UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005 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.
1,309,729,180 shares of $.01 par value Common Stock
Outstanding on April 29, 2005
THE CHARLES SCHWAB CORPORATION
Quarterly Report on Form 10-Q
For the Quarter Ended March 31, 2005
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 - 13
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 14 - 23
Item 3. Quantitative and Qualitative Disclosures
About Market Risk 24
Item 4. Controls and Procedures 25
Part II - Other Information
Item 1. Legal Proceedings 25
Item 2. Unregistered Sales of Equity Securities
and Use of Proceeds 26
Item 3. Defaults Upon Senior Securities 26
Item 4. Submission of Matters to a Vote of Security Holders 26
Item 5. Other Information 26
Item 6. Exhibits 26
Signature 27
Part I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Income
(In millions, except per share amounts)
(Unaudited)
Three Months Ended
March 31,
2005 2004
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Revenues
Asset management and administration fees $ 547 $ 507
Trading revenue 207 361
Interest revenue 412 263
Interest expense (138) (54)
------- -------
Net interest revenue 274 209
Other 31 31
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Total 1,059 1,108
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 454 482
Occupancy and equipment 82 102
Professional services 62 58
Depreciation and amortization 54 56
Communications 51 61
Advertising and market development 36 62
Commissions, clearance and floor brokerage 9 9
Restructuring charges 21 -
Other 44 34
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Total 813 864
- ------------------------------------------------------------------------------------------------------------------------------------
Income from continuing operations before taxes on income 246 244
Taxes on income (95) (85)
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Income from continuing operations 151 159
Gain (loss) from discontinued operations, net of tax (6) 2
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income $ 145 $ 161
====================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,326 1,375
- ------------------------------------------------------------------------------------------------------------------------------------
Earnings Per Share - Basic
Income from continuing operations $ .11 $ .12
Gain (loss) from discontinued operations, net of tax - -
Net income $ .11 $ .12
Earnings Per Share - Diluted
Income from continuing operations $ .11 $ .12
Gain (loss) from discontinued operations, net of tax - -
Net income $ .11 $ .12
- ------------------------------------------------------------------------------------------------------------------------------------
Dividends Declared Per Common Share $ .020 $ .014
- ------------------------------------------------------------------------------------------------------------------------------------
See Notes to Condensed Consolidated Financial Statements.
- 1 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Balance Sheet
(In millions, except share and per share amounts)
(Unaudited)
March 31, December 31,
2005 2004
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 2,140 $ 2,778
Cash and investments segregated and on deposit for federal or other
regulatory purposes(1) (including resale agreements of $11,018 in 2005
and $12,901 in 2004) 18,452 19,019
Securities owned - at market value (including securities pledged of $5
in 2005 and $8 in 2004) 5,555 5,335
Receivables from brokers, dealers and clearing organizations 543 482
Receivables from brokerage clients - net 9,732 9,841
Loans to banking clients - net 7,148 6,822
Loans held for sale 27 20
Equipment, office facilities and property - net 874 903
Goodwill - net 811 811
Intangible assets - net 150 153
Other assets 973 969
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 46,405 $ 47,133
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 11,428 $ 11,118
Drafts payable 297 363
Payables to brokers, dealers and clearing organizations 1,364 1,468
Payables to brokerage clients 26,394 27,154
Accrued expenses and other liabilities 1,278 1,396
Short-term borrowings (including federal funds purchased
of $166 in 2005 and $7 in 2004) 792 663
Long-term debt 577 585
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Total liabilities 42,130 42,747
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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 1,773 1,769
Retained earnings 3,372 3,258
Treasury stock - 82,795,943 and 61,434,850 shares in 2005 and 2004,
respectively, at cost (811) (591)
Unamortized stock-based compensation (51) (59)
Accumulated other comprehensive loss (22) (5)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,275 4,386
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 46,405 $ 47,133
====================================================================================================================================
(1) Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes at March 31, 2005 and December 31, 2004, excluding $200 million of intercompany repurchase agreements,
were $18,194 million and $19,004 million, respectively. On April 4, 2005 and January 4, 2005, the Company deposited $159 million
and $426 million, respectively, into its segregated reserve bank accounts.
See Notes to Condensed Consolidated Financial Statements.
- 2 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Cash Flows
(In millions)
(Unaudited)
Three Months Ended
March 31,
2005 2004
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 145 $ 161
Adjustments to reconcile net income to net cash used for operating activities:
Loss (gain) from discontinued operations, net of tax 6 (2)
Depreciation and amortization 54 56
Tax benefit from, and amortization of, stock-based awards 8 19
Deferred income taxes (14) 21
Other 10 3
Originations of loans held for sale (120) (215)
Proceeds from sales of loans held for sale 113 201
Net change in:
Cash and investments segregated and on deposit for federal or other
regulatory purposes 567 502
Securities owned (excluding securities available for sale) 61 29
Receivables from brokers, dealers and clearing organizations (60) 112
Receivables from brokerage clients 103 (677)
Other assets 27 8
Drafts payable (66) 136
Payables to brokers, dealers and clearing organizations (104) 52
Payables to brokerage clients (760) (638)
Accrued expenses and other liabilities (129) (39)
Net cash used for discontinued operations - (51)
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Net cash used for operating activities (159) (322)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (641) (490)
Proceeds from maturities, calls and mandatory redemptions of securities
available for sale 320 320
Net increase in loans to banking clients (326) (289)
Purchase of equipment, office facilities and property - net (23) (34)
Net cash used for discontinued operations - (341)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (670) (834)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net increase in deposits from banking clients 310 963
Net change in short-term borrowings 129 (241)
Dividends paid (26) (19)
Purchase of treasury stock (234) -
Proceeds from stock options exercised and other 12 20
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 191 723
- ------------------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (638) (433)
Cash and Cash Equivalents at Beginning of Period 2,778 2,785
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $2,140 $2,352
====================================================================================================================================
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 Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
1. Basis of Presentation
The Charles Schwab Corporation (CSC) 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 273 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 36 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 accompanying unaudited condensed consolidated financial statements
include CSC and its majority-owned subsidiaries (collectively referred to as the
Company). These financial statements have been prepared pursuant to the rules
and regulations of the Securities and Exchange Commission (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, including the presentation
of discontinued operations on the Company's condensed consolidated statement of
cash flows, have been reclassified to conform to the 2005 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 Annual Report
on Form 10-K for the year ended December 31, 2004. The Company's results for any
interim period are not necessarily indicative of results for a full year or any
other interim period.
2. New Accounting Standards
A revision to Statement of Financial Accounting Standards (SFAS) No. 123,
Share-Based Payment, which supersedes APB No. 25 (SFAS No. 123R) and was issued
in December 2004, requires that the cost resulting from all share-based payments
be recognized as an expense in the consolidated financial statements, and also
changes the classification of certain tax benefits in the consolidated statement
of cash flows. In April 2005, the SEC adopted a new rule that delays the
compliance dates for SFAS No. 123R to January 1, 2006. Beginning in the first
quarter of 2006, the Company will record compensation expense for unvested stock
option awards over the future periods in which the awards vest. Based on stock
options outstanding at March 31, 2005, pre-tax compensation expense related to
stock option awards would be approximately $18 million in 2006 and $6 million in
2007, which equates to a decrease in EPS of $.01 in 2006. The amount and timing
of total future compensation expense related to stock option grants will vary
based upon additional awards, if any, cancellations, forfeitures, or
modifications of existing awards, and employee severance terms.
SFAS No. 153 - Exchanges of Nonmonetary Assets was issued in December 2004
and is effective beginning July 1, 2005. This statement amends Accounting
Principles Board Opinion (APB) No. 29 - Accounting for Nonmonetary Transactions.
SFAS No. 153 replaces an exception provided by APB No. 29 with a general
exception for exchange transactions that do not have commercial substance and
are therefore not expected to result in significant changes in the cash flows of
the reporting entity. The adoption of this statement is not expected to have a
material impact on the Company's financial position, results of operations, EPS,
or cash flows.
- 4 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
3. Stock Incentive Plans
The Company's stock incentive plans provide for granting options to
employees, officers, and directors. Options are granted for the purchase of
shares of common stock at an exercise price not less than market value on the
date of grant, and expire within seven or ten years from the date of grant.
Options generally vest annually over a three- to four-year period from the date
of grant.
A summary of option activity follows:
- --------------------------------------------------------------------------------
2005 2004
-------------------- --------------------
Weighted- Weighted-
Number Average Number Average
of Exercise of Exercise
Options Price Options Price
Outstanding at
beginning of year 133 $ 14.88 136 $ 15.25
Granted 1 $ 10.95 1 $ 13.73
Exercised (2) $ 7.17 (4) $ 5.57
Canceled (1) $ 11.59 (1) $ 16.79
Forfeited (4) $ 20.99 (2) $ 20.82
- --------------------------------------------------------------------------------
Outstanding
at March 31 127 $ 14.80 130 $ 15.42
================================================================================
Exercisable
at March 31 96 $ 15.94 87 $ 15.41
- --------------------------------------------------------------------------------
Available for future
grant at March 31 41 43
- --------------------------------------------------------------------------------
Weighted-average fair
value of options granted in
quarter ended March 31 $ 3.03 $ 3.95
- --------------------------------------------------------------------------------
The Company applies Accounting Principles Board Opinion No. 25 - Accounting
for Stock Issued to Employees, and related interpretations, for its stock-based
employee compensation plans. Because the Company grants stock option awards at
market value, there is no compensation expense recorded when the awards are
granted. Expense is recognized if the original terms of an award are
subsequently modified, which has occurred in connection with restructuring and
severance activities. Compensation expense for restricted stock awards is based
on the market value of the shares awarded at the date of grant and is amortized
on a straight-line basis over the vesting period. The unamortized portion of the
award is recorded as unamortized stock-based compensation in stockholders'
equity.
The Company uses a binomial option pricing 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 weighted
average of the assumptions used to value the options were as follows:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2005 2004
- --------------------------------------------------------------------------------
Expected dividend yield .48% .48%
Expected volatility 32% 36%
Risk-free interest rate 3.9% 4.0%
Expected life (in years) 3.5 4.0
- --------------------------------------------------------------------------------
Had compensation expense for the Company's stock option awards been
determined based on the binomial or Black-Scholes fair value, as described
above, at the grant dates for awards under those plans consistent with the fair
value method of SFAS No. 123 - Accounting for Stock-Based Compensation, the
Company would have recorded additional compensation expense and its net income
and earnings per share (EPS) would have been reduced to the pro forma amounts
presented in the following table:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2005 2004
Expense for stock-based
compensation (after-tax) (1):
As reported $ 4 $ 3
Pro forma (2) $ 18 $ 27
- --------------------------------------------------------------------------------
Net income:
As reported $ 145 $ 161
Pro forma $ 131 $ 137
- --------------------------------------------------------------------------------
Basic EPS:
As reported $ .11 $ .12
Pro forma $ .10 $ .10
Diluted EPS:
As reported $ .11 $ .12
Pro forma $ .10 $ .10
- --------------------------------------------------------------------------------
(1) Includes compensation expense related to restricted stock awards of
$3 million in each of the first quarters of 2005 and 2004, respectively.
(2) Includes pro forma compensation expense related to stock options granted in
both current and prior periods. Pro forma stock option compensation is
amortized on a basis consistent with the vesting terms over the vesting
period beginning with the month in which the option was granted.
- 5 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
4. Restructuring
2004 Cost Reduction Effort
- --------------------------
The Company's 2004 cost reduction effort was designed to mitigate the
financial impact of a series of pricing changes which began in 2004 and to
strengthen the Company's 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.
The Company recorded pre-tax restructuring charges of $21 million in the
first quarter of 2005, primarily comprised of severance costs for approximately
160 employees terminated in the first quarter of 2005, and remaining severance
costs for employees terminated in the fourth quarter of 2004 which became
contractual obligations only when the terminated employees signed severance
agreements in the first quarter of 2005. A summary of pre-tax restructuring
charges for the first quarter of 2005 is as follows:
- --------------------------------------------------------------------------------
Three months ended March 31, 2005
- --------------------------------------------------------------------------------
Workforce reduction:
Severance pay and benefits $ 18
Charges for officers' stock-based compensation 2
- --------------------------------------------------------------------------------
Total workforce reduction 20
- --------------------------------------------------------------------------------
Facilities reduction:
Non-cancelable lease costs, net of estimated
sublease income 1
- --------------------------------------------------------------------------------
Total restructuring charges $ 21
================================================================================
A summary of the activity in the restructuring reserve related to the
Company's 2004 cost reduction effort for the first quarter of 2005 is as
follows:
- --------------------------------------------------------------------------------
Workforce Facilities
Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at December 31, 2004 $ 50 $ 68 $ 118
Restructuring charges 20 1 21
Cash payments (34) (8) (42)
Non-cash charges (1) (2) - (2)
Other (2) - 1 1
- --------------------------------------------------------------------------------
Balance at March 31, 2005 $ 34 (3) $ 62 (4) $ 96
================================================================================
(1) Primarily includes charges for officers' stock-based compensation.
(2) Primarily includes the accretion of facilities restructuring reserves,
which are initially recorded at net present value. Accretion expense is
recorded in occupancy and equipment expense on the Company's condensed
consolidated statement of income.
(3) 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.
(4) 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.
Previous Initiatives
- --------------------
The Company's previous restructuring initiatives included workforce
reductions, reductions in operating facilities, the removal of certain systems
hardware, software, and equipment from service, and the withdrawal from certain
international operations. These initiatives reduced operating expenses and
adjusted the Company's organizational structure to improve productivity, enhance
efficiency, and increase profitability. There were no restructuring charges
recorded in either of the first quarters of 2005 or 2004 related to these
restructuring initiatives.
- 6 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
A summary of the activity in the restructuring reserve related to the
Company's previous restructuring initiatives for the first quarter of 2005 is as
follows:
- --------------------------------------------------------------------------------
Workforce Facilities
Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at December 31, 2004 $ 1 $ 142 $ 143
Cash payments (1) (15) (16)
Other (1) - 3 3
- --------------------------------------------------------------------------------
Balance at March 31, 2005 $ - $ 130 (2) $ 130
================================================================================
(1) Primarily includes the accretion of facilities restructuring reserves,
which are initially recorded at net present value, as well as certain
adjustments related to deferred rent. Accretion expense is recorded in
occupancy and equipment expense on the Company's condensed consolidated
statement of income.
(2) Includes $2 million, $59 million, and $69 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.
The actual costs of these restructuring initiatives could differ from the
estimated costs, depending primarily on the Company's ability to sublease
properties.
5. Discontinued Operations
On October 29, 2004, the Company completed the sale of its capital markets
business to UBS Securities LLC and UBS Americas Inc. (collectively referred to
as UBS). Pursuant to the purchase agreement, UBS acquired all of the partnership
interests of Schwab Capital Markets L.P. and all of the outstanding capital
stock of SoundView Technology Group, Inc. (collectively referred to as Schwab
Soundview Capital Markets, or SSCM) for $265 million in cash. SSCM comprised
substantially all of the previously-reported Capital Markets segment.
Following the sale, the Company will not have significant continuing
involvement in the operations of the capital markets business and will not
continue any significant revenue-producing or cost-generating activities of the
capital markets business. Therefore, the results of operations, net of income
taxes, and cash flows of the capital markets business have been presented as
discontinued operations on the Company's statements of income and cash flows for
all periods. In connection with the sale, the Company entered into eight-year
order routing and execution services agreements with UBS for handling of
Schwab's equity and listed options order flow. The Company deferred $28 million
of the purchase price, representing the fair value of these services agreements,
to be recognized as revenue over the eight-year term on a straight-line basis.
Following the sale, UBS will generally execute equity orders without commission
or other charges. Certain ongoing fees will apply for orders that require
special handling or entail additional costs. However, such fees are expected to
be insignificant. During a transition period, the Company will be reimbursed for
certain services provided to UBS and will also pass through to UBS third-party
fees and costs associated with the operations of the capital markets business.
These indirect payments will not be reflected as revenues or expenses of the
Company. The Company's cash flows related to these services agreements are
considered insignificant.
On January 31, 2003, the Company sold its United Kingdom 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.
For the first quarter of 2005, the Company recorded a loss from
discontinued operations, net of tax, of $6 million, which included a tax
adjustment, facility exit costs, and severance costs for transitional employees
associated with the Company's sale of its capital markets business.
A summary of revenues and gains from discontinued operations for the first
quarter of 2004 is as follows:
- --------------------------------------------------------------------------------
Three months ended March 31, 2004
- --------------------------------------------------------------------------------
Revenues $ 85
Total pre-tax gains $ 3
After-tax gains $ 2
- --------------------------------------------------------------------------------
In addition to the restructuring reserves discussed in note "4 -
Restructuring," the Company retained certain restructuring-related obligations
following the sales of SSCM and CSE, and recorded reserves for severance,
facilities leases and systems. A summary of the activity in these reserves for
the first quarter of 2005 is as follows:
- --------------------------------------------------------------------------------
Workforce Facilities
Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at December 31, 2004 $ 23 $ 38 $ 61
Restructuring charges (1) - 2 2
Cash payments (18) (2) (20)
- --------------------------------------------------------------------------------
Balance at March 31, 2005 $ 5 (2) $ 38 (3) $ 43
================================================================================
(1) Included in gain (loss) from discontinued operations.
(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 2015.
- 7 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
The Company also retained a liability for above-market lease rates for
certain facilities leases expiring through 2011. This liability was recorded as
part of the Company's purchase accounting for the acquisition of SoundView
Technology Group, Inc. in January 2004. The remaining liability was $22 million
and $23 million at March 31, 2005 and December 31, 2004, respectively. The
decrease in the liability balance was primarily due to cash payments of
$1 million.
6. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
- --------------------------------------------------------------------------------
March 31, December 31,
2005 2004
- --------------------------------------------------------------------------------
Residential real estate mortgages $5,698 $ 5,342
Consumer loans 959 971
Other 518 536
- --------------------------------------------------------------------------------
Total loans 7,175 6,849
Less: allowance for credit losses (27) (27)
- --------------------------------------------------------------------------------
Loans to banking clients - net $7,148 $ 6,822
================================================================================
Included in the loan portfolio are nonaccrual loans totaling $2 million at
March 31, 2005 and $1 million at December 31, 2004. Nonaccrual loans are
considered impaired by the Company, and represent all of the Company's
nonperforming assets at both March 31, 2005 and December 31, 2004. For each of
the first quarters of 2005 and 2004, 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 less than $1 million at March 31, 2005 and $4 million at
December 31, 2004.
Recoveries and charge-offs related to the allowance for credit losses on
the loan portfolio were immaterial for each of the first quarters of 2005 and
2004.
7. Deposits from Banking Clients
Deposits from banking clients consist of money market and other savings
deposits, certificates of deposit, and noninterest-bearing deposits. Deposits
from banking clients are as follows:
- --------------------------------------------------------------------------------
March 31, December 31,
2005 2004
- --------------------------------------------------------------------------------
Interest-bearing deposits $10,733 $10,280
Noninterest-bearing deposits 695 838
- --------------------------------------------------------------------------------
Total $11,428 $11,118
================================================================================
The average rate paid by the Company on its interest-bearing deposits from
banking clients was 1.46% and 1.30% for the first quarters of 2005 and 2004,
respectively.
8. 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:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2005 2004
- --------------------------------------------------------------------------------
Service cost and expenses $ 3 $ 3
Interest cost 4 4
Expected return on plan assets (6) (5)
Amortization of prior service cost (1) (1)
Amortization of net loss 2 1
- --------------------------------------------------------------------------------
Net periodic benefit expense $ 2 $ 2
================================================================================
The net periodic benefit expense related to health care and life insurance
benefits were less than $500,000 for each of the first quarters of 2005 and
2004.
- 8 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
9. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is presented in the following table:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2005 2004
- --------------------------------------------------------------------------------
Net income $ 145 $ 161
Other comprehensive income (loss):
Change in unrealized gain (loss) on
cash flow hedging instruments:
Unrealized gain 10 6
Income tax expense (4) (2)
- --------------------------------------------------------------------------------
Net 6 4
- --------------------------------------------------------------------------------
Change in unrealized gain (loss)
on securities available for sale:
Unrealized gain (loss) (38) 24
Income tax (expense) benefit 15 (9)
- --------------------------------------------------------------------------------
Net (23) 15
- --------------------------------------------------------------------------------
Total (17) 19
- --------------------------------------------------------------------------------
Comprehensive income $ 128 $ 180
================================================================================
10. Earnings Per Share
Basic EPS excludes dilution and is computed by dividing net income by the
weighted-average number of common shares outstanding for the period. Diluted EPS
reflects the potential reduction in EPS that could occur if securities or other
contracts to issue common stock were exercised or converted into common stock.
EPS under the basic and diluted computations are presented in the following
table:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2005 2004
- --------------------------------------------------------------------------------
Net income $ 145 $ 161
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - basic 1,310 1,348
Common stock equivalent shares
related to stock incentive plans 16 27
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,326 1,375
================================================================================
Basic EPS:
Income from continuing operations $ .11 $ .12
Gain (loss) from discontinued
operations, net of tax - -
Net income $ .11 $ .12
- --------------------------------------------------------------------------------
Diluted EPS:
Income from continuing operations $ .11 $ .12
Gain (loss) from discontinued
operations, net of tax - -
Net income $ .11 $ .12
- --------------------------------------------------------------------------------
The computation of diluted EPS excludes outstanding stock options to
purchase 73 million and 75 million shares for the first quarters of 2005 and
2004, 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.
- 9 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
11. Regulatory Requirements
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Board of Governors of the Federal
Reserve System (the Federal Reserve Board) under the Bank Holding Company Act of
1956, as amended (the Act).
Under the Act, the Federal Reserve Board has established consolidated
capital requirements for bank holding companies. The regulatory capital and
ratios of the Company, U.S. Trust, United States Trust Company of New York
(U.S. Trust NY), U.S. Trust Company, National Association (U.S. Trust NA), and
Schwab Bank are presented in the following table:
- --------------------------------------------------------------------------------
2005 2004
--------------- ---------------
March 31, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,393 16.7% $ 3,527 19.8%
U.S. Trust $ 722 13.9% $ 666 15.4%
U.S. Trust NY $ 397 10.0% $ 357 10.7%
U.S. Trust NA $ 289 24.5% $ 262 29.3%
Schwab Bank $ 389 21.6% $ 281 28.4%
Total Capital:
Company $ 3,426 16.9% $ 3,556 20.0%
U.S. Trust $ 747 14.4% $ 693 16.0%
U.S. Trust NY $ 419 10.6% $ 381 11.4%
U.S. Trust NA $ 292 24.8% $ 265 29.6%
Schwab Bank $ 391 21.7% $ 281 28.5%
Tier 1 Leverage:
Company $ 3,393 7.5% $ 3,527 7.9%
U.S. Trust $ 722 7.5% $ 666 8.0%
U.S. Trust NY $ 397 5.6% $ 357 5.6%
U.S. Trust NA $ 289 10.5% $ 262 12.3%
Schwab Bank $ 389 8.6% $ 281 9.6%
- --------------------------------------------------------------------------------
(1) Minimum tier 1 capital, total capital, and tier 1 leverage ratios are 4%,
8%, and 3%-5%, respectively, for bank holding companies and banks.
Additionally, Schwab Bank is subject to a minimum tier 1 leverage ratio of
8% for its first three years of operations (i.e., through April 2006).
Well-capitalized tier 1 capital, total capital, and tier 1 leverage ratios
are 6%, 10%, and 5%, respectively.
Based on their respective regulatory capital ratios at March 31, 2005 and
2004, 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 banking
regulatory 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 March 31,
2005, 2% of aggregate debits was $199 million, which exceeded the minimum dollar
requirement for Schwab of $1 million. At March 31, 2005, Schwab's net capital
was $1.1 billion (11% of aggregate debit balances), which was $927 million in
excess of its minimum required net capital and $629 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.
12. Commitments and Contingent Liabilities
Guarantees: The Company recognizes, at the inception of a guarantee, a
liability for the estimated fair value of the obligation undertaken in issuing
the guarantee. The fair values of the obligations relating to standby letters of
credit (LOCs) are estimated based on fees charged to enter into similar
agreements, considering the creditworthiness of the counterparties. The fair
values of the obligations relating to other guarantees are estimated based on
transactions for similar guarantees or expected present value measures.
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. 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. These indemnification
agreements have various expiration dates and the Company's liability under these
agreements is generally limited. At March 31, 2005, the Company's maximum
potential liability under the indemnification agreements with limits is
approximately $190 million. The Company previously recorded a liability of
approximately $30 million reflecting the estimated fair value of these
indemnifications. The fair value of these indemnifications is not necessarily
indicative of amounts that would be paid in the event a payment was required.
- 10 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
LOCs are conditional commitments issued by U.S. Trust to guarantee the
performance of a client to a third party. For example, LOCs can be used to
guarantee performance under lease and other agreements by professional business
corporations and for other purposes. The credit risk involved in issuing LOCs is
essentially the same as that involved in extending loans. LOCs are generally
partially or fully collateralized by cash, marketable equity securities,
marketable debt securities (including corporate and U.S. Treasury debt
securities), and other assets. At March 31, 2005, U.S. Trust had LOCs
outstanding totaling $62 million which are short-term in nature and generally
expire within one year. At March 31, 2005, the liability recorded for these LOCs
is 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 LOCs, in favor of the clearing houses, that are
guaranteed by multiple banks. At March 31, 2005, the outstanding value of these
LOCs totaled $630 million. In connection with its securities lending activities,
Schwab is required to provide collateral to certain brokerage clients. Schwab
satisfies the collateral requirements by arranging LOCs, in favor of these
brokerage clients, that are guaranteed by multiple banks. At March 31, 2005, the
outstanding value of these LOCs totaled $92 million. No funds were drawn under
these LOCs at March 31, 2005.
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 Company and its affiliates have been named in
various legal proceedings arising from the conduct of its business. Some of
these legal actions include claims for substantial damages or unspecified
damages. The Company believes it has strong defenses and is vigorously
contesting such actions. The Company is also involved, from time to time, in
investigations and proceedings by regulatory and other governmental agencies,
which may result in adverse judgments, fines or penalties. It is inherently
difficult to predict the ultimate outcome of these legal and regulatory matters,
particularly in cases in which claimants seek substantial or unspecified
damages, and a substantial judgment, settlement or penalty could be material to
the Company's operating results for a particular future period, depending on the
Company's results for that period. However, based on current information, it is
the opinion of management, after consultation with counsel, that the resolution
of these matters will not have a material adverse impact on the financial
condition, results of operations, or cash flows of the Company.
As part of the sale of SSCM to UBS, the Company agreed to indemnify UBS for
expenses associated with certain litigation, including multiple purported
securities class actions against SoundView Technology Group, Inc. (SoundView)
and certain of its subsidiaries filed in the United District Court for the
Southern District of New York, brought on behalf of persons who either directly
or in the aftermarket purchased IPO securities between March 1997 and December
2000. The Company is vigorously contesting the claims on behalf of SoundView.
13. Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk or
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 and short-term
borrowings. The Swaps are structured for U.S. Trust to receive a variable rate
of interest and pay a fixed rate of interest. Information on these Swaps is
summarized in the following table:
- --------------------------------------------------------------------------------
March 31, December 31,
2005 2004
- --------------------------------------------------------------------------------
Notional principal amount $ 900 $ 625
Weighted-average variable interest rate 2.97% 2.39%
Weighted-average fixed interest rate 4.23% 4.25%
Weighted-average maturity (in years) 3.2 3.3
- --------------------------------------------------------------------------------
These Swaps have been 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. At March 31, 2005, U.S. Trust recorded a
derivative asset of $12 million and a derivative liability of $7 million related
to these Swaps. At December 31, 2004, U.S. Trust recorded a derivative asset of
$3 million and a derivative liability of $9 million related to these Swaps.
Based on current interest rate assumptions and assuming no additional Swap
agreements are entered into, U.S. Trust expects to reclassify approximately
$5 million, or $3 million after tax, from other comprehensive loss to interest
expense over the next twelve months.
- 11 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
CSC uses Swaps to effectively convert the interest rate characteristics of
a portion of its Medium-Term Notes from fixed to variable. These Swaps are
structured for CSC to receive a fixed rate of interest and pay a variable rate
of interest based on the three-month LIBOR rate. The variable interest rates
reset every three months. Information on these Swaps is summarized in the
following table:
- --------------------------------------------------------------------------------
March 31, December 31,
2005 2004
- --------------------------------------------------------------------------------
Notional principal amount $ 293 $ 293
Weighted-average variable interest rate 5.36% 4.85%
Weighted-average fixed interest rate 7.57% 7.57%
Weighted-average maturity (in years) 4.0 4.3
- --------------------------------------------------------------------------------
These Swaps have been designated as fair value hedges under SFAS No. 133,
and are recorded on the Company's condensed consolidated balance sheet. Changes
in the fair value of the Swaps are completely offset by changes in fair value of
the hedged Medium-Term Notes. Therefore, there is no effect on net income. At
March 31, 2005 and December 31, 2004, CSC recorded a derivative asset of
$7 million and $13 million, respectively, for these Swaps. Concurrently, the
carrying value of the Medium-Term Notes was increased by $7 million and
$13 million, at March 31, 2005 and December 31, 2004, respectively.
Forward sale and interest rate lock commitments: 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 these forward sale commitments are
recorded on the Company's condensed consolidated balance sheet, with gains or
losses recorded in other comprehensive income (loss). At March 31, 2005 and
December 31, 2004, the derivative asset or liability recorded by Schwab Bank for
these forward sale commitments was immaterial.
Additionally, Schwab Bank uses forward sale commitments to hedge interest
rate lock commitments issued on mortgage loans that will be held for sale.
Schwab Bank considers the fair value of these commitments to be zero at the
commitment date, with subsequent changes in fair value determined solely based
on changes in market interest rates. Any changes in fair value of the interest
rate lock commitments are completely offset by changes in fair value of the
related forward sale commitments. Schwab Bank had interest rate lock commitments
on mortgage loans to be held for sale with principal balances totaling
approximately $115 million and $110 million at March 31, 2005 and December 31,
2004, respectively. The fair values of these interest rate lock commitments and
the related forward sale commitments were immaterial at both March 31, 2005 and
December 31, 2004.
14. 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. As a result of the Company's exit from the capital markets business
in 2004, the previously-reported Capital Markets segment has been eliminated.
In the first quarter of 2005, the Company refined its activity-based
costing model related to its allocation of certain support costs (e.g.,
corporate and general administrative expenses), which reduced costs allocated to
the U.S. Trust segment and increased costs allocated to the remaining segments.
Previously-reported segment information has been revised to reflect this change.
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 excluding items such as non-operating
revenues, restructuring charges, impairment charges, discontinued operations,
and extraordinary items, which the Company defines as adjusted operating income
before taxes. Intersegment revenues are not material and are therefore not
disclosed. Total revenues, income from continuing operations before taxes on
income, and net income are equal to the amounts as reported on the Company's
condensed consolidated statement of income.
- 12 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data,
Option Price Amounts, Ratios, and as Noted)
(Unaudited)
Financial information for the Company's reportable segments is presented in
the following table:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2005 2004
- --------------------------------------------------------------------------------
Revenues:
Individual Investor $ 599 $ 677
Institutional Investor 238 233
U.S. Trust 207 181
Unallocated 15 17
- --------------------------------------------------------------------------------
Total $1,059 $1,108
================================================================================
Income from continuing operations
before taxes on income:
Individual Investor $ 142 $ 153
Institutional Investor 83 78
U.S. Trust (1) 35 11
Unallocated 7 2
Excluded items ((2)) (21) -
- --------------------------------------------------------------------------------
Income from continuing operations
before taxes on income 246 244
Taxes on income (95) (85)
Gain (loss) from discontinued
operations, net of tax (6) 2
- --------------------------------------------------------------------------------
Net income $ 145 $ 161
================================================================================
(1) Amounts include costs (e.g., corporate and general administrative expenses)
of $10 million in each of the first quarters of 2005 and 2004 allocated to
U.S. Trust.
(2) In the first quarter of 2005, consists of pre-tax restructuring charges of
$21 million, or $13 million after tax (see note "4 - Restructuring").
15. Supplemental Cash Flow Information
Certain information affecting the cash flows of the Company is presented in
the following table:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2005 2004
- --------------------------------------------------------------------------------
Income taxes paid $ 2 $ 28
- --------------------------------------------------------------------------------
Interest paid:
Brokerage client cash balances $ 80 $ 15
Deposits from banking clients 36 24
Long-term debt 9 12
Short-term borrowings 8 3
Other 4 2
- --------------------------------------------------------------------------------
Total interest paid $ 137 $ 56
================================================================================
- 13 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations
Overview
Performance Metrics: Management of the Charles Schwab Corporation (CSC) and
its subsidiaries (collectively referred to as the Company) focuses on several
key financial and non-financial metrics in evaluating the Company's financial
position and operating performance. Results for the first quarter of 2005 are
shown in the following table:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
2005 2004 Change
- --------------------------------------------------------------------------------
Client Activity Metrics:
Net new client assets (in billions) $ 16.1 $ 13.8 17%
Client assets (in billions, at quarter end) $1,077.2 $996.3 8%
Daily average revenue trades
(in thousands) 191.3 178.0 7%
Company Financial Metrics:
Revenue growth (decline) from
prior year's quarter (1) (4%) 28%
Pre-tax profit margin from
continuing operations (1) 23.2% 22.0%
Return on stockholders' equity 13% 14%
Annualized revenue per average
full-time equivalent employee (1)
(annualized, in thousands) $ 302 $ 272 11%
Revenue on client assets (2) 40 45 (11%)
- --------------------------------------------------------------------------------
(1) All amounts have been adjusted to reflect the sale of the Company's capital
markets business.
(2) Represents annualized basis points of revenue per dollar of client assets.
The first quarter of 2005 was marked by rising interest rates, continuing
concerns about energy prices, and flat to down securities markets. Also during
the first quarter of 2005, the Company completed a series of price reductions,
including lower online equity commissions for certain retail investors and
active traders, as well as enhanced its personal service capabilities by
expanding relationship-based investment help to independent investors with
larger portfolios and more complex needs. Net new client assets of $16.1 billion
for the first quarter of 2005 were up 17% from the year-ago level and included
$10.5 billion into accounts with an ongoing advice component. Additionally,
assets in client accounts equaled $1.077 trillion at March 31, 2005, up 8% from
a year ago and just under the record $1.089 trillion level set one month
earlier. While client daily average revenue trades increased by 7% in the first
quarter of 2005 compared to the year-ago level, the Company's commission pricing
reductions resulted in a 43% decline in its trading revenue over the same period
to $207 million. However, the Company's non-trading revenues (which include
asset management and administration fees, net interest revenue, and other
revenues) reached a new record of $852 million, up 14% from the year-ago period,
which limited the overall declines in revenue on client assets and total
revenues to 5 basis points and 4%, respectively. During the first quarter of
2005, annualized revenue per average full-time equivalent employee exceeded
$300,000 for the first time in five years, reflecting management's continued
focus on productivity.
Restructuring: The Company recorded pre-tax restructuring charges of
$21 million in the first quarter of 2005, primarily comprised of severance costs
for approximately 160 employees terminated in the first quarter of 2005, and
remaining severance costs for employees terminated in the fourth quarter of 2004
which became contractual obligations only when the terminated employees signed
severance agreements in the first quarter of 2005. Estimated additional charges
for, or expense savings from, cost reduction efforts to be implemented during
the remainder of 2005 have not yet been finalized.
As of March 31, 2005, the remaining facilities restructuring reserve of
$230 million is net of estimated future sublease income of approximately
$310 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 both March 31, 2005
and December 31, 2004, approximately 80% of the total square footage targeted
for sublease under the restructuring initiatives has been subleased.
The actual costs of the Company's restructuring initiatives, as detailed in
note "4 - Restructuring" in the Notes to Condensed Consolidated Financial
Statements, could differ from the estimated costs, depending primarily on the
Company's ability to sublease properties.
Discontinued Operations: On October 29, 2004, the Company completed the
sale of its capital markets business to UBS Securities LLC and UBS Americas
Inc., (collectively referred to as UBS) and thereby eliminated the revenues and
expenses unique to the capital markets business, including commissions earned on
trades from institutional clients, principal transaction revenues on OTC listed
and Nasdaq market-making operations, and commission expense and floor-brokerage
expense on institutional client trading activity. In connection with the sale,
the Company entered into eight-year order routing and execution services
agreements with UBS for handling of Charles Schwab & Co., Inc. (Schwab)'s equity
and listed
- 14 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
options order flow. Pursuant to these agreements, UBS will generally execute
equity orders without commission or other charges. Certain ongoing fees will
apply for orders that require special handling or entail additional costs, and
such fees are expected to be insignificant. The results of operations, net of
income taxes, and cash flows of the capital markets business have been presented
as discontinued operations on the Company's condensed consolidated statements of
income and of cash flows for all periods. For the first quarter of 2005, the
Company recorded a loss from discontinued operations, net of tax, of $6 million,
which included a tax adjustment, facility exit costs, and severance costs for
transitional employees associated with the Company's sale of its capital markets
business.
Subsequent Events
On April 28, 2005, the Board of Directors increased the quarterly cash
dividend from $.020 per share to $.022 per share, payable May 23, 2005 to
stockholders of record May 9, 2005, and authorized the repurchase of up to $300
million of CSC's common stock.
Effective May 9, 2005, Peter K. Scaturro was appointed Chief Executive
Officer of U.S. Trust, replacing Alan J. Weber.
Quarterly Results of Operations
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
2005 2004 Change
- --------------------------------------------------------------------------------
Non-trading revenues $ 852 $ 747 14%
Trading revenue 207 361 (43%)
- --------------------------------------------------------------------------------
Total revenues 1,059 1,108 (4%)
Expenses excluding interest 813 864 (6%)
- --------------------------------------------------------------------------------
Income from continuing operations
before taxes on income 246 244 1%
Taxes on income (95) (85) 12%
- --------------------------------------------------------------------------------
Income from continuing operations 151 159 (5%)
Gain (loss) from discontinued operations,
net of tax (6) 2 n/m
- --------------------------------------------------------------------------------
Net income $ 145 $ 161 (10%)
================================================================================
Earnings per share - diluted $ .11 $ .12 (8%)
After-tax profit margin 13.7% 14.5%
Effective income tax rate on income from
continuing operations 38.6% 34.8%
- --------------------------------------------------------------------------------
n/m Not meaningful.
The increase in non-trading revenues was due to increases in net interest
revenue, resulting primarily from higher levels of market interest rates and
loans to clients, and asset management and administration fees, resulting
primarily from higher levels of client assets and higher asset-based fees from
certain client relationships. The decrease in trading revenue was primarily due
to lower average revenue earned per revenue trade resulting from reductions in
the Company's commission pricing, partially offset by higher client trading
activity.
The decrease in expenses excluding interest was mainly due to a
$28 million, or 6%, decrease in compensation and benefits expense, primarily due
to a reduction in full-time equivalent employees, partially offset by higher
levels of discretionary bonuses and incentives to employees, and a $26 million,
or 42%, decrease in advertising and market development expense, primarily due to
decreased television and other media spending. The increase in the effective
income tax rate from the first quarter of 2004 was primarily due to a favorable
tax settlement in the first quarter of 2004, and higher state taxes in 2005.
Segment Information: The Company provides financial services to individuals and
institutional clients through three segments - Individual Investor,
Institutional Investor, and U.S. Trust. The Individual Investor segment includes
the Company's retail brokerage and banking operations. The Institutional
Investor segment provides custodial, trading and support services to independent
investment advisors, 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.
As detailed in note "14 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements, income from continuing operations before
taxes on income was $246 million for the first quarter of 2005, up $2 million,
or 1%, from the first quarter of 2004 primarily due to an increase of $24
million, or 218%, in the U.S. Trust segment, partially offset by restructuring
expense. The increase in the U.S. Trust segment was primarily due to higher
asset-based fees and expenses that were essentially unchanged from the
prior-year level.
REVENUES
- --------
The Company categorizes its revenues as either non-trading or trading. As
shown in the following table, non-trading revenues increased, while trading
revenue decreased, in the first quarter of 2005 from the first quarter of 2004.
- 15 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Sources of Revenues
Three Months Ended March 31,
- ------------------------------------------------------------------------------------------------------------------------------------
Growth Rate
1-year 2005 2004
----------------------------------------------
2004-2005 Amount Percent Amount Percent
------------------------------------------------------------
Non-Trading Revenues
Asset management and administration fees
Mutual fund service fees:
Proprietary funds (Schwab Funds(R),
Excelsior(R), and other) 3% $ 219 20% $ 213 19%
Mutual Fund OneSource(R) 14% 105 10% 92 8%
Other 14% 16 1% 14 1%
Asset management and related services 10% 207 20% 188 17%
- ------------------------------------------------------------------------------------------------------------------------------------
Asset management and administration fees 8% 547 51% 507 45%
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest revenue
Interest revenue:
Margin loans to clients 36% 141 13% 104 9%
Investments, client-related 81% 112 11% 62 6%
Loans to banking clients 30% 79 7% 61 6%
Securities available for sale 63% 49 5% 30 3%
Other n/m 31 3% 6 -
- ------------------------------------------------------------------------------------------------------------------------------------
Interest revenue 57% 412 39% 263 24%
Interest expense:
Brokerage client cash balances n/m 81 8% 15 1%
Deposits from banking clients 44% 39 4% 27 3%
Long-term debt 13% 9 1% 8 1%
Short-term borrowings 200% 6 - 2 -
Other 50% 3 - 2 -
- ------------------------------------------------------------------------------------------------------------------------------------
Interest expense 156% 138 13% 54 5%
- ------------------------------------------------------------------------------------------------------------------------------------
Net interest revenue 31% 274 26% 209 19%
- ------------------------------------------------------------------------------------------------------------------------------------
Other - 31 3% 31 3%
- ------------------------------------------------------------------------------------------------------------------------------------
Total Non-Trading Revenues 14% 852 80% 747 67%
- ------------------------------------------------------------------------------------------------------------------------------------
Trading Revenue
Commissions (44%) 188 18% 336 30%
Principal transactions (24%) 19 2% 25 3%
- ------------------------------------------------------------------------------------------------------------------------------------
Total Trading Revenue (43%) 207 20% 361 33%
- ------------------------------------------------------------------------------------------------------------------------------------
Total Revenues (4%) $ 1,059 100% $ 1,108 100%
====================================================================================================================================
n/m Not meaningful
- 16 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
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:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
2005 2004 Change
- --------------------------------------------------------------------------------
Individual Investor $ 599 $ 677 (12%)
Institutional Investor 238 233 2%
U.S. Trust 207 181 14%
Unallocated 15 17 (12%)
- --------------------------------------------------------------------------------
Total $1,059 $1,108 (4%)
================================================================================
The decrease in revenues in the Individual Investor segment from the first
quarter of 2004 was primarily due to lower average revenue earned per revenue
trade as a result of significant reductions in commission pricing for a wide
range of clients in 2004, partially offset by higher daily average revenue
trades. The increase in the U.S. Trust segment was primarily due to higher
asset-based fees relative to asset levels for certain client relationships. See
note "14 - 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 include mutual fund service fees,
as well as fees for other asset-based financial services provided to individual
and institutional clients.
The increase in asset management and administration fees from the first
quarter of 2004 was primarily due to higher levels of client assets and higher
asset-based fees from certain client relationships, including increases in
average assets in Schwab's Mutual Fund OneSource service.
Net Interest Revenue
- --------------------
Net interest revenue is the difference between interest earned on certain
assets (mainly margin loans to clients, investments of segregated client cash
balances, loans to banking clients, and securities available for sale) and
interest paid on supporting liabilities (mainly deposits from banking clients
and brokerage client cash balances).
Client-related daily average balances, interest rates, and average net
interest spread for the first quarters of 2005 and 2004 are summarized in the
following table:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31,
2005 2004
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $ 18,796 $ 21,041
Average interest rate 2.40% 1.18%
Margin loans to clients:
Average balance outstanding $ 9,613 $ 8,844
Average interest rate 5.90% 4.69%
Loans to banking clients:
Average balance outstanding $ 6,857 $ 5,800
Average interest rate 4.60% 4.20%
Securities available for sale:
Average balance outstanding $ 5,133 $ 3,456
Average interest rate 3.85% 3.44%
Average yield on interest-earning assets 3.79% 2.62%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $ 23,519 $ 23,924
Average interest rate 1.37% .25%
Interest-bearing banking deposits:
Average balance outstanding $ 10,678 $ 8,215
Average interest rate 1.46% 1.30%
Other interest-bearing sources:
Average balance outstanding $ 1,595 $ 2,841
Average interest rate 2.11% .79%
Average noninterest-bearing portion $ 4,607 $ 4,161
Average interest rate on funding sources 1.27% .48%
Summary:
Average yield on interest-earning assets 3.79% 2.62%
Average interest rate on funding sources 1.27% .48%
- --------------------------------------------------------------------------------
Average net interest spread 2.52% 2.14%
================================================================================
The increase in net interest revenue from the first quarter of 2004 was
primarily due to higher levels of market interest rates and changes in the
composition of interest-earning assets, including increases in loans to banking
clients, securities available for sale, and margin loan balances, partially
offset by a decrease in client-related investments. Additionally, the Company's
average net interest spread increased from the first quarter of 2004 as the
average yield on interest-earning assets increased more than the average
interest rate on funding sources.
- 17 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Trading Revenue
- ---------------
Trading revenue includes commission and principal transaction revenues. The
Company earns commission revenues by executing client trades. Principal
transaction revenues are primarily comprised of revenues from client fixed
income securities trading activity.
The decrease in trading revenue from the first quarter of 2004 was
primarily due to lower average revenue earned per revenue trade as a result of
significant reductions in commission pricing for a wide range of clients in the
first quarter of 2005 and second and fourth quarters of 2004, partially offset
by higher daily average revenue trades.
As shown in the following table, average revenue earned per revenue trade
decreased 46% while daily average revenue trades executed by the Company
increased 7% in the first quarter of 2005.
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
2005 2004 Change
- --------------------------------------------------------------------------------
Daily average revenue trades
(in thousands) (1) 191.3 178.0 7%
Accounts that traded (in thousands) 1,357 1,459 (7%)
Average revenue trades
per account that traded 8.6 7.6 13%
Trading frequency proxy (2) 3.6 4.1 (12%)
Number of trading days 61.0 62.0 (2%)
Average revenue earned
per revenue trade (3) $17.95 $33.16 (46%)
Online trades as a percentage of
total trades 91% 89%
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate trading revenue (i.e., commission revenue or revenue from fixed
income securities trading).
(2) Represents annualized revenue trades per $100,000 in total client assets.
(3) All amounts have been adjusted to reflect the sale of the Company's capital
markets business.
The Company continually monitors its pricing in relation to competitors and
periodically adjusts prices to enhance its competitive position.
EXPENSES EXCLUDING INTEREST
- ---------------------------
As shown in the table below, total expenses excluding interest decreased in
the first quarter of 2005 primarily due to lower levels of compensation and
benefits expense, advertising and market development expense, and occupancy and
equipment expense, partially offset by higher levels of restructuring charges.
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
2005 2004 Change
- --------------------------------------------------------------------------------
Compensation and benefits $ 454 $ 482 (6%)
Occupancy and equipment 82 102 (20%)
Professional services 62 58 7%
Depreciation and amortization 54 56 (4%)
Communications 51 61 (16%)
Advertising and market development 36 62 (42%)
Commissions, clearance and floor brokerage 9 9 -
Restructuring charges 21 - n/m
Other 44 34 29%
- --------------------------------------------------------------------------------
Total $ 813 $ 864 (6%)
================================================================================
Expenses as a percentage of total revenues:
Total expenses, excluding interest 77% 78%
Compensation and benefits 43% 44%
Advertising and market development 3% 6%
- --------------------------------------------------------------------------------
n/m Not meaningful.
- 18 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Compensation and Benefits
- -------------------------
The decrease in compensation and benefits expense from the first quarter of
2004 was primarily due to a reduction in full-time equivalent employees through
the Company's 2004 cost reduction effort and lower levels of employee benefits,
partially offset by higher levels of discretionary bonuses to employees and
incentive compensation. The following table shows a comparison of certain
compensation and benefits components and employee data:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
2005 2004 Change
- --------------------------------------------------------------------------------
Salaries and wages $ 271 $ 313 (13%)
Incentive and variable compensation 105 85 24%
Employee benefits and other 78 84 (7%)
- --------------------------------------------------------------------------------
Total $ 454 $ 482 (6%)
================================================================================
Full-time equivalent employees (1)
(in thousands)
At quarter end 13.9 16.5 (16%)
Average 14.0 16.3 (14%)
- --------------------------------------------------------------------------------
(1) Includes full-time, part-time and temporary employees, and persons employed
on a contract basis. All amounts have been adjusted to reflect the sale of
the Company's capital markets business.
See note "2 - New Accounting Standards" in the Notes to Condensed
Consolidated Financial Statements for a discussion of future compensation
expense related to stock option awards.
Expenses Excluding Compensation and Benefits
- --------------------------------------------
The decrease in advertising and market development expense from the first
quarter of 2004 was primarily due to the Company's decreased television and
other media spending. The decrease in occupancy and equipment expense from the
first quarter of 2004 was primarily due to the Company's restructuring
initiatives and other expense reduction measures (see Overview - Restructuring).
Liquidity and Capital Resources
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Board of Governors of the Federal
Reserve System (Federal Reserve Board) under the Bank Holding Company Act of
1956, as amended. CSC conducts virtually all business through its wholly owned
subsidiaries. The capital structure among CSC and its subsidiaries is designed
to provide each entity with capital and liquidity to meet its operational needs
and regulatory requirements. See note "11 - Regulatory Requirements" in the
Notes to Condensed Consolidated Financial Statements.
Liquidity
CSC
CSC's liquidity needs are generally met through cash generated by its
subsidiaries, as well as cash provided by external financing. As discussed
below, Schwab 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 March 31, 2005,
the Company and its depository institution subsidiaries are considered well
capitalized.
CSC has liquidity needs that arise from its Senior Medium-Term Notes,
Series A (Medium-Term Notes), as well as from the funding of cash dividends,
acquisitions, and other investments. The Medium-Term Notes, of which
$386 million was issued and outstanding at March 31, 2005, have maturities
ranging from 2005 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 - Debt Issuances). 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 Ratings, Ltd. (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 March 31, 2005, all of these notes
remained unissued.
CSC has a Registration Statement under the Securities Act of 1933 on Form
S-3 on file with the SEC 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. At March 31, 2005,
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 March 31, 2005, no commercial paper has been issued.
CSC's ratings for these short-term
- 19 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
borrowings are P-1 by Moody's, A-2 by S&P, and F1 by Fitch.
CSC maintains an $800 million committed, unsecured credit facility with a
group of nineteen banks which is scheduled to expire in June 2005. CSC plans to
establish a replacement facility when the current facility expires. This
facility was unused during the first quarter of 2005. 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 $771 million of the $821 million uncommitted,
unsecured bank credit lines, provided by eight banks that are primarily utilized
by Schwab to manage short-term liquidity. The amount available to CSC under
these lines is lower than the amount available to Schwab because the credit line
provided by one of these banks is only available to Schwab. These lines were not
used by CSC during the first quarter of 2005.
Schwab
Liquidity needs relating to client trading and margin borrowing activities
are met primarily through cash balances in brokerage client accounts, which were
$26.1 billion and $27.0 billion at March 31, 2005 and December 31, 2004,
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.
The Company has a lease financing liability related to an office building
and land under a 20-year lease. The remaining lease financing liability of
$133 million at March 31, 2005 is being reduced by a portion of the lease
payments over the remaining lease term.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of eight banks totaling $821 million at March 31,
2005 (as noted previously, $771 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. These lines were not used by Schwab during the
first quarter of 2005.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with eight banks in favor of the OCC aggregating $630 million at
March 31, 2005. Schwab pays a fee to maintain these arrangements. In connection
with its securities lending activities, Schwab is required to provide collateral
to certain brokerage clients. Schwab satisfies the collateral requirements by
arranging letters of credit (LOCs), in favor of these brokerage clients, which
are guaranteed by multiple banks. At March 31, 2005, the outstanding value of
these LOCs totaled $92 million. No funds were drawn under these LOCs at
March 31, 2005.
Schwab is subject to regulatory requirements that are intended to ensure
the general financial soundness and liquidity of broker-dealers. These
regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying
cash dividends, or making unsecured advances or loans to its parent or employees
if such payment would result in net capital of less than 5% of aggregate debit
balances or less than 120% of its minimum dollar requirement of $1 million. At
March 31, 2005, Schwab's net capital was $1.1 billion (11% of aggregate debit
balances), which was $927 million in excess of its minimum required net capital
and $629 million in excess of 5% of aggregate debit balances. Schwab has
historically targeted net capital to be at least 10% of its aggregate debit
balances, which primarily consist of client margin loans.
To manage Schwab's regulatory capital requirement, CSC provides Schwab with
a $1.4 billion subordinated revolving credit facility which is scheduled to
expire in September 2005. The amount outstanding under this facility at
March 31, 2005 was $220 million. Borrowings under this subordinated lending
arrangement qualify as regulatory capital for Schwab.
U.S. Trust
The liquidity needs of U.S. Trust Corporation (USTC, and with its
subsidiaries collectively referred to as U.S. Trust) are generally met through
deposits from banking clients, equity capital, and borrowings.
Certain Schwab brokerage clients can sweep the excess cash held in their
accounts into a money market deposit account at U.S. Trust. At March 31, 2005,
these balances totaled $630 million.
In addition to traditional funding sources such as deposits, federal funds
purchased, and repurchase agreements, USTC's depository institution subsidiaries
have established their own external funding sources. At March 31, 2005,
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
- 20 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
$1.9 billion. At March 31, 2005, $625 million was outstanding under these
facilities. Additionally, at March 31, 2005, U.S. Trust had $166 million of
federal funds purchased.
U.S. Trust also engages in intercompany repurchase agreements with Charles
Schwab Bank, N.A. (Schwab Bank) and Schwab. At March 31, 2005, U.S. Trust had
$400 million and $200 million in repurchase agreements outstanding with Schwab
Bank and Schwab, respectively.
CSC provides U.S. Trust with a $300 million short-term credit facility
maturing in December 2006. Borrowings under this facility do not qualify as
regulatory capital for U.S. Trust. The amount outstanding under this facility
was $30 million at March 31, 2005.
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. These Swaps are structured for U.S. Trust to receive a variable rate of
interest and pay a fixed rate of interest. At March 31, 2005, these Swaps have a
notional value of $650 million and a fair value of $13 million. For a complete
discussion of the Swaps with third parties, see note "13 - Financial Instruments
Subject to Off-Balance Sheet Risk, Credit Risk or Market Risk" in the Notes to
Condensed Consolidated Financial Statements.
U.S. Trust is subject to the Federal Reserve Board's risk-based and
leverage capital guidelines. These regulations require banks and bank holding
companies to maintain minimum levels of capital. In addition, USTC's depository
institution subsidiaries are subject to limitations on the amount of dividends
they can pay to USTC.
Schwab Bank
Schwab Bank's current liquidity needs are generally met through deposits
from banking clients and equity capital.
Certain Schwab brokerage clients can sweep the excess cash held in their
accounts into a money market deposit account at Schwab Bank. At March 31, 2005,
these balances totaled $4.3 billion.
Schwab Bank has access to traditional funding sources such as deposits,
federal funds purchased, and repurchase agreements. Additionally, CSC provides
Schwab Bank with a $100 million short-term credit facility maturing in December
2005. Borrowings under this facility do not qualify as regulatory capital for
Schwab Bank. No funds were drawn under this facility at March 31, 2005.
Schwab Bank maintains a credit facility with the FHLB. At March 31, 2005,
$316 million was available, and no funds were drawn under this facility.
Schwab Bank is subject to the same risk-based and leverage capital
guidelines as U.S. Trust (see discussion above), except that Schwab Bank is
subject to a minimum tier 1 leverage ratio of 8% for its first three years of
operations (i.e., through April 2006). 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 "Item 7 - Management's Discussion and Analysis of Results of
Operations and Financial Condition - Liquidity and Capital Resources - Liquidity
Risk Factors" in the Company's Annual Report on Form 10-K for the year ended
December 31, 2004. There have been no material changes to these liquidity risk
factors in the first quarter of 2005.
Cash and Capital Resources
The Company's cash position (reported as cash and cash equivalents on its
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, levels of capital expenditures,
acquisition activity, banking client deposit activity, brokerage and banking
client loan activity, financing activity in short-term borrowings and long-term
debt, payment of dividends, and repurchases of CSC's common stock. The
combination of these factors can cause significant fluctuations in the levels of
cash and cash equivalents during specific time periods. For example, cash and
cash equivalents during the first nine months of 2004 decreased by $689 million,
or 25%, to $2.1 billion, but during the full year 2004, cash and cash
equivalents decreased by just $7 million to $2.8 billion.
In the first quarter of 2005, cash and cash equivalents decreased
$638 million, or 23%, to $2.1 billion primarily due to increases in loans to
banking clients and securities available for sale, repurchases of common stock,
and movements of brokerage client-related funds to meet segregation
requirements. These decreases were partially offset by increases in deposits
from banking clients, primarily related to sweep money market deposit accounts,
and short-term borrowings. Management does not believe that the decline in cash
and cash equivalents in the first quarter of 2005 is an indication of a trend.
Certain Schwab brokerage clients can sweep the excess cash held in their
brokerage accounts into these money
- 21 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
market deposit accounts at Schwab Bank or U.S. Trust. At March 31, 2005, these
sweep deposit balances totaled $4.9 billion, up $330 million from December 31,
2004. This sweep deposit activity is reflected on the Company's condensed
consolidated statement of cash flows as a cash outflow from payables to
brokerage clients (classified as an operating activity) and a cash inflow to
deposits from banking clients (classified as a financing activity).
The Company's capital expenditures were $23 million in the first quarter of
2005 compared to $34 million in the first quarter of 2004, or 2% and 3% of
revenues for each period, respectively. Capital expenditures in the first
quarter of 2005 were primarily for software and equipment relating to the
Company's information technology systems. Capital expenditures as described
above include the capitalized costs for developing internal-use software of
$12 million in the first quarter of 2005 and $19 million in the first quarter of
2004.
The Company increased its short-term borrowings by $129 million during the
first quarter of 2005.
During the first quarter of 2005, 2 million of the Company's stock options,
with a weighted-average exercise price of $7.17, were exercised with cash
proceeds received by the Company of $12 million and a related tax benefit of
$2 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 quarter of 2005, CSC repurchased 21 million shares of its
common stock for $234 million. CSC did not repurchase any of its common stock in
the first quarter of 2004. As of March 31, 2005, CSC has no remaining authority
to repurchase its common stock.
During the first quarters of 2005 and 2004, the Company paid common stock
cash dividends of $26 million and $19 million, respectively.
The Company monitors both the relative composition and absolute level of
its capital structure. The Company's total financial capital (long-term debt
plus stockholders' equity) at March 31, 2005 was $4.9 billion, down
$119 million, or 2%, from December 31, 2004 primarily due to lower stockholders'
equity mainly resulting from repurchases of common stock. At March 31, 2005, the
Company had long-term debt of $577 million, or 12% of total financial capital,
that bears interest at a weighted-average rate of 7.08%. At March 31, 2005, the
Company's stockholders' equity was $4.3 billion, or 88% of total financial
capital.
Off-Balance-Sheet Arrangements
The Company enters into various off-balance-sheet arrangements in the
ordinary course of business. For discussion on the Company's off-balance-sheet
arrangements, see "Item 7 - Management's Discussion and Analysis of Results of
Operations and Financial Condition - Liquidity and Capital Resources" in the
Company's Annual Report on Form 10-K for the year ended December 31, 2004, and
note "12 - Commitments and Contingent Liabilities" in the Notes to Condensed
Consolidated Financial Statements.
Risk Management
For discussion on the Company's principal risks and some of the policies
and procedures for risk identification, assessment, and mitigation, see "Item 7
- - Management's Discussion and Analysis of Results of Operations and Financial
Condition - Risk Management" in the Company's Annual Report on Form 10-K for the
year ended December 31, 2004. See Liquidity and Capital Resources of this report
for a discussion on liquidity risk; and see Item 3 - Quantitative and
Qualitative Disclosures About Market Risk for additional information relating to
market risk.
Given the nature of the Company's revenues, expenses, and risk profile, the
Company's earnings and CSC's common stock price have been and may continue to be
subject to significant volatility from period to period. The Company's results
for any interim period are not necessarily indicative of results for a full year
or any other interim period. Risk is inherent in the Company's business.
Consequently, despite the Company's attempts to identify areas of risk, oversee
operational areas involving risk, and implement policies and procedures designed
to mitigate risk, there can be no assurance that the Company will not suffer
unexpected losses due to operating or other risks.
Critical Accounting Policies
Certain of the Company's accounting policies that involve a higher degree
of judgment and complexity are discussed in "Item 7 - Management's Discussion
and Analysis of Results of Operations and Financial Condition - Critical
Accounting Policies" in the Company's Annual Report on Form 10-K for the year
ended December 31, 2004. There have been no material changes to these critical
accounting policies during the first quarter of 2005.
- 22 -
THE CHARLES SCHWAB CORPORATION
Management's Discussion and Analysis of Financial
Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, and as Noted)
Forward-Looking Statements
In addition to historical information, 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 impact on the Company's results of
operations of recording stock option expense (see note "2 - New Accounting
Standards" in the Notes to Condensed Consolidated Financial Statements); the
impact of legal proceedings and contingent liabilities (see note "12 -
Commitments and Contingent Liabilities" in the Notes to Condensed Consolidated
Financial Statements and Part II - Other Information, Item 1 - Legal
Proceedings); net interest expense under interest rate swaps (see note "13 -
Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk or Market
Risk" in the Notes to Condensed Consolidated Financial Statements); the impact
of the firm-wide cost reduction effort on the Company's results of operations
(see Overview - Restructuring); sources of liquidity and capital (see Liquidity
and Capital Resources - Liquidity); and the Company's cash position and cash
flows (see Liquidity and Capital Resources - Cash and Capital Resources).
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 Quarterly
Report on 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, earnings and cash balances; the level of the Company's
stock repurchase activity; the amount of loans to the Company's banking and
brokerage clients; changes in revenues and profit margin due to cyclical
securities markets and fluctuations in interest rates; the level and continuing
volatility of equity prices; a significant downturn in the securities markets
over a short period of time or a sustained decline in securities prices, trading
volumes, and investor confidence; geopolitical developments affecting the
securities markets, the economy, and investor sentiment; the effects of the
Company's or its competitors pricing, product and service decisions; the
Company's ability to recognize the expected benefits of acquisitions or
dispositions; the effects of changes in taxation laws and regulations (including
tax rate changes, new tax laws and revised tax law interpretations), as well as
the effect of strategic transactions (including business combinations,
acquisitions, and dispositions) on the Company's effective income tax rate; 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; and intensified industry competition and consolidation.
-23-
THE CHARLES SCHWAB CORPORATION
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 $61 million and $54 million
at March 31, 2005 and December 31, 2004, 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 both March 31, 2005 and December 31, 2004, CSC had $386 million
aggregate principal amount of Medium-Term Notes outstanding, with fixed interest
rates ranging from 6.21% to 8.05%. CSC uses interest rate Swaps to effectively
convert the interest rate characteristics of $293 million of these Medium Term
Notes from fixed to variable. See "Interest Rate Swaps" below.
At both March 31, 2005 and December 31, 2004, 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 values of these
obligations at March 31, 2005 and December 31, 2004, based on estimates of
market rates for debt with similar terms and remaining maturities, approximated
their carrying amounts.
Interest Rate Swaps
As part of its consolidated asset and liability management process, the
Company utilizes Swaps to manage interest rate risk. For a discussion of such
Swaps, see note "13 - Financial Instruments Subject to Off-Balance Sheet Risk,
Credit Risk or Market Risk" in the Notes to Condensed Consolidated Financial
Statements.
Forward Sale and Interest Rate Lock Commitments
For a discussion of Schwab Bank's forward sale and interest rate lock
commitments related to its loans held for sale portfolio, see note "13 -
Financial Instruments Subject to Off-Balance Sheet Risk, Credit Risk or Market
Risk" in the Notes to Condensed Consolidated Financial Statements.
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 200 basis point increase or decrease in interest
rates relative to the Company's current base rate forecast on simulated net
interest revenue over the next twelve months at March 31, 2005 and December 31,
2004.
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March 31, December 31,
Percentage Increase (Decrease) 2005 2004
- --------------------------------------------------------------------------------
Increase of 200 basis points 4.8% 5.7%
Decrease of 200 basis points (4.7%) (5.9%)
- --------------------------------------------------------------------------------
While the simulations show a modest reduction in exposure to rate changes
at March 31, 2005 from December 31, 2004, the Company remains positioned to
experience increases in net interest revenue as rates rise and decreases as
rates fall.
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THE CHARLES SCHWAB CORPORATION
Item 4. Controls and Procedures
Evaluation of disclosure 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 defined in Rule 13a-15(e) under the Securities
Exchange Act of 1934) as of March 31, 2005. Based on this evaluation, the
Company's Chief Executive Officer and Chief Financial Officer have concluded
that as of March 31, 2005, the Company's disclosure controls and procedures were
not effective due to deficiencies in the Company's controls and procedures for
reporting compensation information for executive officers. Management identified
these deficiencies in March 2005, in the course of compiling compensation data
for the Company's 2005 proxy statement. These deficiencies, individually or in
the aggregate, do not affect the Company's financial statements and are not
material weaknesses or significant deficiencies in internal control over
financial reporting. The Company has been taking steps to enhance its disclosure
controls and procedures relating to executive compensation.
Changes in internal control over financial reporting: No change in the
Company's internal control over financial reporting (as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934) was identified during the
quarter ended March 31, 2005 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
CSC and its subsidiaries have been named as parties in various legal
actions, which include the matters described in the Company's Annual Report on
Form 10-K for the year ended December 31, 2004. It is inherently difficult to
predict the ultimate outcome of these matters, particularly in cases in which
claimants seek substantial or unspecified damages, and a substantial judgment,
settlement or penalty could be material to the Company's operating results for a
particular future period, depending on the Company's results for that period.
However, based on current information, it is the opinion of management, after
consultation with counsel, that the resolution of these matters will not have a
material adverse impact on the financial condition, results of operations, or
cash flows of the Company.
Subsequent event: As disclosed previously, during October 2004 a
consolidated amended class action complaint was filed in U.S. District court in
Maryland on behalf of purchasers of CSC stock, against CSC, Schwab, U.S. Trust
Company, National Association, United States Trust Company of New York and
certain current and former CSC and U.S. Trust officers and directors. Plaintiffs
had alleged violations of federal securities laws for failure to disclose
alleged improper mutual fund trading practices, and were seeking unspecified
compensatory damages. In April 2005, plaintiffs agreed to a voluntary dismissal
of these claims with prejudice.
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THE CHARLES SCHWAB CORPORATION
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
(c) Issuer Purchases of Equity Securities
The following table summarizes purchases made in the open market by or on
behalf of CSC of its common stock for each calendar month in the first quarter
of 2005.
- --------------------------------------------------------------------------------
(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
- --------------------------------------------------------------------------------
January 8 $11.33 8 $149
February 9 10.71 9 48
March 4 10.94 4 -
- --------------------------------------------------------------------------------
Total 21 $10.98 21 $ -
================================================================================
(1) All shares were repurchased under authorization by CSC's Board of Directors
covering up to $300 million of common stock publicly announced by the
Company on December 9, 2004.
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
None.
Item 6. Exhibits
The following exhibits are filed as part of this quarterly report on Form 10-Q.
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.274 Summary of Director Compensation.
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.
- --------------------------------------------------------------------------------
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THE CHARLES SCHWAB CORPORATION
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
THE CHARLES SCHWAB CORPORATION
(Registrant)
Date: May 9, 2005 /s/ Christopher V. Dodds
---------------------- ----------------------------
Christopher V. Dodds
Executive Vice President and
Chief Financial Officer
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