Letter from the CFO
“In eight of the last 11 years, we generated positive operating leverage, a noteworthy feat for any financial services company during one of the most challenging economic environments in history.”
Peter Crawford, Chief Financial Officer
Is This It?
For those of you who have followed or owned SCHW for more than a decade, you may recall our reassuring mantra in the darkest of days: the “coiled spring.” I’ve looked back, and I believe the first public references to the “coiled spring” were at our 2009 Business Update and in our 2010 Annual Report—after that it seemed like it was mentioned at every Business Update through 2015. Even though our asset growth over the past decade continued at an impressive enough pace to earn us the industry moniker “asset-gathering machine,” the macroeconomic environment did not always convert that strong business growth into record financial results.
The “coiled spring” referred to the pent-up earnings power in our model that was poised to occur when the environment was more favorable. And so, while we waited for rates and markets to improve, we continued growing assets and exercising discipline in our model, balancing near-term profitability with investments for the long-term growth of the business. In eight of the last 11 years, we generated positive operating leverage, a noteworthy feat for any financial services company during one of the most challenging economic environments in history.
In December 2015, at last, the Fed started raising rates, and the “coiled spring” started to release. From 2016–2018, we not only drove record asset gathering, we also realized the best years in our company’s history in terms of revenue, pre-tax profit margin, and net income. We shared much of that benefit with clients—nearly $400 million in annualized client cost savings since 2017. But with money fund fee waivers (which ran at $750 million a year at their peak) essentially eliminated; with the nine Fed Funds rate hikes having expanded our net interest margin (NIM) over 80 bps (from 1.57% in the third quarter of 2015 to 2.39% in 2018); and with transfers of sweep money fund balances to bank and broker-dealer sweep totaling $81 billion since 2016 (with the remaining transfers expected by mid-2019), the questions I am getting from many of you now are: “Is there anything left?” “Is there still more juice in the orange?” “Has Schwab peaked?”
It’s only natural to wonder this. It reminds me of when a friend and I decided to cycle across the U.S. from San Francisco to Boston upon graduating college. Just as we passed through the western states and rested for a day in the Tetons, we looked at each other and wondered whether we could sustain the pace and complete the trip. What we discovered was that while the next 3,100 miles had different terrain and challenges than the first part of the trip, we actually increased our pace.
So, is this it for Schwab? We believe, unequivocally, the answer is no. Let’s examine what led to such remarkable 2018 results, and then we’ll discuss what’s ahead.
“How did we fare amidst this somewhat tumultuous environment? With our best performance ever.”
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In the 2017 Annual Report, I outlined our initial 2018 performance expectations: assuming 6.5% S&P 500® Index appreciation, a slight rise in daily average revenue trades (DARTs) from 2017, one rate hike in June 2018, and an average 10-year Treasury yield of 2.55%, we believed we could produce low teens revenue growth, a gap between revenue and expense growth of 100–200 basis points, and a pre-tax profit margin of around 43%.
So what happened? 2018 began with strong market momentum from a historical nine consecutive quarters of positive returns, but it got interesting in February as the CBOE Volatility Index® had its largest one-day increase ever of 116%. And while things seemed to settle down from March through November, with record highs for most indices mid-year, the markets certainly went on a wild ride at the end of the year. As Walt mentioned in his letter, even though by most economic measures things seemed okay, the market and the economy took somewhat divergent paths in 2018, and we finished the year with the S&P down 6%. The Fed raised the target overnight rate not just once, but four times, affecting broader rates, with an average 1-month LIBOR yield of 2.02% and average 10-year Treasury yield at 2.91%.
How did we fare amidst this somewhat tumultuous environment? With our best performance yet. Clients continued to turn to Schwab, and we gathered a record $227.8 billion in core net new assets, more than double those in 2008. With an organic asset growth rate of 7% and a supportive environment for much of the year, we crossed the $10 billion revenue mark for the first time, producing 18% growth over 2017. Net interest revenue set a record at $5.8 billion, up 36% year-over-year due to the Fed’s rate normalization and higher interest-earning assets, which reflect both client cash allocations and the transfer of sweep money market funds to bank and broker-dealer sweep. As we progressed with these transfers, the corresponding money fund revenue naturally declined, yet positive flows in our advice solutions and other investment products kept asset management and administration fees at $3.2 billion, down just 5% from last year. Record trading activity from our clients resulted in trading revenue reaching $763 million, up 17% from 2017.
Probably the most notable change in 2018 was our expansion of capital return. While much of our capital supported balance sheet growth of 22% (from both sweep transfers and organic activity), the macroeconomic environment and our performance left us in an excess capital position. Throughout 2018, we raised the quarterly cash dividend 63%, and after 10 years, we resumed stock repurchases, buying back $1 billion by year-end. Altogether, our revenue, expenses, and capital return, along with tax reform, resulted in a 52% increase in diluted earnings per share (EPS). 2018 was certainly a year where the Schwab financial formula was not just working, it was producing record performance.
Core New New Assets and Organic Growth Rate (In Billions at Year-End)
Our Financial Formula
It probably makes sense to take a moment to review what we mean by that formula. Although we may seem complex—with nearly $300 billion in total balance sheet assets and a broker-dealer, a bank, and an asset manager as our primary subsidiaries—our financial formula (how we actually operate) is very straightforward. It all centers on our core strategy: “Through Clients’ Eyes.” By focusing on our clients’ needs, we attract assets, and we translate that business growth into solid revenue growth through multiple sources. With disciplined expense and capital management, we convert that revenue growth into higher levels of bottom-line performance.
Historically, we have spoken about our formula as having the following components: organic asset growth in the mid-single-digit range and market appreciation at a 6.5% long-term average together help to create total asset growth in the upper single-digit or low double-digit range. We then seek to monetize those assets and, depending on the environment, we can get to a similar growth range for revenue. Then we manage our expenses, which we believe could have a low-to-mid-single-digit growth rate, to create margin expansion as well as pre-tax income growth that is stronger than revenue growth. Depending on our capital needs, we can potentially generate EPS growth at a level higher than that pre-tax income growth.
When we look at the past 10 years, from 2009 to 2018, here’s how our actual results line up with the formula:
So while in any one year the formula might not work perfectly, you can see that through the cycle, it delivers.
Net Revenues (In Millions At Year-End)
Pre-Tax Profit Margin
Return on Equity
So, what’s ahead? First and foremost, the financial formula should endure. Why? The simple answer is: It works. We have shown that pursuing our “Through Clients’ Eyes” strategy drives asset growth. And plenty of opportunity remains. We estimate total investable wealth (consisting of assets in defined contribution, retail wealth management and brokerage, and registered investment advisor channels, along with bank deposits) exceeds $45 trillion. With a market share of less than 10%, there are still many investors who would be better served by working with us. We see no structural reason why our “asset-gathering machine” in the next 10 years will be any less effective than in the past. Schwab is a growth company—it’s in our DNA. We will remain ever-focused on gathering the largest possible amount of investable wealth, year after year.
What does this all mean for 2019? First, let’s discuss the current environment. One word comes to mind: uncertainty. For 2019, there are several dynamics at play in terms of rates, the market, DARTs, and cash balances (to name just a few). So, for simplicity’s sake, let’s assume a 6.5% market appreciation off of mid-January levels, one Fed rate hike in June 2019, the average 10-year Treasury yield at 2.80%, and DARTs up 5%. As client cash is a significant variable, we should think in terms of a potential range of outcomes. For example, if clients continue their recent trend of sorting more transactional cash into higher-yielding alternatives beyond the first quarter of 2019, our balance sheet could decline for the year, perhaps by 8% or so. If clients are done with that process after the first quarter, we could see the balance sheet grow, perhaps in the low to mid-single-digits. Given that span of potential balance sheet growth, revenue growth could range from 7%–11%.
On the expense side, we are convinced we can continue to bend our cost curve in the future as our investments focus on driving both growth and efficiency. We often talk about our expense discipline—knowing when to invest more and when to pull back. 2016–2018 were examples where we spent much more, with an average three-year growth rate of 11%—but it isn’t necessary, realistic, or prudent to spend at that rate every year. In the long run, we anticipate expenses growing at the low-to-mid-single-digit rate. But this doesn’t mean that every year we will generate the same amount or even any operating leverage. Just as in the past, there may be years when the revenue environment is more favorable than others, and that can play a role in determining our investments and profitability. Our focus is on operating as efficiently as we can so that EOCA declines and margins expand over time, eventually reaching a natural peak margin consistent with sustaining an appropriate level of investment—rest assured that we are doing nothing to artificially constrain our profitability.
I’m often asked about our efforts to drive efficiency, given our already low cost structure and what we’re getting for the increased spending we’ve been doing the last few years. As efficient as we are, with the advances in technology and data analytics, we have an enormous opportunity to drive even greater efficiency across our business. We are confident that our efforts will pay dividends in the years ahead with lower EOCA, lower expense growth, and a more stable foundation on which to continue growing.
"I see the financial formula working – evolving to be not just about growth but about growth and meaningful capital return."
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Amidst all of the uncertainty and potential revenue variability for 2019, we expect to moderate our expense growth from its recent double-digit pace to between 6% and 7%, implying an operating leverage range of 0–500 basis points and a minimum pre-tax profit margin of 45%. We remain convinced that our owners would rather see us invest appropriately in the business—to both support the growth we have achieved and fuel growth and efficiency in the years ahead—than manage profit margin to some arbitrary level. Just as in the past, however, if the environment pans out even better than our assumptions, then we would expect stronger revenue to yield a stronger margin. So, our 2019 outlook contemplates profitable growth even if there is no significant help from DARTs, cash balances, short-term and long-term rates, or the market.
Expense as a Percentage of Average Client Assets (In Basis Points)
As we support business growth and aim to keep our consolidated Tier 1 Leverage Ratio within our 6.75%–7.00% operating objective, our anticipated capital return priorities will likely encompass both common dividends and share repurchases. To the extent we’re generating excess capital, we’d look to maintain our regular cash dividend at the middle or upper end of our 20%–30% of earnings target range and to utilize our Board’s recent $4 billion Share Repurchase authorization opportunistically. Any potential repurchases will help strengthen EPS as we sustain a healthy balance sheet.
I am fortunate enough to have been with Schwab since 2001 and have experienced nearly two decades of our challenges and successes. I am excited about what’s ahead. I see growth—in the retail channel, in the registered investment advisor channel, in new clients coming to Schwab, in younger clients, in clients seeking advice, in our existing branches, in our independent branches. I see huge efficiency and productivity opportunities—in serving clients more digitally, in attracting clients more effectively via our marketing, in driving more scale in our back office, in helping our frontline employees be more productive, in broadening the reach of our platforms. I see the financial formula working—evolving to be not just about growth, but about growth and meaningful capital return. I see employee and management commitment—in operating “through clients’ eyes,” in effective risk management, in maximizing shareholder value.
So, is this it? Not even close.
February 27, 2019
Fueling Ongoing Growth
We’ll continue building forward momentum by staying true to our strategy of seeing “Through Clients’ Eyes” and anticipating their needs. We are incredibly optimistic about the opportunities ahead.