Charles Schwab Corporation is an American company based in San Francisco, California. Charles Schwab offers commercial banking, stock brokerage, and wealth management advisory services to both retail and institutional clients. The company's chairman is its founder Charles Schwab.
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 June 30, 1998 Commission file number 1-9700 THE CHARLES SCHWAB CORPORATION (Exact name of Registrant as specified in its charter) Delaware 94-3025021 (State or other jurisdiction (I.R.S. Employer Identification No.) of incorporation or organization) 101 Montgomery Street, San Francisco, CA 94104 (Address of principal executive offices and zip code) Registrant's telephone number, including area code: (415) 627-7000 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No --- --- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 266,930,923 shares of $.01 par value Common Stock Outstanding on July 28, 1998
THE CHARLES SCHWAB CORPORATION THE CHARLES SCHWAB CORPORATION Quarterly Report on Form 10-Q For the Quarter Ended June 30, 1998 Index Page ---- Part I - Financial Information Item 1. Condensed Consolidated Financial Statements: Statement of Income 1 Balance Sheet 2 Statement of Cash Flows 3 Notes 4-6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 7-20 Item 3. Quantitative and Qualitative Disclosures About Market Risk 20-21 Part II - Other Information Item 1. Legal Proceedings 21 Item 2. Changes in Securities and Use of Proceeds 21 Item 3. Defaults Upon Senior Securities 21 Item 4. Submission of Matters to a Vote of Security Holders 21-22 Item 5. Other Information 22 Item 6. Exhibits and Reports on Form 8-K 22 Signature 23 FORWARD-LOOKING STATEMENTS In addition to historical information, this interim report contains forward-looking statements that reflect management's expectations. These statements relate to, among other things, Company contingencies, strategy, revenues, profit margin, sources of liquidity, capital expenditures, and the Year 2000 project. Achievement of the expressed expectations is subject to certain risks and uncertainties that could cause actual results to differ materially from those expectations. See "Description of Business" in Management's Discussion and Analysis of Financial Condition and Results of Operations in this interim report for a discussion of important factors that may cause such differences.
THE CHARLES SCHWAB CORPORATION Part 1 - FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements <TABLE> THE CHARLES SCHWAB CORPORATION CONDENSED CONSOLIDATED STATEMENT OF INCOME (In thousands, except per share amounts) (Unaudited) <CAPTION> Three Months Ended Six Months Ended June 30, June 30, 1998 1997 1998 1997 ---- ---- ---- ---- <S> <C> <C> <C> <C> Revenues Commissions $ 299,332 $ 261,396 $ 597,177 $ 536,315 Mutual fund service fees 136,360 101,824 261,742 196,522 Interest revenue, net of interest expense(1) 116,277 82,485 220,868 159,208 Principal transactions 59,078 63,598 111,736 132,733 Other 26,913 21,481 50,843 41,660 - ---------------------------------------------------------------------------------------------------------------- Total 637,960 530,784 1,242,366 1,066,438 - ---------------------------------------------------------------------------------------------------------------- Expenses Excluding Interest Compensation and benefits 278,813 224,119 544,686 444,957 Communications 53,026 45,511 100,070 91,212 Occupancy and equipment 51,536 38,490 96,706 73,904 Advertising and market development 27,567 25,954 67,717 61,789 Depreciation and amortization 35,255 29,686 69,450 57,459 Commissions, clearance and floor brokerage 20,509 22,217 39,858 44,661 Professional services 22,433 16,573 41,480 30,454 Other 22,940 22,491 44,184 45,939 - ---------------------------------------------------------------------------------------------------------------- Total 512,079 425,041 1,004,151 850,375 - ---------------------------------------------------------------------------------------------------------------- Income before taxes on income 125,881 105,743 238,215 216,063 Taxes on income 49,525 41,781 93,895 85,366 - ---------------------------------------------------------------------------------------------------------------- Net Income $ 76,356 $ 63,962 $ 144,320 $ 130,697 ================================================================================================================ Weighted-average number of common shares outstanding(2, 3) 273,128 271,637 273,976 271,439 ================================================================================================================ Earnings Per Share(2) Basic $ .29 $ .24 $ .55 $ .50 Diluted $ .28 $ .23 $ .53 $ .48 ================================================================================================================ Dividends Declared Per Common Share(2) $ .040 $ .033 $ .080 $ .066 ================================================================================================================ (1) Interest revenue is presented net of interest expense. Interest expense for the three months ended June 30, 1998 and 1997 was $160,643 and $133,126, respectively. Interest expense for the six months ended June 30, 1998 and 1997 was $316,238 and $256,256, respectively. (2) Reflects the September 1997 three-for-two common stock split. (3) Amounts shown are used to calculate diluted earnings per share. See Notes to Condensed Consolidated Financial Statements. - 1 - </TABLE>
<TABLE> THE CHARLES SCHWAB CORPORATION CONDENSED CONSOLIDATED BALANCE SHEET (In thousands, except per share amounts) (Unaudited) <CAPTION> June 30, December 31, 1998 1997 ---- ---- <S> <C> <C> Assets Cash and cash equivalents $ 915,528 $ 797,447 Cash and investments required to be segregated under federal or other regulations (including resale agreements of $5,110,264 in 1998 and $4,707,187 in 1997) 7,109,290 6,774,024 Receivable from brokers, dealers and clearing organizations 405,448 267,070 Receivable from customers - net 9,021,642 7,751,513 Securities owned - at market value 232,389 282,569 Equipment, office facilities and property - net 364,518 342,273 Intangible assets - net 50,791 55,854 Other assets 165,536 210,957 - --------------------------------------------------------------------------------------------------------------- Total $ 18,265,142 $ 16,481,707 =============================================================================================================== Liabilities and Stockholders' Equity Drafts payable $ 226,035 $ 268,644 Payable to brokers, dealers and clearing organizations 1,339,115 1,122,663 Payable to customers 14,622,864 13,106,202 Accrued expenses and other liabilities 471,442 478,032 Borrowings 391,004 361,049 - --------------------------------------------------------------------------------------------------------------- Total liabilities 17,050,460 15,336,590 - --------------------------------------------------------------------------------------------------------------- Stockholders' equity: Preferred stock - 9,940 shares authorized; $.01 par value per share; none issued Common stock - 500,000 shares authorized; $.01 par value per share; 267,688 shares issued in 1998 and 1997 2,677 2,677 Additional paid-in capital 209,519 241,422 Retained earnings 1,078,659 955,496 Treasury stock - 1,093 shares in 1998 and 1,753 shares in 1997, at cost (37,535) (35,401) Unearned ESOP shares (1,471) (2,769) Unamortized restricted stock compensation (38,685) (17,228) Foreign currency translation adjustment 1,518 920 - --------------------------------------------------------------------------------------------------------------- Total stockholders' equity 1,214,682 1,145,117 - --------------------------------------------------------------------------------------------------------------- Total $ 18,265,142 $ 16,481,707 =============================================================================================================== See Notes to Condensed Consolidated Financial Statements. - 2 - </TABLE>
<TABLE> THE CHARLES SCHWAB CORPORATION CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (In thousands) (Unaudited) <CAPTION> Six Months Ended June 30, 1998 1997 ---- ---- <S> <C> <C> Cash flows from operating activities Net income $ 144,320 $ 130,697 Noncash items included in net income: Depreciation and amortization 69,450 57,459 Compensation payable in common stock 15,036 13,300 Deferred income taxes 460 (8,553) Other 324 1,643 Change in securities owned - at market value 50,180 (62,113) Change in other assets 44,809 43,710 Change in accrued expenses and other liabilities 28,957 25,785 - --------------------------------------------------------------------------------------------------------- Net cash provided before change in customer-related balances 353,536 201,928 - --------------------------------------------------------------------------------------------------------- Change in customer-related balances: Cash and investments required to be segregated under federal or other regulations (330,678) 197,937 Receivable from brokers, dealers and clearing organizations (135,818) (66,250) Receivable from customers (1,268,545) (900,557) Drafts payable (42,817) (15,871) Payable to brokers, dealers and clearing organizations 215,009 176,030 Payable to customers 1,510,485 595,674 - --------------------------------------------------------------------------------------------------------- Net change in customer-related balances (52,364) (13,037) - --------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 301,172 188,891 - --------------------------------------------------------------------------------------------------------- Cash flows from investing activities Purchase of equipment, office facilities and property - net (85,401) (69,621) - --------------------------------------------------------------------------------------------------------- Net cash used by investing activities (85,401) (69,621) - --------------------------------------------------------------------------------------------------------- Cash flows from financing activities Proceeds from borrowings 30,000 10,000 Dividends paid (21,285) (17,571) Purchase of treasury stock (122,477) (15,702) Proceeds from stock options exercised and other 15,926 3,590 - --------------------------------------------------------------------------------------------------------- Net cash used by financing activities (97,836) (19,683) - --------------------------------------------------------------------------------------------------------- Effect of exchange rate changes on cash and cash equivalents 146 550 - --------------------------------------------------------------------------------------------------------- Increase in cash and cash equivalents 118,081 100,137 Cash and cash equivalents at beginning of period 797,447 633,317 - --------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 915,528 $ 733,454 ========================================================================================================= See Notes to Condensed Consolidated Financial Statements. - 3 - </TABLE>
THE CHARLES SCHWAB CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Basis of Presentation The accompanying unaudited condensed consolidated financial statements include The Charles Schwab Corporation (CSC) and its subsidiaries (collectively referred to as the Company). CSC is a holding company engaged, through its subsidiaries, in securities brokerage and related financial services. CSC's principal subsidiary, Charles Schwab & Co., Inc. (Schwab), is a securities broker-dealer with 278 domestic branch offices in 47 states, as well as a branch in both the Commonwealth of Puerto Rico and the United Kingdom. Another subsidiary, Mayer & Schweitzer, Inc. (M&S), a market maker in Nasdaq and other securities, provides trade execution services to broker-dealers, including Schwab, and institutional customers. Other subsidiaries include Charles Schwab Investment Management, Inc., the investment advisor for Schwab's proprietary mutual funds, and Charles Schwab Europe, a retail discount securities brokerage firm located in the United Kingdom. These financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (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. All adjustments were of a normal recurring nature. All material intercompany balances and transactions have been eliminated. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company's 1997 Annual Report to Stockholders, which are incorporated by reference in the Company's 1997 Annual Report on Form 10-K and the Company's Quarterly Report on Form 10-Q for the period ended March 31, 1998. The Company's results for any interim period are not necessarily indicative of results for a full year. Certain items in prior periods' financial statements have been reclassified to conform to the 1998 presentation. New Accounting Standards Statement of Financial Accounting Standards (SFAS) No. 125 - Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, was adopted by the Company in 1997, except for certain financial assets for which the effective date had been delayed by SFAS No. 127 - Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125, which was adopted by the Company effective January 1, 1998. SFAS No. 125 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. The adoption of these statements did not have an effect on the Company's financial position, results of operations, earnings per share or cash flows. SFAS No. 130 - Reporting Comprehensive Income, was adopted by the Company effective January 1, 1998. This statement establishes standards for the reporting and display of comprehensive income, which includes net income and changes in equity except those resulting from investments by, or distributions to, stockholders. Comprehensive income is as follows (in thousands): - -------------------------------------------------------------------------------- Three Six Months Ended Months Ended June 30, June 30, 1998 1997 1998 1997 - -------------------------------------------------------------------------------- Net income $ 76,356 $ 63,962 $144,320 $130,697 Foreign currency translation adjustment (136) 914 598 (1,651) - -------------------------------------------------------------------------------- Total comprehensive income $ 76,220 $ 64,876 $144,918 $129,046 ================================================================================ SFAS No. 131 - Disclosures about Segments of an Enterprise and Related Information, was issued in 1997 and the Company is required to adopt this statement at December 31, 1998. This statement establishes standards for disclosures related to business operating segments. The adoption of this statement will not have an effect on the Company's financial position, results of operations, earnings per share or cash flows, but will impact financial statement disclosure. SFAS No. 133 - Accounting for Derivative Instruments and Hedging Activities, was issued in June 1998 and the Company is required to adopt this statement by January 1, 2000. This statement establishes accounting and reporting standards requiring that every derivative instrument be recorded on the balance sheet as either an asset or liability, measured at its fair value. The statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. While the Company is currently evaluating the effects of this statement, its adoption is not expected to have an impact on the Company's financial position, results of operations, earnings per share or cash flows. Statement of Position 98-1 - Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, was issued in March 1998 and is effective for fiscal years beginning after December 15, 1998. This statement requires that certain costs incurred for purchasing or developing software for internal use be capitalized and amortized over the software's useful life. Currently, the Company capitalizes costs incurred for purchasing software for internal use, but expenses costs incurred for developing software for internal use. While the Company is currently evaluating the effects of this statement, its adoption is expected to have an impact on the Company's financial position, results of operations, and earnings per share. Earnings Per Share SFAS No. 128 - Earnings Per Share, requires a dual presentation of basic and diluted earnings per share (EPS). Basic EPS excludes dilution and is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential reduction in EPS that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Earnings per share under the basic and diluted computations are as follows (in thousands, except per share amounts): - ------------------------------------------------------------------------------- Three Six Months Ended Months Ended June 30, June 30, 1998 1997 1998 1997 - ------------------------------------------------------------------------------- Net income $ 76,356 $ 63,962 $144,320 $130,697 =============================================================================== Basic Shares (1): Weighted-average common shares outstanding 263,910 261,978 264,298 261,759 =============================================================================== Diluted Shares (1): Weighted-average common shares outstanding 263,910 261,978 264,298 261,759 Common stock equivalent shares related to stock incentive plans 9,218 9,659 9,678 9,680 - ------------------------------------------------------------------------------- Diluted weighted- average common shares outstanding 273,128 271,637 273,976 271,439 =============================================================================== Basic EPS (1) $ .29 $ .24 $ .55 $ .50 =============================================================================== Diluted EPS (1) $ .28 $ .23 $ .53 $ .48 =============================================================================== (1) Reflects the September 1997 three-for-two common stock split. Regulatory Requirements Schwab and M&S are subject to the Uniform Net Capital Rule under the Securities Exchange Act of 1934 (the Rule) and each compute net capital under the alternative method permitted by this Rule, which requires the maintenance of minimum net capital, as defined, of the greater of 2% of aggregate debit balances arising from customer transactions or a minimum dollar amount, which is based on the type of business conducted by the broker-dealer. The minimum dollar amount for both Schwab and M&S is $1 million. Under the alternative method, a broker-dealer may not repay subordinated borrowings, pay cash dividends, or make any unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar amount requirement. At June 30, 1998, Schwab's net capital was $931 million (10% of aggregate debit balances), which was $751 million in excess of its minimum required net capital and $481 million in excess of 5% of aggregate debit balances. At June 30, 1998, M&S' net capital was $5 million (532% of aggregate debit balances), which was $4 million in excess of its minimum required net capital. Schwab and Charles Schwab Europe had portions of their cash and investments segregated for the exclusive benefit of customers at June 30, 1998, in accordance with applicable regulations. M&S had no such cash reserve requirement at June 30, 1998. Commitments and Contingent Liabilities The staff of the SEC has indicated that it intends to recommend to the SEC that it initiate a civil enforcement action against numerous broker-dealers and individuals, including M&S and certain individuals associated with M&S, in connection with certain customs and practices in the trading of Nasdaq securities. The subject matter of the allegations is similar and related to those in the U.S. Department of Justice antitrust proceeding settled by M&S in July 1996, the SEC's enforcement action against the National Association of Securities Dealers, Inc. and Nasdaq settled in August 1996, and the private antitrust actions settled by M&S in December 1997. Between August 12, 1993 and November 17, 1995, Schwab was named as a defendant in eleven class action lawsuits in seven states. The class actions all purport to be brought on behalf of customers of Schwab who purchased or sold securities for which Schwab received "order flow" payments from the market maker, stock dealer or third party who executed the transaction. The complaints generally allege that Schwab failed to disclose and remit such payments to members of the class, and generally seek damages equal to the payments received by Schwab. Through June 1998, one of the actions was voluntarily dismissed and six were resolved favorably to Schwab on the grounds that the claims asserted are preempted by federal law. The remaining four cases are pending in state courts in Texas, California and Louisiana. The action in California has been dismissed, and plaintiffs have filed an appeal. The actions in Texas and in Natchitoches Parish, Louisiana, have been stayed. On April 8, 1998, in a case filed in the Civil District Court for the Parish of Orleans in Louisiana, the Louisiana Court of Appeals unanimously ruled in favor of Schwab's motion to dismiss on the grounds of federal preemption. On May 4, 1998, this action was remanded to the district court for resolution of an issue relating to Schwab's compliance with SEC Rule 10b-10, which governs disclosure on customer confirmations. The ultimate outcome of the legal proceedings described above and the various other civil actions, arbitration proceedings, and claims pending against the Company cannot be determined at this time, and the results of these legal proceedings cannot be predicted with certainty. There can be no assurance that these legal proceedings will not have a material adverse effect on the Company's results of operations in any future period, depending partly on the results for that period, and a substantial judgment could have a material adverse impact on the Company's financial condition and results of operations. However, it is the opinion of management, after consultation with outside legal counsel, that the ultimate outcome of these actions will not have a material adverse impact on the financial condition or operating results of the Company. Supplemental Cash Flow Information Certain information affecting the cash flows of the Company follows (in thousands): - ------------------------------------------------------- Six Months Ended June 30, 1998 1997 - ------------------------------------------------------- Income taxes paid $ 62,037 $ 67,961 ======================================================= Interest paid: Customer cash balances $279,552 $221,877 Stock-lending activities 19,576 16,929 Borrowings 11,543 9,144 Other 5,604 4,102 - ------------------------------------------------------- Total interest paid $316,275 $252,052 =======================================================
THE CHARLES SCHWAB CORPORATION Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Description of Business The Charles Schwab Corporation (CSC) and its subsidiaries (collectively referred to as the Company) provide securities brokerage and related financial services for 5.3 million active customer accounts(a). Customer assets were $427.6 billion at June 30, 1998. CSC's principal subsidiary, Charles Schwab & Co., Inc. (Schwab), is a securities broker-dealer with 278 domestic branch offices in 47 states, as well as a branch in both the Commonwealth of Puerto Rico and the United Kingdom. Another subsidiary, Mayer & Schweitzer, Inc. (M&S), a market maker in Nasdaq and other securities, provides trade execution services to broker-dealers and institutional customers. Other subsidiaries include Charles Schwab Investment Management, Inc., the investment advisor for Schwab's proprietary mutual funds, and Charles Schwab Europe, a retail discount securities brokerage firm located in the United Kingdom. The Company's strategy is to attract and retain customer assets by focusing on a number of areas within the financial services industry - retail brokerage, mutual funds, support services for independent investment managers, equity securities market-making and 401(k) defined contribution plans. To pursue its strategy and its objective of long-term profitable growth, the Company plans to continue to leverage its competitive advantages. These advantages include a nationally recognized brand, a broad range of products and services, multi-channel delivery systems and an ongoing investment in technology. The Company's nationwide advertising and marketing programs are designed to distinguish the Schwab brand as well as its products and services. These programs helped the Company open 347,000 new customer accounts and gather $17.5 billion in net new customer assets during the second quarter of 1998. The Company offers a broad range of value-oriented products and services to meet customers' varying investment and financial needs. The Company also offers access to extensive investment news and information. The Company's branch office network assists investors in developing asset allocation strategies and evaluating their investment choices. Branch staff also refer investors who desire additional guidance to independent investment managers through the Schwab AdvisorSource(TM) service. Schwab provides custodial, trading and support services to over 5,300 independent investment managers. As of June 30, 1998, Schwab held $128.3 billion in customer assets in accounts managed by these investment managers. The Company's Mutual Fund Marketplace(R) provides customers with the ability to invest in 1,527 mutual funds from 246 fund families, including 923 Mutual Fund OneSource(R) funds. - -------- (a) Accounts with balances or activity within the preceding twelve months. The Company's multi-channel delivery systems allow customers to choose how they prefer to do business with the Company. To enable customers to obtain services in person with a Company representative, the Company maintains a network of branch offices. Telephonic access to the Company is provided primarily through four regional customer telephone service centers and two online customer support centers that operate both during and after normal market hours. Additionally, customers are able to obtain financial information and execute trades on an automated basis through the Company's electronic brokerage channels that provide both online and telephonic access. Online channels include PC-based services such as SchwabLink(R) - a service for investment managers, and the Charles Schwab Web Site(TM) - an information and trading service on the Internet. Automated telephonic channels include TeleBroker(R) - Schwab's touch-tone telephone trading service, and VoiceBroker(TM) - Schwab's voice recognition quote service. Schwab provides every retail customer access to all delivery channels and flat-fee pricing for Internet-based trades. The Company's ongoing investment in technology is a key element in enhancing its delivery systems, providing fast and consistent customer service, and reducing processing costs. The Company uses technology to empower its customers to manage their financial affairs and is a forerunner in driving technological advancements in the financial services industry. During the second quarter of 1998, Schwab introduced the Mutual Fund Performance Profile(TM), a new Internet-based investment service which enables investors to evaluate the historical performance of mutual funds in their portfolios. Also during the second quarter of 1998, Charles Schwab Europe launched the first Web site in the United Kingdom to offer online trading in sterling securities listed on the London Stock Exchange. In addition, Schwab introduced a Web site that enables investors to review their accounts and trade securities in Chinese. The Company's operations are highly dependent on the integrity of its computer and technological systems and the Company's success depends, in part, on its ability to make timely enhancements and additions to its technology to anticipate customer demands. To the extent the Company experiences system interruptions, errors or downtime (which could result from a variety of causes, including changes in customer use patterns, technological failure, changes to its systems, linkages with third-party systems, and power failures), the Company's business and operations could be negatively impacted. The Company faces significant competition from companies seeking to attract customer financial assets, including full commission brokerage firms, discount brokerage firms, mutual fund companies and banks. Certain of these competitors have significantly greater financial resources than the Company, particularly given the acceleration of the consolidation trend within the financial services industry in the first half of 1998. In addition, the recent expansion and customer acceptance of conducting financial transactions online has attracted competition from providers of online services and software development companies. In the first half of 1998, price competition continued in the area of online investing as competitors sought to gain market share in this rapidly growing area. Increased competition can be expected due to the low barriers to entry for the establishment and operation of online investment services. The Company experienced declines in its average commission per revenue trade in the first half of 1998 mainly due to the Company's integration of its online and traditional brokerage services and reduction of the price of online trades for most of its customers, causing an increase in the proportion of trades placed through its online brokerage channels. As the Company focuses on further enhancements to its electronic service offering, average commission per revenue trade is expected to continue to decline. These competitive factors, pricing changes and trading trends may negatively impact the Company's revenue growth and profit margin. The Company's business, like that of other securities brokerage firms, is directly affected by the fluctuations in securities trading volumes and price levels that occur in fundamentally cyclical financial markets. Since transaction-based revenues continue to represent a majority of the Company's revenues, the Company may experience significant variations in revenues from period to period. The Company adjusts its expenses in anticipation of and in response to changes in financial market conditions and customer trading patterns. Certain of the Company's expenses (including variable compensation, portions of communications, and commissions, clearance and floor brokerage) vary directly with changes in financial performance or customer trading activity. Expenses relating to the level of temporary employees, contractors, overtime hours, professional services, and advertising and market development are adjustable over the short term to help the Company achieve its financial objectives. Additionally, developmental spending (including branch openings, product and service rollouts, and technology enhancements) is discretionary and can be altered in response to market conditions. However, a significant portion of the Company's expenses such as salaries and wages, occupancy and equipment, and depreciation and amortization do not vary directly, at least in the short term, with fluctuations in revenues or securities trading volumes. Also, the Company views its developmental spending as essential for future growth and therefore attempts to avoid major adjustments in such spending unless faced with a sustained slowdown in customer trading activity. Given the nature of the Company's revenues and expenses, and the economic and competitive factors discussed above, the Company's earnings and common stock price may be subject to significant volatility from period to period. The Company's results for any interim period are not necessarily indicative of results for a full year. In addition to historical information, this interim report contains forward-looking statements that reflect management's expectations. These statements relate to, among other things, Company contingencies (see "Commitments and Contingent Liabilities" note in the Notes to Condensed Consolidated Financial Statements), the Company's strategy (see Description of Business), revenues (see Principal Transactions), profit margin (see Principal Transactions), sources of liquidity (see Liquidity and Capital Resources-Liquidity), capital expenditures (see Liquidity and Capital Resources-Cash Flows and Capital Resources), and the Year 2000 project (see Liquidity and Capital Resources-Year 2000). Achievement of the expressed expectations is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed expectations. Important factors that may cause such differences are noted throughout this interim report and include, but are not limited to: the effect of customer trading patterns on Company revenues and earnings; changes in technology; computer system failures; risks associated with the Year 2000 computer system conversions; the effects of competitors' pricing, product and service decisions and intensified competition; evolving regulation and changing industry customs and practices adversely affecting the Company; adverse results of litigation; changes in revenues and profit margin due to cyclical securities markets and interest rates; and a significant downturn in the securities markets over a short period of time or a sustained decline in securities prices and trading volumes. Three Months Ended June 30, 1998 Compared To Three Months Ended June 30, 1997 Financial Overview Net income for the second quarter of 1998 was $76 million, up 19% from second quarter 1997 net income of $64 million. Diluted earnings per share for the second quarters of 1998 and 1997 were $.28 and $.23 per share, respectively. Share and per share data have been restated to reflect the effects of the September 1997 three-for-two common stock split. Second quarter 1998 revenues were $638 million, up 20% from $531 million for the second quarter of 1997, primarily due to a 15% increase in commission revenues, a 34% increase in mutual fund service fees, and a 41% increase in interest revenue, net of interest expense (referred to as net interest revenue). These increases mainly resulted from higher trading volume and increases in customer assets and margin loans to customers. During the second quarter of 1998, total trading activity reached record levels as shown in the following table (in thousands): - ------------------------------------------------------------- Three Months Ended June 30, Percent Daily Average Trades 1998 1997 Change - ------------------------------------------------------------- Revenue Trades Online 48.9 22.6 116% TeleBroker(R) 7.9 10.9 (28) Regional customer telephone service centers, branch offices and other 31.2 30.5 2 - ------------------------------------------------------------- Total 88.0 64.0 38% ============================================================= Mutual Fund OneSource(R) Trades Online 17.0 12.5 36% TeleBroker 1.0 1.2 (17) Regional customer telephone service centers, branch offices and other 21.4 18.8 14 - ------------------------------------------------------------- Total 39.4 32.5 21% ============================================================= Total Daily Average Trades Online 65.9 35.1 88% TeleBroker 8.9 12.1 (26) Regional customer telephone service centers, branch offices and other 52.6 49.3 7 - ------------------------------------------------------------- Total 127.4 96.5 32% ============================================================= Assets in Schwab customer accounts were $427.6 billion at June 30, 1998, an increase of $121.3 billion, or 40%, from a year ago as shown in the table below. This increase resulted from net new customer assets of $77.8 billion and net market gains of $43.5 billion. - ---------------------------------------------------------- Growth in Schwab Customer Assets and Accounts (In billions, at quarter end, June 30, Percent except as noted) 1998 1997 Change - ---------------------------------------------------------- Assets in Schwab customer accounts Schwab One(R) and other cash equivalents (1) $ 13.8 $ 11.1 24% SchwabFunds(R): Money market funds (1) 55.5 43.8 27 Equity and bond funds 11.2 5.4 107 - ----------------------------------------------------------- Total SchwabFunds 66.7 49.2 36 - ----------------------------------------------------------- Mutual Fund Marketplace(R)(2): Mutual Fund OneSource 69.3 49.5 40 All other 58.0 42.9 35 - ----------------------------------------------------------- Total Mutual Fund Marketplace 127.3 92.4 38 Equity and other securities(2) 196.4 130.4 51 Fixed income securities 32.3 29.3 10 Margin loans outstanding (8.9) (6.1) 46 - ----------------------------------------------------------- Total $ 427.6 $ 306.3 40% =========================================================== Net growth in assets in Schwab customer accounts (for the quarter ended) Net new customer assets $ 17.5 $ 12.0 46% Net market gains 3.4 26.7 (87) - ----------------------------------------------------------- Net growth $ 20.9 $ 38.7 (46%) ============================================================ New Schwab customer accounts (in thousands, for the quarter ended) 347.3 290.1 20% Active Schwab customer accounts (in millions) 5.3 4.4 20 ============================================================ (1) Represents a component of customer cash and equivalents. (2) Excludes money market funds and all of Schwab's proprietary money market, equity and bond funds. Total operating expenses excluding interest during the second quarter of 1998 were $512 million, up 20% from $425 million for the second quarter of 1997, primarily resulting from additional staff and related costs. The after-tax profit margin for the second quarter of 1998 was 12.0%, down slightly from 12.1% for the second quarter of 1997. The annualized return on stockholders' equity for the second quarter of 1998 was 26%, down from 27% for the second quarter of 1997, reflecting the Company's higher equity base in the second quarter of 1998. REVENUES - ------------------------------------------------------------- Three Months Ended June 30, Composition of Revenues 1998 1997 - ------------------------------------------------------------- Commissions 47% 49% Mutual fund service fees 21 19 Net interest revenue 18 16 Principal transactions 9 12 Other 5 4 - ------------------------------------------------------------ Total 100% 100% ============================================================= Commissions Commission revenues for the Company were $299 million for the second quarter of 1998, up $38 million, or 15%, from the second quarter of 1997. As shown in the table below, the total number of revenue trades executed by the Company has increased 35% as the Company's customer base has grown. Average commission per revenue trade decreased 15%. This decrease was mainly due to the Company's reduction of the price of online trades for most of its customers in the first quarter of 1998, causing relatively more trades to be placed through online brokerage channels. - --------------------------------------------------------- Three Months Commissions Earned Ended on Customer Revenue June 30, Percent Trades 1998 1997 Change - --------------------------------------------------------- Customer accounts that traded during the quarter (in thousands) 1,263 1,000 26% Average customer revenue trades per account 4.38 4.09 7 Total revenue trades (in thousands) 5,534 4,091 35 Average commission per revenue trade $ 54.12 $ 63.59 (15) Commissions earned on customer revenue trades (in millions) (1) $ 299 $ 260 15 ========================================================= (1) Excludes commissions on trades with specialists totaling $1 million in the second quarter of 1997. Attracting new customer accounts is important in generating commission revenues. Schwab added 347,000 new customer accounts during the second quarter of 1998, an increase of 20% from the 290,000 new accounts added during the second quarter of 1997. Mutual Fund Service Fees Mutual fund service fees were $136 million for the second quarter of 1998, up $35 million, or 34%, from the second quarter of 1997. This increase was primarily due to significant increases in customer assets in funds purchased through Schwab's Mutual Fund OneSource(R) service, and in customer assets in Schwab's proprietary funds, collectively referred to as the SchwabFunds(R) (see Growth in Schwab Customer Assets and Accounts table in Financial Overview). The Company earns mutual fund service fees for transfer agent services, shareholder services, administration and investment management provided to the SchwabFunds, as well as record keeping and shareholder services provided to funds in the Mutual Fund OneSource service. Net Interest Revenue Net interest revenue was $116 million for the second quarter of 1998, up $34 million, or 41%, from the second quarter of 1997 as shown in the following table (in millions): - ------------------------------------------------------------ Three Months Ended June 30, 1998 1997 - ------------------------------------------------------------ Interest Revenue Margin loans to customers $ 169 $ 111 Investments, customer-related 96 96 Other 12 8 - ------------------------------------------------------------ Total 277 215 - ------------------------------------------------------------ Interest Expense Customer cash balances 142 116 Stock-lending activities 10 10 Borrowings 6 5 Other 3 2 - ------------------------------------------------------------ Total 161 133 - ------------------------------------------------------------ Net interest revenue $ 116 $ 82 ============================================================ Customer-related daily average balances, interest rates and average net interest margin for the second quarters of 1998 and 1997 are summarized in the following table (dollars in millions): - ----------------------------------------------------------- Three Months Ended June 30, 1998 1997 - ----------------------------------------------------------- Interest-Earning Assets (customer-related): Investments: Average balance outstanding $ 7,290 $ 7,193 Average interest rate 5.29% 5.36% Margin loans to customers: Average balance outstanding $ 8,825 $ 5,774 Average interest rate 7.67% 7.73% Average yield on interest-earning assets 6.59% 6.42% Funding Sources (customer-related and other): Interest-bearing customer cash balances: Average balance outstanding $12,841 $10,406 Average interest rate 4.44% 4.47% Other interest-bearing sources: Average balance outstanding $ 1,345 $ 1,108 Average interest rate 4.32% 4.56% Average noninterest-bearing portion $ 1,929 $ 1,453 Average interest rate on funding sources 3.90% 3.98% Summary: Average yield on interest-earning assets 6.59% 6.42% Average interest rate on funding sources 3.90% 3.98% - ----------------------------------------------------------- Average net interest margin 2.69% 2.44% =========================================================== The increase in net interest revenue from the second quarter of 1997 was primarily due to higher levels of margin loans to customers. Principal Transactions Principal transaction revenues were $59 million for the second quarter of 1998, down $5 million, or 7%, from the second quarter of 1997. This decrease was primarily due to lower average revenue per principal transaction (see discussion below), partially offset by greater share volume handled by M&S. Certain new Securities and Exchange Commission (SEC) rules and rule amendments, known as the Order Handling Rules, have significantly altered the manner in which orders for both Nasdaq and exchange-listed securities are handled. These rules were implemented in phases between January 20, 1997 and October 13, 1997. Additionally, in June 1997, most major U.S. securities markets, including Nasdaq and the New York Stock Exchange, Inc., began quoting and trading securities in increments of one-sixteenth dollar per share instead of one-eighth dollar per share for most securities, and these markets are currently considering further reductions in the increments by which securities are priced. Mainly as a result of these regulatory changes and changes in industry customs and practices, average revenue per principal transaction declined in the second quarter of 1998 as compared to the same period in 1997. Average revenue per principal transaction increased, however, in the second quarter of 1998 compared to the first quarter of 1998. Since the change to trading securities in increments of one-sixteenth dollar per share was implemented in June 1997 and the Order Handling Rules were not fully implemented until October 1997, the Company expects M&S' average revenue per principal transaction for 1998 to be materially less than during comparable periods of 1997. Two proposed regulatory changes, the National Association of Securities Dealers, Inc.'s (NASD) Next Nasdaq trading system, and the Primary Market Maker Rules, have the potential to further reduce M&S' principal transaction revenues, although the Company is working with the NASD to modify these proposals to minimize their impact. See "Commitments and Contingent Liabilities" note in Item 1. Notes to Condensed Consolidated Financial Statements regarding certain civil litigation relating to various principal transaction activities. Expenses Excluding Interest Compensation and benefits expense was $279 million for the second quarter of 1998, up $55 million, or 24%, from the second quarter of 1997 primarily due to a greater number of employees. The following table shows a comparison of certain compensation and benefits components and employee data (in thousands): - ------------------------------------------------------------- Three Months Ended June 30, 1998 1997 - ------------------------------------------------------------- Compensation and benefits expense as a % of revenues 44% 42% Variable compensation as a % of compensation and benefits expense 21% 20% Compensation for temporary employees, contractors and overtime hours as a % of compensation and benefits expense 15% 15% Full-time equivalent employees(1) 13.2 11.2 Revenues per average full-time equivalent employee $48.1 $47.1 ============================================================= (1) Includes full-time, part-time and temporary employees, and persons employed on a contract basis. Occupancy and equipment expense was $52 million in the second quarter of 1998, up $13 million, or 34%, from the second quarter of 1997. This increase was primarily due to additional lease expenses on the Company's expanded office space, as well as increased lease and maintenance expenses on data processing equipment. Advertising and market development expense was $28 million in the second quarter of 1998, up $2 million, or 6%, from the second quarter of 1997. This increase was primarily due to online advertising, as well as increased media spending, partially offset by reduced direct mail spending. Advertising and market development expense was 4% and 5% of revenues for the second quarters of 1998 and 1997, respectively. Depreciation and amortization expense was $35 million in the second quarter of 1998, up $6 million, or 19%, from the second quarter of 1997. This increase was primarily due to newly acquired data processing equipment which expanded the Company's customer service capacity. Professional services expense was $22 million in the second quarter of 1998, up $6 million, or 35%, from the second quarter of 1997. This increase was primarily due to consulting fees related to customer service enhancements. The Company's effective income tax rate for the second quarters of 1998 and 1997 was 39.3% and 39.5%, respectively. Six Months Ended June 30, 1998 Compared To Six Months Ended June 30, 1997 Financial Overview Net income for the first half of 1998 was $144 million, up 10% from first half 1997 net income of $131 million. Diluted earnings per share for the first halves of 1998 and 1997 were $.53 and $.48 per share, respectively. Revenues for the first half of 1998 were $1,242 million, up 17% from $1,066 million for the first half of 1997, primarily due to a 33% increase in mutual fund service fees, a 39% increase in net interest revenue, and an 11% increase in commission revenues. These increases mainly resulted from increases in customer assets and margin loans to customers, as well as higher trading volume. During the first half of 1998, trading activity reached record levels as shown in the following table (in thousands): - ------------------------------------------------------------- Six Months Ended June 30, Percent Daily Average Trades 1998 1997 Change - ------------------------------------------------------------- Revenue Trades Online 45.8 21.9 109% TeleBroker(R) 8.5 11.8 (28) Regional customer telephone service centers, branch offices and other 32.4 32.3 - - ------------------------------------------------------------- Total 86.7 66.0 31% ============================================================= Mutual Fund OneSource(R) Trades Online 17.3 12.7 36% TeleBroker 1.2 1.4 (14) Regional customer telephone service centers, branch offices and other 21.6 20.3 6 - ------------------------------------------------------------- Total 40.1 34.4 17% ============================================================= Total Daily Average Trades Online 63.1 34.6 82% TeleBroker 9.7 13.2 (27) Regional customer telephone service centers, branch offices and other 54.0 52.6 3 - ------------------------------------------------------------- Total 126.8 100.4 26% ============================================================= Total operating expenses excluding interest during the first half of 1998 were $1,004 million, up 18% from $850 million for the first half of 1997, primarily resulting from additional staff and related costs. The after-tax profit margin for the first half of 1998 was 11.6%, down from 12.3% for the first half of 1997. The annualized return on stockholders' equity for the first half of 1998 was 24%, down from 28% for the first half of 1997, reflecting the Company's higher equity base in the first half of 1998. REVENUES - ------------------------------------------------------------- Six Months Ended June 30, Composition of Revenues 1998 1997 - ------------------------------------------------------------- Commissions 48% 50% Mutual fund service fees 21 18 Net interest revenue 18 15 Principal transactions 9 12 Other 4 5 - ------------------------------------------------------------- Total 100% 100% ============================================================= Commissions Commission revenues for the Company were $597 million for the first half of 1998, up $61 million, or 11%, from the first half of 1997. As shown in the table below, the total number of revenue trades executed by the Company has increased 30% as the Company's customer base has grown. Average commission per revenue trade decreased 14%. This decrease was mainly due to the Company's reduction of the price of online trades described in the comparison between the three-month periods. - ------------------------------------------------------------- Six Months Commissions Earned Ended on Customer Revenue June 30, Percent Trades 1998 1997 Change - ------------------------------------------------------------- Customer accounts that traded during the period (in thousands) 1,923 1,541 25% Average customer revenue trades per account 5.59 5.35 4 Total revenue trades (in thousands) 10,756 8,251 30 Average commission per revenue trade $ 55.46 $ 64.57 (14) Commissions earned on customer revenue trades (in millions) (1) $ 596 $ 533 12 ============================================================= (1) Excludes commissions on trades with specialists totaling $1 million in the first half of 1998 and $3 million in the first half of 1997. Schwab added 705,000 new customer accounts during the first half of 1998, an increase of 20% from the 587,000 new accounts added during the first half of 1997. Mutual Fund Service Fees Mutual fund service fees were $262 million for the first half of 1998, up $65 million, or 33%, from the first half of 1997. This increase was generally attributable to the factors described in the comparison between the three-month periods. Net Interest Revenue Net interest revenue was $221 million for the first half of 1998, up $62 million, or 39%, from the first half of 1997 as shown in the following table (in millions): - ------------------------------------------------------------ Six Months Ended June 30, 1998 1997 - ------------------------------------------------------------ Interest Revenue Margin loans to customers $ 318 $ 210 Investments, customer-related 194 190 Other 25 15 - ------------------------------------------------------------ Total 537 415 - ------------------------------------------------------------ Interest Expense Customer cash balances 280 225 Stock-lending activities 20 18 Borrowings 12 9 Other 4 4 - ------------------------------------------------------------ Total 316 256 - ------------------------------------------------------------ Net interest revenue $ 221 $ 159 ============================================================ Customer-related daily average balances, interest rates and average net interest margin for the first halves of 1998 and 1997 are summarized in the following table (dollars in millions): - ----------------------------------------------------------- Six Months Ended June 30, 1998 1997 - ----------------------------------------------------------- Interest-Earning Assets (customer-related): Investments: Average balance outstanding $ 7,323 $ 7,211 Average interest rate 5.36% 5.32% Margin loans to customers: Average balance outstanding $ 8,333 $ 5,563 Average interest rate 7.68% 7.62% Average yield on interest-earning assets 6.60% 6.32% Funding Sources (customer-related and other): Interest-bearing customer cash balances: Average balance outstanding $12,570 $10,253 Average interest rate 4.49% 4.42% Other interest-bearing sources: Average balance outstanding $ 1,274 $ 1,043 Average interest rate 4.43% 4.47% Average noninterest-bearing portion $ 1,812 $ 1,478 Average interest rate on funding sources 3.96% 3.91% Summary: Average yield on interest-earning assets 6.60% 6.32% Average interest rate on funding sources 3.96% 3.91% - ----------------------------------------------------------- Average net interest margin 2.64% 2.41% =========================================================== The increase in net interest revenue from the first half of 1997 was primarily due to higher levels of margin loans to customers. Principal Transactions Principal transaction revenues were $112 million for the first half of 1998, down $21 million, or 16%, from the first half of 1997. This decrease was primarily due to lower average revenue per principal transaction (see discussion in the comparison between the three-month periods), partially offset by greater share volume handled by M&S. See "Commitments and Contingent Liabilities" note in Item 1. Notes to Condensed Consolidated Financial Statements regarding certain civil litigation relating to various principal transaction activities. Expenses Excluding Interest Compensation and benefits expense was $545 million for the first half of 1998, up $100 million, or 22%, from the first half of 1997 primarily due to a greater number of employees. The following table shows a comparison of certain compensation and benefits components and employee data (in thousands): - ------------------------------------------------------------- Six Months Ended June 30, 1998 1997 - ------------------------------------------------------------- Compensation and benefits expense as a % of revenues 44% 42% Variable compensation as a % of compensation and benefits expense 19% 21% Compensation for temporary employees, contractors and overtime hours as a % of compensation and benefits expense 15% 14% Full-time equivalent employees(1) 13.2 11.2 Revenues per average full-time equivalent employee $93.9 $96.5 ============================================================= (1) Includes full-time, part-time and temporary employees, and persons employed on a contract basis. Advertising and market development expense was $68 million in the first half of 1998, up $6 million, or 10%, from the first half of 1997. This increase was primarily attributable to online advertising, as well as increased media spending, partially offset by reduced production and direct mail spending. Advertising and market development expense was 5% and 6% of revenues for the first halves of 1998 and 1997, respectively. Explanations of fluctuations in occupancy and equipment, depreciation and amortization, and professional services presented in the three-month results generally explain fluctuations in those expenses between the six-month periods. The Company's effective income tax rate for the first halves of 1998 and 1997 was 39.4% and 39.5%, respectively. Liquidity and Capital Resources Liquidity Schwab Liquidity needs relating to customer trading and margin borrowing activities are met primarily through cash balances in customer accounts, which were $14.0 billion and $12.7 billion at June 30, 1998 and December 31, 1997, respectively. Earnings from Schwab's operations are the primary source of liquidity for capital expenditures and investments in new services, marketing, and technology. Management believes that customer cash balances and operating earnings will continue to be the primary sources of liquidity for Schwab in the future. Schwab is subject to regulatory requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying cash dividends, or making unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar amount requirement of $1 million. At June 30, 1998, Schwab had $931 million of net capital (10% of aggregate debit balances), which was $751 million in excess of its minimum required net capital and $481 million in excess of 5% of aggregate debit balances. Schwab has historically targeted net capital to be 10% of its aggregate debit balances, which primarily consist of customer margin loans. To achieve this target, as customer margin loans have grown, a larger portion of cash flows have been retained to support aggregate debit balances. To manage Schwab's regulatory capital position, CSC provides Schwab with a $450 million subordinated revolving credit facility maturing in September 1999, of which $390 million was outstanding at June 30, 1998. At quarter end, Schwab also had outstanding $25 million in fixed-rate subordinated term loans from CSC maturing in 2000. Borrowings under these subordinated lending arrangements qualify as regulatory capital for Schwab. For use in its brokerage operations, Schwab maintained uncommitted, unsecured bank credit lines totaling $620 million at June 30, 1998. Schwab used such borrowings for six days during the first half of 1998, with the daily amounts borrowed averaging $87 million. These lines were unused at June 30, 1998. To satisfy the margin requirement of customer option transactions with the Options Clearing Corporation, Schwab had unsecured letter of credit agreements with six banks totaling $500 million at June 30, 1998. Schwab pays a fee to maintain these letter of credit agreements. No funds were drawn under these agreements during the first half of 1998. M&S M&S' liquidity needs are generally met through earnings generated by its operations. Most of M&S' assets are liquid, consisting primarily of cash and cash equivalents, receivable from brokers, dealers and clearing organizations, and marketable securities. M&S' liquidity is affected by the same net capital regulatory requirements as Schwab (see discussion above). At June 30, 1998, M&S had $5 million of net capital (532% of aggregate debit balances), which was $4 million in excess of its minimum required net capital. M&S may borrow up to $35 million under a subordinated lending arrangement with CSC. Borrowings under this arrangement qualify as regulatory capital for M&S. This facility was unused during the first half of 1998. CSC CSC's liquidity needs are generally met through cash generated by its subsidiaries, as well as cash provided by external financing. As discussed above, Schwab and M&S are subject to regulatory requirements that may restrict them from certain transactions with CSC. Management believes that funds generated by the operations of CSC's subsidiaries will continue to be the primary funding source in meeting CSC's liquidity needs and maintaining Schwab's and M&S' net capital. CSC has liquidity needs that arise from its issued and outstanding $391 million Senior Medium-Term Notes, Series A (Medium-Term Notes), as well as from the funding of cash dividends, common stock repurchases, and acquisitions. The Medium-Term Notes have maturities ranging from 1998 to 2008 and fixed interest rates ranging from 5.67% to 7.72% with interest payable semiannually. The Medium-Term Notes are rated A3 by Moody's Investors Service and A- by Standard & Poor's Ratings Group. At June 30, 1998, $55 million in Senior or Senior Subordinated Medium-Term Notes, Series A, remained unissued under CSC's registration statement with respect to such securities. On July 8, 1998, SEC declared effective CSC's registration statement covering the issuance of up to an additional $150 million in Senior or Senior Subordinated Medium-Term Notes, Series A, bringing the aggregate principal amount of such notes available to be issued to $205 million. CSC may borrow under committed, unsecured credit facilities aggregating $350 million with a group of 10 banks. One-half of the commitments under these facilities expires in June 1999, and the other half expires in June 2001. The funds are available for general corporate purposes for which CSC pays a commitment fee on the unused balance. The terms of these facilities require CSC to maintain minimum levels of stockholders' equity, and Schwab and M&S to maintain specified levels of net capital, as defined. The Company believes that these restrictions will not have a material effect on its ability to meet future dividend or funding requirements. These facilities were unused during the first half of 1998. Cash Flows and Capital Resources Net income plus depreciation and amortization was $214 million for the first half of 1998, up 14% from $188 million for the first half of 1997, allowing the Company to finance its operations primarily with internally generated funds. Depreciation and amortization expense related to equipment, office facilities and property was $64 million for the first half of 1998, as compared to $52 million for the first half of 1997, or 5% of revenues for each period. Amortization expense related to intangible assets was $5 million for both of the first halves of 1998 and 1997. The Company's capital expenditures were $85 million in the first half of 1998 and $70 million in the first half of 1997, or 7% of revenues for each period. Capital expenditures in the first half of 1998 were for leasehold improvements, equipment relating to continued enhancements of the Company's data processing systems, as well as additional office furniture and equipment. In addition, the Company opened six new branch offices during the first half of 1998, compared to 19 branch offices opened during the first half of 1997. Capital expenditures may vary from period to period as business conditions change. The Company issued $30 million in Medium-Term Notes during the first half of 1998. During the first half of 1998, the Company repurchased 3,333,500 shares of its common stock for $123 million. During the full year of 1997, the Company repurchased 820,000 shares of its common stock for $18 million. From the inception of the repurchase plan in 1988 through June 30, 1998, the Company has repurchased 43,440,800 shares of its common stock for $287 million. During the first half of 1998, the Company paid common stock cash dividends totaling $21 million, up from $18 million paid during the first half of 1997. The Company monitors both the relative composition and absolute level of its capital structure. The Company's total financial capital (borrowings plus stockholders' equity) at June 30, 1998 was $1,606 million, up $100 million, or 7% from December 31, 1997. At June 30, 1998, the Company had borrowings of $391 million, or 24% of total financial capital, that bear interest at a weighted-average rate of 6.64%. At June 30, 1998, the Company's stockholders' equity was $1,215 million, or 76% of total financial capital. Year 2000 Many existing computer programs use only two digits to identify a specific year and therefore may not accurately recognize the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the year 2000. Due to the Company's dependence on computer technology to operate its business, and the dependence of the financial services industry on computer technology, the nature and impact of Year 2000 processing failures on the Company's business could be material. The Company is currently modifying its computer systems in order to enable its systems to process data and transactions incorporating year 2000 dates without material errors or interruptions. As of June 30, 1998, the Company completed modifying the critical mainframe trading systems of Schwab to enable those systems to process Year 2000 data and transactions without material errors or interruptions. As of June 30, 1998, the Company also completed installation of those modifications into Schwab's production systems, and had commenced additional post-installation testing to confirm the readiness of those systems to process Year 2000 dates and transactions. The Company plans to have its significant systems modified by the end of 1998. The success of the Company's plan depends in part on parallel efforts being undertaken by other entities with which the Company's systems interact and therefore, the Company is taking steps to determine the status of these other entities' Year 2000 compliance. There can be no assurance that all such other entities will provide accurate and complete information, or that all their systems in fact will achieve full Year 2000 compliance. Other entities' Year 2000 processing failures might have a material adverse impact on the Company's systems and operations. The Company's plan may be affected by regulatory changes, changes in industry customs and practices, and significant systems modifications unrelated to the Year 2000 project including upgrades and additions to capacity, and the cost and continued availability of qualified personnel and other resources. The Company currently estimates that it will cost approximately $42 million to $50 million to modify its core brokerage computer systems, which include Schwab's critical trading systems and certain additional systems, to be Year 2000 compliant. The Company currently estimates that the cost of completing the Company's entire Year 2000 project, including core brokerage computer systems, distributed applications, facilities, and systems in subsidiaries other than Schwab, but excluding potential costs related to the implementation of contingency plans which address possible Year 2000 failures of third-party systems or the Company's systems, is approximately $60 million to $75 million. This estimate excludes the time that may be spent by management and administrative staff in guiding and assisting the information technology effort described above. As of June 30, 1998, the Company had incurred approximately $21 million of the estimated cost of the entire project. The cost of the project is based on the Company's estimates, which make numerous assumptions about future events. However, there can be no assurance that these estimates will be correct and actual costs could differ materially from these estimates. The Company expects to fund all Year 2000 related costs through operating cash flows and a reallocation of the Company's overall developmental spending. In accordance with generally accepted accounting principles, Year 2000 expenditures will be expensed as incurred. Euro Conversion Accommodating transactions in the new euro currency, scheduled to take effect January 1, 1999, is not expected to have a material financial impact on the Company. Item 3. Quantitative and Qualitative Disclosures About Market Risk Financial Instruments Held For Trading Purposes The Company held government and other securities with a fair value of approximately $13 million at June 30, 1998. These securities, and the associated interest rate risk, are not material to the Company's financial position, results of operations or cash flows. Through Schwab and M&S, the Company maintains inventories in exchange-listed, Nasdaq and other securities on both a long and short basis. The fair value of these securities at June 30, 1998 was $36 million in long positions and $34 million in short positions. The potential loss or gain in fair value, using a hypothetical 10% increase or decrease in prices, respectively, is estimated to be approximately $200,000 due to the offset of change in fair value in long and short positions. In addition, the Company generally enters into exchange-traded option contracts to hedge against potential losses in inventory positions. This hypothetical 10% change in fair value of these securities at June 30, 1998 would not be material to the Company's financial position, results of operations or cash flows. The notional amount of option contracts was not material to the Company's consolidated balance sheet at June 30, 1998. Financial Instruments Held For Purposes Other Than Trading For its working capital and reserves required to be segregated under federal or other regulations, the Company invests in money market funds, resale agreements, certificates of deposit, and commercial paper. Money market funds do not have maturity dates and do not present a material market risk. The other financial instruments, as shown in the following table, are fixed rate investments with short maturities for which fair value approximates carrying value and which do not present a material interest rate risk (dollars in millions): - -------------------------------------------------------------- Principal amount Fair by maturity date value June 30, June 30, 1999 Thereafter 1998 - -------------------------------------------------------------- Resale agreements (1) $5,210 --- $5,210 Weighted-average interest rate 5.54% Certificates of deposit $1,387 --- $1,387 Weighted-average interest rate 5.55% Commercial paper $ 328 --- $ 328 Weighted-average interest rate 6.15% ============================================================== (1) Includes resale agreements of $5,110 million included in cash and investments required to be segregated under federal or other regulations and $100 million included in cash and cash equivalents. At June 30, 1998, CSC had $391 million aggregate principal amount of Medium-Term Notes, with fixed interest rates ranging from 5.67% to 7.72%. The Company has fixed cash flow requirements regarding these Medium-Term Notes due to the fixed rate of interest. The fair value of these Medium-Term Notes at June 30, 1998, based on estimates of market rates for debt with similar terms and remaining maturities, approximated their carrying amount. The table below presents the principal amount of these Medium-Term Notes by year of maturity (dollars in millions): Year Ending Weighted-Average Principal December 31, Interest Rate Amount - ------------------------------------------------------------ 1998 6.1% $ 40 1999 6.8% 40 2000 6.3% 48 2001 7.0% 39 2002 7.0% 40 Thereafter 6.7% 184 ============================================================ The Company maintains investments in mutual funds, approximately $46 million at June 30, 1998, to fund obligations under its deferred compensation plan, which is available to certain employees. Any decrease in the fair value of these investments would be offset by a reduction in the deferred compensation plan obligation and would not affect the Company's financial position, results of operations or cash flows. PART II - OTHER INFORMATION Item 1. Legal Proceedings The discussion of legal proceedings in Notes to Condensed Consolidated Financial Statements, under "Commitments and Contingent Liabilities" in Part I - Financial Information, Item 1., is incorporated herein by reference. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders At the Company's Annual Meeting of Stockholders held on May 11, 1998, its stockholders voted upon the following proposals: Proposal No. 1 - Election of Two Directors: Shares Shares For Against --- ------- Donald G. Fisher 244,919,527 4,810,584 Anthony M. Frank 244,910,852 4,819,259 There were no abstentions or broker non-votes with respect to the election of directors. Proposal No. 2 - Amendment to the 1992 Stock Incentive Plan -- Amendment to the 1992 Stock Incentive Plan to increase the maximum number of shares that may be granted to any one employee in any one year. Shares Shares For Against Abstentions --- ------- ----------- 215,927,172 33,002,938 800,001 There were no broker non-votes with respect to the amendment to the 1992 Stock Incentive Plan. A total of 249,730,111 shares were present in person or by proxy at the Annual Meeting. 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 - -------------------------------------------------------------- 10.197 Credit Agreement (364-Day Commitment), between the Registrant and each of the banks listed therein, dated as of June 26, 1998 (supersedes Exhibit 10.196), filed as Exhibit 10.1 to the Registrant's Current Report on Form 8-K dated July 17, 1998, and incorporated herein by reference. 10.198 Credit Agreement (3-Year Commitment), between the Registrant and each of the banks listed therein, dated as of June 26, 1998 (supersedes Exhibit 10.196), filed as Exhibit 10.2 to the Registrant's Current Report on Form 8-K dated July 17, 1998, and incorporated herein by reference. 12.1 Computation of Ratio of Earnings to Fixed Charges. 27.1 Financial Data Schedule (electronic only). - -------------------------------------------------------------- (b) Reports on Form 8-K On July 17, 1998, the Registrant filed a Current Report on Form 8-K relating to up to $205 million aggregate principal amount of debt securities issuable by the Registrant pursuant to Registration Statement Numbers 333-54001 and 333-12727 declared effective by the SEC on July 8, 1998 and November 1, 1996, respectively. Certain exhibits relating to the Medium-Term Notes, Series A, which are issuable pursuant to the Registration Statements, are contained in the Current Report.
THE CHARLES SCHWAB CORPORATION SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE CHARLES SCHWAB CORPORATION (Registrant) Date: August 11, 1998 /s/ Steven L. Scheid --------------- ----------------------------- Steven L. Scheid Executive Vice President and Chief Financial Officer