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From Joe Martinetto, Chief Financial Officer
Keeping Our Commitments in a Tough Environment
There’s no question that the big driver of our story for 2009 was the macro economic environment and its pervasive effects on our business. Let’s acknowledge last year’s apparent paradox right up front — in many ways, 2009 “felt” better than 2008, yet it ended up being much tougher on our financial performance. In my comments to you this year, I’d like to start by describing the forces that caused such a situation so that I can review our 2009 results in proper context, and then I’ll move on to discuss our financial picture as we enter 2010.
With the economy showing signs of improvement and the equity markets rebounding from their March 2009 lows, our clients saw the market value of their assets at Schwab rise by more than $260 billion in the last nine months of the year. In addition, as Walt mentioned, the strength of engagement measures such as phone calls, branch and Web site visits, and trading activity provided clear signs that investors continued to seek Schwab’s help in finding the right way forward in the midst of a shifting environment. Tough as that environment was, our net new assets were down from 2008 levels, but as Walt also mentioned, at $87.3 billion they were still far ahead of the pace reported by any other firm.
Coupling strong engagement with ongoing success in building our client base and attracting new assets helped drive substantial expansion of the company’s earnings power in several ways. For example, the dollar value of client assets held at Schwab in fee-generating mutual funds — including proprietary, Mutual Fund OneSource®, and Clearing balances — rose by $61.2 billion, or 15 percent, during 2009, even after a $38.5 billion decline in money fund positions. In addition, balances in ongoing advised relationships rose to $62 billion by year-end 2009, a 49 percent increase over 2008. And the company’s average balance of interest-earning assets, which are primarily funded by client cash inflows, rose by $14.8 billion, or 34 percent, between 2008 and 2009, reaching $58.6 billion last year.
That all certainly sounds like good news, and it is — Schwab’s growth is the envy of the industry. During 2009, however, the revenue generated by client assets was severely constrained by continued declines in short-term interest rates. How, one might reasonably ask, could rates keep falling even after the Fed Funds target was set at essentially zero at the end of 2008? In short, the Federal Reserve has been so successful at pumping liquidity into our financial system to support the economic recovery that borrowing rates have dropped to negligible levels even for terms of six months to a year.
Since our money funds by law must invest in relatively short-term assets, yields on a number of them dropped so low in 2009 that we were forced to waive more than $220 million of our management fees in order to pay even a nominal 1 basis point return to clients. These waivers outweighed the growth in fee-generating assets and resulted in a 20 percent year-over-year drop in asset management and administration fees.
Furthermore, we keep a large portion of our interest-earning assets in shorter term securities to help ensure we’re always ready to accommodate client cash needs. As the yield on those assets continued to decline during 2009 and we literally ran out of room to lower the rate paid on client cash, the resulting drop in our net interest margin overwhelmed the effect of balance sheet growth, and our net interest revenue declined by 28 percent. Finally, while client trading activity remained healthy in 2009, trading revenue declined by 8 percent as the market volatility and record-setting volumes of late 2008 eventually eased.
 All in all, revenues declined 19 percent in 2009. That’s basically what we expected in a flat Fed Funds environment, although we got there in a different way than we’d projected at the start of the year, with higher-than-expected balance sheet growth offsetting our lower-than-expected net interest margin. Knowing our revenues were likely to remain under pressure, we came into the year with a plan to reduce expenses by at least 7 percent, and we delivered on that commitment. A major part of that effort was a complex realignment of staffing and office space utilization across the country, which culminated in a 7 percent reduction in headcount, a 29 percent reduction of our square footage in relatively high-cost San Francisco, and the more efficient allocation of staff across other operating hubs in Phoenix, Denver, and Austin. That expense discipline, in turn, enabled us to deliver a pre-tax profit margin of 30.4 percent and a 17 percent return on equity for 2009; not records for us, certainly, but solid results and right in line with our expectations given the environment.
I’d like to say the hard work is done and all we have to do in 2010 is sit back and watch the client assets roll in and the revenue dollars pile up. Actually, we do believe that our revenue story is finally poised for improvement now that the economy seems to be solidly on a recovery track and interest rates can’t do much more harm. Even if the Fed Funds target is not raised from year-end 2009 levels, we currently believe that the sequential improvement in net interest revenue we achieved in the fourth quarter of 2009 will spread to our other major sources of revenue during the first half of this year, and that the company will achieve year-over-year revenue growth of at least 1 percent in 2010. To the extent the Fed Funds target is adjusted upward starting in the middle of the year and ends 2010 at 1 percent, we’d expect revenue growth to reach approximately 15 percent.
With revenues likely on the mend, the hard part is expense discipline. I’ve said this before and it bears repeating: Schwab is a growth company, managed by folks who come to work every day thinking about how to do a better job for clients, how to offer them better products, better service, and better value. We love our competitive strength, the world-class, seemingly inexorable asset gathering, but we’re always coming up with more ideas about how to enhance that momentum than we can effectively pursue with the managerial bandwidth and resources at hand. So, our ability to apply judgment — to prioritize our reinvestment in the company and work on the things that matter most to our clients — remains critical.
In 2010, we see an opportunity to push harder on projects that will benefit clients, as well as the need to spend a little more to accommodate the strong growth we’ve continued to achieve even as the financial and economic crisis of the last few years has played out. We therefore expect expenses to rise by at least 4 percent between 2009 and 2010. We also expect, however, that any upside to that increase will be linked to the higher level of revenue growth projected when interest rates begin to rise. If that happens, we’d expect to increase employee bonuses as appropriate while keeping other expenses at their planned levels. By staying disciplined, we believe we can continue to successfully balance investment for long-term growth with near-term profitability in 2010, which we’d translate into pre-tax profit margins of at least 25 percent and 35 percent, respectively, in our flat-rate and 1 percent Fed Funds rate scenarios.
We continue to focus on growth, knowing that the full earnings power associated with that growth will become clear as interest rates inevitably move toward more sustainable levels. We also continue to focus on the conservative financial management that our clients, stockholders, and employees expect from Schwab. I come to work every day knowing it’s my job to ensure the company is ready to support the growth that my colleagues are so busily generating, and to do so as a stable, enduring institution. We appreciate your ongoing support as we aim for sustained, profitable growth in 2010 and beyond.
Joe Martinetto
March 10, 2010
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