Room to run
By the end of 2016, we could see that our financial story for the year would be the one we aimed for at the outset: making the most of an improving environment. The financial formula I’ve described to you in so many conversations and presentations during my tenure as CFO once again worked as specified. We drove solid business growth by following our “Through Clients’ Eyes” strategy, we delivered solid revenue growth through diversified sources, and we achieved improved profitability through continued expense discipline. And what a set of results! In 2016, we attained 11% growth in client assets to a record $2.78 trillion; 17% growth in revenues to a record $7.5 billion; a 4.3 percentage point increase in our pre-tax profit margin to a record 40%; a 31% lift in our net income to a record $1.9 billion; and a 14% return on equity (ROE), our highest in seven years. As we all know now, the environment did help—economic conditions improved, equity market returns were solidly positive, and interest rates inched further away from the ultra-low levels of recent years. Yet 2016 included a series of significant rough patches that made our strong full-year results far from certain, and that reinforced the importance of our disciplined, flexible approach to managing spending. We believe that combination of discipline and flexibility is crucial to our ability to successfully balance near-term profitability with reinvesting to drive long-term growth.
Let’s review how we managed through the ups and downs of 2016 to arrive at our record level of performance, and then we can discuss the path forward from here.
As I said, we entered 2016 poised to make the most of an improving environment. The Federal Reserve had just taken its first step away from its zero-interest-rate policy of the post–financial crisis era, and economic growth looked strong enough to warrant at least one more move during the year, which we included in our plans. Our baseline outlook also included relatively flat long-term interest rates and a 6.5% improvement in the S&P 500® Index over year-end 2015, along with a potential decline in revenue trades due to an expected slowdown in client portfolio turnover. So improving overall, but I think you’ll agree we weren’t counting on an extraordinary amount of help from external factors. And that’s an important point—we don’t need an extraordinary environment to produce strong results. All we need is for the environment not to work against us. With those assumptions, we expected to turn strong growth in our client base into mid-teens revenue growth. That solid revenue growth would give us breathing room for increased investment to support needed expansion of our team, our products and services, and our infrastructure to better serve clients. We planned for expense growth right around the double-digit mark, which in turn would enable us to deliver a revenue/ expense growth gap of approximately 500 basis points and a pre-tax profit margin of around 39%. After nearly a decade of hard work, we had positioned ourselves to invest more aggressively and still achieve a profit margin comparable to the record we set in 2008, while serving a client base more than twice as large and coping with an environment that was literally taking an estimated $4 billion in revenue away from us through lower interest rates. Were we fired up? You bet.
The first rough patch hit almost immediately in the first quarter. U.S. and global (i.e., China) economic data showed signs of weakness, and the major equity indices fell by double-digit percentages before regaining their footing. While these jolts didn’t knock us off course relative to our scenario for the year, they cast strong doubt on the strength of the environment overall and the likelihood of further Fed rate action. We therefore reassessed our spending expectations with an eye towards slowing the pace of increase without disrupting our priorities.
Things settled down for a while, but then the second patch hit around mid-year, as the United Kingdom debated and ultimately held its referendum on whether to remain in the European Union—Brexit. Market volatility spiked, with the S&P Global Broad Market Index losing a record $3 trillion in value over just two trading sessions. Yet once again, the environment eventually calmed as underlying economic data showed ongoing progress. The big news for us during this period was the Fed’s decision to forgo the mid-year rate hike we had included in our scenario. So even though concerns regarding economic growth, the general direction of interest rates, and equity valuations abated somewhat as we passed into the second half of 2016, there was still plenty of uncertainty surrounding the near-term outlook. We therefore chose to hold the line on our adjusted spending plans and remain vigilant in monitoring conditions.
Importantly, even without that mid-year rate hike, shortterm interest rates began to lift due to technical factors. In particular, the advent of new rules regarding the structure and management of money market funds led to an increase in LIBOR as institutions chose to reallocate their holdings in advance of these rules taking effect. Our retail-focused money fund balances were relatively unaffected, so we were able to benefit from these higher rates through a further reduction in related management fee waivers, as well as through improved net interest revenue from client cash balances at our bank and broker-dealer.
The third rough patch hit later in the year, during the run-up to our presidential election. In the midst of a hard-fought campaign season featuring strongly contrasting visions for the country’s direction, volatility rose and both market valuations and trading activity took a step back. With the decision settled and economic progress continuing, volatility once again retreated and the markets reflected increased optimism. Against this backdrop, the Fed finally moved ahead with their second rate hike at their December meeting.
So we lived through a year where the environment was less helpful than expected for major stretches, yet a late rally and rate move helped the final tally look okay—nominal GDP growth running at 2.5% or better, the S&P 500 up roughly 10%, and of course, that second rate hike. Clients brought us $125.5 billion in net new assets, and their assets housed at Schwab grew 11% overall to $2.78 trillion. We turned our business growth and the improved interest rate environment into 17% revenue growth by generating record levels of net interest revenue and asset management and administration fees, which more than offset lower revenue from trading and a decline in other revenue from the conclusion of certain litigation. That’s over $1 billion in expanded revenues in just one year. Compared to our baseline scenario, we ended up producing more revenue, a larger revenue/expense growth gap, and a higher pre-tax profit margin than we expected.
In hindsight, could we have used that revenue lift to reinvest even more aggressively in the business? I remain convinced we made the right choices. In the end, expense growth was trimmed only modestly to 9%, or a still substantial $384 million. We kept up with our growing client base, and we funded our priorities while avoiding the potential disruption and loss of momentum that can accompany having to retrench in the face of environmental pressures. The environment threw us a series of shocks that left interest rates and market valuations below expectations, which we were able to navigate with relative stability because we didn’t allow ourselves to get overextended. We’re far better off sitting here in a position of strength, able to choose our next steps, versus being forced to triage spending cuts across infrastructure, initiatives, and staff.
We are proud of our 2016 financial performance. And while we got banged around a bit along the way, we finished the year just as fired up as we started. How do we build on a year like this? I’ll say it one more time: by doing exactly what we’ve been doing—continuing to drive solid business growth by executing our “Through Clients’ Eyes” strategy, generating solid revenue growth through diversified sources, and delivering improved financial performance through sustained expense discipline.
In 2017, we believe flexibility and discipline will remain front and center in our financial management. Recently, we announced a series of price reductions that share some of the benefits of the scale that we’ve built in the business and should continue to help drive growth in the future. It’ll take a while to assess client reaction to our recent pricing moves, and while signs currently point to continued economic recovery, the extent and pace of future Fed rate actions are by no means certain. So we start with a game plan for the world as it is. Assuming the economy keeps moving forward, the S&P 500 appreciates at its long-term average rate of 6.5% for the year, and interest rates stay essentially where they started, we believe we can turn continued success with clients into low double-digit revenue growth. In that “no rate hike” scenario, we’d expect to continue reinvesting at a strong pace that leaves room for a 200–300 basis point gap between revenue and expense growth and a pre-tax profit margin of at least 41%. It’s the combination of discipline and flexibility that will enable us to continue making the most of whatever the environment ultimately sends our way—and that will help us adapt our spending as appropriate to balance the aggressive pursuit of opportunities to drive long-term stockholder value with strong near-term profitability.
I should touch on balance sheet and capital management before wrapping up. Our focus remains on managing the company’s balance sheet to support growth initiatives and further our strategy of optimizing the spread earned on client cash sweep balances. We completed approximately $8 billion in bulk transfers of client cash balances from money market funds to Schwab Bank during 2016. These transfers, along with growth in bank deposits from our ongoing asset gathering, helped increase interest-earning assets on our balance sheet by 22% to $216 billion at year-end. We supported this growth with capital generated through earnings and the issuance of approximately $1.4 billion in additional preferred stock. As part of managing Schwab’s capital levels, we maintain a target range for common stock dividends equal to 20% to 30% of earnings; consistent with our improving earnings picture, we increased our quarterly cash dividend by 17% during the year to $0.07, and another 14% to $0.08, in the first quarter of 2017. We ended 2016 with a Tier-1 Leverage ratio of 7.2%. Our solid capital position and healthy returns (remember that 14% ROE!) are another important aspect of our ability to continue driving profitable growth.
The bottom line, now that we’re through the struggles of recent years to rebuild our profitability, is that we have given the company room to run. We have the sheer size and revenues, the resources, the record profit margin, and the operating efficiency (measured in expense per dollar of client assets) to chart our own course to building a greater share of investable wealth in the United States. We have the room to reinvest in our infrastructure, products, and services; the room to drive growth by disrupting the industry on behalf of our clients; the room to offer an ever-better value and investing experience and still deliver increased profits to our owners. There’s no magic here—we just believe we’ve worked at our formula harder and longer than others and are better positioned to drive success going forward. Because if we follow the formula, we create a virtuous cycle that can be extended for years to come—a cycle that should lead to both increased market share and profits. This is made possible by a culture that recognizes our ability to do well for clients is dependent upon our ability to do well for owners, and that therefore embraces the need for financial discipline. I couldn’t be effective in helping the company make the countless trade-offs needed to navigate the environment we’ve faced over the past decade without the willing partnership of Chuck, Walt, and the rest of the Executive Council. I see this culture as a huge strength of the company, a strength worthy of the consistent effort required to sustain it through successive generations of management.
As many of you are aware, I’m stepping out of the CFO role effective with our Annual Stockholders’ Meeting in May. After 10 years, it’s more than time for me to let someone else take over the controls. You’re in good hands with Peter Crawford—he gets it. He gets what makes Schwab special and what makes our financial formula so important and powerful. And for better or worse, you’re not getting rid of me—I’m going to focus on working to ensure Schwab continues to have the systems, infrastructure, and capabilities it needs as an ever-more formidable leader in financial services. We’ve been through a lot in the past decade, and it might be a little stretch to say I’ve had fun every single day I’ve been in this job, but I believe fiercely in this company and what it stands for, and for me there’s no more rewarding work anywhere on earth. I’m personally grateful for all the support you’ve shown over the years, and we’ll aim to remain worthy of that support as we move ahead.
March 2, 2017