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, 2003March 31, 2004 Commission file number 1-9700
THE CHARLES SCHWAB CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware 94-3025021
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
120 Kearny Street, San Francisco, CA 94108
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (415) 627-7000
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X No
--- ---
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
1,356,592,5381,364,824,930 shares of $.01 par value Common Stock
Outstanding on October 31, 2003April 30, 2004
THE CHARLES SCHWAB CORPORATION
Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 2003March 31, 2004
Index
Page
----
Part I - Financial Information
Item 1. Condensed Consolidated Financial Statements:
Statement of Income 1
Balance Sheet 2
Statement of Cash Flows 3
Notes 4 - 11
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12 - 2922
Item 3. Quantitative and Qualitative Disclosures About Market Risk 2922 - 3124
Item 4. Controls and Procedures 3224
Part II - Other Information
Item 1. Legal Proceedings 3225 - 26
Item 2. Changes in Securities, and Use of Proceeds 32and Issuer Purchases
of Equity Securities 26
Item 3. Defaults Upon Senior Securities 3226
Item 4. Submission of Matters to a Vote of Security Holders 3226
Item 5. Other Information 3226
Item 6. Exhibits and Reports on Form 8-K 32 - 3326
Signature 3427
Part I - FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Income
(In millions, except per share amounts)
(Unaudited)
Three Months Ended
Nine Months Ended
September 30, September 30,March 31,
2004 2003 2002 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Revenues
Asset management and administration fees $ 467505 $ 431 $1,340 $1,316428
Commissions 320 305 873 893390 240
Interest revenue 236 287 719 899263 239
Interest expense (55) (83) (183) (264)
------- ------- ------- -------(53) (64)
------ ------
Net interest revenue 181 204 536 635210 175
Principal transactions 45 47 121 14752 33
Other 38 33 99 11424
- ------------------------------------------------------------------------------------------------------------------------------------
Total 1,051 1,020 2,969 3,1051,190 900
- ------------------------------------------------------------------------------------------------------------------------------------
Expenses Excluding Interest
Compensation and benefits 445 466 1,311 1,391
Other compensation - merger retention programs - - - 22528 417
Occupancy and equipment 108 109 330 338106 111
Depreciation and amortization 71 78 218 24059 76
Communications 62 62 180 19565 60
Professional services 60 37
Advertising and market development 32 50 101 153
Professional services 45 41 126 13462 48
Commissions, clearance and floor brokerage 21 19 54 53
Restructuring charges 37 159 61 18823 13
Impairment charges - - 5
-
Other 33 37 107 9540 36
- ------------------------------------------------------------------------------------------------------------------------------------
Total 854 1,021 2,493 2,809943 803
- ------------------------------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations before taxes on income and extraordinary gain 197 (1) 476 296247 97
Taxes on income (73) - (152) (110)(86) (23)
- ------------------------------------------------------------------------------------------------------------------------------------
Income (loss) from continuing operations before extraordinary gain 124 (1) 324 186
Gain (loss)161 74
Loss from discontinued operations, net of tax 3- (3) - (10)
Extraordinary gain on sale of corporate trust business, net of tax expense - - - 12
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income (Loss) $ 127161 $ (4) $ 324 $ 188
====================================================================================================================================71
===================================================================================================================================
Weighted-Average Common Shares Outstanding - Diluted 1,366 1,358 1,361 1,382
====================================================================================================================================1,375 1,357
- ------------------------------------------------------------------------------------------------------------------------------------
Earnings Per Share - Basic
Income (loss) from continuing operations before extraordinary gain $ .09 -.12 $ .24 $ .14
Gain (loss).05
Loss from discontinued operations, net of tax - -
- $ (.01)
Extraordinary gain, net of tax expense - - - $ .01
Net income (loss) $ .09 -.12 $ .24 $ .14.05
Earnings Per Share - Diluted
Income (loss) from continuing operations before extraordinary gain $ .09 -.12 $ .24 $ .14
Gain (loss).05
Loss from discontinued operations, net of tax - -
- $ (.01)
Extraordinary gain, net of tax expense - - - $ .01
Net income (loss) $ .09.12 $ .05
- $ .24 $ .14
====================================================================================================================================------------------------------------------------------------------------------------------------------------------------------------
Dividends Declared Per Common Share $ .014 $ .011
$ .036 $ .033
====================================================================================================================================
All periods have been adjusted to summarize the impact of The Charles Schwab Corporation's sale of its United Kingdom brokerage
subsidiary, Charles Schwab Europe, in gain (loss) from discontinued operations.- ------------------------------------------------------------------------------------------------------------------------------------
See Notes to Condensed Consolidated Financial Statements.
- 1 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Balance Sheet
(In millions, except share and per share amounts)
(Unaudited)
September 30,March 31, December 31,
2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Assets
Cash and cash equivalents $ 2,5152,414 $ 3,1142,832
Cash and investments segregated and on deposit for federal or other
regulatory purposes(1) (including resale agreements of $17,891$16,294 in 20032004
and $16,111$16,824 in 2002) 22,419 21,0052003) 20,841 21,343
Securities owned - at market value (including securities pledged of $374$2
in 20032004 and $337$131 in 2002) 2,744 1,7162003) 4,211 4,023
Receivables from brokers, dealers and clearing organizations 306 222504 556
Receivables from brokerage clients - net 7,666 6,8459,258 8,581
Loans to banking clients - net 5,616 4,5556,025 5,736
Loans held for sale 75 -44 29
Equipment, office facilities and property - net 976 868943 956
Goodwill - net 605 6031,030 835
Intangible assets - net 175 144
Other assets 838 777839 831
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 43,76046,284 $ 39,70545,866
====================================================================================================================================
Liabilities and Stockholders' Equity
Deposits from banking clients $ 6,5089,271 $ 5,2318,308
Drafts payable 149 134291 154
Payables to brokers, dealers and clearing organizations 3,171 1,4762,724 2,661
Payables to brokerage clients 26,124 26,40126,547 27,184
Accrued expenses and other liabilities 1,318 1,3021,255 1,330
Short-term borrowings 1,402 508755 996
Long-term debt 776 642779 772
- ------------------------------------------------------------------------------------------------------------------------------------
Total liabilities 39,448 35,69441,622 41,405
- ------------------------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock - 9,940,000 shares authorized; $.01 par value per share;
none issued - -
Common stock - 3 billion shares authorized; $.01 par value per share;
1,392,091,544 and 1,391,991,1801,392,091,544 shares issued in 20032004 and 2002,2003, respectively 14 14
Additional paid-in capital 1,747 1,7441,758 1,749
Retained earnings 3,007 2,7693,254 3,125
Treasury stock - 36,841,29327,928,584 and 47,195,63134,452,710 shares in 20032004 and 2002,2003,
respectively, at cost (348) (465)(249) (319)
Unamortized stock-based compensation (96) (33)(121) (95)
Accumulated other comprehensive loss (12) (18)income (loss) 6 (13)
- ------------------------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 4,312 4,0114,662 4,461
- ------------------------------------------------------------------------------------------------------------------------------------
Total $ 43,76046,284 $ 39,70545,866
====================================================================================================================================
(1) Amounts included represent actual balances on deposit, whereas cash and investments required to be segregated for federal or
other regulatory purposes were $21,845$20,299 million and $21,252$21,005 million at September 30, 2003March 31, 2004 and December 31, 2002,2003, respectively. On
OctoberApril 2, 2003,2004, the Company withdrew $170$143 million of excess segregated cash. On January 2, 2003,5, 2004, the Company deposited $655$221
million into its segregated reserve bank accounts.
See Notes to Condensed Consolidated Financial Statements.
- 2 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statement of Cash Flows
(In millions)
(Unaudited)
NineThree Months Ended
September 30,March 31,
2004 2003 2002
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net income $ 324161 $ 18871
Adjustments to reconcile net income to net cash used for operating activities:
Depreciation and amortization 218 24059 76
Impairment charges - 5 -
Tax benefit from, and amortization of, stock-based awards 19 227
Deferred income taxes 5 44
Non-cash restructuring charges 9 17
Extraordinary gain on sale of corporate trust business, net of tax expense - (12)26 15
Other (11) (1)3 4
Originations of loans held for sale (1,267)(215) -
Proceeds from sales of loans held for sale 1,197201 -
Net change in:
Cash and investments segregated and on deposit for federal or other
regulatory purposes (2,142) (1,531)502 (1,978)
Securities owned (excluding securities available for sale) (118) 4212 (45)
Receivables from brokers, dealers and clearing organizations (102) 24555 13
Receivables from brokerage clients (825) 2,540(677) 520
Other assets (66) (60)11 15
Drafts payable 14 (177)137 139
Payables to brokers, dealers and clearing organizations 1,719 26964 819
Payables to brokerage clients 418 (2,134)(638) 49
Accrued expenses and other liabilities (71) (69)(171) (216)
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for operating activities (674) (377)(451) (506)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Investing Activities
Purchases of securities available for sale (1,725) (1,085)(490) (460)
Proceeds from sales of securities available for sale 369 578- 14
Proceeds from maturities, calls and mandatory redemptions of securities
available for sale 537 275413 135
Net increase in loans to banking clients (1,063) (483)
Proceeds from sale of banking client loans - 196(289) (97)
Purchase of equipment, office facilities and property - net (101) (114)(35) (32)
Cash payments for business combinations and investments, net of cash received (9) -acquired (289) (8)
Proceeds from sales of subsidiaries - 53 26
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash used for investing activities (1,939) (607)(690) (395)
- ------------------------------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities
Net change in deposits from banking clients 1,277 (748)963 (24)
Net increasechange in short-term borrowings 894 182
Proceeds from long-term debt - 100(241) 261
Repayment of long-term debt (100) (203)- (22)
Dividends paid (49) (45)(19) (15)
Purchase of treasury stock - (32) (230)
Proceeds from stock options exercised 24 23and other 20 7
- ------------------------------------------------------------------------------------------------------------------------------------
Net cash provided by (used for) financing activities 2,014 (921)723 175
- ------------------------------------------------------------------------------------------------------------------------------------
Decrease in Cash and Cash Equivalents (599) (1,905)(418) (726)
Cash and Cash Equivalents at Beginning of Period 2,832 3,114 4,407
- ------------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Period $ 2,5152,414 $ 2,5022,388
====================================================================================================================================
See Notes to Condensed Consolidated Financial Statements.
- 3 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Amounts and Ratios)
(Unaudited)
1. Basis of Presentation
The Charles Schwab Corporation (CSC)(CSC, and with its majority-owned
subsidiaries collectively referred to as the Company) is a financial holding
company engaged, through its subsidiaries, in securities brokerage, banking, and
related financial services. Charles Schwab & Co., Inc. (Schwab) is a securities
broker-dealer with 352339 domestic branch offices in 48 states, as well as a branch
in the Commonwealth of Puerto Rico. U.S. Trust Corporation (USTC, and with its
subsidiaries collectively referred to as U.S. Trust) is a wealth management firm
that through its subsidiaries also provides fiduciary services and private
banking services with 3438 offices in 1315 states. Other subsidiaries include
Charles Schwab Investment Management, Inc., the investment advisor for Schwab's
proprietary mutual funds, Schwab Capital Markets L.P. (SCM), a market maker in
Nasdaq, exchange-listed, and other securities providing trade execution services
primarily to broker-dealers and institutional clients, CyberTrader, Inc.
(CyberTrader), an electronic trading technology and brokerage firm providing
services to highly active, online traders, and Charles Schwab Bank, N.A. (Schwab
Bank), a retail bank which commenced operations in the second quarter of 2003.
On January 31, 2003, the Company sold its United Kingdom (U.K.) brokerage
subsidiary, Charles Schwab Europe (CSE), to Barclays PLC. The results of the
operations of CSE, net of income taxes, have been presented as discontinued
operations on the Condensed Consolidated Statement of Income.
The accompanying unaudited condensed consolidated financial statements
include CSC and its majority-owned subsidiaries (collectively referred to as the
Company).subsidiaries. These financial statements have
been prepared pursuant to the rules and regulations of the Securities and
Exchange Commission (SEC) and, in the opinion of management, reflect all
adjustments necessary to present fairly the financial position, results of
operations, and cash flows for the periods presented in conformity with
generally accepted accounting principles in the U.S. (GAAP). All adjustments
were of a normal recurring nature, except as discussed in Note "6 -
Discontinued Operations."nature. Certain items in prior periods' financial
statements have been reclassified to conform to the 20032004 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 20022003 Annual
Report to Stockholders, which is filed as Exhibit 13.1 to the Company's
Form 10-K for the year ended December 31, 2002, and the Company's Quarterly Reports on Form 10-Q
for the periods ended March 31, 2003 and June 30, 2003. The Company's results for any
interim period are not necessarily indicative of results for a full year or any
other interim period.
2. New Accounting Standards
FinancialStandard
SEC Staff Accounting Standards Board Interpretation (FIN)Bulletin (SAB) No. 45 -
Guarantor's105 "Application of Accounting
and Disclosure RequirementsPrinciples to Loan Commitments" was released in March 2004. This release
summarizes the SEC staff position regarding the application of GAAP to loan
commitments accounted for Guarantees, Including
Indirect Guarantees of Indebtedness of Others, wasas derivative instruments. The Company accounts for
interest rate lock commitments issued in November 2002. This
interpretation addresseson mortgage loans that will be held for
sale as derivative instruments. Consistent with SAB No. 105, the disclosures to be made by a guarantor in its
interim and annual financial statements about its obligations under certain
guarantees. FIN No. 45 also clarifies that a guarantor is required to recognize,
at the inception of a guarantee, a liability forCompany
considers the fair value of these commitments to be zero at the obligation undertakencommitment date,
with subsequent changes in issuing the guarantee. In accordance with FIN No. 45,fair value determined solely on changes in market
interest rates. As of March 31, 2004, the Company adoptedhad interest rate lock
commitments on mortgage loans to be held for sale with principal balances
totaling approximately $230 million, the disclosure requirements on December 31, 2002 and the
recognition requirements on January 1, 2003. The adoptionfair value of FIN No. 45 did not
have a material impact on the Company's financial position, results of
operations, earnings per share (EPS), or cash flows.
FIN No. 46 - Consolidation of Variable Interest Entities, an Interpretation
of Accounting Research Bulletin No. 51 - Consolidated Financial Statements, was
issued in January 2003. This interpretation provides new criteria for
determining whether a company is required to consolidate (i.e., record the
assets and liabilities on the balance sheet) a variable interest entity. Upon
adoption of this interpretation in the first quarter of 2003, the Company
consolidated a special purpose trust (Trust) that was formed in 2000 to finance
the acquisition and renovation of an office building and land. The Trust,
through an agent, raised the $245 million needed to acquire and renovate the
building and land by issuing long-term debt ($235 million) and raising equity
capital ($10 million). Upon adoption, the Company recorded: the building and
land at a cost of $245 million, net of accumulated depreciation of $16 million;
long-term debt of $235 million; and a net reduction of accrued expenses and
other liabilities of $7 million. The cumulative effect of this accounting changewhich was immaterial.
The building is being depreciated on a straight-line basis over twenty
years. The long-term debt consists of a variable-rate note maturing in June
2005. The interest rate on the note was 1.55% at September 30, 2003, and ranged
from 1.54% to 1.66% during the quarter, and 1.54% to 1.82% for the first nine
months of 2003. The building and land have been pledged as collateral for the
long-term debt. At September 30, 2003, the carrying value of the building and
land was $221 million (net of accumulated depreciation of $24 million).
Additionally, the Company has guaranteed the debt of the Trust up to a maximum
of $202 million. The lender does not have recourse to any other assets of the
Company.
- 4 -
The annual impact of the adoption of FIN No. 46 on the Company's Condensed
Consolidated Statement of Income is to cease both amortizing the shortfall of
the residual value guarantee and recording rent expense on the lease and to
record both the depreciation on the building and the interest expense associated
with the debt. The adoption of FIN No. 46 did not have and is not expected to
have a material impact on the Company's results of operations, EPS, or cash
flows.
Statement of Financial Accounting Standards (SFAS) No. 149 - Amendment of
Statement 133 on Derivative Instruments and Hedging Activities was issued in
April 2003. This statement amends and clarifies financial accounting and
reporting for derivative instruments, including certain derivative instruments
embedded in other contracts and for hedging activities under SFAS No. 133 -
Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 also
amends certain other existing pronouncements. The Company adopted the provisions
of this statement on June 30, 2003. The adoption of this statement did not have
and is not expected to have a material impact on the Company's financial
position, results of operations, EPS, or cash flows.
SFAS No. 150 - Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity was issued in May 2003. This
statement establishes standards for how to classify and measure certain
financial instruments with characteristics of both liabilities and equity (e.g.,
redeemable preferred stock). The Company adopted the provisions of this
statement on July 1, 2003. The adoption of this statement did not have an impact
on the Company's financial position, results of operations, EPS, or cash flows.
3. Stock Incentive Plans
The Company's stock incentive plans provide for granting options to
employees, officers, and directors. Options are granted for the purchase of
shares of common stock at an exercise price not less than market value on the
date of grant, and expire within ten years from the date of grant. Options
generally vest over a four-year period from the date of grant.
A summary of option activity follows:
- --------------------------------------------------------------------------------
2004 2003
2002
----------------- ------------------------------------- ------------------
Weighted- Weighted-
Number Average Number Average
of Exercise of Exercise
Options Price Options Price
- --------------------------------------------------------------------------------
Outstanding at
beginning of year 136 $ 15.25 156 $15.38 153 $16.20
Granted:
Quarter ended March 31$ 15.38
Granted 1 $ 13.73 -(1) $ 9.26
7 $13.15
Quarter ended June 30 2 $ 8.93 2 $12.12
Quarter ended September 30 -(1) $11.30 2 $ 9.68
- --------------------------------------------------------------------------------
Total granted 2 $ 9.09 11 $12.42
Exercised (4) $ 6.23 (4)5.57 (1) $ 6.535.82
Canceled (12) $18.58 (8) $20.58(3) $ 19.54 (6) $ 18.09
- --------------------------------------------------------------------------------
Outstanding at
September 30 142 $15.26 152 $15.92March 31 130 $ 15.42 149 $ 15.34
================================================================================
Exercisable at
September 30 85 $14.27 73 $12.65March 31 87 $ 15.41 77 $ 13.30
- --------------------------------------------------------------------------------
Available for future
grant at September 30 41 47March 31 43 39
- --------------------------------------------------------------------------------
Weighted-average fair
value of options granted:
Quartergranted in
quarter ended March 31 $ 4.343.95 $ 6.33
Quarter ended June 30 $ 3.96 $ 5.51
Quarter ended September 30 $ 5.06 $ 4.584.34
- --------------------------------------------------------------------------------
(1) Less than 500,000 options were granted during each of the first and third
quartersquarter of 2003.
The Company changed its option pricing model from the Black-Scholes model
to a binomial model for all options granted on or after January 1, 2004. The
fair valuevalues of each optionstock options granted is estimated as of the grant dateprior to January 1, 2004 were determined
using the Black-Scholes model. The Company believes that the binomial model
offers greater flexibility in reflecting the characteristics of employee stock
options. The binomial model takes into account similar inputs to a Black-Scholes
model such as volatility, dividend yield rate, and risk-free interest rate. In
addition to these assumptions, the binomial model considers the contractual term
of the option, the probability that the option will be exercised prior to the
end of its contractual life, and the probability of termination or retirement of
the option holder in computing the value of the option. The Company determines
these probabilities generally based on analysis of historical trends of such
events. The assumptions used in the respective option pricing model with the following assumptions:models were as
follows:
- --------------------------------------------------------------------------------
Three Months Ended March 31, June 30, September 30,
-------------- ------------- -------------2004 2003 2002 2003 2002 2003 2002
- --------------------------------------------------------------------------------
Expected dividend yield .30% .30% .30% .30% .30%.48% .30%
Expected volatility 36% 52% 50% 49% 50% 49% 50%
Risk-free interest rate 4.0% 2.9% 4.1% 2.6% 4.4% 2.9% 3.5%
Expected life (in years) 5 5 5 5 5n/a(1) 5
- --------------------------------------------------------------------------------
(1) The binomial model assumptions include the option contractual term of 10
years and the historical data of option exercises and employee
terminations, rather than an estimate of the option's expected life.
The Company applies Accounting Principles Board Opinion No. 25 - Accounting
for Stock Issued to Employees, and related interpretations, for its stock-based
employee
- 5 - compensation plans. Because the Company grants stock option awards at
market value, there is no compensation expense recorded, except for
restructuring-related expense for modifications of officers' stock options.
- 5 -
Had compensation expense for the Company's stock option awards been
determined based on the Black-Scholes or binomial fair value, as described
above, at the grant dates for awards under those plans consistent with the fair
value method of SFAS No. 123 - Accounting for Stock-Based Compensation, the
Company would have recorded additional compensation expense and its net income
and EPSearnings per share (EPS) would have been reduced to the pro forma amounts
presented in the following table:
- --------------------------------------------------------------------------------
Three
Nine
Months Ended
Months Ended
September 30, September 30,March 31,
2004 2003 2002 2003 2002
- --------------------------------------------------------------------------------
Compensation expense for stock
options (after-tax):
As reported $ 6- $ - $ 6 $ 2
Pro forma (1) $ 3124 $ 36 $ 89 $11429
- --------------------------------------------------------------------------------
Net income (loss)income:
As reported $ 161 $ 71
Pro forma $ 137 $ 42
- --------------------------------------------------------------------------------
EPS (2):
As reported $127 $ (4) $324 $188.12 $ .05
Pro forma $102 $ (40) $241.10 $ 76
- --------------------------------------------------------------------------------
Basic EPS:
As reported $.09 $ - $.24 $.14
Pro forma $.08 $(.03) $.18 $.06
Diluted EPS:
As reported $.09 $ - $.24 $.14
Pro forma $.07 $(.03) $.18 $.06.03
- --------------------------------------------------------------------------------
(1) Includes pro forma compensation expense related to stock options granted in
both current and prior periods. Pro forma stock option compensation is
amortized on a straight-line basis over the vesting period beginning with
the month in which the option was granted.
(2) Represents both basic and diluted EPS.
4. Restructuring
In 2001, the Company initiated a restructuring plan to reduce operating
expenses due to economic uncertainties and difficult market conditions. This
restructuring plan was completed inThe Company's 2003, 2002, and 2001 restructuring initiatives included
a workforce reduction, a
reductionreductions, reductions in operating facilities, and the removal of certain
systems hardware, software, and equipment from service. Included in these initiatives were costs
associated withservice, and the withdrawal from
certain international operations. In the third quarter of 2002, the Company commenced additional
restructuring initiatives due to continued difficult market conditions. These initiatives were intended to reducereduced operating expenses
and adjustadjusted the Company's organizational structure to improve productivity,
enhance efficiency, and increase profitability. The restructuring initiativesThere were substantially
completed in 2002 and primarily included further reductions in the Company's
workforce and facilities.
In the third quarter of 2003, the Company commenced additional
restructuring initiatives to further adjust the Company's workforce and
facilities in response to the market environment and the 2002 restructuring
initiatives, which resulted in the centralization of several support functions.
The third quarter initiatives included mandatory staff reductions of 175
employees and the consolidation of certain facilities, including 20 Schwab
domestic branch offices. The Company recorded pre-taxno restructuring
charges of
$31 million in the third quarter of 2003 related to these restructuring
initiatives.
The Company recorded total pre-tax restructuring charges of $37 million and
$61 million in the third quarter of 2003 and first nine months of 2003,
respectively. These charges include the amounts noted above related to the 2003
restructuring initiatives, as well as charges primarily due to changes in
estimates of sublease income associated with previously announced efforts to
sublease excess facilities. The Company recorded total pre-tax restructuring
charges of $159 million and $188 million in the third quarter of 2002 and first
nine months of 2002, respectively, all of which related to its 2001 and 2002
restructuring initiatives. The actual costseither of the Company's restructuring
initiatives could differ from the estimated costs, depending primarily on the
Company's ability to sublease properties.
- 6 -first quarters of 2004 or 2003.
A summary of the activity in the restructuring reserve related to the
Company's restructuring initiatives for the thirdfirst
quarter of 2003 and the nine
months ended September 30, 20032004 is as follows:
- --------------------------------------------------------------------------------
Three months ended Workforce Facilities
September 30, 2003 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at June 30, 2003 $ 27 $ 218 $ 245
Restructuring charges 21 16 37
Cash payments (12) (20) (32)
Non-cash charges (1) (8) (1) (9)
Other (2) - 2 2
- --------------------------------------------------------------------------------
Balance at September 30, 2003 $ 28 (3) $ 215 (4) $ 243
================================================================================
- --------------------------------------------------------------------------------
Nine months ended Workforce Facilities
September 30, 2003March 31, 2004 Reduction Reduction Total
- --------------------------------------------------------------------------------
Balance at December 31, 20022003 $ 6823 $ 227201 $ 295
Balance related to discontinued
operations - (3) (3)
Restructuring charges 21 40 61224
Cash payments (53) (54) (107)(10) (16) (26)
Non-cash charges (1) (8) (1) (9)- (1)
Other (2) - 6 63 3
- --------------------------------------------------------------------------------
Balance at September 30, 2003March 31, 2004 $ 28 (3)12(3) $ 215 (4)188(4) $ 243200
================================================================================
(1) Primarily includes charges for officers' stock option compensation and
write-downs of fixed assets.stock-based compensation.
(2) Primarily includes the accretion of facilities restructuring reserves,
which are initially recorded at net present value. Accretion expense is
recorded in occupancy and equipment expense on the Company's Condensed
Consolidated Statement of Income.
(3) Includes $4$8 million, $12$3 million, and $12$1 million related to the Company's
2001,2003, 2002, and 20032001 restructuring initiatives, respectively. The Company
expects to substantially utilize the remaining workforce reduction reserve
through cash payments for severance pay and benefits over the respective
severance periods through 2005.
(4) Includes $123$8 million, $85$72 million, and $7$108 million related to the Company's
2001,2003, 2002, and 20032001 restructuring initiatives, respectively. The Company
expects to substantially utilize the remaining facilities reduction reserve
through cash payments for the net lease expense over the respective lease
terms through 2017.
5. Sale of Corporate Trust Business In June 2001, U.S. Trust sold its Corporate Trust business to The Bank of
New York Company, Inc. During the first quarter of 2002, the Company recorded an
extraordinary gain of $22 million, or $12 million after tax, which represented
the remaining proceeds from this sale that were realized upon satisfaction of
certain client retention requirements.
6. Discontinued Operations
On January 31, 2003, the Company sold its United Kingdom (U.K.) brokerage
subsidiary, Charles Schwab Europe (CSE), to Barclays PLC. The results of the
operations of CSE, net of income taxes, have been presented as discontinued
operations on the Condensed Consolidated Statement of Income. A summary of
revenues and pre-tax gains (losses) for CSE is as follows:
- --------------------------------------------------------------------------------
Three Nine
Months Ended Months Ended
September 30, September 30,
2003 2002 2003 2002
- --------------------------------------------------------------------------------
Revenues $ - $ 11 $ 4 $ 34
Pre-tax gains (losses) $ 5 $ (5) $ - $(16)
After-tax gains (losses) $ 3 $ (3) $ - $(10)
- --------------------------------------------------------------------------------
An after-tax loss of $2 million on the sale was recorded in the first
quarter of 2003 and included the estimated costs associated with certain CSE
obligations that were retained by the Company, principally related to facilities
leases and other contracts. In the third quarter of 2003, the Company recorded a
pre-tax gain of $5 million (after-tax gain of $3 million) primarily due to
changes in estimates of costs related to this sale.
7. Business AcquisitionAcquisitions and Divestiture
In June 2003, the Company sold its investment in Aitken Campbell, a
market-making joint venture in the U.K., to the Company's joint venture partner,
TD Waterhouse Group, Inc. In the first quarter of 2003, the Company recorded an
impairment charge of $5 million pre taxpre-tax to reduce the carrying value of its
investment and a deferred income tax benefit of $16 million that was realized
following the completion of the sale.million. The Company's share
of Aitken Campbell's historical earnings, which was accounted for under the
equity method, haswas not
been material to the Company's results of operations, EPS, or
cash flows.
In JuneOctober 2003, the Company announced that U.S. Trust agreed to acquireacquired State Street Corporation's Private
Asset Management group, a provider of wealth management services to clients in
the New England area, for $365 million.
In January 2004, the Company completed its acquisition of SoundView
Technology Group, Inc. (SoundView), a research-driven securities firm providing
institutional investors with fundamental research on companies in selected
growth-related industries, for approximately $340 million, or $289 million net
of SoundView's cash and cash equivalents acquired. Additionally, the Company
recorded securities owned of $93 million related to be
paid in cash, subjectthis acquisition. As a
result of a preliminary purchase price allocation, the Company recorded goodwill
of $195 million and intangible assets of $21 million related to certain possible adjustments. See note "16 - Subsequent
Event" for further discussion on this
acquisition.
- 76 -
8.6. Loans to Banking Clients and Related Allowance for Credit Losses
An analysis of the composition of the loan portfolio is as follows:
- --------------------------------------------------------------------------------
September 30,March 31, December 31,
2004 2003 2002
- --------------------------------------------------------------------------------
Residential real estate mortgages $ 4,514 $ 3,580$4,923 $4,624
Consumer loans 681 630723 735
Other 447 369406 404
- --------------------------------------------------------------------------------
Total loans 5,642 4,5796,052 5,763
Less: allowance for credit losses (26) (24)(27) (27)
- --------------------------------------------------------------------------------
Loans to banking clients - net $ 5,616 $ 4,555$6,025 $5,736
================================================================================
Included in the loan portfolio are nonaccrual loans totaling $1 million at
both September 30, 2003March 31, 2004 and December 31, 2002.2003. Nonaccrual loans are considered
impaired by the Company, and represent all of the Company's nonperforming assets
at both September 30, 2003March 31, 2004 and December 31, 2002.2003. For each of the three-quarters ended
March 31, 2004 and nine-month periods ended September 30, 2003, and 2002, the impact of interest revenue which would have been
earned on nonaccrual loans versus interest revenue recognized on these loans was
not material to the Company's results of operations.
The amount of loans accruing interest that were contractually 90 days or
more past due was immaterial at both September 30, 2003March 31, 2004 and December 31, 2002.2003.
Recoveries and charge-offs related to the allowance for credit losses on
the loan portfolio were not material for each of the three-quarters ended March 31,
2004 and nine-month
periods ended September 30, 2003 and 2002.
9.2003.
7. Deposits from Banking Clients
Deposits from banking clients consist of money market and other savings
deposits, noninterest-bearing deposits and certificates of deposit.deposit, and noninterest-bearing deposits. Deposits
from banking clients are as follows:
- --------------------------------------------------------------------------------
September 30,March 31, December 31,
2004 2003 2002
- --------------------------------------------------------------------------------
Interest-bearing deposits $ 5,951 $ 4,471$8,565 $7,585
Noninterest-bearing deposits 557 760706 723
- --------------------------------------------------------------------------------
Total $ 6,508 $ 5,231$9,271 $8,308
================================================================================
The average rate paid by the Company on its interest-bearing deposits from
banking clients was 1.72%1.30% and 2.39%2.06% for the three-month periods ended September 30,March 31,
2004 and 2003, respectively.
8. Pension and 2002, respectively, and 1.90% and 2.37%Other Postretirement Benefits
U.S. Trust maintains a trustee managed, noncontributory, qualified defined
benefit pension plan for the nine-month periodsbenefit of eligible U.S. Trust employees, the
U.S. Trust Corporation Employees' Retirement Plan (the Pension Plan). U.S. Trust
also provides certain health care and life insurance benefits for active
employees and certain qualifying retired employees and their dependents.
The following table summarizes the components of the net periodic benefit
expense related to the Pension Plan and health care and life insurance benefits:
- --------------------------------------------------------------------------------
2004 2003
---------------- ----------------
Three months ended September 30, 2003Pension Health & Pension Health &
March 31, Plan Life Plan Life
- --------------------------------------------------------------------------------
Service cost and 2002, respectively.
10.expenses $ 3 $ - $ 3 $ -
Interest cost 4 - 5 -
Expected return on
plan assets (5) - (6) -
Amortization of
prior service cost (1) - - -
Amortization of
net loss 1 - - -
- --------------------------------------------------------------------------------
Net periodic benefit expense $ 2 $ - $ 2 $ -
================================================================================
9. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is presented in the following table:
- --------------------------------------------------------------------------------
Three
Nine
Months Ended
Months Ended
September 30, September 30,March 31,
2004 2003 2002 2003 2002
- --------------------------------------------------------------------------------
Net income (loss) $127 $ (4) $324 $188161 $ 71
Other comprehensive income (loss):
Net gain (loss) on cash flow
hedging instruments 7 (8) 13 (10)
Foreign currency translation
adjustment - 2 5 84 3
Change in net unrealized gain
on securities available for sale (10) 10 (12) 1715 (1)
Foreign currency translation
adjustment - 5
- --------------------------------------------------------------------------------
Total comprehensive income,
net of tax $124 $ - $330 $203180 $ 78
================================================================================
- 87 -
11.10. 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
Nine
Months Ended
Months Ended
September 30, September 30,March 31,
2004 2003 2002 2003 2002
- --------------------------------------------------------------------------------
Net income (loss) $ 127161 $ (4) $ 324 $ 18871
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - basic 1,348 1,342 1,358 1,341 1,364
Common stock equivalent shares
related to stock incentive plans 24 - 20 1827 15
- --------------------------------------------------------------------------------
Weighted-average common
shares outstanding - diluted 1,366 1,358 1,361 1,3821,375 1,357
================================================================================
Basic EPS:
Income (loss) from continuing operations before
extraordinary gain $ .09.12 $ - $ .24 $ .14
Gain (loss).05
Loss from discontinued operations,
net of tax - -
- $(.01)
Extraordinary gain, net of
tax expense - - - $ .01
Net income (loss) $ .09.12 $ - $ .24 $ .14.05
- --------------------------------------------------------------------------------
Diluted EPS:
Income (loss) from continuing operations before
extraordinary gain (1) $ .09.12 $ - $ .24 $ .14
Gain (loss).05
Loss from discontinued operations,
net of tax - -
- $(.01)
Extraordinary gain, net of
tax expense - - - $ .01
Net income (loss) $ .09.12 $ - $ .24 $ .14.05
- --------------------------------------------------------------------------------
(1) For the three months ended September 30, 2002 this computation excludes
common stock equivalent shares related to stock incentive plans of
14 million because inclusion of such shares would be antidilutive.
The computation of diluted EPS excludes outstanding stock options to
purchase 8875 million and 114118 million shares for the three months ended September 30,March 31,
2004 and 2003, and 2002, respectively, and 111 million and 114 million
shares for the nine months ended September 30, 2003 and 2002, 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.
12.11. Regulatory Requirements
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Board of Governors of the Federal
Reserve System (the Federal Reserve Board) under the Bank Holding Company Act of
1956, as amended (the Act).
Under the Act, the Federal Reserve Board has established consolidated
capital requirements for bank holding companies. The regulatory capital and
ratios of the Company, U.S. Trust, United States Trust Company of New York
(U.S. Trust NY), U.S. Trust Company, National Association (U.S. Trust NA), and
Schwab Bank are presented in the following table:
- --------------------------------------------------------------------------------
2004 2003
2002
----------------- -----------------
September 30,--------------- ---------------
March 31, Amount Ratio(1) Amount Ratio(1)
- --------------------------------------------------------------------------------
Tier 1 Capital:
Company $ 3,784 23.6%3,527 19.8% $ 3,574 23.5%3,526 25.4%
U.S. Trust $ 647 15.3%666 15.4% $ 618 17.5%604 16.4%
U.S. Trust NY $ 361 10.3%357 10.7% $ 381 13.4%356 11.8%
U.S. Trust NA(2) $ 262 29.3% $ 229 37.4%
Schwab Bank(2)Bank(3) $ 276 60.0%281 28.4% - -
Total Capital:
Company $ 3,813 23.7%3,556 20.0% $ 3,601 23.7%3,554 25.6%
U.S. Trust $ 673 15.9%693 16.0% $ 641 18.2%629 17.1%
U.S. Trust NY $ 384 10.9%381 11.4% $ 401 14.1%378 12.5%
U.S. Trust NA(2) $ 265 29.6% $ 232 37.9%
Schwab Bank(2)Bank(3) $ 276 60.0%281 28.5% - -
Tier 1 Leverage:
Company $ 3,7843,527 7.9% $ 3,526 9.0% $ 3,574 9.6%
U.S. Trust $ 647666 8.0% $ 604 8.8% $ 618 9.5%
U.S. Trust NY $ 361 5.9%357 5.6% $ 381 7.3%356 6.4%
U.S. Trust NA(2) $ 262 12.3% $ 229 14.5%
Schwab Bank(2)Bank(3) $ 276 24.7%281 9.6% - -
- --------------------------------------------------------------------------------
(1) Minimum tier 1 capital, total capital, and tier 1 leverage ratios are 4%,
8%, and 3%-5%, respectively, for bank holding companies and banks.
Additionally, Schwab Bank is subject to a minimum tier 1 leverage ratio of
8% for its first three years of operations. Well-capitalized tier 1
capital, total capital, and tier 1 leverage ratios are 6%, 10%, and 5%,
respectively. Each of CSC's other depository institution subsidiaries
exceed the well-capitalized standards set forth by the banking regulatory
authorities.
(2) During 2003, U.S. Trust consolidated its regional subsidiary banks located
outside of New York and New Jersey into U.S. Trust NA, a single
nationally-chartered banking entity. Amounts and ratios for March 31, 2003
have been calculated based on this consolidation.
(3) Schwab Bank commenced operations in the second quarter of 2003. Therefore,
Schwab Bank regulatory capital and ratios are not presented for 2002.March 31,
2003.
Based on their respective regulatory capital ratios at September 30,March 31, 2004 and
2003,
and 2002, the Company, U.S. Trust, U.S. Trust NY, and U.S. Trust NYNA are considered
well capitalized (the highest category). pursuant to Federal Reserve Board
guidelines. Additionally, based on its regulatory
- 8 -
capital ratios at September 30, 2003,March 31, 2004, Schwab Bank is also considered well
capitalized. There are no conditions or events that management believes have
changed the Company's, U.S. Trust's, U.S. Trust NY's, U.S. Trust NA's, or Schwab
Bank's well-capitalized status.
In the first quarter of 2003, the Company implemented a value-at-risk (VAR)
model to estimate the risks associated with its inventory portfolios. Since VAR
is considered to be a
- 9 -
comprehensive measurement tool for estimating market risk, the Federal Reserve
Board requires certain bank holding companies to incorporate VAR in determining
their Tier 1 Capital and Total Capital ratios. The implementation of VAR had the
effect of increasing both the Company's Tier 1 Capital and Total Capital ratios
by .9% at September 30, 2003.
Schwab and SCM are subject to the Uniform Net Capital Rule under the
Securities Exchange Act of 1934 (the Rule). Schwab and SCM compute net capital
under the alternative method permitted by this Rule. This method requires the
maintenance of minimum net capital, as defined, of the greater of 2% of
aggregate debit balances arising from client transactions or a minimum dollar
requirement, which is based on the type of business conducted by the
broker-dealer. The minimum dollar requirement for both Schwab and SCM is
$1 million. Under the alternative method, a broker-dealer may not repay
subordinated borrowings, pay cash dividends, or make any unsecured advances or
loans to its parent or employees if such payment would result in net capital of
less than 5% of aggregate debit balances or less than 120% of its minimum dollar
requirement. At September 30, 2003,March 31, 2004, Schwab's net capital was $1.2 billion (16%(13% of
aggregate debit balances), which was $1.1$1.0 billion in excess of its minimum
required net capital and $832$738 million in excess of 5% of aggregate debit
balances. At September 30, 2003,March 31, 2004, SCM's net capital was $76$65 million, which was
$75$64 million in excess of its minimum required net capital.
13.12. Commitments and Contingent Liabilities
Guarantees: The Company provides certain indemnifications (i.e., protection
against damage or loss) to counterparties in connection with the disposition of
certain of its assets. Such indemnifications typically relate to title to the
assets transferred, ownership of intellectual property rights (e.g., patents),
accuracy of financial statements, compliance with laws and regulations, failure
to pay, satisfy or discharge any liability, or to defend claims, as well as
errors, omissions, and misrepresentations. These indemnification agreements have
various expiration dates and the Company's liability under these agreements is
generally limited to certain maximum amounts. The Company, however, remains subject to certain
uncapped potential liabilities. Other than the possible uncapped obligations, at
September 30, 2003,At March 31, 2004, the Company's
maximum potential liability under these indemnification agreements is limited to
approximately $100 million. Standby letters of credit (LOCs) are conditional commitments issued by
U.S. Trust to guarantee the performance of a client to a third party. At
September 30, 2003, U.S. Trust had LOCs outstanding totaling $73 million, which
are short-term in nature and generally expire within one year.
In accordance with FIN No. 45, 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 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 does not believe that any material loss
related to indemnification agreements, including
the uncapped indemnification obligations, or LOCssuch indemnifications is likely and therefore at
September 30, 2003, the liabilities recordedno liability for these
indemnifications has been recognized.
The Company has clients that sell (i.e., write) listed option contracts
that are cleared by various clearing houses. The clearing houses establish
margin requirements on these transactions. The Company satisfies the margin
requirements by arranging standby letters of credit (LOCs), in favor of the
clearing houses, that are guaranteed by multiple banks. At March 31, 2004, the
outstanding value of these LOCs totaled $630 million. No funds were drawn under
these LOCs at March 31, 2004.
The Company also provides guarantees are
immaterial.to securities clearing houses and
exchanges under their standard membership agreement, which requires members to
guarantee the performance of other members. Under the agreement, if another
member becomes unable to satisfy its obligations to the clearing houses and
exchanges, other members would be required to meet shortfalls. The Company's
liability under these arrangements is not quantifiable and may exceed the cash
and securities it has posted as collateral. However, the potential requirement
for the Company to make payments under these arrangements is remote.
Accordingly, no liability has been recognized for these transactions.
Legal contingencies: The nature of the Company's business subjects it to
claims, lawsuits, regulatory examinations, and other proceedings in the ordinary
course of business. The results of these matters cannot be predicted with
certainty. There can be no assurance that these matters will not have a material
adverse effect on the Company's results of operations in any future period,
depending partly on the results for that period, and a substantial judgment
could have a material adverse impact on the Company's financial condition,
results of operations, and cash flows. However, it is the opinion of management,
after consultation with legal counsel, that the ultimate outcome of these
existing claims and proceedings will not have a material adverse impact on the
financial condition, results of operations, or cash flows of the Company.
For further discussion of legal proceedings, see Part II - Other
Information, Item 1 - Legal Proceedings.
14.- 9 -
13. Segment Information
The Company structures its segments according to its various types of
clients and the services provided to those clients. These segments have been
aggregated, based on similarities in economic characteristics, types of clients,
services provided, distribution channels, and regulatory environment, into four
reportable segments - Individual Investor, Institutional Investor, Capital
Markets, and U.S. Trust.
Financial informationIn the first quarter of 2004, the Company changed its methodology for the
Company's reportablecomputation of its segment information. The new methodology utilizes an
activity-based costing model to allocate traditional income statement line item
expenses (e.g., compensation and benefits, depreciation, and professional
services) to the business activities driving segment expenses (e.g., client
service, opening new accounts, or business development). Previously-reported
segment information has been revised to reflect this new methodology.
Previously, except for the U.S. Trust segment, for which expenses were directly
incurred, technology, corporate, and general administrative expenses were
allocated to the remaining segments is presentedgenerally in the following table.proportion to either their
respective revenues or average full-time equivalent employees.
The Company periodically reallocates certain revenues and expenses among
the segments to align them with the changes in the Company's organizational
structure. Previously-reported segment information has been revised to reflect
changes during the year in the Company's internal organization. The Company
evaluates the performance of its segments based on adjusted operating income
before taxes (a non-GAAP income measure), which excludes items such as
restructuring charges, acquisition-relatedacquisition- and merger-related charges, impairment
charges, discontinued operations, and extraordinary gains.items. Intersegment revenues
are not material and are therefore not disclosed. Total revenues, income from
continuing operations before taxes on income, and extraordinary gain, and net income are equal to the
- 10 -
amounts as reported on the Company's Condensed Consolidated Statement of Income.
Financial information for the Company's reportable segments is presented in
the following table:
- --------------------------------------------------------------------------------
Three
Nine
Months Ended
Months Ended
September 30, September 30,March 31,
2004 2003 2002 2003 2002
- --------------------------------------------------------------------------------
Revenues:
Individual Investor $ 605685 $ 584 $1,699 $1,774522
Institutional Investor 210 211 602 632232 191
Capital Markets 78 65 208 19690 36
U.S. Trust 158 160 460 503181 149
Unallocated 2 2
- --------------------------------------------------------------------------------
Total $1,051 $1,020 $2,969 $3,105$1,190 $ 900
================================================================================
Adjusted operating income
(loss)
before taxes:
Individual Investor $ 153172 $ 95 $ 293 $ 22941
Institutional Investor 53 37 174 16272 68
Capital Markets (4) (5) (7) 93 (10)
U.S. Trust (1) 32 31 82 1116 14
Unallocated (6) (11)
- --------------------------------------------------------------------------------
Adjusted operating income
before taxes 234 158 542 511247 102
Excluded items (2) (37) (159) (66) (215)- (5)
- --------------------------------------------------------------------------------
Income (loss) from continuing
operations before taxes on
income and extraordinary gain 197 (1) 476 296247 97
Taxes on income (73) - (152) (110)
Gain (loss)(86) (23)
Loss from discontinued
operations, net of tax (3) 3- (3) - (10)
Extraordinary gain on sale of
corporate trust business,
net of tax expense - - - 12
- --------------------------------------------------------------------------------
Net Income (Loss) $ 127161 $ (4) $ 324 $ 18871
================================================================================
(1) Excludes an extraordinary pre-tax gain of $22 million forIn accordance with the nine months
ended September 30, 2002 relating to the sale of U.S. Trust's Corporate
Trust business (see note "5 - Sale of Corporate Trust Business").
(2) Includes restructuring charges of $37Company's new cost allocation methodology, amounts
include costs ($15 million and $61$12 million (see note "4
- Restructuring") forin the threefirst quarter of 2004 and
nine months ended September 30, 2003, respectively. Also includesrespectively) allocated to U.S. Trust.
(2) Includes an impairment charge of $5 million related to the Company's
investment in its U.K. market-making operation for the ninethree months ended
September 30,March 31, 2003 (see note "7"5 - Business AcquisitionAcquisitions and Divestiture"). Includes restructuring charges of $159 million and
$188 million for the three and nine months ended September 30, 2002,
respectively, and acquisition-related charges of $27 million for the nine
months ended September 30, 2002.
(3) Represents the impact of the Company's sale of its U.K. brokerage
subsidiary, which was previously included in the Individual Investor
segment (see note "6"1 - Discontinued Operations"Basis of Presentation").
15.- 10 -
14. Supplemental Cash Flow Information
Certain information affecting the cash flows of the Company is presented in
the following table:
- --------------------------------------------------------------------------------
NineThree
Months Ended
September 30,March 31,
2004 2003 2002
- --------------------------------------------------------------------------------
Income taxes paid $ 16728 $ 8112
- --------------------------------------------------------------------------------
Interest paid:
Deposits from banking clients $ 24 $ 21
Brokerage client cash balances $ 63 $ 135
Deposits from banking clients 65 6315 24
Long-term debt 33 5112 15
Short-term borrowings 12 193 5
Other 13 52 3
- --------------------------------------------------------------------------------
Total interest paid $ 18656 $ 27368
================================================================================
Non-cash investing and financing activities:
Consolidation of special purpose trust: (1)
Building and land - $ 229
-
Long-term debtNote payable and other liabilities - $ 228 -
Common stock and options issued
for purchase of businesses $ 4 $ 4
- --------------------------------------------------------------------------------
(1) Upon adoption of FINFinancial Accounting Standards Board Interpretation No. 46
- Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51 - Consolidated Financial Statements, in
the first quarter of 2003, the Company consolidated a special purpose
trust.
See note "2 - New Accounting
Standards."
16.15. Subsequent Event
U.S. Trust's acquisitionEvents
On April 20, 2004, the Board of State Street Corporation's Private Asset
Management group closedDirectors increased the quarterly cash
dividend from $.014 per share to $.020 per share, payable May 19, 2004 to
stockholders of record May 5, 2004.
On April 22, 2004, the Company filed a Registration Statement under the
Securities Act of 1933 on October 31, 2003.Form S-3 relating to a universal shelf registration
for the issuance of up to $1.0 billion aggregate amount of various securities,
including common stock, preferred stock, debt securities, and warrants. This
Registration Statement was declared effective by the SEC on May 5, 2004. The
Company currently intends to use any proceeds from the issuance of these
securities for general corporate purposes, including, but not limited to,
working capital and possible acquisitions.
- 11 -
THE CHARLES SCHWAB CORPORATION
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Description of Business
The Company:Overview: After seeing positive returns and strong trading volumes in
January, securities market returns softened in February and March in response to
mixed economic and geopolitical developments and concerns about rising interest
rates. Despite the slowing of client activity as the first quarter progressed,
daily average revenue trades for the period were still above the year-ago level
by 55%. Other indicators of client re-engagement continued in the first quarter
- - net inflows to equity and balanced mutual funds totaled $8.6 billion in the
first quarter of 2004, compared to net outflows of $197 million in the first
quarter of 2003, and margin loans reached $9.1 billion as of March 31, 2004, up
47% from March 31, 2003. Additionally, assets in client accounts were
$996.3 billion at March 31, 2004, an increase of $233.7 billion, or 31%, from a
year ago.
The Charles Schwab Corporation (CSC) and its subsidiaries (collectively
referred to as the Company) provide securities brokerage, banking, and related
financial services for 7.67.5 million active client accounts(a). Client
assets in these accounts totaled $876.7 billion at September 30, 2003. Charles Schwab &
Co., Inc. (Schwab) is a securities broker-dealer with 352339 domestic branch
offices in 48 states, as well as a branch in the Commonwealth of Puerto Rico.
U.S. Trust Corporation (USTC, and with its subsidiaries collectively referred to
as U.S. Trust) is a wealth management firm that through its subsidiaries also
provides fiduciary services and private banking services with 3438 offices in 1315
states. Other subsidiaries include Charles Schwab Investment Management, Inc.
(CSIM), the investment advisor for Schwab's proprietary mutual funds, Schwab
Capital Markets L.P. (SCM), a market maker in Nasdaq, exchange-listed, and other
securities providing trade execution services primarily to broker-dealers and
institutional clients, CyberTrader, Inc. (CyberTrader), an electronic trading
technology and brokerage firm providing services to highly active, online
traders, and Charles Schwab Bank, N.A. (Schwab Bank), a retail bank which
commenced operations in the second quarter of 2003.
The Company provides financial services to individuals, institutional
clients, and broker-dealers through four segments - Individual Investor,
Institutional Investor, Capital Markets, and U.S. Trust. The Individual Investor
segment includes the Company's retail brokerage and banking operations. The
Institutional Investor segment provides custodial, trading and support services
to independent investment advisors (IAs), serves company 401(k) plan sponsors
and third-party administrators, and supports company stock option plans. The
Capital Markets segment provides trade execution services in Nasdaq,
exchange-listed, and other securities primarily to broker-dealers, including
Schwab, and institutional clients. The U.S. Trust segment provides investment,
wealth management, custody, fiduciary, and private banking services to
individual and institutional clients.
Management of the Company focuses on several key financial and
non-financial metrics (as shown in the following table) in evaluating the
Company's financial position and operating performance:
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Key Metrics 2004 2003 Change
- --------------------------------------------------------------------------------
Client Activity Metrics:
Net new client assets (in billions) $ 13.8 $ 14.2 (3%)
Client assets
(in billions, at quarter end) $996.3 $762.6 31%
Daily average revenue trades
(in thousands) 178.0 114.6 55%
Company Financial Metrics:
Revenue growth (decline) from
prior year's quarter 32% (14%)
After-tax profit margin 13.5% 7.9%
Return on stockholders' equity 14% 7%
Net income growth (decline) from
prior year's quarter 127% (24%)
Revenue per average full-time
equivalent employee
(annualized, in thousands) $ 284 $ 217 31%
- --------------------------------------------------------------------------------
Management continues to believe that the key to sustaining and improving
the Company's competitive position will be its ability to combine people and
technology in ways that are intended to provide investors with the access,
information, guidance, advice and control they expect - as well as high-quality
service - all at a lower cost than traditional providers of financial services.
Business Strategy: The Company's primary strategy is to servemeet the financial
services needs of individual investors either directly or indirectly through intermediaries,and independent IAs. To sustain and
advance this core franchise, the Company remains focused on improving service
for these clients and building stronger relationships with them. The Company
provides investors and IAs or corporate retirement plan sponsors. The Company'swith products and services that are designedtailored to meet clients' varying investment and financial needs, including help
and advice and access to extensive investment research, news and information.
The Company's infrastructure and resources are focused on pursuing six strategic
priorities:
o providing the(a)
support a full spectrum of affluent investors with the advice,
relationships,investment styles and choices that support their desired investment outcomes;
o delivering the information, technology, service,life stages, and pricing needed to
remain a leader(b) utilize
its scale in serving active traders;
o continuing to provide high-quality service to emerging affluent clients -
those with less than $250,000 in assets;
o providing individual investing services through employers, including
retirementtrading, operations, distribution and option plans as well as personal brokerage accounts;
o offering selected banking services and developing investment products that
give clients greater control and understanding of their finances; and
o retaining a strong capital markets business to address investors' financial
product and trade execution needs.marketing.
For further discussion of the Company's business strategy, see
"Management's Discussion and Analysis of
- ----------
(a) Accounts with balances or activity within the preceding eight months.
- 12 -
Results of Operations and Financial Condition - Description of Business -
Business Strategy" in the Company's 20022003 Annual Report to Stockholders, which is
filed as Exhibit 13.1 to the Company's Form 10-K for the year ended December 31,
2002.2003. See also Item 1 - Business - Narrative Description of Business - "Products, Services, and Advice Offerings"Business
Strategy in the Company's Form 10-K for the year ended December 31, 2002.2003.
Significant recent developments relating to certain of these strategic priorities, as well
as other significant developments, follow:
Services for Affluent Investors: The Company's full-service advice and
relationship service offering includes Schwab Advisor Network(R), Schwab Private
Client(TM), and Schwab Equity Ratings(TM). The Schwab Advisor Network is a
referral program that provides investors who want the assistance of an
independent professional with access to approximately 330 participating IAs.
Schwab Private Client is a fee-based service designed to help clients who want
access to an ongoing, face-to-face advice relationship with a designated Schwab
consultant while retaining day-to-day responsibility for their investment
decisions. Schwab Equity Ratings provide clients with an objective stock rating
system
- --------
(a) Accounts with balances or activity within the preceding eight months.
Reflects the removal of 192,000 accounts in the second quarter of 2003
related to the Company's withdrawal from the Employee Stock Purchase Plan
business and the transfer of those accounts to other providers.
- 12 -
on more than 3,000 stocks, assigning each equity a single grade: A, B, C, D, or
F.
For investors enrolled in Schwab Private Client,three main avenues for
growth include:
Service/Offer Expansion: In February 2004, the Company introduced the
Schwab
Personal Portfolio Dividend Equity(TM) account,Choice(TM), its suite of investing and advice services for individual
investors. Schwab Personal Choice consists of eight different offers that range
from low-priced, technology-based active trading to highly customized wealth
management delivered by IAs, with a managed account that
invests primarilyrange of self-directed and advised investing
services in dividend-paying stocks that have been rated A or B bybetween. In combination with services from U.S. Trust and
CyberTrader, Schwab Equity Ratings.
SchwabPersonal Choice is focused on enhancingdesigned to give investors control over
the support services it offers to IAs. IAs
provide customizedlevel of trading technology, service and personalizedadvice they utilize, the level of
professional involvement in their portfolio management they receive, and financial planning
serviceshow
they pay for those services. In addition, Schwab Personal Choice is designed so
that clients are guided to investors who prefer to delegateappropriate service solutions based primarily on
their financial management
responsibilities to an independent professional. Duringneeds and preferences, rather than portfolio size or trading frequency.
Product Expansion: The Schwab and AXA Rosenberg Fund adoption was completed in
the thirdfirst quarter of 2003,2004, formalizing the introduction of the new Laudus
Group(TM) of 11 mutual funds. In addition to providing clients with more choice,
this adoption provides the Company sponsoredwith a seriesdistribution presence on over 100
third-party mutual fund and 401(k) platforms.
Business Diversification: In the first quarter of 13 Institutional Workshops across the
country. These workshops provided over 800 IA back office staff with training
and suggestions designed to improve operating efficiency as part of our overall
effort to help IAs focus on growing their practices. In addition, The Schwab
Fund for Charitable Giving(R) introduced Charitable Asset Management, a service
which enables IAs working with our Services for Investment Managers group or
U.S. Trust to manage the donated assets in client Charitable Gift Accounts of
$500,000 or more in a flexible, personalized manner.
In June 2003,2004, the Company announced that U.S. Trust agreed to acquire State
Street Corporation's Private Asset Management group (PAM)completed
its acquisition of SoundView Technology Group, Inc. (SoundView), a
providerresearch-driven securities firm providing institutional investors with
fundamental research on companies in selected growth-related industries, for
approximately $340 million, or $289 million net of wealth
management services to clients in the New England area, for $365 million to be
paid inSoundView's cash subject to certain possible adjustments. This transaction is
intended to provide U.S. Trust with an immediate presence in an important wealth
market, as well as enable the Company to add a full array of private banking
capabilities to complement the investment management and fiduciary services
already provided by PAM. See note "16 - Subsequent Event" in the Notes to
Condensed Consolidated Financial Statements for further discussion on this
acquisition.
Services for Active Traders: In the third quarter of 2003, the Company
announced a price reduction for those clients who trade more than 30 times a
quarter - commissions were lowered to $14.95, or $.01 per share for trades over
1,000 shares with a $14.95 minimum.cash
equivalents acquired. Additionally, the Company introducedrecorded securities owned of $93
million related to this acquisition. As a result of a preliminary purchase price
allocation, the Profit Taking Strategies online seminar, which covers strategies for settingCompany recorded goodwill of $195 million and adheringintangible assets
of $21 million related to price targets.this acquisition. The Company also commenced abegan the process
of leveraging its new service that enables
CyberTrader(R) clients toplatform's combination of trade E-mini S&P 500(R)execution and Nasdaq 100 stock index
futures contracts.
Corporate Services: In the third quarter of 2003, the Company launched a
new service for participants in bundled 401(k) plans serviced by Schwab.
Participants in these plans now have either online, telephonic, or in-person
access to customized advice provided by a third party, including specific
recommendations about savings rates and the core investment fund choices
available in a given retirement plan. Participants also have the option of
automatic account rebalancing.
Banking and Other Financial Products: Schwab Bank received final regulatory
approvals and commenced operations as a retail bank in the second quarter of
2003. Schwab Bank is focused on providing mortgage, home equity line of credit,
and deposit services to Schwab's existing clients, as well as newfundamental
research capabilities into stronger relationships with institutional clients.
Schwab Bank offers its products through a variety of channels, including its
main office in Reno, Nevada, as well as telephone and online channels. During
the third quarter of 2003, Schwab Bank originated $1.1 billion in first
mortgages and outstanding home equity lines of credit totaled $101 million at
quarter end. In addition, Schwab Bank's loan commitments at September 30, 2003
included approximately $350 million in first mortgages and approximately
$450 million in new home equity lines of credit. Currently, substantially all
fixed-rate first mortgage loans originated by Schwab Bank are intended for sale,
and are classified as held for sale on the Company's Condensed Consolidated
Balance Sheet. Schwab Bank had total assets of $1.6 billion and deposits from
banking clients of $1.2 billion at September 30, 2003.
Capital Markets: In the third quarter of 2003, the Company increased its
institutional equities trading capabilities by adding 2 more professionals to
lead its sales function for exchange-listed securities and a new Chicago office.
Revenues from institutional equities trading were $91 million in the first nine
months of 2003, up 78% from the first nine months of 2002. Institutional
equities trading is an integral part of the Schwab Liquidity Network(TM), a
market-making system that pools the orders of the Company's individual investor
client base with those of hundreds of broker-dealers and institutional
investment firms in a manner designed to offer greater opportunities for the
best possible price on most stock trades. The Schwab Liquidity Network traded
over 11,000 securities at September 30, 2003, up from about 5,000 securities at
its launch in February 2003.
Other SignificantRegulatory Developments: The Company introduced the Schwab Dividend
Equity Fund(TM), a mutual fund designed to offer clients current income and
capital appreciation by primarily investing in dividend-paying stocks that havehas been rated A or B by Schwab Equity Ratings. This fund, which recognizes the
importance of recent changes in dividend taxation, is the fourth member of the
SchwabFunds Family(R) that utilizes Schwab Equity Ratings to help guide stock
selection.
Regulatory Developments: As with other major mutual fund companies in the
United States and broker-dealers that
- 13 -
distribute mutual fund shares, affiliates of the Company are responding to inquiries and
subpoenas from federal and state regulators as part of an industry-wide review
ofauthorities relating to mutual fund trading,
distribution, and servicing practices. These inquiries
include examinations by the Securitiesat or through Company affiliates, and Exchange Commission of affiliates of
CSC and USTC, and subpoenas issued to affiliates of USTC by the New York State
Attorney General. The Company is cooperating with regulators and ishas been
conducting its own review of fund trading, distribution and servicing practices at or
through Company affiliates. Among other things, the Company is investigatingsuch processes. As disclosed previously, with
respect to U.S. Trust, these investigations have been focusing on circumstances
in which a small number of parties were permitted to engage in short-term
trading of certain Excelsior(R) Funds. The short-term trading activities
permitted under these arrangements were terminated when U.S. Trust's Excelsior(R) Funds;Trust strengthened
its policies and a limited numberprocedures in July 2003. U.S. Trust is assessing the impact of
instances atthis short-term trading activity on the Excelsior Funds, and has committed to
taking remedial action as appropriate. At Schwab, in which fund orders maythese investigations have been
enteredfocusing on a small percentage of trades through Schwab's Mutual Fund
MarketPlace(R) service that were received from the client prior to market close,
but were modified shortly after market close, in each case after employees
contacted the client when the trades as originally submitted were rejected by
Schwab's computer systems during processing. To date, the Company's internal
review has found no evidence of any intention on the part of Schwab employees to
circumvent rules or processed
afterpolicies, no evidence of arrangements with Schwab clients to
permit late trading or market timing through the 4:00 p.m. E.S.T. closing time in a manner contraryMutual Fund MarketPlace, and no
evidence of trading activity by clients or employees to Schwab policies.
The Company's investigation is ongoing andtake advantage of
post-market close information.
Although the Company is takingunable to predict the ultimate outcome of these
matters, any enforcement actions instituted as a result of the investigations
may subject the Company to fines, penalties or other administrative remedies.
The Company is cooperating with regulators, and has taken steps to ensure
compliance withenhance its
existing policies onand procedures to further discourage, detect, and prevent
market timing and late trading.
In addition, various securities regulators are considering new regulations
concerning mutual fund distributionLawsuits have been filed against the Company and servicing, someU.S. Trust and affiliates
alleging breaches of which, if adopted,
could have a negative impact on mutual fund investing generally, including
investments through mutual fund supermarkets such as the Company's Mutual Fund
Marketplace(R) service. The Company is currently unableduties and violations of law with respect to predict whether any
such regulations will be adopted or the final form of any potential new
regulations.these matters.
See Part II - Other Information, Item 1 - Legal Proceedings.
Risk Management
For discussion on the Company's principal risks and some of the policies
and procedures for risk identification, assessment, and mitigation, see
"Management's Discussion and Analysis of Results of Operations and Financial
Condition - Risk Management" in the Company's 20022003 Annual Report to
Stockholders, which is filed as Exhibit 13.1 to the Company's Form 10-K for the
year ended December 31, 2002.2003. See Liquidity and Capital Resources of this report
for a discussion on liquidity risk; and see Item 3 - Quantitative and
Qualitative Disclosures About Market Risk for additional information relating to
market risk.
The Company expects to continue to evaluate and consider potential
strategic transactions, including business combinations, acquisitions and
dispositions of businesses, services, and other assets. At any given time, the
Company may be engaged in discussions or negotiations with respect to one or
more of such transactions. Any such transaction could have a material impact on
the Company's financial position, results of operations, earnings per share
(EPS), or cash flows. There is no assurance that any such discussions or
negotiations will result in the consummation of any transaction. In addition,
the process of integrating any acquisition may create unforeseen operating
difficulties, expenditures, and other risks.
Given the nature of the Company's revenues, expenses, and risk profile, the
Company's earnings and CSC's
- 13 -
common stock price have been and may continue to be subject to significant
volatility from period to period. The Company's results for any interim period
are not necessarily indicative of results for a full year or any other interim
period. Risk is inherent in the Company's business. Consequently, despite the
Company's attempts to identify areas of risk, oversee operational areas
involving risk, and implement policies and procedures designed to mitigate risk,
there can be no assurance that the Company will not suffer unexpected losses due
to operating or other risks.
Forward-Looking Statements
This Quarterly Report on Form 10-Q contains "forward-looking statements"
within the meaning of Section 27A of the Securities Act, and Section 21E of the
Securities Exchange Act of 1934. Forward-looking statements are identified by
words such as "believe," "anticipate," "expect," "intend," "plan," "will,"
"may," and other similar expressions. In addition, any statements that refer to
expectations, projections or other characterizations of future events or
circumstances are forward-looking statements. These forward-looking statements,
which reflect management's beliefs, objectives, and expectations as of the date
hereof, are necessarily estimates based on the best judgment of the Company's
senior management. These statements relate to, among other things, the Company's
ability to achievepursue its strategic prioritiesbusiness strategy and the Company's ability to sustain and
improve its competitive position (see Description of Business - Business
Strategy),; the impactoutcome of potential new regulations concerning mutual
fund distribution and servicingpending regulatory investigations (see Description of
Business - Business Strategy
- - Regulatory Developments), the potential impact of future strategic
transactions (see Risk Management), the impact of expense reduction measures on
the Company's results of operations (see Financial Overview),; sources of liquidity and capital (see
Liquidity and Capital Resources - Liquidity and - Commitments),; the Company's
cash position and cash flows and capital expenditures (see Liquidity and Capital Resources - Cash and
Capital Resources), the impact
of the Company's trading risk as estimated by a value-at-risk measurement
methodology (see Item 3 - Quantitative and Qualitative Disclosures About Market
Risk - Financial Instruments Held For Trading Purposes),; net interest expense under interest rate swaps and the
change in designation of certain interest rate swaps (see Item 3 - Quantitative
and Qualitative Disclosures About Market Risk - Financial Instruments Held For
Purposes Other Than Trading - Interest Rate Swaps),; and contingent liabilities
(see Part II - Other Information, Item 1 - Legal Proceedings). Achievement of
the expressed beliefs, objectives, and expectations described in these
statements is subject to certain risks and uncertainties that could cause actual
results - 14 -
to differ materially from the expressed beliefs, objectives, and
expectations. Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of this Form 10-Q
or, in the case of documents incorporated by reference, as of the date of those
documents.
Important factors that may cause such differences are noted in this interim
report and include, but are not limited to: the Company's success in building
fee-based relationships with its clients; the effect of client trading patterns
on Company revenues and earnings; changes in revenues and profit margin due to
cyclical securities markets and fluctuations in interest rates; the level and
continuing volatility of equity prices; a significant downturn in the securities
markets over a short period of time or a sustained decline in securities prices,
trading volumes, and investor confidence; geopolitical developments affecting
the securities markets, the economy, and investor sentiment; the size and number
of the Company's insurance claims; and a significant decline in the real estate
market, including the Company's ability to sublease certain properties. Other
more general factors that may cause such differences include, but are not
limited to: the Company's inability to attract and retain key personnel; the
timing and impact of changes in the Company's level of investments in personnel,
technology, or advertising; changes in technology; computer system failures and
security breaches; evolving legislation, regulation and changing industry
practices adversely affecting the Company; adverse results of litigation or
regulatory matters; the inability to obtain external financing at acceptable
rates; the effects of competitors' pricing, product and service decisions; and
intensified industry competition and consolidation.
Critical Accounting Policies
Certain of the Company's accounting policies that involve a higher degree
of judgment and complexity are discussed in "Management's Discussion and
Analysis of Results of Operations and Financial Condition - Critical Accounting
Policies" in the Company's 20022003 Annual Report to Stockholders, which is filed as
Exhibit 13.1 to the Company's Form 10-K for the year ended December 31, 2002.2003.
There have been no material changes to these critical accounting policies during
the first nine monthsquarter of 2003.2004.
- 14 -
Three Months Ended September 30, 2003March 31, 2004 Compared To
Three Months Ended September 30, 2002March 31, 2003
All references to EPSearnings per share (EPS) information in this report
reflect diluted earnings per share unless otherwise noted.
FINANCIAL OVERVIEW
Total revenues for the first quarter of 2004 were $1.2 billion, up
$290 million, or 32%, from the first quarter of 2003. The Company's financial performance in the third quarter of 2003 reflects
continued improvement in the market environment, which led to higher levels of
client asset valuations and trading activity. The Company's trading revenues
increased 4% from the third quarter of 2002, primarily due to higher client
trading activity, partially offset by lower average revenue per trade (reflected
in commission revenues).
Non-tradingnon-trading
revenues, which include asset management and administration fees, interest
revenue, net of interest expense (referred to as net interest revenue), and
other revenues, increased 3%19% in the thirdfirst quarter of 20032004 compared to the
year-ago level. The increase in non-trading revenues was primarilylargely due to
an 8% increaseincreases in asset management and administration fees, partially offset by
an 11% decrease inresulting primarily from
higher levels of client assets and higher asset-based fees from certain client
relationships, and net interest revenue.revenue, resulting primarily from higher levels
of interest-earning assets. The increase in asset managementCompany's trading revenues, which include
commissions and administration fees wasprincipal transaction revenues, increased 62% from the first
quarter of 2003, primarily due to increases in average assets in and
service fees earned on Schwab's Mutual Fund OneSource(R) service, as well as
higher account fees. The decrease in net interest revenues was primarily due to
lower rates received on and lower levels of margin loans to clients.client trading activity.
Total expenses excluding interest during the thirdfirst quarter of 20032004 were
$854$943 million, down 16%up 17% from the thirdfirst quarter of 2002.2003. This decreaseincrease was primarily
due to lower restructuring chargeshigher compensation and decreases in almost allbenefits expense
categories as a result of higher levels of
incentive compensation and discretionary bonuses to employees and the
restoration of the Company's continued expense reduction measures.
On January 31, 2003, the Company sold its United Kingdom (U.K.) brokerage
subsidiary, Charles Schwab Europe (CSE), to Barclays PLC (Barclays). The results
of CSE's operations have been summarized401(k) employee contribution match, as gain or loss from discontinued
operations, net of tax, on the Condensed Consolidated Statement of Income. The
reported gain was $3 million for the third quarter of 2003, primarily due to
changeswell as
increases in estimates of costs related to this sale, compared to a loss of
$3 million for the third quarter of 2002. The Company's consolidated prior
period revenues, expenses,professional services and taxes on income have been adjusted to reflect
this presentation. For further information, see note "6 - Discontinued
Operations" in the Notes to Condensed Consolidated Financial Statements.advertising and market development
expense.
Income from continuing operations before taxes on income and extraordinary
gain was $197$247 million
for the thirdfirst quarter of 2003, compared to a $1 million
loss2004, up 155% from continuing operations before taxes and extraordinary gain in the thirdfirst quarter of 2002.2003. This
increase was primarily due to the combination of factors discussed separately
above - lower restructuring chargeshigher revenues, partially offset by increases in compensation and
declines in almost
allbenefits expense, categories, as well as higher revenues.professional services, and advertising and market development
expense. Net income for the thirdfirst quarter of 20032004 was $127$161 million, or $.09$.12 per
share, compared to a net loss of
$4 million forup 127% from the thirdfirst quarter of 2002.2003. The change from a net loss toincrease in net income was
primarily due to higher income from continuing operations before taxes on income
and extraordinary gain as discussed above. The Company's after-tax profit margin for the thirdfirst quarter
of 20032004 was 12.1%13.5%, up from (.4%)7.9% for the thirdfirst quarter of 2002.2003. The annualized
return on - 15 -
stockholders' equity for the thirdfirst quarter of 20032004 was 12%14%, up from 0%7%
for the thirdfirst quarter of 2002.
In the third quarter of 2003, net income of $127 million included the
following items which in total had the effect of decreasing after-tax income by
$20 million: $23 million of restructuring charges and a $3 million gain from
discontinued operations. In the third quarter of 2002, net loss of $4 million
included the following items which in total had the effect of decreasing
after-tax income by $103 million: $100 million of restructuring charges and a $3
million loss from discontinued operations.2003.
Segment Information: In evaluating the Company's financial performance, of the Company's
segments,
management uses adjusted operating income, a non-generally accepted accounting
principles (non-GAAP) income measure which excludes the items described in the
precedingfollowing paragraph. Management believes that adjusted operating income is a
useful indicator of the ongoing financial performance of the Company's segments,
and a tool that can provide meaningful insight into financial performance
without the effects of certain material items that are not expected to be an
ongoing part of operations.operations (e.g., extraordinary items, non-operating revenues,
restructuring charges, impairment charges, acquisition- and merger-related
charges, and discontinued operations).
Net income and adjusted operating income were the same for the first
quarter of 2004. In the first quarter of 2003, net income of $71 million
included the following items which in total had the effect of increasing
after-tax income by $8 million: a $5 million investment write-down related to
the Company's United Kingdom (U.K.) market-making operation, a $3 million loss
from discontinued operations, and a $16 million tax benefit associated with the
Company's sale of its U.K. market-making operation.
As detailed in note "14"13 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements, adjusted operating income before taxes was
$234$247 million for the thirdfirst quarter of 2003,2004, up $76$145 million, or 48%142%, from the
thirdfirst quarter of 20022003 primarily due to increases of $58$131 million, or 61%320%, in
the Individual Investor segment, and
$16$4 million, or 43%6%, in the Institutional
Investor segment, and $13 million, in the Capital Markets segment. These
increases were partially offset by a decrease of $8 million, or 57%, in the
U.S. Trust segment. The increaseincreases in the Individual and Institutional Investor
segment wassegments were primarily due to lower expenses as a result of
the Company's expense reduction measures and higher revenues resulting from increased client
trading activity.activity and levels of client assets. The increase in the Institutional InvestorCapital
Markets segment was primarily due to lower expenses as a result ofhigher revenues resulting from increased
trading volume. The decrease in the Company's expense
reduction measures.
Restructuring: In 2001, the Company initiated a restructuring plan to reduce
operating expensesU.S. Trust segment was due to economic uncertaintiesexpense growth
outpacing revenue growth primarily related to higher compensation-related
expense and difficult market
conditions.the integration of State Street Corporation's Private Asset
Management group (PAM) acquisition.
Restructuring: The restructuring plan was completed inCompany's 2003, 2002, and 2001 restructuring initiatives
included a
workforce reduction, a reductionreductions, reductions in operating facilities, and the removal
of certain systems hardware, software, and equipment from service. Included in
these initiatives were costs associated withservice, and the
withdrawal from certain international operations. In the third quarter of 2002, the Company commenced additional
restructuring initiatives due to continued difficult market conditions. These
initiativesThere were intended to reduce operating expenses and adjust the Company's
organizational structure to improve productivity, enhance efficiency, and
increase profitability. These restructuring initiatives were substantially
completed in 2002 and primarily included further reductions in the Company's
workforce and facilities.
In the third quarter of 2003, the Company commenced additional
restructuring initiatives to further adjust the Company's workforce and
facilities in response to the market environment and the 2002 restructuring
initiatives, which resulted in the centralization of several support functions.
These initiatives include mandatory staff reductions of approximately 265
employees and the consolidation of certain facilities. Although the workforce
and facilities decisions were made and communicated in the third quarter, the
accounting treatment of the related expense spans both the third and fourth
quarters of 2003. The Company recorded pre-tax restructuring charges of
$31 million in the third quarter of 2003, primarily reflecting severance costs
for approximately 175 employees and the consolidation of certain facilities,
including 20 Schwab domestic branch offices. The Company expects to recognize
pre-taxno restructuring
charges in the fourth quarter of 2003 of approximately
$20 million, reflecting severance costs for the approximately 90 remaining
employees who were notified in the third quarter and the consolidation of
certain facilities, including 13 additional Schwab domestic branch offices. The
Company expects that selective hiring in certain areas will offset someeither of the mandatory staff reductions. The actual costsfirst quarters of these restructuring initiatives
could differ from the estimated costs, depending primarily on the Company's
ability to sublease properties. The Company estimates that its 2003
restructuring initiatives will reduce pre-tax operating expenses for full-year
2004 by approximately $40 million compared to annualized third quarter of 2003
operating expenses. The Company expects, however, that these reductions will be
substantially offset by reinvestment in other areas of the Company.
The Company recorded total pre-tax restructuring charges of $37 million in
the third quarter ofor 2003. These charges include amounts related to the 2003
restructuring initiatives, as well as charges primarily due to changes in
estimates of sublease income associated with previously announced efforts to
sublease excess facilities. The Company recorded total pre-tax restructuring
charges of $159 million in the third quarter of 2002, all of which related to
its 2001 and 2002 restructuring initiatives.
As of September 30, 2003, the remaining facilities restructuring reserve of
$215 million related to the Company's restructuring initiatives is net of
estimated future sublease income of approximately $320 million. This estimated
future sublease income amount is determined based upon a number of factors,
including current and expected commercial real estate lease rates in the
respective properties' real estate markets, and estimated vacancy periods prior
to execution of tenant subleases. At September 30, 2003, approximately 45% of
the total square footage targeted for sublease under the restructuring
initiatives has been subleased, up from approximately 25% at December 31, 2002.
- 16 -
For further information on the Company's restructuring initiatives, see
note "4 - Restructuring" in the Notes to Condensed Consolidated Financial
Statements.
REVENUES
Revenues increased by $31 million, or 3%Discontinued Operations: On January 31, 2003, the Company sold its U.K.
brokerage subsidiary, Charles Schwab Europe (CSE), to $1.1 billion inBarclays PLC. The results
of CSE's operations have been summarized as loss from
- 15 -
discontinued operations, net of tax, on the third
quarterCondensed Consolidated Statement of
2003 compared to the third quarter of 2002, primarily due to a
$36 million,Income.
REVENUES
The Company categorizes its revenues as either non-trading or 8%, increase in asset management and administration fees and a
$15 million, or 5%, increase in commission revenues, partially offset by a
$23 million, or 11%, decrease in net interest revenue. The Company's non-trading
revenues represented 65% of total revenues for each of the third quarters of
2003 and 2002 astrading. As
shown in the following table:table (in millions), non-trading, trading, and total
revenues in the first quarter of 2004 all increased from the first quarter of
2003.
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,March 31, Percent
Composition of Revenues 2004 2003 2002Change
- --------------------------------------------------------------------------------
Non-trading revenues:
Asset management and
administration fees 44% 42%$ 505 $ 428 18%
Net interest revenue 17210 175 20
Other 4 333 24 38
- --------------------------------------------------------------------------------
Total non-trading revenues 65 65748 627 19
- --------------------------------------------------------------------------------
Trading revenues:
Commissions 30 30390 240 63
Principal transactions 5 552 33 58
- --------------------------------------------------------------------------------
Total trading revenues 35 35442 273 62
- --------------------------------------------------------------------------------
Total 100% 100%$1,190 $ 900 32%
================================================================================
Percentage of total revenues:
Non-trading revenues 63% 70%
Trading revenues 37% 30%
- --------------------------------------------------------------------------------
While the Individual Investor and Institutional Investor segments generate
both tradingnon-trading and non-tradingtrading revenues, the Capital Markets segment generates
primarily trading revenues and the U.S. Trust segment generates primarily
non-trading revenues. Revenues by segment are as shown in the following table
(in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
March 31, Percent
Revenues by Segment 2004 2003 Change
- --------------------------------------------------------------------------------
Individual Investor $ 685 $ 522 31%
Institutional Investor 232 191 21
Capital Markets 90 36 150
U.S. Trust 181 149 21
Unallocated 2 2 -
- --------------------------------------------------------------------------------
Total revenues $1,190 $ 900 32%
================================================================================
The $31 millionincreases in revenues in the Individual and Institutional Investor
segments from the first quarter of 2003 were primarily due to higher trading
volume and levels of client assets. The increase in revenues fromin the third
quarter of 2002Capital
Markets segment was primarily due to increases in revenues of $21 million, or
4%,higher trading volume. The increase in the
Individual InvestorU.S. Trust segment was primarily due to the acquisition of PAM and $13 million, or 20%, in the Capital
Markets segment.higher levels
of client assets. See note "14"13 - Segment Information" in the Notes to Condensed
Consolidated Financial Statements for financial information by segment.
Asset Management and Administration Fees
Asset management and administration fees, as shown in the table below (in
millions), include mutual fund service fees, as well as fees for other
asset-based financial services provided to individual and institutional clients.
The Company earns mutual fund service fees for
recordkeeping and shareholder services provided to third-party funds, and for
transfer agent services, shareholder services, administration, and investment
management provided to its proprietary funds. These fees are based upon the
daily balances of client assets invested in third-party funds and upon the
average daily net assets of the Company's proprietary funds. Mutual fund service
fees are earned through the Individual Investor, Institutional Investor, and
U.S. Trust segments. The Company also earns asset management and administration
fees for financial services, including investment management and consulting,
trust and fiduciary services, custody services, financial and estate planning,
and private banking services, provided to individual and institutional clients.
These fees are primarily based on the value and composition of assets under
management and are earned through the U.S. Trust, Individual Investor, and
Institutional Investor segments.
Asset management and administration fees were $467 million for the third
quarter of 2003, up $36 million from the third quarter of 2002, as shown in the
following table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,March 31, Percent
Asset Management and Administration Fees 2004 2003 2002 Change
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds (SchwabFunds(R),
Excelsior(R), and other) $223 $218 2%$ 213 $ 217 (2%)
Mutual Fund OneSource(R) 76 61 2592 59 56
Other 1314 10 3040
Asset management and related services 155186 142 931
- --------------------------------------------------------------------------------
Total $467 $431 8%$ 505 $ 428 18%
================================================================================
The increase in asset management and administration fees from the first
quarter of 2003 was primarily due to higher asset-based fees from certain client
relationships and higher levels of client assets, as well as increases in
average assets in and service fees earned on SchwabsSchwab's Mutual Fund OneSource
service, and higher asset-based fees from certain client
relationships.
Assets in client accounts were $876.7 billion at September 30, 2003, an
increase of $149.9 billion, or 21%, from a year ago as shown in the following
table. This increase from a year ago included net new client assets of
$41.4 billion and net market gains of $108.5 billion related to client accounts.
- 17 -
- --------------------------------------------------------------------------------
Change in Client Assets and Accounts
(In billions, at quarter end, September 30, Percent
except as noted) 2003 2002 Change
- --------------------------------------------------------------------------------
Assets in client accounts
Schwab One(R), other cash
equivalents and deposits
from banking clients $ 31.8 $ 29.0 10%
Proprietary funds (SchwabFunds(R),
Excelsior(R) and other):
Money market funds 124.4 129.2 (4)
Equity and bond funds 30.7 26.8 15
- --------------------------------------------------------------------------------
Total proprietary funds 155.1 156.0 (1)
- --------------------------------------------------------------------------------
Mutual Fund Marketplace(R) (1):
Mutual Fund OneSource(R) 90.1 70.0 29
Mutual fund clearing services 28.4 19.8 43
All other 88.3 68.5 29
- --------------------------------------------------------------------------------
Total Mutual Fund Marketplace 206.8 158.3 31
- --------------------------------------------------------------------------------
Total mutual fund assets 361.9 314.3 15
- --------------------------------------------------------------------------------
Equity and other securities (1) 355.9 272.9 30
Fixed income securities (2) 134.6 117.5 15
Margin loans outstanding (7.5) (6.9) 9
- --------------------------------------------------------------------------------
Total client assets $876.7 $726.8 21%
================================================================================
Net change in assets
in client accounts
(for the quarter ended)
Net new client assets $ 10.6 $ 10.6
Net market gains (losses) 21.4 (80.8)
- ---------------------------------------------------------------------
Net growth (decline) $ 32.0 $(70.2)
=====================================================================
New client accounts
(in thousands, for the
quarter ended) 123.9 159.6 (22%)
Active client accounts
(in millions) (3) 7.6 8.0 (5%)
- --------------------------------------------------------------------------------
Active online Schwab client
accounts (in millions) (4) 4.0 4.2 (5%)
Online Schwab client assets $341.5 $279.1 22%
- --------------------------------------------------------------------------------
(1) Excludes all proprietary money market, equity, and bond funds.
(2) Includes $23.8 billion and $15.1 billion at September 30, 2003 and 2002,
respectively, of certain other securities serviced by Schwab's fixed income
division, including exchange-traded unit investment trusts, real estate
investment trusts, and corporate debt.
(3) Active client accounts are defined as accounts with balances or activity
within the preceding eight months. Reflects the removal of 192,000 accounts
in the second quarter of 2003 related to the Company's withdrawal from the
Employee Stock Purchase Plan business and the transfer of those accounts to
other providers.
(4) Active online accounts are defined as all active individual and U.S.
dollar-based international accounts within a household that has had at
least one online session within the past twelve months. Excludes
independent investment advisor accounts and U.S. Trust accounts.service.
Commissions
The Company earns commission revenues, by executing client trades primarily through the
Individual Investor and Institutional Investor segments, as well as the Capital
Markets segment. These revenues are affected by the number of client accounts
that trade, the average number of revenue-generating trades per account, and the
average revenue earned per revenue trade. As shown in the following table (in
millions), commission revenues for the Company were $320 million for the third
quarter of 2003, up $15 million, or 5%, from the third quarter of 2002. This
increase was primarily due to higher daily average trades, partially offset by lower average revenue per revenue trade.executing client trades.
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,March 31, Percent
Commissions 2004 2003 2002 Change
- --------------------------------------------------------------------------------
Equity and other securities $ 267326 $ 254 5%193 69%
Mutual funds 35 26 35
Options 29 30 (3)
Options 24 21 1438
- --------------------------------------------------------------------------------
Total $ 320390 $ 305 5%240 63%
================================================================================
TotalThe increase in commission revenues from the first quarter of 2003 was
primarily due to higher daily average trades. Commission revenues include
$17$53 million in the thirdfirst quarter of 20032004 and $20 million in the thirdfirst quarter of
20022003 related to Schwab's institutional trading business. Additionally,
commission revenues include $18 million in the first quarter of 2004 and
$17 million in the first quarter of 2003 related to certain securities serviced
by Schwab's fixed income division, including exchange-traded unit investment
trusts, real estate investment trusts, and corporate debt. Schwab's fixed income
division also generates principal transaction revenues.
Additionally, commission revenues include $29 million in the third quarter of
2003 and $15 million in the third quarter of 2002 related to Schwab's
institutional trading business. Schwab's institutional trading business also
generates principal transaction revenues, as well as other revenues.
- 1816 -
The Company's client trading activity is shown in the following table (in
thousands):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30, Percent
Daily Average Trades (1) 2003 2002 Change
- --------------------------------------------------------------------------------
Revenue Trades (2)
Online 125.9 107.3 17%
TeleBroker(R) and Schwab by Phone(TM) 4.8 5.4 (11)
Regional client telephone service
centers, branch offices, and other 14.4 16.4 (12)
- --------------------------------------------------------------------------------
Total 145.1 129.1 12%
================================================================================
Mutual Fund OneSource(R) and
Other Asset-Based Trades
Online 52.6 47.9 10%
TeleBroker and Schwab by Phone .4 .3 33
Regional client telephone service
centers, branch offices, and other 5.0 8.3 (40)
- --------------------------------------------------------------------------------
Total 58.0 56.5 3%
================================================================================
Total Daily Average Trades
Online 178.5 155.2 15%
TeleBroker and Schwab by Phone 5.2 5.7 (9)
Regional client telephone service
centers, branch offices, and other 19.4 24.7 (21)
- --------------------------------------------------------------------------------
Total 203.1 185.6 9%
================================================================================
(1) Effective in the third quarter of 2003, the Company considers reduced
exchange trading sessions as half days in calculating daily average trades.
(2) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
As shown in the following table, the total number of clientdaily average revenue trades executed by
the Company has increased 12% as the trading activity per account
that traded has increased, slightly offset by decreases55% in the numberfirst quarter of client
accounts that traded during the quarter and the number of trading days.2004.
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,March 31, Percent
Trading Activity 2004 2003 2002 Change
- --------------------------------------------------------------------------------
TotalDaily average revenue trades
(in thousands) (1) 9,215 8,263 12%178.0 114.6 55%
Accounts that traded during
the quarter (in thousands) 1,267 1,284 (1)1,459 1,108 32
Average revenue trades
per account that traded 7.3 6.4 147.6 6.3 21
Trading frequency proxy (2) 3.8 3.9 (3)4.1 3.5 17
Number of trading days (3) 63.5 64.0 (1)62.0 61.0 2
Average revenue earned
per revenue trade $36.96 $39.71 (7)$37.59 $37.30 1
Online trades as a percentage of
total trades 89% 85%
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
(2) Represents annualized revenue trades per $100,000 in total client assets.
(3) Effective in the third quarter of 2003, the Company considers reduced
exchange trading sessions as half days.
The Company continually monitors its pricing in relation to competitors and
periodically adjusts prices to enhance its competitive position, as well as to
attract and retain clients. Competitive pricing actions have escalated recently,
and the Company is actively evaluating changes to the commission rates and fee
structures for certain clients.
Net Interest Revenue
Net interest revenue, as shown in the following table (in millions), is the
difference between interest earned on certain assets (mainly margin loans to
clients, investments of segregated client cash balances, loans to banking
clients, and securities available for sale) and interest paid on supporting
liabilities (mainly deposits from banking clients and brokerage client cash
balances and deposits from banking
clients)balances). Net interest revenue is affected by changes in the volume and mix of
these assets and liabilities, as well as by fluctuations in interest rates and
hedging strategies.
Substantially all of the Company's net interest revenue is earned through
the Individual Investor, Institutional Investor, and U.S. Trust segments.
- 19 -
Net interest revenue was $181 million for the third quarter of 2003, down
$23 million, or 11%, from the third quarter of 2002 as shown in the following
table (in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,March 31, Percent
2004 2003 2002 Change
- --------------------------------------------------------------------------------
Interest RevenueRevenue:
Margin loans to clients $ 86104 $ 107 (20%)82 27%
Investments, client-related 67 87 (23)62 75 (17)
Loans to banking clients 57 59 (3)61 56 9
Securities available for sale 17 20 (15)30 16 88
Other 9 14 (36)6 10 (40)
- --------------------------------------------------------------------------------
Total 236 287 (18)263 239 10
- --------------------------------------------------------------------------------
Interest ExpenseExpense:
Deposits from banking clients 27 23 17
Brokerage client cash balances 14 41 (66)
Deposits from banking clients 23 24 (4)15 25 (40)
Long-term debt 8 10 (20)
Short-term borrowings 4 62 3 (33)
Other 6 2 n/m1 3 (67)
- --------------------------------------------------------------------------------
Total 55 83 (34)53 64 (17)
- --------------------------------------------------------------------------------
Net interest revenue $ 181210 $ 204 (11%)175 20%
================================================================================
n/m Not meaningful- 17 -
Client-related daily average balances, interest rates, and average net
interest spread for the thirdfirst quarters of 20032004 and 20022003 are summarized in the
following table (dollars in(in millions):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,March 31,
2004 2003 2002
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $ 22,16821,096 $ 18,24721,231
Average interest rate 1.20% 1.90%1.18% 1.44%
Margin loans to clients:
Average balance outstanding $ 7,1598,846 $ 7,3446,399
Average interest rate 4.78% 5.79%4.70% 5.21%
Loans to banking clients:
Average balance outstanding $ 5,1885,800 $ 4,2264,546
Average interest rate 4.38% 5.57%4.20% 5.02%
Securities available for sale:
Average balance outstanding $ 1,7763,456 $ 1,5901,517
Average interest rate 3.76% 5.22%3.44% 4.39%
Average yield on interest-earning assets 2.50% 3.47%2.62% 2.77%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $ 23,26923,924 $ 22,23223,003
Average interest rate .25% .71%.42%
Interest-bearing banking deposits:
Average balance outstanding $ 5,4278,215 $ 4,1234,570
Average interest rate 1.72% 2.39%1.30% 2.06%
Other interest-bearing sources:
Average balance outstanding $ 2,8982,840 $ 1,0222,164
Average interest rate .98% 2.18%.79% 1.25%
Average noninterest-bearing portion $ 4,6974,219 $ 4,0303,956
Average interest rate on funding sources .49% .89%.48% .65%
Summary:
Average yield on interest-earning assets 2.50% 3.47%2.62% 2.77%
Average interest rate on funding sources .49% .89%.48% .65%
- --------------------------------------------------------------------------------
Average net interest spread 2.01% 2.58%
================================================================================2.14% 2.12%
- --------------------------------------------------------------------------------
The decreaseincrease in net interest revenue from the thirdfirst quarter of 20022003 was
primarily due to lower rates receivedchanges in the composition of interest-earning assets,
including increases in margin loan balances and securities available for sale.
In addition, the decline in yields on client-related investments, and lower
levels of, and lower rates received on, margin loansinterest-earning assets due to clients andchanges in
the Company's cash and cash equivalents, partiallyinterest rate environment was offset by lower interest rates paid on brokerage client cash balances and higher average balances of client-related
investments.funding
sources.
Principal Transactions
Principal transaction revenues, as shown in the following table (in
millions), are primarily comprised of revenues from client fixed income
securities trading activity, which are included in the
Capital Markets, Individual Investor, and Institutional Investor segments, and net gains from market-making activities in
equity securities, which are included
in the Capital Markets segment. Factors that influence principal transaction
revenues include the volume of client trades, market price volatility, average
- 20 -
revenue per equity share traded, and changes in regulations and industry
practices.
Principal transaction revenues were $45 million for the third quarter of
2003, down $2 million, or 4%, from the third quarter of 2002, as shown in the
following table (in millions):securities.
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,March 31, Percent
Principal Transactions 2004 2003 2002 Change
- --------------------------------------------------------------------------------
Equity securities $ 27 $ 12 125%
Fixed income securities $ 22 $ 25 (12%)
Equity securities 2321 19 21
Other - 3 (100)
- --------------------------------------------------------------------------------
Total (1) $ 4552 $ 47 (4%)33 58%
================================================================================
(1) Includes $6 million in the third quarter of 2003 and $9 million in the
third quarter of 2002 related to Schwab's institutional trading business.
The decreaseincrease in principal transaction revenues from the first quarter of
2003 was primarily due to lower
average revenue per equity share traded, partially offset by higher equity share volume handled by SCM as a result
of increased institutional trading activity as well as lowerand higher levels of revenues from client fixed
income securities trading activity, and revenues related to Schwab's specialist operations.
Other Revenues
Other revenues include fees for services (such as order handling fees),
account service fees, net gains and losses on certain investments, and software
maintenance fees. Other revenues are earned primarily through the Individual
Investor, Institutional Investor, and U.S. Trust segments. These revenues were
$38 million for the third quarter of 2003, up $5 million, or 15%, from the third
quarter of 2002. This increase was primarily due to net losses on investments in
2002 and gains on sales of loans in 2003, partially offset by lower service fees
in 2003.average revenue
per equity share traded.
EXPENSES EXCLUDING INTEREST
As shown in the table below (in millions), total expenses excluding
interest increased in the first quarter of 2004 primarily due to higher levels
of compensation and benefits expense, professional services, and advertising and
market development expense.
- --------------------------------------------------------------------------------
Three Months
Ended
Composition of Expenses, March 31, Percent
Excluding Interest 2004 2003 Change
- --------------------------------------------------------------------------------
Compensation and benefits $ 528 $ 417 27%
Occupancy and equipment 106 111 (5)
Depreciation and amortization 59 76 (22)
Communications 65 60 8
Professional services 60 37 62
Advertising and market development 62 48 29
Commissions, clearance and floor brokerage 23 13 77
Impairment charges - 5 (100)
Other 40 36 11
- --------------------------------------------------------------------------------
Total $ 943 $ 803 17%
================================================================================
Expenses as a percentage of
total revenues:
Total expenses, excluding interest for79% 89%
Compensation and benefits 44% 46%
Advertising and market development 5% 5%
- --------------------------------------------------------------------------------
- 18 -
Compensation and Benefits
Compensation and benefits expense includes salaries and wages, incentive
and variable compensation, related employee benefits and taxes, and retention
program costs arising from certain acquisitions and mergers.
The increase in compensation and benefits expense from the thirdfirst quarter of
2003 was $854 million, down $167 million, or 16%, from the third quarter of 2002,
primarily due to lower restructuring charges and decreases in almost all expense
categories as a result of the Company's continued expense reduction measures.
Compensation and benefits expense was $445 million for the third quarter of
2003, down $21 million, or 5%, from the third quarter of 2002 primarily due to a
reduction in full-time equivalent employees and lower levels of employee
benefits, partially offset by higher levels of incentive compensation and
discretionary bonuses to employees.employees, costs associated with employees retained
from acquisitions, and higher employee benefits. The following table shows a
comparison of certain compensation and benefits components and employee data (dollars in(in
millions, except as noted):
- --------------------------------------------------------------------------------
Three Months
Ended
September 30,March 31, Percent
Compensation and Benefits 2004 2003 2002 Change
- --------------------------------------------------------------------------------
Salaries and wages $ 293327 $ 320 (8%)305 7%
Incentive and variable compensation 93 73 27111 49 127
Employee benefits and other 59 73 (19)89 63 41
Retention programs (1) 1 - n/m
- --------------------------------------------------------------------------------
Total $ 445528 $ 466 (5%)417 27%
================================================================================
Compensation and benefits expense as a
% of total revenues 42% 46%
Incentive and variable compensation as a
% of compensation and benefits expense 21% 16%
Compensation for temporary employees,
contractors and overtime hours as a
% of compensation and benefits expense 6% 6%
Full-time equivalent employees
(at end of quarter, in thousands) (2) 16.9 16.5 2%
- --------------------------------------------------------------------------------
(1) 16.0 18.8 (15%)
Revenues per average full-time equivalent
employee (in thousands) $65.5 $54.5 20%
- -------------------------------------------------------------------------------
(1)Relates to programs put in place to retain certain employees related to
acquisitions and mergers.
(2) Includes full-time, part-time and temporary employees, and persons employed
on a contract basis.
n/m Not meaningful.
Employee benefits and other expenses decreased by $14 million, or 19%,expense increased from
the third quarter of 2002 primarily due to the continued suspension of the
Company's 401(k) employer contribution, which began in the first quarter of
2003 as well asprimarily due to the restoration of the Company's 401(k) employee
contribution match, which was suspended in 2003 (except for a reductiondiscretionary
award to certain non-officer employees made in full-time equivalent employees, partially offset
bythe fourth quarter of 2003).
Expenses Excluding Compensation and Benefits
The increase in professional services expense from the first quarter of
2003 was primarily due to higher health benefit costs.
Advertisinglevels of consulting fees in several areas,
including new and expanded products and services, and information technology
projects. The increase in advertising and market development expense was $32 million forfrom the
thirdfirst quarter of 2003 down $18 million, or 36%, from the third quarter of 2002. The
decrease was primarily due to reductions, as part of the Company's expense
reduction measures, inincreased television
and print media spending.
Taxes on Income
The Company's effective income tax expense rate was 37.1%34.8% for the thirdfirst quarter of
2003,2004, compared to a tax benefit rate of 33.3%22.8% for the third quarter
of 2002.
- 21 -
Nine Months Ended September 30, 2003 Compared To Nine
Months Ended September 30, 2002
FINANCIAL OVERVIEW
The Company's financial performance in the first nine months of 2003
reflects a continued rebound in the securities markets in the third quarter of
2003, following a difficult market environment which pressured both client asset
valuations and trading activity for most of the first half of the year. The
Company's trading revenues in the first nine months of 2003 decreased 4% from
the year-ago period, primarily due to lower average revenue per equity share
traded in the Capital Markets segment (reflected in principal transaction
revenues), and lower client trading activity in the Individual Investor and
Institutional Investor segments (reflected in commission revenues).
Non-trading revenues decreased 4% in the first nine months of 2003 compared
to the year-ago level. The decrease in non-trading revenues was primarily due to
a 16% decrease in net interest revenue and a 13% decrease in other revenues,
partially offset by a 2% increase in asset management and administration fees.
Average margin loans to clients in the first nine months of 2003 decreased 21%
from year-ago levels, which primarily caused the decline in net interest
revenue. Total expenses excluding interest during the first nine months of 2003
were $2.5 billion, down 11% from $2.8 billion during the first nine months of
2002. This decrease was primarily due to lower restructuring charges and
decreases in almost all expense categories as a result of the Company's
continued expense reduction measures.
The reported loss from discontinued operations related to the Company's
sale of its U.K. brokerage subsidiary was $10 million for the first nine months
of 2002, compared to a net gain of zero for the first nine months of 2003. For
further information, see note "6 - Discontinued Operations" in the Notes to
Condensed Consolidated Financial Statements.
In June 2003, the Company sold its investment in Aitken Campbell, a
market-making joint venture in the U.K., to the Company's joint venture partner,
TD Waterhouse Group, Inc. In the first quarter of 2003, the Company recorded an
impairment charge of $5 million pre tax to reduce the carrying value of its
investment and an income tax benefit of $16 million.2003. The Company's share of
Aitken Campbell's historical earnings, which was accounted for under the equity
method, has not been material to the Company's results of operations, EPS, or
cash flows.
Income from continuing operations before taxes on income and extraordinary
gain was $476 million for the first nine months of 2003, up 61% from the first
nine months of 2002. This
increase was primarily due to the combination of
factors discussed separately above - lower restructuring charges and declines in
almost all expense categories, partially offset by lower revenues. Net income
for the first nine months of 2003 was $324 million, or $.24 per share, up 72%
from $188 million, or $.14 per share, for the first nine months of 2002. The
Company's after-tax profit margin for the first nine months of 2003 was 10.9%,
up from 6.1% for the first nine months of 2002. The annualized return on
stockholders' equity for the first nine months of 2003 was 10%, up from 6% for
the first nine months of 2002.
In the first nine months of 2003, net income of $324 million included the
following items which in total had the effect of decreasing after-tax income by
$16 million: $38 million of restructuring charges, a $5 million investment
write-down related to the Company's U.K. market-making operation, a $16 million tax benefit associated with the Company's sale
of its U.K. market-making operation and an $11 million tax benefit associated with the Company's merger
with U.S. Trust. In the first nine months of 2002, net income of $188 million
included the following items which in total had the effect of decreasing
after-tax income by $131 million: a $10 million loss from discontinued
operations, a $12 million extraordinary gain on the sale of U.S. Trust's
corporate trust business, $117 million of restructuring charges, and $16 million
of acquisition-related charges.
Segment Information: As detailed in note "14 - Segment Information" in the Notes
to Condensed Consolidated Financial Statements, adjusted operating income before
taxes (a non-GAAP income measure) was $542 million for the first nine months of
2003, up $31 million, or 6%, from the first nine months of 2002 primarily due to
increases of $64 million, or 28%, in the Individual Investor segment and
$12 million, or 7%, in the Institutional Investor segment, partially offset by a
decrease of $29 million, or 26%, in the U.S. Trust segment. Additionally, the
Capital Markets segment had a loss before taxes and excluded items of $7 million
in the first nine months of 2003, compared to income before taxes and excluded
items of $9 million in the first nine months of 2002. The changes in the
Individual and Institutional Investor segments were due to lower expenses as a
result of the Company's expense reduction measures, partially offset by lower
client trading activity. The decrease in the U.S. Trust segment was primarily
due to lower average client assets related to declines in market valuations. The
decrease in the Capital Markets segment was primarily due to expense growth,
primarily compensation expense, which exceeded revenue growth.
Restructuring: The Company recorded total pre-tax restructuring charges of
$61 million in the first nine months of 2003. These charges include $31 million
related to the Company's 2003 restructuring initiatives, as well as charges
primarily due to changes in estimates of sublease income associated with
previously announced efforts to sublease
- 22 -
excess facilities. The Company recorded total pre-tax restructuring charges of
$188 million in the first nine months of 2002, all of which related to its 2001
and 2002 restructuring initiatives.
For further information on the Company's restructuring initiatives, see
note "4 - Restructuring" in the Notes to Condensed Consolidated Financial
Statements.
REVENUES
Revenues decreased by $136 million, or 4%, to $3.0 billion in the first
nine months of 2003 compared to the first nine months of 2002, due to a
$99 million, or 16%, decrease in net interest revenue, a $26 million, or 18%,
decrease in principal transaction revenues, a $20 million, or 2%, decrease in
commission revenues, and a $15 million, or 13%, decrease in other revenues,
partially offset by a $24 million, or 2%, increase in asset management and
administration fees. The Company's non-trading revenues represented 67% of total
revenues in the first nine months of 2003 and 2002 as shown in the following
table:
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30,
Composition of Revenues 2003 2002
- --------------------------------------------------------------------------------
Asset management and administration fees 45% 42%
Net interest revenue 18 20
Other 4 5
- --------------------------------------------------------------------------------
Total non-trading revenues 67 67
- --------------------------------------------------------------------------------
Commissions 29 29
Principal transactions 4 4
- --------------------------------------------------------------------------------
Total trading revenues 33 33
- --------------------------------------------------------------------------------
Total 100% 100%
================================================================================
The $136 million decrease in revenues from the first nine months of 2002
was due to decreases in revenues of $75 million, or 4%, in the Individual
Investor segment, $30 million, or 5%, in the Institutional Investor segment, and
$43 million, or 9%, in the U.S. Trust segment, partially offset by a
$12 million, or 6%, increase in the Capital Markets segment. 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 were $1.3 billion for the first
nine months of 2003, up $24 million, or 2%, from the first nine months of 2002,
as shown in the following table (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Asset Management and Administration Fees 2003 2002 Change
- --------------------------------------------------------------------------------
Mutual fund service fees:
Proprietary funds
(SchwabFunds(R), Excelsior(R) and other) $ 663 $ 655 1%
Mutual Fund OneSource(R) 200 204 (2)
Other 36 30 20
Asset management and related services 441 427 3
- --------------------------------------------------------------------------------
Total $1,340 $1,316 2%
================================================================================
The increase in asset management and administration fees was primarily due
to higher account fees and increases in average assets in and service fees
earned on Schwab's proprietary funds, partially offset by a decrease in average
U.S. Trust client assets.
During the first nine months of 2003, both net new client assets and new
accounts decreased from the first nine months of 2002 as shown in the following
table:
- --------------------------------------------------------------------------------
Nine Months
Ended
Change in Client Assets and Accounts September 30, Percent
(In billions, except as noted) 2003 2002 Change
- --------------------------------------------------------------------------------
Net change in assets
in client accounts
Net new client assets $ 31.3 $ 37.5
Net market gains (losses) 80.6 (156.6)
- -------------------------------------------------------------------
Net growth (decline) $ 111.9 $(119.1)
===================================================================
New client accounts
(in thousands) 446.8 616.5 (28%)
- --------------------------------------------------------------------------------
Commissions
As shown in the following table (in millions), commission revenues for the
Company were $873 million for the first nine months of 2003, down $20 million,
or 2%, from the first nine months of 2002. This decrease was primarily due to
lower daily average trades and lower revenue per revenue trade.
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Commissions 2003 2002 Change
- --------------------------------------------------------------------------------
Equity and other securities $ 722 $ 741 (3%)
Mutual funds 82 84 (2)
Options 69 68 1
- --------------------------------------------------------------------------------
Total $ 873 $ 893 (2%)
================================================================================
- 23 -
Total commission revenues include $52 million in each of the first nine
months of 2003 and 2002 related to certain securities serviced by Schwab's fixed
income division, including exchange-traded unit investment trusts, real estate
investment trusts, and corporate debt. Additionally, commission revenues include
$76 million in the first nine months of 2003 and $31 million in the first nine
months of 2002 related to Schwab's institutional trading business.
The Company's client trading activity is shown in the following table (in
thousands):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Daily Average Trades (1) 2003 2002 Change
- --------------------------------------------------------------------------------
Revenue Trades (2)
Online 114.5 112.8 2%
TeleBroker(R) and Schwab by Phone(TM) 4.6 5.9 (22)
Regional client telephone service
centers, branch offices, and other 14.7 16.2 (9)
- --------------------------------------------------------------------------------
Total 133.8 134.9 (1%)
================================================================================
Mutual Fund OneSource(R) and
Other Asset-Based Trades
Online 50.8 47.0 8%
TeleBroker and Schwab by Phone .4 .4 -
Regional client telephone service
centers, branch offices, and other 5.3 10.2 (48)
- --------------------------------------------------------------------------------
Total 56.5 57.6 (2%)
================================================================================
Total Daily Average Trades
Online 165.3 159.8 3%
TeleBroker and Schwab by Phone 5.0 6.3 (21)
Regional client telephone service
centers, branch offices, and other 20.0 26.4 (24)
- --------------------------------------------------------------------------------
Total 190.3 192.5 (1%)
================================================================================
(1) Effective in the third quarter of 2003, the Company considers reduced
exchange trading sessions as half days in calculating daily average trades.
(2) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
As shown in the following table, the total number of revenue trades
executed by the Company has decreased 1% as the number of client accounts that
traded has declined, while the trading activity per account that traded has
increased.
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Trading Activity 2003 2002 Change
- --------------------------------------------------------------------------------
Total revenue trades
(in thousands) (1) 25,088 25,367 (1%)
Accounts that traded during
the period (in thousands) 2,249 2,474 (9)
Average revenue trades
per account that traded 11.2 10.3 9
Trading frequency proxy (2) 3.7 3.8 (3)
Number of trading days (3) 187.5 188.0 -
Average revenue earned
per revenue trade $37.33 $37.87 (1)
- --------------------------------------------------------------------------------
(1) Includes all client trades (both individuals and institutions) that
generate either commission revenue or revenue from principal markups (i.e.,
fixed income).
(2) Represents annualized revenue trades per $100,000 in total client assets.
(3) Effective in the third quarter of 2003, the Company considers reduced
exchange trading sessions as half days.
Net Interest Revenue
Net interest revenue was $536 million for the first nine months of 2003,
down $99 million, or 16%, from the first nine months of 2002 as shown in the
following table (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
2003 2002 Change
- --------------------------------------------------------------------------------
Interest Revenue
Margin loans to clients $ 252 $ 368 (32%)
Investments, client-related 218 255 (15)
Loans to banking clients 169 178 (5)
Securities available for sale 52 59 (12)
Other 28 39 (28)
- --------------------------------------------------------------------------------
Total 719 899 (20)
- --------------------------------------------------------------------------------
Interest Expense
Brokerage client cash balances 62 134 (54)
Deposits from banking clients 69 69 -
Long-term debt 27 37 (27)
Short-term borrowings 11 19 (42)
Other 14 5 180
- --------------------------------------------------------------------------------
Total 183 264 (31)
- --------------------------------------------------------------------------------
Net interest revenue $ 536 $ 635 (16%)
================================================================================
Client-related and other daily average balances, interest rates, and
average net interest spread for the first nine months of 2003 and 2002 are
summarized in the following table (dollars in millions):
- 24 -
- --------------------------------------------------------------------------------
Nine Months Ended
September 30,
2003 2002
- --------------------------------------------------------------------------------
Interest-Earning Assets (client-related and other):
Investments (client-related):
Average balance outstanding $ 21,839 $ 17,425
Average interest rate 1.34% 1.96%
Margin loans to clients:
Average balance outstanding $ 6,716 $ 8,504
Average interest rate 5.02% 5.79%
Loans to banking clients:
Average balance outstanding $ 4,829 $ 4,139
Average interest rate 4.70% 5.75%
Securities available for sale:
Average balance outstanding $ 1,663 $ 1,568
Average interest rate 4.17% 5.07%
Average yield on interest-earning assets 2.65% 3.64%
Funding Sources (client-related and other):
Interest-bearing brokerage client cash balances:
Average balance outstanding $ 23,105 $ 22,496
Average interest rate .36% .80%
Interest-bearing banking deposits:
Average balance outstanding $ 4,879 $ 3,908
Average interest rate 1.90% 2.37%
Other interest-bearing sources:
Average balance outstanding $ 2,579 $ 1,035
Average interest rate 1.12% 2.23%
Average noninterest-bearing portion $ 4,484 $ 4,197
Average interest rate on funding sources .58% .93%
Summary:
Average yield on interest-earning assets 2.65% 3.64%
Average interest rate on funding sources .58% .93%
- --------------------------------------------------------------------------------
Average net interest spread 2.07% 2.71%
================================================================================
The decrease in net interest revenue from the first nine months of 2002 was
due to the factors described in the comparison between the three-month periods.
Principal Transactions
Principal transaction revenues were $121 million for the first nine months
of 2003, down $26 million, or 18%, from the first nine months of 2002, as shown
in the following table (in millions):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Principal Transactions 2003 2002 Change
- --------------------------------------------------------------------------------
Fixed income securities $ 67 $ 72 (7%)
Equity securities 52 66 (21)
Other 2 9 (78)
- --------------------------------------------------------------------------------
Total (1) $121 $147 (18%)
================================================================================
(1) Includes $12 million in the first nine months of 2003 and $16 million in
the first nine months of 2002 related to Schwab's institutional trading
business.
The decrease in principal transaction revenues was due to the factors
described in the comparison between the three-month periods.
Other Revenues
Other revenues were $99 million for the first nine months of 2003, down
$15 million, or 13%, from the first nine months of 2002. This decrease was due
to lower payments for order flow in 2003, and proceeds from the settlement of a
lawsuit and higher net gains on investments, both in 2002, partially offset by
gains on sales of loans in 2003.
EXPENSES EXCLUDING INTEREST
Total expenses excluding interest were $2.5 billion for the first nine
months of 2003, down $316 million, or 11%, from the first nine months of 2002,
primarily due to lower restructuring charges and decreases in almost all expense
categories as a result of the Company's continued expense reduction measures.
Compensation and benefits expense was $1.3 billion for the first nine
months of 2003, down $80 million, or 6%, from the first nine months of 2002,
primarily due to the factors described in the comparison between the three-month
periods.
The following table shows a comparison of certain compensation and benefits
components and employee data (dollars in millions, except as noted):
- --------------------------------------------------------------------------------
Nine Months
Ended
September 30, Percent
Compensation and Benefits 2003 2002 Change
- --------------------------------------------------------------------------------
Salaries and wages $ 897 $ 957 (6%)
Incentive and variable compensation 228 203 12
Employee benefits and other 186 231 (19)
- --------------------------------------------------------------------------------
Total $1,311 $1,391 (6%)
================================================================================
Compensation and benefits expense as a
% of total revenues 44% 45%
Incentive and variable compensation as a
% of compensation and benefits expense 17% 15%
Compensation for temporary employees,
contractors and overtime hours as a
% of compensation and benefits expense 6% 6%
Revenues per average full-time equivalent
employee (in thousands) $182.1 $163.3 12%
- --------------------------------------------------------------------------------
Employee benefits and other expenses decreased by $45 million, or 19%, from
the first nine months of 2002 primarily due to the factors described in the
comparison between the three-month periods.
- 25 -
Advertising and market development expense was $101 million for the first
nine months of 2003, down $52 million, or 34%, from the first nine months of
2002. This decrease was due to the factors described in the comparison between
the three-month periods.
The Company's effective income tax rate was 31.9% for the first nine months
of 2003, down from 37.7% for the first nine months of 2002. The decrease was due
to tax benefits in 2003 related to the Company's merger with U.S. Trust and the
Company's sale of its U.K. market-making operation.
Liquidity and Capital Resources
CSC is a financial holding company, which is a type of bank holding company
subject to supervision and regulation by the Board of Governors of the Federal
Reserve BoardSystem (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 "12"11 - Regulatory Requirements" in the
Notes to Condensed Consolidated Financial Statements.
Liquidity
CSC
CSC's liquidity needs are generally met through cash generated by its
subsidiaries, as well as cash provided by external financing. As discussed
below, Schwab, CSC's depository institution subsidiaries, and SCM are subject to
regulatory requirements that may restrict them from certain transactions with
CSC. Management believes that funds generated by the operations of CSC's
subsidiaries will continue to be the primary funding source in meeting CSC's
liquidity needs, meetingproviding adequate liquidity to meet CSC's depository
institution subsidiaries' capital guidelines, and maintaining Schwab's and SCM's
net capital. Based on their respective regulatory capital ratios at September 30, 2003,March 31,
2004, the Company and its depository institution subsidiaries are considered
well capitalized.
CSC has liquidity needs that arise from its Senior Medium-Term Notes,
Series A (Medium-Term Notes), as well as from the funding of cash dividends,
acquisitions, and other investments. The Medium-Term Notes, of which
$466 million was issued and outstanding at September 30, 2003,March 31, 2004, have maturities
ranging from 2004 to 2010 and fixed interest rates ranging from 6.04% to 8.05%
with interest payable semiannually (see Item 3 - Quantitative and Qualitative
Disclosures About Market Risk - Financial Instruments Held For Purposes Other
Than Trading - Interest Rate Swaps). The Medium-Term Notes are rated A2 by
Moody's Investors Service (Moody's), A- by Standard & Poor's Ratings Group
(S&P), and A by Fitch IBCA, Inc. (Fitch).
CSC has a prospectus supplement on file with the Securities and Exchange
Commission enabling CSC to issue up to $750 million in Senior or Senior
Subordinated Medium-Term Notes, Series A. At September 30, 2003,March 31, 2004, all of these notes
remained unissued.
- 19 -
CSC has authorization from its Board of Directors to issue commercial paper
up to the amount of CSC's committed, unsecured credit facility (see below), not
to exceed $1.5 billion. At September 30, 2003,March 31, 2004, no commercial paper has been issued.
CSC's ratings for these short-term borrowings are P-1 by Moody's, A-2 by S&P,
and F1 by Fitch.
CSC maintains an $800 million committed, unsecured credit facility with a
group of twenty banks which is scheduled to expire in June 2004. CSC plans to
establish a replacement facility when the current facility expires. This
facility replaced a facility that expired in June 2003. These facilities werewas unused during the first nine monthsquarter of 2003.2004. Any issuances under CSC's
commercial paper program (see above) will reduce the amount available under this
facility. The funds under this facility are available for general corporate
purposes and CSC pays a commitment fee on the unused balance of this facility.
The financial covenants in this facility require CSC to maintain a minimum level
of tangible net worth, and Schwab and SCM to maintain specified levels of net
capital, as defined. Management believes that these restrictions will not have a
material effect on its ability to meet foreseeable dividend or funding
requirements.
CSC also has direct access to $778$782 million of the $828$832 million uncommitted,
unsecured bank credit lines, provided by nine banks that are primarily utilized
by Schwab to manage short-term liquidity. The amount available to CSC under
these lines is lower than the amount available to Schwab because the credit line
provided by one of these banks is only available to Schwab. These lines were not
used by CSC during the first nine monthsquarter of 2003.2004.
See note "15 - Subsequent Events" in the Notes to Condensed Consolidated
Financial Statements for a discussion of a $1.0 billion universal shelf
registration statement.
Schwab
Liquidity needs relating to client trading and margin borrowing activities
are met primarily through cash balances in brokerage client accounts, which were
$25.5$26.4 billion and $24.9$25.6 billion at September 30, 2003March 31, 2004 and December 31, 2002,2003,
respectively. Management believes that brokerage client cash balances and
operating earnings will continue to be the primary sources of liquidity for
Schwab in the future.
Upon adoption of Financial Accounting Standards Board Interpretation
(FIN) No. 46 - Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 51 - Consolidated Financial Statements in the
first quarter of 2003, the Company consolidated a special purpose trust (Trust)
and recorded a note payable of $235 million, which was outstanding at March 31,
2004. The interest rate on the note was 1.52% at March 31, 2004, and ranged from
1.52% to 1.58% during the quarter. The building and land have been pledged as
collateral for the note payable. Additionally, the Company has guaranteed the
debt of the Trust up to a maximum of $202 million. The lender does not have
recourse to any other assets of the Company.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of nine banks totaling $832 million at March 31,
2004 (as noted previously, $782 million of these lines are also available for
CSC to use). The need for short-term borrowings arises primarily from timing
differences between cash flow requirements and the scheduled liquidation of
interest-bearing investments. Schwab used such borrowings for 4 days during the
first quarter of 2004, with the daily amounts borrowed averaging $52 million.
The amount outstanding under these lines was $95 million at March 31, 2004.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab has unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
March 31, 2004. Schwab pays a fee to maintain these letters of credit. No funds
were drawn under these letters of credit at March 31, 2004.
Schwab is subject to regulatory requirements that are intended to ensure
the general financial soundness and liquidity of broker-dealers. These
regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying
cash dividends, or making unsecured advances or loans to its parent or employees
if such payment would result in net capital of less than 5% of aggregate debit
- 26 -
balances or less than 120% of its minimum dollar requirement of $1 million. At
September 30, 2003,March 31, 2004, Schwab's net capital was $1.2 billion (16%(13% of aggregate debit
balances), which was $1.1$1.0 billion in excess of its minimum required net capital
and $832$738 million in excess of 5% of aggregate debit balances. Schwab has
historically targeted net capital to be at least 10% of its aggregate debit
balances, which primarily consist of client margin loans.
To manage Schwab's regulatory capital requirement, CSC provides Schwab with
a $1.4 billion subordinated revolving credit facility which is scheduled to
expire in September 2004. The amount outstanding under this facility at
September 30, 2003March 31, 2004 was $220 million. Borrowings under thesethis subordinated lending
arrangementsarrangement qualify as regulatory capital for Schwab.
Upon adoption of Financial Accounting Standards Board Interpretation
(FIN) No. 46 - Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin No. 5120 - Consolidated Financial Statements in the
first quarter of 2003, the Company consolidated a special purpose trust (Trust)
that was formed in 2000 to finance the acquisition and renovation of an office
building and land. See note "2 - New Accounting Standards" in the Notes to
Condensed Consolidated Financial Statements. Upon adoption of FIN No. 46 in the
first quarter of 2003, Schwab recorded long-term debt totaling $235 million,
which was outstanding at September 30, 2003. The long-term debt consists of a
variable-rate note maturing in June 2005. The interest rate on the note was
1.55% at September 30, 2003, and ranged from 1.54% to 1.66% during the quarter,
and 1.54% to 1.82% for the first nine months of 2003. The building and land have
been pledged as collateral for the long-term debt. Additionally, the Company has
guaranteed the debt of the Trust up to a maximum of $202 million. The lender
does not have recourse to any other assets of the Company.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured
bank credit lines with a group of nine banks totaling $828 million at
September 30, 2003 (as noted previously, $778 million of these lines are also
available for CSC to use). The need for short-term borrowings arises primarily
from timing differences between cash flow requirements and the scheduled
liquidation of interest-bearing investments. Schwab used such borrowings for 6
days during the first nine months of 2003, with the daily amounts borrowed
averaging $22 million. There were no borrowings outstanding under these lines at
September 30, 2003.
To satisfy the margin requirement of client option transactions with the
Options Clearing Corporation (OCC), Schwab had unsecured letter of credit
agreements with nine banks in favor of the OCC aggregating $630 million at
September 30, 2003. Schwab pays a fee to maintain these letters of credit. No
funds were drawn under these letters of credit at September 30, 2003.
U.S. Trust
U.S. Trust's liquidity needs are generally met through earnings generated
bydeposits from
banking clients, equity capital, and borrowings.
Certain Schwab brokerage clients can sweep the excess cash held in their
accounts into a money market deposit account at U.S. Trust. At March 31, 2004,
these balances totaled $323 million.
In addition to traditional funding sources such as deposits, federal funds
purchased, and repurchase agreements, USTC's depository institution subsidiaries
have established their own external funding sources. At March 31, 2004,
U.S. Trust had $52 million in Trust Preferred Capital Securities outstanding
with a fixed interest rate of 8.41%. Certain of USTC's depository institution
subsidiaries have established credit facilities with the Federal Home Loan Bank
System (FHLB) totaling $758 million. At March 31, 2004, $475 million was
outstanding under these facilities. Additionally, at March 31, 2004, U.S. Trust
had $184 million of federal funds purchased.
U.S. Trust also engages in intercompany repurchase agreements with Schwab
Bank. At March 31, 2004, U.S. Trust had $400 million in repurchase agreements
outstanding with Schwab Bank.
CSC provides U.S. Trust with a $300 million short-term credit facility
maturing in December 2006. Borrowings under this facility do not qualify as
regulatory capital for U.S. Trust. The amount outstanding under this facility
was $45 million at March 31, 2004.
In the first quarter of 2004, U.S. Trust entered into an interest rate swap
agreement (Swap) with CSC to hedge the interest rate risk associated with its
operations.variable rate deposits from banking clients. At March 31, 2004, this Swap has a
notional value of $400 million and an immaterial fair value.
U.S. Trust is subject to the Federal Reserve Board's risk-based and
leverage capital guidelines. These regulations require banks and bank holding
companies to maintain minimum levels of capital. In addition, USTC's depository
institution subsidiaries are subject to limitations on the amount of dividends
they can pay to USTC.
In addition to traditional funding sources such as deposits, federal funds
purchased, and repurchase agreements, USTC's depository institution subsidiaries
have established their own external funding sources. At September 30, 2003,
U.S. Trust had $50 million in Trust Preferred Capital Securities outstanding
with a fixed interest rate of 8.41%. Certain of USTC's depository institution
subsidiaries have established credit facilities with the Federal Home Loan Bank
System (FHLB) totaling $758 million. At September 30, 2003, $500 million was
outstanding under these facilities. Additionally, at September 30, 2003,
U.S. Trust had $546 million of federal funds purchased and $354 million of
repurchase agreements outstanding.
CSC provides U.S. Trust with a $300 million short-term credit facility
maturing in December 2003. Borrowings under this facility do not qualify as
regulatory capital for U.S. Trust. The amount outstanding under this facility
was $45 million at September 30, 2003.
SCM
SCM's liquiditycapital needs are generally met through its equity capital and
borrowings from CSC. Most of SCM's assets are liquid, consisting primarily of
cash and cash equivalents, marketable securities, and receivables from brokers,
dealers and clearing organizations.
SCM's liquidity is affected by the same regulatory net capital requirements
as Schwab (see discussion above). At September 30, 2003, SCM's net capital was
$76 million, which was $75 million in excess of its minimum required net
capital.
SCM may borrow up to $150 million under a revolving subordinated lending arrangement
with CSC which is scheduled to expire in August 2004. Borrowings under this
arrangement qualify as regulatory capital for SCM. The amount outstanding under
this facility at September 30, 2003March 31, 2004 was $50 million. The advances under this
facility satisfy increased intra-day capital needs at SCM to support the
expansion of its institutional equities and trading businesses. In addition, CSC
provides SCM with a $50 million short-term credit facility. Borrowings under
this arrangement do not qualify as regulatory capital for SCM. No funds were
drawn under this facility at September 30, 2003.
- 27 -March 31, 2004.
SCM is subject to the same regulatory net capital requirements as Schwab
(see discussion above). At March 31, 2004, SCM's net capital was $65 million,
which was $64 million in excess of its minimum required net capital.
Schwab Bank
Schwab Bank's current liquidity needs are generally met through deposits
from banking clients and equity capital.
Certain Schwab brokerage clients can sweep the excess cash held in their
accounts into a money market deposit account at Schwab Bank. At March 31, 2004,
these balances totaled $2.5 billion.
Schwab Bank has access to traditional funding sources such as deposits,
federal funds purchased, and repurchase agreements. Additionally, CSC provides
Schwab Bank with a $100 million short-term credit facility which matures in
December 2005. Borrowings under this facility do not qualify as regulatory
capital for Schwab Bank. No funds were drawn under this facility at March 31,
2004.
Schwab Bank is subject to the same risk-based and leverage capital
guidelines as U.S. Trust (see discussion above), except that Schwab Bank is
subject to a minimum tier 1 leverage ratio of 8% for its first three years of
operations. In addition, Schwab Bank is subject to limitations on the amount of
dividends it can pay to CSC.
Schwab Bank has access to traditional funding sources such as deposits,
federal funds purchased, and repurchase agreements. Additionally, CSC provides
Schwab Bank with a $100 million short-term credit facility which matures in
December 2005. Borrowings under this facility do not qualify as regulatory
capital for Schwab Bank. No funds were drawn under this facility at
September 30, 2003.
Liquidity Risk Factors
Specific risk factors which may affect the Company's liquidity position are
discussed in "Management's Discussion and Analysis of Results of Operations and
Financial Condition - Liquidity and Capital Resources - Liquidity Risk Factors"
in the Company's 20022003 Annual Report to Stockholders, which is filed as
Exhibit 13.1 to the Company's Form 10-K for the year ended December 31, 2002.2003.
There have been no material changes to these liquidity risk factors in the first
nine monthsquarter of 2003.2004.
Cash and Capital Resources
The Company's cash position (reported as cash and cash equivalents on the
Condensed Consolidated Balance Sheet) and cash flows are affected by changes in
brokerage client cash balances and the associated amounts required to be
segregated under federal or other regulatory guidelines. Timing differences
between cash and investments actually
- 21 -
segregated on a given date and the amount required to be segregated for that
date may arise in the ordinary course of business and are addressed by the
Company in accordance with applicable regulations. Other factors which affect
the Company's cash position and cash flows include investment activity in
securities owned, levels of capital expenditures, acquisition activity, banking
client deposit and loan activity, financing activity in short-term borrowings
and long-term debt, payment of dividends, and repurchases of CSC's common stock.
In the first nine monthsquarter of 2003,2004, cash and cash equivalents decreased
$599$418 million, or 19%15%, to $2.5$2.4 billion primarily due to movements of brokerage
client-related funds to meet segregation requirements, and increasesan increase in
investments in securities available for sale and loans to
banking clients, the acquisition of SoundView, and a decrease in short-term
borrowings. These decreases were partially offset by increasesan increase in deposits
from banking clients, primarily related to sweep money market deposit accounts.
Certain Schwab brokerage clients can sweep the excess cash held in their
brokerage accounts into these money market deposit accounts at Schwab Bank or
U.S. Trust. At March 31, 2004, these sweep deposit balances totaled
$2.8 billion, up $1.2 billion from December 31, 2003. This sweep deposit
activity is reflected on the Condensed Consolidated Statement of Cash Flows as a
cash outflow from payables to brokerage clients (classified as an operating
activity) and short-term borrowings.a cash inflow for deposits from banking clients (classified as a
financing activity). Management does not believe that thisthe decline in cash and
cash equivalents in the first quarter of 2004 is an indication of a trend.
The Company's capital expenditures were $101$35 million in the first nine
monthsquarter of
20032004 compared to $114$32 million in the first nine monthsquarter of 2002,2003, or 3% and 4% of
revenues for each period, respectively. Capital expenditures in the first
nine monthsquarter of 20032004 were primarily for software and equipment relating to the
Company's information technology systems and certain facilities. Capital
expenditures as described above include the capitalized costs for developing
internal-use software of $46$19 million in the first nine monthsquarter of 20032004 and
$53$14 million in the first nine monthsquarter of 2002.2003.
During the first nine monthsquarter of 2003,2004, 4 million of the Company's stock options,
with a weighted-average exercise price of $6.23,$5.57, were exercised with cash
proceeds received by the Company of $24$20 million and a related tax benefit of
$4$8 million. The cash proceeds are recorded as an increase in cash and a
corresponding increase in stockholders' equity. The tax benefit is recorded as a
reduction in income taxes payable and a corresponding increase in stockholders'
equity.
The Company increased its long-term debt by $235 million (see discussion
above in "Liquidity - Schwab") and repaid $100 million of long-term debt during
the first nine months of 2003.
The Company increasedreduced its short-term borrowings by $894$241 million during the
first nine monthsquarter of 2003, primarily at U.S. Trust to fund increases2004.
CSC did not repurchase any of its common stock in loans to
banking clients.the first quarter of
2004. During the first nine monthsquarter of 2003, CSC repurchased 4 million shares of its
common stock for $32 million. During the first nine monthsAs of 2002,March 31, 2004, CSC
repurchased 24 million shares of its common stock for $230 million. On March 14,
2003, the Board of Directors authorized the repurchase of up to an additional
$250 million of CSC's common stock. Including the amount remaining under an
authorization granted by the Board of Directors on September 20, 2001, CSC now has authority to
repurchase a totalup to $318 million of $318 million.its common stock.
During the first nine monthsquarters of 20032004 and 2002,2003, the Company paid common stock
cash dividends of $49$19 million and $45$15 million, respectively. See note "15 -
28 -Subsequent Events" in the Notes to Condensed Consolidated Financial Statements
for a discussion of an increase in the quarterly cash dividend.
The Company monitors both the relative composition and absolute level of
its capital structure. The Company's total financial capital (long-term debt
plus stockholders' equity) at September 30, 2003March 31, 2004 was $5.1$5.4 billion, up $435$208 million,
or 9%4%, from December 31, 20022003 primarily due to higher stockholders' equity
and a net increase in long-term debt.equity. At
September 30, 2003,March 31, 2004, the Company had long-term debt of $776$779 million, or 15%14% of total
financial capital, that bears interest at a weighted-average rate of 5.64%5.58%. At
September 30, 2003,March 31, 2004, the Company's stockholders' equity was $4.3$4.7 billion, or 85%86% of
total financial capital.
Commitments
A summary of the Company's principal contractual obligations and other
commitments as of September 30, 2003 is shown in the following table (in
millions). Management believes that funds generated by its operations, as well
as cash provided by external financing, will continue to be the primary funding
sources in meeting these obligations and commitments.
- --------------------------------------------------------------------------------
2004- 2007-
2003 2006 2008 Thereafter Total
- --------------------------------------------------------------------------------
Operating leases (1) $ 100 $ 579 $ 298 $ 625 $1,602
Long-term debt (2) - 440 53 258 751
Credit-related financial
instruments (3) 1,569 171 - - 1,740
Other commitments (4) 5 10 - - 15
- --------------------------------------------------------------------------------
Total $1,674 $1,200 $ 351 $ 883 $4,108
================================================================================
(1) Includes minimum rental commitments, net of sublease commitments, and
maximum guaranteed residual values under noncancelable leases for
equipment.
(2) Excludes the effect of interest rate swaps, see Item 3 - Quantitative and
Qualitative Disclosures About Market Risk - Financial Instruments Held For
Purposes Other Than Trading - Interest Rate Swaps.
(3) Includes U.S. Trust and Schwab Bank firm commitments to extend credit
primarily for mortgage loans to banking clients and standby letters of
credit.
(4) Includes committed capital contributions to venture capital funds.
In addition to the commitments summarized above, in the ordinary course of
its business the Company has entered into various agreements with third-party
vendors, including agreements for advertising, sponsorships of sporting events,
data processing equipment purchases, licensing, and software installation. These
agreements typically can be canceled by the Company if notice is given according
to the terms specified in the agreements.
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 approximately $78$77 million and $34$74 million
at September 30, 2003March 31, 2004 and December 31, 2002,2003, respectively. These securities, and the
associated interest rate risk, are not material to the Company's financial
position, results of operations, or cash flows.
The Company maintains inventories in exchange-listed, Nasdaq, and other
equity securities on both a long and short basis. The fair value of these
securities at September 30, 2003 and December 31, 2002 areis shown in the following table (in millions):
- --------------------------------------------------------------------------------
September 30,March 31, December 31,
Equity Securities 2004 2003 2002
- --------------------------------------------------------------------------------
Long positions $ 89120 $ 7997
Short positions (59) (7)(79) (74)
- --------------------------------------------------------------------------------
Net long positions $ 3041 $ 7223
================================================================================
Using a hypothetical 10% increase or decrease in prices, the potential loss
or gain in fair value is estimated to be approximately $3 million and $7 million
at September 30, 2003 and December 31, 2002, respectively.
In addition, the Company may enter into exchange-traded futures and options
contracts based on equity market indices to hedge potential losses in equity
inventory positions. There were no open futures or options contracts at
September 30, 2003. The notional amounts and fair values of these futures and
options contracts are shown in the following table (in millions):
- --------------------------------------------------------------------------------
September 30, DecemberMarch 31, Exchange-traded Contracts 2003 2002
- --------------------------------------------------------------------------------
Net Short Futures (1):
Notional Amount - $ 63
Fair Value - $ 61
Long Put Options:
Notional Amount - $ 4
Fair Value - -
- --------------------------------------------------------------------------------
(1) Notional amount represents original contract price of the futures. Fair
value represents the index price. The difference between the notional and
fair value amounts are settled daily in accordance with futures market
requirements.
Using a hypothetical 10% increase or decrease in the underlying indices,
the potential loss or gain in fair value was estimated to be approximately
$6 million at December 31, 2002, which would substantially offset the
- 29 -
potential loss or gain on the equity securities previously discussed.
Value-at-risk2004.
Value-At-Risk
All trading activities are subject to market risk limits established by the
Company's businesses and approved by senior management who are independent of
the businesses.
- 22 -
The Company manages trading risk through position policy limits, value-at-risk
(VAR)(VaR) measurement methodology, and other market sensitivity measures. Based on
certain assumptions and historical relationships, VARVaR estimates a potential loss
from adverse changes in the fair values of the Company's overnight trading
positions.
To calculate VAR, the Company uses a 99%
confidence level with a one-day holding period for most instruments. Stress
testing is performed on a regular basis to estimate the potential loss from
severe market conditions. It is the responsibility of the Company's Risk
Management department, in conjunction with the businesses, to develop stress
scenarios and use the information to assess the ongoing appropriateness of
exposure levels and limits.
The Company holds fixed income securities and equities for trading
purposes. The estimated VARVaR for both fixed income securities and equities at
September 30, 2003March 31, 2004 and the high, low, and daily average during the first nine
monthsquarter of
20032004 was $1 million or less for each category and stated period.
The VAR model is a risk analysis tool that attempts to measure the
potential losses in fair value, earnings, or cash flows from changes in market
conditions and may not represent actual losses in fair value that may be
incurred by the Company. The Company believes VAR provides an indication as to
the Company's loss exposure in future periods. However, VAR relies on historical
data and statistical relationships. As a result, VAR must be interpreted with an
understanding of the method's strengths and limitations. The Company actively
works to improve its measurement and use of VAR.
Financial Instruments Held For Purposes Other Than Trading
Debt Issuances
At September 30,March 31, 2004 and December 31, 2003, CSC had $466 million aggregate principal amount of
Medium-Term Notes, with fixed interest rates ranging from 6.04% to 8.05%. At
December 31, 2002, CSC had $566 million aggregate
principal amount of Medium-Term Notes, with fixed interest rates ranging from
6.04% to 8.05%. See "Interest Rate Swaps" below.
At September 30, 2003March 31, 2004 and December 31, 2002,2003, U.S. Trust had $50$52 million Trust
Preferred Capital Securities outstanding, with a fixed interest rate of 8.41%.
The Company has fixed cash flow requirements regarding these long-term debt
obligations due to the fixed rate of interest. The fair value of these
obligations at September 30, 2003March 31, 2004 and December 31, 2002,2003, based on estimates of
market rates for debt with similar terms and remaining maturities, approximated
their carrying amount.
Interest Rate Swaps
As part of its consolidated asset and liability management process, the
Company utilizes interest rate swap agreements (Swaps)Swaps to manage interest rate risk.
U.S. Trust uses LIBOR-based Swaps to hedge the interest rate risk
associated with its variable rate deposits from banking clients. The Swaps are
structured for U.S. Trust to receive a variable rate of interest and pay a fixed
rate of interest. Information on these Swaps is summarized in the following
table:
- --------------------------------------------------------------------------------
September 30,March 31, December 31,
2004 2003 2002
- --------------------------------------------------------------------------------
Notional principal amount (in millions) $ 705625 $ 790705
Weighted-average variable interest rate 1.13% 1.57%1.12% 1.17%
Weighted-average fixed interest rate 6.51% 6.41% 6.38%
Weighted-average maturity (in years) 1.3 1.8.8 1.0
- --------------------------------------------------------------------------------
These Swaps have been designated as cash flow hedges under SFAS No. 133 -
Accounting for Derivative Instruments and Hedging Activities, and are recorded
on the Condensed Consolidated Balance Sheet, with changes in their fair values
primarily recorded in other comprehensive income (loss), a component of
stockholders' equity. At September 30, 2003March 31, 2004 and December 31, 2002,2003, U.S. Trust
recorded a derivative liability of $43$26 million and $64$33 million, respectively,
for these Swaps. Based on current interest rate assumptions and assuming no
additional SwapsSwap agreements are entered into, U.S. Trust expects to reclassify
approximately $32$19 million, or $19$11 million after tax, from other comprehensive
loss to interest expense over the next twelve months.
Due to a divergence between LIBOR rates and the variable rate paid on
banking client deposits, certain of these Swaps with a combined notional amount
of $400 million will not be designated as cash flow hedges for accounting
purposes beginning in the second quarter of 2004. Because these Swaps mature
over the remainder of 2004, this change in accounting designation will not
impact results of operations for full-year 2004, but will impact the timing of
recognition of market gains and losses on these Swaps in the remaining quarterly
reporting periods in 2004. The Company does not expect this change in
designation of Swaps to have a material impact on its financial position,
results of operations, EPS, or cash flows.
CSC uses Swaps to effectively convert the interest rate characteristics of
a portion of its Medium-Term Notes from fixed to variable. These Swaps are
structured for CSC to receive a fixed rate of interest and pay a variable rate
of interest based on the three-month LIBOR rate. The variable interest rates
reset every three months. Information on these Swaps is summarized in the
following table:
- 30 -
- --------------------------------------------------------------------------------
September 30,March 31, December 31,
2004 2003 2002
- --------------------------------------------------------------------------------
Notional principal amount (in millions) $ 293 $ 293
Weighted-average variable interest rate 3.59% 3.87%3.57% 3.62%
Weighted-average fixed interest rate 7.57% 7.57%
Weighted-average maturity (in years) 5.5 6.35.0 5.3
- --------------------------------------------------------------------------------
These Swaps have been designated as fair value hedges under SFAS No. 133,
and are recorded on the Condensed Consolidated Balance Sheet. Changes in fair
value of the Swaps are completely offset by changes in fair value of the hedged
Medium-Term Notes. Therefore, there is no effect on net income. At September 30,March 31,
2004 and December 31, 2003, CSC recorded a derivative asset of $25$26 million and
$19 million, respectively, for these Swaps. Concurrently, the carrying value of
the Medium-Term Notes was increased by $25 million.$26 million and $19 million, at March 31,
2004 and December 31, 2003, respectively.
- 23 -
Loans Held for Sale
Schwab Bank's loans held for sale portfolio consists of fixed-ratefixed- and
hybridadjustable-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. At
September 30, 2003, theThese forward sale commitments werehave been designated as cash flow hedging
instruments of the loans held for sale in effective cash flow hedges.sale. Accordingly, the fair values of the
forward sale commitments are recorded on the Condensed Consolidated Balance
Sheet, with gains or losses recorded in other comprehensive income (loss). At
September 30,March 31, 2004 and December 31, 2003, the derivative assetliability recorded by
Schwab Bank for these forward sale commitments was immaterial.
Deferred Compensation
The Company maintains investments in mutual funds related to its deferred
compensation plan, which is available to certain employees. These investments
were approximately $68 million and $49 million at September 30, 2003 and
December 31, 2002, respectively. These securities, and the associated market
risk, are not material to the Company's financial position, results of
operations, or cash flows.
Value-at-risk
The estimated VAR for equities held for purposes other than trading, which
primarily consist of mutual funds related to the Company's deferred compensation
plan and an equity investment, was $2 million at September 30, 2003 with a high,
low, and daily average of $2 million, $1 million, and $1 million, respectively,
during the first nine months of 2003. The estimated VAR for short-term
investments, which are subject to interest rate risk, held for purposes other
than trading at September 30, 2003 and the high, low, and daily average during
the first nine months of 2003 was $1 million or less for each. The estimated VAR
for foreign exchange investments, which consist of equity investments in the
Company's international subsidiaries, at September 30, 2003 and the high, low,
and daily average during the first nine months of 2003 was $1 million or less
for each.
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 margin loanbalance growth or decline for client loans, deposits,
and brokerage client cash, balance growth
or decline, changes in the level and term structure of interest
rates, the repricing of financial instruments, prepayment and reinvestment
assumptions, loan, banking deposit, and brokerage client cash balanceproduct pricing and volume assumptions. The simulations involve
assumptions that are inherently uncertain and, as a result, the simulations cannot precisely
estimate net interest revenue or precisely predict the impact of changes in
interest rates on net interest revenue. Actual results may differ from simulated
results due to the timing, magnitude, and frequency of interest rate changes as
well as changes in market conditions and management strategies, including
changes in asset and liability mix.
As demonstrated by the simulations presented below, the Company is
positioned so that the consolidated balance sheet produces an increase in net
interest revenue when interest rates rise and, conversely, a decrease in net
interest revenue when interest rates fall (i.e., interest-earning assets are
repricing more quickly than interest-bearing liabilities).
The simulations in the following table assume that the asset and liability
structure of the consolidated balance sheet would not be changed as a result of
the simulated changes in interest rates. As the Company actively manages its
consolidated balance sheet and interest rate exposure, in all likelihood the
Company would take steps to manage any additional interest rate exposure that
could result from changes in the interest rate environment. The following table
shows the results of a gradual 100 basis point increase or decrease in interest
rates relative to the Company's current base rate forecast on simulated net
interest revenue over the next twelve months at September 30, 2003March 31, 2004 and December 31,
2002.2003.
- --------------------------------------------------------------------------------
Impact on Net Interest Revenue September 30,March 31, December 31,
Percentage Increase (Decrease) 2004 2003 2002
- --------------------------------------------------------------------------------
Increase of 100 basis points 2.0% 5.3%.9% 1.7%
Decrease of 100 basis points (7.8%(7.1%) (12.1%(6.4%)
- --------------------------------------------------------------------------------
- 31 -
Item 4. Controls and Procedures
The Company's management, with the participation of the Company's Chief
Executive Officer and Chief Financial Officer, has evaluated the effectiveness
of the Company's disclosure controls and procedures as of September 30, 2003.March 31, 2004. Based
on this evaluation, the Company's Chief Executive Officer and Chief Financial
Officer have concluded, as of March 31, 2004, that the Company'sCompany s disclosure
controls and procedures arewere effective for gathering, analyzing,in recording, processing, summarizing,
and disclosingreporting the information the Company is required to disclose in the reports
it files under the Securities Exchange Act of 1934, within the time periods
specified in the Securities and Exchange Commission's rules and forms. Such
evaluation did not identify any change in the Company's internal control over
financial reporting that occurred during the quarter ended September 30, 2003March 31, 2004 that
has materially affected, or is reasonably likely to materially affect, the
Company's internal control over financial reporting.
- 24 -
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
United States Trust CompanyDescribed below are certain new legal proceedings and certain developments
with respect to pending legal proceedings during the quarter ended March 31,
2004.
In March 2004, a lawsuit was filed in federal court in the Southern
District of New York (U.S.by an Excelsior(R) Funds shareholder alleging violations of
the federal security laws and breaches of fiduciary duty by the Charles Schwab
Trust NY) was Escrow AgentCompany (CSTC), USTC, the Excelsior Funds, and Indenture Trusteesix current or former
members of the Excelsior Funds board in connection with an offering of approximately
$130 million in senior secured redeemable notes issued in July 1998 by Epic
Resorts, LLC (Epic Notes). In January 2002, certain noteholders filed a
complaintmarket-timing and/or
late trading in the SupremeExcelsior Funds. The lawsuit seeks unspecified compensatory
damages, as well as attorneys' fees and costs. The defendants intend to
vigorously defend against this action and the five other class action lawsuits
that were previously disclosed relating to allegations of market-timing in the
Excelsior Funds.
In March 2004, a stockholders' derivative action was filed in California
Superior Court in San Francisco against CSC and fourteen current or former CSC
directors. The action claims that the directors breached their fiduciary duties
to Schwab and its stockholders by allegedly failing to maintain adequate
controls to prevent market timing, late trading, and the disclosure of New York, New York Countyportfolio
holdings information in Excelsior Funds. The lawsuit seeks the recovery of
unspecified compensatory damages and attorneys' fees from the fourteen named
individuals, along with the return of all salaries and other remuneration they
received as directors. CSC is named as a nominal defendant, although no damages
are sought against U.S. Trust NY, alleging that U.S. Trust NY failedCSC. The defendants intend to complyvigorously defend against the
allegations.
In March 2004, CSTC was dismissed as a defendant in one of two previously
disclosed market-timing lawsuits (CSTC has not been served in the other lawsuit)
brought by employees of the Janus Capital Group (Janus) mutual funds, which had
named CSTC as a defendant in connection with its obligationsrole as Escrow Agentdirected trustee for
the Janus 401(k) and Indenture Trustee on the Epic Notes. In August 2003, the
parties agreed to a settlement of the case. Under the terms of the settlement,
plaintiffs released U.S. Trust NY from all liability. Other than an immaterial
deductible, the settlement was paid by USTC's insurance carrier. Although USTC
sold its Corporate Trust business in 2001, under the sale agreement, USTC
retained responsibility for certain litigation, including this case.
As with other major mutual fund companies in the United States and
broker-dealers that distribute mutual fund shares, affiliates of theretirement plans.
The Company arehas been responding to inquiries and subpoenas from federal and
state regulators as part of an
industry-wide review ofauthorities relating to mutual fund trading, distribution, and servicing
practices.at or through Company affiliates, and has been conducting its own review of such
processes. For further information, see Regulatory Developments in Part I -
Financial Information, Item 2 - Management's Discussion and Analysis of
Financial Condition and Results of Operations - Description of BusinessBusiness.
In January 2004, CSC completed its acquisition of SoundView Technology
Group, Inc. (SoundView). Under the acquisition agreement, CSC assumed
responsibility for SoundView's assets and liabilities, including existing
litigation matters in which SoundView is named as a defendant. SoundView and one
or more of its subsidiaries (or one or more entities to which SoundView or its
subsidiaries is a successor) are among the numerous financial institutions named
as defendants in multiple purported securities class actions filed in the United
States District Court for the Southern District of New York (the IPO Allocation
Cases) between 2001 and 2002. The IPO Allocation Cases allege improper practices
in connection with the allocation of shares of IPO securities (and in some
instances, follow-on offering shares) and were brought on behalf of persons who
either directly or in the aftermarket purchased such securities during the time
period between March 1997 and December 2000. The plaintiffs allege that
SoundView (or its named subsidiaries) and the other underwriters named as
defendants in the IPO Allocation Cases required persons receiving allocations of
IPO shares (and in some instances, follow-on offering shares) to pay excessive
and undisclosed commissions on unrelated trades and to purchase shares in the
aftermarket at specific escalating prices in violation of the federal securities
laws. The plaintiffs seek unspecified compensatory damages, as well as interest,
attorneys' fees, and costs. SoundView (and/or one or more of its subsidiaries)
has been named in 48 purported class action cases, which have been consolidated
into 31 actions, each involving a different company's IPO (and in some
instances, follow-on offering). SoundView did not serve as lead underwriter in
any of the offerings at issue in the IPO Allocation Cases. In addition to the
actions in which SoundView is a defendant, SoundView (or one or more of its
subsidiaries) had an underwriting commitment in certain of the actions in which
SoundView is not named as a defendant, and depending on the outcome of those
actions, may have indemnification obligations to the lead underwriter.
Additionally, the companies that issued stock in the offerings at issue in the
IPO Allocation Cases have stated their intention to seek indemnification from
the underwriters. An additional lawsuit filed by a single individual plaintiff
against SoundView and other underwriters containing similar allegations relating
to IPO practices and seeking similar relief is pending as a related case before
the same district court judge. SoundView believes it has defenses to these
actions and intends to vigorously defend against such litigation.
The nature of the Company's business subjects it to claims, lawsuits,
regulatory examinations, and other proceedings in the ordinary course of
business. The ultimate outcome of the matters described above and the various
other lawsuits, arbitration proceedings, and claims pending against the Company
cannot be determined at this time, and the results of these matters cannot be
predicted with certainty. There can be no assurance that these matters will not
have a material adverse effect on the Company's results of operations in any
future period, depending partly on the results for that period, and a
substantial judgment could have a material adverse impact on the Company's
financial
- Business Strategy.25 -
condition, results of operations, and cash flows. However, it is the opinion of
management, after consultation with legal counsel, that the ultimate outcome of
these existing claims and proceedings will not have a material adverse impact on
the financial condition, results of operations, or cash flows of the Company.
Item 2. Changes in Securities, and Use of Proceeds and Issuer Purchases of Equity
Securities
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) The following exhibits are filed as part of this quarterly report on
Form 10-Q.
- --------------------------------------------------------------------------------
Exhibit
Number Exhibit
- --------------------------------------------------------------------------------
10.256 Separation Agreement and General Release by and among10.257 The Charles Schwab Corporation Charles Schwab & Co., Inc., and John Philip
Coghlan dated July 25, 2003.Deferred Compensation Plan, as amended
through January 1, 2004 (supersedes Exhibit 10.215).
12.1 Computation of Ratio of Earnings to Fixed Charges.
31.1 Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted
Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to Rule 13a-14(a)/15d-14(a), As Adopted
Pursuant to Section 302 of The Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant
to Section 906 of The Sarbanes-Oxley Act of 2002.**
32.2 Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant
to Section 906 of The Sarbanes-Oxley Act of 2002.**
** Furnished as an exhibit to this quarterly report on Form 10-Q.
- --------------------------------------------------------------------------------
- 32 -
(b) Reports on Form 8-K
On July 23, 2003,January 22, 2004, the Registrant furnished a Current Report on Form 8-K
announcing under Item 9 (Information Provided Under Item 12)12, in accordance with Securities and Exchange Commission
Release No. 33-8216, the financial results for the quarter and year ended
June 30,December 31, 2003.
On March 29, 2004, the Registrant furnished a Current Report on Form 8-K
providing under Item 12 certain additional financial information (which was not
required to be filed as part of Exhibit 13.1 to the Company's Form 10-K for the
year ended December 31, 2003) and the Letter from the Chief Financial Officer
included in the Company's 2003 Annual Report to Stockholders.
- 3326 -
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 14, 2003May 10, 2004 /s/ Christopher V. Dodds
------------------------ --------------------------------------------- ----------------------------
Christopher V. Dodds
Executive Vice President and
Chief Financial Officer
- 3427 -