Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

The Charles Schwab Corporation (NYSE:SCHW)

Spring 2012 Schwab Business Update

April 26, 2012 11:00 am ET

Executives

Richard Fowler -

Walter W. Bettinger - Chief Executive Officer, President, Director and Member of Policy Committee

Joseph R. Martinetto - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Analysts

Richard H. Repetto - Sandler O'Neill + Partners, L.P., Research Division

Howard Chen - Crédit Suisse AG, Research Division

Brian Bedell - ISI Group Inc., Research Division

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

Christopher Harris - Wells Fargo Securities, LLC, Research Division

Richard Fowler

Good morning, everyone, and welcome to the Spring 2012 Schwab Business Update. This is Rich Fowler, Head of Investor Relations for Schwab coming to you live once again from the cutting edge Schwab webcast center/converted conference room in beautiful San Francisco. It's looking like an okay day out here starting out. A few clouds, a couple of drops, just enough to be refreshing if you have your top down. But we're building a very pretty good pollen season out here, which I find affects me more in my old age, so I can arrive at the office looking like I've been up all night reading Nicholas Sparks or FOMC minutes or something equally depressing.

Moving on, with me here today are Walt Bettinger and Joe Martinetto. By now, I think we're pretty used to this presentation format. We're doing an interim update today, so we'll spend just an hour with Walt and Joe sharing their perspectives on life at Schwab right now. We'll start up with prepared comments, and we'll go to Q&A until it's time to wrap up.

Before Walt starts us off, let's spend a moment on the ever-popular forward-looking statements. The main point of which is to remind everyone that outcomes can differ from expectations. So please keep an eye on our evolving disclosures. And then let's cover how we'll take questions. Once again, we'll do so via the webcast console and via the dial-in as well. For anyone who doesn't already have it, that number is (800) 871-6752, the conference ID is 38866056. When we start the Q&A session, we'll ask the operator to remind us how the process works. Okay, we have the administrative stuff out of the way. We have our 2 terrific speakers lined up and ready to go. We're audible to the outside world, always a good thing. So let's begin. Walt, would you start us off?

Walter W. Bettinger

Good morning, everyone. Thanks, Rich. Thank you for joining us for our spring 2012 update. I'd like to go ahead and start with a quick and high-level summary of our strategy and managerial viewpoints. First and maybe most importantly, our strategy of viewing every decision we're faced with through the clients' eyes continues to resonate. We continue to believe it's the right strategy for today, for tomorrow and for the long term. The fundamental challenge, in our view, in the financial and investment services business is one of building and maintaining client trust, and we believe our strategy is highly successful at achieving this.

The second, we continue to focus on the areas that are within our control and influence. That means looking at clients, building the earnings power of the franchise for the long term. We do believe that the current interest rate environment is an aberration. It's not likely to be the norm for years and years to come. And then third, although our revenues were significantly impacted by the extraordinary Fed actions under Operation Twist, we are moving past this bump in the road, and we're delivering growth.

In the first quarter, retail investor sentiment did begin to improve. You can see that illustrated on the charts here on this slide that reflect client responses to our surveys. Investors are feeling better about their financial position. They're feeling more and more confident, making decisions at least relative to the past few quarters. That said, the old and, I might even argue, outdated means of evaluating retail client engagement by measuring trading activity really doesn't apply. Investors are engaging instead by adding to their investment accounts, implementing investment decisions. Their cash positions as a percentage of investment assets continue an overall downward trend, at least from the peak of the financial crisis. We are beginning to see an early pickup of net new assets across our client segments. We've seen it from retail, to adviser, to 401(k), and of course, that was reflected in the $39 billion of net new assets and $27 billion of net new core assets that we attracted in the first quarter of this year.

Certainly, recent years have had an impact on the way that investors make decisions and the extent to which they're looking for professional help. This plays directly into many of our strategies. Independent investment advisors keep and continue to experience strong organic growth. Increasingly, our retail investor clients are looking for assistance with their portfolios also. You can see here on the charts today about $850 billion of assets at Schwab are under some form of fiduciary-driven investment advisor relationship. On the retail side, it's about 16% of assets. So it illustrates the significant opportunity before us to both improve client outcomes, as well as to monetize our retail client asset.

Now when we look back at the first quarter from a metrics standpoint, we're further encouraged because both new accounts, as well as net new core assets were at their highest levels since the first quarter of 2008. Now some might ask why we break out the difference between net new assets and core net new assets. Our belief is that transparency begets trust. And just as we've strived to build trust with our clients, we've started to build trust with our owners, with the analysts who cover our stock and with the general public. We all know that the approximate revenue we earn per dollar of client asset is somewhere between 25 and 30 basis points today and in a more normal interest rate environment, are likely somewhere between 35 and 40 basis points. So to the extent we bring in assets that do not reflect, at least on average, these levels of revenue streams, so for example, assets from our mutual fund clearing business, we feel that transparency and trust is served by identifying this for you.

Overall, you can also see client assets, as well as our retail Client Promoter Score or Net Promoter Score, both were at all-time record levels at the end of the first quarter, again, further offering us encouragement around future growth, as well as future financial performance.

Now as I mentioned earlier, the Fed's extraordinary decision to purchase about 3/4 of our nation's debt issuance by the Treasury during 2011, largely under Operation Twist, negatively impacted our revenue. The 10-year Treasury yield, which is the closest proxy for the yield we're able to earn on our balance sheet investments given the conservative approach we take to investing, that fell somewhere between 100 and 125 basis points during 2011. When you apply that to the $110 billion or so balance sheet that we have at Schwab, the revenue impact certainly created the bump in the road that I referenced. However, we believe that this troughed in the fourth quarter, and what we've seen since then is a reflection of some of the growth potential within our company. Revenue up 7% sequentially, earnings up 20% sequentially. So a strong bounce off this trough from Q4 of '11 to Q1 of '12.

From an operating standpoint, we continue to utilize our 5 operating priorities under our "through clients' eyes" strategy umbrella to drive our execution. Of course, those are: diversified client acquisition, win-win monetization, long-term client retention, expense discipline and effective capital management.

Let me take a minute to review with you several of our key current initiatives from an execution standpoint. I won't touch on all these, but I thought it'd be worth spending a few minutes identifying some highlights on several of them. First, our Schwab Index Advantage program, which is our index-oriented 401(k), offers customized advice for every participant. It's gaining strong early traction in the marketplace. We have several hundred clients interested in this -- in moving to this program. We already have 10 or 12 who've made the commitment. We expect that to continue to accelerate fairly rapidly. Again, for those of you maybe not as familiar with the program, it's very attractive to fiduciaries relative to trying to select actively managed funds as it uses all index products.

And for participants, in my opinion, it simply delivers a better experience, lower cost and advice for them that is far more customized than the blunt instrument of, say, a target-date fund that only looks at a participant's age and then treats every participant exactly the same.

Our Independent Branch Services program, we now have 2,300 candidate leads to date. We've signed 5 leaders who will oversee franchised branches. We'll open our third location here next month. We're still looking for somewhere around a dozen or so locations by year end of 2012, although I do want to emphasize that, as we've indicated, this is a long-term strategy, and we are focused on quality rather than quantity. That's so critical for the pioneers in an effort like this. Just as a frame of reference, the average franchise strategy takes 3 years to get to 20 locations and 8 years to get to 100. So I just think it's important to have that as context around what we're doing with our franchise strategy.

New prospect website, we've had very positive client prospect feedback. Engagement is up significantly. A prospect online chat with our new site, it's up 55% year-over-year. That's Q1 '12 over Q1 '11. And our yield rates are also up. The yield rate is the percentage of visitors who actually then go on to schwab.com and open a new account. That's up 11% year-over-year and up 44%, if you look at just March of '12 versus March of '11. So our new prospect website appears to be driving significant traffic, as well as new account generation.

On the lending side, we continue to see strong activity since we began our transition away from partnering with PHH to partnering with Quicken Loans. We're seeing about 1,400 leads a week for mortgages, and our cycle time is running under 35 days for mortgages, and that compares to where we were 80-plus days in the past with our prior partner. So very encouraging with Quicken Loans.

Let me mention a little bit about optionsXpress. We continue to deliver more and more functionality to our clients. Most recently, we introduced our instant move money feature that makes it very easy for clients to move money seamlessly between Schwab accounts and optionsXpress accounts. Dual households, which are clients who have an account at both optionsXpress as well as Schwab are growing quickly. They're ahead of plan. Clients who open an optionsXpress account, they bring in more assets and they trade with more frequency than the previous client base at optionsXpress.

We've also made the educational content that is quite rich from optionsXpress available to all of our Schwab clients via our active trading learning center. And as you may have seen in the press, we are working through a series of issues with regulators that stem from some activities prior to our acquisition of the firm.

Global investing, we'll be launching our online trading capability with somewhere around 12 countries, 8 currencies later this summer, very exciting, tremendous transparency delivered to the investor around the various ways to purchase global stocks, whether it'd be ADRs, over the counter, or directly on the exchange of the local security, with transparency as to the benefits, pros and cons of each. It's a very exciting capability. Looking forward to introducing.

Mention quickly, Compliance11, the progress there. Compliance11 is the software firm that we acquired recently that is a leader in providing compliance software to companies. They continue to experience strong growth. We just signed up our 400th client. When we first began speaking with Compliance11 last year, their total clients were in the mid-200s. And when we closed the deal, near the end of last year, we were in the low 300s. So continue to experience strong growth. We've begun the integration of the strategy of Compliance11 along with our Designated Brokerage capability, where we are the leader in the industry in working with companies that have to monitor the trading and investing of their employees. And we continue to work and invest on the technology front. Our aim is to bring out a next-generation solution under Compliance11 later this year.

Let me just make one last quick comment here on Advisor Services. We have introduced 3 new platforms under our Schwab Intelligent Integration, and we continue to bring in new advisors to that business. Already, so far this year, we've added over 40 advisory firms. We break this out by firms, not by individual brokers. So over 40 firms and a very consistent flow of advisors breaking away and deciding to become independent as an RIA.

To go ahead and close my presentation today, I wanted to review with all of you an illustration that we think paints the picture as to why we're so confident in our strategies, as well as our efforts. Now in all likelihood, the figures on this page are probably very familiar to you listeners. As my assumption is, that all or virtually all of you have probably already calculated similar numbers in your models. However, we wanted to show you our version of how the formula works if we extrapolate out a few years into the future.

What we've done is we've shown 3 scenarios of potential revenue out 5 years from now. So beginning at 1/1/12 and taking us to the end of 2016. So 3 scenarios in the box here, and let me just walk through them quickly. The top scenario takes our current state, and it assumes no changes for the next 5 years other than the long-standing assumption that we've used, which is a 6.5% growth rate in equity markets. In other words, we've made an assumption of no change in interest rates, no change in asset mix, net new assets continue to grow at approximately 6% of our base. Now that's similar to the rate that we have been growing net new assets during this low interest rate environment. The overall revenue per dollar of client assets, what we sometimes refer to as ROCA, revenue on client assets, remains right where it is today. That's about 27 basis points. So really no changes other than our assumption around equity market growth. And under that scenario, our math leads us to a 12% compounded revenue growth rate over the next 5 years.

Now the middle scenario keeps every assumption exactly the same as the first scenario. However, it illustrates that interest rates begin to rise at the beginning of 2015. And they rise at a fairly steady rate until the end of 2016, at which by that fourth quarter, our firmwide revenue per dollar of client assets is back to 37 basis points. Now that's the actual level of revenue per dollar of client assets that we were achieving at the beginning of 2008. So we've just carried it back to right where we were the beginning of 2008, again, with rates beginning to rise at the beginning of 2015. And under that scenario, you can see over the 5 years, revenue compounds at a 19% growth rate and ends up around $10.5 billion.

And then under the scenario at the bottom of the chart, we make one more assumption change from the middle scenario. We increased our net new asset growth rate to the middle of the historical range that we've achieved of 8% to 10%, I think. So we used 9% in this bottom scenario. We don't assume that begins to occur until, again, 2015 at a point in time that interest rates would begin to increase. And under that scenario, revenue compounds at a 20% rate over the next 5 years and gets slightly in excess of $11 billion.

Now we did not, in any of these mathematical calculations, include the potential impact from some of our execution strategies. So for example, we didn't assume that we achieved a higher penetration rate from a percentage standpoint in, say, advisory sales within retail. We didn't factor in anything for Schwab Index Advantage, our 401(k) program. We didn't factor in anything for independent branch strategies. For that matter, we didn't even factor in anything for financial management steps we might take like additional transfers of money market fund assets over to our balance sheet. If you take the interest rate levels comparable to Q1 '08, then every $10 billion that we might move to the balance sheet from the money market funds would generate approximately an incremental $430 million of annual revenue. So we just wanted to make sure that we shared with all of you the math that we look at. Again, my assumption is, there's no surprises here and everyone is very familiar with these numbers from your own models. But we just thought it would be appropriate to share with you the math that we look at.

So with that, let me go ahead. And Joe, I'll pass the baton over to you, and you can go into some more details on our financials.

Joseph R. Martinetto

I was never a runner like Rich, so I hope I don't drop the baton here. But there's some great pictures out there, if you guys want to go find them, of Rich in his heyday. While we had an incredibly compelling story for long-term growth, but I think we're equally as confident in how the formula translates into growth here in the near term. So what I'd like to do now is turn our attention to a little closer point in time and look at Q1 first, which is actually a great business case for how the formula does work when we get to an environment where we're not facing economic headwinds. And then I'll go ahead and update you throughout the rest of the deck on some of the main drivers of earnings as we look forward through the remainder of 2012.

So let's jump into Q1 and hit the economic environment here pretty quickly. So for the first time in a long time, we actually got a little bit help out of the environment. Instead of talking about markets that were flat to down, we're actually talking about market valuations that were up. Now everybody talks about the S&P being up about 12% in the quarter. That's great if you're actually a long holder and you're computing your gains in the quarter. I'd remind you as somebody who's computing fees that we're looking at average increases as opposed to point-to-point ends. And on average, the S&P was still up about 6%. So we had some help there in the quarter from that, and we will have some continuing help into Q2 if the equity markets stay with valuations consistent with where they are today. So we've got a little bit of help coming from the equity markets.

Not really the same story from the fixed income market. You can see here that the 10-year rate on average was basically flat quarter-over-quarter. We had a period where we got a little bit of spike here at the end of the first quarter, and at the beginning of the second quarter, we've given that back up already. So I think we've got a number on here of 1.98% as of last night. The last I looked before I came down, we were back to 1.94%. So the Treasury market's moving around a little bit, still seems a little bit range bound. I'd say at this point that it's not really helpful, but not really harmful. It's just kind of sitting there within a reasonable range. So overall, an economic environment that's benign to somewhat helpful.

In that kind of an environment, as Walt had said earlier, we were able to see some pretty substantial sequential improvement. So when you start breaking that down into a little bit more detail, what we were really pleased to see was all of the main revenue lines were up sequentially quarter-over-quarter. So the lift that I talked about in market valuations, along with our continued inroads with advisory product sales, led to a 6% lift in asset management and admin fees in the quarter. Net interest revenue was up 10%. Now and people will remember that we talked about the large impact of prepayment amortizations or the large impact of amortizations related to prepayments that we took in the fourth quarter. That drove about 60% of that 10% lift. But the remainder of it was driven by continued growth in the balance sheet. So the growth in client franchise continued to drive that line forward.

Finally, trading revenue up 4% on DARTs, they were up 4%. So good news is, DARTs have settled into a range. As we get back into the scenarios, we'll see that we are running a little bit below our loftier expectations for growth in trades. But the fact of the matter is, we're probably in a range here now as we move into the summer months, particularly in a year where we're facing a contested presidential election. That doesn't tend to generally bode well for seeing big lift in trade count. But that aside, we were able to put up in total a lift in revenues of 7% quarter-over-quarter. The discipline that we've continued to exhibit around expenses of only 2% expense growth quarter-over-quarter. And if you stripped out the impacts of payroll taxes, which kick back in at the beginning of every year, we actually would've seen expenses down slightly over the fourth quarter. All of that together combining for a 20% lift in earnings in one quarter over the prior quarter. That's the way the business model is supposed to work, and so everything that we've been saying about what happens to the company's financials in a more benign economic environment, we were able to demonstrate that in the first quarter here.

As we start looking forward to the remainder of the year, a quick update here on net interest margin. At 167 basis points in Q1, we were a little bit better than, I think, we had believed and probably many of the folks out there had factored into their expectations. Prepayment activity was a little bit slower than we thought it was going to be, and that was somewhat helpful. We also invested pretty heavily into March when we saw rates a little bit better. So both of those things are helpful. That said, we do tend to expect that we're going to see some continuing downward pressure on net interest margin as we move through the remainder of the year. We continue to get cash flows in that we're reinvesting at rates that are below where our average rates are today. Now -- and this pressure is very modest, but we do expect to see the margin continue to decline some through the remainder of the year. For now, we're going to stick with that 160 basis point estimate for the end of the year. Could we be a little bit better than that? We could absolutely be a couple of basis points better than that if everything plays through in our favor. But frankly, it's just too early in the year to make a revision to that number, and there's too many moving parts that can adjust it. So for now we're going to stick with that, but we'll continue to provide updates as we move through the course of the year.

So as we talk about too many moving parts, the same story is really true as we start talking about money fund revenues. We've tried several different approaches to try to make this a simple story, and the fact of the matter is, it really just isn't. We run 3 substantially different kinds of portfolios all embedded in money funds. We have muni funds, we have prime funds, and we have Treasury and government funds. And all of those instruments price off of different kinds of instruments in the market. The muni funds tend to price more with the SIFMA market. The prime funds historically had moved along with LIBOR. We've seen distortions in that, and LIBOR is obviously being continuously impacted by what's going on in Europe. And today, we would say the repo curve maybe is a little bit better proxy and then the government market moves pretty much in line with the posted government rates. But those 3 markets can, at points in time, all move in different manners. And so to try to pick a single rate and say, that's going to be the thing that everybody should look at, unfortunately, it's just not that simple. So I think we've tried to simplify it and at this point are saying, I don't know that we've got a great proxy for everybody to look at. We probably have to look at the 3 markets independently. But all of that said, we did get some help ,particularly out of the Treasury market, with some firmness in rates as we got into the first quarter of the year. So on balances that actually declined, we were able to produce net revenues in the money funds that were up slightly versus where they were in the fourth quarter of last year.

As we look forward to the remainder of the year, if rates and balances stay where they are as of the first quarter, we would expect again some modest improvement in those net money fund fee revenues, up to the $60 million to $65 million range from the $59 million that we experienced in the first quarter. That said, I'd also put some caution out that post tax time, it's pretty typical to see the government start to slow bill issuance. And if they do this year as they typically do, we would expect to see a little softness in the Treasury market. So again, rates may not stay this firm as we move through the remainder of the year, but for now, we're going to say, if rates stay flat, we would expect revenues to stay in that $60 million to $65 million range going forward.

So as we pull all this together, and I wish I could show people my page here that I'm looking at as opposed to the one up on the screen because I've got little arrows drawn on mine. Next to the S&P, I've got a little up arrow because we're getting a little bit of help out of the market that we weren't expecting. I got a flat one next to the rate environment because it's pretty much playing out at about in line with our expectations and a down arrow next to the DARTs because I think 20% was maybe a little bit aggressive for DART lift. We aren't there in Q1 and likely aren't going to get there as we move through the summer. But as you put all that together, we're about on track with the scenario that we laid out up at the top of the page, that more benign kind of economic scenario translating into that 8% revenue growth and a pretax margin of about 30%.

So one piece of housekeeping here that I want to make sure everybody picks up around the preferred dividend, because of the timing of our board meetings relative to the need to get the dividend declared and paid in time, it is likely that we will be declaring the preferred dividend in the second quarter. And the dividend is accrued at the time it's declared, not at the time it's paid. So you are likely to see the second quarter earnings number impacted by the preferred dividend as opposed to the third quarter earnings number. And just to remind everybody that the math here is, you subtract the dividend out from net income to get into net income available for common, and then you divide that by the number of shares to get to EPS. So just keep in your minds that we are likely to declare that dividend in Q2 as opposed to Q3.

Moving on to the balance sheet and capital. Walt talked a little bit about what we're seeing on the client cash balance side as that sense of optimism with the consumers continues to impact their activities in the market. We did see a slowing in the growth of the balance sheet quarter-over-quarter. If you look down in the capital section, you'll note that the leverage ratio was up about 20 basis points. We talked about an almost 40 basis point impact from the increase of the preferred, but I'll remind everybody the leverage ratio is calculated on average assets as opposed to ending assets. So when you get the kind of growth we experienced in the balance sheet in the fourth quarter, we get the lagging impact on that first quarter average still picking up that growth in the balance sheet. So some of that capital was consumed funding the growth that we'd already experienced at the end of the year.

Moving on to credit. We've got a good story to tell on the loan book here. We saw improvements in the metrics around delinquencies and nonaccruals, and as a result of that, we didn't take any additional loan loss reserve in the first quarter. Now to make sure I'm really clear here, we didn't release any reserves, we just didn't take any additional reserves against our loan book, and we thought that was appropriate against the credit experience that we were seeing in that book. Contrary to that, when we look at the temporary -- other than temporary impairment in the investment securities book, we saw a little jump in those numbers. Again, that was tied to some new metrics that we were able to see in the marketplace for the first time. So we got reporting from a number of servicers around modified loans that were being reported as performing in the loan pools supporting the securities that we held. Because we continue to see in the marketplace a higher rate of recidivism on those modified loans, we adjusted our loss factors related to those pools and took our loss factors up a little bit. So what I would say is, we're trued-up to all the information that we've got today in the marketplace, and I would encourage people to think about that difference in the $18 million number that we recorded in the first quarter versus the high single digits number that we've been recording more consistently for the past year or so. That difference was really a true-up to those new facts that were available in the market around credit, not necessarily indicative of an ongoing run rate that we would expect to experience as we move forward through the remainder of the year.

So we bring it all together, both in the short run and in the long run. That drive of client acquisition, along with the move to continue to monetize the client assets, are both going to combine to drive revenue growth going forward. We'll manage expenses appropriately as we have now for a number of years for the environment we find ourselves in to make sure that we're returning appropriately to shareholders in the near term and making the investments that are necessary to continue to grow the firm in the long run.

On the capital management front, we continue to deploy it. We believe in the best manner available to earn returns for our shareholders. Right now, that means that we're putting the majority of what we're generating or virtually all of what we're generating to work to support the growth of the balance sheet and continue to drive revenues that way as opposed to using the excess capital to return to shareholders in the forms of buyback, and that's what we would expect to do at least through the remainder of the year based on what we can see at this point. But again, as we bring it all together, we're confident that we can grow revenues and grow earnings, both in the near term and in the long term, as long as we don't see a continued deterioration in the interest rate environment.

So at that point, I'd like to turn it back to Rich, and we'll open it up for questions.

Richard Fowler

Okay, thanks, Joe. Operator, could you just walk us through quickly one more time how to do the phone-based questions? And then of course, everybody knows that they can use the ask-a-question box on the webcast console.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Rich Repetto.

Richard H. Repetto - Sandler O'Neill + Partners, L.P., Research Division

My question is, Walt, when you talked about the 16% retail in advised offerings, and I'm just trying to see -- this is something, like sort of organically that you market to yourself or you try to convert your own customers to these offerings. Where can you get this number to go to? You feel comfortable that you could get it as a target. And then, a little bit on how it might impact, I know the ROCA on these advised offerings is higher, but how you look at sort of the incremental profitability there.

Walter W. Bettinger

Sure. I don't know that we have actually stated a percentage where we think it can get to, but we think there is a meaningful runway up from 16%. There are hundreds of billions of dollars there of assets that are not under an advisory relationship, and we are in ongoing conversations with clients on a daily basis around whether they would be best served by that or not. Fundamentally, what we want to do is do what is in the best interest of the client. For some clients, it is in their best interest to move into an advisory offer. In some cases, they're better off as a self-directed investor. So we want to what's client's best interest. In terms of the revenue, the revenue swing is fairly substantial for our client who moves from a self-directed position typically into an advisory-based solution. Often a self-directed investor holds individual securities that have no ongoing revenue stream. They may have some mutual funds where we could be generating a modest amount of revenue. Most of our advisory solutions generate for us somewhere between, say, 70 and 100 basis points worth of revenue that we don't have to share with a third party. So the lift is meaningful as clients move into those advisory relationships. And therefore, it's very attractive for us from an earnings standpoint. But I just want to emphasize that really the driving factor for us is what's going to be in the client's best interest.

Richard H. Repetto - Sandler O'Neill + Partners, L.P., Research Division

Got it. And if I could, just one follow-up. Joe, you did talk about capital levels. I guess the question is, you were also, I believe, going through a transition to new regulators, OCC and the Fed. I was just trying to see how those negotiations going. And also I didn't quite get whether you implemented the guidance in regards to the performing second liens against nonperforming first, whether that's even an issue or did you implement it?

Joseph R. Martinetto

So from a capital standpoint, I'd say, at this point, we're pretty far along our preliminary conversations with the regulators, and they have a high degree of comfort with where we sit in terms of capital from everything they've given us. We have a high degree of comfort in terms of capital. So I think, were we to request permission to buy back stock or, frankly, we don't really need permission at this point, but we would probably want to have a conversation with our regulators just to maintain a good relationship there. Were we to engage in that conversation, my guess is, we could likely move forward with buybacks at this point if we chose to. But as I said in the remarks, at this point, we've got uses for that capital internally to support growth at returns that we think are acceptable, and that's the first place that the capital is going to go. But I don't think at this point we're constrained by regulators as much as we are by the dynamics of the business in terms of how we want to use the capital we're generating. The second part of the question, a little more detail about exactly what you're asking here?

Richard H. Repetto - Sandler O'Neill + Partners, L.P., Research Division

Well, I don't think this is an issue with you all, but if you have an accruing, a performing second lien or home equity loan, the regulators are encouraging you to put it in nonaccrual status if it is tied to a nonperforming first lien. So even though it's performing, if it's tied to a nonperforming first lien, they want you to put it in nonaccrual.

Joseph R. Martinetto

Yes, I've got to admit, I don't know the details on that. I do know that we've carried our -- all the troubled debt restructurings inside of our nonaccrual numbers for 12 months until we've cleared that 12 month barrier. I'd have to go back and check explicitly on whether we did that for seconds that are tied to firsts. But I can tell you that performance on the seconds portfolio continues to be even better than the first portfolio. So I don't think it's a big issue. My guess is that we've adopted the guidance, but I'd need to confirm that.

Operator

Your next question comes from Howard Chen.

Howard Chen - Crédit Suisse AG, Research Division

Walt, the long term revenue potential you frame is pretty compelling. I'm just curious how you and the team think about the incremental margin on those revenues. And while 2016 is some time away, what are some of the things you'd like to invest in that maybe you're holding back on now?

Walter W. Bettinger

To the first part of your question, we don't anticipate anything changing in the way that we manage the company from today, in the environment we're living in today into an environment that is a lot more attractive, like the math shows as you get out into 2015, 2016. We don't operate with a targeted margin percent. Rather, we apply very, very rigorous discipline to every spending decision, every investment decision that we would make to make sure that it's creating long term shareholder value. And then the balance of the revenue falls to the bottom line, and then we look to make the most appropriate decisions at that point to the extent there is excess capital. So I think the way we run the company today, with the discipline that we have at a $5 billion revenue level, would be exactly the same as we would run the company in a more normalized environment out into the future. With respect to the second part of the question, things that we would invest in, in frankness, Howard, I'm probably hesitant to share some of that because we've been known to have 1 or 2 competitors participate in these calls, too. So I mean, there are some things that we think about and that we anticipate potentially investing in. If at the point in time the environment improves, they still make strategic sense and will provide returns to our shareholders. But I don't know at this point that we're going to go through any specifics on them. I'm sorry for not answering that part.

Howard Chen - Crédit Suisse AG, Research Division

No worries. And just secondly, you're seeing some acceleration in the core growth rate of the franchise. Just hoping to get your broad thoughts on what you're seeing, any changes on the competitive landscape, whether it be by the wirehouses, major banks and some of the discount players.

Walter W. Bettinger

I don't think we've seen any significant competitive environment changes. I think that for a lot of our clients and new households, the environment feels a little bit better, and they're generating a little bit more wealth. Their bonuses may be a little bit bigger at work than they were back in '08, '09 and '10. And we're the beneficiary of that just like we suffered along with them as they experienced more financial challenges in their personal lives.

Howard Chen - Crédit Suisse AG, Research Division

Okay, great. And then finally for me, Joe, you touched a little bit about the leverage and capital adequacy questions, but was just hoping to get a broader regulatory update in terms of where you are in the Fed transition and maybe thoughts on nonbank SIFI and money market reform as you all see it now.

Joseph R. Martinetto

Sure. So on the transition, this is, as I've said before, going to be a long-term cycle here until if and when we see the rules actually converge. So at some point in the future, my guess is we will see the treatment of thrift holding companies converge with bank holding companies, and we'll be all brought into one big bucket of financial institutions. But until that occurs, we'll continue to work with our regulators to make sure that they understand what we're doing and try to navigate those waters. But I don't expect to see even when that convergence of regulation happens substantial changes in our business as a result of that. The bottom line is, we're not brought into the SIFI bucket today, and it doesn't look like from the rules that have been proposed that we'll be brought into the non-bank SIFI bucket. But at some point, if those rules do converge, there is a potential that we could get pulled in as a bank if that's what happens. It looks like at this point, the biggest risk of that versus everything else that we're already trying to make changes around internally to come into compliance with the way the Fed would like to see things versus how the OTS like to see things would be a potential for getting some additional capital surcharge related to being over $50 billion. But I'd point out to people, we're not a large trading company, we're not a large international company. I would expect that we'll fall at the lower end of any capital surcharge that would be introduced. And with that, because the capital surcharges all go against the risk-adjusted numbers, our risk-adjusted numbers are so far in excess of any regulatory minimum that it's hard to see where that's going to have any impact at all in how we operate the company. From a money fund perspective, I don't know that we've got a whole lot more to add than what's already out in the popular press. I think we, like everybody, are waiting to see if and when a rule actually gets proposed. I would expect that there's going to be a fairly long comment period with a lot of comments that'll be entered. We obviously have some perspectives on the strength of the money funds and the changes that have already been made to 2a-7 and the strengthening of the liquidity positions and the credit positions in those funds. We believe today, having watched them come through the crisis of last summer, that those funds are in substantially better positions than they were in, in the beginning of the financial crisis, and we're hoping that, that's going to be factored into any thinking around rulemaking that ultimately gets promulgated.

Richard Fowler

Joe, let me cut in with some from the console. A couple of questions have come in. I know it's something that we give a lot of thought to, so I thought it might be good for you to enlarge on the situation vis-à-vis the bank and capital. And when we think about a normalizing environment and rates lifting, and obviously a big part of that, that revenue impact is going to be in the bank as a legal entity, how do we think about return on equity with the bank over the long term? What sort of expectations do we have for that?

Joseph R. Martinetto

So if you go back to precrisis levels of returns at the bank, we were well into the mid to high 20s in terms of return on capital. The only thing that's really changed in terms of the dynamic of the capital returns at the bank and what we see as a more normalized rate environment would be the fact that right now, the leverage ratio target is at 7.5% versus the old 6% target. So if we stay at a 7.5% target, that'll obviously have an impact, but there's even then, no reason to believe that we couldn't be around a 20% return on capital at the bank. There is some hope. I think the regulators have been kind enough to give us a guideline now to follow in terms of how to engage in a conversation with them around capital levels and a lot of that depends on running stress tests. And those of you who understand the structure of our bank could probably do this work on the back of the envelope and be pretty accurate. The risk components at the back are pretty small and self-contained. So as we run the bank through stress tests, it looks like we've got not just an adequate level of capital, but to us an excess level of capital. So we're hoping to engage with the OCC on a conversation around that 7.5% target to see if we can maybe whittle that down some going forward. But even without that, I would expect the bank is still going to be accretive for us toward returns on capital across the company.

Richard Fowler

Do we have another question from the phone, operator?

Operator

Your next question comes from Brian Bedell.

Brian Bedell - ISI Group Inc., Research Division

A question on both the intermediate and long-term view in terms of your cash management strategy with the money market funds in the bank. Maybe if you could just walk us through some scenarios of, if we did get money market fund regulation, to what extent you would prefer to move -- to try to sweep some of that cash into the bank, which obviously you generate much stronger returns from and should be accretive. And then to what extent the fact that the client cash as a percentage of client assets continues to move down? Do you feel that gives you a much bigger cushion to deploy that type of strategy?

Walter W. Bettinger

Well, let me just first step back and cover the strategy of how we view cash at the bank. The predominance of cash that we have at the bank and that we would like to have at the bank is yield inelastic. In other words, it's sweep balances that clients expect to deploy within a reasonably short period of time into investment vehicles. And therefore, it is highly yield inelastic, and therefore, we're able to capture a fairly meaningful level of spread. To the extent clients are in money market funds as a cash investment strategy, and therefore, are presumably more yield sensitive, I don't think that we would be anxious to move that cash over into a balance sheet-oriented product like at the bank, where our spreads and of course, therefore, our returns, as Joe was just referencing, would be diminished. And so I think our expectation is, and I don't mean to make the answer too complex, but it is a little bit of a complex answer, Brian, that to the extent yield inelastic cash balances were affected by changes in money market regulation, I could envision that money potentially being money we would like to move to the bank. To the extent yield elastic or yield-sensitive cash balances were affected by money market fund regulation, I would not expect that we would want to move that to the bank. So if you get regulatory change that, for example, impacts prime money funds, which seems to be, if we were to get it, and it were to survive all the comments, the debate and maybe even litigation, it would seem most likely that prime money fund assets, at least in our business model, would head toward maybe a [indiscernible] type of money market fund as opposed to the balance sheet.

Brian Bedell - ISI Group Inc., Research Division

Great. It sounds like obviously you'd do the right thing for the client, and at the same time, you do have quite a bit of flexibility with the balance sheet strategy.

Walter W. Bettinger

We do, and that's exactly right. We're not under a model where we're trying to force clients who are yield-sensitive into a lower-yielding bank product simply because it generates more revenue for us. Again, just like my answer on the advisory solutions, our strategies at the highest level all revolve around what's in the best interest of the client, and we've only utilized the bank as a monetization tool with respect to yield inelastic balances.

Brian Bedell - ISI Group Inc., Research Division

That's great. And then just a follow-up on that, on the net new asset outlook, obviously, the 8% to 10% is the sort of the aspirational goal, and you put up the 6% on those scenario slides. I guess the first question is, are those just scenarios and not your actual view over the next few years? And then secondly, dovetailing into that, if you can give us an update on the 401(k) plan traction, maybe just expand your earlier comments and whether you think that will contribute to net new assets, materially, say, by 2013 or 2014.

Walter W. Bettinger

So let me take the second one first on the 401(k). I don't know that we're, at this point, going to say that it will be materially contributing by '13 or '14, although it is possible. It's so early; it's a little hard to tell. And again, we're only in the market right now with our mutual fund version of Schwab Index Advantage. The ETF version will be coming out, and there's a lot of demand that we are hearing from sponsors for the ETF version. A lot saying, I love this concept, I'm really interested, I think it's brilliant the way that you figured out how to handle things like fractional shares and address the, I would say, not realistic concerns around intraday trading with our ability to deal with free-riding issues. They are very interested, but they want to wait until we have the ETF version. So it's just a little hard to say, but I do think, in time, without putting a time constraint around it, it will have a meaningful impact in terms of our net new assets. And now that I've answered the second one first...

Joseph R. Martinetto

6% run rate.

Walter W. Bettinger

So yes, on net new assets, all we tried to do is show you math. We did not give you projections of anything that we believe around execution outcomes. In fact, we tried to clearly exclude those things to just show you math on that projection. Our viewpoint is still that through the cycle, we believe that we will average somewhere between 8% and 10% on net new assets through the cycle. Obviously, this part of the cycle has been a quite lengthy one and still appears to have some unfortunate legs to it. But it was not a -- it's not a projection or an estimate. We just tried to do simple math and make it as easy to understand as possible without us changing a bunch of levers in the different illustrations we showed you.

Operator

Your next question comes from Jeff Hopson.

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

In terms of the assets that are moving into the advisory platform, I guess, any change in the pace of that activity? And then in the RIA channel specifically, any kind of at the margin change in asset allocation of where clients and/or RIAs are putting their money?

Walter W. Bettinger

I think then on the retail side, the conversion of assets to advisory is fairly steady. Now you do see periodic pickups when the market does well. And you may see it slow a bit during more difficult market environments. But things have been so volatile, Jeff, for so long, it's really hard to draw parallels between that. So I would categorize it as fairly steady. Now we have seen a bit of a shift in where that money goes. We've had a lot of interest, for example, in Windhaven. I think we included in one of the slides the fairly rapid growth in Windhaven and the success there. So you've had a little bit of a shift in where it goes from an advisory standpoint. But I think the overall rate is fairly steady. Now in the advisory business, asset mixes continue to trend, I'd say, at a modest rate, but a fairly steady rate toward lower expense investment vehicles. So more ETFs, more index-oriented products, more passive management, things along those lines that generate probably less revenue than certainly, I'd say, 10 years ago. That trend is steady. Although again, we're talking big numbers. That's $800-ish billion, $700 billion to $800-ish billion. And so those changes occur fairly modestly over time, but I think it is steady.

J. Jeffrey Hopson - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then within those passive products, any change in asset class? Or any change in the velocity, I guess, of activity at all?

Walter W. Bettinger

I don't think we've seen a significant change. I mean, advisors have been -- maybe they've done, I'd say, a fairly good job of getting into the markets and staying in the markets. So their cash weightings tended to go down faster, and they've maybe caught a bit more of the upswing in the market. The only thing I'm hesitant a little bit in saying that is, we've continued to build out our cash solutions for our retail clients, like high-yield checking and things like that. And of course, we don't tend to enroll clients of advisors in that. And so even though retail cash weighting is higher than advisor, I don't know that it's necessarily because their investment cash is higher as opposed to we're just deeper into their cash wallet. But advisors, I think, if I were to look at it on average and over a longer period of time, have done a fairly effective job of ensuring their clients were fully invested and able to catch market upswings.

Operator

Your next question comes from Chris Harris.

Christopher Harris - Wells Fargo Securities, LLC, Research Division

I wanted to follow up on the index 401(k). It does sound like you guys are getting good traction there. I'm wondering, though, in your conversations with plan sponsors, what are you guys finding as the biggest objection to really wanting to take your -- with Schwab's plan? I mean, you guys in my mind have clearly a very compelling offering, and just wondering what it is that folks could possibly be objecting to if there is any objection at this point.

Walter W. Bettinger

I think, Chris, what we've seen is, it's not so much an objection. They're just -- it requires a bit of time to understand it because it is so different than what has been the "industry norm" for so long. So most people would say, target funds are better than just giving someone a lineup of 25 funds and saying make your own portfolio, right? I mean, that's probably a fair conclusion. But they're not near as attractive as if you can have customized advice for every person, takes into account not just age, but risk tolerance, outside assets, spouse or partner situation. All the information a client's willing to share can be built into it. It's just that those kind of things haven't been available at a reasonable enough price point to make them practical for broad swatches of the population in general. So I mean, that's an example. What we have found is that the sales cycle is longer than traditional marketing of these type of solutions because you are, in effect, educating an entire committee about something that is vastly different. But what we haven't seen is after they've gone through that education, people say, "Well, this doesn't make sense." What we've seen them say is, "Why wouldn't I do this? Lower risk for me as a fiduciary, lower cost for my participants who are self-directed, lower cost for my participants who want professional help and that professional help is more customized, why wouldn't I do this, what am I missing?"

Christopher Harris - Wells Fargo Securities, LLC, Research Division

Okay, yes, that makes sense. And then in IBS, I know it's still really early days for you guys, but do you have anything that you guys could share with us as to like how that offering is being accepted right now or how it's being received or maybe any kind of data in and around how those early branches have been performing?

Walter W. Bettinger

Well, we just have a very small sample set, right, because of where we've been opened. But I think the early sample set, without giving away too much metric because it'd be almost describing 1 or 2 branches, right? And that might be uncomfortable for our franchise partners there. So the early results are very strong results in a matter of months that may have been anticipated to take an entire year. So we're very encouraged with what is happening with the franchise we have out. Now again, in fairness, we are being very careful and selective as we put our pioneers into these positions. So we're not signing up people that we don't have great confidence will be quite successful. The Schwab model is very unique and different. When you speak to someone who may have been in the business for, say, 10 years and has built up, pick a number, $25 million in assets, it sounds on initial blush to them, how could I do $10 million of net new assets a year when I've taken 10 years to do $25 million? But of course, with our brand and our product set and solutions and our penetrations, that number is, we think, quite attainable, and I think the results will show that and are already showing that. But there is a process by which a candidate needs to realize that they're not playing the same game they were playing before. This is a whole new ball game when you're a franchise with Schwab.

Richard Fowler

Okay, I'm going to stop us there. We've gone a couple of minutes over, so probably from me talking too much at the beginning. So thanks, everybody, for your time today. We appreciate it. One quick administrative note. We still have an issue with e-mailing out of our server here, so we're going to post the slides on the IR side as quickly as possible for those of you who want them. So we'll get those up as quick as we can. That'd be the best place to get them within the next hour or so. So again, thanks for your time. We appreciate it. And we'll get together again in 3 months. Take care.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: The Charles Schwab's CEO Hosts Spring 2012 Schwab Business Update (Transcript)
This Transcript
All Transcripts