Schwab Charles Corp Q1 FY2022 Earnings Call

And we're live. Good morning, everyone. Welcome to Schwab's Spring 2022 Business Update. This is Rich Fowler, Head of Investor Relations. First off, we want to thank you for spending some time with us today. We hope everyone on the call and your families remain safe and well as the pandemic continues on its downward path. We have a full program today, including our President, Rick Wurster's inaugural interim update participation. Let's do a quick administrative review and get right into it. As indicated in the holding slides, Walt, Rick, and Peter are the presenters today. The program remains at 60 minutes with a Q&A session following the prepared remarks. Jeff Edwards will once again moderate the Q&A session. We'll take questions from the dial-in and the webcast console. Additionally, we will post the slides on the IR site as Peter begins his remarks. Please make note of the forward-looking statement language, as always. And with that, Walt, will you start us off?

Thanks, Rich. Good morning, everyone. Thanks for joining us this morning. Consistency, it's a word that I spend a lot of time on, and it's a word that is critical at Schwab. It means that we're committed to a consistent business strategy, a consistent commitment to feeding the virtuous cycle of innovating on behalf of investors, a consistent financial reporting cadence, a consistent commitment to our employees and the communities that we live and work in, and a consistent long-term approach. It's focused not just on the current year but on years to come. But when I talk about consistency, I also want to emphasize that it doesn't mean that we have to be slow or stodgy or unwilling to be disruptive. Frankly, I don't think I've ever heard anyone refer to Schwab as unwilling to be disruptive. But it does mean that clients can count on us through good times for investing as we enjoyed much of last year, as well as in more difficult times. It means that they know we work hard to improve on our shortcomings and that we will continue to innovate, enhance, and keep their best interest at the forefront of our firm. I think as all of you know who have followed our company, taking a long-term client-centric approach is not always easy. But after almost 14 years as CEO, I am as committed as ever to my belief that it is really the only path to rewarding long-term stockholders. In the first quarter of this year, we executed on that exact approach despite it being a tough quarter for investors. And clients continue to reward us with their business, over 1 million new brokerage accounts, over $120 billion in net new assets. We're just going to continue investing to better serve them and innovate on their behalf. Importantly, we're also going to remain consistent in our strategic approach, Through Clients' Eyes, and that is our North Star. So let's take a look at some of the details from the first quarter and the implications for our long-term emphasis. It was a fairly brutal quarter for investors, whether they were conservative, aggressive, or anywhere in between. We had 4-decade-high inflation, and the resulting anticipated increase in interest rates really punished fixed income investors. And of course, the equity market declined rather sharply before we saw a modest comeback a bit late in that first quarter. But despite it being a difficult quarter, again, clients continued to trust us. They continued to bring their hard-earned investment dollars to Schwab and opened new accounts with us. We maintained an organic growth rate in terms of core net new assets at the same consistent level we've been able to deliver for over a decade. We've done that in good times. We've done it in more difficult times. Of course, we've done it even as we've grown larger, had a much larger base, and therefore, presumably more challenging. Taking a look at the next slide, investor sentiment felt pretty hard during the quarter. It turned quite a bit negative, then we had a small recovery in the market late again in the quarter, which created a little bit of a lift off the floor from where we were in sentiment. But we saw the sentiment manifest itself throughout the quarter, things like margin loan balances falling about $6 billion from year-end. And although trading activity was relatively robust overall, I think as Peter is going to discuss in his section, the mix of those trades changed and reflected much more of what we might consider a risk-off viewpoint by investors. But again, with our commitment to consistency, it means we don't slam on the gas or slam on the brakes depending on environmental factors that are going on around us. Instead, our strategic efforts are designed to enhance services to clients for years to come, delivering financial benefits to stockholders over the years. As you would expect, we will continue making investments for the long term consistent with the 3 key strategic initiatives that we've shared with you multiple times.

Thank you, Walt, and hello, everyone. I'm thrilled to be here today to share an update on the progress we have made this year to advance our key strategic initiatives. Walt talked about consistency. Our actions continue to be guided by our Through Clients' Eyes strategy. With that as our North Star, we're focused on the 3 actions that you see on this page: achieving even more scale and efficiency, pursuing win-win monetization, and meeting the segmented needs of our clients. In this quarter, we've made progress on all fronts, and I'd like to start by sharing some of the updates on scale and efficiency. In the first quarter, the key measure of our scale and efficiency, our expense on client assets, or EOCA, was 15 basis points or 13 basis points on an adjusted basis. Although that's up slightly from recent levels due to seasonal expenses and the market decline, we continue to believe that this lower cost to serve provides us with a competitive edge. To illustrate the power of the investments we've made in digital and technology capabilities, it's remarkable that we have bolstered our trading system capacity by more than 5x over the last 5 years. This means that we have the ability to handle in a few minutes the same system volume we would have handled in an entire day only a few years ago. As we think about the future for us in scale and efficiency, our top priority remains consistent: the integration of Ameritrade. We've made consistent and more progress on this front in the first quarter of this year, including duly licensing Ameritrade financial consultants. This has several important benefits, including making client day 1 easier, providing the opportunity to introduce our wealth management capabilities, and improving retention and win-win monetization. Speaking of win-win monetization, I spoke in January about 3 areas where we see the opportunity to help more clients and grow: asset management, wealth management, and lending. I'm going to focus my comments today on 2 of those areas: asset management and lending. On the proprietary asset management side, I'm thrilled to share that we launched Schwab Personalized Indexing. Our proprietary launch provides tax benefits to investors and brings the minimum on our platform for direct indexing down to $100,000 from the $250,000 level that it was at for the third-party product that has been on our platform. That $100,000 minimum is still at a level where we think meaningful tax benefits can be provided to clients. We launched it at 40 basis points for retail clients and 25 basis points for advisers, which are very competitive fee points. You can expect us to continually innovate in this area, and stay tuned for more updates as it relates to personalization and a digital experience within our personalized indexing offer. In February, we launched our new strategic relationship with T. Rowe Price. This launch has a number of client benefits, including providing RIAs with no transaction fee access to T. Rowe's lowest-cost institutional share class funds. Turning now to lending. I've talked previously about the potential upside to enhancing our lending offer for both institutional and retail clients. Most importantly, I think this would be a win for clients. Clients are asking to do their loans through Schwab, and we know they can access our industry-leading low rates here. We've made a lot of progress on this front this year. We've cut our pledged asset line. Our PAL cycle time is down significantly. We've created a new lending experience for our ultra-high net worth clients. We've also worked with Rocket Mortgage to make it easier for our $5 million-plus clients to get a mortgage. All of this has resulted in our Client Promoter Scores for lending being at 77 in the first quarter, which is near all-time highs, suggesting clients are seeing the value from this offer.

Thanks, Rick. It's a wonderful summary of several of the efforts going on across the firm to better serve our clients and build stockholder value over time. Someone asked me in a meeting Tuesday morning, they said, 'Walt, what are you going to do about the decline in SCHW that happened on Monday?' And it probably shouldn't surprise any of you what my answer was. I said, 'It's pretty simple. We're going to keep focusing on our clients and our prospects. We're going to keep executing on the virtuous cycle. We're only scratching the surface of the available domestic market with about 12% penetration.' And when we do those things well, I'm confident in our future prospects. We never panic. We never try to pull rabbits out of the hat. We're never going to try and make short-term results by deviating from an approach that has worked for 50 years. So just to wrap things up in my segment, yes, it's a tough environment for investors. But our all-weather financial model performed quite strongly during a period of market turbulence. And when I look out through the course of 2022, I am very optimistic about our earnings potential. More on that will come from Peter. But no matter how the year unfolds, you can count on the fact that we will remain consistent in the areas that matter most: a strategy based on seeing the world Through Clients' Eyes, a set of competitive advantages that we continue to enhance, a commitment to the virtuous cycle that continually rewards our clients, employees, and long-term stockholders.

Excellent. Well, thank you very much, Walt. So you all heard Walt and Rick talk about the continued success we're having winning clients despite somewhat more subdued investor sentiment and engagement; the progress we're making in bringing new solutions to our clients and advancing our strategic priorities; and finally, about the huge opportunity we have to broaden our moat and continue to drive strong organic growth. In my time today, I want to talk about how our all-weather business model helped us produce results. They were off last year's record level but still quite strong considering the various headwinds we faced. I'll discuss our evolving investment management thinking and how we're positioned to benefit significantly if the Fed hikes rates as expected. Finally, I'll provide an update on our capital management approach moving forward. The message you should hear is that regardless of how someone might have viewed our recent quarter's financial results, our Through Clients' Eyes strategy is working and our business model is working, producing strong financial performance with the potential for an acceleration of revenue growth in the quarters ahead should the Fed follow through on their tightening cycle. So let's talk about some of the cross-currents that influenced our financial performance in the first quarter. At our winter business update a few months ago, we highlighted some of the questions that would shape our operating and financial performance in 2022. As Walt talked about, the quarter was a challenging one for our clients and investors in general. As we look at the quarter from the context of our business model, some of the developments have been helpful: the decline in COVID cases, clearly; the rise in long-term interest rates; and continued robust trading activity. While others have presented challenges, specifically rapidly rising inflation; a Fed funds rate, which, of course, is expected to rise dramatically over the next several quarters but which remain near 0 for most of the quarter; a decline in equity markets that Walt referenced; and a less exuberant attitude among investors in general and our clients in particular. Now despite some of those challenging dynamics, we were able to deliver financial performance that was a bit below last year's record level but still quite solid. As we said previously, with the acquisition of Ameritrade, we are more exposed to dynamics that can fluctuate in less predictable ways: trading behavior, margin utilization, and securities lending to name a few. In Q1, the risk-off sentiment among clients impacted all these drivers and weighed on our results, resulting in revenue that was down 1% from the unprecedented Q1 of 2021. We limited growth in adjusted expenses to 4% year-over-year, which produced an adjusted pretax margin close to 45%, a 26% return on tangible common equity, and $0.77 of adjusted EPS. Comparing conditions to the financial scenario we shared in January, the equity market decline has obviously been a negative while the Fed hiked in March consistent with our scenario. Trading activity was a bit higher than the scenario contemplated. But as we'll discuss in a moment, as Walt previewed, the mix of trades was different than what we saw last year, which produced lower revenue per trade. The scenario seemed consistent with securities lending revenue and margin utilization, but both were down from the fourth quarter, 20% in the case of securities lending, which of course adversely impacted our net interest margin and revenue. Balance sheet growth tracked a little higher than contemplated in this scenario given the strong asset gathering and somewhat lower net purchase activity by clients. It's always a little tricky comparing results for a single quarter with a scenario that covers the full year, especially given the assumption in the January scenario for 2 more rate hikes in 2022, which should increase revenue growth and pretax margins in subsequent quarters. But our financial results thus far have been pretty close to what the scenario anticipated for the first quarter. On the expense side, our results were very much consistent with our financial plan, meaning that we're sticking with our expectation for full year adjusted expense growth of 6% to 7%, excluding, of course, any variation based on our bonus funding.

Great. Thank you very much, Peter. Let's go ahead and turn to the phone lines. Operator, first question, please?

And the first question today is from Ken Worthington from JPMorgan.

So you mentioned that you're building cash on the balance sheet in part as a function to prepare, I think for cash sorting is how I interpreted it. And there is a benefit of being able to invest for higher rates in the future. How much cash do you want to or feel you need to have on hand in coming quarters to meet these needs? Is this 15% level that we saw in the first quarter the right level that you would expect to be at in future quarters? Or should it go higher before it starts to go lower?

Thank you for the question, Ken. I anticipate that our cash levels will decrease over time due to some of the purchasing activities we mentioned. For instance, we are looking into investing some of it into a treasury ladder as an alternative to holding cash, which would help us lock in some forward rates and protect us if rates don't rise as expected. However, I still believe our cash levels will remain above the typical target range of 5% to 7%.

Peter, I appreciate your updated commentary on AOCI. But it looks like you're going to cross $700 billion over the next few quarters. You're only about 3% away now. However, it seems like you disagree with this just given your expectation for cash sorting. So I was just wondering if you could elaborate on the comment you made in the prepared remarks.

Sure. The short answer is that it depends. It's certainly possible that we could reach that threshold in the next couple of quarters. However, if the client's cash sorting evolves in a way similar to what we experienced from 2015 to 2019, it could slow down the growth of our balance sheet or even reverse some of that growth, pushing the timeline further back. Regardless, we believe this is a manageable issue for us. We are aware of how this affects our regulatory capital, but from my perspective as CFO, the fundamental profile of the company remains unchanged by accounting conventions. When we manage our capital and consider the level we want to maintain to support the business, the most challenging scenario for us is if interest rates decline and cash accumulates on our balance sheet. This situation would effectively bring our negative AOCI back to zero with falling interest rates. Thus, we see this as a very manageable situation.

So I guess another question here just on the balance sheet. So on the NIM commentary for 4Q by kind of mid-1.80s, what is the expectation at that point for prepay amortization? What's the assumption there? How much drag, I guess, is left? I think you have about 50 basis points today. So what's embedded? And then in terms of just the mix and thinking about kind of the loan book, you obviously have some good traction on mortgage lending and refinance activity as you guys talked about. It seems like that might slow here just in the rising rate environment. So maybe talk a little bit about kind of the outlook for growing the loan book. And are there other products that could offset that? And even would you do an acquisition to kind of accelerate other areas of loan growth?

Sure. On the prepayment amortization, we saw about a basis point reduction in premium amortization between Q4 and Q1. Embedded within that NIM outlook that we shared is our expectation that, again assuming rates continue as they have, that we can see another similar-sized reduction between Q1 and Q2 and probably between Q1 and Q4, somewhere on the order of 10 basis points, plus or minus improvement in the premium level. In terms of loan growth, we do think there's a lot of opportunity for growth. Clearly, the refinancing wave has largely passed, and we're entering more of a new purchase market for mortgages. But our rates are still very compelling. Despite the success we've had with growing our lending solutions, there's still a lot of clients out there who haven't yet turned to us for their lending needs. It's good for them and it's good for us both financially and strategically. We see a big opportunity to increase awareness of the Schwab Bank capabilities and pricing, etc. With pledged asset line, Rick referenced the improvement in cycle times, which continues to be a significant opportunity. We are very much underpenetrated in that product relative to peer firms. We're working hard to again increase awareness and improve processes there to make it more accessible.

Given the high net worth expansion strategy, I guess, thinking also about advisory services in the RIA business, can you talk about making alternatives available on your platform, obviously, with the theme of democratization of alternative investments and still some 1% to 2% types of allocations and clamoring for that? Are you seeing demand from your clients, your advisers as well? And are there plans to add a lot more capabilities for alternatives on to your platform? Thank you for the question. I would highlight two key points. First, we have a significant amount of resources available for clients today in the alternative investment space, covering both adviser services and investor services. Next, there is an increasing demand for alternatives, and we recognize that there are improvements we can implement, especially in the retail sector. Therefore, you can expect to see more developments from us in this area in the near future. We currently offer a solid selection of alternative options for retail clients, but we also believe we can enhance the types of vehicles and strategies available to our investor services clients. As a result, you can anticipate further advancements in what we already consider a strong foundation of attractive options that benefit both our adviser and investor services clients.

All right. Well, that brings us to the top of the hour. I want to thank you all for your questions. Walt used the word consistency in his opening remarks, and I think that's an apt word to describe our business strategy as well as our ALM and investing strategy. I would also use the word humility to understand that there’s a lot happening right now in the environment that we can't completely predict. We can't necessarily completely predict what investor sentiment is going to do, what the Fed is going to do, or what's going to happen with interest rates. So given that humility, we also want to ensure we maintain a lot of flexibility moving forward. But we're very excited and confident for what the future will bring both financially and strategically, and we look forward to giving you another update in July. Thanks, everyone.