Schwab Charles Corp Q4 FY2022 Earnings Call

Good morning, everyone, from the Lone Star state, and welcome to Schwab's 2023 Spring Business Update. This is Jeff Edwards, Head of Investor Relations, and I'm joined today by our Co-Chairman and CEO, Walt Bettinger; President, Rick Wurster and CFO, Peter Crawford. Before we jump into the presentation, I'd like to touch on a few housekeeping items. Today's setup is obviously a little bit unique with the business update immediately following this morning's release of our strong first quarter results. That being said, our time here today will still be dedicated to providing you with a broad strategic update of our growing business. Similar to past events, I will be helping facilitate Q&A. So given recent events, the team has a fair amount they like to share with you. So dedicated Q&A time may end up being slightly shorter than usual. Therefore, it is very important that we all strictly adhere to the one question, no follow-up format that has been in place now for several quarters. And we also ask that you vector clarifying a more tactical questions regarding the recently reported quarter to the IR team. Today's slides should be available on the IR website momentarily. And finally, before we move on, let's not forget the mighty wall of words, which reminds us all that the future is uncertain, so please stay in touch with our disclosures. I'd like to turn it over to Walt then.

Thank you, Jeff, and hello, everyone. Thanks for joining us for our April business update. This is an important opportunity for our team at Schwab to speak directly with all of you to speak with accuracy and facts and to speak with clarity and transparency. We know that the past few weeks have been very challenging for long-term stockholders, which, of course, all of our executives at Schwab are also, including me. Let me start by making a few crystal clear statements. First, our clients, although curious and somewhat surprised about the downward movement in our stock price, remain fully engaged with us and are bringing substantial assets to Schwab on both the retail side and the RIA advisor side. We are winning in the marketplace among clients. Anyone suggesting otherwise is mistaken. Simply put, our franchise strength and financial model remain very much intact. Second, we did not and have not changed our multi-decade approach to conservatively managing our bank balance sheet. Any suggestions to the contrary are false. And although our near-term cost of funding are higher than recent historical levels, and as a result, will impact our near-term earnings, this cost is temporary and should diminish over the coming quarters and could wind down between now and the end of 2024. And third, we are well into the execution of the conversion of the former Ameritrade clients to Schwab. And as we progress through this conversion and beyond, we will ultimately realize substantial expense savings, well beyond the remaining $500 million to $600 million we originally committed to as part of the Ameritrade integration synergies. Now looking at the first quarter, it was a complex environment for investors. Although the equity markets overall performed quite well, investor sentiment was actually quite negative throughout the quarter. The Fed raised interest rates another 50 basis points, while the 5- and 10-year yield on treasuries fell by 39 and 40 basis points, respectively. And yet despite negative investor sentiment, this wasn't reflected in our clients' engagement with us. Clients entrusted us with over $130 billion in core net new assets, with the monthly level increasing each of the 3 months of the quarter, peaking with over $50 billion in March and achieving an organic growth rate in excess of 7%, once again validating our long-term track record of growing client assets in every economic environment. In addition to growth in client assets, clients remained engaged with us in other areas with another quarter of over 1 million new client accounts, over 5 million daily average trades, a Client Promoter Score or Net Promoter Score of 66 and almost $9 billion moved into our investment advisory solutions. Let's go ahead and transition from our client results to discuss some of the corporate financial areas that have been in the press on the minds of investors. And in too many cases, falsely described by some competitors who have tried without much success, as evidenced by our near record March level of net new asset flows to scare clients into leaving Schwab. Again, our franchise and financial model are strong. We have substantial liquidity. We have capital well in excess of regulatory requirements, and our strong profit margins deliver ongoing organic capital formation, which can be used to meet future capital needs. We have industry-leading levels of FDIC insured balances at our bank, our investors' bank. Our balance sheet and investments were and are conservatively managed and managed in a manner consistent with how we have managed our bank balance sheet for the last 2 decades. For our long-term stockholders, we have great confidence in our ability to deliver a combination of growth and capital return, just as we have for almost 50 years. So I'd like to go into a bit more detail now on each one of these statements...

Well, thank you very much, Walt. So there are 3 key points I want you to take away from my portion of the presentation today. First, we're navigating this extraordinary period from a position of strength with robust organic growth, high level profitability, strong and growing capital levels and access to significant liquidity. Second, although the volume of client cash allocation activity has exceeded the expectations embedded in the financial scenario we shared a few months ago, as Walt mentioned, we are seeing signs of the pace beginning to moderate, and we continue to expect a resumption of deposit growth in 2023. And third, our focus at Schwab remains on our clients. And while the various dynamics we're working through create some near-term headwinds, our business continues to power ahead, reinforcing our confidence about the long-term strength of our diversified model and our ability to keep delivering on our through-the-cycle financial formula. Let's start by briefly reviewing our first quarter results, which we released earlier this morning. Among the many advantages we have as we navigate through this period is our financial strength, our sustained earnings power. There has been so much attention to the balance sheet and dynamics influencing net interest revenue that it feels like some have lost sight of the fact that nearly 50% of our revenue comes from other sources such as asset management fees and trading. And while the remaining half is generated through net interest revenue, roughly 1/3 of our interest-earning assets are floating rate, meaning the yield on those assets has increased dramatically in the last 12 months. That diversified all-weather revenue model is reflected in our strong Q1 financial performance, during which we grew revenue by 10% versus the first quarter of 2022. We grew adjusted earnings per share by 21%, and we delivered an adjusted pretax margin of nearly 46%, a level nearly unsurpassed in the financial services industry. Turning to the balance sheet. The evolution of our balance sheet during the quarter reflected continued client cash realignment. We supported this by utilizing temporary funding sources, including issuing more CDs and securing additional advances from the FHLB. Our usage of these was front-loaded and increased modestly by our decision consistent with our conservative management approach to build extra liquidity within our banks, almost doubling the amount of cash on hand in the month of March. Now we also opted to suspend our buybacks during the quarter. And our strong earnings supported organic capital formation, which allowed us to maintain our Tier 1 leverage ratio at 7.1%, well above the regulatory minimum...

Thank you, Peter, and hello, everyone. In the winter business update, I described how well Schwab is positioned to sustain our organic growth rate of 5% to 7% over the long term through a combination of growth from existing clients, attracting new clients and growth from our strategic initiatives. First quarter was a great example of this as we grew net new assets by over 7%. As I shared with you our business results, I'd like to leave you with 3 takeaways. First, our business is thriving, and we again delivered strong organic client growth. Second, through the volatility in March, we saw an increase in net new assets and client engagement and asset flows that the bank remains steady. We emerged from a crisis not weaker, but stronger. Third, our strategic initiatives are paying off and lots of opportunity remains. Let's dive into the results in more detail. To put it simply, we are winning across all fronts. We're winning with existing clients, with new clients and on both the retail and RIA sides of our business. Within Investor Services, we attracted $60 billion in core net new assets. In addition, we saw an 18% year-over-year increase in high net worth, net new assets in the quarter. Our note trade-offs approach continues to attract clients and engender trust from our existing clients, and that was particularly true in a period of uncertainty. As I mentioned in our winter business update, our client base continues to get younger with 56% of new-to-firm households under 40 this quarter. This is notable because with an average age under 50, our clients are still accumulating assets. Within Advisor Services, we had an outstanding quarter of growth with $71 billion in core net new assets. When the going got tough in March, our growth accelerated with $32 billion in NNA in March alone in Advisor Services. In periods of uncertainty and heightened volatility, advisors win. They win because they are trusted fiduciaries with clients' best interest in mind. And we win because we are the trusted partner of RIAs and partner with them to deliver for clients in all environments. Our TOA ratio remained high and was in excess of 2% for the quarter. We are committed to helping RIAs of all sizes grow by delivering the leading custody platform with no fees, alongside practice management support, industry advocacy and relationship support RIAs can count on. In summary, our business is thriving. Our note trade-off approach was recognized by the industry. The third-party accolades you see on the screen speak to the way we serve our clients each and every day. We were recognized by Investor's Business Daily as the #1 online retail broker overall, by J.D. Power as the #1 full-service broker and for the sixth consecutive year Schwab was named one of Fortune Magazine's top 50 World's Most Admired Companies.

Operator, let's turn to the queue and please remind everyone how they can ask a question that they'd like.

And our first question is from Dan Fannon with Jefferies.

A lot of debate that this cycle has raised the client awareness for cash. And given the ease of access and movement today, the historical cash allocations are likely to be different going forward. So as you look over the long term, how do you think about sweet cash in the percentages and how that may be different than what we've seen historically?

Thanks, Dan. I'm going to go ahead and comment on this. So I think when you look at client cash realigning, we feel fairly confident that the metrics we've shown have good basis in history. I guess I would encourage you to think of a client cash aligning. It's an event, it's not a process. And I'm going to illustrate that by an example. If you have a retail client that has, say, built up $50,000 in cash during the pandemic period. And they look at that and say, well, I want to keep $20,000 of that liquid available for immediate trading or other uses, paying bills, they don't take that $30,000 and say, 'Well, I'm going to move $10,000 this quarter and $10,000 next quarter and then $10,000 several quarters in the future.' It's an event. They reinvest the $30,000. And so what you generally will see is you'll see a rapid acceleration of client cash realigning early in the process of rate rise, let's call it in the first year. And then you begin to see it go the other way. And we think, as it goes the other way, it goes the other way in a relatively accelerating manner because, again, the event has occurred. The client, in my example, has moved their entire $30,000. So we understand the question. We think that the cash, as we indicated, the cash realigning process is slowing. We are very encouraged by what we see in April with measurable slowing. Again, we're looking at 3 consecutive months of declines, and we feel very good about the chart and the results we're able to share with you.

And does that conclude your question Mr. Fannon?

Walt and Peter, thank you for holding this timely call. I hope you consider maintaining this format in the future. My question relates to the first inquiry. We estimate a $44 billion decrease in our balance sheet, including cash or uninvested sweep cash, supported by the organic close in March that you mentioned. However, I've noticed some changes in your terminology. Do we still anticipate an 8% to 12% decline in average interest-earning assets, Peter? Does this take into account the protection of AOCI, and are you considering that when managing risk? Is the expected 8% to 12% decline in average interest-earning assets still valid by December?

Thanks, Rich, for your question. So yes, we still do think that 8% to 12% decline in interest-earning assets is the right way to think about it. The way that we fund those assets may be a bit different than what we had anticipated when we shared at the winter business update, but the overall asset decline is a function of the assets rolling off and that sort of the gradual roll off of our securities portfolio.

I was hoping we can double-click on some of your capital management comments. It sounds like if you were to start to include AOCI changes in capital, you expect it to be a bit of an organic build, and you provided some sort of stats around it. Why not sell a significant chunk of the securities portfolio? I understand it will crystallize the loss, but your Tier 1 leverage actually will not move significantly when you do that. So help us think through maybe some puts and takes from doing something like that, taking the loss but also at the same time, significantly enhancing the firm's earnings power since $60 billion plus of that securities book is massively at the water?

Thank you for the question. I'd like to say a few things. You are correct that selling a significant portion of our securities portfolio would actually improve our capital levels, particularly our tangible capital levels. We have stated multiple times that we see no reason to be forced into selling securities, considering our strong access to liquidity and the nature of our deposit base. Furthermore, I prefer not to speculate or discuss hypothetical situations regarding when we might sell the securities portfolio. I can say that we see no need to do so. We are always focused on what is best for our shareholders, but we definitely wouldn’t make that decision right now, especially given the market volatility surrounding firms that have opted to sell.

You broke the BDA investments, I think, in the third-party BDAs this quarter. With BDA balances down $20 billion in 1Q '23 and floating rate securities down to $2.2 billion in the quarter, do you foresee having to break the TD managed BDA investments? If so, is this a charge that you would be responsible for? And what do you foresee as the charges needed to maintain this program, given your outlook for sorting this year?

Ken, it's Jeff. There's a lot of nuance to that question, so to save time, let's discuss it offline where we can go through what's available and all the public disclosures. If you have another question you'd like to ask, feel free.

Peter, if you could just comment on the pace of the wholesale borrowing. If we are seeing the cash sorting flow throughout the year, why not wind that down more quickly instead of having that conclude more in 2024? It seems like if you are in a position where the balance sheet will start growing again later in the year, you would be in a position between the organic growth of cash coming in from the securities portfolios and cash growth from clients that you could potentially wind most of that down certainly by year-end or at the beginning of 2024? Any comment on the pace of that.

Some of the CDs we issue have set terms, so we cannot easily recall them. The FHLB advances come with different terms as well. However, I mentioned that our choice to increase cash in March led us to accelerate some of that activity. As we observe the pace of client realignment slowing, it is reasonable to expect that we will initiate fewer advances and allow the existing ones to mature. The important thing about these advances is that they are limited and temporary. They will not be a long-term part of our financial outlook, and we will aim to pay them off as quickly as possible.

I want to circle back multiyear commentary around the ability to deliver substantial expense savings beyond the $500 million to $600 million or so. I was just hoping you might be able to help quantify how meaningful that could be? Is that $1 billion? Is that $2 billion? And maybe you can expand on where that's coming from? What are some of the actions that you guys might be able to take to hit that? And how do you ensure this doesn't hit the overall growth in customer and overall assets?

Yes. Thanks, Mike. So I don't think, at this point, we're going to quantify the extent that we believe that we can generate ongoing expense savings beyond the $500 million to $600 million that we have committed to and have remaining in the integration, but we think it is substantial. And yes, it's important to keep in mind that, as we approach this integration, one of the decisions we made was that getting the integration right was our #1 priority. And therefore, we were willing to spend quite aggressively along the way to ensure that there was nothing that got in the way of ensuring the integration went as well as smoothly as it could possibly go, even if it meant ratcheting up spending to a level that was much higher than maybe we would have thought several years ago. So we have the opportunities that I mentioned, and then we have the opportunity after multiple years of allowing spending to grow relatively quickly to do a step back and evaluate it overall. And our early work gives us the confidence to say that it is meaningfully higher than the remaining synergies, but I don't think we're ready to quantify it yet. The one thing I will make clear though is, as we have done in the past when we made moves around expense that were significant, we will protect the client experience. So we will not be looking at impacting the parts of the organization that build relationships with clients that serve clients and that deliver that client experience.

Also appreciate you tightening up the window between this and the earnings. Super helpful. Walt or Peter, just a question, as you think about lessons learned from this cycle versus prior cycles, and I appreciate you're consistently running the franchise, but should we be assuming a higher core deposit beta all else being equal to avoid these kinds of dynamics we've all experienced in the last month or so? And on the other side of the earning asset side, would you envision running a more liquid earning asset strategy, all else being equal?

Thank you for the question, Bill. Our approach to deposit pricing remains consistent. Our clients typically have two types of cash: transactional and investment. For transactional cash, we aim to provide a competitive rate, currently at 45 basis points, which is significantly better than what clients can earn in traditional checking accounts. We also offer a variety of options for investment cash that are often industry-leading, such as access to treasuries, brokered CDs, and purchase money funds. This strategy has served us well for many years. The specific rate we pay for transactional cash—whether it's 45, 65, or 100 basis points—has little impact on client behavior. I don't expect this aspect of our philosophy to change. Of course, we will learn from our experiences and adapt to any regulatory changes, but I am confident that we will continue to thrive as we have in the past, whether during the dot-com bubble burst, when we launched the bank under Fed supervision, or when we eliminated commissions. In every instance, we adapted and emerged stronger by staying focused on our clients and meeting their needs. If we continue to do that, everything else will fall into place.

Great. And operator, I think we have time for one last question.

Our last question is from Ben Budish with Barclays.

I just wanted to ask kind of about your approach to buybacks. You mentioned earlier in the call that you had suspended them for the meantime. What are the sort of data points you are looking at or indicators that would cause you to get more positive and feel comfortable resuming there?

Yes. Thanks, Ben. I think what we would like to see a little bit more clarity on the regulatory front and what's going to happen with how capital is treated and a timeline there. As I said, we feel very confident in our ability to build into the potential inclusion of AOCI into our regulatory capital ratios, but we'd like to see a little bit more clarity there before we would, I think, strongly consider or look to resume the buybacks. Of course, our buybacks are always opportunistic, not programmatic, as we've said multiple times, but I think that's probably one of the key points we want to wait for.

Thank you all for being here and providing your feedback on the timing of this update in relation to our earnings report. We'll strive to be responsive to your input on the best timing for these updates. As many of you know, I have been the CEO of Schwab for 15 years, and during that time, I've experienced various market conditions, both positive and challenging. What's consistently clear to me is that long-term success relies on a focus on our clients. There will always be situations that have a short-term impact, and we are not unaware of these developments. We recognize that our recent actions have influenced our near-term earnings as we have proactively engaged with clients of all sizes over the past year, helping them understand their investment options for cash. I want to emphasize that focusing on clients is the right approach, and it is what we would do again in similar circumstances. We understand that sustainable success hinges on prioritizing our clients, and our bank stands out as it specifically serves investors. We acknowledge that challenging times will pass; history shows that the firms that remain resilient during these storms are those that prioritize client relations. You can continue to rely on Schwab, as you have in the past, for that commitment in the future. Thank you once more for your time today, and we appreciate your thoughtful questions.

Thank you. That concludes today's conference. Thank you all for participating. You may disconnect at this time.