Letter from the CFO
“While we have worked long and hard to create certain competitive advantages, they are not unassailable. Our scale, diversified operating model, and strong brand provide a sturdy foundation, but only by guarding against complacency can we meet the expectations of our various stakeholders: clients, stockholders, and employees.”
Chief Financial Officer
Wow, what a year! As I reflect on all that’s happened since I last wrote to you, I see 2019 as a monumental—even historic—year for Schwab where we stepped decisively into our next era of growth. Over my past few CFO letters, we have talked about having “Room to Run,” “Raising our Sights,” and, most recently, even pondering whether 2018 represented Schwab’s peak performance. The connective tissue across those previous letters was a confidence that, by continuing to execute our “Through Clients’ Eyes” strategy while effectively leveraging our competitive advantages, we could maintain or increase our positive momentum. I hope you agree that our results for 2019 and recent years have more than delivered on that commitment. Yet it would be foolish to think that this success represents the final summit. All of us on the Schwab leadership team are fully aware that we currently stand looking up at an even higher peak. We have a big opportunity to continue to execute our strategy and seek to attract the broadest possible swath of investable wealth in the U.S., while serving the needs of individual investors and independent advisors. But what does that really mean within a competitive industry such as financial services?
To me, it boils down to a combination of our relentless focus on clients and a healthy amount of self-awareness. We understand that while we have worked long and hard to create certain competitive advantages that exist today, they are not unassailable. Our scale, diversified operating model, and strong brand provide a sturdy foundation from which we are able to proactively drive further efficiency, enhance our leading service culture, and innovate on behalf of our clients. Only by guarding against complacency can we meet the expectations of our various stakeholders: clients, stockholders, and employees. But perhaps the bigger question is whether this is feasible without significant tailwinds at our back.
We certainly think so. Over the past decade, the Schwab team has deliberately worked to improve our positioning across a diverse array of environments. We have always taken pride in our ability to weather storms and still deliver for our clients. Historically, our focus on flexibility may have felt more defensive in nature. Our 2019 story, however, unfolded differently than in years past. Our mission, client-focused strategy, and sustained investment of sweat equity and financial capital have helped create a differentiated firm that can harness its strengths to generate an enviable organic growth rate while offering clients a “no trade-offs” approach to investing. So when the macroeconomic environment shifted on us early in the year, we stood ready to not just weather the storm, but to actually press ahead and go on the offensive. Whether it was removing the final barrier to investing by reducing headline equity commission rates to $01, signing the USAA and TD Ameritrade acquisition agreements, or launching innovative new products such as Schwab Intelligent Portfolios Premium™ and Schwab Intelligent Income™, we sought ways to evolve on behalf of our clients while still creating long-term value for stockholders. With all of the excitement sparked by these bold steps, it’s easy to look ahead to the future. But before we shift our gaze to the horizon, let’s review what I feel was one of the most exciting 12 months in Schwab’s history.
"Chuck Schwab built this company with a culture based on listening to our clients, maintaining a healthy respect for our competitors, and being ready to drive disruption to ensure we remain well-positioned for long-term, profitable growth."
As we began 2019, there was, as usual, significant uncertainty. To set expectations amidst this backdrop, we outlined a range of potential financial outcomes built upon certain key assumptions: 6.5% annual market appreciation from mid-January levels, one Fed Funds rate increase in June 2019, an average 10-year Treasury yield of 2.80%, a ~5% uptick in daily average revenue trades (DARTs), and client cash sorting behavior that was expected to result in a net change to our balance sheet ranging from high single-digit contraction to modest growth. Based on these inputs, we believed we could produce top-line revenue growth of 7%–11%. Simultaneously, by limiting expense growth to 6%–7%, we anticipated delivering at least a 45% pre-tax margin across the potential scenarios.
Needless to say, events unfolded a bit differently than our initial expectations. Equity markets achieved record levels—with the S&P 500® up 29% for the full year—despite a challenging mix of geopolitical, economic, and other environmental dynamics. Concerns regarding the strength of the economy prompted the Federal Reserve to abruptly pivot from its multiyear tightening cycle toward monetary easing, highlighted by three rate cuts. These actions impacted the entire curve, with the yields on the 10-year Treasury averaging 2.14% for the year. The yield curve even inverted for a portion of the year, which was a reflection of investors’ concerns relating to Brexit, persistent international trade conflict, and other mounting sources of uncertainty.
Despite this moderately challenging backdrop, we made the decision in October to reduce online trade commissions to $01— an action that negatively impacted our financial results for the year, but which we’re confident will benefit stockholders longer term. As I outlined in my CFO commentary following the move, we estimated the quarterly revenue impact of the commission cuts at approximately $90–$100 million before any offsets. Given the less than favorable macroeconomic environment, it would have been easy for us to kick the can down the road, to hold off on responding to the proliferation of free commission offers for just a little longer…and a little longer, and so on. But that approach is not what has made us successful for over four decades. Chuck Schwab built this company with a culture based on listening to our clients, maintaining a healthy respect for our competitors, and being ready to forgo some near-term financial performance, when appropriate, to ensure we remain well positioned for long-term, profitable growth.
Core Net New Assets and Organic Growth Rate
(In Billions At Year-End)
So after incorporating all of these factors, how did our performance measure up relative to expectations? Our “no trade-offs” approach to serving investors’ needs helped us remain a trusted partner for clients, who rewarded us with $212 billion in core net new assets (NNA)—a 7% organic growth rate and the second consecutive year of core NNA in excess of $200 billion. Our revenue grew 6% year-over-year, slightly below the initial range we outlined, as the headwinds created by the sharp drop in rates and forgone commission revenue more than offset the uplift from rising equity markets. Our record revenue was boosted by net interest revenue, which rose to a record $6.5 billion, up 12% year-over-year. This growth rate was driven by higher average investment yields—despite those three Fed rate cuts—and an increase in client cash balances. Asset management and administration fees were $3.2 billion, essentially flat relative to last year, due to rising balances in third-party mutual funds, along with growing enrollment in our advisory solutions, largely offsetting declines in Mutual Fund OneSource® and lower money market fund revenue due to sweep transfers. The aforementioned October commission reductions, coupled with slightly softer investor engagement, resulted in $617 million in trading revenue, down 19% versus 2018.
In response to the challenging environment, we took steps to reduce our planned spending levels in 2019 relative to our initial outlook. Expenses of $5.9 billion were up 5% and included $62 million in severance charges associated with a 3% reduction in our workforce and $25 million in costs related to our two pending acquisitions (which together contributed approximately 1.5 percentage points to that expense growth). This disciplined approach helped us achieve a record 45.2% pre-tax profit margin and a 19% return on equity for the year—our second consecutive year of at least 45% and 19%, respectively.
In 2019, Schwab continued to demonstrate the ability to grow and return capital to stockholders. Our framework for capital management remained unchanged from prior years, with growth being the primary focus. We raised our common dividend 31% to $0.17 per share, comfortably within our target 20%–30% payout ratio, and we opportunistically repurchased $2.2 billion worth of shares, or approximately 55% of the most recent $4 billion authorization. Tying it all together, our ability to operate with the appropriate discipline and flexibility, along with prudent capital management, enabled us to deliver 9% earnings per share growth on top of 2018’s stellar results, despite a less than favorable environment and those nonroutine expense items.
“The service that we provide to our clients propelled us in 2019 and will continue to be our focus in 2020 and beyond.”
Pre-Tax Profit Margin
Return on Equity
Net Revenues (In Millions At Year-End)
On the Horizon
Now let’s shift our focus to the year ahead. While the industry in which we operate continues to change a lot, our approach remains consistent: do right by our clients, work to strengthen our competitive position, and invest for growth—yet remain flexible in our spending to deliver solid financial performance in different environments. As Walt notes in his letter, it is paramount that we keep our primary focus on the long-term success of our clients and our firm while remaining cognizant of delivering on our near-term financial commitments. Consistent execution of this balancing act is what has made us successful. We remain confident that we can continue to employ sound judgement to make the necessary trade-offs, so our clients don’t have to.
I believe 2020 will be somewhat of a “transitional” year from a financial standpoint, as the actions we’ve taken to benefit clients inevitably play out within the context of the broader economic backdrop. In framing the outlook for the coming year, we are not including anything relating to the pending TD Ameritrade acquisition. Consistent with years past, we start with a core set of assumptions: 6.5% equity market appreciation from January 10, 2020, levels, no Fed rate cuts, an average yield on the 10-year U.S. Treasury of 1.93%, and daily average trades (DATs) up 11% versus the prior year. It is important to note that following the October trading commission actions, we are transitioning to focus on DAT rather than DART, as we believe this measure will provide more meaningful insight regarding client activity and engagement. Similar to recent years, client cash trends will play a significant role in how our 2020 financial story plays out. While we believe cash sorting—clients reassessing the appropriate mix of transactional cash and relatively higher-yielding, off-balance-sheet alternatives—remains on the wane, our expectation is that some level of sorting likely persists going forward. Another trend to watch over the coming months and quarters will be aggregate client allocations to cash. During the last six months of 2019, our clients were net sellers of equities—in spite of the strong market performance. If this selling continues—and sorting stops—we could see our balance sheet grow by as much as 12%. If, however, those equity sales cease and clients continue to deploy more of their cash into higher-yielding alternatives, we might expect the balance sheet to finish flat for the year. Under that potential span of balance sheet outcomes, year-over-year total revenue growth could range from 0% to 4%.
Turning to expenses, we remain intent on driving toward a long-range expectation of low-to-mid single-digit percentage annual growth. We are very proud of the progress we made on this front during 2019, in large part by harvesting initial gains from our digitalization efforts and ongoing refresh of our technology infrastructure. We expect to unlock more savings over the coming year, which will keep the needle moving in the right direction on our core expense growth trajectory. Given our pending acquisitions, there will undoubtedly be some “noise” in the numbers as we execute on the respective integration plans. It is worth noting that we expect to eventually initiate the use of select non-GAAP measures, including, but not limited to, a core expense growth rate, to help illustrate our fundamental operating performance alongside our reported results. We believe that delineating between core expenses and well-defined, transaction-specific costs will be a useful way to communicate our progress against our financial and operating objectives. For the coming year, we project GAAP expense growth of 6%–7%, which includes the roll-off of 1.5% in 2019 non-routine expenses, 4%–5% in underlying core Schwab expense growth, and a total 3.5% contribution from USAA-related costs. That transaction remains on track for closing in mid-2020.
Expense as a Percentage of Average Client Assets (In Basis Points)
Over the years, you’ve heard us talk about threading the needle to manage for long-term growth while still achieving appropriate near-term results. I expect this important balancing act will be front and center during 2020. Our anticipated expense growth rate should ensure we won’t disrupt our strong underlying business momentum, while still pushing forward on key initiatives such as Application Modernization and Digital Transformation. Bringing together the range of potential revenue outcomes outlined above with our outlook for expenses, it’s not unreasonable to anticipate some sequential pre-tax profit margin pressure—though we’d expect to remain solidly north of 40%. That being said, we believe there’s potential to generate positive operating leverage as the year progresses. We do not view this possibility as a step back or a glitch in our financial formula, but rather as a natural part of our ongoing journey.
As the CFO of a growth company, I hope it’s evident from reading my past and current letters that supporting ongoing business growth remains our number one priority from a capital management perspective. We will continue to manage the firm to our long-term objective of a 6.75%– 7.00% consolidated Tier 1 Leverage Ratio. To the extent we generate excess capital beyond what is required to sustain our growth and maintain our regular cash dividend within the 20%–30% earnings target range, we expect to utilize the remaining capacity under the current repurchase authorization to opportunistically buy back shares, as appropriate.
With two acquisitions to work through, 2020 will undoubtedly be one of the busiest years in the firm’s history. It will be more important than ever that we continue to strive for that optimal balance between flexibility and discipline. By effectively managing this fulcrum point, we expect to deliver on our organic growth goals as well as begin to capture potential value from the pending transactions. We have developed a realistic roadmap, and we remain confident that we are well positioned to succeed, regardless of how the year ahead unfolds. The time is now to press ahead on behalf of our clients and continue building the future of modern wealth management.
I said previously that 2020 may be a transitional year. But I also think it has the opportunity to be a transformational year as well—a year that lays the foundation for the next decade or more of growth.
Thank you as always for your ongoing support, and I look forward to sharing this next chapter in Schwab’s story with you.
March 4, 2020
Key Competitive Advantages
1 Commissions for all U.S.- and Canadian-listed stocks, exchange-traded funds, and options traded online or via mobile devices were reduced from $4.95 to $0; options trades are still subject to the standard $0.65 per-contract fee.