SWS Group Inc. F4Q09 (Qtr End 06/26/09) Earnings Call Transcript

Aug.27.09 | About: SWS Group, (SWS)

SWS Group Inc. (NYSE:SWS)

F4Q09 (Qtr End 06/26/09) Earnings Call

August 27, 2009 10:00 am ET


Meg Gupton - Corporate Communications

Don Hultgren - CEO

Ken Hanks - CFO

John Holt - President and CEO of SWS Securities, FSB

Jim Ross - President and CEO of Southwest Securities and SWS Financial


Joel Jeffrey - Keefe, Bruyette & Woods

Hugh Miller - Sidoti & Co.

Edward Hemmelgarn - Shaker Investments

Charles Glovsky - Independence Investment

Steven Fu - Fox-Pitt Kelton

Meg Gupton

Good morning and welcome to the SWS Group's quarterly conference call and webcast. This is Meg Gupton of the SWS Corporate Communications Staff. We are pleased you could join us today.

The quarterly earnings press release can be found on our site at swsgroupinc.com or on the Yahoo! Finance website under SWS News. Market professionals on our distribution list should also have received slides for today's call via e-mail. If you would like to be added to our e-mail list to receive press releases or to be notified of future quarterly calls, please contact us at 214-859-6351.

This conference call is being webcast live on the Internet along with the accompanying slides at swsgroupinc.com. It will be archived for the next 30 days. During the question-and-answer session, call participants can access the queue to ask questions by pressing star 1 on their telephone. Those participating via the Internet can ask questions from the link provided on the webcast page or by e-mailing them to questions@swst.com.

This presentation contains forward-looking statements. You are cautioned that any forward-looking statements, including those predicting or forecasting future events or results, which depend on future events for their accuracy, embody projections or assumptions, or express the intent, belief or current expectations of the company or management, are not guarantees of future performance and involve risks and uncertainties.

Actual results may differ materially as a result of various factors, some of which are out of our control, including, but not limited to, volume of trading in securities, volatility of securities prices and interest rates, availability of lines of credit, customer margin loan activity, creditworthiness of our correspondents and customers, demand for housing, and other factors discussed in our annual report on Form 10-K and in our other reports filed with and available from the Securities and Exchange Commission.

This conference also contains references to non-GAAP financial information, which is being presented, to provide additional information regarding the company's operations and should not be used in place of GAAP measures. The company's press release and today's slides include reconciliations of these non-GAAP measures with the company's GAAP results.

At this point, it is a pleasure to introduce Mr. Don Hultgren, Chief Executive Officer of SWS.

Don Hultgren

Thank you, Meg. Good morning, everyone. Thank you for joining us for a discussion of our fourth quarter as well as our fiscal year for 2009.

I'd like to kick off by introducing those who are here with me today to participate on the call. That would include Ken Hanks, who is the Chief Financial Officer of SWS Group; John Holt, who is the President and Chief Executive Officer of our bank, SWS Securities, FSB; and Jim Ross, who is the President and Chief Executive Officer of Southwest Securities and SWS Financial.

Our agenda for today is as follows: I will provide an overview of the fourth quarter and fiscal 2009. I will review some noteworthy items and touch on some important events since our last conference call. Ken Hanks will provide a more detailed review of the fourth quarter. John will provide an update on activities at the bank. Then I will discuss our market position and our three primary growth initiatives. Finally, we will open it up for questions.

As Meg said, if you have a question and you are on the phone, you can dial star one and you will join us for the queue, or if you would like to submit a question by e-mail, you can do that at questions@swst.com.

Let me start with the fourth quarter overview.

Revenues in the quarter decreased from $128 million in last year's fourth quarter to $122 million this quarter. Net income decreased from $8.4 million in last year's fourth quarter to $3.6 million in this year's fourth quarter. Earnings per share in the fourth quarter decreased from $0.31 last year to $0.13 this year. We ended the quarter with a book value of $12.48. For the full fiscal year, revenue was $486 million, up from $478 million last year.

Income from continuing operations was $24 million, down from $32 million last year. Diluted earnings per share from continuing operations were $0.87, compared to $1.13 last year. We also recorded an extraordinary gain last year related to our purchase of M.L. Stern that brought total earnings per share to $1.17 last year.

For this quarter year, we are providing a non-GAAP reconciliation that shows operating results adjusted for our previously announced other than temporary impairment charge that was required by accounting rules. The charge relates to the decline in two common stocks that we hold as investments; NYSE Euronext, which has the symbol of NYX and U.S. Home Systems, which has a symbol of USHS.

Their depressed values have been designated other than temporary impairments and accounting rules require that we take a charge in the quarter ending June 26, 2009. This slide shows the impact of this charge on the full year in the fourth quarter is $0.12 per share. Without this charge, our full year earnings per share would have been $0.99 and our fourth quarter earnings per share would have been $0.25.

Moving on to noteworthy items; we try each quarter to point out items that we believe were important to the quarter. As we just discussed in the previous slide, the impact of the impairment charge for marketable securities was $5 million pre-tax or $0.12 per share after-tax. The adjustment had no impact on book value as these securities were being reported at market value with the adjustment being run through the equity section as other comprehensive income or loss.

As we discussed before, these securities were acquired through various transactions and are not part of our core business operation. During the quarter, we continued to enjoy strong activity in our retail recruiting, very similar to what you are seeing in other regional firms. We ended the year with 230 advisors in our PCG group, well up from the 207 advisors at the start of the year. We transferred an additional $10 million in capital to the bank in the fourth quarter.

As we discussed in the last quarter, we intend to maintain the Bank's capital at the well-capitalized level and we also want to be able to take advantage of the growth opportunities that we see in the market. We made great progress on the M.L. Stern integration during the quarter. We have substantially completed the staff integration, completed the withdrawal of Tower as investment manager and are now looking at opportunities to enhance our recruiting on the West Coast.

Important events; in each quarter, we also like to highlight items that have developed since our last conference call. After the end of fiscal 2009, we experienced and announced a loss related to the proprietary trading of the corresponding customer. This loss will impact our clearing segment results in the first quarter of fiscal 2010 and is estimated to be $6.3 million pre-tax charge.

The details of the loss are as follows: The new correspondent that was set up to trade directly on a guaranteed basis with the NASDAQ Exchange shorted past the preset limits for his broker dealer. The alerts sent to us by the monitoring system could have protected us against such a loss if they had been acted on promptly. Unfortunately, there was a delay in the communication of the alert within our organization and a misunderstanding on how to cease trading during a trading session.

The result was the correspondent trade until the end of the trading session while ignoring our repeated attempts to contact. At the end of the session, the correspondent was short 2.3 million shares of a stock. The loss resulted in the next morning when the stock gapped up $4.84 on the open. Our trading department then handled the buy-in of the short in an orderly fashion.

The loss that we announced is net of a substantial cash deposit that was in our possession. We are completing an internal investigation related to this, and to-date, have changed our notification procedures and clarified with all responsible personnel the procedure for terminating a correspondent's trading rights on an exchange during a trading session. We believe our new practices will prevent an issue of this nature happening in the future.

On a positive note, we are beginning to remodel several West Coast offices to allow for continued expansion of our retail group. We believe that the current recruiting environment will continue to provide us with good opportunities to recruit and expand on the West Coast. We have also accepted an invitation to present at the Bank of America-Merrill Lynch small and mid-cap conference coming up in Boston on September 21. We are excited about our story and we are looking forward to the additional exposure that this conference would give us to the institutional community.

Now, let me turn it over to Ken for additional detail. Ken?

Ken Hanks

Today, I would like to spend a few moments discussing fiscal year and quarterly financial results on a summary basis, then move on to a more detailed discussion of our operating result and conclude by discussing our segment results.

For the fourth quarter, net revenue, that is operating revenue plus interest revenues less interest expense, was $99 million, up $11.2 million or 13% while pre-tax income was down 54% to $5.3 million. The impairment charge on NYX and U.S. Home Systems discussed earlier accounted for most of the fourth quarter earnings change. Net revenues were up by $80 million or 27% for the year while pre-tax earnings were down $10.7 million or 22%.

On an overall basis, while we are never happy with declining earnings, two large unusual charges impacted our 2009 fiscal year. First, was the first quarter $5.4 million charge related to the Lehman bankruptcy, and second is the $5 million impairment charge recorded at the end of the fiscal year.

Without these two items, pre-tax profits would have been in line with last year, an amazing accomplishment given the environment over the past year. While we recorded a healthy increase in net revenue, the $91 million increase in our operating expenses outpaced the revenue increase. There are a few major items contributing to these results.

First of all, M.L. Stern revenues are included in our numbers for the full fiscal year while they were only in fourth quarter numbers in 2008. Stern recorded net revenue of $47.2 million and expenses of $45.2 million for a pre-tax profit of $2 million. Last year's results included net revenues of $12.1 million, expenses of $11.1 million and profits of $1 million. Therefore, $34.1 million of the operating expense increase is related to full year operations of Stern.

Robust fixed income revenues were the other major factor in both revenue and operating expense increase. Taxable fixed income commission revenue was up $43.8 million versus last year, as volatility and lack of liquidity increased spread, which led to great opportunities for this business unit. Related fixed income commission expense was up $29.2 million for the year.

Other expense increases included the $5 million impairment charge, the $5.4 million write-off related to the Lehman Bros. bankruptcy that we incurred in the first quarter, increased provision for loan losses at the Bank of $9.8 million, as well as increased REO and other expenses at the Bank of $4 million.

I am now going to turn to a review of the individual operating revenue items. Net revenues from clearing were down 17% for the quarter. In the quarter, we processed 800,000 trades, down from 7.4 million in the same quarter a year ago, but up from the 700,000 processed in the third quarter.

Substantially, reduced volume from one of our bank trading correspondents, coupled with the loss of another day trader early in the year, led to the decline in tickets. Clearing revenue was up 15% from the third quarter, as revenue from new correspondents began to pick up.

Revenue per ticket in the June 2009 quarter was $3.54 versus $0.45 per ticket in the same quarter last year. This change is primarily attributed to the reduced volume from day trader in the current quarter over last year. For the full year, clearing revenue was down $2.4 million. We processed 9.4 million tickets in fiscal 2009, versus 31.6 million in fiscal 2008.

Commissions were up $7.8 million or 22% in the quarter. Taxable fixed income, and, to a lesser extent, municipal fixed income commissions were up during the quarter exceeding the decline in Private Client Group commissions.

For the full year commission revenue was up $67.6 million. Just over a third of the increase, $25.6 million was from Stern. The taxable fixed income department recorded its best year ever with an increase in commissions of $43.8 million. Municipal finance also posted an increase of $5.8 million.

Our retail businesses on the other hand were down $4.7 million due to a pessimistic outlook on the part of the retail investors, not surprising given the challenging economic environment throughout fiscal 2009.

Portfolio trading had a down year primarily because the UIT market has been out of favor in the last few months and the primary clients of portfolio trades are the unit trust complexes.

Investment banking and advisory fees were down 22% in the quarter with substantially all of the declines in the corporate finance area. Public finance rebounded from the sluggish third quarter to finish the fourth quarter about even with the fourth quarter of 2008. For the full fiscal year, investment banking and advisory fees were down slightly about 3%. Revenue in the Tower subsidiary helped offset reduced revenues from the challenging corporate finance environment and a sluggish new issue market for municipal finance.

Net gains on principal transactions, which are derived principally from trading in fixed income securities, were up $10 million in the fourth quarter, as compared to the fourth quarter of last year, again driven by our fixed income business. The great results from our fixed income businesses extended to the full fiscal year were net gains on principal transactions increased $26.2 million over fiscal 2008.

Other revenue in the fourth quarter was flat with last year's fourth quarter. For the year, other revenue was down $12.6 million due to declines in the value of our venture capital investment and deferred comp plan investment as well as reduced revenue from insurance products, losses on REO properties and reduced fee income.

Net interest revenue, which is interest revenue less interest expense, of $25.4 million was down 11.8% from last year's quarter. The Bank's net interest was up 41% while net interest at the brokerage was down 58%. The decrease in brokerage net interest was evident in both the securities lending business where our securities lending area saw spreads decrease by 47 basis points to 83 basis points while balances declined 36% over last year and in customer interest where reduced margin balances and reduced spread earned on credit balances impacted our net interest earnings.

Net interest at the bank was up 41% due to higher average loan balances as well as the imposition of floors at the time of loan renewal. For the year net interest was up $2.3 million or 2%. Again the Bank was responsible for the growth in net interest as it was able to increase the spread on its loans as interest rates began to stabilize. It also continued to grow the loan book with average loan balances up 26% over last year.

On the brokerage side, the persistent low interest rate environment continually impacts the spread we earn on the stock loan book and on our customer margin and cash balances.

Average margin balances in the customer side of the brokerage business of $133 million are down 18% from the previous quarter and down 50% from the same quarter last year.

Credit balances are up slightly from March, but are down 28% from last year. Stock loan balances are down for both comparative periods. The Bank's average loan balance was up 2% over the March quarter and up 17% over the prior year. The commercial real estate portfolio continues to grow and the purchased mortgage program continues to benefit from the attractive mortgage interest environment.

Now, I am going to turn to operating expenses. Operating expenses were up $17.3 million from the prior year's quarter. Commissions associated primarily with fixed income areas accounted for $7.5 million of the increase. Appreciation and deferred compensation plan assets added $2.3 million to our compensation expense and recruiting expenses were also higher. The $10.4 million increase in other expense was the other main driver of increased expenses. The provision for loan losses accounted for $3.7 million of this increase as we recorded $4.9 million versus a $1.1 million provision in the last June quarter.

The loan loss provision totaled 14.7 at the end of the quarter which is 1.28% of total loans. Other expenses is also where we recorded the other than temporary impairment on our NYX and U.S. Home Systems stock of $5 million.

Lastly, the Bank's FDIC special assessment and increased legal fees caused the rest of the change. For the full fiscal year, operating expenses were up $90.7 million with compensation expense contributing $55.2 million of the total increase. Of this, M.L. Stern contributed $24.2 million while variable commission expense in the fixed income businesses accounted for substantially all of the rest.

Occupancy and equipment expense was up $5.9 million due primarily to the acquisition of Stern. Other expense was up significantly to $24.6 million again due to increased loan loss provision at the Bank of $9.8 million, the other than temporary impairment of securities, the first quarter $5.4 million write-off of a receivable from Lehman, and $4 million in FDIC total assessments and REO expenses at the bank and $1.6 million in increased legal fees.

This slide presents operating results by segment for the fourth quarter. Our first segment is clearing. The business encompasses our share of all the fee revenue collected from our correspondent or their customer, as well as the net interest earned on correspondent and correspondent customer accounts. For the fourth quarter, this segment earned $1 million, down from $1.4 million last year.

Clearing fees were down $550,000 from last year and compressed interest spreads continue to produce reduced interest in this segment. Expenses were down as well, which offset some of the impact of the reduced revenue.

The retail segment encompasses our Private Client Group as well as our independent contractor brokers that are housed in SWS Financial Services along with our M.L. Stern business. This segment also includes the product lines that directly support these sales forces.

The retail segment posted a 12% decline in revenue and a pre-tax loss of $1.5 million. The economic environment had a direct impact on revenues in this segment while the interest rate environment has depressed spreads on balance. We have continued to recruit and selectively expand our retail location, which has increased fixed expenses over last year's fourth quarter. We are investing in this business and we have had an exciting recruiting environment with substantial opportunity.

The institutional segment consists of our brokerage businesses that service institutional customers. These include fixed income sales and trading, public finance, corporate finance, equity and portfolio trading as well as stock loans. Pre-tax for this segment was up 17% as taxable fixed income closed out the year very strong. The municipal area posted fourth quarter results down from last year, but up from the sequential quarter.

The interest rate environment and declining balances resulted in a 56% decline in stock loans pre-tax profits. Spreads were down 47 basis points from the June quarter of last year. The equity trading side of the institutional business was up 40% over last year while the corporate finance area continued to suffer in the current environment.

The banking segment produced an increase in net revenue of 36% while pre-tax profits were up 26%. This is good news in a quarter where the loan loss provision was almost $4.9 million.

John Holt, the CEO will provide additional color on the banking environment a little later in the call.

The other segment includes corporate investment as well as the unallocated corporate administration costs. This is where we recorded the other than temporary impairment charge on our investment, the results of our venture capital investment as well as the administrative cost of accounting, legal and other corporate shared programs.

We present fiscal year segment results on this slide. For the full year, clearing posted a 28% decrease in net revenue but a 55% decrease from pre-tax income. Fee revenue was down about 17% over last year primarily due to reduced fees from two day trading accounts. Net interest revenue was off by 56% as the continued loan low rate environment negatively impacted spreads in the business. We reduced expenses in this segment by over $4 million primarily in compensation and allocated technology expenses.

The retail segment revenues were up 24% over last year. The acquisition of M.L. Stern accounted for most of the changes in this segment. Overall, M.L. Stern contributed net revenue of $47.2 million, operating expenses of $45.2 million and pre-tax of $2 million. Last year when we owned M.L. Stern for the fourth quarter only, Stern produced revenues of $12.1 million, operating expenses of $11.1 million and pre-tax profits of $1 million.

Our existing retail business showed the effects of the recession by posting revenue down 16%. Commissions and fees from insurance products as well as net interest income all showed a decline. Full year results for the institutional segment flowed similar to fourth quarter results with revenue up 50% and pre-tax income up 41%. Taxable fixed income posted revenues up over 160% while pre-tax income was up 390%.

The municipal trading area also posted a 111% improvement over last year while the banking businesses, both corporate and public suffered in the challenging environment. Public finance pre-tax was down 68% while corporate finance finished the year down to $1.5 million loss. The portfolio trading business was about even with last year. Stock owned spreads were 23 basis points higher for the year, but reduced balances in the unit led to a 30% decline in pre-tax income.

Lastly, I would like to discuss a few operating statistics for the quarter. Tickets processed increased 89% from last year's quarter while increasing 14% over March. Our Private Client Group reps are up significantly only last year. The total employee headcount is down slightly from last year to 1,107.

I would now like to turn it over to John Holt, CEO of Southwest Securities, FSB, our bank subsidiary.

John Holt

Thanks, Ken. Good morning. I would like to update our listeners on the Bank's earnings for the quarter as well as provide insight into credit quality, commercial banking and mortgage purchase.

The banking segment reported pre-tax income for the quarter of $4.7 million, which was primarily driven by an improvement from the third quarter of fiscal 2009 and the average net interest margin of 38 basis points to north of 5%, a gain on investment of $1.2 million and another quarter of strong funding volume of $2.3 billion in our mortgage purchase area.

During the quarter, the Bank fully accrued $700,000 related to the FDIC special assessment and we anticipate additional assessments to be imposed from the banking industry going forward.

A $1.2 million gain on investment was related to a $2.4 million investment in a Dallas-based private equity fund, which generates investment credit to help satisfy the Bank's Community Reinvestment Act requirements.

The gains were the result of a fund changing its recording of financial results from a tax basis to a GAAP basis. Loan growth of 2% for the quarter was moderated and concentrated in our newer market areas, as our commercial bankers bring over their best customers to new commercial relationships.

Additionally, during the quarter, the Bank received $10 million in capital and ended with a 12.1% risk-based capital ratio. Deposit growth outpaced loan growth as we replaced short-term borrowings with our lower cost deposits, which are primarily provided by our brokerage customers. These deposits account for nearly 85% of the Bank's total deposits and are a very efficient and stable source of funding.

Non-performing assets decreased slightly and stand at 3.6% of total assets, down from 3.9% for the linked quarter. Of note, since the Bank does not have a large investment portfolio or fixed asset, our NPA ratio is more analogous representing non-performing assets as a percentage of total loans.

Non-performing assets are heavily concentrated in land development, interim construction, residential and commercial real estate. We expect these levels to remain elevated, however anticipate fluctuations in commercial real estate to be larger due to the FAS spread. REO represents over 25 million of our non-performing assets

REO represents over $25 million of our non-performing assets and is balanced between lot and land development, residential interim construction and commercial real estate. However, our residential interim construction REO has worked itself down on a year-over-year basis as we have been successful in selling the single-family homes that are located primarily in the North Texas area.

As the larger commercial real estate and lot and land development non-performing assets move into REO, we anticipate longer marketing periods, and thus, these balances to remain elevated. We are actively marketing our properties and closed approximately $6.3 million during the quarter, and have experienced continued interest in our real assets.

The provision for loan losses remained elevated at $4.9 million while net charge-offs decreased to $1.3 million, resulting in an increase to the allowance for 1.3% of loans held for investment. We anticipate losses in provision expense to remain at current levels for the next few quarters, as we continue to grow the allowance in concert with loan growth, take into consideration deterioration in the commercial banking loan portfolio and in accordance with our underlying allowance methodology.

The expansion of our net interest margin was driven by a meaningful reduction in the cost of funds coupled with an increase in the gross yield as we work to [set those] on new and existing commercial loans and mortgage purchase customers. The 5.17% average net interest margin really exhibits the core earnings power of the broker bank model, and I'm encouraged as we continue to grow out the loan portfolios in the new areas of commercial banking.

Our core earnings remain strong as we continue to actively work through our troubled credits. We remain focused on pursuing a controlled growth strategy and building out our commercial banking franchise across Texas and the Southwest.

With that, I'll turn it back over to Don.

Don Hultgren

Thank you, John. As a reminder, if you have questions and you are on the phone, you can dial star one to get in the queue, or if you would like to e-mail us the question, it's questions@swst.com. I thought being that we were wrapping up the fiscal year, it would be a good idea to show some of the highlights of things that we are particularly proud of, especially given the market environment that we were in over the past year.

We opened five banking centers this year. We went into the year with nine centers. We came out of the year with 14. This is allowing us to take advantage of opportunities to hire experienced bankers and grow our loan book. We open two Private Client Group offices this year as well, and we hired a net 27 new advisors in Private Client Group during the fiscal year.

As we mentioned, we posted a record year in taxable fixed income as that department was able to take advantage of opportunities presented in these unusual market times. It was all in all a good year for SWS Group.

I would like to recap our market position. We are the largest full service brokerage firm headquartered in the Southwest. We are the fourth largest bank headquartered in Dallas. We are one of the largest clearing firms in the United States based on our number of clients.

Now, turning to our map, I'd like to show you that this is the target market for our bank and for our Private Client Group. This is important because we believe that we are building a very valuable franchise in these blue states. There is very limited competition from regional brokerage firms in this region of the country. At the same time, as we have discussed with you before, we are sweeping substantial amount of the cash balances from the brokerage firm to the bank where today they represent over 80% of the deposits at the bank.

Another important distinction to our broker bank model is that virtually all of the $1.4 billion in loans that were made by the Bank were underwritten by our own bankers and approved by our own committees, so that we have actually established additional relationships through the banking side, so that we have in this target market both a relationship driven brokerage firm and a relationship driven bank.

We believe we are building a very valuable franchise. Reviewing who we are, we are growing broker bank, and by that I mean our brokerage customers are providing the funds for our lending. That's very different from banks that are trying to achieve synergies by cross-selling. The synergies for our broker bank come from following the cash balances that allow us to better build our banking segment.

So we again are building that franchise, and, at the same time, we are continuing to try to take advantage of the operating leverage that we have within our organization. We own our own operating system and the more business we can put through that, the better our earnings and margins will be. We are a fixed cost operation, so as you look at our lines of business, retail brokerage, institutional brokerage, and clearing, all send business to that same system and all serve to enhance our operating leverage. This is a time of great opportunity for SWS Group.

In recent years we have succeeded in focusing the firm on those business areas where we have the ability to capture market share. We have brought in professionals with fresh ideas and energy to help us grow our bank and broker dealer, and our balance sheet remains strong. We are well positioned at a time in our industry when others are struggling.

Today, there are many talented professionals available to join our team. I believe these conditions mean that in the quarters ahead we should be able to continue to expand our core businesses. Hopefully, the credit markets will loosen and provide greater access to capital so that we can take full advantage of this opportunity, but we continue to see financial reps available in the Private Client Group area, we continue to see them in the institutional area and we continue to see great experienced bankers available for our bank. I look forward in the months ahead to be able to talk with you about capitalizing on these great opportunities.

In closing, these are exciting times for SWS Group and we are a financially strong firm facing unusually good opportunities in a tough market. I want to thank our employees who go above and beyond the call of duty every day. SWS Group has great employees and I am proud to be on their team. I want to thank our customers, you are the reason we are here and we strive to earn your business every day. I want to thank our shareholders who have demonstrated their confidence in our strategy.

With that, thank you all for participating on the call. Now, I would like to open it up for questions. Again, if you have the question on the phone, it's star one, or if you would like to submit a question online, it's questions@swst.com.

Question-and-Answer Session


Our first question comes from Joel Jeffrey. You may ask your question.

Joel Jeffrey - Keefe, Bruyette & Woods

Just a question. On the PCS business, you guys have lost money there in the last two quarters. I mean, is this basically tied to the M.L. Stern integration or is this something we should sort of expect going forward as you guys continue to build out the business?

Don Hultgren

I think it is a combination of a lot of things, Joel. Certainly as we continue to build out the business, there are costs associated with bringing the brokers on board. In terms of compensation, there are costs that are part of opening new branch offices. It is also a combination of a pretty tough retail market right now. I don't think we have seen the confidence come back to this market.

So I think if what we are hearing from all the economists that perhaps we are at the nadir here of the recession that we may begin to see more activity and we maybe seeing more activity on margin.

So essentially what we are doing is we are buying straw hats in the wintertime. The producers that we are bringing on board are not currently producing at their historic levels. So I think what we are doing is very much loading our gun and we are going to be ready when the time comes. It is very similar to what we did in the fixed income department. We almost tripled the size of the fixed income department when the yield curve was inverted.

Joel Jeffrey - Keefe, Bruyette & Woods

Then, looking at the bank, your total capital ratios now look like they are around 12%. I mean, you appear to be pretty well capitalized. Is this based on expectations for significant growth in the loan portfolio or are you building up in case of substantial deterioration or a combination of that?

John Holt

The answer would be it would be a combination. I think with the current regulatory environment that we are in that capital is king and making sure that we are not too close to the well-capitalized position and we have some cushion as part of it, but we also have enough capital in there for growth when we see opportunities to expand the loan book.

Joel Jeffrey - Keefe, Bruyette & Woods

I know you down streamed another $10 million down, how much of excess capital is there available at the broker currently?

Don Hultgren

Right now, our excess net capital is about $112 million.

Joel Jeffrey - Keefe, Bruyette & Woods

Are you still sticking to that $100 million buffer on the institutional side for stock loan business or is that a little bit more flexible these days?

Don Hultgren

We are still above that. We're still trying to manage to that, but if there are opportunities at the bank we may test that. Right now, it doesn't look like we are going to have to do that. So we still operate trying to keep the excess above $100 million.

Joel Jeffrey - Keefe, Bruyette & Woods

Just lastly, the $3.2 million in the gains you had on investments and marketable securities, can you just give us a little more color on that? Is that all tied to the bank's investment or was there something else in there?

Don Hultgren

The $3.2 million?

Joel Jeffrey - Keefe, Bruyette & Woods

Yes. Looking at the non-GAAP reconciliation page on the slide deck on page 10.

Ken Hanks

That is the impairment charge for NYX and U.S. Home Systems.

Don Hultgren

So it's not a gain, Joel.

Joel Jeffrey - Keefe, Bruyette & Woods

Okay, sorry, I was reading it incorrectly.

John Holt

Joel, I would like to draw your attention to one other thing on the Private Client Group question you had earlier. If you go back through the segment results there for the year and also my comments that I made, you will discover that the total revenue for Private Client Group, if you took the $114 million and took out the $47 million that was M.L. Stern for the year, our total Private Client Group had $67 million, I mean our total retail had $67 million in revenues.

If you did that same type of calculation for last year, you took the $92 million in revenues and reduced it by the $12 million in Stern revenue that were just in the fourth quarter you will have $80 million. So retail revenues were down $13 million for the year and it's based on the environment and that's what ended up producing the losses that we had in the last quarter.

Don Hultgren

So what you are saying is we increased by 20?

John Holt

Even though we have increased the reps by 28 people, 27, total revenues were down. The retail investor is not out there walking into the office every day.


Our next question comes from Hugh Miller.

Hugh Miller - Sidoti & Co.

I had a couple of questions. First of all, I guess in looking at some of the progress you did make on the PCG side, I think you added about 23 reps during the year, had roughly about a reduction of 10 independent reps during the year. As we look out on the recruiting environment and what you guys are seeing, what's a realistic expectation for us with regards to the headcount expansion next year? I mean is it on par, is it higher, is it lower? Thoughts there.

Don Hultgren

Jim Ross a long time ago taught me not to focus on headcount. Said, he could give me as many heads as I wanted. So we are really focusing on the quality of the producers. We are trying to find producers today that come to us with trailing 12 production, that's north of $300,000. We are seeing a substantial number of those types of people out there, Hugh.

I would actually tell you it's a question of growing responsibly, because there is so much opportunity out there, I think that frankly you saw us for quite a few years where we didn't have substantial growth. I think that fiscal 2010 you are probably going to see us have again double-digit growth in terms of the number of reps that we are going to add. There is still a lot of opportunity for us. It's a buyer's market.

Hugh Miller - Sidoti & Co.

I guess, is there any comments you can then make on that with regards to the independent channel and the difference there in what you are seeing?

Don Hultgren

I think you're going to see that to grow. We were sort of in the process of calling out some of the smaller producers. I guess, we have got Jim Ross sitting here and I might let him answer his own question.

Jim Ross

Don, you do it so well. The independent channel, if you look at this market environment, the smaller independent contractor producer, they are just kind of giving it up right now. Quite honestly, it is extremely challenging for somebody, that's a smaller producer regardless of the support system, regardless of payout to make this their full focus of their career. So we are seeing an awful lot of that low end independent contractor just decides that they are going to do something else with their career.

At the same time, we are doing great job recruiting and bringing on more independent contractor oriented brokers, we're bringing on people with a much higher trailing 12 that's off from their historic trailing 12, now they're coming in. This environment is one that you have to be very patient along way because when a financial advisor joins us, if the employee networks and/or joins us in an independent contractor network, in either case no matter how strong their relationships are that client is in no hurry to make acquisitions to start trading, the clients are all pretty much sitting on the sideline right now.

Hugh Miller - Sidoti & Co.

Maybe a question for John here. It looks like obviously the non-performing assets on a sequential basis were down a little bit with actually a movement up in the REO property. The REO property, that's not included in your NPA statistic, correct?

John Holt

It is included.

Hugh Miller - Sidoti & Co.

Okay, it is included. Can you give us a thought or comment on the appraisal values you guys were getting in on the REO property relative to I guess what you had them on the books for?

John Holt

Yes, we don't do a separate analysis of that as it comes in. However, we do write it down to the value when it's taken back and repossessed. So, I guess anecdotally I'd say that it isn't taking the hits that some of the other parts of the country as because it's primarily located in the North Texas market.

Hugh Miller - Sidoti & Co.

Okay, so when you actually go through the REO process you don't get a new updated appraisal value?

John Holt

We do. That's why I was saying, but when it comes in, we absolutely get a new appraisal and bring it into REO at the appraised value and take the appropriate write down. Having said that in the current environment, the appraisers have gotten awfully aggressive and so maybe as they were a little high in the past maybe they're a little low today.

Hugh Miller - Sidoti & Co.

Just the last question for you, John, with regards to the commercial real estate portfolio and the expansion that you did during the quarter. Obviously, we're seeing a lot of other people that are shying away from that area just given some of the risks on the horizon. Can you just talk about I guess the risks you do see there, some of the rewards and the strategy on a go-forward basis with that?

John Holt

Obviously in our market there are two very large financial institutions that failed recently. Those particular borrowers that are at those particular institutions in the Texas market has some good portfolio type clients that we were able to bring over. I guess a couple of things that I would say is there is a lot more stringent underwriting done and we're able to get better loan to values, more cash into the transactions and certainly better pricing as that's been the impact on our net interest margin.

Hugh Miller - Sidoti & Co.

So it certainly seems as though it's more opportunistic in nature and not necessarily that your view of the commercial real estate market has changed materially?

John Holt

That is correct.


Our next question comes from Edward Hemmelgarn.

Edward Hemmelgarn - Shaker Investments

Just a couple of questions. Can you just talk again, what was the nature or how did you acquire these investments in the NYX and USHS?

Don Hultgren

The NYX was as a result of ownership that we had in Archipelago. We had gotten that ownership many years ago when we helped them, when they were just getting up and running. They gave us that in appreciation for the help we gave to them. In the US Home Systems, we've sold them a consumer finance business from our bank and took stock as a result of that. So, yes, well that's right. Ken has given me the sign. Archipelago eventually got turned into; you know we also had our seat on the exchange, which also all ended up being part of the NYX.

Ken Hanks

Ed, this is Ken. The seat conversion back in '05 or '04 I think it was, was about 80,000 of the shares that we have at NYX, the rest was a result of compensation we received for a loan we had it made when Archipelago was originally being formed, when it was first made an ECN. They cleared here and we gave them assistance and that's the other 26,000 odd shares.

Edward Hemmelgarn - Shaker Investments

How long have you had the USHS loan part of the investment?

Ken Hanks

About two years after we purchased the bank they had a subsidiary that did home improvement loans, mainly deck that was somewhat nationwide. We sold that business to US Home Systems that year. We took actually a large gain because we got a lot of the purchase price was cash and then part of it was stock, the commissions of stock that was (inaudible).

Edward Hemmelgarn - Shaker Investments

How was the decision or where is the decision made to continue to hold on to these equity investments? What process do you follow to try to decide whether you're going to hold on to something like this or you're going to sell it? Because I mean obviously by holding on to it you've decided this is part of your ongoing business, and so I'm just wondering where it's at and who's making these decisions?

Don Hultgren

Well, we didn't certainly didn't consider it to be part of our ongoing business. We had moved it to a place on the balance sheet, where if we were making the adjustments to value on the balance sheet, but it wasn't affecting our earning. Go ahead, Ken.

Ken Hanks

Well, Ed, both of these investments started out as investments that were locked up for extended periods of time. The US Home Systems was a couple years and then we had the added complexity of we had common Board members, and therefore we were considered a control person.

We finally have actually gotten rid of all of that relationship at this point in time. So at this point it is something that we could sell. The NYX was a deal that had a three-year lock up on it and part of the stock rolled out each year. Actually I guess it was about a year ago, May that they early released the last leg of the stock, so now it is all also free and clear.

Don Hultgren

I would agree with you that we are not in the investment business and you may see us in the future act accordingly.

Edward Hemmelgarn - Shaker Investments

Okay, I understand now that I mean, you were locked up and it was difficult for you to dispose of these.

Ken Hanks

Right. I think we're pretty point in time.

Don Hultgren

We don't believe at this point in time we're locked up. As I said earlier, it does not make sense for us to be in the investment business.


Our next question comes from Charles Glovsky. You may ask your question.

Charles Glovsky - Independence Investment

If I remember right in last quarter's conference call, you tried to lower expectations about fixed income results and unusual circumstances might not be repeated, but you turned another great quarter. Don, you've been talking about opportunities there. Could you be a little bit more specific? Where are these gains coming from? Are you taking more principal risk? Have you added more traders? What's the dynamic that's going on there?

Don Hultgren

We're not taking more risk; our inventory levels are pretty lean. It's been the volatility and the spread. The corporate fixed income market has just been very robust across the board. At the same time, you've got major players that have dropped out of the market, some of the players like Lehman and those type of guys, I don't care to name them all, but back in 2007, Charles, was when we really almost tripled the sales force in fixed income.

It's like a microcosm of what we're trying to do in retail. We were tripling that sales force when the yield curve was inverted. So we could take advantage of something like this, but I would tell you, the kind of market that we're in there was certainly not something I would have expected to happen. It continues to be very strong, and I would continue to tell you that I don't believe that it's going to maintain that that kind of strength for the whole fiscal year.

Charles Glovsky - Independence Investment

Is there any particular niche that you guys are carving out?

Don Hultgren

We're really strong in trading corporate bonds, traditional corporate bonds. We are considered a Tier 1 player there, which means that we're amongst the biggest. I think there are 27 Tier 1 players and we probably rank about somewhere around 20th in terms of volume. We have a very outsized fixed income operation for the size firm that we are.


Our next question then comes from [David Nodd]. You may ask your question.

Unidentified Analyst

I was just going to ask whether more information could be given on the bank. What kind of loans they have, what's the exposure to commercial real estate or lots and land, that kind of thing? There just isn't a great deal here with the non-performing level of assets and so forth that it's about roughly not quite half the assets of the Bank. Could something more be given in that regard in the future, because it is such an important part of the SWS?

John Holt

David, this is John Holt. In the K we're going to have some schedules that we haven't had in the past and that should come out here shortly, then we'll have a little more detail and breakout in that area.


Our next question comes from Steven Fu. You may ask your question.

Steven Fu - Fox-Pitt Kelton

My first question would be on the institutional side. Revenues, obviously the pretax income was pretty solid, but the revenue was down a little bit on sequential basis. I'm just kind of wondering what the drivers there were just based on because most of your peers have posted up sequential results at least on the top line for their institutional businesses.

Ken Hanks

What was the sequential institutional down?

Steven Fu - Fox-Pitt Kelton

I've got it down at about 4%.

Ken Hanks

Its a couple million bucks I think. Well, the way it kind of lined up I guess, about $3 million of the sequential down was related to the taxable fixed income business, our overall muni finance was actually up a couple million, our stock loan, net revenue was down about a million and our portfolio trading was flat. So, it's really the combination really of the stock loan, taxable fixed income and muni together.

Steven Fu - Fox-Pitt Kelton

Then switching gears over to the PCG side; I guess, I'm just wondering how the recruiting environment for FA's, how has that changed over the last nine months? Are you seeing today still the same quality and quantity of people that you were seeing six or nine months ago? Is it getting incrementally more expensive to sort of recruit these people or has that sort of stayed status quo is over the past nine months?

Jim Ross

This is Jim Ross. If I look at the environment today versus over the last nine months, there are more people talking to us today of higher trailing 12 production, etc. No, it's not more expensive, in some ways it's getting to be a little bit less expensive. Now that's probably just because we're getting more economies scale of the recruiting process than in the branches where they're joining.

It continues to grow as far as marketplace out there without a doubt. A lot of what's happening is a broker joins us in a market area and he comes over and six months later he's really happy. He has got a lot of buddy and he talks to them and we're seeing this incrementally ramp up and that is cheaper to do that next one or next two or three, and where we were talking to one, now we're talking to three. That's a very rambling explanation, I'm sorry.

Steven Fu - Fox-Pitt Kelton

Then on the clearing side you guys had talked about growing the correspondents and you just had a pretty good, actually the corresponding count actually increased this quarter for the first time in quite some time. So I guess I'm wondering is that a trend that you expect to continue. Is the people that you're talking to there still pretty healthy? Has the issue with that one correspondent affected your discussions with potential correspondents there?

Don Hultgren

Steven, no, I don't think that has affected it. Again that appears in my mind to be a one-off situation that we've been able to get our hands around and remediate. So as far as our pipeline is concerned, our sales force has now been with us for well over a year and it was a brand-new sales force across the board. So those guys have been improving their pipeline.

So I am optimistic about the number of correspondents going forward. I would say cautiously optimistic, because we continue to be in the kind of market where it's difficult enough on brokerage firms without doing a conversion. So your success in the market like this can be dampened a little bit. These guys have been out at it, and I'm comfortable that the pipeline here is better than it's been in the past.

Steven Fu - Fox-Pitt Kelton

Then my last question I guess is for John. On the bank, the net yield, you saw a pretty good jump there. Is this 517 level kind of something that's sustainable? How should we think about that yield going forward?

John Holt

I think that probably in the short-term it is. I know that application volume in the mortgage purchase area has a lot to do with that. So if we watch and we see, as we have recently, fewer mortgage applications in there, then my guesses are the balances could come down in that particular area.


Thank you. That concludes our questions for today.

Ken Hanks

Actually we have some questions from the Web that we'll read and answer. The first one says, with the M.L. Stern Group now integrated, can you provide guidance on where normalized commission and benefit expense should be as a percent of net revenue? For the year it was 53%, should we expect it to continue to increase or stabilize the revenues percentage?

I think that question really relates to total comp and benefits percentage of 63%. I think 63, it could be as low as 61 sometimes, I don't think it will be much higher than 63. It really does the difference which revenue generating area is the star really has a lot to do with what the comp and benefits is going to be, but I do think that a 61% to a 63% is a good gap.

The next question is also from the Internet and it's actually two part. The question is how are you collateralizing the new real estate loans, where are the properties located and what type of properties are they?

John Holt

We're focused on owner occupied real estate and that would be with lower loan to value and lower cost. So we're really looking at a lot more money in the transaction. These are primarily relationship oriented lending primarily in our newer markets, which would include North Texas, Austin, New Mexico and El Paso. Any update on the Arlington Kia dealership, we're working on getting a disposition of this property.

Ken Hanks

I guess the collateralization on those loans is the property are also guarantees?

John Holt

So the other segment there would be that the majority of these relationships have personal guarantees from the owners of the businesses, because a lot of times these will be in shell entities for the real estate guaranteed by the operating business.

Don Hultgren

All right, well that looks like that sums up the questions. Again, I just want to wrap up and say we're very focused on our broker bank. We're focused on improving our flow of business to get our operating leverage and we're in a fabulous environment to get that done. We look forward to talking to you about that in the quarters ahead. Thank you all and have a good day.

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.


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