UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998 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)
101 Montgomery Street, San Francisco, CA 94104
(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 the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
267,284,289* shares of $.01 par value Common Stock
Outstanding on October 27, 1998
* Excludes the effects of the three-for-two common stock split declared
October 22, 1998, payable December 11, 1998.
THE CHARLES SCHWAB CORPORATION
THE CHARLES SCHWAB CORPORATION
Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 1998
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 4-6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 7-21
Item 3. Quantitative and Qualitative Disclosures About Market
Risk 21-22
Part II - Other Information
Item 1. Legal Proceedings 22
Item 2. Changes in Securities and Use of Proceeds 22
Item 3. Defaults Upon Senior Securities 22
Item 4. Submission of Matters to a Vote of Security Holders 22
Item 5. Other Information 22
Item 6. Exhibits and Reports on Form 8-K 22
Signature 23
FORWARD-LOOKING STATEMENTS In addition to historical information, this interim
report contains forward-looking statements that reflect management's
expectations. These statements relate to, among other things, Company
contingencies, strategy, revenues, profit margin, sources of liquidity, capital
expenditures, and the Year 2000 project. Achievement of the expressed
expectations is subject to certain risks and uncertainties that could cause
actual results to differ materially from those expectations. See "Description of
Business" in Management's Discussion and Analysis of Financial Condition and
Results of Operations in this interim report for a discussion of important
factors that may cause such differences.
THE CHARLES SCHWAB CORPORATION
Part 1 - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
THE CHARLES SCHWAB CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(In thousands, except per share amounts)
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
---- ---- ---- ----
Revenues
Commissions $ 337,031 $ 322,679 $ 934,208 $ 858,994
Mutual fund service fees 143,977 112,155 405,719 308,677
Interest revenue, net of interest expense(1) 124,346 94,013 345,214 253,221
Principal transactions 74,823 61,252 186,559 193,985
Other 25,094 21,740 75,937 63,400
- -----------------------------------------------------------------------------------------------------------------
Total 705,271 611,839 1,947,637 1,678,277
- -----------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 290,684 255,104 835,370 700,061
Communications 53,449 45,790 153,519 137,002
Occupancy and equipment 50,796 39,279 147,502 113,183
Advertising and market development 34,009 29,303 101,726 91,092
Depreciation and amortization 35,175 34,948 104,625 92,407
Commissions, clearance and floor brokerage 20,379 26,290 60,237 70,951
Professional services 22,240 19,865 63,720 50,319
Other 36,040 34,320 80,224 80,259
- -----------------------------------------------------------------------------------------------------------------
Total 542,772 484,899 1,546,923 1,335,274
- -----------------------------------------------------------------------------------------------------------------
Income before taxes on income 162,499 126,940 400,714 343,003
Taxes on income 64,727 50,415 158,622 135,781
- -----------------------------------------------------------------------------------------------------------------
Net Income $ 97,772 $ 76,525 $ 242,092 $ 207,222
=================================================================================================================
Weighted-average number of common shares outstanding(2, 3) 273,460 273,001 273,806 271,964
=================================================================================================================
Earnings Per Share (3)
Basic $ .37 $ .29 $ .92 $ .79
Diluted $ .35 $ .28 $ .88 $ .76
=================================================================================================================
Dividends Declared Per Common Share (3) $ .040 $ .033 $ .120 $ .099
=================================================================================================================
Pro forma weighted-average number of common shares
outstanding(2, 4) 410,190 409,501 410,709 407,946
=================================================================================================================
Pro Forma Earnings Per Share (4)
Basic $ .25 $ .20 $ .61 $ .53
Diluted $ .24 $ .19 $ .59 $ .51
=================================================================================================================
Pro Forma Dividends Declared Per Common Share (4) $ .027 $ .022 $ .080 $ .066
=================================================================================================================
(1) Interest revenue is presented net of interest expense. Interest expense for the three months ended
September 30, 1998 and 1997 was $166,780 and $142,338, respectively. Interest expense for the nine months
ended September 30, 1998 and 1997 was $483,018 and $398,594, respectively.
(2) Amounts shown are used to calculate diluted earnings per share.
(3) Excludes the effects of the three-for-two common stock split declared October 22, 1998, payable
December 11, 1998.
(4) Pro forma amounts include the effects of the three-for-two common stock split declared October 22, 1998,
payable December 11, 1998.
See Notes to Condensed Consolidated Financial Statements.
- 1 -
THE CHARLES SCHWAB CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEET
(In thousands, except per share amounts)
(Unaudited)
September 30, December 31,
1998 1997
---- ----
Assets
Cash and cash equivalents $ 1,020,972 $ 797,447
Cash and investments required to be segregated under federal or other
regulations (including resale agreements of $5,680,448 in 1998
and $4,707,187 in 1997) 7,765,920 6,774,024
Receivable from brokers, dealers and clearing organizations 331,388 267,070
Receivable from customers - net 8,940,251 7,751,513
Securities owned - at market value 212,538 282,569
Equipment, office facilities and property - net 389,784 342,273
Intangible assets - net 49,270 55,854
Other assets 135,890 210,957
- --------------------------------------------------------------------------------------------------------------
Total $18,846,013 $16,481,707
==============================================================================================================
Liabilities and Stockholders' Equity
Drafts payable $ 186,268 $ 268,644
Payable to brokers, dealers and clearing organizations 1,163,981 1,122,663
Payable to customers 15,347,265 13,106,202
Accrued expenses and other liabilities 491,589 478,032
Borrowings 351,002 361,049
- --------------------------------------------------------------------------------------------------------------
Total liabilities 17,540,105 15,336,590
- --------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940 shares authorized; $.01 par value
per share; none issued
Common stock - 500,000 shares authorized; $.01 par value per share;
267,688 shares issued in 1998 and 1997* 2,677 2,677
Additional paid-in capital 201,082 241,422
Retained earnings 1,165,827 955,496
Treasury stock - 852 shares in 1998 and 1,753 shares in 1997,
at cost* (28,049) (35,401)
Unearned ESOP shares (359) (2,769)
Unamortized restricted stock compensation (37,686) (17,228)
Foreign currency translation adjustment 2,416 920
- --------------------------------------------------------------------------------------------------------------
Total stockholders' equity 1,305,908 1,145,117
- --------------------------------------------------------------------------------------------------------------
Total $18,846,013 $16,481,707
==============================================================================================================
* Excludes the effects of the three-for-two common stock split declared October 22, 1998, payable
December 11, 1998.
See Notes to Condensed Consolidated Financial Statements.
- 2 -
THE CHARLES SCHWAB CORPORATION
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(In thousands)
(Unaudited)
Nine Months Ended
September 30,
1998 1997
---- ----
Cash flows from operating activities
Net income $ 242,092 $ 207,222
Noncash items included in net income:
Depreciation and amortization 104,625 92,407
Compensation payable in common stock 27,797 21,843
Deferred income taxes 16,362 (19,403)
Other 2,757 2,711
Change in securities owned - at market value 70,031 (48,303)
Change in other assets 58,488 34,343
Change in accrued expenses and other liabilities 58,463 121,178
- ----------------------------------------------------------------------------------------------------------
Net cash provided before change in customer-related balances 580,615 411,998
- ----------------------------------------------------------------------------------------------------------
Change in customer-related balances:
Cash and investments required to be segregated under
federal or other regulations (979,845) 638,761
Receivable from brokers, dealers and clearing organizations (60,529) (178,053)
Receivable from customers (1,187,221) (2,064,932)
Drafts payable (83,084) 6,776
Payable to brokers, dealers and clearing organizations 38,012 385,098
Payable to customers 2,227,345 1,123,564
- ----------------------------------------------------------------------------------------------------------
Net change in customer-related balances (45,322) (88,786)
- ----------------------------------------------------------------------------------------------------------
Net cash provided by operating activities 535,293 323,212
- ----------------------------------------------------------------------------------------------------------
Cash flows from investing activities
Purchase of equipment, office facilities and property - net (144,842) (103,215)
- ----------------------------------------------------------------------------------------------------------
Net cash used by investing activities (144,842) (103,215)
- ----------------------------------------------------------------------------------------------------------
Cash flows from financing activities
Proceeds from borrowings 30,000 61,000
Repayment of borrowings (40,047) (24,685)
Dividends paid (31,925) (26,382)
Purchase of treasury stock (147,884) (16,230)
Proceeds from stock options exercised and other 22,268 11,320
- ----------------------------------------------------------------------------------------------------------
Net cash provided (used) by financing activities (167,588) 5,023
- ----------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash and cash equivalents 662 (786)
- ----------------------------------------------------------------------------------------------------------
Increase in cash and cash equivalents 223,525 224,234
Cash and cash equivalents at beginning of period 797,447 633,317
- ----------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 1,020,972 $ 857,551
==========================================================================================================
See Notes to Condensed Consolidated Financial Statements.
- 3 -
THE CHARLES SCHWAB CORPORATION
NOTES TO CONDENSED
CONSOLIDATED FINANCIAL
STATEMENTS
(Unaudited)
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
include The Charles Schwab Corporation (CSC) and its subsidiaries (collectively
referred to as the Company). CSC is a holding company engaged, through its
subsidiaries, in securities brokerage and related financial services. CSC's
principal subsidiary, Charles Schwab & Co., Inc. (Schwab), is a securities
broker-dealer with 279 domestic branch offices in 47 states, as well as a branch
in the Commonwealth of Puerto Rico, the United Kingdom and the U.S. Virgin
Islands. Another subsidiary, Mayer & Schweitzer, Inc. (M&S), a market maker in
Nasdaq and other securities, provides trade execution services to
broker-dealers, including Schwab, and institutional customers. Other
subsidiaries include Charles Schwab Investment Management, Inc., the investment
advisor for Schwab's proprietary mutual funds, and Charles Schwab Europe, a
retail discount securities brokerage firm located in the United Kingdom.
These financial statements have been prepared pursuant to the rules and
regulations of the Securities and Exchange Commission 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. All adjustments were
of a normal recurring nature. 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 1997 Annual Report to Stockholders, which are
incorporated by reference in the Company's 1997 Annual Report on Form 10-K and
the Company's Quarterly Reports on Form 10-Q for the periods ended March 31,
1998 and June 30, 1998. The Company's results for any interim period are not
necessarily indicative of results for a full year.
Certain items in prior periods' financial statements have been
reclassified to conform to the 1998 presentation.
New Accounting Standards
Statement of Financial Accounting Standards (SFAS) No. 125 -- Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities, was adopted by the Company in 1997, except for certain financial
assets for which the effective date had been delayed by SFAS No. 127 -- Deferral
of the Effective Date of Certain Provisions of FASB Statement No. 125, which was
adopted by the Company effective January 1, 1998. SFAS No. 125 provides
accounting and reporting standards for transfers and servicing of financial
assets and extinguishments of liabilities. The adoption of these statements did
not have an effect on the Company's financial position, results of operations,
earnings per share or cash flows.
SFAS No. 130 -- Reporting Comprehensive Income, was adopted by the Company
effective January 1, 1998. This statement establishes standards for the
reporting and display of comprehensive income, which includes net income and
changes in equity except those resulting from investments by, or distributions
to, stockholders. Comprehensive income is as follows (in thousands):
- ---------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
1998 1997 1998 1997
- ---------------------------------------------------------------------------
Net income $ 97,772 $ 76,525 $242,092 $207,222
Foreign currency
translation adjustment 898 (1,717) 1,496 (3,368)
- ---------------------------------------------------------------------------
Total comprehensive
income $ 98,670 $ 74,808 $243,588 $203,854
===========================================================================
SFAS No. 131 -- Disclosures about Segments of an Enterprise and Related
Information, was issued in 1997 and the Company is required to adopt this
statement at December 31, 1998. This statement establishes standards for
disclosures related to business operating segments. The adoption of this
statement will not have an effect on the Company's financial position, results
of operations, earnings per share or cash flows, but will impact financial
statement disclosure.
SFAS No. 133 -- Accounting for Derivative Instruments and Hedging
Activities, was issued in June 1998 and the Company is required to adopt this
statement by January 1, 2000. This statement establishes accounting and
reporting standards requiring that every derivative instrument be recorded on
the balance sheet as either an asset or liability, measured at its fair value.
The statement requires that changes in the derivative's fair value be recognized
currently in earnings unless specific hedge accounting criteria are met. While
the Company is currently evaluating the effects of this statement, its adoption
is not expected to have an impact on the Company's financial position, results
of operations, earnings per share or cash flows.
Statement of Position 98-1 -- Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use, was issued in March 1998 and is
effective for fiscal years beginning after December 15, 1998. This statement
requires that certain costs incurred for purchasing or developing software for
internal use be capitalized and amortized over the software's useful life.
Currently, the Company capitalizes costs incurred for purchasing software for
internal use, but expenses costs incurred for developing software for internal
use. While the Company is currently evaluating the effects of this statement,
its adoption is expected to have an impact on the Company's financial position,
results of operations, and earnings per share.
Earnings Per Share
SFAS No. 128 -- Earnings Per Share, requires a dual presentation of basic
and diluted earnings per share (EPS). 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. Earnings per share under the basic and
diluted computations are as follows (in thousands, except per share amounts):
- -------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
1998 1997 1998 1997
- -------------------------------------------------------------------------
Net income $ 97,772 $ 76,525 $242,092 $207,222
=========================================================================
Basic Shares (1):
Weighted-average
common shares
outstanding 264,562 262,787 264,387 262,106
=========================================================================
Diluted Shares (1):
Weighted-average
common shares
outstanding 264,562 262,787 264,387 262,106
Common stock
equivalent shares
related to stock
incentive plans 8,898 10,214 9,419 9,858
- -------------------------------------------------------------------------
Diluted weighted-
average common
shares outstanding 273,460 273,001 273,806 271,964
=========================================================================
Basic EPS (1) $ .37 $ .29 $ .92 $ .79
=========================================================================
Diluted EPS (1) $ .35 $ .28 $ .88 $ .76
=========================================================================
(1) Excludes the effects of the three-for-two common stock split declared
October 22, 1998, payable December 11, 1998.
Regulatory Requirements
Schwab and M&S are subject to the Uniform Net Capital Rule under the
Securities Exchange Act of 1934 (the Rule) and each compute net capital under
the alternative method permitted by this Rule, which requires the maintenance of
minimum net capital, as defined, of the greater of 2% of aggregate debit
balances arising from customer transactions or a minimum dollar amount, which is
based on the type of business conducted by the broker-dealer. The minimum dollar
amount for both Schwab and M&S is $1 million. Under the alternative method, a
broker-dealer may not repay subordinated borrowings, pay cash dividends, or make
any unsecured advances or loans to its parent or employees if such payment would
result in net capital of less than 5% of aggregate debit balances or less than
120% of its minimum dollar amount requirement. At September 30, 1998, Schwab's
net capital was $943 million (11% of aggregate debit balances), which was $764
million in excess of its minimum required net capital and $495 million in excess
of 5% of aggregate debit balances. At September 30, 1998, M&S' net capital was
$29 million (2,168% of aggregate debit balances), which was $28 million in
excess of its minimum required net capital.
Schwab and Charles Schwab Europe had portions of their cash and
investments segregated for the exclusive benefit of customers at September 30,
1998, in accordance with applicable regulations. M&S had no such cash reserve
requirement at September 30, 1998.
Commitments and Contingent Liabilities
Between August 12, 1993 and November 17, 1995, Schwab was named as a
defendant in eleven class action lawsuits in seven states. The class actions all
purport to be brought on behalf of customers of Schwab who purchased or sold
securities for which Schwab received "order flow" payments from the market
maker, stock dealer or third party who executed the transaction. The complaints
generally allege that Schwab failed to disclose and remit such payments to
members of the class, and generally seek damages equal to the payments received
by Schwab. Through September 1998, one of the actions was voluntarily dismissed
and six were resolved favorably to Schwab on the grounds that the claims
asserted are preempted by federal law. The remaining four cases are pending in
state courts in California, Texas and Louisiana. On October 5, 1998, the
California Court of Appeals affirmed the dismissal of the action in that state.
The Texas action and one of the two Louisiana actions are stayed and there has
been no recent activity in the other Louisiana action.
The ultimate outcome of the legal proceedings described above and the
various other civil actions, arbitration proceedings, and claims pending against
the Company cannot be determined at this time, and the results of these legal
proceedings cannot be predicted with certainty. There can be no assurance that
these legal proceedings will not have a material adverse effect on the Company's
results of operations in any future period, depending partly on the results for
that period, and a substantial judgment could have a material adverse impact on
the Company's financial condition and results of operations. However, it is the
opinion of management, after consultation with outside legal counsel, that the
ultimate outcome of these actions will not have a material adverse impact on the
financial condition or operating results of the Company.
Supplemental Cash Flow Information
Certain information affecting the cash flows of the Company follows (in
thousands):
- --------------------------------------------------------
Nine Months Ended
September 30,
1998 1997
- --------------------------------------------------------
Income taxes paid $ 98,382 $112,338
========================================================
Interest paid:
Customer cash balances $427,595 $349,912
Stock-lending activities 30,039 27,086
Borrowings 24,024 18,602
Other 7,899 6,127
- --------------------------------------------------------
Total interest paid $489,557 $401,727
========================================================
Subsequent Events
During the period October 1 through October 27, 1998, the Company
repurchased and recorded as treasury stock a total of 66,500 shares of its
common stock for approximately $2 million. As of October 27, 1998, authorization
granted by the Company's Board of Directors allows for future repurchases of
816,900 shares.
On October 22, 1998, the Board of Directors approved a three-for-two split
of the Company's common stock, which will be effected in the form of a 50% stock
dividend. The stock dividend is payable December 11, 1998 to stockholders of
record November 13, 1998. Share and per share data have not been restated to
reflect this transaction.
On October 22, 1998, the Board of Directors increased the quarterly cash
dividend from $.040 per share to $.042 per share payable November 27, 1998 to
stockholders of record November 13, 1998.
THE CHARLES SCHWAB CORPORATION
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Description of Business
The Charles Schwab Corporation (CSC) and its subsidiaries (collectively
referred to as the Company) provide securities brokerage and related financial
services for 5.5 million active customer accounts(a). Customer assets were
$408.2 billion at September 30, 1998. CSC's principal subsidiary, Charles Schwab
& Co., Inc. (Schwab), is a securities broker-dealer with 279 domestic branch
offices in 47 states, as well as a branch in the Commonwealth of Puerto Rico,
the United Kingdom and the U.S. Virgin Islands. Another subsidiary, Mayer &
Schweitzer, Inc. (M&S), a market maker in Nasdaq and other securities, provides
trade execution services to broker-dealers and institutional customers. Other
subsidiaries include Charles Schwab Investment Management, Inc., the investment
advisor for Schwab's proprietary mutual funds, and Charles Schwab Europe, a
retail discount securities brokerage firm located in the United Kingdom.
- --------------------------------------------------------------------------------
(a) Accounts with balances or activity within the preceding twelve months.
Effective October 30, 1998, active customer accounts will be defined as accounts
with balances or activity within the preceding eight months. This change is
expected to decrease active customer accounts by approximately 100,000.
- --------------------------------------------------------------------------------
The Company's strategy is to attract and retain customer assets by
focusing on a number of areas within the financial services industry -- retail
brokerage, mutual funds, support services for independent investment managers,
equity securities market-making and 401(k) defined contribution plans. To pursue
its strategy and its objective of long-term profitable growth, the Company plans
to continue to leverage its competitive advantages. These advantages include a
nationally recognized brand, a broad range of products and services,
multi-channel delivery systems and an ongoing investment in technology.
The Company's nationwide advertising and marketing programs are designed
to distinguish the Schwab brand as well as its products and services. These
programs helped the Company open 278,000 new customer accounts and gather $19.3
billion in net new customer assets during the third quarter of 1998.
The Company offers a broad range of value-oriented products and services
to meet customers' varying investment and financial needs. The Company also
offers access to extensive investment news and information. The Company's branch
office network assists investors in developing asset allocation strategies and
evaluating their investment choices. Internet access is available to investors
at most of the branches. Branch staff also refer investors who desire additional
guidance to independent investment managers through the Schwab AdvisorSource(TM)
service. Schwab provides custodial, trading and support services to 5,400
independent investment managers. As of September 30, 1998, Schwab held $121.8
billion in customer assets in 647,000 accounts managed by these investment
managers. The Company's Mutual Fund Marketplace(R) provides customers with the
ability to invest in 1,550 mutual funds from 247 fund families, including 963
Mutual Fund OneSource(R) funds. During the third quarter of 1998, Schwab
introduced a new service that provides customers with access to debt
underwritings lead-managed by Credit Suisse First Boston.
The Company's multi-channel delivery systems allow customers to choose how
they prefer to do business with the Company. To enable customers to obtain
services in person with a Company representative, the Company maintains a
network of branch offices. Telephonic access to the Company is provided
primarily through four regional customer telephone service centers and two
online customer support centers that operate both during and after normal market
hours. Additionally, customers are able to obtain financial information and
execute trades on an automated basis through the Company's electronic brokerage
channels that provide both online and telephonic access. Online channels include
PC-based services such as SchwabLink(R) -- a service for investment managers,
and the Charles Schwab Web Site(TM) -- an information and trading service on the
Internet. Automated telephonic channels include TeleBroker(R) -- Schwab's
touch-tone telephone trading service, and VoiceBroker(TM) -- Schwab's voice
recognition quote and trading service. Schwab provides every retail customer
access to all delivery channels and flat-fee pricing for Internet-based trades.
The Company's ongoing investment in technology is a key element in
enhancing its delivery systems, providing fast and consistent customer service,
and reducing processing costs. The Company uses technology to empower its
customers to manage their financial affairs and is a forerunner in driving
technological advancements in the financial services industry. During the third
quarter of 1998, Schwab improved its Web site to provide online customers with
customized account information displays and a stock screening tool.
The Company's operations are highly dependent on the integrity of its
computer and technological systems and the Company's success depends, in part,
on its ability to make timely enhancements and additions to its technology to
anticipate customer demands. To the extent the Company experiences system
interruptions, errors or downtime (which could result from a variety of causes,
including changes in customer use patterns, technological failure, changes to
its systems, linkages with third-party systems, and power failures), the
Company's business and operations could be negatively impacted.
The Company faces significant competition from companies seeking to
attract customer financial assets, including full commission brokerage firms,
discount brokerage firms, mutual fund companies and banks. Certain of these
competitors have significantly greater financial resources than the Company,
particularly given the acceleration of the consolidation trend within the
financial services industry in the first nine months of 1998. In addition, the
recent expansion and customer acceptance of conducting financial transactions
online has attracted competition from providers of online services and software
development companies. In the first nine months of 1998, price competition
continued in the area of online investing as competitors sought to gain market
share in this rapidly growing area. Increased competition can be expected due to
the low barriers to entry for the establishment and operation of online
investment services. The Company experienced declines in its average commission
per revenue trade in the first nine months of 1998 mainly due to the Company's
integration of its online and traditional brokerage services and reduction of
the price of online trades for most of its customers, causing an increase in the
proportion of trades placed through its online brokerage channels. As the
Company focuses on further enhancements to its electronic service offering,
average commission per revenue trade is expected to continue to decline. These
competitive factors, pricing changes and trading trends may negatively impact
the Company's revenue growth and profit margin.
The Company's business, like that of other securities brokerage firms, is
directly affected by the fluctuations in securities trading volumes and price
levels that occur in fundamentally cyclical financial markets. Since
transaction-based revenues continue to represent a majority of the Company's
revenues, the Company may experience significant variations in revenues from
period to period.
The Company adjusts its expenses in anticipation of and in response to
changes in financial market conditions and customer trading patterns. Certain of
the Company's expenses (including variable compensation, portions of
communications, and commissions, clearance and floor brokerage) vary directly
with changes in financial performance or customer trading activity. Expenses
relating to the level of temporary employees, contractors, overtime hours,
professional services, and advertising and market development are adjustable
over the short term to help the Company achieve its financial objectives.
Additionally, developmental spending (including branch openings, product and
service rollouts, and certain information technology systems improvements) is
discretionary and can be altered in response to market conditions. However, a
significant portion of the Company's expenses such as salaries and wages,
occupancy and equipment, and depreciation and amortization do not vary directly,
at least in the short term, with fluctuations in revenues or securities trading
volumes. Also, the Company views its developmental spending as essential for
future growth and therefore attempts to avoid major adjustments in such spending
unless faced with a sustained slowdown in customer trading activity. Given the
nature of the Company's revenues and expenses, and the economic and competitive
factors discussed above, the Company's earnings and common stock price may 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.
In addition to historical information, this interim report contains
forward-looking statements that reflect management's expectations. These
statements relate to, among other things, Company contingencies (see
"Commitments and Contingent Liabilities" note in the Notes to Condensed
Consolidated Financial Statements), the Company's strategy, revenues and profit
margin (see Description of Business), sources of liquidity (see Liquidity and
Capital Resources-Liquidity), capital expenditures (see Liquidity and Capital
Resources-Cash Flows and Capital Resources), and the Year 2000 project (see
Liquidity and Capital Resources-Year 2000). Achievement of the expressed
expectations is subject to certain risks and uncertainties that could cause
actual results to differ materially from the expressed expectations. Important
factors that may cause such differences are noted throughout this interim report
and include, but are not limited to: the effect of customer trading patterns on
Company revenues and earnings; changes in technology; computer system failures;
risks associated with the Year 2000 computer system conversions; the effects of
competitors' pricing, product and service decisions and intensified competition;
evolving regulation and changing industry customs and practices adversely
affecting the Company; adverse results of litigation; changes in revenues and
profit margin due to cyclical securities markets and interest rates; and a
significant downturn in the securities markets over a short period of time or a
sustained decline in securities prices and trading volumes.
Three Months Ended September 30, 1998
Compared To Three Months Ended
September 30, 1997
Financial Overview
Net income for the third quarter of 1998 was a record $98 million, up 28%
from third quarter 1997 net income of $77 million. Diluted earnings per share
for the third quarters of 1998 and 1997 were $.35 and $.28 per share,
respectively. Share and per share data have not been restated to reflect the
effects of the three-for-two common stock split declared October 22, 1998,
payable December 11, 1998.
Third quarter 1998 revenues were a record $705 million, up 15% from $612
million for the third quarter of 1997, primarily due to a 28% increase in mutual
fund service fees and a 32% increase in interest revenue, net of interest
expense (referred to as net interest revenue). These increases mainly resulted
from increases in customer assets and margin loans to customers. During the
third quarter of 1998, total trading activity reached record levels as shown in
the following table (in thousands):
- -------------------------------------------------------------
Three Months
Ended
September 30, Percent
Daily Average Trades 1998 1997 Change
- -------------------------------------------------------------
Revenue Trades
Online 58.1 30.8 89%
TeleBroker(R) 8.1 12.9 (37)
Regional customer telephone
service centers, branch offices
and other 33.4 33.7 (1)
- -------------------------------------------------------------
Total 99.6 77.4 29%
=============================================================
Mutual Fund OneSource(R) Trades
Online 18.8 13.2 42%
TeleBroker 1.1 1.4 (21)
Regional customer telephone
service centers, branch offices
and other 22.4 20.2 11
- -------------------------------------------------------------
Total 42.3 34.8 22%
=============================================================
Total Daily Average Trades
Online 76.9 44.0 75%
TeleBroker 9.2 14.3 (36)
Regional customer telephone
service centers, branch offices
and other 55.8 53.9 4
- -------------------------------------------------------------
Total 141.9 112.2 26%
=============================================================
Assets in Schwab customer accounts were $408.2 billion at September 30,
1998, an increase of $63.5 billion, or 18%, from a year ago as shown in the
table below. This increase from September 30, 1997 resulted from net new
customer assets of $80.7 billion offset by net market losses of $17.2 billion.
- -----------------------------------------------------------
Growth in Schwab Customer
Assets and Accounts
(In billions, at quarter end, September 30, Percent
except as noted) 1998 1997 Change
- -----------------------------------------------------------
Assets in Schwab customer accounts
Schwab One(R) and other
cash equivalents (1) $ 14.7 $ 11.6 27%
SchwabFunds(R):
Money market funds (1) 63.0 46.4 36
Equity and bond funds 11.0 6.8 62
- -----------------------------------------------------------
Total SchwabFunds 74.0 53.2 39
- -----------------------------------------------------------
Mutual Fund Marketplace(R)(2):
Mutual Fund OneSource 59.0 56.9 4
All other 51.7 48.1 7
- -----------------------------------------------------------
Total Mutual Fund
Marketplace 110.7 105.0 5
Equity and other securities(2) 183.3 151.8 21
Fixed income securities 34.4 30.2 14
Margin loans outstanding (8.9) (7.1) 25
- -----------------------------------------------------------
Total $ 408.2 $ 344.7 18%
===========================================================
Net growth (decline) in assets
in Schwab customer accounts
(for the quarter ended)
Net new customer assets $ 19.3 $ 16.4 18%
Net market gains (losses) (38.6) 22.0 n/m
- -----------------------------------------------------------
Net growth (decline) $ (19.3) $ 38.4 n/m
===========================================================
New Schwab customer accounts
(in thousands, for the
quarter ended) 278.4 294.1 (5%)
Active Schwab customer accounts
(in millions) 5.5 4.6 20%
===========================================================
(1) Represents a component of customer cash and equivalents.
(2) Excludes money market funds and all of Schwab's proprietary
money market, equity and bond funds.
n/m Not meaningful.
Total operating expenses excluding interest during the third quarter of
1998 were $543 million, up 12% from $485 million for the third quarter of 1997,
primarily resulting from additional staff and related costs.
The after-tax profit margin for the third quarter of 1998 was 13.9%, up
from 12.5% for the third quarter of 1997. The annualized return on stockholders'
equity for the third quarter of 1998 was 31%, up from 30% for the third quarter
of 1997.
REVENUES
As the Company's mutual fund service fees and net interest revenue
continued to grow at rates that exceeded the growth rate of total revenues,
non-trading revenues increased to 41% of total revenues for the third quarter of
1998, from 37% for the third quarter of 1997 as shown in the table below.
- -------------------------------------------------------------
Three Months
Ended
September 30,
Composition of Revenues 1998 1997
- -------------------------------------------------------------
Commissions 48% 53%
Principal transactions 11 10
- -------------------------------------------------------------
Total trading revenues 59 63
- -------------------------------------------------------------
Mutual fund service fees 20 18
Net interest revenue 18 15
Other 3 4
- -------------------------------------------------------------
Total non-trading revenues 41 37
- -------------------------------------------------------------
Total 100% 100%
=============================================================
Commissions
Commission revenues for the Company were $337 million for the third
quarter of 1998, up $14 million, or 4%, from the third quarter of 1997. As shown
in the table below, the total number of revenue trades executed by the Company
has increased 29% as the Company's customer base has grown. Average commission
per revenue trade decreased 18%. This decrease was mainly due to the Company's
integration of its online and traditional brokerage services and reduction of
the price of online trades for most of its customers in the first quarter of
1998, causing an increase in the proportion of trades placed through its online
brokerage channels.
- -----------------------------------------------------------
Three Months
Commissions Earned Ended
on Customer Revenue September 30, Percent
Trades 1998 1997 Change
- -----------------------------------------------------------
Customer accounts that
traded during the quarter
(in thousands) 1,333 1,153 16%
Average customer
revenue trades
per account 4.78 4.30 11
Total revenue
trades (in thousands) 6,376 4,955 29
Average commission
per revenue trade $52.83 $64.61 (18)
Commissions earned
on customer revenue
trades (in millions) (1) $ 337 $ 320 5
===========================================================
(1) Excludes commissions on trades with specialists totaling
$3 million in the third quarter of 1997.
Schwab added 278,000 new customer accounts during the third quarter of
1998, a decrease of 5% from the 294,000 new accounts added during the third
quarter of 1997.
Mutual Fund Service Fees
Mutual fund service fees were $144 million for the third quarter of 1998,
up $32 million, or 28%, from the third quarter of 1997. This increase was
primarily due to a significant increase in customer assets in Schwab's
proprietary funds, collectively referred to as the SchwabFunds(R), as well as an
increase in customer assets in funds purchased through Schwab's Mutual Fund
OneSource(R) service (see Growth in Schwab Customer Assets and Accounts table in
Financial Overview). The Company earns mutual fund service fees for transfer
agent services, shareholder services, administration and investment management
provided to the SchwabFunds, as well as record keeping and shareholder services
provided to funds in the Mutual Fund OneSource service.
Net Interest Revenue
Net interest revenue was $124 million for the third quarter of 1998, up
$30 million, or 32%, from the third quarter of 1997 as shown in the following
table (in millions):
- ------------------------------------------------------------
Three Months
Ended
September 30,
1998 1997
- ------------------------------------------------------------
Interest Revenue
Margin loans to customers $ 181 $ 129
Investments, customer-related 96 99
Other 14 8
- ------------------------------------------------------------
Total 291 236
- ------------------------------------------------------------
Interest Expense
Customer cash balances 148 126
Stock-lending activities 10 10
Borrowings 7 5
Other 2 1
- ------------------------------------------------------------
Total 167 142
- ------------------------------------------------------------
Net interest revenue $ 124 $ 94
============================================================
Customer-related daily average balances, interest rates and average net
interest margin for the third quarters of 1998 and 1997 are summarized in the
following table (dollars in millions):
- -----------------------------------------------------------
Three Months Ended
September 30,
1998 1997
- -----------------------------------------------------------
Interest-Earning Assets (customer-related):
Margin loans to customers:
Average balance outstanding $ 9,359 $ 6,614
Average interest rate 7.69% 7.73%
Investments:
Average balance outstanding $ 7,195 $ 7,193
Average interest rate 5.24% 5.47%
Average yield on interest-earning assets 6.63% 6.55%
Funding Sources (customer-related
and other):
Interest-bearing customer cash balances:
Average balance outstanding $13,364 $10,943
Average interest rate 4.40% 4.56%
Other interest-bearing sources:
Average balance outstanding $ 1,341 $ 1,185
Average interest rate 4.32% 4.40%
Average noninterest-bearing portion $ 1,849 $ 1,679
Average interest rate on funding sources 3.90% 3.99%
Summary:
Average yield on interest-earning assets 6.63% 6.55%
Average interest rate on funding sources 3.90% 3.99%
- -----------------------------------------------------------
Average net interest margin 2.73% 2.56%
===========================================================
The increase in net interest revenue from the third quarter of 1997 was
primarily due to higher levels of margin loans to customers.
Principal Transactions
Principal transaction revenues were $75 million for the third quarter of
1998, up $14 million, or 22%, from the third quarter of 1997. This increase was
primarily due to greater share volume handled by M&S, partially offset by lower
average revenue per principal transaction (see discussion below). The remainder
of the increase was primarily due to higher revenues related to Schwab's
specialist operations.
Certain Securities and Exchange Commission (SEC) rules and rule
amendments, known as the Order Handling Rules, have significantly altered the
manner in which orders for both Nasdaq and exchange-listed securities are
handled. These rules were implemented in phases between January 20, 1997 and
October 13, 1997. Additionally, in June 1997, most major U.S. securities
markets, including Nasdaq and the New York Stock Exchange, Inc., began quoting
and trading securities in increments of one-sixteenth dollar per share instead
of one-eighth dollar per share for most securities, and these markets are
currently considering further reductions in the increments by which securities
are priced. Mainly as a result of these regulatory changes and changes in
industry customs and practices, average revenue per principal transaction
declined in the third quarter of 1998 as compared to the same period in 1997.
Average revenue per principal transaction increased, however, in the third
quarter of 1998 compared to the first and second quarters of 1998. Since the
change to trading securities in increments of one-sixteenth dollar per share was
implemented in June 1997 and the Order Handling Rules were not fully implemented
until October 1997, M&S' average revenue per principal transaction in 1998 has
been materially less than during comparable periods of 1997.
Expenses Excluding Interest
Compensation and benefits expense was $291 million for the third quarter
of 1998, up $36 million, or 14%, from the third quarter of 1997 primarily due to
a greater number of employees. The following table shows a comparison of certain
compensation and benefits components and employee data (in thousands):
- -------------------------------------------------------------
Three Months
Ended
September 30,
1998 1997
- -------------------------------------------------------------
Compensation and benefits expense as a
% of revenues 41% 42%
Variable compensation as a
% of compensation and benefits expense 25% 27%
Compensation for temporary employees,
contractors and overtime hours as a
% of compensation and benefits expense 14% 13%
Full-time equivalent employees(1) 13.0 12.0
Revenues per average full-time equivalent
employee $54.1 $52.2
=============================================================
(1) Includes full-time, part-time and temporary employees,
and persons employed on a contract basis.
Occupancy and equipment expense was $51 million in the third quarter of
1998, up $12 million, or 29%, from the third quarter of 1997. This increase was
primarily due to additional lease expenses on the Company's expanded office
space, as well as increased lease and maintenance expenses on data processing
equipment.
Commissions, clearance and floor brokerage expense was $20 million in the
third quarter of 1998, down $6 million, or 22%, from the third quarter of 1997.
This decrease was primarily due to a decrease in the fees paid by M&S to
broker-dealers for orders received for execution.
The Company's effective income tax rate for the third quarters of 1998 and
1997 was 39.8% and 39.7%, respectively.
Nine Months Ended September 30, 1998
Compared To Nine Months Ended
September 30, 1997
Financial Overview
Net income for the first nine months of 1998 was $242 million, up 17% from
net income for the first nine months of 1997 of $207 million. Diluted earnings
per share for the first nine months of 1998 and 1997 were $.88 and $.76 per
share, respectively.
Revenues for the first nine months of 1998 were $1,948 million, up 16%
from $1,678 million for the first nine months of 1997, primarily due to a 31%
increase in mutual fund service fees, a 36% increase in net interest revenue,
and a 9% increase in commission revenues. These increases mainly resulted from
increases in customer assets and margin loans to customers, as well as higher
trading volume. During the first nine months of 1998, trading activity reached
record levels as shown in the following table (in thousands):
- -------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Daily Average Trades 1998 1997 Change
- -------------------------------------------------------------
Revenue Trades
Online 50.0 24.9 101%
TeleBroker(R) 8.4 12.2 (31)
Regional customer telephone
service centers, branch offices
and other 32.7 32.8 ---
- -------------------------------------------------------------
Total 91.1 69.9 30%
=============================================================
Mutual Fund OneSource(R) Trades
Online 17.8 12.9 38%
TeleBroker 1.1 1.4 (21)
Regional customer telephone
service centers, branch offices
and other 21.9 20.2 8
- -------------------------------------------------------------
Total 40.8 34.5 18%
=============================================================
Total Daily Average Trades
Online 67.8 37.8 79%
TeleBroker 9.5 13.6 (30)
Regional customer telephone
service centers, branch offices
and other 54.6 53.0 3
- -------------------------------------------------------------
Total 131.9 104.4 26%
=============================================================
Total operating expenses excluding interest during the first nine months
of 1998 were $1,547 million, up 16% from $1,335 million for the first nine
months of 1997, primarily resulting from additional staff and related costs.
The after-tax profit margin for the first nine months of 1998 was 12.4%,
up from 12.3% for the first nine months of 1997. The annualized return on
stockholders' equity for the first nine months of 1998 was 26%, down from 29%
for the first nine months of 1997, reflecting the Company's higher equity base
in the first nine months of 1998.
REVENUES
As the Company's mutual fund service fees and net interest revenue
continued to grow at rates that exceeded the growth rate of total revenues,
non-trading revenues increased to 42% of total revenues for the first nine
months of 1998, from 37% for the first nine months of 1997 as shown in the table
below.
- -------------------------------------------------------------
Nine Months
Ended
September 30,
Composition of Revenues 1998 1997
- -------------------------------------------------------------
Commissions 48% 51%
Principal transactions 10 12
- -------------------------------------------------------------
Total trading revenues 58 63
- -------------------------------------------------------------
Mutual fund service fees 21 18
Net interest revenue 18 15
Other 3 4
- -------------------------------------------------------------
Total non-trading revenues 42 37
- -------------------------------------------------------------
Total 100% 100%
=============================================================
Commissions
Commission revenues for the Company were $934 million for the first nine
months of 1998, up $75 million, or 9%, from the first nine months of 1997. As
shown in the table below, the total number of revenue trades executed by the
Company has increased 30% as the Company's customer base has grown. Average
commission per revenue trade decreased 16%. This decrease was mainly due to the
Company's reduction of the price of online trades described in the comparison
between the three-month periods.
- ---------------------------------------------------------
Nine Months
Commissions Earned Ended
on Customer Revenue September 30, Percent
Trades 1998 1997 Change
- ---------------------------------------------------------
Customer accounts that
traded during the period
(in thousands) 2,405 2,028 19%
Average customer
revenue trades
per account 7.12 6.51 9
Total revenue
trades (in thousands) 17,131 13,206 30
Average commission
per revenue trade $ 54.48 $ 64.59 (16)
Commissions earned
on customer revenue
trades (in millions) (1) $ 933 $ 853 9
=========================================================
(1) Excludes commissions on trades with specialists totaling
$1 million in the first nine months of 1998 and $6 million
in the first nine months of 1997.
Schwab added 984,000 new customer accounts during the first nine months of
1998, an increase of 12% from the 881,000 new accounts added during the first
nine months of 1997.
Mutual Fund Service Fees
Mutual fund service fees were $406 million for the first nine months of
1998, up $97 million, or 31%, from the first nine months of 1997. This increase
was generally attributable to the factors described in the comparison between
the three-month periods.
Net Interest Revenue
Net interest revenue was $345 million for the first nine months of 1998,
up $92 million, or 36%, from the first nine months of 1997 as shown in the
following table (in millions):
- ------------------------------------------------------------
Nine Months
Ended
September 30,
1998 1997
- ------------------------------------------------------------
Interest Revenue
Margin loans to customers $ 499 $ 339
Investments, customer-related 290 290
Other 39 23
- ------------------------------------------------------------
Total 828 652
- ------------------------------------------------------------
Interest Expense
Customer cash balances 428 350
Stock-lending activities 30 28
Borrowings 19 14
Other 6 7
- ------------------------------------------------------------
Total 483 399
- ------------------------------------------------------------
Net interest revenue $ 345 $ 253
============================================================
Customer-related daily average balances, interest rates and average net
interest margin for the first nine months of 1998 and 1997 are summarized in the
following table (dollars in millions):
- -----------------------------------------------------------
Nine Months Ended
September 30,
1998 1997
- -----------------------------------------------------------
Interest-Earning Assets (customer-related):
Margin loans to customers:
Average balance outstanding $ 8,678 $ 5,917
Average interest rate 7.69% 7.66%
Investments:
Average balance outstanding $ 7,280 $ 7,205
Average interest rate 5.32% 5.37%
Average yield on interest-earning assets 6.61% 6.40%
Funding Sources (customer-related
and other):
Interest-bearing customer cash balances:
Average balance outstanding $12,838 $10,486
Average interest rate 4.46% 4.47%
Other interest-bearing sources:
Average balance outstanding $ 1,295 $ 1,091
Average interest rate 4.39% 4.45%
Average noninterest-bearing portion $ 1,825 $ 1,545
Average interest rate on funding sources 3.94% 3.94%
Summary:
Average yield on interest-earning assets 6.61% 6.40%
Average interest rate on funding sources 3.94% 3.94%
- -----------------------------------------------------------
Average net interest margin 2.67% 2.46%
===========================================================
The increase in net interest revenue from the first nine months of 1997
was primarily due to higher levels of margin loans to customers.
Principal Transactions
Principal transaction revenues were $187 million for the first nine months
of 1998, down $7 million, or 4%, from the first nine months of 1997. This
decrease was due to lower average revenue per principal transaction (see
discussion in the comparison between the three-month periods), partially offset
by greater share volume handled by M&S, higher revenues related to Schwab's
specialist operations, and increased revenues from customer trading in fixed
income securities for which Schwab earns a mark-up.
Expenses Excluding Interest
Compensation and benefits expense was $835 million for the first nine
months of 1998, up $135 million, or 19%, from the first nine months of 1997
primarily due to a greater number of employees. The following table shows a
comparison of certain compensation and benefits components and employee data (in
thousands):
- --------------------------------------------------------------
Nine Months
Ended
September 30,
1998 1997
- --------------------------------------------------------------
Compensation and benefits expense as a
% of revenues 43% 42%
Variable compensation as a
% of compensation and benefits expense 22% 23%
Compensation for temporary employees,
contractors and overtime hours as a
% of compensation and benefits expense 14% 14%
Full-time equivalent employees(1) 13.0 12.0
Revenues per average full-time equivalent
employee $148.0 $148.8
==============================================================
(1) Includes full-time, part-time and temporary employees, and
persons employed on a contract basis.
Occupancy and equipment expense was $148 million for the first nine months
of 1998, up $34 million, or 30%, from the first nine months of 1997. This
increase was generally attributable to the factors described in the comparison
between the three-month periods.
Commissions, clearance and floor brokerage expense was $60 million for the
first nine months of 1998, down $11 million, or 15%, from the first nine months
of 1997. This decrease was generally attributable to the factors described in
the comparison between the three-month periods.
The Company's effective income tax rate for both of the first nine months
of 1998 and 1997 was 39.6%.
Liquidity and Capital Resources
Liquidity
Schwab
Liquidity needs relating to customer trading and margin borrowing
activities are met primarily through cash balances in customer accounts, which
were $14.8 billion and $12.7 billion at September 30, 1998 and December 31,
1997, respectively. Earnings from Schwab's operations are the primary source of
liquidity for capital expenditures and investments in new services, marketing,
and technology. Management believes that customer cash balances and operating
earnings will continue to be the primary sources of liquidity for Schwab in the
future.
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 amount requirement of $1
million. At September 30, 1998, Schwab had $943 million of net capital (11% of
aggregate debit balances), which was $764 million in excess of its minimum
required net capital and $495 million in excess of 5% of aggregate debit
balances. Schwab has historically targeted net capital to be 10% of its
aggregate debit balances, which primarily consist of customer margin loans. To
achieve this target, as customer margin loans have grown, a larger portion of
cash flows have been retained to support aggregate debit balances.
To manage Schwab's regulatory capital position, CSC provides Schwab with a
$450 million subordinated revolving credit facility maturing in September 1999,
of which $380 million was outstanding at September 30, 1998. At quarter end,
Schwab also had outstanding $25 million in fixed-rate subordinated term loans
from CSC maturing in 2000. Borrowings under these subordinated lending
arrangements qualify as regulatory capital for Schwab.
For use in its brokerage operations, Schwab maintained uncommitted,
unsecured bank credit lines totaling $570 million at September 30, 1998. Schwab
used such borrowings for six days during the first nine months of 1998, with the
daily amounts borrowed averaging $87 million. These lines were unused at
September 30, 1998.
To satisfy the margin requirement of customer option transactions with the
Options Clearing Corporation, Schwab had unsecured letter of credit agreements
with six banks totaling $550 million at September 30, 1998. Schwab pays a fee to
maintain these letter of credit agreements. No funds were drawn under these
agreements during the first nine months of 1998.
M&S
M&S' liquidity needs are generally met through earnings generated by its
operations. Most of M&S' assets are liquid, consisting primarily of cash and
cash equivalents, marketable securities, and receivable from brokers, dealers
and clearing organizations.
M&S' liquidity is affected by the same net capital regulatory requirements
as Schwab (see discussion above). At September 30, 1998, M&S had $29 million of
net capital (2,168% of aggregate debit balances), which was $28 million in
excess of its minimum required net capital.
M&S may borrow up to $35 million under a subordinated lending arrangement
with CSC. Borrowings under this arrangement qualify as regulatory capital for
M&S. This facility was unused during the first nine months of 1998.
CSC
CSC's liquidity needs are generally met through cash generated by its
subsidiaries, as well as cash provided by external financing. As discussed
above, Schwab and M&S 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 and maintaining Schwab's
and M&S' net capital.
CSC has liquidity needs that arise from its issued and outstanding $351
million Senior Medium-Term Notes, Series A (Medium-Term Notes), as well as from
the funding of cash dividends, common stock repurchases, and acquisitions. The
Medium-Term Notes have maturities ranging from 1999 to 2008 and fixed interest
rates ranging from 5.78% to 7.72% with interest payable semiannually. The
Medium-Term Notes are rated A3 by Moody's Investors Service and A- by Standard &
Poor's Ratings Group.
On July 8, 1998, the SEC declared effective CSC's registration statement
covering the issuance of up to an additional $150 million in Senior or Senior
Subordinated Medium-Term Notes, Series A, bringing the aggregate principal
amount of such notes available to be issued to $205 million. At September 30,
1998, $205 million of these notes remained unissued.
CSC may borrow under committed, unsecured credit facilities aggregating
$350 million with a group of 10 banks. One-half of the commitments under these
facilities expires in June 1999, and the other half expires in June 2001. The
funds are available for general corporate purposes for which CSC pays a
commitment fee on the unused balance. The terms of these facilities require CSC
to maintain minimum levels of stockholders' equity, and Schwab and M&S to
maintain specified levels of net capital, as defined. The Company believes that
these restrictions will not have a material effect on its ability to meet future
dividend or funding requirements. These facilities were unused during the first
nine months of 1998.
Cash Flows and Capital Resources
Net income plus depreciation and amortization was $347 million for the
first nine months of 1998, up 16% from $300 million for the first nine months of
1997, allowing the Company to finance its operations primarily with internally
generated funds. Depreciation and amortization expense related to equipment,
office facilities and property was $97 million for the first nine months of
1998, as compared to $80 million for the first nine months of 1997, or 5% of
revenues for each period. Amortization expense related to intangible assets was
$8 million for the first nine months of 1998, as compared to $12 million for the
first nine months of 1997.
The Company's capital expenditures were $145 million in the first nine
months of 1998 and $103 million in the first nine months of 1997, or 7% and 6%
of revenues for each period, respectively. Capital expenditures in the first
nine months of 1998 were for equipment relating to the Company's information
technology systems, leasehold improvements, and additional office furniture and
equipment. The Company opened seven new domestic branch offices during the first
nine months of 1998, compared to 27 domestic branch offices opened during the
first nine months of 1997. Capital expenditures may vary from period to period
as business conditions change.
The Company issued $30 million and repaid $40 million in Medium-Term Notes
during the first nine months of 1998.
During the first nine months of 1998, 4,301,900 of the Company's stock
options, with a range of exercise prices from $1.28 to $30.96, were exercised
with cash proceeds received by the Company of $22 million.
During the first nine months of 1998, the Company repurchased 4,103,200
shares of its common stock for $148 million. During the full year of 1997, the
Company repurchased 820,000 shares of its common stock for $18 million. From the
inception of the repurchase plan in 1988 through September 30, 1998, the Company
has repurchased 44,210,400 shares of its common stock for $312 million. See
"Subsequent Events" note in Item 1. Notes to Condensed Consolidated Financial
Statements.
In October 1998, the Board of Directors approved a three-for-two split of
the Company's common stock, which will be effected in the form of a 50% stock
dividend. The stock dividend is payable December 11, 1998 to stockholders of
record November 13, 1998. Share and per share data have not been restated to
reflect this transaction.
During the first nine months of 1998, the Company paid common stock cash
dividends totaling $32 million, up from $26 million paid during the first nine
months of 1997. See "Subsequent Events" note in Item 1. Notes to Condensed
Consolidated Financial Statements.
The Company monitors both the relative composition and absolute level of
its capital structure. The Company's total financial capital (borrowings plus
stockholders' equity) at September 30, 1998 was $1,657 million, up $151 million,
or 10% from December 31, 1997. At September 30, 1998, the Company had borrowings
of $351 million, or 21% of total financial capital, that bear interest at a
weighted-average rate of 6.70%. At September 30, 1998, the Company's
stockholders' equity was $1,306 million, or 79% of total financial capital.
Year 2000
Many existing computer programs use only two digits to identify a specific
year and therefore may not accurately recognize the upcoming change in the
century. If not corrected, many computer applications could fail or create
erroneous results by or at the year 2000. Due to the Company's dependence on
computer technology to operate its business, and the dependence of the financial
services industry on computer technology, the nature and impact of Year 2000
processing failures on the Company's business, financial position, results of
operations or cash flows could be material. The Company is currently modifying
its computer systems in order to enable its systems to process data and
transactions incorporating year 2000 dates without material errors or
interruptions. Because systems critical to the Company's functioning other than
its computer systems may be affected by the century change, the Company's Year
2000 compliance efforts also encompass facilities and equipment which rely on
date-dependent technology, such as, building equipment that contains embedded
technology.
Status of Compliance Efforts
The Company's Year 2000 compliance efforts are directed towards defined
categories of actions, which include awareness, inventory, assessment,
remediation, testing, installation, contingency planning and vendor management.
With respect to particular business units, the work associated with those
categories may be performed in phases or simultaneously with other categories of
Year 2000 tasks, depending on the nature of the work to be performed and the
technology and business requirements of the specific business unit. For
instance, the Company's contingency planning efforts continue simultaneously
with remediation efforts, but inventory efforts generally constituted a phase
undertaken prior to assessment.
Currently, the focus of the Company's efforts is the completion of
remediation and testing, and continuing contingency planning and vendor
management efforts. The Company anticipates that work on the awareness,
contingency planning, and vendor management phases of the project will continue
through the century change. The Company anticipates that the installation,
remediation and testing will be completed by mid-1999. The Company's domestic
subsidiaries which will be participating in the industry-wide test sponsored by
the Securities Industry Association in the first half of 1999 are implementing
plans to be prepared to participate in the tests.
The Company's vendor management initiatives include creating inventories
of vendors, analyzing the results of the inventories to assess the criticality
of specific vendor relationships in order to formulate plans for dealing with
possible Year 2000 issues, inquiring directly as to the status of vendors' Year
2000 compliance efforts, and continuing contacts with vendors to monitor the
progress of vendors who may not yet have achieved Year 2000 compliance. These
initiatives also include joint testing with selected critical vendors, joint
contingency planning with selected critical vendors, and addressing Year 2000
concerns with new vendors. The vendor management initiatives include computer
system vendors as well as vendors of goods and services which comprise or rely
upon date-dependent technology, such as embedded technology.
The success of the Company's Year 2000 compliance efforts depends in part
on parallel efforts being undertaken by vendors and other third parties with
which the Company's systems interact and therefore, the Company is taking steps
to determine the status of critical third parties' Year 2000 compliance. There
can be no assurance that all such third parties will provide accurate and
complete information, or that all their systems in fact will achieve full Year
2000 compliance. Third parties' Year 2000 processing failures might have a
material adverse impact on the Company's systems and operations. The Company's
plan may be affected by regulatory changes, changes in industry customs and
practices, and significant systems modifications unrelated to the Year 2000
project including upgrades and additions to capacity, and the cost and continued
availability of qualified personnel and other resources.
The progress of the Company's Year 2000 compliance efforts is managed and
reviewed by senior management and by the Company's Year 2000 Corporate Steering
Committee, which is responsible for maintaining awareness of Year 2000 issues
throughout the Company, monitoring overall progress of the project, resolving
issues, and providing strategic direction. The Company's Board of Directors
receives regular status reports on the project.
Contingency Planning and Risks
The Company commenced its contingency planning efforts in 1997. Its
contingency planning process is intended to create, update, and implement, as
necessary, plans in the event of Year 2000 errors or failures of third parties
with whom the Company interacts or who supply critical services or goods to the
Company, or of the Company itself.
In management's opinion, currently there is not sufficient reliable
information available to enable the Company to determine whether any specific
Year 2000 failures are reasonably likely to occur. The Company continues to take
steps to reduce this uncertainty by participating in industry conferences,
communicating with business alliance partners, monitoring the progress of
critical vendors, monitoring national and international governmental and
industry initiatives, and working with professional consultants and advisors.
Given the uncertainty of predicting at this point which, if any, Year 2000
errors or failures are reasonably likely to occur, the Company's contingency
planning process targets systems, transactions, processes, and third parties in
the light of their respective criticality to the Company's business, results of
operations, or financial condition.
Compliance Cost Estimates
The Company currently estimates that it will cost approximately $42
million to $50 million to modify its core brokerage computer systems, which
include Schwab's critical trading systems and certain additional systems, to be
Year 2000 compliant. The Company currently estimates that the cost of completing
the Company's entire Year 2000 project, including core brokerage computer
systems, distributed applications, facilities, and systems in subsidiaries other
than Schwab, but excluding potential costs related to the implementation of
contingency plans which address possible Year 2000 failures of third-party
systems or the Company's systems, is approximately $60 million to $75 million.
This estimate excludes the time that may be spent by management and
administrative staff not specifically dedicated to the Year 2000 project. As of
September 30, 1998, the Company had incurred approximately $34 million of the
estimated cost of the entire project.
The estimated cost and timing of the project are based on the Company's
estimates, which make numerous assumptions about future events. However, there
can be no assurance that these estimates will be correct and actual costs and
timing could differ materially from these estimates. The Company expects to fund
all Year 2000 related costs through operating cash flows and a reallocation of
the Company's overall developmental spending. This reallocation did not result
in the delay of any critical information technology projects. In accordance with
generally accepted accounting principles, Year 2000 expenditures will be
expensed as incurred.
European Economic and Monetary Union
On January 1, 1999, eleven of the fifteen member countries of the European
Union (referred to as the participating countries) are scheduled to establish
fixed conversion rates between their existing national currencies and the euro
and adopt the euro as their common legal currency. The United Kingdom is not a
participating country and will not change its national currency on January 1,
1999. As a retail discount securities brokerage firm in the United Kingdom,
Charles Schwab Europe will continue to trade securities in sterling, and does
not need to modify its information technology systems to accommodate the euro
conversion for its current business operations. Therefore, the euro conversion
is not expected to have a material financial impact on the Company based on its
current business operations.
Item 3. Quantitative and Qualitative
Disclosures About Market Risk
Financial Instruments Held For Trading Purposes
The Company held government and corporate fixed income securities with a
fair value of approximately $11 million at September 30, 1998. These securities,
and the associated interest rate risk, are not material to the Company's
financial position, results of operations or cash flows.
Through Schwab and M&S, the Company maintains inventories in
exchange-listed and Nasdaq equity securities on both a long and short basis. The
fair value of these securities at September 30, 1998 was $37 million in long
positions and $46 million in short positions. The potential loss or gain in fair
value, using a hypothetical 10% increase or decrease in prices, respectively, is
estimated to be approximately $900,000 due to the offset of change in fair value
in long and short positions. In addition, the Company generally enters into
exchange-traded option contracts to hedge against potential losses in equity
inventory positions. This hypothetical 10% change in fair value of these
securities at September 30, 1998 would not be material to the Company's
financial position, results of operations or cash flows. The notional amount of
option contracts was not material to the Company's consolidated balance sheet at
September 30, 1998.
Financial Instruments Held For Purposes Other Than Trading
For its working capital and reserves required to be segregated under
federal or other regulations, the Company invests in money market funds, resale
agreements, certificates of deposit, and commercial paper. Money market funds do
not have maturity dates and do not present a material market risk. The other
financial instruments, as shown in the following table, are fixed rate
investments with short maturities for which fair value approximates carrying
value and which do not present a material interest rate risk (dollars in
millions):
- -------------------------------------------------------------
Principal amount Fair
by maturity date value
Sep. 30, Sep. 30,
1999 Thereafter 1998
- -------------------------------------------------------------
Resale agreements $5,680 --- $5,680
Weighted-average
interest rate 5.43%
Certificates of deposit $1,559 --- $1,559
Weighted-average
interest rate 5.51%
Commercial paper $ 553 --- $ 553
Weighted-average
interest rate 5.82%
=============================================================
At September 30, 1998, CSC had $351 million aggregate principal amount of
Medium-Term Notes, with fixed interest rates ranging from 5.78% to 7.72%. The
Company has fixed cash flow requirements regarding these Medium-Term Notes due
to the fixed rate of interest. The fair value of these Medium-Term Notes at
September 30, 1998, based on estimates of market rates for debt with similar
terms and remaining maturities, approximated their carrying amount. The table
below presents the principal amount of these Medium-Term Notes by year of
maturity (dollars in millions):
- ------------------------------------------------------------
Year Ending Weighted-Average Principal
December 31, Interest Rate Amount
- ------------------------------------------------------------
1999 6.8% $ 40
2000 6.3% 48
2001 7.0% 39
2002 7.0% 40
2003 6.4% 43
Thereafter 6.7% 141
============================================================
The Company maintains investments in mutual funds, approximately $42
million at September 30, 1998, to fund obligations under its deferred
compensation plan, which is available to certain employees. Any decrease in the
fair value of these investments would be offset by a reduction in the deferred
compensation plan obligation and would not affect the Company's financial
position, results of operations or cash flows.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
The discussions of legal proceedings in Notes to Condensed Consolidated
Financial Statements, under "Commitments and Contingent Liabilities" in Part I -
Financial Information, Item 1., is incorporated herein by reference. See also
the Company's Quarterly Reports on Form 10-Q for the periods ended March 31,
1998 and June 30, 1998.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) The following exhibits are filed as part of this quarterly report on Form
10-Q.
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
3.9 Second Restated Bylaws, as amended on September 22, 1998, of the
Registrant (supersedes Exhibit 3.8 to the Registrant's Form 10-Q
for the quarter ended September 30, 1996).
10.199 The Charles Schwab Corporation Deferred Compensation Plan, as
amended through July 24, 1998 (supersedes Exhibit 10.162 to the
Registrant's Form 10-Q for the quarter ended September 30, 1996).
12.1 Computation of Ratio of Earnings to Fixed
Charges.
27.1 Financial Data Schedule (electronic only).
- --------------------------------------------------------------------------------
(b) Reports on Form 8-K
On July 17, 1998, the Registrant filed a Current Report on Form 8-K
relating to up to $205 million aggregate principal amount of debt
securities issuable by the Registrant pursuant to Registration Statement
Numbers 333-54001 and 333-12727 declared effective by the SEC on July 8,
1998 and November 1, 1996, respectively. Certain exhibits relating to the
Medium-Term Notes, Series A, which are issuable pursuant to the
Registration Statements, are contained in the Current Report.
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: November 10, 1998 /s/ Steven L. Scheid
----------------- -------------------------------------
Steven L. Scheid
Executive Vice President and
Chief Financial Officer