Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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.
1,346,975,598 shares of $.01 par value Common Stock
Outstanding on October 29, 2004
THE CHARLES SCHWAB CORPORATION
Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 2004
Index
Page
Part I - Financial Information ----
Item 1. Condensed Consolidated Financial Statements:
Statement of Income 1
Balance Sheet 2
Statement of Cash Flows 3
Notes 4 - 14
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 15 - 29
Item 3. Quantitative and Qualitative Disclosures About
Market Risk 29 - 30
Item 4. Controls and Procedures 30
Part II - Other Information
Item 1. Legal Proceedings 31
Item 2. Unregistered Sales of Equity Securities and
Use of Proceeds 31
Item 3. Defaults Upon Senior Securities 31
Item 4. Submission of Matters to a Vote of Security Holders 31
Item 5. Other Information 32
Item 6. Exhibits 32 - 33
Signature 34
Part I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Income
(In millions, except per share amounts)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
2004 2003 2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 523 $ 468 $1,547 $1,345
Commissions 163 290 738 793
Interest revenue 317 235 855 717
Interest expense (72) (54) (177) (182)
------- ------- ------- -------
Net interest revenue 245 181 678 535
Principal transactions 22 22 69 70
Other 47 36 110 91
- ------------------------------------------------------------------------------------------------------------------------------------
Total 1,000 997 3,142 2,834
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 455 418 1,430 1,230
Occupancy and equipment 97 106 299 322
Depreciation and amortization 58 69 167 212
Communications 53 59 170 169
Professional services 62 44 181 123
Advertising and market development 43 31 151 100
Commissions, clearance and floor brokerage 9 10 29 29
Restructuring charges 112 35 114 59
Impairment charges - - - 5
Other 39 29 116 101
- ------------------------------------------------------------------------------------------------------------------------------------
Total 928 801 2,657 2,350
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before taxes on income 72 196 485 484
Taxes on income (26) (72) (173) (154)
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations 46 124 312 330
Gain (loss) from discontinued operations, net of tax (87) 3 (79) (6)
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $ (41) $ 127 $ 233 $ 324
====================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,364 1,366 1,370 1,361
- ------------------------------------------------------------------------------------------------------------------------------------
Earnings Per Share - Basic
Income from continuing operations $ .03 $ .09 $ .23 $ .24
Gain (loss) from discontinued operations, net of tax $ (.06) - $ (.06) -
Net income (loss) $ (.03) $ .09 $ .17 $ .24
Earnings Per Share - Diluted
Income from continuing operations $ .03 $ .09 $ .23 $ .24
Gain (loss) from discontinued operations, net of tax $ (.06) - $ (.06) -
Net income (loss) $ (.03) $ .09 $ .17 $ .24
- ------------------------------------------------------------------------------------------------------------------------------------
Dividends Declared Per Common Share $ .020 $ .014 $ .054 $ .036
- ------------------------------------------------------------------------------------------------------------------------------------
See Notes to Condensed Consolidated Financial Statements.
- 1 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Balance Sheet
(In millions, except share and per share amounts)
(Unaudited)
September 30, December 31,
2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 2,096 $ 2,785
Cash and investments segregated and on deposit for federal or other
regulatory purposes(1) (including resale agreements of $12,899 in 2004
and $16,824 in 2003) 19,560 21,341
Securities owned - at market value (including securities pledged of $2
in 2004 and $131 in 2003) 4,304 3,934
Receivables from brokers, dealers and clearing organizations 330 476
Receivables from brokerage clients - net 9,154 8,581
Loans to banking clients - net 6,202 5,736
Loans held for sale 1,059 29
Equipment, office facilities and property - net 932 943
Goodwill - net 810 810
Intangible assets - net 148 141
Other assets 969 829
Assets of discontinued operations 371 261
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 45,935 $ 45,866
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 10,199 $ 8,308
Drafts payable 254 152
Payables to brokers, dealers and clearing organizations 2,151 2,633
Payables to brokerage clients 25,896 27,184
Accrued expenses and other liabilities 1,304 1,216
Short-term borrowings 840 996
Long-term debt 611 772
Liabilities of discontinued operations 125 144
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 41,380 41,405
- ------------------------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940,000 shares authorized; $.01 par value per share;
none issued - -
Common stock - 3 billion shares authorized; $.01 par value per share;
1,392,091,544 shares issued 14 14
Additional paid-in capital 1,763 1,749
Retained earnings 3,256 3,125
Treasury stock - 40,913,709 and 34,452,710 shares in 2004 and 2003,
respectively, at cost (366) (319)
Unamortized stock-based compensation (104) (95)
Accumulated other comprehensive loss (8) (13)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,555 4,461
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 45,935 $ 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 $19,040 million at September 30, 2004, excluding $200 million of intercompany repurchase
agreements, and $21,004 million at December 31, 2003. On October 4, 2004, the Company withdrew $178 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)
Nine Months Ended
September 30,
2004 2003
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 233 $ 324
Adjustments to reconcile net income to net cash provided by (used for) operating activities:
Loss from discontinued operations, net of tax 79 6
Depreciation and amortization 167 212
Impairment charges - 5
Tax benefit from, and amortization of, stock-based awards 44 19
Deferred income taxes 30 3
Other 4 1
Originations of loans held for sale (696) (1,267)
Proceeds from sales of loans held for sale 701 1,197
Net change in:
Cash and investments segregated and on deposit for federal or other
regulatory purposes 1,781 (2,142)
Securities owned (excluding securities available for sale) 64 (57)
Receivables from brokers, dealers and clearing organizations 146 (65)
Receivables from brokerage clients (574) (825)
Other assets (176) (64)
Drafts payable 101 13
Payables to brokers, dealers and clearing organizations (482) 1,717
Payables to brokerage clients (1,289) 418
Accrued expenses and other liabilities 1 (127)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) operating activities 134 (632)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (1,968) (1,725)
Proceeds from sales of securities available for sale 599 369
Proceeds from maturities, calls and mandatory redemptions of securities
available for sale 1,019 537
Net increase in loans to banking clients (1,498) (1,063)
Purchase of equipment, office facilities and property - net (151) (97)
Cash payments for business combinations and investments, net of cash acquired - (9)
Proceeds from sales of subsidiaries - 53
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (1,999) (1,935)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net increase in deposits from banking clients 1,891 1,277
Net change in short-term borrowings (156) 894
Proceeds from long-term debt 136 -
Repayment of long-term debt (294) (100)
Dividends paid (74) (49)
Purchase of treasury stock (149) (32)
Proceeds from stock options exercised and other 30 24
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 1,384 2,014
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash (used for) provided by discontinued operations (208) 28
- ------------------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (689) (525)
Cash and Cash Equivalents at Beginning of Period 2,785 2,979
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 2,096 $ 2,454
====================================================================================================================================
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 283 domestic branch offices in 45 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, CyberTrader, Inc., an electronic trading technology
and brokerage firm providing services to highly active, online traders, and
Charles Schwab Bank, N.A. (Schwab Bank), a retail bank which commenced
operations in the second quarter of 2003.
The 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, except as discussed in note "5 - Discontinued
Operations" related to the Company's exit from the capital markets business and
the sale of Charles Schwab Europe (CSE). Certain items in prior periods'
financial statements have been reclassified to conform to the 2004 presentation.
All material intercompany balances and transactions have been eliminated. These
financial statements should be read in conjunction with the consolidated
financial statements and notes thereto included in the Company's 2003 Annual
Report to Stockholders, which is filed as Exhibit 13.1 to the Company's
Form 10-K for the year ended December 31, 2003, and the Company's Quarterly
Reports on Form 10-Q for the periods ended March 31, 2004 and June 30, 2004. The
Company's results for any interim period are not necessarily indicative of
results for a full year or any other interim period.
2. New Accounting Standards
SEC Staff Accounting Bulletin (SAB) No. 105 "Application of Accounting
Principles to Loan Commitments" was released in March 2004. This release
summarizes the SEC staff position regarding the application of GAAP to loan
commitments accounted for as derivative instruments. The Company accounts for
interest rate lock commitments issued on mortgage loans that will be held for
sale as derivative instruments. Consistent with SAB No. 105, the Company
considers the fair value of these commitments to be zero at the commitment date,
with subsequent changes in fair value determined solely on changes in market
interest rates. As of September 30, 2004, the Company had interest rate lock
commitments on mortgage loans to be held for sale with principal balances
totaling approximately $130 million, the fair value of which was immaterial.
Emerging Issues Task Force Issue (EITF) No. 03-01 "The Meaning of
Other-Than-Temporary Impairment and Its Application to Certain Investments" was
ratified by the Financial Accounting Standards Board (FASB) in March 2004. This
EITF addresses how to determine the meaning of other-than-temporary impairment
and its application to investments classified as either available-for-sale or
held-to-maturity under Statement of Financial Accounting Standards
(SFAS) No. 115 - Accounting for Certain Investments in Debt and Equity
Securities (including individual securities and investments in mutual funds),
and investments accounted for under the cost method or the equity method. In
September 2004, the FASB delayed the effective date of the portion of this EITF
that relates to measuring and recognizing other-than-temporary impairment until
implementation guidance is finalized. This delay does not suspend the
requirement to recognize other-than-temporary impairment required by existing
accounting literature. The Company's investments classified as available for
sale are primarily comprised of U.S. government sponsored agency and private
mortgage-backed securities and collateralized mortgage obligations. At
September 30, 2004, the gross unrealized loss on these investments, caused by
recent interest rate increases, was $13 million. Because the decline in market
value is attributable to changes in interest rates and not credit quality, the
Company does not consider these investments to be other-than-temporarily
impaired.
- 4 -
3. Stock Incentive Plans
The Company's stock incentive plans provide for granting options to
employees, officers, and directors. Options are granted for the purchase of
shares of CSC's common stock at an exercise price not less than the market value
on the date of grant, and expire within seven or ten years from the date of
grant. Options generally vest over a three- to four-year period from the date of
grant.
A summary of option activity follows:
- --------------------------------------------------------------------------------
2004 2003
---------------- ----------------
Weighted- Weighted-
Number Average Number Average
of Exercise of Exercise
Options Price Options Price
- --------------------------------------------------------------------------------
Outstanding at
beginning of year 136 $ 15.25 156 $ 15.38
Granted:
Quarter ended March 31 1 $ 13.73 -(1) $ 9.26
Quarter ended June 30 -(1) $ 10.21 2 $ 8.93
Quarter ended September 30 19 $ 9.11 -(1) $ 11.30
- --------------------------------------------------------------------------------
Total granted 20 $ 9.32 2 $ 9.09
Exercised (6) $ 4.85 (4) $ 6.23
Canceled (9) $ 18.74 (12) $ 18.58
- --------------------------------------------------------------------------------
Outstanding
at September 30 141 $ 14.68 142 $ 15.26
================================================================================
Exercisable
at September 30 91 $ 15.80 85 $ 14.27
- --------------------------------------------------------------------------------
Available for future
grant at September 30 30 41
- --------------------------------------------------------------------------------
Weighted-average fair
value of options granted:
Quarter ended March 31 $ 3.95 $ 4.34
Quarter ended June 30 $ 3.52 $ 3.96
Quarter ended September 30 $ 2.71 $ 5.06
- --------------------------------------------------------------------------------
(1) Less than 500,000 options were granted.
The Company changed its option pricing model from the Black-Scholes model
to a binomial model for all options granted on or after January 1, 2004. The
fair values of stock options granted prior to January 1, 2004 were determined
using the Black-Scholes model. The Company believes that the binomial model
offers greater flexibility in reflecting the characteristics of employee stock
options. The binomial model takes into account similar inputs to a Black-Scholes
model such as volatility, dividend yield rate, and risk-free interest rate. In
addition to these assumptions, the binomial model considers the contractual term
of the option, the probability that the option will be exercised prior to the
end of its contractual life, and the probability of termination or retirement of
the option holder in computing the value of the option. The Company determines
these probabilities generally based on analysis of historical trends of such
events. The assumptions used in the respective option pricing models were as
follows:
- --------------------------------------------------------------------------------
Three Months Ended
March 31, June 30, September 30,
2004 2003 2004 2003 2004 2003
- --------------------------------------------------------------------------------
Expected dividend yield .48% .30% .48% .30% .48% .30%
Expected volatility 36% 52% 36% 49% 36% 49%
Risk-free interest rate 4.0% 2.9% 4.6% 2.6% 3.9% 2.9%
Expected life (in years) 4 5 4 5 3 5
- --------------------------------------------------------------------------------
The Company applies Accounting Principles Board Opinion No. 25 - Accounting
for Stock Issued to Employees, and related interpretations, for its stock-based
employee compensation plans. Because the Company grants stock option awards with
an exercise price not less than the market value of CSC's common stock on the
date of grant, there is no compensation expense recorded, except for
restructuring-related expense for modifications of officers' stock options.
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 Nine
Months Ended Months Ended
September 30, September 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Compensation expense for stock
options (after-tax):
As reported $ 1 $ 6 $ 1 $ 6
Pro forma (1) $ 25 $ 31 $ 69 $ 89
- --------------------------------------------------------------------------------
Net income (loss):
As reported $ (41) $ 127 $ 233 $ 324
Pro forma $ (65) $ 102 $ 165 $ 241
- --------------------------------------------------------------------------------
Basic EPS:
As reported $(.03) $ .09 $ .17 $ .24
Pro forma $(.05) $ .08 $ .12 $ .18
Diluted EPS:
As reported $(.03) $ .09 $ .17 $ .24
Pro forma $(.05) $ .07 $ .12 $ .18
- --------------------------------------------------------------------------------
(1) Includes pro forma compensation expense related to stock options granted in
both current and prior periods. Pro forma stock option compensation is
generally amortized on a straight-line basis over the vesting period
beginning with the month in which the option was granted.
- 5 -
4. Restructuring
2004 Cost Reduction Effort
- --------------------------
In the second quarter of 2004, the Company commenced a firm-wide cost
reduction effort designed to mitigate the financial impact of its recent pricing
changes and to strengthen its productivity and efficiency. The goals of this
effort include eliminating work that is not essential to meeting client service
standards or the Company's ongoing operating needs, reengineering work processes
to maximize productivity, minimizing organizational complexity through
functional streamlining, and addressing business unit performance across the
Company. During the second quarter of 2004, the Company reallocated certain
client service functions from its Orlando regional telephone service center to
other centers. In the third quarter of 2004, the Company consolidated 38 branch
offices into nearby locations, closed 15 additional branch offices, and took
steps to streamline its technology organization. Additionally, the Company
reduced its operating facilities, primarily by exiting certain administrative
office space in California.
The Company recorded pre-tax restructuring charges of $112 million and
$116 million in the third quarter and first nine months of 2004, respectively,
reflecting severance costs for approximately 1,050 employees and facilities
reduction charges. A summary of pre-tax restructuring charges related to the
Company's 2004 cost reduction effort is as follows:
- --------------------------------------------------------------------------------
Three Nine
Period ended September 30, 2004 Months Months
- --------------------------------------------------------------------------------
Workforce reduction:
Severance pay and benefits $ 54 $ 58
Non-cash compensation expense for officers'
stock options 2 2
- --------------------------------------------------------------------------------
Total workforce reduction 56 60
- --------------------------------------------------------------------------------
Facilities reduction:
Non-cancelable lease costs, net of estimated
sublease income 56 56
- --------------------------------------------------------------------------------
Total restructuring charges $112 $116
================================================================================
A summary of the activity in the restructuring reserve related to the
Company's 2004 cost reduction effort for the third quarter and first nine months
of 2004 is as follows:
- --------------------------------------------------------------------------------
Three months ended Workforce Facilities
September 30, 2004 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at June 30, 2004 $ 4 $ - $ 4
Restructuring charges 56 56 112
Cash payments (21) (2) (23)
Non-cash charges(1) (5) - (5)
- --------------------------------------------------------------------------------
Balance at September 30, 2004 $ 34(2) $ 54(3) $ 88
================================================================================
- --------------------------------------------------------------------------------
Nine months ended Workforce Facilities
September 30, 2004 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at December 31, 2003 $ - $ - $ -
Restructuring charges 60 56 116
Cash payments (21) (2) (23)
Non-cash charges(1) (5) - (5)
- --------------------------------------------------------------------------------
Balance at September 30, 2004 $ 34(2) $ 54(3) $ 88
================================================================================
(1) Primarily includes charges for officers' stock-based compensation.
(2) 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 2006.
(3) 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 2014.
2003, 2002, and 2001 Initiatives
- --------------------------------
The Company's 2003, 2002, and 2001 restructuring initiatives included
workforce reductions, reductions in operating facilities, the removal of certain
systems hardware, software, and equipment from service, and the withdrawal from
certain international operations. These initiatives reduced operating expenses
and adjusted the Company's organizational structure to improve productivity,
enhance efficiency, and increase profitability. The Company recorded a pre-tax
restructuring credit of $2 million in the first nine months of 2004 related to
these restructuring initiatives, primarily due to changes in estimates of
sublease income associated with previously announced efforts to sublease excess
facilities. The Company recorded total pre-tax restructuring charges of
$35 million and $59 million in the third quarter and first nine months of 2003,
respectively.
- 6 -
A summary of the activity in the restructuring reserve related to the
Company's 2003, 2002, and 2001 restructuring initiatives for the third quarter
and first nine months of 2004 is as follows:
- --------------------------------------------------------------------------------
Three months ended Workforce Facilities
September 30, 2004 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at June 30, 2004 $ 7 $ 166 $ 173
Restructuring charges (1) 1 -
Cash payments (3) (12) (15)
Non-cash charges (1) (1) - (1)
Other (2) - 2 2
- --------------------------------------------------------------------------------
Balance at September 30, 2004 $ 2(3) $ 157(4) $ 159
================================================================================
- --------------------------------------------------------------------------------
Nine months ended Workforce Facilities
September 30, 2004 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at December 31, 2003 $ 19 $ 201 $ 220
Restructuring charges (1) (1) (2)
Cash payments (14) (49) (63)
Non-cash charges (1) (2) - (2)
Other (2) - 6 6
- --------------------------------------------------------------------------------
Balance at September 30, 2004 $ 2(3) $ 157(4) $ 159
================================================================================
(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 Condensed Consolidated
Statement of Income.
(3) Balance is related to the Company's 2002 restructuring initiatives. 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 $6 million, $62 million, and $89 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. Discontinued Operations
On August 31, 2004, the Company entered into a definitive purchase
agreement with UBS Securities LLC and UBS Americas Inc. (collectively referred
to as UBS) in which UBS agreed to acquire all of the partnership interests of
Schwab Capital Markets L.P. and all of the outstanding capital stock of
SoundView Technology Group, Inc. (collectively referred to as Schwab Soundview
Capital Markets, or SSCM) for $265 million in cash. In this transaction, the
Company and Schwab also committed to eight-year order routing and execution
services agreements with UBS for the handling of Schwab's equity and listed
options order flow. SSCM comprises substantially all of the Capital Markets
segment. See note "19 - Subsequent Events" for details on the closing of this
transaction.
The results of operations, net of income taxes, and cash flows of SSCM have
been presented as discontinued operations on the Condensed Consolidated
Statements of Income and of Cash Flows, respectively, and the assets and
liabilities of SSCM have each been combined and presented as assets and
liabilities of discontinued operations on the Condensed Consolidated Balance
Sheet. The Company's consolidated prior period revenues, expenses, taxes on
income, assets, liabilities, and cash flows have been adjusted to reflect this
presentation.
The carrying amounts of SSCM assets and liabilities are as follows:
- --------------------------------------------------------------------------------
September 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Assets
Cash $ 97 $ 49
Receivables from brokers, dealers
and clearing organizations 1 80
Securities owned 97 89
Goodwill and intangible assets 145 28
Other assets 31 15
- --------------------------------------------------------------------------------
Total assets $ 371 $ 261
- --------------------------------------------------------------------------------
Liabilities
Payables to brokers, dealers
and clearing organizations $ - $ 28
Accrued expenses and other liabilities 125 116
- --------------------------------------------------------------------------------
Total liabilities $ 125 $ 144
- --------------------------------------------------------------------------------
On January 31, 2003, the Company sold its United Kingdom (U.K.) brokerage
subsidiary, 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 Company retained certain
restructuring-related obligations following the sale of CSE, primarily related
to facilities leases. The restructuring reserve balance related to CSE, which is
net of estimated sublease income, is $13 million and $14 million at
September 30, 2004 and December 31, 2003, respectively. The decrease in the
reserve balance was due to cash payments and other adjustments of $4 million,
substantially offset by a charge of $3 million for changes in estimates of
facilities sublease income.
- 7 -
A summary of revenues and gains (losses) for discontinued operations is as
follows:
- --------------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Revenues (1) $ 49 $ 55 $ 215 $ 144
Write-down of SSCM investment (2) $(105) $ - $(105) $ -
Pre-tax profit (loss) (3) $ (26) $ 6 $ (13) $ (8)
Total pre-tax gains (losses) $(131) $ 6 $(118) $ (8)
After-tax gains (losses) $ (87) $ 3 $ (79) $ (6)
- --------------------------------------------------------------------------------
(1) Includes revenues of $4 million in the first nine months of 2003 related to
CSE.
(2) Reflects a goodwill impairment charge of $95 million and a charge to reduce
the carrying amount of the SSCM investment to its approximate fair value
less selling costs.
(3) Excludes write-down of SSCM investment. Includes restructuring charges
related to SSCM of $16 million in the third quarter and first nine months
of 2004, and $2 million in the third quarter and first nine months of 2003.
Includes CSE post-sale adjustments of a $3 million loss in the third
quarter and first nine months of 2004, and a $5 million gain in the third
quarter of 2003.
6. Business Acquisitions and Divestiture
In January 2004, the Company completed its acquisition of SoundView
Technology Group, Inc. (SoundView) 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 purchase price allocation, the Company
recorded goodwill of $194 million and intangible assets of $21 million related
to this acquisition. In August 2004, the Company agreed to sell SSCM, including
all outstanding capital stock of SoundView. See note "5 - Discontinued
Operations" for further discussion.
In October 2003, U.S. Trust acquired State Street Corporation's Private
Asset Management group, a provider of wealth management services to clients in
the New England area, for $365 million.
In June 2003, the Company sold its investment in Aitken Campbell, a
market-making joint venture in the U.K., to the Company's joint venture partner,
TD Waterhouse Group, Inc. In the first quarter of 2003, the Company recorded an
impairment charge of $5 million pre-tax to reduce the carrying value of its
investment and a deferred income tax benefit of $16 million. The Company's share
of Aitken Campbell's historical earnings, which was accounted for under the
equity method, was not material to the Company's results of operations, EPS, or
cash flows.
7. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
- --------------------------------------------------------------------------------
September 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Residential real estate mortgages $ 4,880 $ 4,624
Consumer loans 877 735
Other 474 404
- --------------------------------------------------------------------------------
Total loans 6,231 5,763
Less: allowance for credit losses (29) (27)
- --------------------------------------------------------------------------------
Loans to banking clients - net $ 6,202 $ 5,736
================================================================================
Included in the loan portfolio are nonaccrual loans totaling $1 million at
both September 30, 2004 and December 31, 2003. Nonaccrual loans are considered
impaired by the Company, and represent all of the Company's nonperforming assets
at both September 30, 2004 and December 31, 2003. For each of the third quarters
and first nine months of 2004 and 2003, the impact of interest revenue which
would have been earned on nonaccrual loans versus interest revenue recognized on
these loans was not material to the Company's results of operations.
The amount of loans accruing interest that were contractually 90 days or
more past due was immaterial at both September 30, 2004 and December 31, 2003.
Recoveries and charge-offs related to the allowance for credit losses on
the loan portfolio were not material for each of the third quarters and first
nine months of 2004 and 2003.
8. Loans Held for Sale
In the third quarter of 2004, U.S. Trust reclassified $1.0 billion of
existing loans to banking clients to loans held for sale, reflecting a
securitization transaction expected to be completed in the fourth quarter of
2004. See note "19 - Subsequent Events" for further discussion.
Loans held for sale also include fixed- and adjustable-rate mortgage loans
originated by Schwab Bank and intended for sale. Schwab Bank's loans held for
sale are stated at lower of cost or market value. Market value is determined
using quoted market prices.
- 8 -
9. 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:
- --------------------------------------------------------------------------------
September 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Interest-bearing deposits $ 9,545 $ 7,585
Noninterest-bearing deposits 654 723
- --------------------------------------------------------------------------------
Total $10,199 $ 8,308
================================================================================
The average rate paid by the Company on its interest-bearing deposits from
banking clients was 1.02% and 1.72% for the third quarters of 2004 and 2003,
respectively, and 1.12% and 1.90% for the first nine months of 2004 and 2003,
respectively.
10. Long-term Debt
Long-term debt consists of the following:
- --------------------------------------------------------------------------------
September 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Senior Medium-Term Notes, Series A $ 408 $ 466
Lease financing liability 135 -
Note payable - 235
8.41% Trust Preferred Capital Securities 52 52
Fair value adjustment (1) 16 19
- --------------------------------------------------------------------------------
Total $ 611 $ 772
================================================================================
(1) Represents the fair value adjustment related to hedged Medium-Term Notes.
Upon adoption of Financial Accounting Standards Board Interpretation
(FIN) No. 46 - Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51 - Consolidated Financial Statements, in the
first quarter of 2003, the Company consolidated a special purpose trust (Trust)
and recorded a note payable of $235 million. This Trust was formed in 2000 to
finance the acquisition and renovation of an office building and land.
In June 2004, the Company exercised its option to purchase this property
from the Trust and repaid $99 million of the note payable. Simultaneously, the
Company completed a transaction on this property with American Financial Realty
Trust, a publicly-traded real estate investment trust, resulting in proceeds of
$136 million, which was used to repay the remainder of the note payable, and a
20-year lease. This transaction was accounted for as a financing. The lease
financing liability of $136 million will be reduced by a portion of the lease
payments over the 20-year term.
Annual maturities on long-term debt outstanding at September 30, 2004 are
as follows:
- --------------------------------------------------------------------------------
2004 $ 23
2005 60
2006 72
2007 43
2008 20
Thereafter 377
- --------------------------------------------------------------------------------
Total maturities 595
Fair value adjustment 16
- --------------------------------------------------------------------------------
Total $ 611
================================================================================
11. Pension and Other Postretirement Benefits
U.S. Trust maintains a trustee managed, noncontributory, qualified defined
benefit pension plan, the U.S. Trust Corporation Employees' Retirement Plan (the
Pension Plan), for the benefit of eligible U.S. Trust employees. U.S. Trust also
provides certain health care and life insurance benefits for active employees
and certain qualifying retired employees and their dependents.
The following table summarizes the components of the net periodic benefit
expense related to the Pension Plan and health care and life insurance benefits:
- --------------------------------------------------------------------------------
2004 2003
---------------- ----------------
Three months ended Pension Health & Pension Health &
September 30, Plan Life Plan Life
- --------------------------------------------------------------------------------
Service cost and expenses $ 3 $ - $ 3 $ -
Interest cost 5 - 5 -
Expected return on
plan assets (6) - (6) -
Amortization of
prior service cost (1) - - -
Amortization of
net loss 1 - - -
- --------------------------------------------------------------------------------
Net periodic benefit expense $ 2 $ - $ 2 $ -
================================================================================
- --------------------------------------------------------------------------------
2004 2003
---------------- ----------------
Nine months ended Pension Health & Pension Health &
September 30, Plan Life Plan Life
- --------------------------------------------------------------------------------
Service cost and expenses $ 8 $ - $ 10 $ -
Interest cost 13 1 14 1
Expected return on
plan assets (16) - (18) -
Amortization of
prior service cost (3) - - -
Amortization of
net loss 4 - - -
- --------------------------------------------------------------------------------
Net periodic benefit expense $ 6 $ 1 $ 6 $ 1
================================================================================
- 9 -
12. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is presented in the following table:
- --------------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Net income (loss) $ (41) $ 127 $ 233 $ 324
Other comprehensive income (loss):
Net gain on cash flow
hedging instruments 2 7 11 13
Change in net unrealized gain (loss)
on securities available for sale 19 (10) (7) (12)
Foreign currency translation
adjustment 1 - 1 5
- --------------------------------------------------------------------------------
Total comprehensive income (loss),
net of tax $ (19) $ 124 $ 238 $ 330
================================================================================
13. Earnings Per Share
Basic EPS excludes dilution and is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted EPS
reflects the potential reduction in EPS that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
EPS under the basic and diluted computations are presented in the following
table:
- --------------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Net income (loss) $ (41) $ 127 $ 233 $ 324
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - basic 1,344 1,342 1,348 1,341
Common stock equivalent shares
related to stock incentive plans 20 24 22 20
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,364 1,366 1,370 1,361
================================================================================
Basic EPS:
Income from continuing operations $ .03 $ .09 $ .23 $ .24
Gain (loss) from discontinued
operations, net of tax (.06) - (.06) -
Net income (loss) $ (.03) $ .09 $ .17 $ .24
- --------------------------------------------------------------------------------
Diluted EPS:
Income from continuing operations $ .03 $ .09 $ .23 $ .24
Gain (loss) from discontinued
operations, net of tax (.06) - (.06) -
Net income (loss) $ (.03) $ .09 $ .17 $ .24
- --------------------------------------------------------------------------------
The computation of diluted EPS excludes outstanding stock options to
purchase 95 million and 88 million shares for the third quarters of 2004 and
2003, respectively, and 95 million and 111 million shares for the first nine
months of 2004 and 2003, respectively, because the exercise prices for those
options were greater than the average market price of the common shares, and
therefore the effect would be antidilutive.
- 10 -
14. 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
--------------- ---------------
September 30, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,513 18.7% $ 3,784 23.6%
U.S. Trust $ 692 14.2% $ 647 15.3%
U.S. Trust NY $ 372 9.9% $ 361 10.3%
U.S. Trust NA(2) $ 283 27.0% $ 254 40.0%
Schwab Bank $ 346 24.3% $ 276 60.0%
Total Capital:
Company $ 3,543 18.8% $ 3,813 23.7%
U.S. Trust $ 719 14.8% $ 673 15.9%
U.S. Trust NY $ 396 10.6% $ 384 10.9%
U.S. Trust NA(2) $ 287 27.2% $ 257 40.5%
Schwab Bank $ 347 24.4% $ 276 60.0%
Tier 1 Leverage:
Company $ 3,513 7.7% $ 3,784 9.0%
U.S. Trust $ 692 7.7% $ 647 8.8%
U.S. Trust NY $ 372 5.5% $ 361 5.9%
U.S. Trust NA(2) $ 283 11.2% $ 254 16.9%
Schwab Bank $ 346 8.8% $ 276 24.7%
- --------------------------------------------------------------------------------
(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 September 30,
2003 have been calculated based on this consolidation.
Based on their respective regulatory capital ratios at September 30, 2004
and 2003, the Company, U.S. Trust, U.S. Trust NY, U.S. Trust NA, and Schwab Bank
are considered well capitalized (the highest category) pursuant to Federal
Reserve Board guidelines. There are no conditions or events that management
believes have changed the Company's, U.S. Trust's, U.S. Trust NY's, U.S. Trust
NA's, or Schwab Bank's well-capitalized status.
Schwab is subject to the Uniform Net Capital Rule under the Securities
Exchange Act of 1934 (the Rule). Schwab computes 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. At
September 30, 2004, 2% of aggregate debits was $186 million, which exceeded the
minimum dollar requirement for Schwab of $1 million. At September 30, 2004,
Schwab's net capital was $1.1 billion (12% of aggregate debit balances), which
was $956 million in excess of its minimum required net capital and $678 million
in excess of 5% of aggregate debit balances. 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.
15. 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 September 30, 2004, the
Company's maximum potential liability under these indemnification agreements is
limited to approximately $100 million. Additionally, the Company has guaranteed
certain payments in the event of a termination of certain mutual fund
sub-advisor agreements, related to the adoption of AXA Rosenberg LLC's U.S.
family of mutual funds, known as the Laudus Funds. The maximum aggregate
guarantee is $75 million through 2011, and $50 million thereafter. The Company
does not believe that any material loss related to such indemnifications is
likely and therefore the liabilities recorded for these guarantees are
immaterial.
The Company has clients that sell (i.e., write) listed option contracts
that are cleared by various clearing houses. The clearing houses establish
margin requirements on these transactions. The Company satisfies the margin
requirements by arranging standby letters of credit (LOCs), in favor of the
clearing houses, that are guaranteed by multiple banks. At September 30, 2004,
the outstanding value of these LOCs
- 11 -
totaled $630 million. No funds were drawn under these LOCs at September 30,
2004.
The Company also provides guarantees to securities clearing houses and
exchanges under their standard membership agreement, which requires members to
guarantee the performance of other members. Under the agreement, if another
member becomes unable to satisfy its obligations to the clearing houses and
exchanges, other members would be required to meet shortfalls. The Company's
liability under these arrangements is not quantifiable and may exceed the cash
and securities it has posted as collateral. However, the potential requirement
for the Company to make payments under these arrangements is remote.
Accordingly, no liability has been recognized for these transactions.
Legal contingencies: The nature of the Company's business subjects it to
claims, lawsuits, regulatory examinations, and other proceedings in the ordinary
course of business. The results of these matters cannot be predicted with
certainty. There can be no assurance that these matters will not have a material
adverse effect on the Company's results of operations in any future period,
depending partly on the results for that period, and a substantial judgment
could have a material adverse impact on the Company's financial condition,
results of operations, and cash flows. However, it is the opinion of management,
after consultation with legal counsel, that the ultimate outcome of these
existing claims and proceedings will not have a material adverse impact on the
financial condition, results of operations, or cash flows of the Company.
16. Financial Instruments Subject to Market Risk
Interest rate swaps: As part of its consolidated asset and liability
management process, the Company utilizes interest rate swap agreements (Swaps)
to manage interest rate risk.
U.S. Trust uses LIBOR-based Swaps to hedge the interest rate risk
associated with its variable rate deposits from banking clients. The Swaps are
structured for U.S. Trust to receive a variable rate of interest and pay a fixed
rate of interest.
Information on these Swaps is summarized in the following table:
- --------------------------------------------------------------------------------
September 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Notional principal amount (in millions) $ 825 $ 705
Weighted-average variable interest rate 1.80% 1.17%
Weighted-average fixed interest rate 4.85% 6.41%
Weighted-average maturity (in years) 2.7 1.0
- --------------------------------------------------------------------------------
At September 30, 2004, Swaps with a combined notional amount of $625
million were designated as cash flow hedges under SFAS No. 133 - Accounting for
Derivative Instruments and Hedging Activities with changes in their fair values
primarily recorded in other comprehensive income (loss), a component of
stockholders' equity.
Due to a divergence between LIBOR rates and the variable rate paid on
banking client deposits, the remaining Swaps with a combined notional amount of
$200 million were de-designated as cash flow hedges for accounting purposes in
the second quarter of 2004. Changes in fair value of these Swaps, which were
immaterial for the third quarter and first nine months of 2004, are recorded in
interest expense. These Swaps mature over the remainder of 2004 and will not
have a material impact on the Company's financial position, results of
operations, EPS, or cash flows.
At September 30, 2004 and December 31, 2003, U.S. Trust recorded a
derivative liability of $13 million and $33 million, respectively, for all U.S.
Trust Swaps. Based on current interest rate assumptions and assuming no
additional Swap agreements are entered into, U.S. Trust expects to reclassify
approximately $7 million, or $4 million after tax, from other comprehensive loss
to interest expense over the next twelve months.
CSC uses Swaps to effectively convert the interest rate characteristics of
a portion of its Medium-Term Notes from fixed to variable. These Swaps are
structured for CSC to receive a fixed rate of interest and pay a variable rate
of interest based on the three-month LIBOR rate. The variable interest rates
reset every three months.
Information on these Swaps is summarized in the following table:
- --------------------------------------------------------------------------------
September 30, December 31,
2004 2003
- --------------------------------------------------------------------------------
Notional principal amount (in millions) $ 293 $ 293
Weighted-average variable interest rate 4.24% 3.62%
Weighted-average fixed interest rate 7.57% 7.57%
Weighted-average maturity (in years) 4.5 5.3
- --------------------------------------------------------------------------------
These Swaps have been designated as fair value hedges under SFAS No. 133,
and are recorded on the Condensed Consolidated Balance Sheet. Changes in the
fair value of the Swaps are completely offset by changes in fair value of the
- 12 -
hedged Medium-Term Notes. Therefore, there is no effect on net income. At
September 30, 2004 and December 31, 2003, CSC recorded a derivative asset of
$16 million and $19 million, respectively, for these Swaps. Concurrently, the
carrying value of the Medium-Term Notes was increased by $16 million and
$19 million, at September 30, 2004 and December 31, 2003, respectively.
17. 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 three
reportable segments - Individual Investor, Institutional Investor, and
U.S. Trust. In the third quarter of 2004, as a result of the Company's exit from
the capital markets business, the previously-reported Capital Markets segment
has been eliminated.
In the first quarter of 2004, the Company changed its methodology for the
computation of its segment information. The new methodology utilizes an
activity-based costing model to allocate traditional income statement line item
expenses (e.g., compensation and benefits, depreciation, and professional
services) to the business activities driving segment expenses (e.g., client
service, opening new accounts, or business development). Previously-reported
segment information has been revised to reflect this new methodology.
Previously, except for the U.S. Trust segment, for which expenses were directly
incurred, technology, corporate, and general administrative expenses were
allocated to the remaining segments generally in proportion to either their
respective revenues or average full-time equivalent employees.
The Company periodically reallocates certain revenues and expenses among
the segments to align them with changes in the Company's organizational
structure. Previously-reported segment information has been revised to reflect
changes during the year in the Company's internal organization. The Company
evaluates the performance of its segments based on adjusted operating income
before taxes (a non-GAAP income measure), which excludes items such as
restructuring charges, acquisition- and merger-related charges, impairment
charges, discontinued operations, and extraordinary items. Intersegment revenues
are not material and are therefore not disclosed. Total revenues, income from
continuing operations before taxes on income, and net income are equal to the
amounts as reported on the Condensed Consolidated Statement of Income.
Financial information for the Company's reportable segments is presented in
the following table:
- --------------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
2004 2003 2004 2003
- --------------------------------------------------------------------------------
Revenues:
Individual Investor $ 557 $ 615 $1,844 $1,720
Institutional Investor 213 212 668 604
U.S. Trust 197 159 572 461
Unallocated 19 11 44 49
- --------------------------------------------------------------------------------
Operating revenues 986 997 3,128 2,834
Non-operating revenue(1) 14 - 14 -
- --------------------------------------------------------------------------------
Total $1,000 $ 997 $3,142 $2,834
================================================================================
Adjusted operating income
before taxes:
Individual Investor $ 85 $ 133 $ 340 $ 286
Institutional Investor 62 82 207 226
U.S. Trust (2) 20 18 37 37
Unallocated 3 (2) 1 (1)
- --------------------------------------------------------------------------------
Adjusted operating income
before taxes 170 231 585 548
Excluded items (3) (98) (35) (100) (64)
- --------------------------------------------------------------------------------
Income from continuing
operations before taxes on
income 72 196 485 484
Taxes on income (26) (72) (173) (154)
Gain (loss) from discontinued
operations, net of tax (87) 3 (79) (6)
- --------------------------------------------------------------------------------
Net Income (Loss) $ (41) $ 127 $ 233 $ 324
================================================================================
(1) Primarily consists of a pre-tax gain on an investment.
(2) In accordance with the Company's new cost allocation methodology, amounts
include costs ($17 million and $15 million in the third quarter of 2004 and
2003, respectively, and $46 million and $45 million in the first nine
months of 2004 and 2003, respectively) allocated to U.S. Trust.
(3) Includes restructuring charges of $112 million and $114 million for the
third quarter and first nine months of 2004, respectively. Includes
restructuring charges of $35 million and $59 million for the third quarter
and first nine months of 2003, respectively (see note "4 - Restructuring")
and a pre-tax gain on an investment of $14 million in the third quarter and
first nine months of 2004. Also includes an impairment charge of $5 million
related to the Company's investment in its U.K. market-making operation for
the first nine months of 2003 (see note "6 - Business Acquisitions and
Divestiture").
- 13 -
18. Supplemental Cash Flow Information
Certain information affecting the cash flows of the Company is presented in
the following table:
- --------------------------------------------------------------------------------
Nine
Months Ended
September 30,
2004 2003
- --------------------------------------------------------------------------------
Income taxes paid $ 139 $ 167
- --------------------------------------------------------------------------------
Interest paid:
Deposits from banking clients $ 85 $ 65
Brokerage client cash balances 58 63
Long-term debt 23 33
Short-term borrowings 3 11
Other 11 13
- --------------------------------------------------------------------------------
Total interest paid $ 180 $ 185
================================================================================
Non-cash investing and financing activities:
Reclassification of banking client loans
to loans held for sale (1) $1,030 -
Consolidation of special purpose trust: (2)
Building and land - $ 229
Note payable and other liabilities - $ 228
Common stock and options issued
for purchase of businesses $ 3 $ 4
- --------------------------------------------------------------------------------
(1) In the third quarter of 2004, U.S. Trust reclassified existing loans to
banking clients to loans held for sale (see note "8 - Loans Held for
Sale").
(2) Upon adoption of FIN No. 46 in the first quarter of 2003, the Company
consolidated a special purpose trust (see note "10 - Long-term Debt").
19. Subsequent Events
On October 4, 2004, the Company announced several changes to its commission
rates, including a reduction of its base online equity commission, expanded
access to $9.95 online equity commissions, and lower commissions on online and
broker-assisted trades of options contracts. These pricing changes became
effective November 1, 2004.
On October 26, 2004, U.S. Trust securitized $1.0 billion of residential
mortgage loans originated through its private banking business and retained
approximately 80% of the mortgage pass-through certificates created by the
securitization process. This securitization transaction will not have a material
impact on the Company's results of operations or EPS.
On October 29, 2004, the Company completed the sale of its capital markets
business, SSCM, to UBS. At closing, the Company and Schwab entered into
eight-year order routing and execution services agreements with UBS for the
handling of Schwab's equity and listed options order flow.
- 14 -
THE CHARLES SCHWAB CORPORATION
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
Description of Business
Overview: In the third quarter of 2004, the Charles Schwab Corporation
(CSC) and its subsidiaries (collectively referred to as the Company) intensified
their focus on serving individual investors and the advisors who work with them.
The Company announced its exit from the capital markets business, which is
expected to be completed during the fourth quarter (see Discontinued Operations
and Subsequent Events for further discussion), and significantly reduced
commission pricing for a wide array of clients. However, continuing geopolitical
and energy market uncertainties, a close presidential race, and summer vacation
season all affected client engagement during much of the third quarter of 2004.
Client daily average revenue trades declined by 10% from the second quarter of
2004, and 12% compared to the year-ago level. The Company's commission pricing
reductions and the downturn in trading activity were the primary causes of the
29% decline in the Company's trading revenues from the second quarter of 2004.
Although client trading activity decreased, the Company's non-trading revenues -
asset management and administration fees, net interest revenue, and other
revenues - reached a record level in the third quarter of 2004, as the Company
continued its focus on building stronger client relationships. Net new client
assets of $13.0 billion for the third quarter of 2004 were up 23% from the
year-ago level. Additionally, assets in client accounts reached $1.0 trillion at
September 30, 2004, an increase of $124.2 billion, or 14%, from a year ago.
The Company provides securities brokerage, banking, and related financial
services for 7.4 million active client accounts(a). Charles Schwab & Co., Inc.
(Schwab) is a securities broker-dealer with 283 domestic branch offices in 45
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, CyberTrader, Inc.,
an electronic trading technology and brokerage firm providing services to highly
active, online traders, and Charles Schwab Bank, N.A. (Schwab Bank), a retail
bank.
The Company provides financial services to individuals and institutional
clients through three segments - Individual Investor, Institutional Investor,
and U.S. Trust. See note "17 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements for a discussion of the previously-reported
Capital Markets segment. The Individual Investor segment includes the Company's
retail brokerage and banking operations. The Institutional Investor segment
provides custodial, trading and support services to independent investment
advisors (IAs), serves company 401(k) plan sponsors and third-party
administrators, and supports company stock option plans. The U.S. Trust segment
provides investment, wealth management, custody, fiduciary, and private banking
services to individual and institutional clients.
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 Nine Months
Ended Ended
September 30, September 30,
Key Metrics 2004 2003 2004 2003
- --------------------------------------------------------------------------------
Client Activity Metrics:
Net new client assets (in billions) (1) $ 13.0 $ 10.6 $ 33.5 $ 31.3
Percent change 23% 7%
Client assets
(in billions, at period end) $1,000.9 $876.7
Percent change 14%
Daily average revenue trades
(in thousands) 128.1 145.1 149.2 133.8
Percent change (12%) 12%
Company Financial Metrics:
Revenue growth (decline) from
prior year's period - 1% 11% (5%)
After-tax profit margin (4.1%) 12.7% 7.4% 11.4%
Return on stockholders' equity (3%) 12% 7% 10%
Net income (loss) growth (decline)
from prior year's period n/m n/m (28%) 72%
Revenue per average full-time
equivalent employee
(annualized, in thousands) $ 260 $ 254 $ 261 $ 237
Percent change 2% 10%
- --------------------------------------------------------------------------------
(1) Includes an individual inflow of $2.1 billion in the third quarter and
first nine months of 2004, and an individual outflow of $6.0 billion in the
first nine months of 2004, related to mutual fund clearing clients.
n/m Not meaningful.
Management continues to believe that the key to sustaining and improving
the Company's competitive position will be its ability to combine people and
technology in ways that provide investors with the access, information,
guidance, advice and control they expect - as well as high-quality service - all
at a lower cost than traditional providers of financial services.
- --------
(a) Accounts with balances or activity within the preceding eight months.
- 15 -
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 operations, distribution, and marketing.
For further discussion of the Company's business strategy, see
"Management's Discussion and Analysis of Results of Operations and Financial
Condition - Description of Business - Business Strategy" in the Company's 2003
Annual Report to Stockholders, which is filed as Exhibit 13.1 to the Company's
Form 10-K for the year ended December 31, 2003. See also Item 1 - Business -
Narrative Description of Business - Business Strategy in the Company's Form 10-K
for the year ended December 31, 2003.
Restructuring: In the second quarter of 2004, the Company commenced a
firm-wide cost reduction effort designed to mitigate the financial impact of its
recent pricing changes and to strengthen its productivity and efficiency. The
goals of this effort include eliminating work that is not essential to meeting
client service standards or the Company's ongoing operating needs, reengineering
work processes to maximize productivity, minimizing organizational complexity
through functional streamlining, and addressing business unit performance across
the Company. During the second quarter of 2004, the Company reallocated certain
client service functions from its Orlando regional telephone service center to
other centers. In the third quarter of 2004, the Company consolidated 38 branch
offices into nearby locations, closed 15 additional branch offices, and took
steps to streamline its technology organization. Additionally, the Company
reduced its operating facilities, primarily by exiting certain administrative
office space in California.
The Company recorded pre-tax restructuring charges of $112 million and
$116 million in the third quarter and first nine months of 2004, respectively,
reflecting severance costs for approximately 1,050 employees and facilities
reduction charges related to the 2004 cost reduction effort.
The Company expects that its 2004 cost reduction effort will result in an
additional 400 to 500 mandatory staff reductions by the end of 2004. The Company
also expects that fourth quarter restructuring charges associated with its 2004
cost reduction effort will be approximately $65 million, or $40 million
after-tax. The Company currently estimates that its 2004 cost reduction efforts
will result in the identification and implementation of approximately
$275 million in annualized cost savings by the end of 2004, with the expectation
that the full benefit of these savings will be realized in 2005. The Company
estimates that its 2004 cost reduction effort will extend through the remainder
of 2004 and into 2005. Estimated additional charges for, or expense savings
from, cost reduction efforts to be implemented during 2005 have not yet been
established.
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. The Company recorded a pre-tax restructuring
credit of $2 million in the first nine months of 2004 related to these
restructuring initiatives, primarily due to changes in estimates of sublease
income associated with previously announced efforts to sublease excess
facilities. The Company recorded total pre-tax restructuring charges of
$35 million and $59 million in the third quarter and first nine months of 2003,
respectively.
As of September 30, 2004, the remaining facilities restructuring reserve of
$211 million is net of estimated future sublease income of approximately
$300 million. This estimated future sublease income amount is determined based
upon a number of factors, including current and expected commercial real estate
lease rates in the respective properties' real estate markets, and estimated
vacancy periods prior to execution of tenant subleases. At September 30, 2004,
approximately 80% of the total square footage targeted for sublease under the
restructuring initiatives has been subleased, up from approximately 65% at
December 31, 2003. The increase in subleased square footage is primarily due to
the subleasing of certain property in New Jersey to a real estate investment
trust in the second quarter of 2004, partially offset by the addition of
properties in the third quarter of 2004 as part of the 2004 cost reduction
effort.
For further information on the Company's restructuring initiatives, see
note "4 - Restructuring" in the Notes to Condensed Consolidated Financial
Statements.
Discontinued Operations: On August 31, 2004, the Company entered into a
definitive purchase agreement with UBS Securities LLC and UBS Americas Inc.
(collectively referred to as UBS) in which UBS agreed to acquire all of the
partnership interests of Schwab Capital Markets L.P. and all of the outstanding
capital stock of SoundView Technology Group, Inc. (collectively referred to as
Schwab Soundview Capital Markets, or SSCM) for $265 million in cash. In this
transaction, the Company and Schwab also committed to eight-year order routing
and execution services agreements with UBS for the handling of Schwab's equity
and listed options order flow. SSCM comprises substantially all of the Capital
Markets segment. See Subsequent Events for details on the closing of this
transaction.
The results of operations, net of income taxes, and cash flows of SSCM have
been presented as discontinued
- 16 -
operations on the Condensed Consolidated Statements of Income and of Cash Flows,
respectively, and the assets and liabilities of SSCM have each been combined and
presented as assets and liabilities of discontinued operations on the Condensed
Consolidated Balance Sheet. The Company's consolidated prior period revenues,
expenses, taxes on income, assets, liabilities, and cash flows have been
adjusted to reflect this presentation.
The Company estimates that it will record charges in the fourth quarter of
2004 of approximately $120 million, or $75 million after tax, related to
severance costs for employees and facilities reduction charges associated with
the withdrawal from the capital markets business.
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.
For further information on the Company's discontinued operations, see note
"5 - Discontinued Operations" in the Notes to Condensed Consolidated Financial
Statements.
Regulatory Developments: On September 14, 2004, the Company announced the
settlement of a charge brought by the U.S. Securities and Exchange Commission
(SEC) against Schwab for violations of Rule 22c-1 of the Investment Company Act
of 1940. As part of the settlement, Schwab agreed to pay a fine of $350,000 and
consent to the entry of a cease and desist order without admitting or denying
wrongdoing. As disclosed previously, an internal review had identified instances
in which Schwab employees accepted substitute mutual fund orders from clients
shortly after the 4:00 p.m. E.S.T. market close when clients' orders were
rejected by Schwab's electronic order systems and could not be processed as
originally submitted. The SEC determined that a number of the order
substitutions in question were not permitted under SEC rules.
As disclosed previously, the Company has been responding to inquiries and
subpoenas from federal and state authorities relating to circumstances in which
a small number of parties were permitted to engage in short-term trading of
certain Excelsior(R)Funds through U.S. Trust. 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.
Subsequent Events
On October 4, 2004, the Company announced several changes to its commission
rates, including a reduction of its base online equity commission, expanded
access to $9.95 online equity commissions, and lower commissions on online and
broker-assisted trades of options contracts. These pricing changes became
effective November 1, 2004. The Company estimates that these pricing changes
will reduce commission revenues by approximately $85 million, depending on
actual client trading patterns, over the twelve months beginning November 2004.
On October 29, 2004, the Company completed the sale of its capital markets
business, SSCM, to UBS. At closing, the Company and Schwab entered into
eight-year order routing and execution services agreements with UBS for the
handling of Schwab's equity and listed options order flow.
For a discussion of certain legal developments since September 30, 2004,
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.
The Company continually evaluates and considers a wide array of potential
strategic transactions, including business combinations, acquisitions and
dispositions of businesses, services, and other assets. Any such transaction
could have a material impact on the Company's financial position, results of
operations, earnings per share (EPS), or cash flows. See Discontinued Operations
for a discussion of the Company's exit from the capital markets business.
Given the nature of the Company's revenues, expenses, and risk profile, the
Company's earnings and CSC's common stock price have been and may continue to be
subject to significant volatility from period to period. The Company's results
for any interim period are not necessarily indicative of results for a full year
or any other interim period. Risk is inherent in the Company's business.
Consequently, despite the Company's attempts to identify areas of risk, oversee
operational areas involving risk, and implement policies and procedures designed
to mitigate risk,
- 17 -
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 impact of the firm-wide cost reduction effort on the Company's
results of operations and the Company's ability to realize the estimated cost
savings (see Description of Business - Restructuring); the impact of the sale of
SSCM on the Company's results of operations (see Description of Business -
Discontinued Operations); the outcome of pending regulatory investigations (see
Description of Business - Regulatory Developments); the potential impact of
future strategic transactions (see Risk Management); the impact of commission
pricing reductions on the Company's results of operations (see Subsequent Events
and Revenues - Commissions); sources of liquidity and capital (see Liquidity and
Capital Resources - Liquidity); the Company's cash position and cash flows (see
Liquidity and Capital Resources - Cash and Capital Resources); and contingent
liabilities (see Part II - Other Information, Item 1 - Legal Proceedings).
Achievement of the expressed beliefs, objectives, and expectations described in
these statements is subject to certain risks and uncertainties that could cause
actual results to differ materially from the expressed beliefs, objectives, and
expectations. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of this Form 10-Q
or, in the case of documents incorporated by reference, as of the date of those
documents.
Important factors that may cause such differences are noted in this interim
report and include, but are not limited to: the Company's success in building
fee-based relationships with its clients; the effect of client trading patterns
on Company revenues and earnings; changes in revenues and profit margin due to
cyclical securities markets and fluctuations in interest rates; the level and
continuing volatility of equity prices; a significant downturn in the securities
markets over a short period of time or a sustained decline in securities prices,
trading volumes, and investor confidence; the Company's ability to recognize the
expected benefits of acquisitions or dispositions; geopolitical developments
affecting the securities markets, the economy, and investor sentiment; the size
and number of the Company's insurance claims; a significant decline in the real
estate market, including the Company's ability to sublease certain properties;
and the scope of severance payments related to workforce reductions. 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 nine months of 2004.
Three Months Ended September 30, 2004 Compared To
Three Months Ended September 30, 2003
All references to EPS information in this report reflect diluted EPS unless
otherwise noted.
FINANCIAL OVERVIEW
Total revenues for the third quarter of 2004 were $1.0 billion, comparable
to the third 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 third quarter of 2004, compared to the year-ago level. The increase in
non-trading revenues was largely due to increases in net interest revenue,
resulting primarily from higher levels of and
- 18 -
changes in the composition of interest-earning assets, and asset management and
administration fees, resulting primarily from higher levels of client assets and
higher asset-based fees from certain client relationships. The Company's trading
revenues, which include commissions and principal transaction revenues,
decreased 41% from the third quarter of 2003, primarily due to lower average
revenue earned per revenue trade resulting from reductions in the Company's
commission pricing, as well as lower client trading activity.
Total expenses excluding interest during the third quarter of 2004 were
$928 million, up 16% from the third quarter of 2003. This increase was due to a
$77 million, or 220%, increase in restructuring charges and a $37 million, or
9%, increase in compensation and benefits expense, primarily due to the
restoration of the Company's 401(k) employee contribution match, as well as
higher levels of discretionary bonuses and incentives to employees.
Income from continuing operations before taxes on income was $72 million
for the third quarter of 2004, down 63% from the third quarter of 2003. This
decrease was primarily due to the combination of factors discussed separately
above. Loss from discontinued operations, net of tax, was $87 million for the
third quarter of 2004, compared to a gain from discontinued operations, net of
tax, of $3 million for the third quarter of 2003. The Company recognized a net
loss of $41 million, or $.03 per share, for the third quarter of 2004, compared
to net income of $127 million, or $.09 per share, for the third quarter of 2003.
The decrease in net income was primarily due to lower income from continuing
operations before taxes on income as discussed above and the loss from
discontinued operations. The Company's after-tax profit margin for the third
quarter of 2004 was (4.1%), compared to 12.7% for the third quarter of 2003. The
annualized return on stockholders' equity for the third quarter of 2004 was
(3%), compared to 12% for the third quarter of 2003.
Segment Information: In evaluating the Company's financial performance,
management uses adjusted operating income, a non-generally accepted accounting
principles (non-GAAP) income measure which excludes items described in the
following paragraph. Management believes that adjusted operating income is a
useful indicator of the ongoing financial performance of the Company's segments,
and a tool that can provide meaningful insight into financial performance
without the effects of certain material items that are not expected to be an
ongoing part of operations (e.g., extraordinary items, non-operating revenues,
restructuring charges, impairment charges, acquisition- and merger-related
charges, and discontinued operations).
In the third quarter of 2004, net loss of $41 million included the
following items which in total had the effect of decreasing after-tax income by
$148 million: a $9 million after-tax gain on an investment, $70 million of
after-tax restructuring charges, and an $87 million after-tax loss from
discontinued operations. In the third quarter of 2003, net income of
$127 million included the following items which in total had the effect of
decreasing after-tax income by $17 million: $20 million of after-tax
restructuring charges and a $3 million after-tax gain from discontinued
operations.
As detailed in note "17 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements, adjusted operating income before taxes was
$170 million for the third quarter of 2004, down $61 million, or 26%, from the
third quarter of 2003 primarily due to decreases of $48 million, or 36%, in the
Individual Investor segment and $20 million, or 24%, in the Institutional
Investor segment. The decrease in the Individual Investor segment was due to
lower average revenue earned per revenue trade resulting from reductions in the
Company's commission pricing, as well as lower client trading activity. The
decrease in the Institutional Investor segment was due to growth in expenses
outpacing growth in revenues primarily as a result of higher client acquisition
and servicing costs.
REVENUES
The Company categorizes its revenues as either non-trading or trading. As
shown in the following table (in millions), non-trading revenues increased,
while trading revenues decreased, in the third quarter of 2004 from the third
quarter of 2003.
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Composition of Revenues 2004 2003 Change
- --------------------------------------------------------------------------------
Non-trading revenues:
Asset management and
administration fees $ 523 $ 468 12%
Net interest revenue 245 181 35
Other 47 36 31
- --------------------------------------------------------------------------------
Total non-trading revenues 815 685 19
- --------------------------------------------------------------------------------
Trading revenues:
Commissions 163 290 (44)
Principal transactions 22 22 -
- --------------------------------------------------------------------------------
Total trading revenues 185 312 (41)
- --------------------------------------------------------------------------------
Total $1,000 $ 997 -
================================================================================
Percentage of total revenues:
Non-trading revenues 82% 69%
Trading revenues 18% 31%
- --------------------------------------------------------------------------------
- 19 -
While the Individual Investor and Institutional Investor segments generate
both non-trading and trading revenues, the U.S. Trust segment generates
primarily non-trading revenues. Revenues by segment are as shown in the
following table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Revenues by Segment 2004 2003 Change
- --------------------------------------------------------------------------------
Individual Investor $ 557 $ 615 (9%)
Institutional Investor 213 212 -
U.S. Trust 197 159 24
Unallocated 19 11 73
- --------------------------------------------------------------------------------
Operating revenues 986 997 (1)
Non-operating revenue (1) 14 - n/m
- --------------------------------------------------------------------------------
Total revenues $1,000 $ 997 -
================================================================================
(1) Primarily consists of a pre-tax gain on an investment.
n/m Not meaningful.
The decrease in revenues in the Individual Investor segment from the third
quarter of 2003 was primarily due to lower average revenue earned per revenue
trade and lower client trading activity. The increase in the U.S. Trust segment
was primarily due to the acquisition of PAM and higher levels of client assets.
See note "17 - 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
September 30, Percent
Asset Management and Administration Fees 2004 2003 Change
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds (SchwabFunds(R),
Excelsior(R), and other) $ 219 $ 223 (2%)
Mutual Fund OneSource(R) 93 76 22
Other 12 13 (8)
Asset management and related services 199 156 28
- --------------------------------------------------------------------------------
Total $ 523 $ 468 12%
================================================================================
The increase in asset management and administration fees from the third
quarter of 2003 was primarily due to higher levels of client assets and higher
asset-based fees from certain client relationships, including increases in
average assets in and service fees earned on Schwab's Mutual Fund OneSource
service.
Commissions
The Company earns commission revenues, as shown in the following table (in
millions), by executing client trades.
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Commissions 2004 2003 Change
- --------------------------------------------------------------------------------
Equity and other securities $ 121 $ 237 (49%)
Mutual funds 22 29 (24)
Options 20 24 (17)
- --------------------------------------------------------------------------------
Total $ 163 $ 290 (44%)
================================================================================
The decrease in commission revenues from the third quarter of 2003 was
primarily due to lower average revenue earned per revenue trade as a result of
significant reductions in commission pricing for a wide range of clients in the
second quarter of 2004, as well as lower daily average revenue trades.
As shown in the following table, average revenue earned per revenue trade
decreased 33% and daily average revenue trades executed by the Company decreased
12% in the third quarter of 2004.
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Trading Activity 2004 2003 Change
- --------------------------------------------------------------------------------
Daily average revenue trades
(in thousands) (1) 128.1 145.1 (12%)
Accounts that traded (in thousands) 1,144 1,267 (10)
Average revenue trades
per account that traded 7.2 7.3 (1)
Trading frequency proxy (2) 2.8 3.8 (26)
Number of trading days 64.0 63.5 1
Average revenue earned
per revenue trade (3) $22.96 $34.11 (33)
Online trades as a percentage of
total trades 88% 87%
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
(2) Represents annualized revenue trades per $100,000 in total client assets.
(3) All periods have been adjusted to reflect the sale of the Company's capital
markets business.
The Company continually monitors its pricing in relation to competitors and
periodically adjusts prices to enhance its competitive position, as well as to
attract and retain clients. The Company continues to actively evaluate
commission rates and fee structures for certain clients. See Subsequent Events.
- 20 -
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
September 30, Percent
2004 2003 Change
- --------------------------------------------------------------------------------
Interest Revenue:
Margin loans to clients $ 114 $ 86 33%
Investments, client-related 77 67 15
Loans to banking clients 74 57 30
Securities available for sale 36 17 112
Other 16 8 100
- --------------------------------------------------------------------------------
Total 317 235 35
- --------------------------------------------------------------------------------
Interest Expense:
Deposits from banking clients 24 23 4
Brokerage client cash balances 29 14 107
Long-term debt 8 8 -
Short-term borrowings 6 4 50
Other 5 5 -
- --------------------------------------------------------------------------------
Total 72 54 33
- --------------------------------------------------------------------------------
Net interest revenue $ 245 $ 181 35%
================================================================================
Client-related daily average balances, interest rates, and average net
interest spread for the third quarters of 2004 and 2003 are summarized in the
following table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,
2004 2003
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $ 20,426 $ 22,096
Average interest rate 1.51% 1.20%
Margin loans to clients:
Average balance outstanding $ 8,953 $ 7,158
Average interest rate 5.05% 4.79%
Loans to banking clients:
Average balance outstanding $ 6,964 $ 5,188
Average interest rate 4.24% 4.38%
Securities available for sale:
Average balance outstanding $ 4,086 $ 1,776
Average interest rate 3.52% 3.76%
Average yield on interest-earning assets 3.03% 2.51%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $ 23,909 $ 23,269
Average interest rate .48% .25%
Interest-bearing banking deposits:
Average balance outstanding $ 9,306 $ 5,427
Average interest rate 1.02% 1.72%
Other interest-bearing sources:
Average balance outstanding $ 2,816 $ 2,899
Average interest rate 1.37% .98%
Average noninterest-bearing portion $ 4,398 $ 4,623
Average interest rate on funding sources .62% .50%
Summary:
Average yield on interest-earning assets 3.03% 2.51%
Average interest rate on funding sources .62% .50%
- --------------------------------------------------------------------------------
Average net interest spread 2.41% 2.01%
================================================================================
The increase in net interest revenue from the third quarter of 2003 was
primarily due to higher levels of and changes in the composition of
interest-earning assets, including increases in margin loan balances, loans to
banking clients and securities available for sale, partially offset by higher
interest rates on brokerage client cash balances due to recent changes in the
interest rate environment.
- 21 -
Principal Transactions
Principal transaction revenues were $22 million in the third quarters of
2004 and 2003, and are primarily comprised of revenues from client fixed income
securities trading activity.
Other Revenues
Other revenues for the third quarter of 2004 were $47 million, up
$11 million, or 31%, from the third quarter of 2003, primarily due to higher net
gains on investments.
EXPENSES EXCLUDING INTEREST
As shown in the table below (in millions), total expenses excluding
interest increased in the third quarter of 2004 primarily due to higher levels
of restructuring charges, compensation and benefits expense, professional
services, and advertising and market development expense, partially offset by
lower levels of depreciation and amortization expense.
- --------------------------------------------------------------------------------
Three Months
Ended
Composition of Expenses, September 30, Percent
Excluding Interest 2004 2003 Change
- --------------------------------------------------------------------------------
Compensation and benefits $ 455 $ 418 9%
Occupancy and equipment 97 106 (8)
Depreciation and amortization 58 69 (16)
Communications 53 59 (10)
Professional services 62 44 41
Advertising and market development 43 31 39
Commissions, clearance and floor brokerage 9 10 (10)
Restructuring charges 112 35 220
Other 39 29 34
- --------------------------------------------------------------------------------
Total $ 928 $ 801 16%
================================================================================
Expenses as a percentage of total revenues:
Total expenses, excluding interest 93% 80%
Compensation and benefits 46% 42%
Advertising and market development 4% 3%
- --------------------------------------------------------------------------------
Compensation and Benefits
The increase in compensation and benefits expense from the third quarter of
2003 was primarily due to higher levels of employee benefits, discretionary
bonuses to employees, and incentive compensation. The following table shows a
comparison of certain compensation and benefits components and employee data (in
millions, except as noted):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Compensation and Benefits 2004 2003 Change
- --------------------------------------------------------------------------------
Salaries and wages $ 294 $ 284 4%
Incentive and variable compensation 89 78 14
Employee benefits and other 72 56 29
- --------------------------------------------------------------------------------
Total $ 455 $ 418 9%
================================================================================
Full-time equivalent employees
(at end of quarter, in thousands) (1) 14.8 15.7 (6%)
- --------------------------------------------------------------------------------
(1) Includes full-time, part-time and temporary employees, and persons employed
on a contract basis. All periods have been adjusted to reflect the sale of
the Company's capital markets business.
Employee benefits and other expenses increased from the third 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 third 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 and the Company's firm-wide cost reduction effort, as well as mutual
fund sub-advisor fees. The increase in advertising and market development
expense from the third quarter of 2003 was primarily due to the Company's
increased television and other media spending. The decrease in depreciation and
amortization expense from the third quarter of 2003 was primarily due to an
increase in fully-amortized assets.
Taxes on Income
The Company's effective income tax rate on income from continuing
operations was 36.1% for the third quarter of 2004, compared to a tax rate of
36.7% for the third quarter of 2003.
- 22 -
Nine Months Ended September 30, 2004 Compared To
Nine Months Ended September 30, 2003
FINANCIAL OVERVIEW
Total revenues for the first nine months of 2004 were $3.1 billion, up
$308 million, or 11%, from the first nine months of 2003. The Company's
non-trading revenues increased 18% in the first nine months of 2004 compared to
the year-ago level primarily due to the factors described in the comparison
between the three-month periods. The Company's trading revenues decreased 6%
from the first nine months of 2003, primarily due to lower average revenue
earned per revenue trade, partially offset by higher client trading activity.
Total expenses excluding interest during the first nine months of 2004 were
$2.7 billion, up 13% from the first nine months of 2003. This increase was
primarily due to the factors described in the comparison between the three-month
periods.
Income from continuing operations before taxes on income was $485 million
for the first nine months of 2004, comparable to the first nine months of 2003.
Loss from discontinued operations, net of tax, was $79 million for the first
nine months of 2004, compared to $6 million for the first nine months of 2003.
Net income for the first nine months of 2004 was $233 million, or $.17 per
share, down 28% from the first nine months of 2003. The decrease in net income
was primarily due to a higher loss from discontinued operations. The Company's
after-tax profit margin for the first nine months of 2004 was 7.4%, down from
11.4% for the first nine months of 2003. The annualized return on stockholders'
equity for the first nine months of 2004 was 7%, down from 10% for the first
nine months of 2003.
Segment Information: In the first nine months of 2004, net income of
$233 million included the following items which in total had the effect of
decreasing after-tax income by $141 million: a $9 million after-tax gain on an
investment, $71 million of after-tax restructuring charges, and a $79 million
after-tax loss from discontinued operations. In the first nine months of 2003,
net income of $324 million included the following items which in total had the
effect of decreasing after-tax income by $20 million: a $6 million after-tax
loss from discontinued operations, $36 million of after-tax restructuring
charges, a $5 million investment write-down related to the Company's U.K.
market-making operation, a $16 million tax benefit associated with the Company's
sale of its U.K. market-making operation, and an $11 million tax benefit
associated with the Company's merger with U.S. Trust.
As detailed in note "17 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements, adjusted operating income before taxes was
$585 million for the first nine months of 2004, up $37 million, or 7%, from the
first nine months of 2003 primarily due to an increase of $54 million, or 19%,
in the Individual Investor segment, partially offset by a decrease of $19
million, or 8%, in the Institutional Investor segment. The increase in the
Individual Investor segment was primarily due to higher revenues resulting from
increased client trading activity and levels of client assets. The decrease in
the Institutional Investor segment was primarily due to the factors described in
the comparison between the three-month periods.
REVENUES
As shown in the following table (in millions), non-trading and total
revenues increased, while trading revenues decreased, in the first nine months
of 2004 from the first nine months of 2003.
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Composition of Revenues 2004 2003 Change
- --------------------------------------------------------------------------------
Non-trading revenues:
Asset management and
administration fees $1,547 $1,345 15%
Net interest revenue 678 535 27
Other 110 91 21
- --------------------------------------------------------------------------------
Total non-trading revenues 2,335 1,971 18
- --------------------------------------------------------------------------------
Trading revenues:
Commissions 738 793 (7)
Principal transactions 69 70 (1)
- --------------------------------------------------------------------------------
Total trading revenues 807 863 (6)
- --------------------------------------------------------------------------------
Total $3,142 $2,834 11%
================================================================================
Percentage of total revenues:
Non-trading revenues 74% 70%
Trading revenues 26% 30%
- --------------------------------------------------------------------------------
Revenues by segment are as shown in the following table (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Revenues by Segment 2004 2003 Change
- --------------------------------------------------------------------------------
Individual Investor $1,844 $1,720 7%
Institutional Investor 668 604 11
U.S. Trust 572 461 24
Unallocated 44 49 (10)
- --------------------------------------------------------------------------------
Operating revenues 3,128 2,834 10
Non-operating revenue (1) 14 - n/m
- --------------------------------------------------------------------------------
Total revenues $3,142 $2,834 11%
================================================================================
(1) Primarily consists of a pre-tax gain on an investment.
n/m Not meaningful.
- 23 -
The increases in revenues in the Individual and Institutional Investor
segments from the first nine months of 2003 were primarily due to higher trading
volume and levels of client assets. The increase in the U.S. Trust segment was
primarily due to the acquisition of PAM and higher levels of client assets. See
note "17 - 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 for the first nine months of 2004
and 2003 are as shown in the table below (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Asset Management and Administration Fees 2004 2003 Change
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds (SchwabFunds(R),
Excelsior(R), and other) $ 648 $ 663 (2%)
Mutual Fund OneSource(R) 278 200 39
Other 41 36 14
Asset management and related services 580 446 30
- --------------------------------------------------------------------------------
Total $1,547 $1,345 15%
================================================================================
The increase in asset management and administration fees from the first
nine months of 2003 was primarily due to the factors described in the comparison
between the three-month periods.
Commissions
Commission revenues for the first nine months of 2004 and 2003 are as shown
in the following table (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Commissions 2004 2003 Change
- --------------------------------------------------------------------------------
Equity and other securities $ 580 $ 642 (10%)
Mutual funds 86 82 5
Options 72 69 4
- --------------------------------------------------------------------------------
Total $ 738 $ 793 (7%)
================================================================================
The decrease in commission revenues from the first nine months of 2003 was
primarily due to lower average revenue earned per revenue trade as a result of
reductions in commission pricing in June 2004, partially offset by higher daily
average revenue trades.
As shown in the following table, average revenue earned per revenue trade
decreased 16%, while daily average revenue trades executed by the Company
increased 12% in the first nine months of 2004.
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Trading Activity 2004 2003 Change
- --------------------------------------------------------------------------------
Daily average revenue trades
(in thousands) (1) 149.2 133.8 12%
Accounts that traded (in thousands) 2,355 2,249 5
Average revenue trades
per account that traded 11.9 11.2 6
Trading frequency proxy (2) 3.4 3.7 (8)
Number of trading days (3) 188.0 187.5 -
Average revenue earned
per revenue trade (4) $29.20 $34.65 (16)
Online trades as a percentage of
total trades 89% 86%
- --------------------------------------------------------------------------------
(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.
(4) All periods have been adjusted to reflect the sale of the Company's capital
markets business.
Net Interest Revenue
Net interest revenue for the first nine months of 2004 and 2003 are as
shown in the following table (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
2004 2003 Change
- --------------------------------------------------------------------------------
Interest Revenue:
Margin loans to clients $ 325 $ 252 29%
Investments, client-related 201 218 (8)
Loans to banking clients 201 169 19
Securities available for sale 99 52 90
Other 29 26 12
- --------------------------------------------------------------------------------
Total 855 717 19
- --------------------------------------------------------------------------------
Interest Expense:
Deposits from banking clients 74 69 7
Brokerage client cash balances 59 62 (5)
Long-term debt 24 27 (11)
Short-term borrowings 11 10 10
Other 9 14 (36)
- --------------------------------------------------------------------------------
Total 177 182 (3)
- --------------------------------------------------------------------------------
Net interest revenue $ 678 $ 535 27%
================================================================================
- 24 -
Client-related daily average balances, interest rates, and average net
interest spread for the first nine months of 2004 and 2003 are summarized in the
following table (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30,
2004 2003
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $ 20,642 $ 21,744
Average interest rate 1.30% 1.34%
Margin loans to clients:
Average balance outstanding $ 8,991 $ 6,715
Average interest rate 4.81% 5.02%
Loans to banking clients:
Average balance outstanding $ 6,369 $ 4,829
Average interest rate 4.20% 4.70%
Securities available for sale:
Average balance outstanding $ 3,848 $ 1,663
Average interest rate 3.43% 4.17%
Average yield on interest-earning assets 2.78% 2.65%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $ 23,938 $ 23,105
Average interest rate .33% .36%
Interest-bearing banking deposits:
Average balance outstanding $ 8,795 $ 4,879
Average interest rate 1.12% 1.90%
Other interest-bearing sources:
Average balance outstanding $ 2,844 $ 2,579
Average interest rate 1.05% 1.12%
Average noninterest-bearing portion $ 4,273 $ 4,388
Average interest rate on funding sources .52% .58%
Summary:
Average yield on interest-earning assets 2.78% 2.65%
Average interest rate on funding sources .52% .58%
- --------------------------------------------------------------------------------
Average net interest spread 2.26% 2.07%
================================================================================
The increase in net interest revenue from the first nine months of 2003 was
primarily due to higher levels of and changes in the composition of
interest-earning assets.
Principal Transactions
Principal transaction revenues for the first nine months of 2004 were
$69 million, down $1 million, or 1%, from the first nine months of 2003.
Other Revenues
Other revenues for the first nine months of 2004 were $110 million, up
$19 million, or 21%, from the first nine months of 2003, primarily due to the
factor described in the comparison between the three-month periods, as well as
higher account service fees.
EXPENSES EXCLUDING INTEREST
As shown in the table below (in millions), total expenses excluding
interest increased in the first nine months of 2004 primarily due to the factors
described in the comparison between the three-month periods.
- --------------------------------------------------------------------------------
Nine Months
Ended
Composition of Expenses, September 30, Percent
Excluding Interest 2004 2003 Change
- --------------------------------------------------------------------------------
Compensation and benefits $1,430 $1,230 16%
Occupancy and equipment 299 322 (7)
Depreciation and amortization 167 212 (21)
Communications 170 169 1
Professional services 181 123 47
Advertising and market development 151 100 51
Commissions, clearance and floor brokerage 29 29 -
Restructuring charges 114 59 93
Impairment charges - 5 (100)
Other 116 101 15
- --------------------------------------------------------------------------------
Total $2,657 $2,350 13%
================================================================================
Expenses as a percentage of total revenues:
Total expenses, excluding interest 85% 83%
Compensation and benefits 46% 43%
Advertising and market development 5% 4%
- --------------------------------------------------------------------------------
Compensation and Benefits
The increase in compensation and benefits expense, as well as the increase
in employee benefits and other expenses, from the first nine months of 2003 was
primarily due to the factors described in the comparison between the three-month
periods. The following table shows a comparison of certain compensation and
benefits components and employee data (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Compensation and Benefits 2004 2003 Change
- --------------------------------------------------------------------------------
Salaries and wages $ 923 $ 864 7%
Incentive and variable compensation 271 185 46
Employee benefits and other 236 181 30
- --------------------------------------------------------------------------------
Total $1,430 $1,230 16%
================================================================================
Expenses Excluding Compensation and Benefits
The increases in professional services and advertising and market
development expense, as well as the decrease in depreciation and amortization
expense, from the first nine months of 2003 were primarily due to the factors
described in the comparison between the three-month periods.
- 25 -
Taxes on Income
The Company's effective income tax rate on income from continuing
operations was 35.7% for the first nine months of 2004, compared to a tax rate
of 31.8% for the first nine months of 2003. The increase was primarily due to
tax benefits in 2003 related to the Company's merger with U.S. Trust and the
Company's sale of its U.K. market-making operation.
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 "14 - 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 and CSC's depository institution subsidiaries are subject to
regulatory requirements that may restrict them from certain transactions with
CSC. Management believes that funds generated by the operations of CSC's
subsidiaries will continue to be the primary funding source in meeting CSC's
liquidity needs, providing adequate liquidity to meet CSC's depository
institution subsidiaries' capital guidelines, and maintaining Schwab's net
capital. Based on their respective regulatory capital ratios at September 30,
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 $408
million was issued and outstanding at September 30, 2004, have maturities
ranging from 2004 to 2010 and fixed interest rates ranging from 6.21% 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, Inc. (Fitch).
CSC has a prospectus supplement on file with the Securities and Exchange
Commission (SEC) enabling CSC to issue up to $750 million in Senior or Senior
Subordinated Medium-Term Notes, Series A. At September 30, 2004, all of these
notes remained unissued.
On May 5, 2004, the SEC declared effective CSC's Registration Statement
under the Securities Act of 1933 on Form S-3 relating to a universal shelf
registration for the issuance of up to $1.0 billion aggregate amount of various
securities, including common stock, preferred stock, debt securities, and
warrants. The Company currently intends to use any proceeds from the issuance of
these securities for general corporate purposes, including, but not limited to,
working capital and possible acquisitions. At September 30, 2004, all of these
securities remained unissued.
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 September 30, 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 2005. This facility
replaced a similar facility that expired in June 2004. These facilities were
unused during the first nine months 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 stockholders' equity, Schwab to maintain minimum net capital ratios, as
defined, and CSC's depository institution subsidiaries to be well capitalized,
as defined. Management believes that these restrictions will not have a material
effect on its ability to meet foreseeable dividend or funding requirements.
CSC also has direct access to $785 million of the $835 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 nine months of 2004.
Schwab
Liquidity needs relating to client trading and margin borrowing activities
are met primarily through cash balances in brokerage client accounts, which were
$25.8 billion and
- 26 -
$25.6 billion at September 30, 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. This Trust was formed in 2000 to
finance the acquisition and renovation of an office building and land. In June
2004, the Company exercised its option to purchase this property from the Trust
and repaid $99 million of the note payable. Simultaneously, the Company
completed a transaction on this property with American Financial Realty Trust, a
publicly-traded real estate investment trust, resulting in proceeds of $136
million, which was used to repay the remainder of the note payable, and a
20-year lease. This transaction was accounted for as a financing. The lease
financing liability of $136 million will be reduced by a portion of the lease
payments over the 20-year term.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of nine banks totaling $835 million at September
30, 2004 (as noted previously, $785 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 9 days during the
first nine months of 2004, with the daily amounts borrowed averaging $62
million. There were no borrowings outstanding under these lines at September 30,
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
September 30, 2004. Schwab pays a fee to maintain these letters of credit. No
funds were drawn under these letters of credit at September 30, 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
September 30, 2004, Schwab's net capital was $1.1 billion (12% of aggregate
debit balances), which was $956 million in excess of its minimum required net
capital and $678 million in excess of 5% of aggregate debit balances. Schwab has
historicallytargeted net capital to be at least 10% of its aggregate debit
balances, which primarily consist of client margin loans.
To manage Schwab's regulatory capital requirement, CSC provides Schwab with
a $1.4 billion subordinated revolving credit facility which is scheduled to
expire in September 2005. The amount outstanding under this facility at
September 30, 2004 was $220 million. Borrowings under this subordinated lending
arrangement qualify as regulatory capital for Schwab.
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 September 30,
2004, these balances totaled $502 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 September 30, 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 $911 million. At September 30, 2004, $725 million was
outstanding under these facilities. Additionally, at September 30, 2004,
U.S. Trust had $114 million of federal funds purchased.
U.S. Trust also engages in intercompany repurchase agreements with Schwab
Bank and Schwab. At September 30, 2004, U.S. Trust had $400 million and
$200 million in repurchase agreements outstanding with Schwab Bank and Schwab,
respectively.
CSC provides U.S. Trust with a $300 million short-term credit facility
maturing in December 2006. Borrowings under this facility do not qualify as
regulatory capital for U.S. Trust. The amount outstanding under this facility
was $40 million at September 30, 2004.
U.S. Trust uses interest rate swap agreements (Swaps) with CSC to hedge the
interest rate risk associated with its variable rate deposits from banking
clients. At September 30, 2004, these Swaps have a notional value of
$650 million and a fair value of $6 million.
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.
- 27 -
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 September 30,
2004, these balances totaled $3.7 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
September 30, 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
nine months 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 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 nine months of 2004, cash and cash equivalents decreased $689
million, or 25%, to $2.1 billion primarily due to increases in loans to banking
clients andsecurities available for sale, movements of brokerage client-related
funds to meet segregation requirements, and net repayments of long-term debt.
These decreases were substantially 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 September 30, 2004, these sweep deposit balances totaled $4.2
billion, up $2.5 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 nine months of 2004 is an indication of a trend.
The Company's capital expenditures were $151 million in the first nine
months of 2004 compared to $97 million in the first nine months of 2003, or 5%
and 3% of revenues for each period, respectively. Capital expenditures in the
first nine months 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 $63 million in the first nine months of 2004 and
$44 million in the first nine months of 2003.
The Company repaid $294 million of long-term debt and increased its
long-term debt by $136 million during the first nine months of 2004 (see
discussion at Liquidity - Schwab).
The Company reduced its short-term borrowings by $156 million during the
first nine months of 2004.
During the first nine months of 2004, 6 million of the Company's stock
options, with a weighted-average exercise price of $4.85, were exercised with
cash proceeds received by the Company of $30 million and a related tax benefit
of $12 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.
During the first nine months of 2004, CSC repurchased 16 million shares of
its common stock for $149 million. During the first nine months of 2003, CSC
repurchased 4 million shares of its common stock for $32 million. As of
September 30, 2004, CSC has authority to repurchase up to $169 million of its
common stock.
During the first nine months of 2004 and 2003, the Company paid common
stock cash dividends of $74 million and $49 million, respectively.
- 28 -
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 September 30, 2004 was $5.2 billion, down
$67 million, or 1%, from December 31, 2003 due to lower long-term debt,
substantially offset by higher stockholders' equity. At September 30, 2004, the
Company had long-term debt of $611 million, or 12% of total financial capital,
that bears interest at a weighted-average rate of 7.06%. At September 30, 2004,
the Company's stockholders' equity was $4.6 billion, or 88% 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 $62 million and $74 million
at September 30, 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.
Financial Instruments Held For Purposes Other Than Trading
Debt Issuances
At September 30, 2004, CSC had $408 million aggregate principal amount of
Medium-Term Notes, with fixed interest rates ranging from 6.21% to 8.05%. At
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 September 30, 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 September 30, 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. For further discussion on
these Swaps, see note "16 - Financial Instruments Subject to Market Risk" in the
Notes to Condensed Consolidated Financial Statements.
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
September 30, 2004 and December 31, 2003, the derivative asset 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
- 29 -
decrease in interest rates relative to the Company's current base rate forecast
on simulated net interest revenue over the next twelve months at September 30,
2004 and December 31, 2003.
- --------------------------------------------------------------------------------
Impact on Net Interest Revenue September 30, December 31,
Percentage Increase (Decrease) 2004 2003
- --------------------------------------------------------------------------------
Increase of 100 basis points 2.8% 1.7%
Decrease of 100 basis points (3.1%) (6.4%)
- --------------------------------------------------------------------------------
The simulations show reduced exposure to falling interest rates at
September 30, 2004 compared to December 31, 2003. This reduced sensitivity
results from higher interest rates and an expectation of interest rates
continuing to increase, both of which lessen the impact of spread compression
between interest-earning assets and brokerage client cash balances and banking
deposits.
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 September 30, 2004.
Based on this evaluation, the Company's Chief Executive Officer and Chief
Financial Officer have concluded, as of September 30, 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
September 30, 2004 that has materially affected, or is reasonably likely to
materially affect, the Company's internal control over financial reporting.
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 September 30,
2004, and a subsequent event relating to Soundview litigation claims.
As previously disclosed, Soundview and one or more of its subsidiaries are
among the numerous financial institutions named as defendants in multiple
purported securities class actions filed in the United District Court for the
Southern District of New York (the IPO Allocation Litigation). The parties, with
the assent of the Court, have selected 17 focus cases as the subject of
case-specific discovery, and, in some instances, class-certification motions.
Wit Capital, a Soundview predecessor, is a defendant in one of the focus cases.
Additionally, Soundview and/or related entities had underwriting commitments in
approximately 11 of the remaining focus cases; Soundview entities are not named
as defendants in these cases, but may have indemnification obligations to the
lead underwriters depending on the outcome of these actions. On October 13,
2004, a federal judge in the Southern District of New York issued a ruling
certifying the existence of a class in the focus cases. The IPO Allocation
Litigation was brought on behalf of persons who either directly or in the
aftermarket purchased IPO securities during the time period between March 1997
and December 2000. The plaintiffs allege that Soundview and the other
underwriters named as defendants required persons receiving allocations of IPO
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. Soundview has been named in 31 of the actions -
each involving a different company's IPO - that have been consolidated with 280
other actions in which Soundview is not named as a defendant. Soundview intends
to vigorously defend against the above mentioned actions. As part of the sale of
Soundview to UBS, the Company has agreed to indemnify UBS for any expenses
associated with these actions.
The Company has been responding to certain inquiries and subpoenas from
federal and state authorities relating to mutual fund trading, distribution, and
servicing at or through Company affiliates, and has conducted 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.
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
- 30 -
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
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. Unregistered Sales of Equity Securities and Use of Proceeds
(c) Issuer Purchases of Equity Securities
The following table summarizes purchases made by or on behalf of CSC of its
common stock for each calendar month in the third quarter of 2004.
- --------------------------------------------------------------------------------
(In millions, except Total Number Approximate
per share amounts) of Shares Dollar Value of
Purchased as Shares that
Total Number Average Part of Publicly May Yet be
of Shares Price Paid Announced Purchased under
Month Purchased (1) per Share Program (1) the Program
- --------------------------------------------------------------------------------
July 3 $ 8.75 3 $ 292
August 13 9.14 13 169
September - - - 169
- --------------------------------------------------------------------------------
Total 16 $ 9.07 16 $ 169
================================================================================
(1) All shares were repurchased under authorizations by CSC's Board of
Directors covering up to $250 million and $500 million of common stock
publicly announced by the Company on March 17, 2003 and September 20, 2001,
respectively. Unless modified or revoked by the Board, the authorizations
do not expire.
The Company may receive shares to pay the exercise price and/or to satisfy
tax withholding obligations by employees who exercise stock options (granted
under employee stock incentive plans), which are commonly referred to as stock
swap exercises. Such exercises represented less than 500,000 per month for each
of the months presented in the above table.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
Effective July 20, 2004, the Company's Board of Directors appointed Charles
R. Schwab as Chief Executive Officer, replacing David S. Pottruck. Mr. Schwab
will continue to serve as Chairman of the Board of Directors.
The following members of the Company's Executive Committee resigned from
the Company during the third quarter of 2004:
- --------------------------------------------------------------------------------
Dawn G. Lepore(1) Vice Chairman - Active Trader, Technology, Operations,
Administration, and Business Strategy
Mary S. McLeod Executive Vice President - Human Resources
Geoffrey J. Penney Executive Vice President and Chief Information Officer
- --------------------------------------------------------------------------------
(1) Resignation is effective October 10, 2004.
Ms. Lepore's, Ms. McLeod's, and Mr. Penney's responsibilities have been
reassigned in conjunction with a corporate reorganization.
- 31 -
Item 6. Exhibits
The following exhibits are filed as part of this quarterly report on Form 10-Q.
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.260 The Charles Schwab Severance Pay Plan, restated as of
September 14, 2004 (supersedes Exhibit 10.254).
10.261 Purchase Agreement by and among The Charles Schwab Corporation,
CS Capital Markets and Co., Schwab Associates and Co., UBS
Securities LLC, and UBS Americas Inc., dated as of August 31,
2004.***
10.262 Equities Order Handling Agreement dated October 29, 2004 by and
among UBS Securities LLC, Schwab Capital Markets L.P., Charles
Schwab & Co., Inc., and The Charles Schwab Corporation. ***
10.263 Separation Agreement, General Release and Waiver of Claims by and
among The Charles Schwab Corporation, Charles Schwab & Co., Inc.,
and David S. Pottruck dated August 2, 2004.
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.
*** Confidential treatment has been requested for certain portions of
this exhibit.
- --------------------------------------------------------------------------------
- 32 -
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: November 8, 2004 /s/ Christopher V. Dodds
--------------------------- -----------------------------
Christopher V. Dodds
Executive Vice President and
Chief Financial Officer
- 33 -