Charles Schwab Corporation (The)

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 Worcester, 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. Though given recent events, the team has a fair amount they'd 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 or 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 now.

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, me included. 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 RAA 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 of that are false. And although our near-term costs 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 five 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 three 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 investor's 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 two decades. And 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. I've publicly stated multiple times and in multiple formats that we cannot foresee any plausible scenario where we would have to sell securities to meet the liquidity needs of our clients. And that's not an accident. Because we have always planned for the potential of time periods where high liquidity needs exceed our available cash. Of course, these time periods tend to occur when the Fed is raising interest rates rapidly. And while this cycle of interest rate increases has been historically rapid, leading clients to realign their investment cash more quickly than we had predicted, our advanced planning ensured that we would have the necessary liquidity to meet their demands. We prepare in part by minimizing the issuance of CDs and or borrowing from the FHLB during more normal times, effectively keeping that dry powder for periods of higher liquidity needs. Of course, accessing this higher-cost funding is not something we expect to be anything other than temporary, currently projected to wind down over the next seven quarters and be largely gone by year-end 2024. I would certainly hope that by this point in time, the short-driven speculation that we would find ourselves in a position where we would be forced to sell securities that have temporary paper losses has been put to bed. From a capital standpoint, we have solid levels today, well in excess of regulatory requirements. Now, we understand the possibility that the AOCI opt-out might well be eliminated and the questions that that raises about the potential need for capital. At this point, if this scenario does play out and a reasonable time frame is afforded to build the capital to support this change, we feel confident today in our ability to build the necessary capital organically, given our strong profit margins. Even in the stressed market environment this past quarter, we achieved an adjusted pre-tax margin of almost 46%. And even under some of the most pessimistic scenarios for the future, we are at least 40% pre-tax. And of course, our unrealized marks on certain securities decline over time. And they've also declined as interest rates have modestly moderated. Declines that you'll see happening when you review our first quarter 10Q. The conservative nature of our bank management is also reflected in the very high percentage of deposits insured under the FDIC limits. At quarter end, approximately 86% of our bank deposits were under the FDIC insured limits. In addition, these deposits are spread among tens of millions of investor accounts. And lastly, there are no groups of investors or advisors who directly influence or encourage collective behavior. The 10 RIA firms whose clients hold the greatest amount of cash on our bank balance sheet account for barely 2% of total bank deposits. And the average transactional cash per account for those RIA firms is less than $13,000. I hope these facts remove any concerns about some sort of coordinated action potentially happening that would meaningfully impact our bank deposits. This is a very important slide. I'd like to dive deeper into our clients' cash behaviors. I know this is a critical area of interest, particularly as it could apply to future levels of bank balance sheet cash and client cash realignments. As I've discussed in the past, when interest rates are near zero, clients tend to commingle their transactional cash and their longer-term investment cash together. Of course, there's very little incentive during times like that to move their investment cash into solutions that offer higher yields than BankSweep. But when interest rates rise, we reach out to clients and suggest they consider realigning their investment cash into other solutions, whatever the client sees fit, whether that would be a purchase money fund, a purchase money market fund, a CD, a treasury security, or an other appropriate cash solution that the client is interested in. And of course, this has been taking place predominantly inside Schwab as rates have been rising over the past year or so. The rate, pace and ultimate level of this realigning has a large impact on our near term financial results. So not surprising. We study it closely and we have models that estimate how it will unfold. By several measures we study, we believe that this cash realigning process is now slowing and getting closer to its end point, which should then likely reverse to a stage where bank balance sheet cash begins to grow as a result of our organic net new asset growth, as well as new accounts that we attract. Now, in terms of the slide, we've included a chart that goes back to 2004, and it illustrates multiple timeframes where interest rates were relatively high, as well as several timeframes where interest rates were near zero, often referred to as ZERP periods. When we study this information on a per account basis, what we see as the most accurate way to model this Transactional cash per account is down to an average of approximately $10.4 thousand, a level as low as we have seen in the past 20 years, and down about 50% from the peak period during the COVID pandemic. From a percent standpoint, transactional cash per account is at a 20-year low of approximately 5%. Now, could it go lower? Yes, of course. But we believe it is closer than ever to finding its ending point. Here's why. If you look at daily Schwab bank cash movements, a key metric for identifying trends, far more important than a quarterly summary. February of this year was lower than January. And if we adjust for the single day after the Silicon Valley bank failure, where cash movement was modestly elevated, March was lower on a per day basis than February. And through the first half of April, even allowing for tax payments, April is also lower than March, measurably lower. Lastly, it's important to recognize that while some clients did readjust their cash allocations in response to the Silicon Valley Bank failure by buying treasuries or CDs or moving from prime money funds to treasury or government money funds, we also saw a sharp increase in new cash coming into Schwab, consistent with being a safe port in the storm. Now this slide is also a particularly important one as it provides factual information around a topic that has been fraught with inaccuracies in the press and blogs alike that, incredibly to me, often relied on speculative information from short sellers and competitors. Schwab Bank is a bank for investors. We manage client cash at our bank conservatively and consistently. We manage this cash in the same way we've managed it for the 20 years that we've had our bank. We make what we consider to be conservative loans, almost exclusively to our existing investment clients. Now, these loans are either backed by our client's securities portfolio or loans against their personal real estate. This makes up about 12% of our assets. We do not make commercial loans as speculated by one of our competitors on national television. The balance is invested primarily in securities. And with this balance, we look to manage credit risk by investing between 85 and 90% in securities backed by the US government or its agencies. That's our approach to credit risk. Now let's talk about duration risk. Again, an area that has been fraught with misinformation. First, let me begin by saying it's important not to confuse, as unfortunately some less than savvy alleged researchers and analysts have, that maturity or weighted average life is not the same as duration. We have many floating rate securities that have a long life, but essentially zero duration, and therefore do not contribute to negative marks with higher interest rates, and of course, offer increased yields as rates rise. Second, we do not now and never have tried to guess future interest rate movements. Doing so is a fool's game. It's like trying to guess stock market movements. We don't guess and we don't try to time interest rate movements. Our approach is very straightforward. We have historically managed our bank investment portfolio to a duration range between 2.75 and four years. And we were approximately three and a half years as rates began to rise in mid 2022. Admittedly, nearer the higher end of our historic range than the lower end, a fair criticism. Importantly, our overall duration across the firm's aggregate balance sheets, which includes the banks and the broker-dealers, was about two and a half years. That is it. Not five, not ten, but two and a half years. We all know that even at two and a half years, this is not low enough to avoid temporary paper losses when rates rise close to 500 basis points in a year. We just felt it was important to be transparent on where we were as this rising rate cycle began. So again, we did not change our historic approach during the COVID pandemic. Contrary to some items I've read and heard, we did not buy securities that would take us out of our historic duration range. Put even more bluntly, we did not go out and load up our securities portfolio with long dated bonds during the pandemic, period. Now, it can be a fair criticism that we should have changed our two decade approach to consistently maintaining a relatively short term duration bank portfolio during the COVID pandemic in favor of holding primarily cash. That's fair to say. And if we would have known that the Federal Reserve was going to raise rates faster than they ever have in history, in retrospect, that would have been a brilliant move to make. What we did do was to begin to build up higher levels of liquid cash in late 2021 as transitory comments about inflation from the Federal Reserve waned, and in early 2022 as the Federal Reserve began discussing increases in interest rates. We increased our normal cash allocation about $60 billion. But given the pace that the Federal Reserve raised rates, and therefore the pace of the resulting client cash realigning, again, in retrospect, $60 billion was not nearly enough. And that led to our need to execute on our other liquidity measures. I started my comments by making clear that our financial model and franchise strength are intact. So the obvious question is how this manifests itself in terms of earnings growth and our ability to deliver for our stockholders. It's well understood that the temporary cost of higher funding from CDs and FHLB loans will impact our near-term revenue growth and earnings. Hopefully, it is also well understood that as these borrowings are paid off, that will be an accelerant to our medium-term earnings. But as client cash realigning moderates and eventually reverses, and the headwinds from higher-cost temporary funding sources diminishes over the next seven quarters, what remains? What remains is an extraordinary company. We have a diverse client base spread across approximately 35 million accounts. We have a track record of delivering exceptionally strong organic asset growth in every environment. We are completing the integration of the former Ameritrade client base and adding world-class trading capabilities, along with approximately 10 million new clients who will be exposed to all the additional products and services that Schwab offers that were not available to Ameritrade. and millions of existing Schwab clients will be exposed to the world-class retail trading platforms that were previously only available to Ameritrade clients. And as a result of the integration process winding down, along with investments that we have made in enhancing efficiency during this integration process, we will be in a position to substantially reduce operating expenses. Again, as I stated, well beyond the remaining $500 to $600 million we originally committed to as part of the Ameritrade integration synergies. It's a powerful formula. It's a winning formula. And I'm confident that it will be a formula that delivers for our long-term stockholders, as it has since we went public in 1987. So Peter, let me turn it over to you to talk some more about our financial results and projections.

Well, thank you very much, Walt. So there are three 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 one third 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 pre-tax 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. 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. I know there's been much written, we'd argue too much written, about the tangible common equity ratios or banking subsidiaries, but those ratios have all increased significantly from the 1231 levels due to both a $2 billion reduction in the unrealized mark-to-market losses and continued strong capital formation. Those of you who followed the company for a while know that we have a long-term orientation, executing a strategy and business model that has delivered for clients and stockholders for multiple decades. I want to emphasize that the current challenges we're facing are quite manageable, and the impact on our financial performance is near-term, which means that Schwab's long-term financial model of growth plus capital return remains firmly intact. Though, as we have discussed, there are some early signs of moderation of the client cash allocation activity, the overall level to start the year has exceeded the assumptions incorporated within the scenario shared at the Winter Business Update. That means we've utilized a higher level of supplemental funding, with the vast majority of that now expected to be paid off by the end of 2024. This temporary, emphasis, temporary mix shift toward higher cost of funds is expected to pressure the next few quarters of revenue, at which point the impact should start to decrease, reverse. And we now expect Q2 revenue to be down a mid to upper single digit percent versus the second quarter of 2022. But it'll have very minimal impact on our long-term financial performance, with our NIM and net interest margins still poised to increase throughout 2024 and approach 3% by the end of 2025, even if rates fall from current levels, as the market anticipates. Now, it's important, I think, to put that NIM outlook into perspective. As I mentioned earlier, net interest revenue only accounts for half of our revenue. And with an adjusted pre-tax margin well in the upper 40s, we can continue to produce margins that would be the envy of most other financial services firms, even as we navigate these dynamics. And remember that as all this has been happening, we have been adding clients, adding net new assets, increasing the adoption of advice and lending, and moving forward on the Ameritrade integration. Now, regarding expenses, disciplined expense management has been a hallmark of our financial formula. And throughout our history, we have taken steps to pull back on our spending when we're facing environmental headwinds without sacrificing the client experience or undermining long-term growth. As Walt said earlier, we feel very confident about our ability to deliver over $500 million of expense synergies by the end of 2024 as we complete the integration of Ameritrade. And as we do so, it's also a good opportunity for us to take a step back and examine our overall spending levels to look for additional efficiencies as we continue our decades-long focus on driving down our expense on client assets, or EOCA, which we view as a key competitive advantage. And finally, our capital position, our capital ratios remain very strong. As Walt noted in his remarks, even if we have to eventually absorb AOCI into our regulatory capital ratios, we see a clear path organically for our Tier 1 leverage ratio, inclusive of AOCI, to exceed 5% within the next year and cross 6.5% by the end of 2024, even if rates stay flat. Thanks to our strong earnings, a reduction in balance sheet assets, even after deposit growth rebounds as we pay off the supplemental funding, and the continued reduction of our AOCI as our securities portfolio matures. And I note that, again, even if rates remain flat, we'd expect those mark-to-market losses to decrease by a further $7 billion between now and the end of 2024, and obviously more if rates fall as the market is expecting. Putting it all together, We're not blind to the near-term dynamics we're navigating, but we're very confident that our financial formula will reassert itself as we emerge from this period. And that formula, of course, starts with taking care of clients, growing accounts and assets, deepening relationships, building our capabilities, expanding our moat. That is what builds long-term earnings power and will be the driver of performance for our stockholders over time. And to tell you more about the strength of our franchise and how we're continuing to serve our clients, it's my pleasure to turn it over to Rick. Thank you, Peter.