The Next Chapter
The crux of Schwab’s story for 2015 was execution–disciplined, focused, grind-it-out execution of our operating plan during yet another year of environmental challenges. Our ongoing success in serving investors and growing our client base is certainly impressive and worthy of celebration. We should also recognize, however, another of Schwab’s core values that enables success over the long term: We work hard to ensure that the day-to-day cost of running the company does not impede our ability to both invest for the future and deliver strong and improving profitability today. Building, maintaining and leveraging scale is critical–the better we are at containing operating costs, the more resources we have available for reinvestment in our clients, and for profits that strengthen our capital base and support business growth. Last year’s course of events provides a textbook example of this principle at work, so let’s start there before turning to the picture for 2016.
We began 2015 with baseline assumptions that included a continued economic recovery and a 6.5% increase in the S&P 500® Index from the year-end 2014 level. The scenario also included modest growth in client revenue trades, basically in line with expected account growth. The rate environment, however, was assumed to remain unchanged from late-2014 levels. Under this scenario we expected to produce mid- to upper-single-digit revenue growth. By limiting growth in dayto- day operating costs, which we call fundamental operating expenses (FOE), to approximately 5% to 6%, we expected to be able to target our project and marketing investments at healthy levels consistent with 2014 spending and still achieve a gap between revenue and expense growth of at least 150 basis points. That gap, in turn, would enable us to deliver a pre-tax profit margin of at least 36%, up from approximately 35% the year before. Overall expected result: solid performance and good progress on our journey to higher profitability, assuming a still-constrained environment.
Reality, though, moved away from our assumptions almost immediately. The S&P 500 struggled to hold positive territory throughout the first half, fell significantly into the red during the summer, and then wheezed its way back to essentially breakeven by year-end. Client revenue trades started 2015 below year-earlier levels and ended with a full-year decrease of 2%. Even our flat interest rate assumption turned out to be generally optimistic, with the 10-year Treasury yield falling below our baseline scenario for much of the year.
The bright spot in the environment came late in the year, as short-term rates finally began to lift ahead of the Fed’s expected rate move, and then the move itself delivered the rest of the roughly 25 basis point impact from mid- December on. We did see improvement in our money fund fees and net interest revenue right away, but the move came too late in the year to have a meaningful effect for 2015.
So notwithstanding another year of gathering assets faster than any other publicly traded U.S. investment services firm and the resiliency of our multiple revenue stream model, the environment weighed on our results–trading revenue fell 5% year-over-year and the lift in asset management and administration fees was limited to 5%, while strong growth in interest-earning assets helped net interest revenue rise by 11%. Overall, our revenues rose approximately 5% yearover- year, not what we hoped or expected starting out, barely scratching the low end of our baseline scenario range.
With the environment buffeting our revenues, we recognized that following our overall expense plan was crucial to maintaining that balance between reinvesting to drive growth and delivering improved profitability. But we also knew that the issue was not as simple as telling every Schwab unit to hit their budgets, because conditions inevitably differ from plan as a given year progresses. Hiring goes faster or slower than expected; development projects get accelerated or hit roadblocks; new information or insights affect our priorities; and so on. As a result, in any given year our finance and business leadership engage in an extensive, ongoing process to work out the trade-offs necessary to ensure that priorities continue to be met while available resources are allocated effectively throughout the firm to build a constantly improving client proposition and long-term stockholder value. When I talk about disciplined execution, it’s that process I’m thinking of.
For 2015, we were facing an already lean operating expense base and a set of priorities, including the launch of Intelligent Portfolios products and some focused hiring, that we felt shouldn’t be disrupted absent a dire revenue picture. At the same time, we were well aware that it was far from certain that the Fed would make any rate move before year-end, so we couldn’t count on help from that direction.
Under those circumstances, we chose to focus on staying within planned expense levels and held FOE growth to 4%, which enabled us to stick to our expected spending on projects and marketing while limiting overall expense growth to 4%. That in turn yielded a 130 basis point difference between revenue and expense growth and a 35.7% pre-tax profit margin. Again, not quite what we hoped or expected starting out, but essentially consistent with our baseline scenario and great results given the environmental challenges we faced.
With that crucial first Fed rate move behind us, the path forward could be a bit brighter. As we finalized our annual planning at the beginning of 2016, the forward rate curve implied that, despite some global market jitters, the U.S. economy was strong enough to support expectations for at least one more Fed move in 2016, and we developed our baseline scenario with that in mind. Our baseline scenario also includes relatively flat long-term rates and a 6.5% improvement in the S&P 500 Index relative to year-end 2015, as well as a potential decline in revenue trades as average portfolio turnover continues to slow.
Against that backdrop, we’d expect to produce another strong year of growth in our client base, and to take advantage of the breathing room provided by the improving rate environment to drive harder on reinvestment for future growth while still delivering a substantial portion of the rate-driven revenue improvement to our owners through increased profitability. With our baseline expectations calling for revenue growth in the mid-teens, we planned for expense growth right around the double-digit mark to support necessary growth in our infrastructure and allow for increases in both project and marketing investments while still delivering a revenue/expense growth gap of at least 500 basis points. That would represent a pre-tax profit margin of approximately 39%, another big step on our journey to higher profitability. And while results may vary from quarter to quarter, our overall expectation remains to deliver about 75% of the lift in 2016 revenue from rising rates to pre-tax profit.
We believe you’ll agree that it’s time for the Schwab story to move to a new chapter, from working within resource constraints while waiting for the Fed, to making the most of an improving environment. Yet we’re all well aware of the questions that persist concerning the health of economies outside the U.S., as well as the strength of the recovery here at home. Our assumptions regarding a rising S&P 500 and an incremental rate hike already feel tough to achieve as I’m writing this, given the equity markets’ start to the year. So we’re going to be very thoughtful about pushing forward–we’re going to be as aggressive as possible where it’s important, and as disciplined as necessary where it matters. That means preparing for a range of environmental and financial outcomes in 2016. Our game plan is straightforward: beginning to ramp up important investments while continuing to maintain expense vigilance and intentional flexibility. We’ve structured our planned spending growth to recognize aspects of FOE, projects and marketing that are important, yet sufficiently discrete in nature to allow for adjustment without undue disruption to our overall priorities–efforts that don’t involve additional hiring or other stickier costs. Similarly, we have prioritized incremental investments in marketing, the client experience and our infrastructure that we can initiate to the extent additional resources become available as the year progresses. Ultimately, our aim is to focus our limited resources on the most valuable investments in order to make meaningful progress towards higher organic growth, and we remain committed to reaching the highest sustainable margin consistent with delivering that growth.
Again, no matter how the environment evolves from here, it’s time for our story to move on. What won’t change is our focus on keeping Schwab’s core financial story as simple as possible–solid business growth that reflects our “Through Clients’ Eyes” strategy, solid revenue growth through diversified sources, and expense discipline leading to improved performance. Simple in concept, but tough to put into action. Working out trade-offs can be difficult, frustrating and even agonizing work, yet we all recognize the necessity of confronting those challenges and maintaining our disciplined approach. The payoff is a lean, nimble, healthy firm that can balance the interests of clients, stockholders and employees while aggressively pursuing the opportunities ahead. Your support helps reinforce our culture of disciplined execution, and we remain committed to earning that support as we move on to the next chapter in the Schwab story.
March 3, 2016