SWS Group's CEO Discusses F2Q2014 Results - Earnings Call Transcript

| About: SWS Group, (SWS)

SWS Group, Inc. (NYSE:SWS)

F2Q2014 Earnings Call

February 06, 2014 10:00 AM ET


Misty Dierking – Executive Assistant

Jim Ross – Chief Executive Officer

Mike Edge – Chief Financial Officer


Joel Jeffrey – KBW

Misty Dierking

Good morning everyone and welcome to the SWS Group Quarterly Conference Call and Webcast. This is Misty Dierking of the SWS Corporate Staff. We are pleased that you could join us today.

The quarterly earnings press release can be found on our website at swst.com or on the Yahoo Finance website under SWS news. Market professionals on our distribution list should have received the slides for today’s call via email. If you would like to be added to our email list to receive press releases or to be notified at future quarterly calls, please contact us at 214-859-6351. This conference call is being webcast live on the internet along with the company slides at swst.com, where it will be archived for the next 30 days. (Operator Instructions)

This presentation contains forward-looking statements, readers 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 and general level of securities prices and interest rates, liquidity in capital markets, availability of borrowing under credit lines, credit agreements and credit facilities, customer margin loan activity, creditworthiness of the our correspondents, trading counterparties and customers, the ability of our borrowers to meet their contractual obligations, the value of the collateral securing the loans that we hold, demand for real estate and investment banking services, general economic conditions especially in Texas and New Mexico, changes in the commercial lending and regulatory environments and the ability to meet regulatory capital requirements and other factors discussed in our most recent Annual Report on Form 10-K, quarterly report on Form 10-Q then 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. Today’s slide s include reconciliations of these non-GAAP measures with the company’s GAAP results.

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

Jim Ross

Thanks Misty and good morning everyone. As we turn to Slide 4, I'd like to introduce my co-presenter this morning Mr. Mike Edge, CFO of SWS Group and on Slide 5, our agenda for the day. Where I’ll touch on the consolidated results for the second quarter and highlight other important developments for SWS Group since our last earnings call. Then Mike Edge will provide a detailed review of the numbers for the quarter including a more detailed discussion of the bank’s results and finally we’ll open it up for questions.

Which as Misty said (Operator Instructions). Now turning to Slide 6, before reviewing our earnings results. I want to briefly address Hilltop Holdings unsolicited offer. As disclosed on January 10, we received an unsolicited offer letter from Hilltop to acquire all of the outstanding common stock that yet Hilltop does not already own for $7 per share in the form of 50% cash and 50% Hilltop common stock.

Consistent with its fiduciary duties and in consultation with its financial and legal advisors. Our Board of Directors has formed a Special Committee comprised of independent directors not affiliated with Hilltop or Oakhill Capital Partners to review Hilltop unsolicited acquisition proposal.

The members of the Special Committee are in alphabetical order Robert A. Buchholz, Tyree B. Miller and Joel T. Williams III. The Special Committee has retained Sandler O'Neill and Partners as its independent financial advisor and Davis Polk & Wardwell as its independent legal advisor. The Special Committee will carefully evaluate Hilltop's proposal and make a recommendation to the Company's Board of Directors.

The Company does not intend to disclose developments regarding these matters unless and until a determination is made that disclosure is necessary or appropriate. Now with that, I want to turn back to the matter at hand today, our second quarter results.

Each of our operating segments reported pretax profits in the second quarter with retail, clearing and banking all demonstrating improvement over last year. While the institutional results were down from last year, the segment still reported pretax income of $5.9 million on net revenues of $27.3 million. Decreases in portfolio trading commissions as well as taxable fixed income, underwriting fees and corporate finance fees were the primary drivers of the decline in institutional segment revenues.

Our retail segment reported increases in both net revenues and pretax profits in the second quarter as compared to last year's quarter reflecting the underlying improvement in retail client activity. Assets under management increased 27% to $1.1 billion from $865 million in last year's second quarter.

Our Clearing segment reported a 12% increase in net revenues, while operating expenses decreased 18% as compared to last year. The mix of tickets processed continued to shift away from high-volume trading firms and move more towards general security broker-dealers resulting in a 45% increase in revenue per ticket in the second quarter as compared to last year.

We continue to see progress at the bank which reported pretax income of $5.3 million in the second quarter versus $3 million last year. The classified assets decreased 41% to $48 million at the end of the quarter from $81.4 million at the same time last year.

The bank recorded a $2.8 million loan loss recapturing the quarter versus $1.5 million loan loss recapturing the same period last year. Capital ratios remained strong Tier 1 (core) capital ratio of 13.8% in total risk-based capital ratio of 27.4%. We continue our focus on controlling cost in order to more closely aligned expenses with current revenues and we believe one of the keys to achieving that goal will be closely monitoring compensation expenses.

As we have previously discussed, we are targeting a compensation ratio calculated as compensation expense divided by net revenues in the low 70% range and have already taken steps to reach that goal including the 7% staff reduction we announced in the first quarter.

It's important to note that our adjusted compensation ratio was 68% in the second quarter. Mike will discuss this in more detail a little later. Additionally, after the end of the second quarter SWS Group loaned remaining $30 million in restricted cash to South West Securities to be used for general corporate purposes.

This will enable South West Securities to reduce its short-term borrowings and further control cost. Turning to Slide 7, we're seeing net revenues were $68.5 million in the quarter compared to $75.3 million last year. For the quarter, we reported pretax income of $1.3 million compared to pretax income of $15.6 million last year.

Net income after tax was $1.7 million or $0.05 per diluted share in the second quarter compared to net income of $10.4 million or $0.09 per diluted share last year. We closed the December quarter with a book value per share of $9.57 versus $11.04 per share in the prior year assuming full exercise of the outstanding warrants current book value per share would be $8.25.

Turning to Slide 8, we believe it's helpful to consider comparative [ph] quarterly results after adjusting for the loan loss recapture and the warrant valuation adjustment in order to better understand the company's performance.

The second quarter included a loan loss recapture of $2.8 million and $2.1 million unrealized loss from the warrant valuation adjustment. In last year's second quarter, we recorded a $1.5 million loan loss recapture and the valuation adjustment of the warrant resulted in $11.8 million unrealized gain.

After adjusting both periods for these items. The adjusted pretax income for the current year second quarter was $502,000 compared to adjusted pretax income of $2.4 million last year. While pretax income declined $1.9 million from last year, that's important to note that last year's quarter included a $3.6 million gain on the sale of US Home Systems common stock.

Turning to Slide 9, we are pleased with the progress we've made in improving our operating results but recognized that much work remains to be done.

In addition to controlling cost, we've remained focused on increasing revenue by building on the underlying strengths of our diverse business lines. We've been successful in retaining key producers and capitalizing on the recent strength of the equity markets and we will continue our efforts in these areas.

At the same time, we expect the challenges posed by the current low interest rate environment to continue and we will closely monitor our hedging and risk management strategies to ensure we are well position to adapt to the resulting market volatility.

Our banking segment has made consistent progress in reducing classified assets, while maintaining strong capital ratios and consistently reporting pretax profits. We will continue to pursue our conservative growth strategy at the bank as we rebuild the loan book and seek opportunities to expand our business in the Texas and New Mexico markets we serve.

Now with that, I'll turn it over to Mike for a review of our financial results for the quarter.

Mike Edge

Thanks Jim and good morning everyone. Turning to Slide 11, we provide detail on net revenues in the quarter. Operating revenues were down 6% from last year and 2% from September. Commission revenues were up $1.6 million from last year. While retail commissions improved 4%, institutional commissions were down 16% primarily due to portfolio trading volumes, which continued to lag compared to last year.

Investment banking and advisory fees were off $1.4 million from last year, $1.2 million of which was related to the corporate finance business that we exited in June. Taxable fixed income fees were also down $1.5 million on reduced underwriting activity in the quarter.

Our municipal finance and retail businesses however, help to offset most of the decline as municipal finance fees increased 13% from last year as a result of the more favorable mix in our public finance deal flow.

Retail fees increased 26% in line with the 27% increase in assets under management. Net gains on principal transactions were down $3.7 million from last year. As the year ago quarter included $3.6 million gain on the sale of our shares of US Home Systems common stock.

I'll provide more detail on this revenue line item on the following slide. Other revenues increase $2.8 million from last year. This increase included $949,000 pickup in gains related to the firms deferred compensation plan investments and third party servicing fee income increased $900,000 due to operational efficiencies.

The bank recorded a $700,000 gain on its interest rate swap transactions in the quarter and a $300,000 increase in gains on SBA loan sales. In addition, net gains on REO sales improved $700,000 offsetting a similar decrease in gains related to the banks equity method investments.

Net interest was off 22% versus last year primarily due to reduction in the size of the bank's loan portfolio and lower interest revenue earned in our taxable and tax-exempt fixed income trading businesses. The increase in net interest income from September was primarily due to stock lending business, which saw higher average balances and improved spreads.

Turning to Slide 12, we provide more detail on the net gains on principal transactions revenue line. We've recorded total net gains on principal transactions, a $7.5 million in the quarter. These results were almost flat with last year after adjusting for the $3.6 million gain on the sale of our shares of US Home Systems common stock which occurred last year.

Well less robust in a year ago, taxable fixed income trading gains improved about 30% from September. Municipal finance gains were up 62% from last year as active inventory management policies and improved demand in the secondary municipal bond market led to the improvement.

Municipal gains feel $1.6 million from September which was the best quarter for tax-exempt trading since June, 2011. Our next slide, Slide 13 you can see the breakdown of expenses for the quarter. Total non-provision operating expenses were down 7% from last year.

Compensation expense was the primary driver of the cost savings. As total compensation was down $3.2 million. Embedded in that figure, there's a $1 million increase and expense associated with the value of the companies deferred compensation plan assets excluding the impact of the deferred compensation plan expense, total compensation was down $4.2 million from last year and $3.9 million from the first quarter.

The bulk of these savings were due to firm wide headcount reductions that we made in the first quarter, which we discussed in the last earnings call. Excluding severance cost associated with that reduction, compensation expense was down $2.7 million from September.

Other expense was down $1.9 million from last year. REO and professional service expenses were down $800,000 and $600,000 respectively. In addition, bank regulatory fees were down $300,000 as we continue to reduce problem asset related expenses.

We recorded $2.8 million loan loss recapture in the quarter, $2.1 million of which was related to a specific impairment reserve on a commercial loan that paid off. Given the continued improvement of the loan book and the absence of additional losses we felt that the additional recapture was warranted.

The warrant valuation contributed in expense of $2.1 million in this quarter versus a gain of $11.8 million last year. Turning to Slide 14, we detailed the components of the compensation ratio. Given that over 70% of our cost were related to compensation. We feel that, a discussion of the compensation ratio is important given all the focus on cost control.

On a GAAP basis, the compensation ratio was 71.2% for the quarter versus 76.2% last quarter and 69% last year. While these numbers are appropriate, we believe that it's helpful to make some adjustments in order to compare the ratios between periods and to our peer group. Excluding the interest expense associated with the $100 million loan from Hilltop and Oakhill and adjusting the year ago quarter to exclude the game of this sale of our shares of US Home System common stock which had no associated compensation expense.

The adjusted compensation ratio for the quarter was 68% versus 72.8% in the prior quarter and 69.4% last year. As mentioned on previous call, we've been focusing on achieving a blended compensation ratio in the low 70s due to persistently lower levels of revenues. So we are pleased with the progress we've made. Moving to Slide 15, you will see the key assumptions underlying the warrant valuation.

Despite the decline in derived volatility and time value from September to December, the $0.50 increase in our stock price increased the value of the warrant by $2.1 million resulting in the corresponding unrealized loss in our financials for the quarter.

On Slide 16, we highlight the detailed components of the diluted earnings per share calculations. As is the case each quarter, we must calculate fully diluted earnings per share based on whether or not the $17.4 million shares related to the Hilltop and Oakhill transaction are diluted.

Fully diluted earnings per share of $0.05 in the quarter does not factor in the warrant shares as they're anti-diluted. However, these shares were not anti-diluted in the year ago period. Moving on to Slide 17, we break out net revenues and pretax income for each of our four business segments.

All business segments were profitable in the quarter. Pretax profits were up versus the prior quarter and from the prior year in all businesses except the institutional segment. Pretax profits in the clearing segment were up $1.5 million from year ago. Improved revenues included higher third party servicing fees which increased by $1.5 million in addition operating expenses were down $900,000 from a year ago, due to a 19% decrease in operations and technology expenses and reduced overall compensation expense.

Retail segment profitability improved significantly in December versus last year as our private client group increased its productivity and retain key producers waiting to a 7% increase in net revenues. Retail assets under management increased 27% leaving to a 26% increase in advisory fees.

In addition, third party servicing fees increased by $400,000 despite the increased production compensation expense was flat with last year, as a relative mix of revenues between our employee brokers and independent contractors resulted in a lower blended compensation ratio.

Legal expenses were also down $300,000 in the quarter as well. Institutional segment profitability fell 36% from last year and 4% from September. Institutional commission revenues were down $2.2 million from last year primarily due to a decline in portfolio trading volume.

Investment banking and advisory fees were also $2.2 million due to a $1.5 million decrease in taxable underwriting fees and $1.2 million reduction in corporate finance fees as we exited that business in June.

On the other hand, municipal finance fees increased $600,000 due to a more favorable mix of deal flow. Net interest was down $600,000 due to a decrease in net interest earned in our taxable and tax-exempt securities. Net interest in stock loan improved from last year at a 50% increase in average stock borrowed balances helped to overcome, an 11 basis point reduction in average spreads.

Operating expenses fell by 8% primarily due to a 14% reduction in compensation expenses in line with weaker revenues. The bank recorded a $2.4 million increase in pretax profits versus last year despite, a 20% decrease in net interest revenues on lower average loan balances and net interest margin.

The quarter included $700,000 increase in related gains from interest rate swap transactions as well as $300,000 increase in gains on SBA loan sales. Excluding the loan loss recapture operating expenses decreased 22% from last year due to a 15% reduction in compensation as well as lower REO expenses and other problem asset related costs.

In addition, the bank recorded $1.4 million increase in as loan loss recapture in the quarter. Moving to Slide 18, we display a number of key metrics from the quarter. Employee headcount is down 3% from September and down 13% from a year ago.

While most of this change relates to last quarter 7% headcount reduction. We've also eliminated a number of other positions primarily through attrition. Retail client assets increased 2% from September and 9% from last year. Net capital of the broker-dealer remained strong at $154 million.

Moving to Slide 19, we provide detail on the banks classified assets. We continue to reduce classified assets in the quarter as total non-performing assets were down 8% from September and down 48% from last year. In addition, the current classified assets fell 28% from September.

Total classified assets were $48 million improved 18% from September and 41% from last year. The classified asset ratio of 27.2% continued to improve 32.6% in September and 42.9% last year.

Turning to Slide 20, we highlight some key statistics at the bank. As mentioned earlier, this quarter included a loan loss recapture of $2.8 million bringing the reserve to loan ratio down to 2.29%. Well about 75% of the recapture was related to a specific impairment reserve on a commercial loan that paid off the remainder was due to lower levels of problem assets, a lack of historical losses and slow growth in the overall loan book.

In addition, we extended the look back on historical losses from six quarters to eight quarters. While we believe, that the current level of reserves is appropriate we will continue to reevaluate the allowance in light of overall loan growth, historical losses and macroeconomic trends.

The banks overall net interest margin of 2.8% is in line with the prior quarter and continues to reflect lower loan balances and more reliance on a lower yielding investment portfolio. Moving to Slide 21, we highlight a few key balances at the bank. The banks investment portfolio ended December at $604 million.

Gross loans held for investment of $538 million were down $3.8 million from September. Primarily due to the mortgage purchase portfolio which continues to struggle in the current refinance market. The bank ended the quarter with (core) capital of 13.8% and risk-based capital of 27.4%.

The broker-dealer continues to provide 88% of the bank's deposits. Now turning to Slide 22, we provide detail on our categories of bank loans. Mortgage purchase balances were down $2 million from September as lower levels of refinancing continued to weigh on balances. While we saw some level of stability versus the prior quarter, we expect continued market volatility, increase competition and uncertainty as new regulations from mortgage originators could represent headwinds going forward.

Excluding mortgage purchase, other gross loans held for investment were down $1.5 million or basically flat from September. We believe our pipeline is strong and we expect to show net loan growth in the coming quarters.

While total commercial real estate loans decreased by $16 million from the prior quarter. We continue to see strong demand in the multi-family portfolio with bounces up 11% from September and up over $74 million from year ago. We are also pleased to see continued traction in the commercial loan book.

Moving into the second half of the fiscal year. We will consider additional alternative for growing our loan portfolio including targeting pool loan purchases that meet our investment loan parameters. In order to supplement, to help [ph] our investment portfolio, while loan originations gain tractions and with that, I'll turn it back over to you, Jim.

Jim Ross

Thanks Mike. In closing, I'd like to reemphasize our core priorities. We will continue our efforts to improve operating results by increasing revenues while controlling cost and improving efficiency across all of our business linings. We remained diligent in our hedging and risk management strategies as we address the challenges posed by the existing low interest rate environment in the corresponding market volatility.

And lastly we continue pursue conservative growth at the bank, while continuing to reduce classified assets and maintain strong capital ratios. I'd like to thank our customers, employees and shareholders for your continued support and dedication and thank you all for joining us on today's call.

Now before we open it up for questions. I want to reiterate that the purpose of today's call is to discuss our earnings results. We thank you in advance for limiting your questions to this topic. With that, I'll open it up for question (Operator Instructions).

Question-and-Answer Session


We do have a question from Joel Jeffrey with KBW. Your line is open.

Joel Jeffrey – KBW

Good morning, guys.

Jim Ross

Good morning.

Joel Jeffrey – KBW

Just a quick question, on that $30 million you talked about moving in to SWS Securities. How bigger impact is that going to have on interest savings?

Mike Edge

Right now, the idea is to use that $30 million in our general operations. We currently borrow from unaffiliated banks and that interest rate is 1.5%. So if nothing else, we anticipate to replace that line of funding and provide general liquidity.

Joel Jeffrey – KBW

Okay and then in terms of the continued reduction in the reserve to loan ratio. Just wondering, do you guys have sort of base target in mind or should we continue to expect this thing to fall as loans come off the books?

Mike Edge

Well, I think there is a number of factors involved here. I believe the 2.2% or so still pretty elevated relative to our peer group but we still have 27% as classified asset ratio, which is pretty elevated. I think as net loan growth takes off and provided there is static environment. As far as the macroeconomic trends and historical losses. I think trending lower is probably reasonable, 1.5%, 2% but it's very hard to predict given all the factors.

Joel Jeffrey – KBW

Okay, I won't ask you about the transaction but they do have one quick question on something you might think is related to it. In terms of the $30 million evaluation allowance you guys have for your DTA, about $11.4 million is that operating losses, is it your understanding that would be the only piece that a potential acquirer could bring on to their books, the $11.4 million or the entire $30 million go on to their books?

Mike Edge

I'm sorry, Joe. I'm not prepared to comment on that.

Joel Jeffrey – KBW

All right, thanks for taking my questions.

Jim Ross

Thank you. At this time, they're telling us we have no more questions. With that, we appreciate everyone's attendance. Thank you very much.


Thank you for your participation in today's conference call. The call has concluded. You may disconnect at this time.

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