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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 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 No.)
of incorporation or organization)
120 Kearny Street, San Francisco, CA 94108
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (415) 627-7000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
1,364,824,930 shares of $.01 par value Common Stock
Outstanding on April 30, 2004
THE CHARLES SCHWAB CORPORATION
Quarterly Report on Form 10-Q
For the Quarter Ended March 31, 2004
Index
Page
----
Part I - Financial Information
Item 1. Condensed Consolidated Financial Statements:
Statement of Income 1
Balance Sheet 2
Statement of Cash Flows 3
Notes 4 - 11
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12 - 22
Item 3. Quantitative and Qualitative Disclosures About Market Risk 22 - 24
Item 4. Controls and Procedures 24
Part II - Other Information
Item 1. Legal Proceedings 25 - 26
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases
of Equity Securities 26
Item 3. Defaults Upon Senior Securities 26
Item 4. Submission of Matters to a Vote of Security Holders 26
Item 5. Other Information 26
Item 6. Exhibits and Reports on Form 8-K 26
Signature 27
Part I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Income
(In millions, except per share amounts)
(Unaudited)
Three Months Ended
March 31,
2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 505 $ 428
Commissions 390 240
Interest revenue 263 239
Interest expense (53) (64)
------ ------
Net interest revenue 210 175
Principal transactions 52 33
Other 33 24
- ------------------------------------------------------------------------------------------------------------------------------------
Total 1,190 900
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 528 417
Occupancy and equipment 106 111
Depreciation and amortization 59 76
Communications 65 60
Professional services 60 37
Advertising and market development 62 48
Commissions, clearance and floor brokerage 23 13
Impairment charges - 5
Other 40 36
- ------------------------------------------------------------------------------------------------------------------------------------
Total 943 803
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before taxes on income 247 97
Taxes on income (86) (23)
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations 161 74
Loss from discontinued operations, net of tax - (3)
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income $ 161 $ 71
===================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,375 1,357
- ------------------------------------------------------------------------------------------------------------------------------------
Earnings Per Share - Basic
Income from continuing operations $ .12 $ .05
Loss from discontinued operations, net of tax - -
Net income $ .12 $ .05
Earnings Per Share - Diluted
Income from continuing operations $ .12 $ .05
Loss from discontinued operations, net of tax - -
Net income $ .12 $ .05
- ------------------------------------------------------------------------------------------------------------------------------------
Dividends Declared Per Common Share $ .014 $ .011
- ------------------------------------------------------------------------------------------------------------------------------------
See Notes to Condensed Consolidated Financial Statements.
- 1 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Balance Sheet
(In millions, except share and per share amounts)
(Unaudited)
March 31, December 31,
2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 2,414 $ 2,832
Cash and investments segregated and on deposit for federal or other
regulatory purposes(1) (including resale agreements of $16,294 in 2004
and $16,824 in 2003) 20,841 21,343
Securities owned - at market value (including securities pledged of $2
in 2004 and $131 in 2003) 4,211 4,023
Receivables from brokers, dealers and clearing organizations 504 556
Receivables from brokerage clients - net 9,258 8,581
Loans to banking clients - net 6,025 5,736
Loans held for sale 44 29
Equipment, office facilities and property - net 943 956
Goodwill - net 1,030 835
Intangible assets - net 175 144
Other assets 839 831
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 46,284 $ 45,866
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 9,271 $ 8,308
Drafts payable 291 154
Payables to brokers, dealers and clearing organizations 2,724 2,661
Payables to brokerage clients 26,547 27,184
Accrued expenses and other liabilities 1,255 1,330
Short-term borrowings 755 996
Long-term debt 779 772
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 41,622 41,405
- ------------------------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940,000 shares authorized; $.01 par value per share;
none issued - -
Common stock - 3 billion shares authorized; $.01 par value per share;
1,392,091,544 and 1,392,091,544 shares issued in 2004 and 2003, respectively 14 14
Additional paid-in capital 1,758 1,749
Retained earnings 3,254 3,125
Treasury stock - 27,928,584 and 34,452,710 shares in 2004 and 2003,
respectively, at cost (249) (319)
Unamortized stock-based compensation (121) (95)
Accumulated other comprehensive income (loss) 6 (13)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,662 4,461
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 46,284 $ 45,866
====================================================================================================================================
(1) Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes were $20,299 million and $21,005 million at March 31, 2004 and December 31, 2003, respectively. On
April 2, 2004, the Company withdrew $143 million of excess segregated cash. On January 5, 2004, the Company deposited $221
million into its segregated reserve bank accounts.
See Notes to Condensed Consolidated Financial Statements.
- 2 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Cash Flows
(In millions)
(Unaudited)
Three Months Ended
March 31,
2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 161 $ 71
Adjustments to reconcile net income to net cash used for operating activities:
Depreciation and amortization 59 76
Impairment charges - 5
Tax benefit from, and amortization of, stock-based awards 19 7
Deferred income taxes 26 15
Other 3 4
Originations of loans held for sale (215) -
Proceeds from sales of loans held for sale 201 -
Net change in:
Cash and investments segregated and on deposit for federal or other
regulatory purposes 502 (1,978)
Securities owned (excluding securities available for sale) 12 (45)
Receivables from brokers, dealers and clearing organizations 55 13
Receivables from brokerage clients (677) 520
Other assets 11 15
Drafts payable 137 139
Payables to brokers, dealers and clearing organizations 64 819
Payables to brokerage clients (638) 49
Accrued expenses and other liabilities (171) (216)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for operating activities (451) (506)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (490) (460)
Proceeds from sales of securities available for sale - 14
Proceeds from maturities, calls and mandatory redemptions of securities
available for sale 413 135
Net increase in loans to banking clients (289) (97)
Purchase of equipment, office facilities and property - net (35) (32)
Cash payments for business combinations and investments, net of cash acquired (289) (8)
Proceeds from sales of subsidiaries - 53
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (690) (395)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net change in deposits from banking clients 963 (24)
Net change in short-term borrowings (241) 261
Repayment of long-term debt - (22)
Dividends paid (19) (15)
Purchase of treasury stock - (32)
Proceeds from stock options exercised and other 20 7
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 723 175
- ------------------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (418) (726)
Cash and Cash Equivalents at Beginning of Period 2,832 3,114
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 2,414 $ 2,388
====================================================================================================================================
See Notes to Condensed Consolidated Financial Statements.
- 3 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Amounts and Ratios)
(Unaudited)
1. Basis of Presentation
The Charles Schwab Corporation (CSC, and with its majority-owned
subsidiaries collectively referred to as the Company) is a financial holding
company engaged, through its subsidiaries, in securities brokerage, banking, and
related financial services. Charles Schwab & Co., Inc. (Schwab) is a securities
broker-dealer with 339 domestic branch offices in 48 states, as well as a branch
in the Commonwealth of Puerto Rico. U.S. Trust Corporation (USTC, and with its
subsidiaries collectively referred to as U.S. Trust) is a wealth management firm
that through its subsidiaries also provides fiduciary services and private
banking services with 38 offices in 15 states. Other subsidiaries include
Charles Schwab Investment Management, Inc., the investment advisor for Schwab's
proprietary mutual funds, Schwab Capital Markets L.P. (SCM), a market maker in
Nasdaq, exchange-listed, and other securities providing trade execution services
primarily to broker-dealers and institutional clients, CyberTrader, Inc.
(CyberTrader), an electronic trading technology and brokerage firm providing
services to highly active, online traders, and Charles Schwab Bank, N.A. (Schwab
Bank), a retail bank which commenced operations in the second quarter of 2003.
On January 31, 2003, the Company sold its United Kingdom (U.K.) brokerage
subsidiary, Charles Schwab Europe (CSE), to Barclays PLC. The results of the
operations of CSE, net of income taxes, have been presented as discontinued
operations on the Condensed Consolidated Statement of Income.
The accompanying unaudited condensed consolidated financial statements
include CSC and its majority-owned subsidiaries. These financial statements have
been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission (SEC) and, in the opinion of management, reflect all
adjustments necessary to present fairly the financial position, results of
operations, and cash flows for the periods presented in conformity with
generally accepted accounting principles in the U.S. (GAAP). All adjustments
were of a normal recurring nature. Certain items in prior periods' financial
statements have been reclassified to conform to the 2004 presentation. All
material intercompany balances and transactions have been eliminated. These
financial statements should be read in conjunction with the consolidated
financial statements and notes thereto included in the Company's 2003 Annual
Report to Stockholders, which is filed as Exhibit 13.1 to the Company's
Form 10-K for the year ended December 31, 2003. The Company's results for any
interim period are not necessarily indicative of results for a full year or any
other interim period.
2. New Accounting Standard
SEC Staff Accounting Bulletin (SAB) No. 105 "Application of Accounting
Principles to Loan Commitments" was released in March 2004. This release
summarizes the SEC staff position regarding the application of GAAP to loan
commitments accounted for as derivative instruments. The Company accounts for
interest rate lock commitments issued on mortgage loans that will be held for
sale as derivative instruments. Consistent with SAB No. 105, the Company
considers the fair value of these commitments to be zero at the commitment date,
with subsequent changes in fair value determined solely on changes in market
interest rates. As of March 31, 2004, the Company had interest rate lock
commitments on mortgage loans to be held for sale with principal balances
totaling approximately $230 million, the fair value of which was immaterial.
- 4 -
3. Stock Incentive Plans
The Company's stock incentive plans provide for granting options to
employees, officers, and directors. Options are granted for the purchase of
shares of common stock at an exercise price not less than market value on the
date of grant, and expire within ten years from the date of grant. Options
generally vest over a four-year period from the date of grant.
A summary of option activity follows:
- --------------------------------------------------------------------------------
2004 2003
------------------ ------------------
Weighted- Weighted-
Number Average Number Average
of Exercise of Exercise
Options Price Options Price
- --------------------------------------------------------------------------------
Outstanding at
beginning of year 136 $ 15.25 156 $ 15.38
Granted 1 $ 13.73 -(1) $ 9.26
Exercised (4) $ 5.57 (1) $ 5.82
Canceled (3) $ 19.54 (6) $ 18.09
- --------------------------------------------------------------------------------
Outstanding at
March 31 130 $ 15.42 149 $ 15.34
================================================================================
Exercisable at
March 31 87 $ 15.41 77 $ 13.30
- --------------------------------------------------------------------------------
Available for future
grant at March 31 43 39
- --------------------------------------------------------------------------------
Weighted-average fair
value of options granted in
quarter ended March 31 $ 3.95 $ 4.34
- --------------------------------------------------------------------------------
(1) Less than 500,000 options were granted during the first quarter of 2003.
The Company changed its option pricing model from the Black-Scholes model
to a binomial model for all options granted on or after January 1, 2004. The
fair values of stock options granted prior to January 1, 2004 were determined
using the Black-Scholes model. The Company believes that the binomial model
offers greater flexibility in reflecting the characteristics of employee stock
options. The binomial model takes into account similar inputs to a Black-Scholes
model such as volatility, dividend yield rate, and risk-free interest rate. In
addition to these assumptions, the binomial model considers the contractual term
of the option, the probability that the option will be exercised prior to the
end of its contractual life, and the probability of termination or retirement of
the option holder in computing the value of the option. The Company determines
these probabilities generally based on analysis of historical trends of such
events. The assumptions used in the respective option pricing models were as
follows:
- --------------------------------------------------------------------------------
Three Months Ended March 31, 2004 2003
- --------------------------------------------------------------------------------
Expected dividend yield .48% .30%
Expected volatility 36% 52%
Risk-free interest rate 4.0% 2.9%
Expected life (in years) n/a(1) 5
- --------------------------------------------------------------------------------
(1) The binomial model assumptions include the option contractual term of 10
years and the historical data of option exercises and employee
terminations, rather than an estimate of the option's expected life.
The Company applies Accounting Principles Board Opinion No. 25 - Accounting
for Stock Issued to Employees, and related interpretations, for its stock-based
employee compensation plans. Because the Company grants stock option awards at
market value, there is no compensation expense recorded, except for
restructuring-related expense for modifications of officers' stock options.
- 5 -
Had compensation expense for the Company's stock option awards been
determined based on the Black-Scholes or binomial fair value, as described
above, at the grant dates for awards under those plans consistent with the fair
value method of SFAS No. 123 - Accounting for Stock-Based Compensation, the
Company would have recorded additional compensation expense and its net income
and earnings per share (EPS) would have been reduced to the pro forma amounts
presented in the following table:
- --------------------------------------------------------------------------------
Three
Months Ended
March 31,
2004 2003
- --------------------------------------------------------------------------------
Compensation expense for stock
options (after-tax):
As reported $ - $ -
Pro forma (1) $ 24 $ 29
- --------------------------------------------------------------------------------
Net income:
As reported $ 161 $ 71
Pro forma $ 137 $ 42
- --------------------------------------------------------------------------------
EPS (2):
As reported $ .12 $ .05
Pro forma $ .10 $ .03
- --------------------------------------------------------------------------------
(1) Includes pro forma compensation expense related to stock options granted in
both current and prior periods. Pro forma stock option compensation is
amortized on a straight-line basis over the vesting period beginning with
the month in which the option was granted.
(2) Represents both basic and diluted EPS.
4. Restructuring
The Company's 2003, 2002, and 2001 restructuring initiatives included
workforce reductions, reductions in operating facilities, the removal of certain
systems hardware, software, and equipment from service, and the withdrawal from
certain international operations. These initiatives reduced operating expenses
and adjusted the Company's organizational structure to improve productivity,
enhance efficiency, and increase profitability. There were no restructuring
charges in either of the first quarters of 2004 or 2003.
A summary of the activity in the restructuring reserve for the first
quarter of 2004 is as follows:
- --------------------------------------------------------------------------------
Three months ended Workforce Facilities
March 31, 2004 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at December 31, 2003 $ 23 $ 201 $ 224
Cash payments (10) (16) (26)
Non-cash charges (1) (1) - (1)
Other (2) - 3 3
- --------------------------------------------------------------------------------
Balance at March 31, 2004 $ 12(3) $ 188(4) $ 200
================================================================================
(1) Primarily includes charges for officers' stock-based compensation.
(2) Primarily includes the accretion of facilities restructuring reserves,
which are initially recorded at net present value. Accretion expense is
recorded in occupancy and equipment expense on the Company's Condensed
Consolidated Statement of Income.
(3) Includes $8 million, $3 million, and $1 million related to the Company's
2003, 2002, and 2001 restructuring initiatives, respectively. The Company
expects to substantially utilize the remaining workforce reduction reserve
through cash payments for severance pay and benefits over the respective
severance periods through 2005.
(4) Includes $8 million, $72 million, and $108 million related to the Company's
2003, 2002, and 2001 restructuring initiatives, respectively. The Company
expects to substantially utilize the remaining facilities reduction reserve
through cash payments for the net lease expense over the respective lease
terms through 2017.
5. Business Acquisitions and Divestiture
In June 2003, the Company sold its investment in Aitken Campbell, a
market-making joint venture in the U.K., to the Company's joint venture partner,
TD Waterhouse Group, Inc. In the first quarter of 2003, the Company recorded an
impairment charge of $5 million pre-tax to reduce the carrying value of its
investment and a deferred income tax benefit of $16 million. The Company's share
of Aitken Campbell's historical earnings, which was accounted for under the
equity method, was not material to the Company's results of operations, EPS, or
cash flows.
In October 2003, U.S. Trust acquired State Street Corporation's Private
Asset Management group, a provider of wealth management services to clients in
the New England area, for $365 million.
In January 2004, the Company completed its acquisition of SoundView
Technology Group, Inc. (SoundView), a research-driven securities firm providing
institutional investors with fundamental research on companies in selected
growth-related industries, for approximately $340 million, or $289 million net
of SoundView's cash and cash equivalents acquired. Additionally, the Company
recorded securities owned of $93 million related to this acquisition. As a
result of a preliminary purchase price allocation, the Company recorded goodwill
of $195 million and intangible assets of $21 million related to this
acquisition.
- 6 -
6. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
- --------------------------------------------------------------------------------
March 31, December 31,
2004 2003
- --------------------------------------------------------------------------------
Residential real estate mortgages $4,923 $4,624
Consumer loans 723 735
Other 406 404
- --------------------------------------------------------------------------------
Total loans 6,052 5,763
Less: allowance for credit losses (27) (27)
- --------------------------------------------------------------------------------
Loans to banking clients - net $6,025 $5,736
================================================================================
Included in the loan portfolio are nonaccrual loans totaling $1 million at
both March 31, 2004 and December 31, 2003. Nonaccrual loans are considered
impaired by the Company, and represent all of the Company's nonperforming assets
at both March 31, 2004 and December 31, 2003. For each of the quarters ended
March 31, 2004 and 2003, the impact of interest revenue which would have been
earned on nonaccrual loans versus interest revenue recognized on these loans was
not material to the Company's results of operations.
The amount of loans accruing interest that were contractually 90 days or
more past due was immaterial at both March 31, 2004 and December 31, 2003.
Recoveries and charge-offs related to the allowance for credit losses on
the loan portfolio were not material for each of the quarters ended March 31,
2004 and 2003.
7. Deposits from Banking Clients
Deposits from banking clients consist of money market and other savings
deposits, certificates of deposit, and noninterest-bearing deposits. Deposits
from banking clients are as follows:
- --------------------------------------------------------------------------------
March 31, December 31,
2004 2003
- --------------------------------------------------------------------------------
Interest-bearing deposits $8,565 $7,585
Noninterest-bearing deposits 706 723
- --------------------------------------------------------------------------------
Total $9,271 $8,308
================================================================================
The average rate paid by the Company on its interest-bearing deposits from
banking clients was 1.30% and 2.06% for the three-month periods ended March 31,
2004 and 2003, respectively.
8. Pension and Other Postretirement Benefits
U.S. Trust maintains a trustee managed, noncontributory, qualified defined
benefit pension plan for the benefit of eligible U.S. Trust employees, the
U.S. Trust Corporation Employees' Retirement Plan (the Pension Plan). U.S. Trust
also provides certain health care and life insurance benefits for active
employees and certain qualifying retired employees and their dependents.
The following table summarizes the components of the net periodic benefit
expense related to the Pension Plan and health care and life insurance benefits:
- --------------------------------------------------------------------------------
2004 2003
---------------- ----------------
Three months ended Pension Health & Pension Health &
March 31, Plan Life Plan Life
- --------------------------------------------------------------------------------
Service cost and expenses $ 3 $ - $ 3 $ -
Interest cost 4 - 5 -
Expected return on
plan assets (5) - (6) -
Amortization of
prior service cost (1) - - -
Amortization of
net loss 1 - - -
- --------------------------------------------------------------------------------
Net periodic benefit expense $ 2 $ - $ 2 $ -
================================================================================
9. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is presented in the following table:
- --------------------------------------------------------------------------------
Three
Months Ended
March 31,
2004 2003
- --------------------------------------------------------------------------------
Net income $ 161 $ 71
Other comprehensive income (loss):
Net gain on cash flow
hedging instruments 4 3
Change in net unrealized gain
on securities available for sale 15 (1)
Foreign currency translation
adjustment - 5
- --------------------------------------------------------------------------------
Total comprehensive income,
net of tax $ 180 $ 78
================================================================================
- 7 -
10. Earnings Per Share
Basic EPS excludes dilution and is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted EPS
reflects the potential reduction in EPS that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
EPS under the basic and diluted computations are presented in the following
table:
- --------------------------------------------------------------------------------
Three
Months Ended
March 31,
2004 2003
- --------------------------------------------------------------------------------
Net income $ 161 $ 71
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - basic 1,348 1,342
Common stock equivalent shares
related to stock incentive plans 27 15
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,375 1,357
================================================================================
Basic EPS:
Income from continuing operations $ .12 $ .05
Loss from discontinued operations,
net of tax - -
Net income $ .12 $ .05
- --------------------------------------------------------------------------------
Diluted EPS:
Income from continuing operations $ .12 $ .05
Loss from discontinued operations,
net of tax - -
Net income $ .12 $ .05
- --------------------------------------------------------------------------------
The computation of diluted EPS excludes outstanding stock options to
purchase 75 million and 118 million shares for the three months ended March 31,
2004 and 2003, respectively, because the exercise prices for those options were
greater than the average market price of the common shares, and therefore the
effect would be antidilutive.
11. Regulatory Requirements
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Board of Governors of the Federal
Reserve System (the Federal Reserve Board) under the Bank Holding Company Act of
1956, as amended (the Act).
Under the Act, the Federal Reserve Board has established consolidated
capital requirements for bank holding companies. The regulatory capital and
ratios of the Company, U.S. Trust, United States Trust Company of New York
(U.S. Trust NY), U.S. Trust Company, National Association (U.S. Trust NA), and
Schwab Bank are presented in the following table:
- --------------------------------------------------------------------------------
2004 2003
--------------- ---------------
March 31, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,527 19.8% $ 3,526 25.4%
U.S. Trust $ 666 15.4% $ 604 16.4%
U.S. Trust NY $ 357 10.7% $ 356 11.8%
U.S. Trust NA(2) $ 262 29.3% $ 229 37.4%
Schwab Bank(3) $ 281 28.4% - -
Total Capital:
Company $ 3,556 20.0% $ 3,554 25.6%
U.S. Trust $ 693 16.0% $ 629 17.1%
U.S. Trust NY $ 381 11.4% $ 378 12.5%
U.S. Trust NA(2) $ 265 29.6% $ 232 37.9%
Schwab Bank(3) $ 281 28.5% - -
Tier 1 Leverage:
Company $ 3,527 7.9% $ 3,526 9.0%
U.S. Trust $ 666 8.0% $ 604 8.8%
U.S. Trust NY $ 357 5.6% $ 356 6.4%
U.S. Trust NA(2) $ 262 12.3% $ 229 14.5%
Schwab Bank(3) $ 281 9.6% - -
- --------------------------------------------------------------------------------
(1) Minimum tier 1 capital, total capital, and tier 1 leverage ratios are 4%,
8%, and 3%-5%, respectively, for bank holding companies and banks.
Additionally, Schwab Bank is subject to a minimum tier 1 leverage ratio of
8% for its first three years of operations. Well-capitalized tier 1
capital, total capital, and tier 1 leverage ratios are 6%, 10%, and 5%,
respectively. Each of CSC's other depository institution subsidiaries
exceed the well-capitalized standards set forth by the banking regulatory
authorities.
(2) During 2003, U.S. Trust consolidated its regional subsidiary banks located
outside of New York and New Jersey into U.S. Trust NA, a single
nationally-chartered banking entity. Amounts and ratios for March 31, 2003
have been calculated based on this consolidation.
(3) Schwab Bank commenced operations in the second quarter of 2003. Therefore,
Schwab Bank regulatory capital and ratios are not presented for March 31,
2003.
Based on their respective regulatory capital ratios at March 31, 2004 and
2003, the Company, U.S. Trust, U.S. Trust NY, and U.S. Trust NA are considered
well capitalized (the highest category) pursuant to Federal Reserve Board
guidelines. Additionally, based on its regulatory
- 8 -
capital ratios at March 31, 2004, Schwab Bank is also considered well
capitalized. There are no conditions or events that management believes have
changed the Company's, U.S. Trust's, U.S. Trust NY's, U.S. Trust NA's, or Schwab
Bank's well-capitalized status.
Schwab and SCM are subject to the Uniform Net Capital Rule under the
Securities Exchange Act of 1934 (the Rule). Schwab and SCM compute net capital
under the alternative method permitted by this Rule. This method requires the
maintenance of minimum net capital, as defined, of the greater of 2% of
aggregate debit balances arising from client transactions or a minimum dollar
requirement, which is based on the type of business conducted by the
broker-dealer. The minimum dollar requirement for both Schwab and SCM is
$1 million. Under the alternative method, a broker-dealer may not repay
subordinated borrowings, pay cash dividends, or make any unsecured advances or
loans to its parent or employees if such payment would result in net capital of
less than 5% of aggregate debit balances or less than 120% of its minimum dollar
requirement. At March 31, 2004, Schwab's net capital was $1.2 billion (13% of
aggregate debit balances), which was $1.0 billion in excess of its minimum
required net capital and $738 million in excess of 5% of aggregate debit
balances. At March 31, 2004, SCM's net capital was $65 million, which was
$64 million in excess of its minimum required net capital.
12. Commitments and Contingent Liabilities
Guarantees: The Company provides certain indemnifications (i.e., protection
against damage or loss) to counterparties in connection with the disposition of
certain of its assets. Such indemnifications typically relate to title to the
assets transferred, ownership of intellectual property rights (e.g., patents),
accuracy of financial statements, compliance with laws and regulations, failure
to pay, satisfy or discharge any liability, or to defend claims, as well as
errors, omissions, and misrepresentations. These indemnification agreements have
various expiration dates and the Company's liability under these agreements is
generally limited to certain maximum amounts. At March 31, 2004, the Company's
maximum potential liability under these indemnification agreements is limited to
approximately $100 million. The Company does not believe that any material loss
related to such indemnifications is likely and therefore no liability for these
indemnifications has been recognized.
The Company has clients that sell (i.e., write) listed option contracts
that are cleared by various clearing houses. The clearing houses establish
margin requirements on these transactions. The Company satisfies the margin
requirements by arranging standby letters of credit (LOCs), in favor of the
clearing houses, that are guaranteed by multiple banks. At March 31, 2004, the
outstanding value of these LOCs totaled $630 million. No funds were drawn under
these LOCs at March 31, 2004.
The Company also provides guarantees to securities clearing houses and
exchanges under their standard membership agreement, which requires members to
guarantee the performance of other members. Under the agreement, if another
member becomes unable to satisfy its obligations to the clearing houses and
exchanges, other members would be required to meet shortfalls. The Company's
liability under these arrangements is not quantifiable and may exceed the cash
and securities it has posted as collateral. However, the potential requirement
for the Company to make payments under these arrangements is remote.
Accordingly, no liability has been recognized for these transactions.
Legal contingencies: The nature of the Company's business subjects it to
claims, lawsuits, regulatory examinations, and other proceedings in the ordinary
course of business. The results of these matters cannot be predicted with
certainty. There can be no assurance that these matters will not have a material
adverse effect on the Company's results of operations in any future period,
depending partly on the results for that period, and a substantial judgment
could have a material adverse impact on the Company's financial condition,
results of operations, and cash flows. However, it is the opinion of management,
after consultation with legal counsel, that the ultimate outcome of these
existing claims and proceedings will not have a material adverse impact on the
financial condition, results of operations, or cash flows of the Company.
For further discussion of legal proceedings, see Part II - Other
Information, Item 1 - Legal Proceedings.
- 9 -
13. Segment Information
The Company structures its segments according to its various types of
clients and the services provided to those clients. These segments have been
aggregated, based on similarities in economic characteristics, types of clients,
services provided, distribution channels, and regulatory environment, into four
reportable segments - Individual Investor, Institutional Investor, Capital
Markets, and U.S. Trust.
In the first quarter of 2004, the Company changed its methodology for the
computation of its segment information. The new methodology utilizes an
activity-based costing model to allocate traditional income statement line item
expenses (e.g., compensation and benefits, depreciation, and professional
services) to the business activities driving segment expenses (e.g., client
service, opening new accounts, or business development). Previously-reported
segment information has been revised to reflect this new methodology.
Previously, except for the U.S. Trust segment, for which expenses were directly
incurred, technology, corporate, and general administrative expenses were
allocated to the remaining segments generally in proportion to either their
respective revenues or average full-time equivalent employees.
The Company periodically reallocates certain revenues and expenses among
the segments to align them with changes in the Company's organizational
structure. Previously-reported segment information has been revised to reflect
changes during the year in the Company's internal organization. The Company
evaluates the performance of its segments based on adjusted operating income
before taxes (a non-GAAP income measure), which excludes items such as
restructuring charges, acquisition- and merger-related charges, impairment
charges, discontinued operations, and extraordinary items. Intersegment revenues
are not material and are therefore not disclosed. Total revenues, income from
continuing operations before taxes on income, and net income are equal to the
amounts as reported on the Company's Condensed Consolidated Statement of Income.
Financial information for the Company's reportable segments is presented in
the following table:
- --------------------------------------------------------------------------------
Three
Months Ended
March 31,
2004 2003
- --------------------------------------------------------------------------------
Revenues:
Individual Investor $ 685 $ 522
Institutional Investor 232 191
Capital Markets 90 36
U.S. Trust 181 149
Unallocated 2 2
- --------------------------------------------------------------------------------
Total $1,190 $ 900
================================================================================
Adjusted operating income
before taxes:
Individual Investor $ 172 $ 41
Institutional Investor 72 68
Capital Markets 3 (10)
U.S. Trust (1) 6 14
Unallocated (6) (11)
- --------------------------------------------------------------------------------
Adjusted operating income
before taxes 247 102
Excluded items (2) - (5)
- --------------------------------------------------------------------------------
Income from continuing
operations before taxes on
income 247 97
Taxes on income (86) (23)
Loss from discontinued
operations, net of tax (3) - (3)
- --------------------------------------------------------------------------------
Net Income $ 161 $ 71
================================================================================
(1) In accordance with the Company's new cost allocation methodology, amounts
include costs ($15 million and $12 million in the first quarter of 2004 and
2003, respectively) allocated to U.S. Trust.
(2) Includes an impairment charge of $5 million related to the Company's
investment in its U.K. market-making operation for the three months ended
March 31, 2003 (see note "5 - Business Acquisitions and Divestiture").
(3) Represents the impact of the Company's sale of its U.K. brokerage
subsidiary, which was previously included in the Individual Investor
segment (see note "1 - Basis of Presentation").
- 10 -
14. Supplemental Cash Flow Information
Certain information affecting the cash flows of the Company is presented in
the following table:
- --------------------------------------------------------------------------------
Three
Months Ended
March 31,
2004 2003
- --------------------------------------------------------------------------------
Income taxes paid $ 28 $ 12
- --------------------------------------------------------------------------------
Interest paid:
Deposits from banking clients $ 24 $ 21
Brokerage client cash balances 15 24
Long-term debt 12 15
Short-term borrowings 3 5
Other 2 3
- --------------------------------------------------------------------------------
Total interest paid $ 56 $ 68
================================================================================
Non-cash investing and financing activities:
Consolidation of special purpose trust: (1)
Building and land - $ 229
Note payable and other liabilities - $ 228
- --------------------------------------------------------------------------------
(1) Upon adoption of Financial Accounting Standards Board Interpretation 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.
15. Subsequent Events
On April 20, 2004, the Board of Directors increased the quarterly cash
dividend from $.014 per share to $.020 per share, payable May 19, 2004 to
stockholders of record May 5, 2004.
On April 22, 2004, the Company filed a 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. This
Registration Statement was declared effective by the SEC on May 5, 2004. 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.
- 11 -
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Description of Business
Overview: After seeing positive returns and strong trading volumes in
January, securities market returns softened in February and March in response to
mixed economic and geopolitical developments and concerns about rising interest
rates. Despite the slowing of client activity as the first quarter progressed,
daily average revenue trades for the period were still above the year-ago level
by 55%. Other indicators of client re-engagement continued in the first quarter
- - net inflows to equity and balanced mutual funds totaled $8.6 billion in the
first quarter of 2004, compared to net outflows of $197 million in the first
quarter of 2003, and margin loans reached $9.1 billion as of March 31, 2004, up
47% from March 31, 2003. Additionally, assets in client accounts were
$996.3 billion at March 31, 2004, an increase of $233.7 billion, or 31%, from a
year ago.
The Charles Schwab Corporation (CSC) and its subsidiaries (collectively
referred to as the Company) provide securities brokerage, banking, and related
financial services for 7.5 million active client accounts(a). Charles Schwab &
Co., Inc. (Schwab) is a securities broker-dealer with 339 domestic branch
offices in 48 states, as well as a branch in the Commonwealth of Puerto Rico.
U.S. Trust Corporation (USTC, and with its subsidiaries collectively referred to
as U.S. Trust) is a wealth management firm that through its subsidiaries also
provides fiduciary services and private banking services with 38 offices in 15
states. Other subsidiaries include Charles Schwab Investment Management, Inc.
(CSIM), the investment advisor for Schwab's proprietary mutual funds, Schwab
Capital Markets L.P. (SCM), a market maker in Nasdaq, exchange-listed, and other
securities providing trade execution services primarily to broker-dealers and
institutional clients, CyberTrader, Inc. (CyberTrader), an electronic trading
technology and brokerage firm providing services to highly active, online
traders, and Charles Schwab Bank, N.A. (Schwab Bank), a retail bank which
commenced operations in the second quarter of 2003.
The Company provides financial services to individuals, institutional
clients, and broker-dealers through four segments - Individual Investor,
Institutional Investor, Capital Markets, and U.S. Trust. The Individual Investor
segment includes the Company's retail brokerage and banking operations. The
Institutional Investor segment provides custodial, trading and support services
to independent investment advisors (IAs), serves company 401(k) plan sponsors
and third-party administrators, and supports company stock option plans. The
Capital Markets segment provides trade execution services in Nasdaq,
exchange-listed, and other securities primarily to broker-dealers, including
Schwab, and institutional clients. The U.S. Trust segment provides investment,
wealth management, custody, fiduciary, and private banking services to
individual and institutional clients.
Management of the Company focuses on several key financial and
non-financial metrics (as shown in the following table) in evaluating the
Company's financial position and operating performance:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Key Metrics 2004 2003 Change
- --------------------------------------------------------------------------------
Client Activity Metrics:
Net new client assets (in billions) $ 13.8 $ 14.2 (3%)
Client assets
(in billions, at quarter end) $996.3 $762.6 31%
Daily average revenue trades
(in thousands) 178.0 114.6 55%
Company Financial Metrics:
Revenue growth (decline) from
prior year's quarter 32% (14%)
After-tax profit margin 13.5% 7.9%
Return on stockholders' equity 14% 7%
Net income growth (decline) from
prior year's quarter 127% (24%)
Revenue per average full-time
equivalent employee
(annualized, in thousands) $ 284 $ 217 31%
- --------------------------------------------------------------------------------
Management continues to believe that the key to sustaining and improving
the Company's competitive position will be its ability to combine people and
technology in ways that are intended to provide investors with the access,
information, guidance, advice and control they expect - as well as high-quality
service - all at a lower cost than traditional providers of financial services.
Business Strategy: The Company's primary strategy is to meet the financial
services needs of individual investors and independent IAs. To sustain and
advance this core franchise, the Company remains focused on improving service
for these clients and building stronger relationships with them. The Company
provides investors and IAs with products and services that are tailored to (a)
support a full spectrum of investment styles and life stages, and (b) utilize
its scale in trading, operations, distribution and marketing.
For further discussion of the Company's business strategy, see
"Management's Discussion and Analysis of
- ----------
(a) Accounts with balances or activity within the preceding eight months.
- 12 -
Results of Operations and Financial Condition - Description of Business -
Business Strategy" in the Company's 2003 Annual Report to Stockholders, which is
filed as Exhibit 13.1 to the Company's Form 10-K for the year ended December 31,
2003. See also Item 1 - Business - Narrative Description of Business - Business
Strategy in the Company's Form 10-K for the year ended December 31, 2003.
Significant recent developments relating to the Company's three main avenues for
growth include:
Service/Offer Expansion: In February 2004, the Company introduced Schwab
Personal Choice(TM), its suite of investing and advice services for individual
investors. Schwab Personal Choice consists of eight different offers that range
from low-priced, technology-based active trading to highly customized wealth
management delivered by IAs, with a range of self-directed and advised investing
services in between. In combination with services from U.S. Trust and
CyberTrader, Schwab Personal Choice is designed to give investors control over
the level of trading technology, service and advice they utilize, the level of
professional involvement in their portfolio management they receive, and how
they pay for those services. In addition, Schwab Personal Choice is designed so
that clients are guided to appropriate service solutions based primarily on
their needs and preferences, rather than portfolio size or trading frequency.
Product Expansion: The Schwab and AXA Rosenberg Fund adoption was completed in
the first quarter of 2004, formalizing the introduction of the new Laudus
Group(TM) of 11 mutual funds. In addition to providing clients with more choice,
this adoption provides the Company with a distribution presence on over 100
third-party mutual fund and 401(k) platforms.
Business Diversification: In the first quarter of 2004, the Company completed
its acquisition of SoundView Technology Group, Inc. (SoundView), a
research-driven securities firm providing institutional investors with
fundamental research on companies in selected growth-related industries, for
approximately $340 million, or $289 million net of SoundView's cash and cash
equivalents acquired. Additionally, the Company recorded securities owned of $93
million related to this acquisition. As a result of a preliminary purchase price
allocation, the Company recorded goodwill of $195 million and intangible assets
of $21 million related to this acquisition. The Company also began the process
of leveraging its new platform's combination of trade execution and fundamental
research capabilities into stronger relationships with institutional clients.
Regulatory Developments: The Company has been responding to inquiries and
subpoenas from federal and state authorities relating to mutual fund trading,
distribution, and servicing at or through Company affiliates, and has been
conducting its own review of such processes. As disclosed previously, with
respect to U.S. Trust, these investigations have been focusing on circumstances
in which a small number of parties were permitted to engage in short-term
trading of certain Excelsior(R) Funds. The short-term trading activities
permitted under these arrangements were terminated when U.S. Trust strengthened
its policies and procedures in July 2003. U.S. Trust is assessing the impact of
this short-term trading activity on the Excelsior Funds, and has committed to
taking remedial action as appropriate. At Schwab, these investigations have been
focusing on a small percentage of trades through Schwab's Mutual Fund
MarketPlace(R) service that were received from the client prior to market close,
but were modified shortly after market close, in each case after employees
contacted the client when the trades as originally submitted were rejected by
Schwab's computer systems during processing. To date, the Company's internal
review has found no evidence of any intention on the part of Schwab employees to
circumvent rules or policies, no evidence of arrangements with Schwab clients to
permit late trading or market timing through the Mutual Fund MarketPlace, and no
evidence of trading activity by clients or employees to take advantage of
post-market close information.
Although the Company is unable to predict the ultimate outcome of these
matters, any enforcement actions instituted as a result of the investigations
may subject the Company to fines, penalties or other administrative remedies.
The Company is cooperating with regulators, and has taken steps to enhance its
existing policies and procedures to further discourage, detect, and prevent
market timing and late trading.
Lawsuits have been filed against the Company and U.S. Trust and affiliates
alleging breaches of duties and violations of law with respect to these matters.
See Part II - Other Information, Item 1 - Legal Proceedings.
Risk Management
For discussion on the Company's principal risks and some of the policies
and procedures for risk identification, assessment, and mitigation, see
"Management's Discussion and Analysis of Results of Operations and Financial
Condition - Risk Management" in the Company's 2003 Annual Report to
Stockholders, which is filed as Exhibit 13.1 to the Company's Form 10-K for the
year ended December 31, 2003. See Liquidity and Capital Resources of this report
for a discussion on liquidity risk; and see Item 3 - Quantitative and
Qualitative Disclosures About Market Risk for additional information relating to
market risk.
Given the nature of the Company's revenues, expenses, and risk profile, the
Company's earnings and CSC's
- 13 -
common stock price have been and may continue to be subject to significant
volatility from period to period. The Company's results for any interim period
are not necessarily indicative of results for a full year or any other interim
period. Risk is inherent in the Company's business. Consequently, despite the
Company's attempts to identify areas of risk, oversee operational areas
involving risk, and implement policies and procedures designed to mitigate risk,
there can be no assurance that the Company will not suffer unexpected losses due
to operating or other risks.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains "forward-looking statements"
within the meaning of Section 27A of the Securities Act, and Section 21E of the
Securities Exchange Act of 1934. Forward-looking statements are identified by
words such as "believe," "anticipate," "expect," "intend," "plan," "will,"
"may," and other similar expressions. In addition, any statements that refer to
expectations, projections or other characterizations of future events or
circumstances are forward-looking statements. These forward-looking statements,
which reflect management's beliefs, objectives, and expectations as of the date
hereof, are necessarily estimates based on the best judgment of the Company's
senior management. These statements relate to, among other things, the Company's
ability to pursue its business strategy and the Company's ability to sustain and
improve its competitive position (see Description of Business - Business
Strategy); the outcome of pending regulatory investigations (see Description of
Business - Regulatory Developments); sources of liquidity and capital (see
Liquidity and Capital Resources - Liquidity and - Commitments); the Company's
cash position and cash flows (see Liquidity and Capital Resources - Cash and
Capital Resources); net interest expense under interest rate swaps and the
change in designation of certain interest rate swaps (see Item 3 - Quantitative
and Qualitative Disclosures About Market Risk - Financial Instruments Held For
Purposes Other Than Trading - Interest Rate Swaps); and contingent liabilities
(see Part II - Other Information, Item 1 - Legal Proceedings). Achievement of
the expressed beliefs, objectives, and expectations described in these
statements is subject to certain risks and uncertainties that could cause actual
results to differ materially from the expressed beliefs, objectives, and
expectations. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of this Form 10-Q
or, in the case of documents incorporated by reference, as of the date of those
documents.
Important factors that may cause such differences are noted in this interim
report and include, but are not limited to: the Company's success in building
fee-based relationships with its clients; the effect of client trading patterns
on Company revenues and earnings; changes in revenues and profit margin due to
cyclical securities markets and fluctuations in interest rates; the level and
continuing volatility of equity prices; a significant downturn in the securities
markets over a short period of time or a sustained decline in securities prices,
trading volumes, and investor confidence; geopolitical developments affecting
the securities markets, the economy, and investor sentiment; the size and number
of the Company's insurance claims; and a significant decline in the real estate
market, including the Company's ability to sublease certain properties. Other
more general factors that may cause such differences include, but are not
limited to: the Company's inability to attract and retain key personnel; the
timing and impact of changes in the Company's level of investments in personnel,
technology, or advertising; changes in technology; computer system failures and
security breaches; evolving legislation, regulation and changing industry
practices adversely affecting the Company; adverse results of litigation or
regulatory matters; the inability to obtain external financing at acceptable
rates; the effects of competitors' pricing, product and service decisions; and
intensified industry competition and consolidation.
Critical Accounting Policies
Certain of the Company's accounting policies that involve a higher degree
of judgment and complexity are discussed in "Management's Discussion and
Analysis of Results of Operations and Financial Condition - Critical Accounting
Policies" in the Company's 2003 Annual Report to Stockholders, which is filed as
Exhibit 13.1 to the Company's Form 10-K for the year ended December 31, 2003.
There have been no material changes to these critical accounting policies during
the first quarter of 2004.
- 14 -
Three Months Ended March 31, 2004 Compared To
Three Months Ended March 31, 2003
All references to earnings per share (EPS) information in this report
reflect diluted earnings per share unless otherwise noted.
FINANCIAL OVERVIEW
Total revenues for the first quarter of 2004 were $1.2 billion, up
$290 million, or 32%, from the first quarter of 2003. The Company's non-trading
revenues, which include asset management and administration fees, interest
revenue, net of interest expense (referred to as net interest revenue), and
other revenues, increased 19% in the first quarter of 2004 compared to the
year-ago level. The increase in non-trading revenues was largely due to
increases in asset management and administration fees, resulting primarily from
higher levels of client assets and higher asset-based fees from certain client
relationships, and net interest revenue, resulting primarily from higher levels
of interest-earning assets. The Company's trading revenues, which include
commissions and principal transaction revenues, increased 62% from the first
quarter of 2003, primarily due to higher client trading activity.
Total expenses excluding interest during the first quarter of 2004 were
$943 million, up 17% from the first quarter of 2003. This increase was primarily
due to higher compensation and benefits expense as a result of higher levels of
incentive compensation and discretionary bonuses to employees and the
restoration of the Company's 401(k) employee contribution match, as well as
increases in professional services and advertising and market development
expense.
Income from continuing operations before taxes on income was $247 million
for the first quarter of 2004, up 155% from the first quarter of 2003. This
increase was primarily due to the combination of factors discussed separately
above - higher revenues, partially offset by increases in compensation and
benefits expense, professional services, and advertising and market development
expense. Net income for the first quarter of 2004 was $161 million, or $.12 per
share, up 127% from the first quarter of 2003. The increase in net income was
primarily due to higher income from continuing operations before taxes on income
as discussed above. The Company's after-tax profit margin for the first quarter
of 2004 was 13.5%, up from 7.9% for the first quarter of 2003. The annualized
return on stockholders' equity for the first quarter of 2004 was 14%, up from 7%
for the first quarter of 2003.
Segment Information: In evaluating the Company's financial performance,
management uses adjusted operating income, a non-generally accepted accounting
principles (non-GAAP) income measure which excludes items described in the
following paragraph. Management believes that adjusted operating income is a
useful indicator of the ongoing financial performance of the Company's segments,
and a tool that can provide meaningful insight into financial performance
without the effects of certain material items that are not expected to be an
ongoing part of operations (e.g., extraordinary items, non-operating revenues,
restructuring charges, impairment charges, acquisition- and merger-related
charges, and discontinued operations).
Net income and adjusted operating income were the same for the first
quarter of 2004. In the first quarter of 2003, net income of $71 million
included the following items which in total had the effect of increasing
after-tax income by $8 million: a $5 million investment write-down related to
the Company's United Kingdom (U.K.) market-making operation, a $3 million loss
from discontinued operations, and a $16 million tax benefit associated with the
Company's sale of its U.K. market-making operation.
As detailed in note "13 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements, adjusted operating income before taxes was
$247 million for the first quarter of 2004, up $145 million, or 142%, from the
first quarter of 2003 primarily due to increases of $131 million, or 320%, in
the Individual Investor segment, $4 million, or 6%, in the Institutional
Investor segment, and $13 million, in the Capital Markets segment. These
increases were partially offset by a decrease of $8 million, or 57%, in the
U.S. Trust segment. The increases in the Individual and Institutional Investor
segments were primarily due to higher revenues resulting from increased client
trading activity and levels of client assets. The increase in the Capital
Markets segment was primarily due to higher revenues resulting from increased
trading volume. The decrease in the U.S. Trust segment was due to expense growth
outpacing revenue growth primarily related to higher compensation-related
expense and the integration of State Street Corporation's Private Asset
Management group (PAM) acquisition.
Restructuring: 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. There were no restructuring
charges in either of the first quarters of 2004 or 2003.
For further information on the Company's restructuring initiatives, see
note "4 - Restructuring" in the Notes to Condensed Consolidated Financial
Statements.
Discontinued Operations: On January 31, 2003, the Company sold its U.K.
brokerage subsidiary, Charles Schwab Europe (CSE), to Barclays PLC. The results
of CSE's operations have been summarized as loss from
- 15 -
discontinued operations, net of tax, on the Condensed Consolidated Statement of
Income.
REVENUES
The Company categorizes its revenues as either non-trading or trading. As
shown in the following table (in millions), non-trading, trading, and total
revenues in the first quarter of 2004 all increased from the first quarter of
2003.
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Composition of Revenues 2004 2003 Change
- --------------------------------------------------------------------------------
Non-trading revenues:
Asset management and
administration fees $ 505 $ 428 18%
Net interest revenue 210 175 20
Other 33 24 38
- --------------------------------------------------------------------------------
Total non-trading revenues 748 627 19
- --------------------------------------------------------------------------------
Trading revenues:
Commissions 390 240 63
Principal transactions 52 33 58
- --------------------------------------------------------------------------------
Total trading revenues 442 273 62
- --------------------------------------------------------------------------------
Total $1,190 $ 900 32%
================================================================================
Percentage of total revenues:
Non-trading revenues 63% 70%
Trading revenues 37% 30%
- --------------------------------------------------------------------------------
While the Individual Investor and Institutional Investor segments generate
both non-trading and trading revenues, the Capital Markets segment generates
primarily trading revenues and the U.S. Trust segment generates primarily
non-trading revenues. Revenues by segment are as shown in the following table
(in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Revenues by Segment 2004 2003 Change
- --------------------------------------------------------------------------------
Individual Investor $ 685 $ 522 31%
Institutional Investor 232 191 21
Capital Markets 90 36 150
U.S. Trust 181 149 21
Unallocated 2 2 -
- --------------------------------------------------------------------------------
Total revenues $1,190 $ 900 32%
================================================================================
The increases in revenues in the Individual and Institutional Investor
segments from the first quarter of 2003 were primarily due to higher trading
volume and levels of client assets. The increase in revenues in the Capital
Markets segment was primarily due to higher trading volume. The increase in the
U.S. Trust segment was primarily due to the acquisition of PAM and higher levels
of client assets. See note "13 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements for financial information by segment.
Asset Management and Administration Fees
Asset management and administration fees, as shown in the table below (in
millions), include mutual fund service fees, as well as fees for other
asset-based financial services provided to individual and institutional clients.
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Asset Management and Administration Fees 2004 2003 Change
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds (SchwabFunds(R),
Excelsior(R), and other) $ 213 $ 217 (2%)
Mutual Fund OneSource(R) 92 59 56
Other 14 10 40
Asset management and related services 186 142 31
- --------------------------------------------------------------------------------
Total $ 505 $ 428 18%
================================================================================
The increase in asset management and administration fees from the first
quarter of 2003 was primarily due to higher asset-based fees from certain client
relationships and higher levels of client assets, as well as increases in
average assets in and service fees earned on Schwab's Mutual Fund OneSource
service.
Commissions
The Company earns commission revenues, as shown in the following table (in
millions), by executing client trades.
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Commissions 2004 2003 Change
- --------------------------------------------------------------------------------
Equity and other securities $ 326 $ 193 69%
Mutual funds 35 26 35
Options 29 21 38
- --------------------------------------------------------------------------------
Total $ 390 $ 240 63%
================================================================================
The increase in commission revenues from the first quarter of 2003 was
primarily due to higher daily average trades. Commission revenues include
$53 million in the first quarter of 2004 and $20 million in the first quarter of
2003 related to Schwab's institutional trading business. Additionally,
commission revenues include $18 million in the first quarter of 2004 and
$17 million in the first quarter of 2003 related to certain securities serviced
by Schwab's fixed income division, including exchange-traded unit investment
trusts, real estate investment trusts, and corporate debt. Schwab's fixed income
division also generates principal transaction revenues.
- 16 -
As shown in the following table, daily average revenue trades executed by
the Company increased 55% in the first quarter of 2004.
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Trading Activity 2004 2003 Change
- --------------------------------------------------------------------------------
Daily average revenue trades
(in thousands) (1) 178.0 114.6 55%
Accounts that traded (in thousands) 1,459 1,108 32
Average revenue trades
per account that traded 7.6 6.3 21
Trading frequency proxy (2) 4.1 3.5 17
Number of trading days (3) 62.0 61.0 2
Average revenue earned
per revenue trade $37.59 $37.30 1
Online trades as a percentage of
total trades 89% 85%
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
(2) Represents annualized revenue trades per $100,000 in total client assets.
(3) Effective in the third quarter of 2003, the Company considers reduced
exchange trading sessions as half days.
The Company continually monitors its pricing in relation to competitors and
periodically adjusts prices to enhance its competitive position, as well as to
attract and retain clients. Competitive pricing actions have escalated recently,
and the Company is actively evaluating changes to the commission rates and fee
structures for certain clients.
Net Interest Revenue
Net interest revenue, as shown in the following table (in millions), is the
difference between interest earned on certain assets (mainly margin loans to
clients, investments of segregated client cash balances, loans to banking
clients, and securities available for sale) and interest paid on supporting
liabilities (mainly deposits from banking clients and brokerage client cash
balances). Net interest revenue is affected by changes in the volume and mix of
these assets and liabilities, as well as by fluctuations in interest rates and
hedging strategies.
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
2004 2003 Change
- --------------------------------------------------------------------------------
Interest Revenue:
Margin loans to clients $ 104 $ 82 27%
Investments, client-related 62 75 (17)
Loans to banking clients 61 56 9
Securities available for sale 30 16 88
Other 6 10 (40)
- --------------------------------------------------------------------------------
Total 263 239 10
- --------------------------------------------------------------------------------
Interest Expense:
Deposits from banking clients 27 23 17
Brokerage client cash balances 15 25 (40)
Long-term debt 8 10 (20)
Short-term borrowings 2 3 (33)
Other 1 3 (67)
- --------------------------------------------------------------------------------
Total 53 64 (17)
- --------------------------------------------------------------------------------
Net interest revenue $ 210 $ 175 20%
================================================================================
- 17 -
Client-related daily average balances, interest rates, and average net
interest spread for the first quarters of 2004 and 2003 are summarized in the
following table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2004 2003
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $ 21,096 $ 21,231
Average interest rate 1.18% 1.44%
Margin loans to clients:
Average balance outstanding $ 8,846 $ 6,399
Average interest rate 4.70% 5.21%
Loans to banking clients:
Average balance outstanding $ 5,800 $ 4,546
Average interest rate 4.20% 5.02%
Securities available for sale:
Average balance outstanding $ 3,456 $ 1,517
Average interest rate 3.44% 4.39%
Average yield on interest-earning assets 2.62% 2.77%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $ 23,924 $ 23,003
Average interest rate .25% .42%
Interest-bearing banking deposits:
Average balance outstanding $ 8,215 $ 4,570
Average interest rate 1.30% 2.06%
Other interest-bearing sources:
Average balance outstanding $ 2,840 $ 2,164
Average interest rate .79% 1.25%
Average noninterest-bearing portion $ 4,219 $ 3,956
Average interest rate on funding sources .48% .65%
Summary:
Average yield on interest-earning assets 2.62% 2.77%
Average interest rate on funding sources .48% .65%
- --------------------------------------------------------------------------------
Average net interest spread 2.14% 2.12%
- --------------------------------------------------------------------------------
The increase in net interest revenue from the first quarter of 2003 was
primarily due to changes in the composition of interest-earning assets,
including increases in margin loan balances and securities available for sale.
In addition, the decline in yields on interest-earning assets due to changes in
the interest rate environment was offset by lower interest rates on funding
sources.
Principal Transactions
Principal transaction revenues, as shown in the following table (in
millions), are primarily comprised of revenues from client fixed income
securities trading activity, and net gains from market-making activities in
equity securities.
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Principal Transactions 2004 2003 Change
- --------------------------------------------------------------------------------
Equity securities $ 27 $ 12 125%
Fixed income securities 25 21 19
- --------------------------------------------------------------------------------
Total $ 52 $ 33 58%
================================================================================
The increase in principal transaction revenues from the first quarter of
2003 was primarily due to higher equity share volume handled by SCM as a result
of increased trading activity and higher levels of revenues from client fixed
income securities trading activity, partially offset by lower average revenue
per equity share traded.
EXPENSES EXCLUDING INTEREST
As shown in the table below (in millions), total expenses excluding
interest increased in the first quarter of 2004 primarily due to higher levels
of compensation and benefits expense, professional services, and advertising and
market development expense.
- --------------------------------------------------------------------------------
Three Months
Ended
Composition of Expenses, March 31, Percent
Excluding Interest 2004 2003 Change
- --------------------------------------------------------------------------------
Compensation and benefits $ 528 $ 417 27%
Occupancy and equipment 106 111 (5)
Depreciation and amortization 59 76 (22)
Communications 65 60 8
Professional services 60 37 62
Advertising and market development 62 48 29
Commissions, clearance and floor brokerage 23 13 77
Impairment charges - 5 (100)
Other 40 36 11
- --------------------------------------------------------------------------------
Total $ 943 $ 803 17%
================================================================================
Expenses as a percentage of
total revenues:
Total expenses, excluding interest 79% 89%
Compensation and benefits 44% 46%
Advertising and market development 5% 5%
- --------------------------------------------------------------------------------
- 18 -
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.
The increase in compensation and benefits expense from the first quarter of
2003 was primarily due to higher levels of incentive compensation and
discretionary bonuses to employees, costs associated with employees retained
from acquisitions, and higher employee benefits. The following table shows a
comparison of certain compensation and benefits components and employee data (in
millions, except as noted):
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Compensation and Benefits 2004 2003 Change
- --------------------------------------------------------------------------------
Salaries and wages $ 327 $ 305 7%
Incentive and variable compensation 111 49 127
Employee benefits and other 89 63 41
Retention programs (1) 1 - n/m
- --------------------------------------------------------------------------------
Total $ 528 $ 417 27%
================================================================================
Full-time equivalent employees
(at end of quarter, in thousands) (2) 16.9 16.5 2%
- --------------------------------------------------------------------------------
(1) Relates to programs put in place to retain certain employees related to
acquisitions and mergers.
(2) Includes full-time, part-time and temporary employees, and persons employed
on a contract basis.
n/m Not meaningful.
Employee benefits and other expense increased from the first quarter of
2003 primarily due to the restoration 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).
Expenses Excluding Compensation and Benefits
The increase in professional services expense from the first quarter of
2003 was primarily due to higher levels of consulting fees in several areas,
including new and expanded products and services, and information technology
projects. The increase in advertising and market development expense from the
first quarter of 2003 was primarily due to the Company's increased television
and print media spending.
Taxes on Income
The Company's effective income tax rate was 34.8% for the first quarter of
2004, compared to a tax rate of 22.8% for the first quarter of 2003. The
increase was primarily due to a tax benefit associated with the Company's sale
of its U.K. market-making operation in the first quarter of 2003.
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 note "11 - Regulatory Requirements" in the
Notes to Condensed Consolidated Financial Statements.
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, CSC's depository institution subsidiaries, and SCM 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 and SCM's
net capital. Based on their respective regulatory capital ratios at March 31,
2004, 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
$466 million was issued and outstanding at March 31, 2004, have maturities
ranging from 2004 to 2010 and fixed interest rates ranging from 6.04% to 8.05%
with interest payable semiannually (see Item 3 - Quantitative and Qualitative
Disclosures About Market Risk - Financial Instruments Held For Purposes Other
Than Trading - Interest Rate Swaps). 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 Securities and Exchange
Commission enabling CSC to issue up to $750 million in Senior or Senior
Subordinated Medium-Term Notes, Series A. At March 31, 2004, all of these notes
remained unissued.
- 19 -
CSC has authorization from its Board of Directors to issue commercial paper
up to the amount of CSC's committed, unsecured credit facility (see below), not
to exceed $1.5 billion. At March 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 twenty banks which is scheduled to expire in June 2004. CSC plans to
establish a replacement facility when the current facility expires. This
facility was unused during the first quarter of 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 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 tangible net worth, and Schwab and SCM to maintain specified levels of net
capital, 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 $782 million of the $832 million uncommitted,
unsecured bank credit lines, provided by nine 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 during the first quarter of 2004.
See note "15 - Subsequent Events" in the Notes to Condensed Consolidated
Financial Statements for a discussion of a $1.0 billion universal shelf
registration statement.
Schwab
Liquidity needs relating to client trading and margin borrowing activities
are met primarily through cash balances in brokerage client accounts, which were
$26.4 billion and $25.6 billion at March 31, 2004 and December 31, 2003,
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, which was outstanding at March 31,
2004. The interest rate on the note was 1.52% at March 31, 2004, and ranged from
1.52% to 1.58% during the quarter. The building and land have been pledged as
collateral for the note payable. Additionally, the Company has guaranteed the
debt of the Trust up to a maximum of $202 million. The lender does not have
recourse to any other assets of the Company.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of nine banks totaling $832 million at March 31,
2004 (as noted previously, $782 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 4 days during the
first quarter of 2004, with the daily amounts borrowed averaging $52 million.
The amount outstanding under these lines was $95 million at March 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
March 31, 2004. Schwab pays a fee to maintain these letters of credit. No funds
were drawn under these letters of credit at March 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
March 31, 2004, Schwab's net capital was $1.2 billion (13% of aggregate debit
balances), which was $1.0 billion in excess of its minimum required net capital
and $738 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 2004. The amount outstanding under this facility at
March 31, 2004 was $220 million. Borrowings under this subordinated lending
arrangement qualify as regulatory capital for Schwab.
- 20 -
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 March 31, 2004,
these balances totaled $323 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 March 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 $758 million. At March 31, 2004, $475 million was
outstanding under these facilities. Additionally, at March 31, 2004, U.S. Trust
had $184 million of federal funds purchased.
U.S. Trust also engages in intercompany repurchase agreements with Schwab
Bank. At March 31, 2004, U.S. Trust had $400 million in repurchase agreements
outstanding with Schwab Bank.
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 $45 million at March 31, 2004.
In the first quarter of 2004, U.S. Trust entered into an interest rate swap
agreement (Swap) with CSC to hedge the interest rate risk associated with its
variable rate deposits from banking clients. At March 31, 2004, this Swap has a
notional value of $400 million and an immaterial fair value.
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.
SCM
SCM's capital needs are generally met through its equity capital and
borrowings from CSC. Most of SCM's assets are liquid, consisting primarily of
cash and cash equivalents, marketable securities, and receivables from brokers,
dealers and clearing organizations.
SCM may borrow up to $150 million under a subordinated lending arrangement
with CSC which is scheduled to expire in August 2004. Borrowings under this
arrangement qualify as regulatory capital for SCM. The amount outstanding under
this facility at March 31, 2004 was $50 million. The advances under this
facility satisfy increased intra-day capital needs at SCM to support the
expansion of its institutional equities and trading businesses. In addition, CSC
provides SCM with a $50 million short-term credit facility. Borrowings under
this arrangement do not qualify as regulatory capital for SCM. No funds were
drawn under this facility at March 31, 2004.
SCM is subject to the same regulatory net capital requirements as Schwab
(see discussion above). At March 31, 2004, SCM's net capital was $65 million,
which was $64 million in excess of its minimum required net capital.
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 March 31, 2004,
these balances totaled $2.5 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 which matures in
December 2005. Borrowings under this facility do not qualify as regulatory
capital for Schwab Bank. No funds were drawn under this facility at March 31,
2004.
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
Specific risk factors which may affect the Company's liquidity position are
discussed in "Management's Discussion and Analysis of Results of Operations and
Financial Condition - Liquidity and Capital Resources - Liquidity Risk Factors"
in the Company's 2003 Annual Report to Stockholders, which is filed as
Exhibit 13.1 to the Company's Form 10-K for the year ended December 31, 2003.
There have been no material changes to these liquidity risk factors in the first
quarter of 2004.
Cash and Capital Resources
The Company's cash position (reported as cash and cash equivalents on the
Condensed Consolidated Balance Sheet) and cash flows are affected by changes in
brokerage client cash balances and the associated amounts required to be
segregated under federal or other regulatory guidelines. Timing differences
between cash and investments actually
- 21 -
segregated on a given date and the amount required to be segregated for that
date may arise in the ordinary course of business and are addressed by the
Company in accordance with applicable regulations. Other factors which affect
the Company's cash position and cash flows include investment activity in
securities owned, levels of capital expenditures, acquisition activity, banking
client deposit and loan activity, financing activity in short-term borrowings
and long-term debt, payment of dividends, and repurchases of CSC's common stock.
In the first quarter of 2004, cash and cash equivalents decreased
$418 million, or 15%, to $2.4 billion primarily due to movements of brokerage
client-related funds to meet segregation requirements, an increase in loans to
banking clients, the acquisition of SoundView, and a decrease in short-term
borrowings. These decreases were partially offset by an increase in deposits
from banking clients, primarily related to sweep money market deposit accounts.
Certain Schwab brokerage clients can sweep the excess cash held in their
brokerage accounts into these money market deposit accounts at Schwab Bank or
U.S. Trust. At March 31, 2004, these sweep deposit balances totaled
$2.8 billion, up $1.2 billion from December 31, 2003. This sweep deposit
activity is reflected on the Condensed Consolidated Statement of Cash Flows as a
cash outflow from payables to brokerage clients (classified as an operating
activity) and a cash inflow for deposits from banking clients (classified as a
financing activity). Management does not believe that the decline in cash and
cash equivalents in the first quarter of 2004 is an indication of a trend.
The Company's capital expenditures were $35 million in the first quarter of
2004 compared to $32 million in the first quarter of 2003, or 3% and 4% of
revenues for each period, respectively. Capital expenditures in the first
quarter of 2004 were primarily for software and equipment relating to the
Company's information technology systems and certain facilities. Capital
expenditures as described above include the capitalized costs for developing
internal-use software of $19 million in the first quarter of 2004 and
$14 million in the first quarter of 2003.
During the first quarter of 2004, 4 million of the Company's stock options,
with a weighted-average exercise price of $5.57, were exercised with cash
proceeds received by the Company of $20 million and a related tax benefit of
$8 million. The cash proceeds are recorded as an increase in cash and a
corresponding increase in stockholders' equity. The tax benefit is recorded as a
reduction in income taxes payable and a corresponding increase in stockholders'
equity.
The Company reduced its short-term borrowings by $241 million during the
first quarter of 2004.
CSC did not repurchase any of its common stock in the first quarter of
2004. During the first quarter of 2003, CSC repurchased 4 million shares of its
common stock for $32 million. As of March 31, 2004, CSC has authority to
repurchase up to $318 million of its common stock.
During the first quarters of 2004 and 2003, the Company paid common stock
cash dividends of $19 million and $15 million, respectively. See note "15 -
Subsequent Events" in the Notes to Condensed Consolidated Financial Statements
for a discussion of an increase in the quarterly cash dividend.
The Company monitors both the relative composition and absolute level of
its capital structure. The Company's total financial capital (long-term debt
plus stockholders' equity) at March 31, 2004 was $5.4 billion, up $208 million,
or 4%, from December 31, 2003 primarily due to higher stockholders' equity. At
March 31, 2004, the Company had long-term debt of $779 million, or 14% of total
financial capital, that bears interest at a weighted-average rate of 5.58%. At
March 31, 2004, the Company's stockholders' equity was $4.7 billion, or 86% of
total financial capital.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Financial Instruments Held For Trading Purposes
The Company holds fixed income securities, which include municipal and
government securities, and corporate bonds, in inventory to meet clients'
trading needs. The fair value of such inventory was $77 million and $74 million
at March 31, 2004 and December 31, 2003, respectively. These securities, and the
associated interest rate risk, are not material to the Company's financial
position, results of operations, or cash flows.
The Company maintains inventories in exchange-listed, Nasdaq, and other
equity securities on both a long and short basis. The fair value of these
securities is shown in the following table (in millions):
- --------------------------------------------------------------------------------
March 31, December 31,
Equity Securities 2004 2003
- --------------------------------------------------------------------------------
Long positions $ 120 $ 97
Short positions (79) (74)
- --------------------------------------------------------------------------------
Net long positions $ 41 $ 23
================================================================================
In addition, the Company may enter into exchange-traded futures and options
contracts based on equity market indices to hedge potential losses in equity
inventory positions. There were no open futures or options contracts at
March 31, 2004.
Value-At-Risk
All trading activities are subject to market risk limits established by the
Company's businesses and approved by senior management who are independent of
the businesses.
- 22 -
The Company manages trading risk through position policy limits, value-at-risk
(VaR) measurement methodology, and other market sensitivity measures. Based on
certain assumptions and historical relationships, VaR estimates a potential loss
from adverse changes in the fair values of the Company's overnight trading
positions.
The Company holds fixed income securities and equities for trading
purposes. The estimated VaR for both fixed income securities and equities at
March 31, 2004 and the high, low, and daily average during the first quarter of
2004 was $1 million or less for each category and stated period.
Financial Instruments Held For Purposes Other Than Trading
Debt Issuances
At March 31, 2004 and December 31, 2003, CSC had $466 million aggregate
principal amount of Medium-Term Notes, with fixed interest rates ranging from
6.04% to 8.05%. See "Interest Rate Swaps" below.
At March 31, 2004 and December 31, 2003, U.S. Trust had $52 million Trust
Preferred Capital Securities outstanding, with a fixed interest rate of 8.41%.
The Company has fixed cash flow requirements regarding these long-term debt
obligations due to the fixed rate of interest. The fair value of these
obligations at March 31, 2004 and December 31, 2003, based on estimates of
market rates for debt with similar terms and remaining maturities, approximated
their carrying amount.
Interest Rate Swaps
As part of its consolidated asset and liability management process, the
Company utilizes Swaps to manage interest rate risk.
U.S. Trust uses LIBOR-based Swaps to hedge the interest rate risk
associated with its variable rate deposits from banking clients. The Swaps are
structured for U.S. Trust to receive a variable rate of interest and pay a fixed
rate of interest. Information on these Swaps is summarized in the following
table:
- --------------------------------------------------------------------------------
March 31, December 31,
2004 2003
- --------------------------------------------------------------------------------
Notional principal amount (in millions) $ 625 $ 705
Weighted-average variable interest rate 1.12% 1.17%
Weighted-average fixed interest rate 6.51% 6.41%
Weighted-average maturity (in years) .8 1.0
- --------------------------------------------------------------------------------
These Swaps have been designated as cash flow hedges under SFAS No. 133 -
Accounting for Derivative Instruments and Hedging Activities, and are recorded
on the Condensed Consolidated Balance Sheet, with changes in their fair values
primarily recorded in other comprehensive income (loss), a component of
stockholders' equity. At March 31, 2004 and December 31, 2003, U.S. Trust
recorded a derivative liability of $26 million and $33 million, respectively,
for these Swaps. Based on current interest rate assumptions and assuming no
additional Swap agreements are entered into, U.S. Trust expects to reclassify
approximately $19 million, or $11 million after tax, from other comprehensive
loss to interest expense over the next twelve months.
Due to a divergence between LIBOR rates and the variable rate paid on
banking client deposits, certain of these Swaps with a combined notional amount
of $400 million will not be designated as cash flow hedges for accounting
purposes beginning in the second quarter of 2004. Because these Swaps mature
over the remainder of 2004, this change in accounting designation will not
impact results of operations for full-year 2004, but will impact the timing of
recognition of market gains and losses on these Swaps in the remaining quarterly
reporting periods in 2004. The Company does not expect this change in
designation of Swaps to have a material impact on its financial position,
results of operations, EPS, or cash flows.
CSC uses Swaps to effectively convert the interest rate characteristics of
a portion of its Medium-Term Notes from fixed to variable. These Swaps are
structured for CSC to receive a fixed rate of interest and pay a variable rate
of interest based on the three-month LIBOR rate. The variable interest rates
reset every three months. Information on these Swaps is summarized in the
following table:
- --------------------------------------------------------------------------------
March 31, December 31,
2004 2003
- --------------------------------------------------------------------------------
Notional principal amount (in millions) $ 293 $ 293
Weighted-average variable interest rate 3.57% 3.62%
Weighted-average fixed interest rate 7.57% 7.57%
Weighted-average maturity (in years) 5.0 5.3
- --------------------------------------------------------------------------------
These Swaps have been designated as fair value hedges under SFAS No. 133,
and are recorded on the Condensed Consolidated Balance Sheet. Changes in fair
value of the Swaps are completely offset by changes in fair value of the hedged
Medium-Term Notes. Therefore, there is no effect on net income. At March 31,
2004 and December 31, 2003, CSC recorded a derivative asset of $26 million and
$19 million, respectively, for these Swaps. Concurrently, the carrying value of
the Medium-Term Notes was increased by $26 million and $19 million, at March 31,
2004 and December 31, 2003, respectively.
- 23 -
Loans Held for Sale
Schwab Bank's loans held for sale portfolio consists of fixed- and
adjustable-rate mortgages, which are subject to a loss in value when market
interest rates rise. Schwab Bank uses forward sale commitments to manage this
risk. These forward sale commitments have been designated as cash flow hedging
instruments of the loans held for sale. Accordingly, the fair values of the
forward sale commitments are recorded on the Condensed Consolidated Balance
Sheet, with gains or losses recorded in other comprehensive income (loss). At
March 31, 2004 and December 31, 2003, the derivative liability recorded by
Schwab Bank for these forward sale commitments was immaterial.
Net Interest Revenue Simulation
The Company uses net interest revenue simulation modeling techniques to
evaluate and manage the effect of changing interest rates. The simulation model
(the model) includes all interest-sensitive assets and liabilities, as well as
Swaps utilized by the Company to hedge its interest rate risk. Key variables in
the model include assumed balance growth or decline for client loans, deposits,
and brokerage client cash, changes in the level and term structure of interest
rates, the repricing of financial instruments, prepayment and reinvestment
assumptions, and product pricing assumptions. The simulations involve
assumptions that are inherently uncertain and, as a result, cannot precisely
estimate net interest revenue or precisely predict the impact of changes in
interest rates on net interest revenue. Actual results may differ from simulated
results due to the timing, magnitude, and frequency of interest rate changes as
well as changes in market conditions and management strategies, including
changes in asset and liability mix.
As demonstrated by the simulations presented below, the Company is
positioned so that the consolidated balance sheet produces an increase in net
interest revenue when interest rates rise and, conversely, a decrease in net
interest revenue when interest rates fall (i.e., interest-earning assets are
repricing more quickly than interest-bearing liabilities).
The simulations in the following table assume that the asset and liability
structure of the consolidated balance sheet would not be changed as a result of
the simulated changes in interest rates. As the Company actively manages its
consolidated balance sheet and interest rate exposure, in all likelihood the
Company would take steps to manage any additional interest rate exposure that
could result from changes in the interest rate environment. The following table
shows the results of a gradual 100 basis point increase or decrease in interest
rates relative to the Company's current base rate forecast on simulated net
interest revenue over the next twelve months at March 31, 2004 and December 31,
2003.
- --------------------------------------------------------------------------------
Impact on Net Interest Revenue March 31, December 31,
Percentage Increase (Decrease) 2004 2003
- --------------------------------------------------------------------------------
Increase of 100 basis points .9% 1.7%
Decrease of 100 basis points (7.1%) (6.4%)
- --------------------------------------------------------------------------------
Item 4. Controls and Procedures
The Company's management, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Company's disclosure controls and procedures as of March 31, 2004. Based
on this evaluation, the Company's Chief Executive Officer and Chief Financial
Officer have concluded, as of March 31, 2004, that the Company s disclosure
controls and procedures were effective in recording, processing, summarizing,
and reporting the information the Company is required to disclose in the reports
it files under the Securities Exchange Act of 1934, within the time periods
specified in the Securities and Exchange Commission's rules and forms. Such
evaluation did not identify any change in the Company's internal control over
financial reporting that occurred during the quarter ended March 31, 2004 that
has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
- 24 -
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Described below are certain new legal proceedings and certain developments
with respect to pending legal proceedings during the quarter ended March 31,
2004.
In March 2004, a lawsuit was filed in federal court in the Southern
District of New York by an Excelsior(R) Funds shareholder alleging violations of
the federal security laws and breaches of fiduciary duty by the Charles Schwab
Trust Company (CSTC), USTC, the Excelsior Funds, and six current or former
members of the Excelsior Funds board in connection with market-timing and/or
late trading in the Excelsior Funds. The lawsuit seeks unspecified compensatory
damages, as well as attorneys' fees and costs. The defendants intend to
vigorously defend against this action and the five other class action lawsuits
that were previously disclosed relating to allegations of market-timing in the
Excelsior Funds.
In March 2004, a stockholders' derivative action was filed in California
Superior Court in San Francisco against CSC and fourteen current or former CSC
directors. The action claims that the directors breached their fiduciary duties
to Schwab and its stockholders by allegedly failing to maintain adequate
controls to prevent market timing, late trading, and the disclosure of portfolio
holdings information in Excelsior Funds. The lawsuit seeks the recovery of
unspecified compensatory damages and attorneys' fees from the fourteen 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. The defendants intend to vigorously defend against the
allegations.
In March 2004, CSTC was dismissed as a defendant in one of two previously
disclosed market-timing lawsuits (CSTC has not been served in the other lawsuit)
brought by employees of the Janus Capital Group (Janus) mutual funds, which had
named CSTC as a defendant in connection with its role as directed trustee for
the Janus 401(k) and retirement plans.
The Company has been responding to inquiries and subpoenas from federal and
state authorities relating to mutual fund trading, distribution, and servicing
at or through Company affiliates, and has been conducting its own review of such
processes. For further information, see Regulatory Developments in Part I -
Financial Information, Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations - Description of Business.
In January 2004, CSC completed its acquisition of SoundView Technology
Group, Inc. (SoundView). Under the acquisition agreement, CSC assumed
responsibility for SoundView's assets and liabilities, including existing
litigation matters in which SoundView is named as a defendant. SoundView and one
or more of its subsidiaries (or one or more entities to which SoundView or its
subsidiaries is a successor) are among the numerous financial institutions named
as defendants in multiple purported securities class actions filed in the United
States District Court for the Southern District of New York (the IPO Allocation
Cases) between 2001 and 2002. The IPO Allocation Cases allege improper practices
in connection with the allocation of shares of IPO securities (and in some
instances, follow-on offering shares) and were brought on behalf of persons who
either directly or in the aftermarket purchased such securities during the time
period between March 1997 and December 2000. The plaintiffs allege that
SoundView (or its named subsidiaries) and the other underwriters named as
defendants in the IPO Allocation Cases required persons receiving allocations of
IPO shares (and in some instances, follow-on offering shares) to pay excessive
and undisclosed commissions on unrelated trades and to purchase shares in the
aftermarket at specific escalating prices in violation of the federal securities
laws. The plaintiffs seek unspecified compensatory damages, as well as interest,
attorneys' fees, and costs. SoundView (and/or one or more of its subsidiaries)
has been named in 48 purported class action cases, which have been consolidated
into 31 actions, each involving a different company's IPO (and in some
instances, follow-on offering). SoundView did not serve as lead underwriter in
any of the offerings at issue in the IPO Allocation Cases. In addition to the
actions in which SoundView is a defendant, SoundView (or one or more of its
subsidiaries) had an underwriting commitment in certain of the actions in which
SoundView is not named as a defendant, and depending on the outcome of those
actions, may have indemnification obligations to the lead underwriter.
Additionally, the companies that issued stock in the offerings at issue in the
IPO Allocation Cases have stated their intention to seek indemnification from
the underwriters. An additional lawsuit filed by a single individual plaintiff
against SoundView and other underwriters containing similar allegations relating
to IPO practices and seeking similar relief is pending as a related case before
the same district court judge. SoundView believes it has defenses to these
actions and intends to vigorously defend against such litigation.
The nature of the Company's business subjects it to claims, lawsuits,
regulatory examinations, and other proceedings in the ordinary course of
business. The ultimate outcome of the matters described above and the various
other lawsuits, arbitration proceedings, and claims pending against the Company
cannot be determined at this time, and the results of these matters cannot be
predicted with certainty. There can be no assurance that these matters will not
have a material adverse effect on the Company's results of operations in any
future period, depending partly on the results for that period, and a
substantial judgment could have a material adverse impact on the Company's
financial
- 25 -
condition, results of operations, and cash flows. However, it is the opinion of
management, after consultation with legal counsel, that the ultimate outcome of
these existing claims and proceedings will not have a material adverse impact on
the financial condition, results of operations, or cash flows of the Company.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity
Securities
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) The following exhibits are filed as part of this quarterly report on
Form 10-Q.
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.257 The Charles Schwab Corporation Deferred Compensation Plan, as amended
through January 1, 2004 (supersedes Exhibit 10.215).
12.1 Computation of Ratio of Earnings to Fixed Charges.
31.1 Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted
Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted
Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant
to Section 906 of The Sarbanes-Oxley Act of 2002.**
32.2 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant
to Section 906 of The Sarbanes-Oxley Act of 2002.**
** Furnished as an exhibit to this quarterly report on Form 10-Q.
- --------------------------------------------------------------------------------
(b) Reports on Form 8-K
On January 22, 2004, the Registrant furnished a Current Report on Form 8-K
announcing under Item 12, in accordance with Securities and Exchange Commission
Release No. 33-8216, the financial results for the quarter and year ended
December 31, 2003.
On March 29, 2004, the Registrant furnished a Current Report on Form 8-K
providing under Item 12 certain additional financial information (which was not
required to be filed as part of Exhibit 13.1 to the Company's Form 10-K for the
year ended December 31, 2003) and the Letter from the Chief Financial Officer
included in the Company's 2003 Annual Report to Stockholders.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
THE CHARLES SCHWAB CORPORATION
(Registrant)
Date: May 10, 2004 /s/ Christopher V. Dodds
-------------- ----------------------------
Christopher V. Dodds
Executive Vice President and
Chief Financial Officer
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