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If 2009 was the year the macro economic environment dominated our story, then I believe 2010 will be remembered for the way we took back control of that story as we rebuilt the company’s business momentum and financial performance.
In my last letter to you, I discussed how the aftermath of the recent financial crisis essentially overwhelmed the progress we’d been making in growing our business, leading to a substantial decline in revenues and profits during 2009.
We entered 2010 with the equity markets on the mend, but facing a still shaky economic recovery, an interest rate environment that had yet to find a bottom, and a lot of investor uncertainty. As a result, we began the year by posting our weakest first quarter net new assets since 2005 and our lowest quarterly revenues and operating earnings in four years.
When a company’s performance hits a low point, as ours did in late 2009 and early 2010, it’s natural to question whether it’s on the right path. Should expenses be cut further or client-related investments delayed? Can revenues be enhanced by taking the business in a different direction or by assuming new or additional risks? At Schwab, we’d been testing ourselves with those questions long before 2010 arrived, basically since the advent of the crisis in 2008. While we moved aggressively to reduce costs early in the economic cycle, the answer in 2010 was to stay the course.
Our clients have made it clear for some time that they want more from us, not less. Access to more investment products, more forms of help and advice, more value. They’ve also made it clear that they expect Schwab to remain a stable profitable financial institution with a healthy balance sheet. Additionally, and very importantly, by the time 2010 began we did not believe we were looking at a deteriorating environment — rather one that was likely to recover at an uncertain pace. Further, while short-term interest rates were still finding ways to creep downwards, we knew they literally couldn’t go much lower, and they were therefore at least heading toward stabilization even if they wouldn’t begin to rebound for some time.
With the environment’s grip on our attention and decision-making fading, our model remaining right on track, and no reason to take on more risk or cut investing in our clients, our main issue came down to the balancing act between the level of that investing for growth and near-term profitability. We felt the stabilizing environment would enable us to post at least some revenue improvement for the year and to begin demonstrating the enhanced earnings power arising from sustained growth in our client base. That growing earnings power would, in turn, enable us to nearly double our spending on client-related initiatives, as Walt mentioned in his letter, while remaining solidly profitable. To sum all this up, we believed that the turn was coming, that the moment had arrived to start putting the crisis and its impact behind us, and that our best path forward was the one we were already on.
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So in 2010 we acted to boost investment in our clients with the intent of driving increased business momentum. How well did that approach work for us? As it turns out, the economy did continue to improve during the year, however tentatively. In addition, while there were certainly periods of heightened volatility, the equity markets regained lost ground, and short-term rates did find a bottom. Walt has already summarized
the great progress we made with clients last year.
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From a financial perspective, we landed right where we expected to be given the environment — revenues were up 1 percent year-over-year — versus a 19 percent decline in 2009 — and expenses were up a bit more, before charges. That revenue improvement is particularly significant because it was achieved even as low interest rates forced us to absorb a total of $433 million in fee waivers on our proprietary money market mutual funds — an increase of more than $200 million from 2009. And with fourth quarter 2010 revenues up 6 percent sequentially and 14 percent year-over-year, we’re beginning 2011 with gathering financial as well as operating momentum.
Before I move on to discussing the road ahead, I should cover several other important points about 2010. First, we raised over $500 million in capital early in the year via our first equity offering since going public in 1987. Our decision to proceed with the offering reflects the conservative approach we take with the company’s financial management — we wanted to ensure that the firm’s capital base would be able to comfortably support sustained growth in client balances during the year even if earnings remained constrained by the environment. As environmental headwinds ease and our profitability strengthens, we’d expect that ongoing growth will be primarily supported by capital generated by earnings.
Another important point about 2010 concerns the charges Walt mentioned, which totaled $321 million after tax. As fellow stockholders, everyone here is acutely aware where that money came from and what it represents in terms of lost opportunity for clients, employees, and owners. The good news is that we were able to settle these matters without harming the company’s financial strength or disrupting our progress in investing for growth. We remain committed to maintaining a healthy balance sheet capable of absorbing significant jolts without impeding the company’s ability to serve clients or operate as it chooses.
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Now to the year ahead — with the outlook improving, we see an opportunity to ramp up our push for long-term growth in advance of a full-blown economic recovery. We currently expect to grow expenses by 8 percent in 2011 relative to the 2010 total excluding YieldPlus and money market fund related charges — about half of that increase is tied to spending on client-related initiatives, including the addition of Windhaven’s operating expenses to our base; the remainder reflects normal growth in core costs as our business expands.
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To the extent that equity market appreciation reaches the mid-single digits and client trading activity picks up modestly as well, we believe that revenue growth could reach 10 percent this year even if the Fed Funds target remains unchanged. With that target still set at 0 to 25 basis points, our “coiled spring” remains very much in effect. For example, a 100 basis point increase in the target during 2011 could lift revenue growth to 25 percent, with only a modest 2 percent incremental impact on expenses.
We managed through the turn in 2010 by sticking to our fundamental management principles — staying focused on clients, limiting risk, and taking a long-term view — and by staying the course on our strategy. We are now leaving behind the story of maneuvering through the financial crisis, and beginning to write our next chapter — the story of driving increased investment in our clients ahead of any improvement in interest rates, and the resulting benefits to the long-term growth of our business. We’re excited about the possibilities, and we hope you are too. We intend to remain worthy of your support as we continue to pursue profitable growth in 2011 and beyond.
Joe Martinetto
March 12, 2011
* Amounts are presented on a continuing operations basis to exclude the impact of the sale of U.S. Trust Corporation, which was completed on July 1, 2007.
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