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 September 30, 1999 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 the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. 819,968,787* shares of $.01 par value Common Stock Outstanding on October 29, 1999 * Reflects the July 1999 two-for-one common stock split.
THE CHARLES SCHWAB CORPORATION Quarterly Report on Form 10-Q For the Quarter Ended September 30, 1999 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 7-22 Item 3. Quantitative and Qualitative Disclosures About Market Risk 22-23 Part II - Other Information Item 1. Legal Proceedings 24 Item 2. Changes in Securities and Use of Proceeds 24 Item 3. Defaults Upon Senior Securities 24 Item 4. Submission of Matters to a Vote of Security Holders 24 Item 5. Other Information 24 Item 6. Exhibits and Reports on Form 8-K 24 Signature 25 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, contingent liabilities, strategy, Internet trade pricing for independent investment managers, 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 "Forward-Looking Statements" 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 Nine Months Ended September 30, September 30, 1999 1998 1999 1998 ---- ---- ---- ---- <S> <C> <C> <C> <C> Revenues Commissions $ 383,826 $ 337,031 $1,320,695 $ 934,208 Mutual fund service fees 192,903 143,977 541,770 405,719 Interest revenue, net of interest expense (1) 182,325 124,346 499,983 345,214 Principal transactions 92,905 74,823 361,053 186,559 Other 31,728 25,094 93,873 75,937 - ----------------------------------------------------------------------------------------------------------------- Total 883,687 705,271 2,817,374 1,947,637 - ----------------------------------------------------------------------------------------------------------------- Expenses Excluding Interest Compensation and benefits 368,610 290,684 1,162,461 835,370 Communications 60,609 53,449 196,684 153,519 Occupancy and equipment 69,082 50,796 190,877 147,502 Advertising and market development 57,716 34,009 164,790 101,726 Depreciation and amortization 40,014 35,175 111,301 104,625 Professional services 40,259 22,240 108,963 63,720 Commissions, clearance and floor brokerage 21,336 20,379 70,225 60,237 Other 22,212 36,040 122,553 80,224 - ----------------------------------------------------------------------------------------------------------------- Total 679,838 542,772 2,127,854 1,546,923 - ----------------------------------------------------------------------------------------------------------------- Income before taxes on income 203,849 162,499 689,520 400,714 Taxes on income 79,270 64,727 271,083 158,622 - ----------------------------------------------------------------------------------------------------------------- Net Income $ 124,579 $ 97,772 $ 418,437 $ 242,092 ================================================================================================================= Weighted-average common shares outstanding - diluted (2) 844,466 820,379 842,875 821,418 ================================================================================================================= Earnings Per Share (2) Basic $ .16 $ .13 $ .52 $ .31 Diluted $ .15 $ .12 $ .50 $ .30 ================================================================================================================= Dividends Declared Per Common Share (2) $ .0140 $ .0134 $ .0420 $ .0400 ================================================================================================================= (1) Interest expense for the three months ended September 30, 1999 and 1998 was $193,961 and $166,780, respectively. Interest expense for the nine months ended September 30, 1999 and 1998 was $543,602 and $483,018, respectively. (2) Reflects the July 1999 two-for-one common stock split. See Notes to Condensed Consolidated Financial Statements. </TABLE>
<TABLE> THE CHARLES SCHWAB CORPORATION CONDENSED CONSOLIDATED BALANCE SHEET (In thousands, except per share amounts) (Unaudited) <CAPTION> September 30, December 31, 1999 1998 ---- ---- <S> <C> <C> Assets Cash and cash equivalents $ 1,632,556 $ 1,155,928 Cash and investments required to be segregated under federal or other regulations (including resale agreements of $7,305,800 in 1999 and $7,608,067 in 1998) 8,406,914 10,242,943 Receivable from brokers, dealers and clearing organizations 409,817 334,334 Receivable from customers - net 13,570,948 9,646,140 Securities owned - at market value 303,980 242,115 Equipment, office facilities and property - net 532,145 396,163 Intangible assets - net 46,097 46,274 Other assets 185,565 200,493 - --------------------------------------------------------------------------------------------------------------- Total $25,088,022 $22,264,390 =============================================================================================================== Liabilities and Stockholders' Equity Drafts payable $ 215,793 $ 324,597 Payable to brokers, dealers and clearing organizations 1,262,107 1,422,300 Payable to customers 20,363,468 18,119,622 Accrued expenses and other liabilities 725,848 618,249 Borrowings 465,012 351,000 - --------------------------------------------------------------------------------------------------------------- Total liabilities 23,032,228 20,835,768 - --------------------------------------------------------------------------------------------------------------- Stockholders' equity: Preferred stock - 9,940 shares authorized; $.01 par value per share; none issued Common stock - 2,000,000 and 500,000 shares authorized in 1999 and 1998, respectively; $.01 par value per share; 819,616 and 803,765 shares issued and outstanding in 1999 and 1998, respectively* 8,196 4,019 Additional paid-in capital 488,258 213,312 Retained earnings 1,635,272 1,254,953 Unearned ESOP shares (981) (1,088) Unamortized restricted stock compensation (76,026) (43,882) Foreign currency translation adjustment 1,075 1,308 - --------------------------------------------------------------------------------------------------------------- Total stockholders' equity 2,055,794 1,428,622 - --------------------------------------------------------------------------------------------------------------- Total $25,088,022 $22,264,390 =============================================================================================================== * Shares issued and outstanding reflect the July 1999 two-for-one common stock split. See Notes to Condensed Consolidated Financial Statements. </TABLE>
<TABLE> THE CHARLES SCHWAB CORPORATION CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS (In thousands) (Unaudited) <CAPTION> Nine Months Ended September 30, 1999 1998 ---- ---- <S> <C> <C> Cash flows from operating activities Net income $ 418,437 $ 242,092 Noncash items included in net income: Depreciation and amortization 111,301 104,625 Compensation payable in common stock 21,419 27,797 Deferred income taxes 10,407 16,362 Other 5,742 2,757 Change in securities owned (61,865) 70,031 Change in other assets 4,513 58,488 Change in accrued expenses and other liabilities 283,389 58,463 - ------------------------------------------------------------------------------------------------------ Net cash provided before change in customer-related balances 793,343 580,615 - ------------------------------------------------------------------------------------------------------ Change in customer-related balances: Cash and investments required to be segregated under federal or other regulations 1,834,530 (979,845) Receivable from brokers, dealers and clearing organizations (76,671) (60,529) Receivable from customers (3,930,185) (1,187,221) Drafts payable (108,183) (83,084) Payable to brokers, dealers and clearing organizations (161,000) 38,012 Payable to customers 2,247,163 2,227,345 - ------------------------------------------------------------------------------------------------------ Net change in customer-related balances (194,346) (45,322) - ------------------------------------------------------------------------------------------------------ Net cash provided by operating activities 598,997 535,293 - ------------------------------------------------------------------------------------------------------ Cash flows from investing activities Purchase of equipment, office facilities and property - net (194,409) (144,842) Costs of internal-use software (46,440) Cash payments for business acquired, net of cash received (5,657) Cash value received on life insurance policies 65,324 - ------------------------------------------------------------------------------------------------------ Net cash used by investing activities (181,182) (144,842) - ------------------------------------------------------------------------------------------------------ Cash flows from financing activities Repayments of loans on life insurance policies (65,321) Proceeds from borrowings 144,000 30,000 Repayment from borrowings (30,068) (40,047) Dividends paid (34,063) (31,925) Purchase of treasury stock (147,884) Proceeds from stock options exercised and other 45,175 22,268 - ------------------------------------------------------------------------------------------------------ Net cash provided (used) by financing activities 59,723 (167,588) - ------------------------------------------------------------------------------------------------------ Effect of exchange rate changes on cash and cash equivalents (910) 662 - ------------------------------------------------------------------------------------------------------ Increase in cash and cash equivalents 476,628 223,525 Cash and cash equivalents at beginning of period 1,155,928 797,447 - ------------------------------------------------------------------------------------------------------ Cash and cash equivalents at end of period $1,632,556 $1,020,972 ====================================================================================================== See Notes to Condensed Consolidated Financial Statements. </TABLE>
THE CHARLES SCHWAB CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) 1. 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 319 domestic branch offices in 47 states, as well as branches in the Commonwealth of Puerto Rico and the U.S. Virgin Islands. Another subsidiary, Charles Schwab Europe (CSE) is a retail securities brokerage firm located in the United Kingdom. Other subsidiaries include Charles Schwab Investment Management, Inc., the investment advisor for Schwab's proprietary mutual funds, and Mayer & Schweitzer, Inc. (M&S), a market maker in Nasdaq and other securities providing trade execution services to broker-dealers and institutional customers. 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 1998 Annual Report to Stockholders, which are incorporated by reference in the Company's 1998 Annual Report on Form 10-K and the Company's Quarterly Reports on Form 10-Q for the periods ended March 31, 1999 and June 30, 1999. 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 1999 presentation. 2. New Accounting Standard Statement of Financial Accounting Standards (SFAS) No. 137 - Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133 - An Amendment of FASB Statement No. 133, was issued in June 1999 and amends the effective date of SFAS No. 133. The Company is required to adopt SFAS No. 133 by January 1, 2001. 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 and such hedge accounting treatment is elected. While the Company is currently evaluating the effects of this statement, its adoption is not expected to have a material impact on the Company's financial position, results of operations, earnings per share or cash flows. 3. Costs of Internal-Use Software Statement of Position 98-1 - Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, was adopted by the Company effective January 1, 1999. This statement requires that certain costs incurred for purchasing or developing software for internal use be capitalized and amortized over the software's estimated useful life of three years. In prior periods, the Company capitalized costs incurred for purchasing internal-use software, but expensed costs incurred for developing internal-use software. In accordance with this statement, prior periods' financial statements were not adjusted to reflect this accounting change. Adoption of this statement resulted in the capitalization of $19 million of internal-use software development costs during the third quarter of 1999, which increased net income by $12 million (net of income taxes of $7 million), or $.01 diluted earnings per share. Adoption of this statement resulted in the capitalization of $46 million of internal-use software development costs during the first nine months of 1999, which increased net income by $28 million (net of income taxes of $18 million), or $.03 diluted earnings per share. 4. Comprehensive Income SFAS No. 130 - Reporting Comprehensive Income, establishes standards for the reporting and display of comprehensive income, which includes net income and changes in equity except those resulting from investments by, or distributions to, stockholders. Comprehensive income is as follows (in thousands): - -------------------------------------------------------------------------------- Three Nine Months Ended Months Ended September 30, September 30, 1999 1998 1999 1998 - -------------------------------------------------------------------------------- Net income $124,579 $ 97,772 $418,437 $242,092 Foreign currency translation adjustment 2,119 898 (233) 1,496 - -------------------------------------------------------------------------------- Total comprehensive income $126,698 $ 98,670 $418,204 $243,588 ================================================================================ 5. Earnings Per Share SFAS No. 128 - Earnings Per Share, requires a dual presentation of basic and diluted earnings per share (EPS). Basic EPS excludes dilution and is computed by dividing net income by the weighted-average number of common shares outstanding for the period. Diluted EPS reflects the potential reduction in EPS that could occur if securities or other contracts to issue common stock were exercised or converted into common stock. Earnings per share under the basic and diluted computations are as follows (in thousands, except per share amounts): - -------------------------------------------------------------------------------- Three Nine Months Ended Months Ended September 30, September 30, 1999 1998 1999 1998 - -------------------------------------------------------------------------------- Net income $124,579 $ 97,772 $418,437 $242,092 ================================================================================ Weighted-average common shares outstanding - basic (1) 812,016 793,687 808,504 793,162 Common stock equivalent shares related to stock incentive plans (1) 32,450 26,692 34,371 28,256 - -------------------------------------------------------------------------------- Weighted-average common shares outstanding - diluted (1) 844,466 820,379 842,875 821,418 ================================================================================ Basic EPS (1) $ .16 $ .13 $ .52 $ .31 ================================================================================ Diluted EPS (1) $ .15 $ .12 $ .50 $ .30 ================================================================================ (1) Reflects the July 1999 two-for-one common stock split. The computation of diluted EPS for the nine months ended September 30, 1999 and 1998, respectively, excludes stock options to purchase 5,040,000 and 20,495,000 shares, 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. 6. Regulatory Requirements Schwab and M&S are subject to the Uniform Net Capital Rule under the Securities Exchange Act of 1934 (the Rule) and each compute net capital under the alternative method permitted by this Rule, which requires the maintenance of minimum net capital, as defined, of the greater of 2% of aggregate debit balances arising from customer transactions or a minimum dollar amount, which is based on the type of business conducted by the broker-dealer. The minimum dollar amount for both Schwab and M&S is $1 million. Under the alternative method, a broker-dealer may not repay subordinated borrowings, pay cash dividends, or make any unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar amount requirement. At September 30, 1999, Schwab's net capital was $1,400 million (10% of aggregate debit balances), which was $1,130 million in excess of its minimum required net capital and $725 million in excess of 5% of aggregate debit balances. At September 30, 1999, M&S' net capital was $12 million, which was $11 million in excess of its minimum required net capital. Schwab and CSE had portions of their cash and investments segregated for the exclusive benefit of customers at September 30, 1999, in accordance with applicable regulations. M&S had no such cash reserve requirement at September 30, 1999. 7. Commitments and Contingent Liabilities The nature of the Company's business subjects it to numerous regulatory investigations, claims, lawsuits and other proceedings in the ordinary course of its business. The results of these legal proceedings 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. However, it is the opinion of management, after consultation with outside legal counsel, that the ultimate outcome of the current matters will not have a material adverse impact on the financial condition or operating results of the Company. 8. Segment Information Under SFAS No. 131 - Disclosures about Segments of an Enterprise and Related Information, the Company structures its segments according to its various types of customers and the services provided to those customers. These segments have been aggregated, based on similarities in economic characteristics, types of customers, services provided, distribution channels and regulatory environment, into three reportable segments - Individual Investor, Institutional Investor and Capital Markets. Financial information for the Company's reportable segments is presented in the table below (in thousands). Intersegment revenues are immaterial and are therefore not disclosed. Total revenues and income before taxes on income are equal to the Company's consolidated amounts as reported in the condensed consolidated statement of income. - -------------------------------------------------------------------------------- Three Nine Months Ended Months Ended September 30, September 30, 1999 1998 1999 1998 - -------------------------------------------------------------------------------- Revenues Individual Investor $629,130 $499,133 $1,979,397 $1,401,660 Institutional Investor 148,988 117,324 436,259 322,353 Capital Markets 105,569 88,814 401,718 223,624 - -------------------------------------------------------------------------------- Total $883,687 $705,271 $2,817,374 $1,947,637 ================================================================================ Income Before Taxes on Income Individual Investor $146,166 $124,478 $ 488,185 $ 315,245 Institutional Investor 42,409 32,797 116,376 83,995 Capital Markets 15,274 5,224 84,959 1,474 - -------------------------------------------------------------------------------- Total $203,849 $162,499 $ 689,520 $ 400,714 ================================================================================ 9. Supplemental Cash Flow Information Certain information affecting the cash flows of the Company follows (in thousands): - -------------------------------------------------------------------------------- Nine Months Ended September 30, 1999 1998 - -------------------------------------------------------------------------------- Income taxes paid $101,860 $ 98,382 ================================================================================ Interest paid: Customer cash balances $486,048 $427,595 Stock-lending activities 23,646 30,039 Borrowings 24,858 24,024 Other 13,049 7,899 - -------------------------------------------------------------------------------- Total interest paid $547,601 $489,557 ================================================================================
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 6.3 million active customer accounts(a). Customer assets in these accounts totaled $595.0 billion at September 30, 1999. CSC's principal subsidiary, Charles Schwab & Co., Inc. (Schwab), is a securities broker-dealer with 319 domestic branch offices in 47 states, as well as branches in the Commonwealth of Puerto Rico and the U.S. Virgin Islands. Another subsidiary, Charles Schwab Europe (CSE), is a retail securities brokerage firm located in the United Kingdom. Other subsidiaries include Charles Schwab Investment Management, Inc., the investment advisor for Schwab's proprietary mutual funds, and Mayer & Schweitzer, Inc. (M&S), a market maker in Nasdaq and other securities providing trade execution services to broker-dealers and institutional customers. - -------- (a) Accounts with balances or activity within the preceding eight months. The Company provides financial services to individuals, institutional customers and broker-dealers through three segments - Individual Investor, Institutional Investor and Capital Markets. The Individual Investor segment includes the Company's domestic and international retail operations. The Institutional Investor segment provides custodial, trading and support services to independent investment managers, and serves company 401(k) plan sponsors and third-party administrators. The Capital Markets segment provides trade execution services in Nasdaq, exchange-listed and other securities primarily to broker-dealers and institutional customers. The Company's mutual fund services are considered a product and not a segment. Mutual fund service fees are included in both the Individual Investor and Institutional Investor segments. 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, 401(k) defined contribution plans and equity securities market-making. 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 strengthen the Schwab brand, as well as distinguish its products and services. The Company primarily uses a combination of network, cable and local television, print media, national and local radio, and athletic event sponsorship in its advertising to investors. These programs helped the Company attract $24.6 billion in net new customer assets and open 282,000 new accounts during the third quarter of 1999. The Company offers a broad range of value-oriented products and services to meet customers' varying investment and financial needs, including access to extensive investment research, news and information. The Company's registered representatives can assist investors in developing asset allocation strategies and evaluating their investment choices, and refer investors who desire additional guidance to independent investment managers through the Schwab AdvisorSource(TM) service. The Company's Mutual Fund Marketplace(R) provides customers with the ability to invest in 1,851 mutual funds from 303 fund families, including 1,127 Mutual Fund OneSource(R) funds. Schwab also provides custodial, trading and support services to approximately 5,700 independent investment managers. As of September 30, 1999, these managers were guiding the investments of 808,000 Schwab customer accounts containing $180.3 billion in assets. The Company responds to changing customer needs with continued product, technology and service innovations. During the third quarter of 1999, Schwab launched an online trading system, Velocity(TM), to provide enhanced trade information and order execution for more active customers. Also during the third quarter of 1999, in an effort to provide all customers with more convenient and efficient service, Schwab enabled customers to open a new account, update contact information, sign up for the Schwab MoneyLink(R) service and request a check entirely through Web-based automated processes. Additionally, customers can now access multiple Schwab accounts using a single sign-on. Further, during the third quarter of 1999 the Company signed an agreement with Donaldson, Lufkin & Jenrette, Inc., Fidelity Global Brokerage Group, Inc., and Spear, Leeds & Kellogg LP to form a new company which will utilize the existing technology of REDIBook ECN LLC's electronic communications network (ECN). This new company intends to rely on the ECN's limit order matching capabilities and the partners' order flow to provide customers with a separate after-hours trading session for most Nasdaq and certain exchange-listed stocks. 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. The Company's branch office network also provides investors with access to the Internet. 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 on an automated basis through the Company's automated telephonic and online channels. Automated telephonic channels include TeleBroker(R), Schwab's touch-tone telephone quote and trading service, and VoiceBroker(TM), Schwab's voice recognition quote and trading service. Online channels include the Charles Schwab Web Site(TM), an information and trading service on the Internet at www.schwab.com, and PC-based services such as SchwabLink(R), a service for investment managers. Schwab provides every retail customer access to all delivery channels and flat-fee pricing for Internet-based trades. During the third quarter of 1999, Schwab announced a plan to provide independent investment managers with enhanced services, including a new Schwab Institutional website and flat-fee pricing for online trades. The Company's ongoing investment in technology is a key element in expanding its product and service offerings, enhancing its delivery systems, providing fast and consistent customer service, reducing processing costs, and facilitating the Company's ability to handle significant increases in customer activity without a corresponding rise in staffing levels. The Company uses technology to empower its customers to manage their financial affairs and is a leader in driving technological advancements in the financial services industry. In July 1999, the Company entered into a joint venture agreement with The Tokio Marine and Fire Insurance Co., Limited (TMI) and certain of its affiliates (collectively, the TMI Group). The Company and each member of the TMI Group are shareholders in a Japanese corporation, Schwab Tokio Marine Securities Co., Ltd. (STMS), in which the Company has a 50% equity interest. STMS, whose business is expected to commence in the first quarter of 2000, will provide retail brokerage and investment services in U.S. dollar-denominated securities to residents of Japan. STMS is currently expected to offer Japanese Yen-denominated securities later in 2000. In the fourth quarter of 1999, pursuant to the joint venture agreement, the Company will make an initial capital contribution of 3.0 billion Yen, or approximately $27 million. The Company may, under certain circumstances, be required to make additional capital contributions pursuant to the joint venture agreements, including contributions to assure that STMS is in compliance with regulatory requirements regarding capital adequacy. 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 1998 Annual Report to Stockholders, which is filed as Exhibit 13.1 to the Company's Form 10-K for the year ended December 31, 1998. See Liquidity and Capital Resources of this report for a discussion on liquidity risk; and see Item 3 - Quantitative and Qualitative Disclosures About Market Risk for additional information relating to market risk. Given the nature of the Company's revenues, expenses and risk profile, the Company's earnings and 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. 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 In addition to historical information, this interim report contains forward-looking statements that reflect management's expectations as of the date hereof. These statements relate to, among other things, contingent liabilities (see note "7 - Commitments and Contingent Liabilities" in the Notes to Condensed Consolidated Financial Statements), the Company's strategy (see Description of Business), Internet trade pricing for independent investment managers (see Revenues-Commissions), 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 described in these statements. Important factors that may cause such differences are noted in this interim report, the Company's 1998 Annual Report to Stockholders and the Company's Form 10-K for the year ended December 31, 1998 and include, but are not limited to: the effect of customer trading patterns on Company revenues and earnings; changes in the Company's level of personnel hiring, investment in new or existing technology, or utilization of public media for advertising; changes in technology; computer system failures; risks and uncertainties associated with the Company's, its vendors', and other third parties' Year 2000 computer systems compliance; the effects of competitors' pricing, product and service decisions and intensified competition; evolving regulation and changing industry practices adversely affecting the Company; adverse results of litigation; the availability of external financing; changes in revenues and profit margin due to cyclical securities markets and interest rates; the level and volatility of equity prices; and a significant downturn in the securities markets over a short period of time or a sustained decline in securities prices and trading volumes. Three Months Ended September 30, 1999 Compared To Three Months Ended September 30, 1998 Financial Overview Net income for the third quarter of 1999 was $125 million, up 27% from third quarter 1998 net income of $98 million. Diluted earnings per share for the third quarters of 1999 and 1998 were $.15 and $.12 per share, respectively. Share and per share data throughout this report have been restated to reflect the effects of the July 1999 two-for-one common stock split. Revenues increased mainly due to higher customer trading volume and an increase in customer assets. Revenues of $884 million in the third quarter of 1999 grew $178 million, or 25%, from the third quarter of 1998 due to increases in revenues of $130 million, or 26%, in the Individual Investor segment, $32 million, or 27%, in the Institutional Investor segment, and $16 million, or 19%, in the Capital Markets segment. See note "8 - Segment Information" in the Notes to Condensed Consolidated Financial Statements for financial information by segment. The Company's trading activity is shown in the following table (in thousands): - -------------------------------------------------------------------------------- Three Months Ended September 30, Percent Daily Average Trades 1999 1998 Change - -------------------------------------------------------------------------------- Revenue Trades Online 97.7 58.1 68% TeleBroker(R)and VoiceBroker(TM) 6.5 8.1 (20) Regional customer telephone service centers, branch offices and other 30.9 33.4 (7) - -------------------------------------------------------------------------------- Total 135.1 99.6 36% ================================================================================ Mutual Fund OneSource(R) Trades Online 20.1 18.8 7% TeleBroker and VoiceBroker .9 1.1 (18) Regional customer telephone service centers, branch offices and other 19.3 22.4 (14) - -------------------------------------------------------------------------------- Total 40.3 42.3 (5%) ================================================================================ Total Daily Average Trades Online 117.8 76.9 53% TeleBroker and VoiceBroker 7.4 9.2 (20) Regional customer telephone service centers, branch offices and other 50.2 55.8 (10) - -------------------------------------------------------------------------------- Total 175.4 141.9 24% ================================================================================ Assets in Schwab customer accounts were $595.0 billion at September 30, 1999, an increase of $186.8 billion, or 46%, from a year ago as shown in the table below. This increase from September 30, 1998 resulted from net new customer assets of $96.1 billion and net market gains of $90.7 billion. - -------------------------------------------------------------------------------- Growth in Schwab Customer Assets and Accounts (In billions, at quarter end, September 30, Percent except as noted) 1999 1998 Change - -------------------------------------------------------------------------------- Assets in Schwab customer accounts Schwab One(R) and other cash equivalents $ 20.1 $ 14.7 37% SchwabFunds(R): Money market funds 82.3 63.0 31 Equity and bond funds 18.9 11.0 72 - -------------------------------------------------------------------------------- Total SchwabFunds 101.2 74.0 37 - -------------------------------------------------------------------------------- Mutual Fund Marketplace(R)(1): Mutual Fund OneSource(R) Retail 41.7 31.5 32 Schwab Institutional(TM)(2) 36.6 27.5 33 - -------------------------------------------------------------------------------- Total Mutual Fund OneSource 78.3 59.0 33 All other 66.1 51.7 28 - -------------------------------------------------------------------------------- Total Mutual Fund Marketplace 144.4 110.7 30 - -------------------------------------------------------------------------------- Total mutual fund assets 245.6 184.7 33 - -------------------------------------------------------------------------------- Equity and other securities (1) 298.8 183.3 63 Fixed income securities 44.0 34.4 28 Margin loans outstanding (13.5) (8.9) 52 - -------------------------------------------------------------------------------- Total $595.0 $408.2 46% ================================================================================ Net growth in assets in Schwab customer accounts (for the quarter ended) Net new customer assets $ 24.6 $ 18.8 Net market losses (21.3) (38.1) - -------------------------------------------------------------------------------- Net growth (decline) $ 3.3 $(19.3) ================================================================================ New Schwab customer accounts (in thousands, for the quarter ended) 282.0 278.4 1% Active Schwab customer accounts (in millions) (3) 6.3 5.5 15% ================================================================================ Active online Schwab customer accounts (in millions) (4) 3.0 2.0 50% Online Schwab customer assets $263.6 $130.5 102% ================================================================================ (1) Excludes money market funds and all of Schwab's proprietary money market, equity and bond funds. (2) Represents assets invested in Mutual Fund OneSource by independent investment managers and retirement plans. (3) Effective with the fourth quarter of 1998, active accounts are defined as accounts with balances or activity within the preceding eight months instead of twelve months as previously defined. This change in definition had the effect of decreasing the number of active accounts by approximately 200,000. Prior quarters have not been restated. (4) Active online accounts are defined as all active accounts within a household that has had at least one online session within the past twelve months. Total operating expenses excluding interest during the third quarter of 1999 were $680 million, up 25% from $543 million for the third quarter of 1998, primarily resulting from additional staff and related costs. The after-tax profit margin for the third quarter of 1999 was 14.1%, up from 13.9% for the third quarter of 1998. The annualized return on stockholders' equity for the third quarter of 1999 was 25%, down from 31% for the third quarter of 1998. REVENUES Revenues grew $178 million, or 25%, in the third quarter of 1999, due to a $58 million, or 47%, increase in interest revenue, net of interest expense (referred to as net interest revenue), a $49 million, or 34%, increase in mutual fund service fees, and a $47 million, or 14%, increase in commission revenues, as well as an $18 million, or 24%, increase in principal transaction revenues. - -------------------------------------------------------------------------------- Three Months Ended September 30, Composition of Revenues 1999 1998 - -------------------------------------------------------------------------------- Commissions 43% 48% Principal transactions 11 11 - -------------------------------------------------------------------------------- Total trading revenues 54 59 - -------------------------------------------------------------------------------- Mutual fund service fees 22 20 Net interest revenue 21 18 Other 3 3 - -------------------------------------------------------------------------------- Total non-trading revenues 46 41 - -------------------------------------------------------------------------------- Total 100% 100% ================================================================================ Commissions The Company earns commission revenues by executing customer trades primarily through the Individual Investor and Institutional Investor segments. These revenues are affected by the number of customer accounts that traded, the average number of commission-generating trades per account, and the average commission per trade. Commission revenues for the Company were $384 million for the third quarter of 1999, up $47 million, or 14%, from the third quarter of 1998. As shown in the table below, the total number of revenue trades executed by the Company has increased 36% as the Company's customer base, as well as customer trading activity per account, has grown. Average commission per revenue trade decreased 15%. This decline was mainly due to an increase in the proportion of trades placed through the Company's online channels, which have lower commission rates than the Company's other channels. In the third quarter of 1999, the Company announced a plan to provide independent investment managers with flat-fee pricing for Internet trades (effective November 1, 1999). This price reduction is designed to enhance the Company's competitive position and to align the pricing of Internet trades for independent investment managers with that offered to most of the Company's individual customers. While the effect of this price reduction cannot be predicted with certainty, management expects that the impact of this reduction on the Company's results of operations will be offset by the lower cost of processing Internet trades and by expected growth in customer assets and trading volumes associated with independent investment managers. This price reduction will only affect the Institutional Investor segment and, based on management's expectations, it will not have a material impact on that segment's revenues. - -------------------------------------------------------------------------------- Three Months Commissions Earned Ended on Customer Revenue September 30, Percent Trades 1999 1998 Change - -------------------------------------------------------------------------------- Customer accounts that traded during the quarter (in thousands) 1,510 1,333 13% Average customer revenue trades per account 5.73 4.78 20 Total revenue trades (in thousands) 8,648 6,376 36 Average commission per revenue trade $44.72 $52.83 (15) Commissions earned on customer revenue trades (in millions) (1) $ 387 $ 337 15 ================================================================================ (1) Includes certain non-commission revenues relating to the execution of customer trades totaling $9 million in the third quarter of 1999 and $7 million in the third quarter of 1998. Excludes commissions on trades relating to specialist operations totaling $6 million in the third quarter of 1999 and $7 million in the third quarter of 1998. Mutual Fund Service Fees 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 customer assets invested in third-party funds and upon the average daily net assets of Schwab's proprietary funds. Mutual fund service fees are earned primarily through the Individual Investor and Institutional Investor segments. Mutual fund service fees were $193 million for the third quarter of 1999, up $49 million, or 34%, from the third quarter of 1998. This increase was primarily due to a significant increase in customer assets in Schwab's proprietary funds, collectively referred to as the SchwabFunds(R), as well as an increase in customer assets in funds purchased through Schwab's Mutual Fund OneSource(R) service. Net Interest Revenue Net interest revenue is the difference between interest earned on assets (mainly margin loans to customers and investments) and interest paid on liabilities (mainly customer cash balances). Net interest revenue is affected by changes in the volume and mix of these assets and liabilities, as well as by fluctuations in interest rates. Substantially all of the Company's net interest revenue is earned by Schwab through the Individual Investor and Institutional Investor segments. Net interest revenue was $182 million for the third quarter of 1999, up $58 million, or 47%, from the third quarter of 1998 as shown in the following table (in millions): - -------------------------------------------------------------------------------- Three Months Ended September 30, Percent 1999 1998 Change - -------------------------------------------------------------------------------- Interest Revenue Margin loans to customers $254 $181 40% Investments, customer-related 99 96 3 Other 24 14 71 - -------------------------------------------------------------------------------- Total 377 291 30 - -------------------------------------------------------------------------------- Interest Expense Customer cash balances 174 148 18 Stock-lending activities 7 10 (30) Borrowings 7 7 Other 7 2 250 - -------------------------------------------------------------------------------- Total 195 167 17 - -------------------------------------------------------------------------------- Net interest revenue $182 $124 47% ================================================================================ Customer-related daily average balances, interest rates and average net interest margin for the third quarters of 1999 and 1998 are summarized in the following table (dollars in millions): - -------------------------------------------------------------------------------- Three Months Ended September 30, 1999 1998 - -------------------------------------------------------------------------------- Interest-Earning Assets (customer-related): Margin loans to customers: Average balance outstanding $13,405 $ 9,359 Average interest rate 7.50% 7.69% Investments: Average balance outstanding $ 8,262 $ 7,195 Average interest rate 4.72% 5.24% Average yield on interest-earning assets 6.44% 6.63% Funding Sources (customer-related and other): Interest-bearing customer cash balances: Average balance outstanding $17,596 $13,364 Average interest rate 3.93% 4.40% Other interest-bearing sources: Average balance outstanding $ 1,339 $ 1,341 Average interest rate 4.23% 4.32% Average noninterest-bearing portion $ 2,732 $ 1,849 Average interest rate on funding sources 3.45% 3.90% Summary: Average yield on interest-earning assets 6.44% 6.63% Average interest rate on funding sources 3.45% 3.90% - -------------------------------------------------------------------------------- Average net interest margin 2.99% 2.73% ================================================================================ The increase in net interest revenue from the third quarter of 1998 was primarily due to higher levels of margin loans to customers, partially offset by higher average customer cash balances. Principal Transactions Principal transaction revenues are primarily comprised of net gains from market-making activities in Nasdaq and other securities transactions effected through the Capital Markets segment. Factors that influence principal transaction revenues include the volume of customer trades, market price volatility, average revenue per share traded, level of underwriting participation and changes in regulations and industry practices. Principal transaction revenues were $93 million for the third quarter of 1999, up $18 million, or 24%, from the third quarter of 1998. This increase was primarily due to greater share volume handled by M&S, partially offset by lower average revenue per share traded. The remainder of the increase was primarily due to higher revenues related to Schwab's underwriting activities. Expenses Excluding Interest Compensation and benefits expense was $369 million for the third quarter of 1999, up $78 million, or 27%, from the third quarter of 1998 primarily due to a greater number of employees and higher variable compensation expense resulting from the Company's financial performance. This change was partially offset by lower accrued liabilities for deferred compensation and estimated payroll taxes on stock options resulting from the decline in CSC's stock price during the quarter, and a decrease in the Company's expected contribution rate to its employee stock ownership plan. The following table shows a comparison of certain compensation and benefits components and employee data (in thousands): - -------------------------------------------------------------------------------- Three Months Ended September 30, 1999 1998 - -------------------------------------------------------------------------------- Compensation and benefits expense as a % of revenues 42% 41% Variable compensation as a % of compensation and benefits expense 22% 25% Compensation for temporary employees, contractors and overtime hours as a % of compensation and benefits expense 15% 14% Full-time equivalent employees(1) 17.4 13.0 Revenues per average full-time equivalent employee $51.9 $54.1 ================================================================================ (1) Includes full-time, part-time and temporary employees, and persons employed on a contract basis. Occupancy and equipment expense was $69 million for the third quarter of 1999, up $18 million, or 36%, from the third quarter of 1998. This increase was primarily due to higher data processing equipment lease and maintenance expenses resulting from the Company's continued investment in technology. Additionally, office lease expenses increased reflecting the Company's continued expansion. Advertising and market development expense was $58 million for the third quarter of 1999, up $24 million, or 70%, from the third quarter of 1998. This increase was primarily a result of the Company's increased television and print media spending. Professional services expense was $40 million for the third quarter of 1999, up $18 million, or 81%, from the third quarter of 1998. This increase was primarily due to consulting fees related to various information technology projects. Other expenses were $22 million for the third quarter of 1999, down $14 million, or 38%, from the third quarter of 1998. This change was primarily due to lower accrued liabilities resulting from the decline in CSC's stock price during the quarter, including estimated local business taxes on stock options and deferred fees for CSC's Board of Directors. This change in other expenses was also due to lower trade errors, partially offset by an increase in higher travel and related costs, and higher volume-related regulatory assessments and dues. The Company's effective income tax rate for the third quarters of 1999 and 1998 was 38.9% and 39.8%, respectively. Nine Months Ended September 30, 1999 Compared To Nine Months Ended September 30, 1998 Financial Overview Net income for the first nine months of 1999 was a record $418 million, up 73% from the first nine months of 1998 net income of $242 million. Diluted earnings per share for the first nine months of 1999 and 1998 were $.50 and $.30 per share, respectively. Revenues increased mainly due to higher customer trading volume. Revenues of $2,817 million in the first nine months of 1999 grew $870 million, or 45%, from the first nine months of 1998 due to increases in revenues of $578 million, or 41%, in the Individual Investor segment, $178 million, or 80%, in the Capital Markets segment, and $114 million, or 35%, in the Institutional Investor segment. See note "8 - Segment Information" in the Notes to Condensed Consolidated Financial Statements for financial information by segment. The Company's trading activity is shown in the following table (in thousands): - -------------------------------------------------------------------------------- Nine Months Ended September 30, Percent Daily Average Trades 1999 1998 Change - -------------------------------------------------------------------------------- Revenue Trades Online 108.1 50.0 116% TeleBroker(R)and VoiceBroker(TM) 8.5 8.4 1 Regional customer telephone service centers, branch offices and other 35.9 32.7 10 - -------------------------------------------------------------------------------- Total 152.5 91.1 67% ================================================================================ Mutual Fund OneSource(R) Trades Online 22.4 17.8 26% TeleBroker and VoiceBroker 1.0 1.1 (9) Regional customer telephone service centers, branch offices and other 21.1 21.9 (4) - -------------------------------------------------------------------------------- Total 44.5 40.8 9% ================================================================================ Total Daily Average Trades Online 130.5 67.8 92% TeleBroker and VoiceBroker 9.5 9.5 Regional customer telephone service centers, branch offices and other 57.0 54.6 4 - -------------------------------------------------------------------------------- Total 197.0 131.9 49% ================================================================================ Assets in Schwab customer accounts were $595.0 billion at September 30, 1999, an increase of $103.9 billion, or 21%, from December 31, 1998. During the first nine months of 1999, net new customer assets and new accounts increased from the first nine months of 1998 as shown in the table below. - -------------------------------------------------------------------------------- Nine Months Growth in Schwab Customer Ended Assets and Accounts September 30, Percent (In billions, except as noted) 1999 1998 Change - -------------------------------------------------------------------------------- Net growth in assets in Schwab customer accounts Net new customer assets $ 73.6 $ 56.6 Net market gains (losses) 30.3 (2.0) - -------------------------------------------------------------------------------- Net growth $ 103.9 $ 54.6 ================================================================================ New Schwab customer accounts (in thousands) 1,092.1 983.8 11% ================================================================================ Total operating expenses excluding interest during the first nine months of 1999 were $2,128 million, up 38% from $1,547 million for the first nine months of 1998, primarily resulting from additional staff and related costs. The after-tax profit margin for the first nine months of 1999 was 14.9%, up from 12.4% for the first nine months of 1998. The annualized return on stockholders' equity for the first nine months of 1999 was 32%, up from 26% for the first nine months of 1998. REVENUES Revenues grew $870 million, or 45%, in the first nine months of 1999, due to a $386 million, or 41%, increase in commission revenues, a $174 million, or 94%, increase in principal transaction revenues, a $155 million, or 45%, increase in net interest revenue and a $136 million, or 34%, increase in mutual fund service fees. - -------------------------------------------------------------------------------- Nine Months Ended September 30, Composition of Revenues 1999 1998 - -------------------------------------------------------------------------------- Commissions 47% 48% Principal transactions 13 10 - -------------------------------------------------------------------------------- Total trading revenues 60 58 - -------------------------------------------------------------------------------- Mutual fund service fees 19 21 Net interest revenue 18 18 Other 3 3 - -------------------------------------------------------------------------------- Total non-trading revenues 40 42 - -------------------------------------------------------------------------------- Total 100% 100% ================================================================================ Commissions Commission revenues for the Company were $1,321 million for the first nine months of 1999, up $386 million, or 41%, from the first nine months of 1998. As shown in the table below, the total number of revenue trades executed by the Company has increased 67% as the Company's customer base, as well as customer trading activity per account, has grown. Average commission per revenue trade decreased 15%. This decline was mainly due to an increase in the proportion of trades placed through the Company's online channels as described in the comparison between the three-month periods. - -------------------------------------------------------------------------------- Nine Months Commissions Earned Ended on Customer Revenue September 30, Percent Trades 1999 1998 Change - -------------------------------------------------------------------------------- Customer accounts that traded during the period (in thousands) 2,822 2,405 17% Average customer revenue trades per account 10.16 7.12 43 Total revenue trades (in thousands) 28,668 17,131 67 Average commission per revenue trade $ 46.36 $ 54.48 (15) Commissions earned on customer revenue trades (in millions) (1) $ 1,329 $ 933 42 ================================================================================ (1) Includes certain non-commission revenues relating to the execution of customer trades totaling $28 million in the first nine months of 1999 and $17 million in the first nine months of 1998. Excludes commissions on trades relating to specialist operations totaling $20 million in the first nine months of 1999 and $18 million in the first nine months of 1998. Mutual Fund Service Fees Mutual fund service fees were $542 million for the first nine months of 1999, up $136 million, or 34%, from the first nine months of 1998. This increase was attributable to the factors described in the comparison between the three-month periods. Net Interest Revenue Net interest revenue was $500 million for the first nine months of 1999, up $155 million, or 45%, from the first nine months of 1998 as shown in the following table (in millions): - -------------------------------------------------------------------------------- Nine Months Ended September 30, Percent 1999 1998 Change - -------------------------------------------------------------------------------- Interest Revenue Margin loans to customers $ 687 $ 499 38% Investments, customer-related 298 290 3 Other 59 39 51 - -------------------------------------------------------------------------------- Total 1,044 828 26 - -------------------------------------------------------------------------------- Interest Expense Customer cash balances 486 428 14 Stock-lending activities 23 30 (23) Borrowings 20 19 5 Other 15 6 150 - -------------------------------------------------------------------------------- Total 544 483 13 - -------------------------------------------------------------------------------- Net interest revenue $ 500 $ 345 45% ================================================================================ Customer-related daily average balances, interest rates and average net interest margin for the first nine months of 1999 and 1998 are summarized in the following table (dollars in millions): - -------------------------------------------------------------------------------- Nine Months Ended September 30, 1999 1998 - -------------------------------------------------------------------------------- Interest-Earning Assets (customer-related): Margin loans to customers: Average balance outstanding $12,563 $ 8,678 Average interest rate 7.31% 7.69% Investments: Average balance outstanding $ 8,602 $ 7,280 Average interest rate 4.63% 5.32% Average yield on interest-earning assets 6.22% 6.61% Funding Sources (customer-related and other): Interest-bearing customer cash balances: Average balance outstanding $16,886 $12,838 Average interest rate 3.85% 4.46% Other interest-bearing sources: Average balance outstanding $ 1,516 $ 1,295 Average interest rate 3.70% 4.39% Average noninterest-bearing portion $ 2,763 $ 1,825 Average interest rate on funding sources 3.34% 3.94% Summary: Average yield on interest-earning assets 6.22% 6.61% Average interest rate on funding sources 3.34% 3.94% - -------------------------------------------------------------------------------- Average net interest margin 2.88% 2.67% ================================================================================ The increase in net interest revenue from the first nine months of 1998 was primarily due to higher levels of margin loans to customers, partially offset by higher average customer cash balances. Principal Transactions Principal transaction revenues were $361 million for the first nine months of 1999, up $174 million, or 94%, from the first nine months of 1998. This increase was primarily due to greater share volume handled by M&S, as well as higher average revenue per share traded. Expenses Excluding Interest Compensation and benefits expense was $1,162 million for the first nine months of 1999, up $327 million, or 39%, from the first nine months of 1998 primarily due to a greater number of employees and higher variable compensation expense resulting from the Company's financial performance. The following table shows a comparison of certain compensation and benefits components and employee data (in thousands): - -------------------------------------------------------------------------------- Nine Months Ended September 30, 1999 1998 - -------------------------------------------------------------------------------- Compensation and benefits expense as a % of revenues 41% 43% Variable compensation as a % of compensation and benefits expense 29% 22% Compensation for temporary employees, contractors and overtime hours as a % of compensation and benefits expense 14% 14% Full-time equivalent employees(1) 17.4 13.0 Revenues per average full-time equivalent employee $181.4 $148.0 ================================================================================ (1) Includes full-time, part-time and temporary employees, and persons employed on a contract basis. Communications expense was $197 million for the first nine months of 1999, up $43 million, or 28%, from the first nine months of 1998. This increase was primarily due to higher customer trading volumes and the introduction of certain online research tools in 1999. Occupancy and equipment expense was $191 million for the first nine months of 1999, up $43 million, or 29%, from the first nine months of 1998. This increase was attributable to the factors described in the comparison between the three-month periods. Advertising and market development expense was $165 million for the first nine months of 1999, up $63 million, or 62%, from the first nine months of 1998. This increase was attributable to the factors described in the comparison between the three-month periods. Professional services expense was $109 million for the first nine months of 1999, up $45 million, or 71%, from the first nine months of 1998. This increase was attributable to the factors described in the comparison between the three-month periods. The Company's effective income tax rate for the first nine months of 1999 and 1998 was 39.3% and 39.6%, 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 $20.1 billion and $17.5 billion at September 30, 1999 and December 31, 1998, respectively. Management believes that customer cash balances and operating earnings will continue to be the primary sources of liquidity for Schwab in the future. Schwab is subject to regulatory requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying cash dividends, or making unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar amount requirement of $1 million. At September 30, 1999, Schwab's net capital was $1,400 million (10% of aggregate debit balances), which was $1,130 million in excess of its minimum required net capital and $725 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, an increasing amount of cash flows have been retained to support aggregate debit balances. To manage Schwab's regulatory capital position, CSC provides Schwab with a $1,400 million subordinated revolving credit facility maturing in September 2001, of which $615 million was outstanding at September 30, 1999. At quarter end, Schwab also had outstanding $25 million in fixed-rate subordinated term loans from CSC maturing in 2001. Borrowings under these subordinated lending arrangements qualify as regulatory capital for Schwab. To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank credit lines totaling $715 million at September 30, 1999 (these lines are also available for CSC to use). Schwab used such borrowings for 22 days during the first nine months of 1999, with the daily amounts borrowed averaging $138 million. These lines were unused at September 30, 1999. To satisfy the margin requirement of customer option transactions with the Options Clearing Corporation (OCC), Schwab had unsecured letter of credit agreements with 11 banks in favor of the OCC aggregating $855 million at September 30, 1999. Schwab pays a fee to maintain these letters of credit. No funds were drawn under these letters of credit at September 30, 1999. 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 marketable securities, receivable from brokers, dealers and clearing organizations, and cash and cash equivalents. M&S' liquidity is affected by the same net capital regulatory requirements as Schwab (see discussion above). At September 30, 1999, M&S' net capital was $12 million, which was $11 million in excess of its minimum required net capital. M&S may borrow up to $35 million under a subordinated lending arrangement with CSC maturing in 2000. Borrowings under this arrangement qualify as regulatory capital for M&S. This facility was unused during the first nine months of 1999. 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 $465 million Senior Medium-Term Notes, Series A (Medium-Term Notes), as well as from the funding of cash dividends, common stock repurchases and acquisitions. The Medium-Term Notes have maturities ranging from 1999 to 2009 and fixed interest rates ranging from 5.90% to 7.50% with interest payable semiannually. The Medium-Term Notes are rated A3 by Moody's Investors Service and A- by Standard & Poor's Ratings Group. CSC has a prospectus supplement on file with the Securities and Exchange Commission enabling CSC to issue up to $395 million in Senior or Senior Subordinated Medium-Term Notes, Series A. At September 30, 1999, $311 million of these notes remained unissued. CSC may borrow under its committed, unsecured credit facilities. CSC maintains a $600 million facility with a group of fourteen banks which expires in June 2000 and a $175 million facility with a group of nine banks which expires in June 2001. The funds under both of these facilities are available for general corporate purposes and CSC pays a commitment fee on the unused balance of these facilities. The financial covenants in 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 foreseeable dividend or funding requirements. These facilities were unused during the first nine months of 1999. CSC also has access to the $715 million uncommitted, unsecured bank credit lines that are primarily utilized by Schwab to manage short-term liquidity. These lines were not used by CSC during the first nine months of 1999. CSE CSE's liquidity needs are generally met through earnings generated by its operations. Most of CSE's assets are liquid, consisting primarily of cash and investments required to be segregated, receivable from brokers, dealers and clearing organizations, and receivable from customers and others. CSE may borrow up to 20 million British pound, equivalent to $33 million at September 30, 1999, under subordinated lending arrangements with CSC. At September 30, 1999, CSE had outstanding 15 million British pound under these arrangements, equivalent to $24 million, with 5 million British pound maturing in 2001 and 10 million British pound maturing in 2003. Cash Flows and Capital Resources Net income plus depreciation and amortization was $530 million for the first nine months of 1999, up 53% from $347 million for the first nine months of 1998, allowing the Company to finance its operations primarily with internally generated funds. Depreciation and amortization expense related to equipment, office facilities and property was $105 million for the first nine months of 1999, as compared to $97 million for the first nine months of 1998, or 4% and 5% of revenues for each period, respectively. Amortization expense related to intangible assets was $6 million for the first nine months of 1999, as compared to $8 million for the first nine months of 1998. The Company's capital expenditures net of proceeds from the sale of fixed assets were $194 million in the first nine months of 1999 and $145 million in the first nine months of 1998, or 7% of revenues for each period. Capital expenditures in the first nine months of 1999 were for equipment relating to the Company's information technology systems, telecommunications equipment, and leasehold improvements. The Company opened twenty-eight new domestic branch offices during the first nine months of 1999, compared to seven domestic branch offices opened during the first nine months of 1998. Capital expenditures may vary from period to period as business conditions change. As reported in the Company's 1998 Annual Report to Stockholders, management expected 1999 capital expenditures to increase 40% over the $190 million level in 1998, and estimated that approximately 75% of the 1999 planned expenditures related to capacity and approximately 25% related to facilities expansion and improvements. Management currently anticipates that full year 1999 capital expenditures will increase approximately 50% to 55% over the 1998 level primarily due to the Company's enhancements to capacity and information technology (approximately 65% of the total 1999 capital expenditures), and facilities expansion and improvements (approximately 35% of the total). The Company issued $144 million and repaid $30 million in Medium-Term Notes during the first nine months of 1999. During the first nine months of 1999, 14,427,100 of the Company's stock options, with a range of exercise prices from $.97 to $27.50, were exercised with cash proceeds received by the Company of $45 million and a related tax benefit of $176 million. The cash proceeds are recorded as an increase in cash and a corresponding increase in stockholders' equity. The tax benefit is recorded as a reduction in income taxes payable and a corresponding increase in stockholders' equity. During the first nine months of 1999, the Company did not repurchase any common stock. During the first nine months of 1998, the Company repurchased 12,309,500 shares of its common stock for $148 million. Since the inception of the repurchase plan in 1988 through September 30, 1999, the Company has repurchased 132,830,700 shares of its common stock for $314 million. At September 30, 1999, authorization granted by the Company's Board of Directors allows for future repurchases of 2,450,600 shares. In April 1999, the Board of Directors approved a two-for-one split of the Company's common stock, effected in the form of a 100% stock dividend. The stock dividend was distributed on July 1, 1999 to stockholders of record June 1, 1999. Share and per share data throughout this report have been restated to reflect this transaction. During the first nine months of 1999, the Company paid common stock cash dividends totaling $34 million, up from $32 million paid during the first nine months of 1998. The Company monitors both the relative composition and absolute level of its capital structure. The Company's total financial capital (borrowings plus stockholders' equity) at September 30, 1999 was $2,521 million, up $741 million, or 42% from December 31, 1998. At September 30, 1999, the Company had borrowings of $465 million, or 18% of total financial capital, that bear interest at a weighted-average rate of 6.71%. At September 30, 1999, the Company's stockholders' equity was $2,056 million, or 82% of total financial capital. Year 2000 Many existing computer programs use only two digits to identify a specific year and therefore may not accurately recognize the upcoming change in the century. If not corrected, many computer applications could fail or create erroneous results by or at the year 2000. Due to the Company's dependence on computer technology to operate its business, and the dependence of the financial services industry on computer technology, the nature and impact of Year 2000 processing failures on the Company's business, financial position, results of operations or cash flows could be material. The Company has modified and tested its computer systems in order to enable its systems to process data and transactions incorporating year 2000 dates without material errors or interruptions. Because systems critical to the Company's functioning other than its computer systems may be affected by the century change, the Company's Year 2000 compliance efforts also encompass facilities and equipment which rely on date-dependent technology, such as building equipment that contains embedded technology. Status of Compliance Efforts The Company's Year 2000 compliance efforts have been directed towards defined categories of actions, which include awareness, inventory, assessment, remediation, testing, installation, contingency planning and vendor management. Attempting to assure that the Company's mission critical systems achieve Year 2000 compliance, that is, that they will operate without material errors or interruptions when processing data and transactions incorporating year 2000 dates, has received the highest priority in the Company's Year 2000 compliance efforts. "Mission critical" systems means systems critical to the ongoing operation of the business. The remediation and associated required testing of the Company's mission critical internal systems are complete, including the systems of the Company's material subsidiaries. Currently, the primary focus of the Company's efforts is contingency planning, year-end planning and maintaining Year 2000 compliance as system changes (including non-Year 2000 related products and enhancements) are introduced. The Company anticipates that work on these phases of the project will continue through the century change. The Company's vendor management initiatives have included creating inventories of vendors, analyzing the results of the inventories to assess the criticality of specific vendor relationships in order to formulate plans for dealing with possible Year 2000 issues, inquiring directly as to the status of vendors' Year 2000 compliance efforts, and continuing contacts with vendors to monitor the progress of vendors who may not yet have achieved Year 2000 compliance. All material vendor compliance efforts for mission critical third-party products and services were completed as of the end of the third quarter of 1999, except for efforts where completion is dependent on third parties whose actions are beyond the Company's control, and except for contingency planning efforts which by their nature will be continuing until the century change is completed. The success of the Company's Year 2000 compliance efforts depends in part on parallel efforts being undertaken by vendors and other third parties with which the Company's systems interact and therefore, the Company has taken steps to determine the status of critical third parties' Year 2000 compliance. There can be no assurance that all such third parties will provide accurate and complete information or that all their systems in fact will achieve full Year 2000 compliance. Third parties' Year 2000 processing failures might have a material adverse impact on the Company's systems and operations. The Company's Year 2000 compliance efforts may also be adversely affected by regulatory changes, changes in industry practices, the cost and continued availability of qualified personnel and other resources, and significant systems modifications unrelated to the Year 2000 project including upgrades and additions to capacity. The progress of the Company's Year 2000 compliance efforts is managed and reviewed by senior management and the Company's Year 2000 Corporate Steering Committee, which is responsible for maintaining awareness of Year 2000 issues throughout the Company, monitoring overall progress of the project, resolving issues, and providing strategic direction. The Company's Board of Directors receives regular status reports on the project. Contingency Planning and Risks The Company commenced its contingency planning efforts in 1997. Its contingency planning process is intended to create, update, and implement, as necessary, plans in the event of Year 2000 errors or failures of third parties with whom the Company interacts or who supply critical services or goods to the Company, or of the Company itself. In management's opinion, there is not sufficient reliable information available to enable the Company to determine whether any specific Year 2000 failures are reasonably likely to occur. However, the Company has developed firm-wide contingency scenarios which take into account multiple simultaneous failures, and corresponding contingency plans. These scenario-based contingency plans are in addition to both contingency plans developed on a business-unit level and the Company's overall business resumption plans. Corresponding staffing and training plans have been completed. A Corporate Command Center is being established for contingency plan activation and centralized communications. The Company continues to take steps to reduce this uncertainty by participating in industry conferences, communicating with business alliance partners, monitoring critical vendors, monitoring national and international governmental and industry initiatives, and working with professional consultants and advisors. Given the uncertainty of predicting which, if any, Year 2000 errors or failures are reasonably likely to occur, the Company's contingency planning process targets systems, transactions, processes, and third parties that are deemed to be critical to the Company's business, results of operations, or financial condition. Compliance Cost Estimates The Company currently estimates that the cost of completing its Year 2000 project, including mission critical and other core brokerage computer systems, distributed applications, facilities, and systems in subsidiaries other than Schwab, is approximately $86 million to $91 million. Additionally, the Company currently anticipates spending prior to the end of 1999 approximately $8 million to complete its contingency plans. This amount does not include the costs of executing such plans if certain contingencies occur. The Company's cost estimates exclude the time that may be spent by staff not specifically dedicated to the Year 2000 project. As of September 30, 1999, the Company had incurred approximately $81 million of the estimated cost of the project and an additional $2 million on its contingency plans. The estimated cost and timing of the project are based on the Company's estimates, which make numerous assumptions about future events. However, there can be no assurance that these estimates will be correct and actual costs and timing could differ materially from these estimates. The Company has funded and expects to fund all Year 2000 related costs through operating cash flows and a reallocation of the Company's overall developmental spending. This reallocation did not result in the delay of any critical information technology projects. In accordance with generally accepted accounting principles, Year 2000 expenditures are expensed as incurred. Item 3. Quantitative and Qualitative Disclosures About Market Risk Financial Instruments Held For Trading Purposes The Company held government securities and certificates of deposit with a fair value of approximately $26 million and $11 million at September 30, 1999 and 1998, respectively. These securities, and the associated interest rate risk, are not material to the Company's financial position, results of operations or cash flows. Through Schwab and M&S, the Company maintains inventories in exchange-listed and Nasdaq equity securities on both a long and short basis. The fair value of these securities at September 30, 1999 was $61 million in long positions and $39 million in short positions. The fair value of these securities at September 30, 1998 was $37 million in long positions and $46 million in short positions. Using a hypothetical 10% increase or decrease in prices, the potential loss or gain in fair value is estimated to be approximately $2,200,000 and $900,000 at September 30, 1999 and 1998, respectively, due to the offset of change in fair value in long and short positions. In addition, the Company generally enters into exchange-traded option contracts to hedge against potential losses in equity inventory positions, thus reducing this potential loss exposure. This hypothetical 10% change in fair value of these securities at September 30, 1999 and 1998 would not be material to the Company's financial position, results of operations or cash flows. The notional amount and fair value of option contracts were not material to the Company's consolidated balance sheets at September 30, 1999 and 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-term maturities and are not subject to material changes in value due to interest rate movements (dollars in millions): - -------------------------------------------------------------------------------- Principal Amount by Maturity Date Fair Value September 30, 2000 Thereafter 1999 1998 - -------------------------------------------------------------------------------- Resale agreements (1) $7,621 $7,621 $5,680 Weighted-average interest rate 5.14% Certificates of deposit $ 940 $ 940 $1,559 Weighted-average interest rate 5.31% Commercial paper $ 240 $ 240 $ 553 Weighted-average interest rate 5.60% ================================================================================ (1) Fair value at September 30, 1999 includes resale agreements of $7,306 million included in cash and investments required to be segregated under federal or other regulations and $315 million included in cash and cash equivalents. At September 30, 1999, CSC had $465 million aggregate principal amount of Medium-Term Notes, with fixed interest rates ranging from 5.90% to 7.50%. At September 30, 1998, CSC had $351 million aggregate principal amount of Medium-Term Notes, with fixed interest rates ranging from 5.78% to 7.72%. The Company has fixed cash flow requirements regarding these Medium-Term Notes due to the fixed rate of interest. The fair value of these Medium-Term Notes at September 30, 1999 and 1998, based on estimates of market rates for debt with similar terms and remaining maturities, approximated their carrying amount. The table below presents the principal amount of these Medium-Term Notes by year of maturity (dollars in millions): - -------------------------------------------------------------------------------- Year Ending Weighted-Average Principal December 31, Interest Rate Amount - -------------------------------------------------------------------------------- 1999 5.9% $ 10 2000 6.3% 48 2001 7.0% 39 2002 7.0% 53 2003 6.5% 49 Thereafter 6.8% 266 ================================================================================ The Company maintains investments in mutual funds, approximately $55 million and $42 million at September 30, 1999 and 1998, respectively, to fund obligations under its deferred compensation plan, which is available to certain employees. Any decrease in the fair value of these investments would result in a comparable decrease 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 None. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) The following exhibits are filed as part of this quarterly report on Form 10-Q. - -------------------------------------------------------------------------------- Exhibit Number Exhibit - -------------------------------------------------------------------------------- 3.10 Fourth Restated Certificate of Incorporation, effective July 30, 1999, of the Registrant, which includes amendments through May 20, 1999 (supersedes Exhibit 3.7). 10.207 The Charles Schwab Corporation 1992 Stock Incentive Plan, restated to include Amendments through May 17, 1999 (supersedes Exhibit 10.203). 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 6, 1999, the Registrant filed a Current Report on Form 8-K relating to up to $395 million aggregate principal amount of debt securities issuable by the Registrant pursuant to Registration Statement Numbers 333-77381 and 333-54001 declared effective by the Securities and Exchange Commission on June 25, 1999 and July 8, 1998, respectively. Certain exhibits relating to the Medium-Term Notes, Series A, which are issuable pursuant to the Registration Statements, are contained in the Form 8-K.
THE CHARLES SCHWAB CORPORATION SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. THE CHARLES SCHWAB CORPORATION (Registrant) Date: November 10, 1999 /s/ Christopher V. Dodds ----------------- ------------------------------------ Christopher V. Dodds Executive Vice President and Chief Financial Officer