage of the Company's bundled offering of
multiple investment choices, education and third-party advice.
Competition in serving investors looking for an advisory relationship
involves a variety of traditional brokerage, asset management, and wealth
advisory firms. Management believes that the Company's competitive strengths in
this arena revolve around its ability to provide clients with an individually
tailored solution - ranging from occasional consultations to an ongoing
relationship with a Schwab Consultant, IA, or U.S. Trust advisor - versus the
more fragmented offerings of other firms.
For active traders, the Company primarily competes with deep-discount,
online-focused firms as well as certain larger financial institutions.
Management believes the Company can continue to attract these clients because it
combines highly competitive pricing and expert tools with extensive service
capabilities - including experienced, knowledgeable teams of trading specialists
and integrated product offerings. The Company also offers these clients access
to all of the other tools, products, and advice available at Schwab to help them
manage their diverse and complex portfolios.
In the IA arena, the Company competes with institutional custodians,
traditional and discount brokers, banks and trust companies. Management believes
that its Schwab Institutional(R) unit can maintain its market leadership
position through a combination of superior service, scale, dedicated resources,
and extensive familiarity with the industry. Schwab Institutional also leverages
technology to provide IAs with the tools and support they need to grow and
manage their practices efficiently.
Overall, management believes that the Company's multi-channel service
delivery model of branch, phone and internet access is essential to its ability
to compete effectively with the wide variety of financial services firms
striving to attract client relationships and assets across the spectrum of
investors. Under this model, the Company can offer personalized service at
competitive prices while giving clients the choice of where, when and how they
do business with the firm. Another important aspect of the Company's ability to
compete is its ongoing focus on efficiency and productivity, as lower costs give
the Company greater pricing flexibility. Management believes that this focus
remains important in light of the recent competitive environment, in which a
number of competitors reduced online trading commission rates and account fees.
Additionally, the Company's nationwide marketing effort is an important
competitive tool because it reinforces the attributes of the Schwab(R), U.S.
Trust(R) and CyberTrader(R) brands, thereby leveraging the local marketing
endeavors of the 3,700 Company staff in the offices and service centers.
In addition to competition from other financial services firms, the Company
faces competition for quality professionals and other personnel, and its ability
to continue to compete effectively will depend upon its ability to attract new
employees and retain existing employees while managing compensation. The
Company's business can also be significantly affected by the general environment
- - economic, corporate, securities market, regulatory and geopolitical
developments all play a role in client asset valuations, trading activity,
interest rates and overall investor engagement. For a discussion of the business
environment faced by the Company in 2004, see "Item 7 - Management's Discussion
and Analysis of Financial Condition and Results of Operations - Description of
Business - Overview."
Products and Services
The Company offers a broad range of products to address its clients'
varying investment and financial needs. Examples of these product offerings
include:
o Brokerage - various asset management accounts including some with
check-writing features, individual retirement accounts, Keogh accounts, 529
college savings accounts, margin loans, and access to fixed income
securities, and equity and debt offerings;
o Banking - first mortgages, home equity lines of credit, pledged-asset
mortgages, certificates of deposit, demand deposit accounts, private
banking accounts, and credit cards; and
o Mutual funds - third-party mutual funds through Mutual Fund Marketplace(R),
including no-load mutual funds through the Mutual Fund OneSource(R)
service, proprietary mutual funds from two fund families - SchwabFunds(R)
and Excelsior(R) Funds, and mutual fund trading and clearing services to
broker-dealers.
In addition, the Company offers a wide array of services designed to meet
the needs of independent, advised, and actively trading investors.
The Company's products and services are made available through its three
segments - Individual Investor, Institutional Investor, and U.S. Trust.
Individual Investors
Clients of the Company, through the Individual Investor segment or
indirectly through the Institutional Investor segment, have access to the
services described below.
- 2 -
THE CHARLES SCHWAB CORPORATION
Independent Investors. For investors who make their own investment
decisions, the Company offers research, analytic tools, performance reports,
market analysis, and educational material. Clients looking for more guidance
have access to online portfolio planning tools, as well as professional advice
from Schwab's investment specialists who can help develop an investment strategy
and carry out investment and portfolio management decisions.
Schwab strives to demystify investing by educating and assisting clients in
the development of investment plans. Educational tools include workshops,
interactive courses, and online information about investing. Additionally,
Schwab provides various Internet-based research and analysis tools which are
designed to help clients achieve better investment outcomes. As an example of
such tools, Schwab Equity Ratings(R) is a quantitative model-based stock rating
system which provides all clients with ratings on approximately 3,000 stocks,
assigning each equity a single grade: A, B, C, D, or F. Stocks are rated based
on specific factors relating to fundamentals, valuation, momentum, and risk, and
ranked so that the number of 'buy consideration' ratings - As and Bs - equals
the number of 'sell consideration' ratings - Ds and Fs.
Advised Investors. The Company seeks to provide clients with customized
advice that is uncomplicated and not influenced by commissions on transactions.
The Company's approach to advice is based on long-term investment strategies and
guidance on portfolio diversification and asset allocation. This approach is
designed to be offered consistently across all of Schwab's delivery channels.
Schwab Private ClientTM features a face-to-face advice relationship with a
designated Schwab consultant who offers individualized service, provides ongoing
investment strategy and execution, and acts as a liaison between clients and a
team of Schwab professionals.
The Schwab Advisor Network(R) is designed for investors who want the
assistance of an independent professional in managing their financial affairs.
The IAs in the Schwab Advisor Network provide investors with personalized
portfolio management, financial planning, and wealth management solutions.
Through this program, certain Schwab clients and potential clients who desire
personalized investment management, wealth management, trust, and private
banking services can also receive referrals to U.S. Trust.
Actively Trading Investors. The Company strives to deliver information,
education, technology, service and pricing which meets the needs of active
traders. For highly active traders, CyberTrader offers integrated Web- and
software-based trading platforms, which incorporate direct access and
intelligent order routing technology, real-time market data, options trading,
and premium stock research. For active traders, Schwab also offers Web- and
software-based trading platforms with account management features, risk
management tools, multi-channel access, and dedicated personal support.
Global Dollar Services. The Company's global dollar business serves both
foreign investors and non-English-speaking U.S. clients who wish to trade or
invest in U.S. dollar-based securities. The Company has a physical presence in
the United Kingdom and Hong Kong. In the U.S., the Company serves Chinese-,
Korean-, Vietnamese- and Spanish-speaking clients through a combination of
designated branch offices and Web-based and telephonic services.
Institutional Investors
Schwab Institutional.(R) Through the Institutional Investor segment, Schwab
provides custodial, trading, technology, Web, and other support services to IAs,
whose services are integral to the Company's advice offerings. To attract and
serve advisors, Schwab Institutional has a dedicated sales force and experienced
registered representatives assigned to individual advisors.
IAs who custody client accounts at Schwab may use proprietary software
which provides IAs with up-to-date client account information, as well as
trading capabilities. Participating IAs may also utilize the Schwab
Institutional website, the core platform for IAs to conduct daily business
activities online with Schwab, including submitting client account information,
and retrieving news and market information; as well as a service which enables
IAs to provide their clients with personalized equity portfolio management by a
variety of institutional asset managers.
Corporate Services. The Company provides 401(k) recordkeeping and other
retirement plan services to corporations and professional organizations. A
dedicated sales force markets these services directly to such organizations, and
the Company also serves plan sponsors indirectly through alliances with
third-party administrators. The Company's bundled 401(k) retirement plan product
offers plan sponsors a wide array of investment options, participant education
and servicing, trustee services, and participant-level recordkeeping.
Participants in these plans have access to customized advice provided by a third
party.
- 3 -
THE CHARLES SCHWAB CORPORATION
U.S. Trust
U.S. Trust provides an array of financial services for affluent clients and
their families. These services include investment and wealth management, trust,
custody, financial and estate planning, and private banking. For clients with
less than $2 million in assets at U.S. Trust, the firm offers Wealth Advisory
Accounts, an investment advisory service that utilizes the Excelsior(R) family
of mutual funds. For clients with $2 million to $50 million in assets, U.S.
Trust provides both individually managed balanced portfolios (i.e., portfolios
that are invested in several different asset classes with the overall goal of
preserving and enhancing those assets) and specialized investment management
services. In addition to investment management services, U.S. Trust provides
specialized fiduciary, financial planning, enhanced master custody, and
philanthropic consulting services to clients that have over $50 million in
assets at U.S. Trust. U.S. Trust also offers private banking services to assist
in meeting the credit and liquidity requirements of its clients.
For institutional clients, including corporations, endowments, foundations,
and pension plans, U.S. Trust provides investment management, brokerage, and
special fiduciary services. Through these investment management services,
U.S. Trust offers a wide range of investment options, including balanced and
specialized domestic and international equity investments, structured
investments, alternative investments, fixed income securities, and short-term
cash management. Institutional clients can also utilize the Excelsior Funds.
Additionally, U.S. Trust offers investment, consulting, and fiduciary services
for employee stock ownership plans.
Regulation
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Federal Reserve Board under the
Bank Holding Company Act of 1956, as amended. CSC's depository institution
subsidiaries, including Schwab Bank and affiliates of U.S. Trust, are subject to
regulation under federal and state law, including supervision by federal and
state banking authorities. For a discussion of bank holding company
requirements, see "Item 8 - Financial Statements and Supplementary Data - Notes
to Consolidated Financial Statements - 22. Regulatory Requirements."
The securities industry in the United States is subject to extensive
regulation under both federal and state laws. Schwab and CyberTrader are
registered as broker-dealers with the SEC, the fifty states, and the District of
Columbia and Puerto Rico. Schwab and CSIM are registered as investment advisors
with the Securities and Exchange Commission (SEC). Additionally, Schwab is
regulated by the Commodities Futures Trading Commission (CFTC) with respect to
the futures and commodities trading activities it conducts as an introducing
broker.
Much of the regulation of broker-dealers has been delegated to
self-regulatory organizations (SROs), namely the national securities exchanges
and the Municipal Securities Rulemaking Board (MSRB). Schwab is a member of a
number of national securities exchanges and is consequently subject to their
rules and regulations. The primary regulators of Schwab and CyberTrader are the
National Association of Securities Dealers (NASD) and, for municipal securities,
the MSRB. The CFTC has designated the National Futures Association (NFA) as
Schwab's primary regulator for futures and commodities trading activities. The
Company's business is also subject to oversight by regulatory bodies in other
countries in which the Company operates.
The principal purpose of regulating broker-dealers and investment advisors
is the protection of clients and the securities markets. The regulations to
which broker-dealers and investment advisors are subject cover all aspects of
the securities business, including, among other things, sales and trading
practices, publication of research, margin lending, uses and safekeeping of
clients' funds and securities, capital adequacy, recordkeeping and reporting,
fee arrangements, disclosure to clients, fiduciary duties owed to advisory
clients, and the conduct of directors, officers and employees.
New legislation, rule changes, or changes in the interpretation or
enforcement of existing federal, state and SRO rules and regulations may
directly affect the operation and profitability of the Company. The
profitability of the Company could also be affected by rules and regulations
which impact the business and financial communities generally, including changes
to the laws governing taxation, electronic commerce, and security of client
data.
The Company is subject to claims, lawsuits, regulatory examinations and
enforcement proceedings in the ordinary course of business, which can result in
settlements, awards, censures, fines, cease and desist orders, or suspension or
expulsion of an affiliate, its officers, or employees.
As registered broker-dealers, certain subsidiaries of CSC, including Schwab
are subject to SEC Rule 15c3-1 (the Net Capital Rule) and related SRO
requirements. The CFTC and NFA also impose net capital requirements. The Net
Capital Rule specifies minimum capital requirements that are intended to ensure
the general financial soundness and liquidity of broker-dealers. Because CSC
itself is not a registered broker-dealer, it is not subject to the Net Capital
Rule. However, if Schwab failed to maintain specified levels of net capital,
such failure would constitute a default by CSC under certain debt covenants.
The Net Capital Rule limits broker-dealers' ability to transfer capital to
parent companies and other affiliates. Compliance with the Net Capital Rule
could limit Schwab's operations and its ability to repay subordinated debt to
CSC, which in turn could limit CSC's ability to repay debt, pay cash dividends
and purchase shares of its outstanding stock.
- 4 -
THE CHARLES SCHWAB CORPORATION
See also "Item 7 - Management's Discussion and Analysis of Financial Condition
and Results of Operation - Liquidity and Capital Resources - Liquidity" and
"Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated
Financial Statements - 22. Regulatory Requirements."
Sources of Revenues
For revenue information by source for the three years ended December 31,
2004, see "Item 7 - Management's Discussion and Analysis of Financial Condition
and Results of Operations - Results of Operations - Revenues."
Available Information
The Company files annual, quarterly, and current reports, proxy statements
and other information with the SEC. You may read and copy any document we file
with the SEC at the SEC's public reference room at 450 Fifth Street, NW,
Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for information on
the public reference room. The SEC maintains an Internet website that contains
annual, quarterly and current reports, proxy and information statements and
other information that issuers (including the Company) file electronically with
the SEC. The SEC's Internet website is www.sec.gov.
On the Company's Internet website, www.aboutschwab.com, the Company posts
the following filings as soon as reasonably practicable after they are
electronically filed with or furnished to the SEC: the Company's annual reports
on Form 10-K, the Company's quarterly reports on Form 10-Q, the Company's
current reports on Form 8-K, and any amendments to those reports filed or
furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of
1934. All such filings on the Company's website are available free of charge.
Item 2. Properties
A summary of the Company's significant locations at December 31, 2004 is
presented in the following table. All locations are leased, except as noted
below. The square footage amounts (in thousands) are presented net of space that
has been subleased to third parties.
- --------------------------------------------------------------------------------
Square Footage
Location Leased Owned
- --------------------------------------------------------------------------------
Corporate office space:
San Francisco, CA (1) 1,607 -
New York, NY (2) 436 -
Service centers:
Phoenix, AZ (3,4) 107 1,009
Denver, CO (3) 274 -
Orlando, FL (3) 106 -
Indianapolis, IN (3) - 113
- --------------------------------------------------------------------------------
(1) Includes Schwab headquarters.
(2) Includes U.S. Trust headquarters.
(3) Includes a regional telephone service center.
(4) Includes two data centers and an administrative support center.
Substantially all of the Company's branch offices are located in leased
premises. The corporate headquarters, data centers, offices, and service centers
generally support all of the Company's segments.
From 2001 to 2004, the Company initiated restructuring initiatives that
included reductions in facilities. For a discussion of such initiatives, see
"Item 7 - Management's Discussion and Analysis of Financial Condition and
Results of Operation - Description of Business" and "Item 8 - Financial
Statements and Supplementary Data - Notes to Consolidated Financial Statements -
3. Restructuring Charges." Properties that are included in the Company's
restructuring initiatives are excluded from the table above.
Item 3. Legal Proceedings
CSC and its subsidiaries have been named as parties in various legal
actions, which include the matters described below. It is inherently difficult
to predict the ultimate outcome of these matters, particularly in cases in which
claimants seek substantial or unspecified damages, and a substantial judgment,
settlement or penalty could be material to the Company's operating results for a
particular future period, depending on the Company's results for that period.
However, based on current information, it is the opinion of management, after
consultation with counsel, that the resolution of these matters will not have a
material adverse impact on the financial condition, results of operations or
cash flows of the Company.
- 5 -
THE CHARLES SCHWAB CORPORATION
Mutual Funds Litigation: Since November 2003, multiple purported class
action and derivative lawsuits have been filed against the Company and certain
affiliates, officers and directors in connection with alleged improper and
illegal mutual fund trading practices.
Two stockholders' derivative actions were filed in California Superior
Court in San Francisco in March and April 2004 against CSC and sixteen current
or former CSC directors. These actions allege that the directors breached their
fiduciary duties to Schwab and its stockholders by allegedly failing to maintain
adequate controls to prevent improper mutual fund trading practices. The
lawsuits seek the recovery of unspecified compensatory damages and attorneys'
fees from the named individuals, along with the return of all salaries and other
remuneration they received as directors. CSC is named as a nominal defendant,
although no damages are sought against CSC.
Several lawsuits filed in federal court relating to mutual fund trading
practices have been consolidated in U.S. District Court in Maryland for the
purpose of consolidated and coordinated pre-trial proceedings. Lead plaintiffs
and lead counsel have been appointed, and lead plaintiffs have filed
consolidated and amended complaints in such actions as follows:
During September 2004, purported Excelsior(R) Fund shareholders filed a
consolidated amended class action complaint against USTC, United States Trust
Company of New York (U.S. Trust NY), Schwab and the Excelsior Funds. Plaintiffs
allege that the defendants breached fiduciary duties and violated various
federal securities laws by permitting market timing and late trading in the
Excelsior Funds and by failing to disclose such timing in the fund prospectuses.
Plaintiffs seek unspecified compensatory and punitive damages, and disgorgement
of investment advisory fees.
During September 2004, certain Excelsior Fund shareholders also filed a
consolidated amended derivative action on behalf of nominal defendants Excelsior
Funds Inc., Excelsior Funds Trust, and Excelsior Tax Exempt Funds Inc. (the Fund
Companies), against CSC, USTC, U.S. Trust NY, U.S. Trust Company, N.A.
(U.S. Trust NA), various current and former officers, directors and trustees of
the Excelsior Funds (the U.S. Trust and Excelsior Defendants) and various
third-party defendants. Plaintiffs allege that the U.S. Trust and Excelsior
Defendants breached fiduciary duties and violated federal securities laws by
permitting market timing in the Excelsior Funds and by failing to disclose such
timing in the fund prospectuses. Plaintiffs seek, on behalf of the Fund
Companies, unspecified monetary damages, as well as removal of the Excelsior
Fund directors, removal of U.S. Trust as advisor to the funds, rescission of
U.S. Trust's investment advisory contracts with the funds, and disgorgement of
management fees and compensation relating to the funds.
During October 2004, certain CSC shareholders filed a consolidated amended
class action complaint on behalf of purchasers of CSC stock, against CSC,
Schwab, U.S. Trust NA, U.S. Trust NY and current and former CSC and U.S. Trust
officers and directors Charles Schwab, Alan Weber, David Pottruck, and Jeffrey
Maurer. Plaintiffs allege that the defendants violated federal securities laws
by failing to disclose alleged improper mutual fund trading practices.
Plaintiffs seek unspecified compensatory damages.
During October 2004, Schwab was named in three additional class action
lawsuits brought on behalf of shareholders in the Invesco, MFS, and
Pilgrim-Baxter mutual fund families. The lawsuits, which were filed in U.S.
District Court in Maryland, allege that Schwab and more than 38 other
broker-dealers, banks, and other financial intermediaries acted as conduits for
market-timing and late-trading activity by disregarding excessive trading on
their platforms and facilitating such activity. Plaintiffs seek unspecified
compensatory and punitive damages.
The Company believes it has strong defenses and is vigorously contesting
each of the above mentioned claims.
Mutual Funds Regulatory Matters: 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 Funds through U.S. Trust. 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.
SoundView Technology Group, Inc. (SoundView) Litigation: As part of the
sale of SoundView to UBS Securities LLC and UBS Americas Inc. (collectively
referred to as UBS), the Company agreed to indemnify UBS for any expenses
associated with certain litigation, including the following matters:
SoundView and certain of its subsidiaries are among the numerous financial
institutions named as defendants in multiple purported securities class actions
filed in the United District Court for the Southern District of New York (the
IPO Allocation Litigation) between June and December 2001. The IPO Allocation
Litigation was brought on behalf of persons who either directly or in the
aftermarket purchased IPO securities between March 1997 and December 2000. The
plaintiffs allege that SoundView and the other underwriters named as defendants
required customers receiving allocations of IPO shares to pay excessive and
undisclosed commissions on unrelated trades and to purchase shares in the
aftermarket at prices higher than the IPO price, in violation of the federal
securities laws. SoundView has been named in 31 of the actions - each involving
a different company's IPO - which
- 6 -
THE CHARLES SCHWAB CORPORATION
have been consolidated with 280 other actions in which SoundView is not named as
a defendant. The parties, with the assent of the Court, have selected 17 of
these cases as focus cases for the purpose of case-specific discovery, and the
Court has certified the existence of a class in the focus cases. Wit Capital, a
SoundView predecessor, is a defendant in one of the focus cases. Additionally,
SoundView and/or related entities had underwriting commitments in approximately
11 other focus cases; SoundView entities are not named as defendants in these
cases, but may have indemnification obligations to the lead underwriters
depending on the outcome of these actions. The Company is vigorously contesting
such claims on behalf of SoundView pursuant to the above-mentioned indemnity.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of the Company's security holders
during the fourth quarter of 2004.
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
The Company's common stock is listed on the New York Stock Exchange and the
Nasdaq Stock Market under the ticker symbol SCH. The number of common
stockholders of record as of February 15, 2005 was 11,666. The closing market
price per share on that date was $10.95.
The other information required to be furnished pursuant to this item is
included in "Item 8 - Financial Statements and Supplementary Data - Notes to
Consolidated Financial Statements - 29. Quarterly Financial Information
(Unaudited)."
(c) Issuer Purchases of Equity Securities
The following table summarizes purchases made by or on behalf of CSC of its
common stock for each calendar month in the fourth quarter of 2004.
- --------------------------------------------------------------------------------
(In millions, except Total Number Approximate
per share amounts) of Shares Dollar Value of
Purchased as Shares that
Total Number Average Part of Publicly May Yet be
of Shares Price Paid Announced Purchased under
Month Purchased (1) per Share Program (1) the Program
- --------------------------------------------------------------------------------
October 7 $ 8.95 7 $109
November 11 9.94 11 -
December 5 11.94 5 234
- --------------------------------------------------------------------------------
Total 23 $10.13 23 $234
================================================================================
(1) All shares were repurchased under authorizations by CSC's Board of
Directors of $300 million, $250 million, and $500 million of common stock
publicly announced by the Company on December 9, 2004, March 17, 2003, and
September 20, 2001, respectively. Both the March 17, 2003 and September 20,
2001 authorizations have been exhausted. Unless modified or revoked by the
Board of Directors, the remaining authorization does not have an expiration
date.
The Company may receive shares to pay the exercise price and/or to satisfy
tax withholding obligations by employees who exercise stock options (granted
under employee stock incentive plans), which are commonly referred to as stock
swap exercises. Such exercises represented less than 500,000 per month for each
of the months presented in the above table.
- 7 -
THE CHARLES SCHWAB CORPORATION
Item 6. Selected Financial Data
Selected Financial and Operating Data
(In Millions, Except Per Share Amounts, Ratios, Number of Domestic Offices,
Average Revenue Per Revenue Trade, and as Noted)
- ------------------------------------------------------------------------------------------------------------------------------------
Growth Rates
-------------------
Compounded Annual
4-Year 1-Year
2000-2004 2003-2004 2004 2003 2002 2001 2000
- ------------------------------------------------------------------------------------------------------------------------------------
Results of Operations
Revenues (1) (5%) 8% $ 4,202 $ 3,896 $ 3,944 $ 4,068 $ 5,199
Expenses excluding interest (1) (4%) 12% $ 3,557 $ 3,179 $ 3,695 $ 3,941 $ 4,183
Income from continuing operations before
extraordinary gain (1) (8%) (13%) $ 414 $ 476 $ 149 $ 75 $ 583
Net income (21%) (39%) $ 286 $ 472 $ 109 $ 199 $ 718
Income from continuing operations per share - basic (1) (8%) (11%) $ .31 $ .35 $ .11 $ .05 $ .43
Income from continuing operations per share - diluted (1) (8%) (14%) $ .30 $ .35 $ .11 $ .05 $ .41
Basic earnings per share (2) (21%) (40%) $ .21 $ .35 $ .08 $ .14 $ .53
Diluted earnings per share (2) (20%) (40%) $ .21 $ .35 $ .08 $ .14 $ .51
Dividends declared per common share 16% 48% $ .074 $ .050 $ .044 $ .044 $ .041
Weighted-average common shares outstanding - diluted 1,365 1,364 1,375 1,399 1,404
Non-trading revenues as a percentage of revenues (1,3) 76% 69% 69% 66% 55%
Trading revenues as a percentage of revenues (1,3) 24% 31% 31% 34% 45%
Effective income tax rate on income from continuing
operations (1) 35.8% 33.6% 40.2% 41.4% 42.6%
Capital expenditures - cash purchases of equipment,
office facilities, property, and internal-use
software development costs, net (4) (27%) 32% $ 194 $ 147 $ 154 $ 295 $ 689
Capital expenditures as a percentage of revenues (4) 5% 4% 4% 7% 13%
====================================================================================================================================
Performance Measures
Pre-tax profit margin (1) 15.3% 18.4% 6.3% 3.1% 19.5%
After-tax profit margin (1) 6.8% 12.1% 2.8% 4.9% 13.8%
Return on stockholders' equity 6% 11% 3% 5% 21%
====================================================================================================================================
Financial Condition (at year end)
Total assets 5% 3% $ 47,133 $ 45,866 $ 39,705 $ 40,464 $ 38,154
Long-term debt (7%) (24%) $ 585 $ 772 $ 642 $ 730 $ 770
Stockholders' equity 1% (2%) $ 4,386 $ 4,461 $ 4,011 $ 4,163 $ 4,230
Assets to stockholders' equity ratio 11 10 10 10 9
Long-term debt to total financial capital
(long-term debt plus stockholders' equity) 12% 15% 14% 15% 15%
====================================================================================================================================
Client Information (at year end)
Client assets (in billions) 6% 12% $1,081.2 $ 966.7 $ 764.8 $ 845.9 $ 871.7
Active client accounts (5) (1%) (3%) 7.3 7.5 8.0 7.8 7.5
Total mutual fund assets (in billions) 8% 14% $ 441.3 $ 386.8 $ 323.8 $ 342.8 $ 330.3
Independent investment advisor client
assets (in billions) (6) 11% 21% $ 348.2 $ 287.1 $ 222.4 $ 235.0 $ 231.3
Independent investment advisor client
accounts (in thousands) (6) 7% 6% 1,316.3 1,238.8 $1,182.4 $1,081.7 $ 986.5
Number of domestic offices (10%) (27%) 273 376 422 429 415
====================================================================================================================================
Employee Information (4)
Full-time equivalent employees
(at year end, in thousands) (14%) (11%) 14.2 16.0 16.4 19.2 25.9
Revenues per average full-time equivalent
employee (in thousands) 5% 10% $ 269 $ 245 $ 214 $ 183 $ 218
Compensation and benefits expense as a
percentage of revenues 45% 43% 44% 44% 44%
====================================================================================================================================
(1) Amounts have been adjusted to summarize the impact of The Charles Schwab Corporation's (the Company's) sales of its capital
markets business, Schwab Soundview Capital Markets, and its United Kingdom (U.K.) brokerage susidiary, Charles Schwab Europe,
in loss from discontinued operations.
(2) Both basic and diluted earnings per share include discontinued operations and extraordinary gains.
(3) Non-trading revenues include asset management and administration fees, net interest revenue, and other revenues. Trading
revenues include commission and principal transaction revenues.
(4) Amounts have been adjusted to reflect the sale of Schwab Soundview Capital Markets.
(5) Reflects the removal of 192,000 accounts in 2003 related to the Company's withdrawal from the Employee Stock Purchase Plan
business and the transfer of those accounts to other providers. Active accounts are defined as accounts with balances or
activity within the preceding eight months.
(6) Represents amounts related to the Schwab Institutional(R) unit.
- 8 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
DESCRIPTION OF BUSINESS
Overview
Securities market returns were mixed for much of 2004 due to the cumulative
effects of ongoing geopolitical, economic and energy market uncertainties,
concerns about rising interest rates, and a close presidential election. While
this environment weighed on client engagement, the Company actively pursued its
strategy of refocusing on its core client base, improving product and service
offerings for those clients, lowering pricing, and streamlining its overall
infrastructure. In addition, the Company embarked on a firm-wide cost reduction
effort designed to mitigate the effects of its price reductions and to improve
overall efficiency and productivity.
During the fourth quarter of 2004, the election was decided and market
returns turned positive. In this improved environment, client asset valuations
recovered and daily average revenue trades rose by 39% over third quarter lows.
The Dow Jones Industrial Average, the Standard and Poor's 500 Index, and the
Nasdaq Composite Index ended 2004 up 3%, 9%, and 9%, respectively. Total client
assets housed at the Company rose by 12% during 2004 to $1.08 trillion; net new
client assets brought to the Company totaled $50.3 billion for the year,
including $16.8 billion in the fourth quarter, the highest in 13 quarters.
Overall, the Company's price cuts contributed to a 14% decline in trading
revenues for 2004, yet continued success in attracting client assets and
building stronger client relationships led to a 17% increase in non-trading
revenues and total revenue growth of 8%. Expenses rose by 12% over 2003 levels,
reflecting the reinstatement of the Company's 401(k) match and the payment of
higher discretionary bonuses, an increased marketing communications investment,
and the recognition of $261 million in after-tax charges relating to the
Company's exit from the capital markets business and its cost reduction effort.
As a result, net income declined by 39% from 2003, and the Company's 2004 profit
margin was 6.8%, compared with 12.1% in the prior year. The Company's 2004 cost
reduction effort enabled the firm to steadily reduce its operating expense base
throughout 2004, and about $300 million in annualized cost savings were
identified and implemented by year end.
The Company generates cash primarily through the revenues of its brokerage
and banking subsidiaries. These revenues are classified into non-trading and
trading categories. The Company earns non-trading revenues primarily through:
o Asset management and administration fees earned through its proprietary and
third-party mutual fund offerings, as well as fee-based investment
management and advisory services; and
o Interest revenue earned on margin loans, loans to banking clients, and
investments.
Non-trading revenues are impacted by securities valuations, interest rates,
the Company's ability to attract new clients, and client activity levels. The
Company earns trading revenues through:
o Commissions earned for executing trades for clients; and
o Principal transaction revenues for trading activity in fixed income
securities.
Trading revenues are impacted by trading volumes, the volatility of equity
prices in the securities markets and commission rates.
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:
- --------------------------------------------------------------------------------
Growth Rate
1-year
2003-2004 2004 2003 2002
- --------------------------------------------------------------------------------
Client Activity Metrics:
Net new client assets
(in billions) (1) (10%) $ 50.3 $ 56.2 $ 47.6
Client assets
(in billions, at year end) 12% $1,081.2 $ 966.7 $ 764.8
Daily average revenue trades
(in thousands) 11% 156.4 140.8 134.1
Company Financial Metrics:
Revenue growth (decline)
from prior year (2) 8% (1%) (3%)
Pre-tax profit margin (2) 15.3% 18.4% 6.3%
Return on stockholders' equity 6% 11% 3%
Revenue per average full-time
equivalent employee
(in thousands) (2) 10% $ 269 $ 245 $ 214
Revenue on client assets (9%) 42 46 49
- --------------------------------------------------------------------------------
(1) Includes an individual outflow of $6.0 billion in 2004 related to a mutual
fund clearing client. Includes inflows of $12.1 billion in 2003 at
U.S. Trust related to the acquisition of State Street Corporation's Private
Asset Management group.
(2) All amounts have been adjusted to reflect the sale of the Company's capital
markets business.
o Net new client assets is defined as the total inflows of client cash and
securities to the firm less client outflows. Management believes that this
metric depicts how well
- 9 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
the Company's products and services appeal to new and existing clients.
o Client assets is the market value of all client assets housed at the
Company. Management considers client assets to be indicative of the
Company's appeal in the marketplace. Additionally, growth in certain
components of client assets (e.g., money market funds) directly impacts
asset management and administration fee revenues.
o Schwab's daily average revenue trades (DART) is deemed by management to be
a key indicator of client engagement with securities markets and the most
prominent driver of commission revenues.
o Management believes that revenue growth, pre-tax profit margin, and return
on stockholders' equity provide broad indicators of the Company's overall
financial health, operating efficiency, and ability to generate acceptable
returns.
o Revenue per average full-time equivalent employee (revenue per FTE) is
considered by management to be the Company's broadest measure of
productivity. With the Company's restructuring initiatives over the past
four years, revenue per FTE has steadily improved to $269,000 in 2004.
o Revenue on client assets is defined as annualized basis points of revenue
per dollar of average client assets. Management believes that this metric
is a key measure of the Company's ability to broaden the number of services
utilized by clients.
Restructuring
The Company recorded pre-tax restructuring charges as follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
2004 Cost Reduction Effort:
Workforce reduction $ 129 - -
Facilities reduction 82 - -
- --------------------------------------------------------------------------------
Total 211 - -
- --------------------------------------------------------------------------------
2003, 2002, and 2001 Initiatives:
Workforce reduction (1) $ 27 $ 140
Facilities reduction 4 49 202
Systems removal - - 1
- --------------------------------------------------------------------------------
Total 3 76 343
- --------------------------------------------------------------------------------
Total $ 214 $ 76 $ 343
================================================================================
2004 Cost Reduction Effort
In the second quarter of 2004, the Company commenced a firm-wide cost
reduction effort designed to mitigate the financial impact of its pricing
changes (see Results of Operations - Financial Overview - Revenues -
Commissions) and to strengthen its productivity and efficiency. The goals of
this effort include eliminating work that is not essential to meeting client
service standards or the Company's ongoing operating needs, reengineering work
processes to maximize productivity, minimizing organizational complexity through
functional streamlining, and addressing business unit performance across the
Company. During 2004, the Company reallocated certain client service functions
from its Orlando regional telephone service center to other centers. The Company
also closed or consolidated 111 branch offices, began opening smaller satellite
offices in selected locations, and took steps to streamline its technology
organization. Additionally, the Company reduced its operating facilities,
primarily by exiting certain administrative office space in California.
The Company recorded pre-tax restructuring charges of $211 million in 2004
related to the 2004 cost reduction effort, primarily reflecting severance costs
for approximately 1,600 employees and facilities reduction charges.
The Company's 2004 cost reduction effort enabled the firm to steadily
reduce its operating expense base throughout 2004, and about $300 million in
annualized cost savings were identified and implemented by year end. The Company
estimates that its 2004 cost reduction effort will result in approximately
$16 million, or $10 million after-tax, of restructuring charges in the first
quarter of 2005. Estimated additional charges for, or expense savings from, cost
reduction efforts to be implemented during 2005 have not yet been determined.
2003, 2002, and 2001 Initiatives
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 help improve
productivity, enhance efficiency, and increase profitability. During 2004, the
Company recorded pre-tax restructuring charges of $3 million related to its
2003, 2002, and 2001 restructuring initiatives, primarily due to changes in
estimates of sublease income associated with previously announced efforts to
sublease excess facilities.
For further information on the Company's restructuring initiatives, see
"Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated
Financial Statements - 3. Restructuring Charges." The actual costs of these
restructuring initiatives could differ from the estimated costs, depending
primarily on the Company's ability to sublease properties. For further
information on the
- 10 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Company's facilities restructuring reserves, see "Critical Accounting Policies."
Corporate Development
Discontinued Operations: On October 29, 2004, the Company completed the sale of
its capital markets business to UBS. Pursuant to the purchase agreement, UBS
acquired all of the partnership interests of Schwab Capital Markets L.P. and all
of the outstanding capital stock of SoundView Technology Group, Inc.
(collectively referred to as Schwab Soundview Capital Markets, or SSCM) for $265
million in cash. At closing, the Company and Schwab entered into eight-year
order routing and execution services agreements with UBS for the handling of
Schwab's equity and listed options order flow. SSCM comprised substantially all
of the previously-reported Capital Markets segment.
The results of operations, net of income taxes, and cash flows of SSCM have
been presented as discontinued operations on the consolidated statements of
income and of cash flows, respectively, and the assets and liabilities of SSCM
prior to the sale have each been combined and presented as assets and
liabilities of discontinued operations on the consolidated balance sheet. The
Company's consolidated prior period revenues, expenses, taxes on income, assets,
liabilities, and cash flows have been adjusted to reflect this presentation.
In January 2003, the Company sold its U.K. brokerage subsidiary, Charles
Schwab Europe (CSE), to Barclays PLC. The results of operations of CSE, net of
income taxes, have been summarized as discontinued operations on the Company's
consolidated statement of income. The Company's consolidated prior period
revenues, expenses, and taxes on income have been adjusted to reflect this
presentation.
For further information on the Company's discontinued operations, see "Item
8 - Financial Statements and Supplementary Data - Notes to Consolidated
Financial Statements - 5. Discontinued Operations."
Divestiture of Investment: 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 2003, the Company recorded
an impairment charge to reduce the carrying value of its investment and an
income tax benefit. 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. For further
information, see "Item 8 - Financial Statements and Supplementary Data Notes
to Consolidated Financial Statements 6. Business Acquisitions and
Divestitures."
Sale of Corporate Trust Business: In June 2001, USTC sold its Corporate Trust
business to The Bank of New York Company, Inc. The Company recognized an
extraordinary gain in 2002 related to this sale, primarily for amounts
recognized upon satisfaction of certain client retention requirements. For
further information, see "Item 8 - Financial Statements and Supplementary Data -
Notes to Consolidated Financial Statements - 4. Sale of Corporate Trust
Business."
RESULTS OF OPERATIONS
Financial Overview
Total revenues were $4.2 billion in 2004, up $306 million, or 8%, from
2003. The Company's non-trading revenues totaled $3.2 billion in 2004, up $471
million, or 17%, from 2003. This increase was primarily due to an increase in
asset management and administration fees resulting primarily from higher levels
of client assets and an increase in net interest revenue resulting primarily
from higher levels of and changes in the composition of interest-earning assets.
Trading revenues totaled $1.0 billion in 2004, down $165 million, or 14%, from
2003. This decrease was primarily due to lower average revenue earned per
revenue trade resulting from reductions in the Company's commission pricing,
partially offset by higher client trading activity.
Total expenses excluding interest for 2004 were $3.6 billion, up $378
million, or 12%, from 2003. This increase was primarily due to a $212 million,
or 13%, increase in compensation and benefits expense resulting from higher
levels of discretionary bonuses to employees, employee benefits, and incentive
compensation, as well as a $138 million, or 182%, increase in restructuring
charges.
Income from continuing operations before taxes on income and extraordinary
gain for 2004 was $645 million, down $72 million, or 10% from 2003, primarily
due to the combination of factors discussed above - higher compensation and
benefits expense and restructuring charges, partially offset by higher levels of
non-trading revenues. Loss from discontinued operations, net of tax, was
$128 million for 2004, compared to $4 million for 2003. Net income for 2004 was
$286 million, or $.21 per share, down 39% from 2003, primarily due to a higher
loss from discontinued operations, net of tax, as well as lower income from
continuing operations before taxes on income and extraordinary gain. The
Company's after-tax profit margin for 2004 was 6.8%, down from 12.1% for 2003.
Return on stockholders' equity was 6% for 2004, down from 11% in 2003.
- 11 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Certain reclassifications have been made to prior year amounts to conform
to the current presentation. All references to earnings per share (EPS)
information in this Management's Discussion and Analysis of Results of
Operations and Financial Condition reflect diluted earnings per share unless
otherwise noted.
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 below.
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 2004, net income of $286 million included the following items which in
total had the effect of decreasing after-tax income by $252 million: $133
million of after-tax restructuring charges, a $128 million after-tax loss from
discontinued operations, and a $9 million after-tax gain on an investment. In
2003, net income of $472 million included the following items which in total had
the effect of decreasing after-tax income by $19 million: $48 million of
after-tax restructuring charges, a $5 million investment write-down related to
the Company's U.K. market-making operation, a $4 million after-tax loss from
discontinued operations, a $16 million tax benefit associated with the Company's
sale of its U.K. market-making operation, an $11 million after-tax gain on the
sale of an investment, and an $11 million tax benefit associated with the
Company's merger with U.S. Trust. In 2002, net income of $109 million included
the following items which in total had the effect of decreasing after-tax income
by $304 million: $211 million of after-tax restructuring charges, a $52 million
after-tax loss from discontinued operations, a $37 million investment write-down
related to the Company's U.K. market-making operation, $16 million of after-tax
acquisition-related charges, and a $12 million after-tax extraordinary gain on
the sale of U.S. Trust's Corporate Trust business.
As detailed in "Item 8 - Financial Statements and Supplementary Data -
Notes to Consolidated Financial Statements - 26. Segment Information," the
Company's adjusted operating income before taxes was $845 million for 2004, up
$64 million, or 8%, from 2003 due to increases of $58 million, or 13%, in the
Individual Investor segment, and $9 million, or 23%, in the U.S. Trust segment,
partially offset by a decrease of $21 million, or 7%, in the Institutional
Investor segment. The increase in the Individual Investor segment was primarily
due to higher revenues resulting from increased client trading activity and
levels of client assets. The decrease in the Institutional Investor segment was
primarily due to growth in expenses outpacing growth in revenues primarily as a
result of higher client acquisition and servicing costs.
Revenues
The Company categorizes its revenues as either non-trading or trading. As
shown in the following table, non-trading and total revenues increased, while
trading revenues decreased from 2003.
- 12 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
====================================================================================================================================
Sources of Revenues
Year Ended December 31,
- ------------------------------------------------------------------------------------------------------------------------------------
Growth Rate 2004 2003 2002
1-year --------------------------------------------------------------
2003-2004 Amount Percent Amount Percent Amount Percent
----------------------------------------------------------------------------
Non-Trading Revenues
Asset management and administration fees
Mutual fund service fees:
Proprietary funds (SchwabFunds(R),
Excelsior(R), and other) (1%) $ 870 21% $ 883 23% $ 874 22%
Mutual Fund OneSource(R) 33% 376 9% 283 7% 264 7%
Other 18% 59 1% 50 1% 41 1%
Asset management and related services 28% 786 19% 616 16% 574 15%
- ------------------------------------------------------------------------------------------------------------------------------------
Asset management and administration fees 14% 2,091 50% 1,832 47% 1,753 45%
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest revenue
Interest revenue:
Margin loans to clients 31% 454 11% 347 9% 459 12%
Investments, client-related 3% 293 7% 284 7% 337 8%
Loans to banking clients 20% 275 7% 230 6% 236 6%
Securities available for sale 88% 139 3% 74 2% 76 2%
Other 58% 52 1% 33 1% 48 1%
- ------------------------------------------------------------------------------------------------------------------------------------
Interest revenue 25% 1,213 29% 968 25% 1,156 29%
Interest expense:
Brokerage client cash balances 49% 113 3% 76 2% 164 4%
Deposits from banking clients 9% 105 3% 96 3% 94 2%
Long-term debt (9%) 32 1% 35 1% 46 1%
Short-term borrowings 38% 18 - 13 - 20 1%
Other (55%) 9 - 20 - 7 -
- ------------------------------------------------------------------------------------------------------------------------------------
Interest expense 15% 277 7% 240 6% 331 8%
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest revenue 29% 936 22% 728 19% 825 21%
- ------------------------------------------------------------------------------------------------------------------------------------
Other 3% 150 4% 146 3% 129 3%
- ------------------------------------------------------------------------------------------------------------------------------------
Total non-trading revenues 17% 3,177 76% 2,706 69% 2,707 69%
- ------------------------------------------------------------------------------------------------------------------------------------
Trading Revenues
Commissions
Equity and other securities (18%) 731 17% 892 23% 925 24%
Mutual funds 2% 112 3% 110 3% 111 3%
Options (2%) 93 2% 95 3% 99 2%
- ------------------------------------------------------------------------------------------------------------------------------------
Commissions (15%) 936 22% 1,097 29% 1,135 29%
- ------------------------------------------------------------------------------------------------------------------------------------
Principal transactions (4%) 89 2% 93 2% 102 2%
- ------------------------------------------------------------------------------------------------------------------------------------
Total trading revenues (14%) 1,025 24% 1,190 31% 1,237 31%
- ------------------------------------------------------------------------------------------------------------------------------------
Total revenues 8% $ 4,202 100% $ 3,896 100% $ 3,944 100%
====================================================================================================================================
- 13 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
While the Individual Investor and Institutional Investor segments generate
both non-trading and trading revenues, the U.S. Trust segment generates
primarily non-trading revenues. Revenues by segment are as shown in the
following table:
- --------------------------------------------------------------------------------
Growth Rate
1-year
2003-2004 2004 2003 2002
- --------------------------------------------------------------------------------
Individual Investor 3% $ 2,444 $ 2,365 $ 2,375
Institutional Investor 9% 897 821 855
U.S. Trust 23% 773 629 651
Unallocated 16% 74 64 63
- --------------------------------------------------------------------------------
Operating revenues 8% 4,188 3,879 3,944
Non-operating revenues (1) (18%) 14 17 -
- --------------------------------------------------------------------------------
Total revenues 8% $ 4,202 $ 3,896 $ 3,944
================================================================================
(1) Primarily consists of pre-tax gains on investments.
The increase in revenues in the U.S. Trust segment was primarily due to the
acquisition of State Street Corporation's Private Asset Management group in
October 2003 and higher levels of client assets. See "Item 8 - Financial
Statements and Supplementary Data - Notes to Consolidated Financial Statements -
26. Segment Information" for financial information by segment for the last three
years.
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
transfer agent services, shareholder services, administration, and investment
management provided to its proprietary funds, and recordkeeping and shareholder
services provided to third-party funds. These fees are based upon the daily
balances of client assets invested in third-party funds and upon the average
daily net assets of the Company's proprietary funds. Mutual fund service fees
are earned through each of the Company's segments. The Company also earns asset
management and administration fees for financial services provided to individual
and institutional clients, including investment management and consulting, trust
and fiduciary services, custody services, financial and estate planning, and
private banking services. These fees are primarily based on the value and
composition of assets under management and are earned through each of the
Company's segments.
The increase in asset management and related service fees from 2003 to 2004
was primarily due to higher levels of client assets and higher asset-based fees
from certain client relationships. The increase in mutual fund service fees from
2003 to 2004 was primarily due to higher average assets in and service fees
earned on Schwab's Mutual Fund OneSource(R) service. The increase in asset
management and related service fees from 2002 to 2003 was primarily due to
higher asset-based fees from certain client relationships, partially offset by a
decrease in account fees. The increase in mutual fund service fees from 2002 to
2003 was due to higher service fees earned on and average assets in Schwab's
Mutual Fund OneSource service, and higher service fees earned on SchwabFunds(R).
Commissions
The Company earns commission revenues by executing client trades primarily
through the Individual Investor and Institutional Investor segments. These
revenues are affected by the number of client accounts that trade, the average
number of revenue-generating trades per account, and the average revenue earned
per revenue trade.
The decrease in commission revenues from 2003 to 2004 was primarily due to
lower average revenue earned per revenue trade as a result of significant
reductions in commission pricing for a wide range of clients in 2004, partially
offset by higher daily average revenue trades. The increase in commission
revenues from 2002 to 2003 was primarily due to higher daily average trades,
partially offset by lower revenue per revenue trade.
Effective in June 2004, the Company lowered its online equity pricing to
$9.95 for clients with more than $1 million in assets at Schwab and also lowered
commission pricing for a wide range of other clients. Additionally, effective in
November 2004, the Company lowered its base online equity commission pricing to
$19.95, expanded access to $9.95 online equity commissions, and lowered
commissions on online and broker-assisted trades of options contracts. Primarily
as a result of these pricing changes, the Company's average revenue earned per
revenue trade declined from $30.97 in May 2004 to $18.82 in December 2004.
- 14 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
As illustrated in the following table, daily average revenue trades
executed by the Company increased 11% in 2004. Average revenue earned per
revenue trade decreased 23% from 2003 to 2004, primarily due to the pricing
changes discussed above. Average revenue earned per revenue trade decreased 7%
from 2002 to 2003, primarily due to decreased pricing of certain equity trades
made through online channels as well as decreased pricing of fixed income
securities trades.
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Daily average revenue trades
(in thousands) (1) 156.4 140.8 134.1
Accounts that traded
(in thousands) 2,749 2,734 2,871
Average revenue trades
per account that traded 14.3 12.9 11.8
Trading frequency proxy (2) 3.4 3.8 3.8
Number of trading days (3) 251.5 250.0 252.0
Average revenue earned
per revenue trade (4) $ 26.34 $ 34.06 $ 36.46
Online trades as a percentage of
total trades 89% 87% 83%
- --------------------------------------------------------------------------------
(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 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.
(4) All amounts have been adjusted to reflect the sale of the Company's capital
markets business.
The Company continually monitors its pricing in relation to competitors and
periodically adjusts prices to enhance its competitive position. The Company
continues to actively evaluate commission rates and fee structures for certain
clients.
Net Interest Revenue
Net interest revenue 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.
The Company's net interest revenue is earned through each of its segments.
In clearing its clients' trades, Schwab holds cash balances payable to clients.
In most cases, Schwab pays its clients interest on cash balances awaiting
investment, and may invest these funds and earn interest revenue. Margin loans
arise when Schwab lends funds to clients on a secured basis to purchase
securities. Pursuant to SEC regulations, client cash balances that are not used
for margin lending are generally segregated into investment accounts that are
maintained for the exclusive benefit of clients.
When investing segregated client cash balances, Schwab must adhere to SEC
regulations that restrict investments to U.S. government securities,
participation certificates, mortgage-backed securities guaranteed by the
Government National Mortgage Association, certificates of deposit issued by U.S.
banks and thrifts, and resale agreements collateralized by qualified securities.
Schwab's policies for credit quality and maximum maturity requirements are more
restrictive than these SEC regulations. In each of the last three years, resale
agreements accounted for over 65% of Schwab's investments of segregated client
cash balances. The average maturities of Schwab's total investments of
segregated client cash balances were 142 days for 2004, 161 days for 2003, and
66 days for 2002. U.S. Trust and Schwab Bank lend funds to banking clients
primarily in the form of mortgage loans. These loans are largely funded by
interest-bearing deposits from banking clients.
- 15 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
The Company's interest-earning assets are financed primarily by
interest-bearing brokerage client cash balances and deposits from banking
clients. Other funding sources include noninterest-bearing brokerage client cash
balances, proceeds from stock-lending activities, short-term borrowings and
long-term debt, as well as stockholders' equity. Client-related daily average
balances, interest rates, and average net interest spread are summarized as
follows:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $20,159 $21,826 $17,869
Average interest rate 1.45% 1.30% 1.89%
Margin loans to clients:
Average balance outstanding $ 9,074 $ 7,025 $ 8,017
Average interest rate 4.99% 4.94% 5.72%
Loans to banking clients:
Average balance outstanding $ 6,453 $ 5,034 $ 4,204
Average interest rate 4.24% 4.56% 5.62%
Securities available for sale:
Average balance outstanding $ 4,031 $ 1,904 $ 1,508
Average interest rate 3.45% 3.91% 5.02%
Average yield on interest-earning assets 2.94% 2.62% 3.51%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $23,788 $23,140 $22,432
Average interest rate .47% .33% .73%
Interest-bearing banking deposits:
Average balance outstanding $ 9,077 $ 5,395 $ 4,046
Average interest rate 1.15% 1.79% 2.33%
Other interest-bearing sources:
Average balance outstanding $ 2,519 $ 2,843 $ 1,094
Average interest rate 1.07% 1.05% 2.03%
Average noninterest-bearing portion $ 4,333 $ 4,411 $ 4,026
Average interest rate on funding sources .61% .57% .89%
Summary:
Average yield on interest-earning assets 2.94% 2.62% 3.51%
Average interest rate on funding sources .61% .57% .89%
- --------------------------------------------------------------------------------
Average net interest spread 2.33% 2.05% 2.62%
- --------------------------------------------------------------------------------
The increase in net interest revenue from 2003 to 2004 was primarily due to
higher levels of and changes in the composition of interest-earning assets,
including increases in margin loan balances, loans to banking clients and
securities available for sale, partially offset by higher interest rates on
brokerage client cash balances due to changes in the interest rate environment.
The decrease in net interest revenue from 2002 to 2003 was primarily due to
changes in the composition of interest-earning assets, including the decline in
margin loan balances and the corresponding increase in client-related
investments. Additionally, the decline in yields on interest-earning assets due
to changes in the interest rate environment from 2002 to 2003 was only partially
offset by lower yields on funding sources.
Since the Company establishes the rates paid on brokerage client cash
balances and certain banking deposits and the rates charged on margin loans, it
manages a substantial portion of its net interest spread. However, the spread is
influenced by external factors such as the interest rate environment and
competition. The Company's average net interest spread increased from 2003 to
2004 as the average yield on interest-earning assets, primarily client-related
investments, increased more than the average interest rate on funding sources.
The Company's average net interest spread decreased from 2002 to 2003 as the
average yield on interest-earning assets, primarily client-related investments,
declined more than the average interest rate on funding sources.
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. Factors that influence
principal transaction revenues include the volume of client trades, market price
volatility, and changes in regulations and industry practices.
Other Revenues
Other revenues include net gains and losses on certain investments, fees
for services (such as transfer of assets), account service fees, and software
maintenance fees. Other revenues are earned through each of the Company's
segments.
- 16 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Expenses Excluding Interest
As shown in the table below, total expenses excluding interest increased in
2004 primarily due to higher compensation and benefits expense and restructuring
charges. Additionally, increases in professional services expense and
advertising and market development expense were substantially offset by
decreases in depreciation and amortization expense and occupancy and equipment
expense.
- --------------------------------------------------------------------------------
Growth Rate
1-year
2003-2004 2004 2003 2002
- --------------------------------------------------------------------------------
Compensation and benefits 13% $ 1,877 $ 1,665 $ 1,755
Occupancy and equipment (10%) 389 430 446
Professional services 40% 245 175 168
Depreciation and amortization (18%) 226 277 309
Communications (2%) 223 228 245
Advertising and market
development 32% 184 139 207
Commissions, clearance and
floor brokerage (3%) 39 40 46
Restructuring charges 182% 214 76 343
Impairment charges (100%) - 5 37
Other 11% 160 144 139
- --------------------------------------------------------------------------------
Total expenses 12% $ 3,557 $ 3,179 $ 3,695
================================================================================
Expenses as a percentage of total revenues:
Total expenses, excluding interest 85% 82% 94%
Compensation and benefits 45% 43% 44%
Advertising and market development 4% 4% 5%
- --------------------------------------------------------------------------------
Compensation and Benefits
Compensation and benefits expense includes salaries and wages, incentive
and variable compensation, related employee benefits and taxes, and retention
program costs arising from certain acquisitions and mergers. Employees receive
variable compensation that is tied to the achievement of specified objectives,
primarily related to revenue growth and profit margin. Therefore, a significant
portion of compensation and benefits expense will fluctuate with these measures.
The increase in compensation and benefits expense from 2003 to 2004 was
primarily due to higher levels of discretionary bonuses to employees, employee
benefits, and incentive compensation. The decrease in compensation and benefits
expense from 2002 to 2003 was primarily due to a reduction in full-time
equivalent employees through the Company's expense reduction measures and lower
levels of employee benefits, partially offset by higher levels of incentive
compensation and discretionary bonuses to employees. The following table shows a
comparison of certain compensation and benefits components and employee data:
- --------------------------------------------------------------------------------
2004 2003 2002
- --------------------------------------------------------------------------------
Salaries and wages $ 1,199 $ 1,150 $ 1,229
Incentive and variable compensation 376 270 233
Employee benefits and other 302 245 293
- --------------------------------------------------------------------------------
Total $ 1,877 $ 1,665 $ 1,755
================================================================================
Full-time equivalent employees (1)
(in thousands)
At year end 14.2 16.0 16.4
Average 15.6 15.9 18.4
- --------------------------------------------------------------------------------
(1) Includes full-time, part-time and temporary employees, and persons employed
on a contract basis. All amounts have been adjusted to reflect the sale of
the Company's capital markets business.
Employee benefits and other expense increased from 2003 to 2004 primarily
due to the reinstatement of the Company's 401(k) employee contribution match,
which was suspended in 2003 (except for a discretionary award to certain
non-officer employees made in the fourth quarter of 2003). Employee benefits and
other expense decreased from 2002 to 2003 primarily due to the suspension of the
Company's 401(k) employer contribution in 2003 as discussed above. Additionally,
employee benefits and other expense includes net pension expense of $7 million
in 2004 and $8 million in 2003 related to U.S. Trust's defined benefit pension
plan, compared to net pension income of less than $1 million for 2002. The
increase in pension expense in 2003 was primarily due to changes in certain
assumptions used to calculate pension expense, including the expected rate of
return on pension plan assets and the discount rate, both effective in 2003.
See "Item 8 - Financial Statements and Supplementary Data - Notes to
Consolidated Financial Statements - 2. Significant Accounting Policies - New
Accounting Standards" for a discussion of future compensation expense related to
stock option awards.
Expenses Excluding Compensation and Benefits
The decreases in occupancy and equipment expense from 2002 to 2004 were
primarily due to the Company's restructuring initiatives and other expense
reduction measures (see Description of Business - Restructuring).
The increases in professional services expense from 2002 to 2004 were
primarily due to higher levels of consulting fees in several areas, including
new and expanded products and services, and information technology projects.
The decreases in depreciation and amortization expense from 2002 to 2004
were primarily due to increases in fully-
- 17 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
amortized assets and the Company's restructuring initiatives and other expense
reduction measures.
The increase in advertising and market development expense from 2003 to
2004 was primarily due to the Company's increased print and other media
spending. The decrease in advertising and market development expense from 2002
to 2003 was primarily due to reductions, as part of the Company's expense
reduction measures, in brand-focused television and other media spending.
Taxes on Income
The Company's effective income tax rate on income from continuing
operations was 35.8% in 2004, 33.6% in 2003 and 40.2% in 2002. The increase in
the effective income tax rate from 2003 to 2004 was primarily due to tax
benefits in 2003 related to the deductibility of certain costs associated with
the Company's merger with U.S. Trust and the Company's sale of its U.K.
market-making operation. The decrease in the effective income tax rate from 2002
to 2003 was primarily due to the tax benefits in 2003 discussed above, as well
as an impairment charge in 2002 related to the Company's U.K. market-making
operation which was not deductible for tax purposes. Management expects the
Company's effective income tax rate in 2005 to be approximately 38%.
LIQUIDITY AND CAPITAL RESOURCES
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 (Federal Reserve Board) under the Bank Holding Company Act of
1956, as amended. CSC conducts virtually all business through its wholly owned
subsidiaries. The capital structure among CSC and its subsidiaries is designed
to provide each entity with capital and liquidity to meet its operational needs
and regulatory requirements. See "Item 8 - Financial Statements and
Supplementary Data - Notes to Consolidated Financial Statements - 22. Regulatory
Requirements."
Liquidity
CSC
CSC's liquidity needs are generally met through cash generated by its
subsidiaries, as well as cash provided by external financing. As discussed
below, Schwab and CSC's depository institution subsidiaries are subject to
regulatory requirements that may restrict them from certain transactions with
CSC. Management believes that funds generated by the operations of CSC's
subsidiaries will continue to be the primary funding source in meeting CSC's
liquidity needs, providing adequate liquidity to meet CSC's depository
institution subsidiaries' capital guidelines, and maintaining Schwab's net
capital. Based on their respective regulatory capital ratios at December 31,
2004 and 2003, the Company and its depository institution subsidiaries are
considered well capitalized.
CSC has liquidity needs that arise from its Senior Medium-Term Notes,
Series A (Medium-Term Notes), as well as from the funding of cash dividends,
acquisitions, and other investments. The Medium-Term Notes, of which
$386 million was issued and outstanding at December 31, 2004, have maturities
ranging from 2005 to 2010 and fixed interest rates ranging from 6.21% to 8.05%
with interest payable semiannually. CSC has entered into interest rate swap
agreements (Swaps) that effectively convert the interest rate characteristics of
a portion of the Medium-Term Notes from fixed to variable. For a complete
discussion of the Swaps, see "Item 8 - Financial Statements and Supplementary
Data - Notes to Consolidated Financial Statements - 24. Financial Instruments
Subject to Off-Balance Sheet Risk, Credit Risk or Market Risk." The Medium-Term
Notes are rated A2 by Moody's Investors Service (Moody's), A- by Standard &
Poor's Ratings Group (S&P), and A by Fitch IBCA, Inc. (Fitch).
CSC has a prospectus supplement on file with the SEC enabling CSC to issue
up to $750 million in Senior or Senior Subordinated Medium-Term Notes, Series A.
At December 31, 2004, all of these notes remained unissued.
In the second quarter of 2004, the SEC declared effective CSC's
Registration Statement under the Securities Act of 1933 on Form S-3 relating to
a universal shelf registration for the issuance of up to $1.0 billion aggregate
amount of various securities, including common stock, preferred stock, debt
securities, and warrants. The Company currently intends to use any proceeds from
the issuance of these securities for general corporate purposes, including, but
not limited to, working capital and possible acquisitions. At December 31, 2004,
all of these securities remained unissued.
CSC has authorization from its Board of Directors (Board) to issue
commercial paper up to the amount of CSC's committed, unsecured credit facility
(see below), not to exceed $1.5 billion. At December 31, 2004, no commercial
paper has been issued. CSC's ratings for these short-term borrowings are P-1 by
Moody's, A-2 by S&P, and F1 by Fitch.
CSC maintains an $800 million committed, unsecured credit facility with a
group of nineteen banks which is scheduled to expire in June 2005. This facility
replaced a facility that expired in June 2004. These facilities were unused in
2004. Any issuances under CSC's commercial paper program (see above) will reduce
the amount available under this facility. The funds under this facility are
available
- 18 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
for general corporate purposes and CSC pays a commitment fee on the unused
balance of this facility. The financial covenants in this facility require CSC
to maintain a minimum level of stockholders' equity, Schwab to maintain minimum
net capital ratios, as defined, and CSC's depository institution subsidiaries to
be well capitalized, as defined. Management believes that these restrictions
will not have a material effect on its ability to meet foreseeable dividend or
funding requirements.
CSC also has direct access to $781 million of the $831 million uncommitted,
unsecured bank credit lines, provided by eight banks, that are primarily
utilized by Schwab to manage short-term liquidity. The amount available to CSC
under these lines is lower than the amount available to Schwab because the
credit line provided by one of these banks is only available to Schwab. These
lines were not used by CSC in 2004.
Schwab
Most of Schwab's assets are readily convertible to cash, consisting
primarily of short-term (i.e., less than 150 days) investment-grade,
interest-earning investments (the majority of which are segregated for the
exclusive benefit of clients pursuant to regulatory requirements), receivables
from brokerage clients, and receivables from brokers, dealers and clearing
organizations. Client margin loans are demand loan obligations secured by
readily marketable securities. Receivables from and payables to brokers, dealers
and clearing organizations primarily represent current open transactions, which
usually settle, or can be closed out, within a few business days.
Liquidity needs relating to client trading and margin borrowing activities
are met primarily through cash balances in brokerage client accounts, which were
$27.0 billion, $25.6 billion, and $24.9 billion at December 31, 2004, 2003, and
2002, respectively. Management believes that brokerage client cash balances and
operating earnings will continue to be the primary sources of liquidity for
Schwab in the future.
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. 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 remaining
lease financing liability of $134 million is being reduced by a portion of the
lease payments over the 20-year term.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of eight banks totaling $831 million at
December 31, 2004 (as noted previously, $781 million of these lines are also
available for CSC to use). The need for short-term borrowings arises primarily
from timing differences between cash flow requirements and the scheduled
liquidation of interest-bearing investments. Schwab used such borrowings for 15
days in 2004, with the daily amounts borrowed averaging $46 million. There were
no borrowings outstanding under these lines at December 31, 2004.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
December 31, 2004. Schwab pays a fee to maintain these arrangements. In
connection with its securities lending activities, Schwab is required to provide
collateral to certain brokerage clients. Schwab satisfies the collateral
requirements by arranging letters of credit (LOCs), in favor of these brokerage
clients, that are guaranteed by multiple banks. At December 31, 2004, the
outstanding value of these LOCs totaled $52 million. No funds were drawn under
these LOCs at December 31, 2004.
Schwab is subject to regulatory requirements that are intended to ensure
the general financial soundness and liquidity of broker-dealers. These
regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying
cash dividends, or making 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 of $1 million. At
December 31, 2004, Schwab's net capital was $1.2 billion (12% of aggregate debit
balances), which was $1.0 billion in excess of its minimum required net capital
and $723 million in excess of 5% of aggregate debit balances. Schwab has
historically targeted net capital to be at least 10% of its aggregate debit
balances, which primarily consist of client margin loans.
To manage Schwab's regulatory capital requirement, CSC provides Schwab with
a $1.4 billion subordinated revolving credit facility which is scheduled to
expire in September 2005. The amount outstanding under this facility at
December 31, 2004 was $220 million. Borrowings under this subordinated lending
arrangement qualify as regulatory capital for Schwab.
- 19 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of
Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
U.S. Trust
U.S. Trust's liquidity needs are generally met through deposits from
banking clients, equity capital, and borrowings.
Certain Schwab brokerage clients can sweep the excess cash held in their
accounts into a money market deposit account at U.S. Trust. At December 31,
2004, these balances totaled $577 million.
In addition to traditional funding sources such as deposits, federal funds
purchased, and repurchase agreements, USTC's depository institution subsidiaries
have established their own external funding sources. At December 31, 2004, U.S.
Trust had $52 million in Trust Preferred Capital Securities outstanding with a
fixed interest rate of 8.41%. Certain of USTC's depository institution
subsidiaries have established credit facilities with the Federal Home Loan Bank
System (FHLB) totaling $1.7 billion. At December 31, 2004, $625 million was
outstanding under these facilities. Additionally, at December 31, 2004, U.S.
Trust had $38 million of federal funds purchased.
U.S. Trust also engages in intercompany repurchase agreements with Schwab
Bank and Schwab. At December 31, 2004, U.S. Trust had $400 million and $200
million in repurchase agreements outstanding with Schwab Bank and Schwab,
respectively.
CSC provides U.S. Trust with a $300 million short-term credit facility
maturing in December 2006. Borrowings under this facility do not qualify as
regulatory capital for U.S. Trust. The amount outstanding under this facility
was $30 million at December 31, 2004.
U.S. Trust uses Swaps with CSC and third parties to hedge the interest rate
risk associated with its variable rate deposits from banking clients. These
Swaps are structured for U.S. Trust to receive a variable rate of interest and
pay a fixed rate of interest. At December 31, 2004, the Swaps with CSC have a
notional value of $650 million and a fair value of $9 million. For a complete
discussion of the Swaps with third parties, see "Item 8 - Financial Statements
and Supplementary Data - Notes to Consolidated Financial Statements - 24.
Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk or Market
Risk."
U.S. Trust is subject to the Federal Reserve Board's risk-based and
leverage capital guidelines. These regulations require banks and bank holding
companies to maintain minimum levels of capital. In addition, USTC's depository
institution subsidiaries are subject to limitations on the amount of dividends
they can pay to USTC.
Schwab Bank
Schwab Bank's current liquidity needs are generally met through deposits
from banking clients and equity capital.
Certain Schwab brokerage clients can sweep the excess cash held in their
accounts into a money market deposit account at Schwab Bank. At December 31,
2004, these balances totaled $4.0 billion.
Schwab Bank has access to traditional funding sources such as deposits,
federal funds purchased, and repurchase agreements. Additionally, CSC provides
Schwab Bank with a $100 million short-term credit facility maturing in December
2005. Borrowings under this facility do not qualify as regulatory capital for
Schwab Bank. No funds were drawn under this facility at December 31, 2004.
In May 2004, Schwab Bank established a credit facility with the FHLB. At
December 31, 2004, $266 million was available, and no funds were drawn under
this facility.
Schwab Bank is subject to the same risk-based and leverage capital
guidelines as U.S. Trust (see discussion above), except that Schwab Bank is
subject to a minimum tier 1 leverage ratio of 8% for its first three years of
operations. In addition, Schwab Bank is subject to limitations on the amount of
dividends it can pay to CSC.
Liquidity Risk Factors
The Company manages risk by maintaining sufficient liquid financial
resources to fund its balance sheet and meet its obligations. The Company's
liquidity needs are met primarily through cash generated by operations, as well
as cash provided by external financing. Risks in meeting thes