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Executives

Philip Pendergraft – CEO

Kevin McAleer – VP & CFO

Analysts

Richard Repetto – Sandler O'Neil

Mike Vinciquerra – BMO

Howard Chen – Credit Suisse

Dave Capps – JPMorgan

David Scharf – JMP Securities

Jeff Graf – Springhouse Capital

Penson Worldwide, Inc. (OTC:PNSN) Q2 2010 Earnings Conference Call July 23, 2010 10:00 AM ET

Operator

Good morning and welcome to the Penson Worldwide conference call. Before we begin, I would like to read Penson's Safe Harbor statement.

Please note that this presentation contains certain forward-looking statements about management's goals, plans, and expectations which are subject to various risks and uncertainties outlined in the Risk Factors section of Penson Securities and Exchange Commission filings.

Actual results could differ materially from those currently anticipated and we disclaim any obligations to update information disclosed in this call as a result of developments which occur afterwards.

(Operator Instructions) I would now like to turn the floor over to Mr. Philip Pendergraft, Chief Executive Officer. Mr. Pendergraft, you may begin.

Philip Pendergraft

Thank you, and thank you for joining us. As usual I'm here with Kevin McAleer, our Chief Financial Officer. We have a presentation that accompanies our remarks today. It can be found on the Penson Investor Relations' page under the events calendar. Look for the PDF accompanying our conference call.

Last night we released our second quarter results. We reported net revenues of just over $71 million, and a net loss of approximately $7.4 million or $0.29 per share. This loss was compromise of three major components.

The first was approximately $4.8 million, pre-tax in expenses related to the recently completed Ridge transaction. The second was approximately $2.8 million in non-operating expenses unrelated to Ridge, primarily severance and legal settlements and reserves. Lastly, was a pre-tax operating loss of $1.9 million equal to about $0.03 per share net after tax.

Now, this operating lost was driven by several factors, lower than expected trading volumes in June here and industry-wide, approximately $1.3 million in lower net interest income from reduced spreads in both our in-house and conduit securities lending businesses as compared to the first quarter 2010, higher than anticipated loss in Australia of about $1.3 million due to both lower revenues and higher cost, and in addition, as we indicated on our last call, we have approximately $1 million for two months of interest expense without the benefit of any offsetting revenues on the portion of our recently raised long-term debt that was incurred principally to increase regulatory net capital in anticipation of the acquisition of the Ridge course one.

Now, while we are not satisfied with our operating performance this quarter, we do remain confident about our strategy and our direction both in the near term and in the future. Our existing business showed reasonable revenue growth in the quarter. The $50 million in revenues acquired from Ridge are the most significant sub-transaction in our history and will shape our growth and plans far into the future.

In addition, the technology and outsourcing agreements with Broadridge will have a significant impact on reducing cost and increasing efficiency and scale as we begin to implement these agreements over the next year. However, we are clearly in the transition period. Interest rates continue to be under pressure and it appears that the European financial issues will forestall any near-term increases in the federal funds rate.

Spreads in our stock lending business has come down impacting growth of higher margin interest income. In industry volumes while up in the quarter were very weak in June, with many concerns that the extreme volatility in May could negatively impact retail volumes for some times to come.

In light of all these, for the rest of the year, we will be strongly focused in four areas. First, we are intensifying our efforts to adjust our cost structure in line with the current operating environment. Second, we are focus on building relationships with our new Ridge correspondents and with providing them with additional products and services, helping them to expand their businesses and providing additional revenues for us. Third, we are continuing to seek new revenue opportunities from new clients and products. And fourth, we are continuing to drive toward fully implementing the technology and outsourcing agreement with Broadridge.

Let's turn to our operating results. In this discussion, I'm excluding the $6 million pre-tax in non-operating cost and comparing numbers on a sequential quarter basis. Rather than go through each company right now, I will focus on the big differences from the first quarter.

Non-interest revenues increased 7% to about $56 million. This represents and 11% increase in clearing and commission fees, while technology and other revenues remain relatively flat. Through May, we were actually up 10% in non-interest around the news and 15% in clearing and commissions when compared to the first quarter or to the first quarter average. But June turned out to be the weakest overall volume month of the year for us or we did not expect another month like May, we also did not expect the magnitude of the decline that we saw in June.

Now, net interest revenues increased 1% to $15.2 million. This reflected level spreads on higher customer balances, which totaled a record $6 billion. In turn, this offset a 30 basis point decline in spread and a 2% decline in balances in our conduit stock lending business.

The good news here is that the extra capital we have on our hands as we indicated in our first quarter call, we are able to reduce our cost of funds in our customer business so we could maintain our 92 basis points spread from the first quarter and benefit from the growth of customer balances. The downside was that both our in-house and conduit stock lending book saw a big decrease in spread.

So, now, total net revenues of $71 million were up 5.5%. They were not up as much as we have anticipated as a result pro forma operating expenses grew faster, of 7% in revenues. This is clearly unacceptable.

While there was little we can do in June to adjust, we have stepped up our cost reduction plans, the right size of infrastructures moving forward. Two big areas where expenses were up were in payroll and other. Payroll is up $1.4 million or 5%. This is partly due to the continued ramp up of our new Australian operation of expected new clients and revenue growth in the quarter.

It was also impacted by the ramp up for the Ridge correspondents and by higher internet-based compensation. Other expenses were up $1.4 million or 22%. New client on boarding cost were significantly higher than anticipated in Australia and our general legal expenses were up meaningfully in the quarter. We do anticipate that other expenses should return to a more normalize level in the third quarter.

Floor brokerage and clearance cost were up 5.2% in line with the 11% increase in clearing and commission revenues, and communication and data processing cost were up 6.5%, a little ahead of Broadridge clearance due to the rigid acquisition and the upcoming TradeKing conversion.

With regards to Australia, despite our success in signing clients, we were negatively impacted by the slowest market condition in four years as well as by fire that expected expenses. Combined, these factors caused us to lose $1.3 million in Australia in the quarter, which was significantly greater than anticipated. Despite this we are still quite positive on our growth strategy in this market as we continue to sign new clients. We now expect to be in the block in the fourth quarter, which is effectively one quarter later than our original plan.

And then as we outlined when we closed on our $200 million financing, we have higher overall interest expense including approximately $1 million for the two months of interest expense without the benefit of hitting revenues on the $50 million of capital allocated to support the Ridge correspondent. All these factors accounted for more than $4 million in reduced pre-tax operating income, which is the difference between the $1.5 million in pre-tax income we made in the first quarter and the $1.9 million in the operating loss we had in the second quarter.

Now, I'd like to turn the call over to Kevin for a few minutes to discuss interest, EBITDA and taxes and then I'll come back to talk a little bit more about our business on the quarter and looking forward to the second half of the year.

Kevin McAleer

Thanks, Phil. If you recall, we had our $200 million long-term at the beginning of May. We used the net proceeds of approximately $195 million to payoff approximately $110 million of short-term bank debt, provide $50 million of support to the Ridge correspondent business and another $35 million of support, future growth across the company.

Therefore, there are three major components to interest expense in Q2. We had $60 million convertible note for all three months, $200 million high yield note for approximately two months and the bank debt of $110 million for about one month. Along with some other smaller item, that adds up to $7.4 million as you can see on the income statement, which includes approximately $1.4 million in non-cash interest.

Looking at the third quarter, we're currently estimating approximately $9.5 million in interest expense including $1.5 million in non-cash interest. That is based on having the convertible note, the high yield note and the Ridge seller, all for three months and without having any bank debt.

EBITDA for the second quarter was $4.4 million and $15.1 million for the six months. Taking into account non-operating expenses in the first and second quarters, we had an adjusted EBITDA of 11.7 million in second quarter and 23.5 million for the first six months. Our amortization will increase to approximately 1.5 million in the third quarter, reflecting a full quarter of the Ridge acquisition.

Now, on taxes, each quarter, we compute the effective tax rate according to general accepted accounting principles by estimating the book income and permanent difference for the entire year and applying the resulting tax rate to the year-to-date income as of the end of the quarter. Items such as state income taxes, foreign income taxes, non-deductible expenses and certain book deductions related to stock compensation are considered in making the annual tax calculation.

Based on our current estimates, we expect the year-to-date and the remainder of the year to be approximately 23%. There could be further fluctuations in the tax rate and subsequent quarters of our outlook for the remainder of the year changes since GAAP requires us to repeat the computation each quarter based on the then current estimate of the remainder of the year.

As for interest rate sensitivity, based on the size and composition of our customer interest earning and interest paying average balances for the second quarter, we have some, have each 25 based point increase in federal fund rate would increase the net revenue by approximately 1.1 million per quarter. That's approximately 10% higher than what we previously said and reflects the addition of 500 million averages in Ridge balances that we receive. Phil, back to you.

Philip Pendergraft

Thanks, Kevin. I'd like to review the $7.6 million in non-operating expenses we had in the quarter and in particular, our new cost savings program since we are tied into the severance charges.

First of all is a $2.8 million expense from investment banking legal and other fees related to the acquisition of the Ridge Clearing contracts, the signing of our 11-year outsourcing agreement with Broadridge and our marketing agreement with Broadridge. Second, is $1.5 million from legal expenses covering two issues. The first is $1 million for the solo related cases we've described in our periodic SEC filings for some time now.

You may recall that in the third quarter of 2008, we established a $2.4 million legal reserve for these matters. This addition to the reserve should completely resolve these issues. The second item relates to an arbitration filed against Penson Financial by former correspondent in Impart Financial Group making a number of serious, but completely false claims. We took this case very seriously, defended it vigorously and won it completely, including an award of legal fees.

Unfortunately, based upon the most recent public filings by Impart's parent, we do not believe that we will be able to collect much of that award and are charging off these fees. Then there are two severance charges, given the current operating environment, it is clearly necessary to reduce our annual compensation expense. The first severance package was approximately $2 million related to the outsourcing agreement with Broadridge and covers expected job reductions over the next 18 months.

Now, we had originally expected this agreement, the technology and outsourcing agreements to save us between 7 and 10 million a year when fully implemented and we now expect to be at the higher end of that range.

I would like to talk about our people for a minute. At the end of June, we had 11,074 people on our team around the world including full time, part time and contract employees. We are proud of and thankful to our team for their contribution to our success. While we had hoped to handle the job losses associated with the Broadridge transaction, largely through attrition, it does now appear that there will be some staff reductions associated with these transitions. This is regrettable, but it is an unfortunate part of the reality of the economic situation in which we are living.

The cost savings from the Broadridge technology and outsourcing contract are vital to our continued success. This has created the need for the $2 million severance charge. We will also be providing affected employees with retention packages, which will impact compensation expense by about $400,000 per quarter over the next five quarters.

Now, the second severance package was $1.3 million and it was a part of a more aggressive program to reduce our overhead in line with the current low interest rate environment and market activity. This is expected to result in annual cost savings of approximately $2 million beginning in the second half of 2010. The majority of these savings have been achieved by consolidating certain technology groups between Nexa Technologies and Penson Financial Services.

Now, in connection with the Ridge acquisition, we have added approximately $4.5 million in annual compensation expense beginning in the third quarter. We had plans for head count increases in our acquisition model and this number is actually coming in slightly under our plan. Overall, when we look at compensation expense post-Ridge, our goal is to hold quarterly operating compensation expense to no more than $29 million including the new employees associated with Ridge and the impact at state pay associated with the outsourcing agreements.

Going forward, we expect no further or no additional Broadridge transaction related expenses and we have eliminated the likelihood of any further legal cost in two major areas. The Broadridge related severance cost should allow us to maximize the value of the technology and outsourcing agreements over the next 18 months and also anticipate reducing payrolls in the third quarter by at least another $2 million on an annual basis, which will result in another severance charge in that quarter and improve compensation expenses going forward.

We are committed to improving the margins in our existing business and on insuring that we benefit fully from the revenues from the new Ridge correspondent.

Now turning to correspondent count, we ended the quarter with 385 correspondent relationships. For the quarter, we added 118 new relationships including 95 from Ridge. Now, we have been saying that Ridge would add about 100 contracts and we actually acquired a 100, exactly. But two didn't generate any revenue in June and so are not in our corresponding count and there were three that were with correspondents that already cleared a portion of the business with Penson and so they are not – so they are excluded from the addition to correspondent count.

Now, we lost or terminated 30 relationships during the quarter. Of these losses, the most significant, approximately 1.4 million per year in annual revenue was actually acquired by another Penson correspondent. So, we don't expect to lose any revenue from that change. The second most significant, about $1.2 million in annual revenue was a relationship that we ask to leave due to regulatory issues with their business.

The remaining 28 firms total or average less than $3,000 a month in current revenue. So, were not significant at all.

Now, pipeline of signed but not yet converted firms were 24 at the end of the second quarter. This was down from 30 at the end of first quarter and reflected our conversion of five firms in Australia during the quarter and our focus on the Ridge acquisition. We should note that we had originally reported a pipeline of 38 clients at the end of the first quarter, that number should actually have been 30.

Now, let's review what's ahead in the second half. The Ridge integration is going very smoothly. It validates the eight months of planning and preparation and also, the outsourcing service model. Revenues from this acquisition are likely to be modestly better than originally expected as we are already beginning to see additional unplanned for benefits from synergies.

These benefits are principally coming in two areas. First, to the addition of the Ridge stock lending box, to our existing securities lending business and second from the Ridge correspondents trading through our smart routers and execution services relationships.

Now, in the third quarter, we will have a full quarter's benefit from the acquisition based upon the current environment, we believe that that should add between $12 and 13 million consisting of approximately 80% non-interest revenues and 20% in net interest revenues and those revenues should generate at least $3.5 million of EBITDA in the quarter.

At Penson U.S., in our U.S. securities clearing business, as we previously announced, Thinkorswim will be transitioning a portion of their business out to TD AMERITRADE. Our latest update is that this transition will begin or will happen somewhere between November and February.

As we previously indicated Thinkorswim accounts were about 6% of our revenues. We anticipate losing about half of that, which includes lowest spread net interest income or approximately 1.7 billion in cash balances. In turn, they should have the effect of improving our spread when all other balances by approximately 22 basis points. Half of the revenues we anticipate keeping will be from futures and FX clearing, which we anticipate will expand as the Thinkorswim platform to AMERITRADE's far larger customer base and revenue from portfolio margin clients and the retirement accounts.

In terms of new U.S. business, we are pleased to announced that Headlands Technologies, a new multi-asset quantitative trading firm founded by well-known industry executives Matthew Andresen, Jason Lehman and Neil Fitzpatrick has find a corresponding clearing agreement with Penson Financial Services. This agreement was finalized just around the time we were issuing our news release last night. While this is a startup firm, we are confident that it will become a significant client.

In addition, we're on track. We're adding trade team in the third quarter. We believe this correspondent to generate between 1 and 2% of our global revenues and add more than $300 million in customer balances.

At Penson GHCO, our new sales oriented management team under the leadership of Streich is doing very well. Year-to-date, they've added a nine introducing brokers; and average seg balances have grown 9% to 521 million from 477 million in the first quarter. They have just entered execution services attracting at team from AMS Global, aimed at serving the needs of the CTA and manage futures markets. We are pleased with this expansion of our execution services capability, which we believe will also generate additional clearing revenues for our future's business.

At Penson Canada, the focus is clearly on the conversion to the Broadridge platform. This conversion is currently scheduled for late in the fourth quarter. The delay here is primarily due to a number of our correspondent who wanted more time to complete their integration work. The reduced technology cost should kick in the first quarter of 2011 and other savings from outsourced services in the second quarter of 2011.

This is a reminder. Of the approximately 6 to 7 million in base technology saving about 40% are anticipated to come from our Canadian operation. With the new features we're getting from Broadridge, from their technology platform, we are lining up new business post-conversion.

In addition, Canada has been very successful of expanding their execution services business capturing trading from U.S. correspondent and from non-correspondent customers as well. Penson Canada was number two in terms of volume on the TFX in June, up from the 20s earlier this year.

At Penson U.K., we are seeing a much more sales oriented management team doing well under the leadership of Clive Triance. To date this year, we have signed six new correspondents in the U.K. with good prospects for additional contracts in the works. This compares to only one new correspondent for all of 2009.

While many of these clients are smaller than our global average, we are also in discussions with several large opportunities. Based in the signings and our current prospect list and discussions underway, we anticipate a steady improvement in our U.K. operations in the second half of the year.

At Penson Australia, although underperforming our original financial plan, we are continuing to sign new business and fully expect to be in the block in the fourth quarter. We are actually finding that the sharply lower volumes in this market are helping us in our marketing efforts and even larger brokers are feeling the pinch and beginning to consider outsourcing as an alternative. As a result, we are having conversation today that we didn't expect to have for a year or two.

To sum it up, from a macro perspective, for the rest of 2010, we anticipate that volumes will remain fairly weak and interest rates are unlikely to change. Despite this, we anticipate returning to operating profitability in the second half of the year. We expect that this will be driven by contribution from the Ridge business, by improvement in our U.K. and Australian businesses and by overall expense reduction. And we also expect continued revenue growth in our U.S. securities and future's businesses.

We do anticipate facing continued challenges in the stock lending arena as spreads remain lower and an interest income in spread overall due to continued low interest rates in the U.S. marketplace. We will likely see a modest decline in overall net interest spread, although we hope to hold interest income stable your balance growth.

Our mission is to fully integrate our new clients to continue to add meaningful clients to our roster to prepare for implementation of the technology and outsourcing agreements with Broadridge and to improve our operating margin through cost control. This will be our focus throughout the rest of the year.

From a longer term perspective, while this was a transition quarter, we are confident that we are doing the right things to improve our competitive position to strengthen our product offering to reduce structural cost and build value for the future. We appreciate your support and interest in Penson. That concludes our formal remarks and at this time, we would be pleased to open the call up to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Rich Repetto from Sandler O'Neil. Please proceed.

Richard Repetto – Sandler O'Neil

Good morning, Phil. Good morning, Kevin.

Philip Pendergraft

Rich, good morning, sir.

Kevin McAleer

Good morning, Rich.

Richard Repetto – Sandler O'Neil

I guess the first question is the Ridge accounts increase your assets by the 500 million and what type of spread do you expect there? Would it be similar to the 92 basis points or did you have over the last couple quarters or what you're outlook there?

Philip Pendergraft

Yes. Richard, it's actually going to be slightly higher. We anticipate –our calculation was that if we have those balances for the second quarter that we would have, that spread would have been three to four basis points higher. So that as we look forward that would be a positive to overall spread. We think stock lending will be a negative and we think net-net that we might see a slight decline in spread overall.

Richard Repetto – Sandler O'Neil

Got it. Okay. That's helpful. And then I guess you talked about terminating the accounts. In the presentation you talked, I believe, about 30 and in the press release was there a different number of terminating accounts?

Philip Pendergraft

Well, I think we have a net –

Richard Repetto – Sandler O'Neil

A net number on the press release.

Philip Pendergraft

Yes. I think we had a net number in the press release.

Richard Repetto – Sandler O'Neil

Okay. Okay, and then I guess lastly, Phil, and this is obviously groundbreaking or transition period, but groundbreaking transaction for you and the scale and operation and I guess maybe if you could give and plus, we're also going through our environmental period of sort of groundbreaking to. So, I guess the question is can you give me an update like on the competitive landscape as you'd go through this. What do you see on the competitive front from the larger competitors and I know you don't normally see things and as much as in your size, but just an update on what the competitive outlook is out there.

Philip Pendergraft

Well, Rich, I'm actually – the Ridge acquisition is some new capabilities to compete, some stronger products and technology to compete in the retail institutional markets and ways we hadn't before and it's really too early for me to be able to tell you how our competitors there might react. We are seeing, I'd say really challenging competition in the very high frequency space. We've seen, over the last quarter or so, we've seen probably more price competition there than we've seen in recent past.

I think that overall, from like, we feel like we are much better positioned competitively as a result of this transaction because we've strengthened our technology capability and we have broadened our footprint so that we're able to compete more effectively in more customer segments.

Now, I will say that we probably have seen, the place where we're seeing part of the most increasing competition, sort of new competition is in Canada, where Fidelity came in last year and then now appears that Pershing will launch sometime late this year. So, I think we will – certainly we know we're going to face stronger competition there, but actually in sort of a perverse way, we think that might help us a little bit because up until now, it's been Penson against the big banks. And so if you were – with two additional brokers competing for business, I think it may actually make it easier for brokers. I think the brokers were gaining much bigger market share from the banks overall and I think that could potentially help us in some ways.

Richard Repetto – Sandler O'Neil

Okay. And maybe just one last thing, I do have one last thing sorry, but the Australia, and just briefly, what gives you the increased comps like you have been spending that but is going to turn profitable, did you say 4Q or 3Q, I think like what's the, what's the drive behind that because you have been spending there I guess.

Philip Pendergraft

So I mean it's really two things Rich, one I mean part of the reason we're significantly behind plan there is that on-boarding cost for our new clients in the second quarter were significantly higher than we had anticipated and so those are largely behind us. The second is that we had – we know what our conversion schedule is and so we know revenue associated with those new customers are, that conversion schedule is a little bit behind what we thought, we had one major customer that pushed us off for about eight weeks, but that we'll convert in early September and so we can just – it's pretty easy for us to look at the expenses we know are falling out that were on-boarding related and then look at the revenue ramp from new customers between now and the fourth quarter and reach out of course the profitability.

We're just – we're probably four months behind where we thought we'd be. And that's even with the lower volumes in that market, I mean we're actually helpful that we'll get, I mean we're not predicting it but if we see a snap back in volume, in that market, we might get there a little faster.

Richard Repetto – Sandler O'Neil

Got it, okay. Thanks Phil and Kevin. I appreciate it.

Philip Pendergraft

Good to talk to you.

Kevin McAleer

Thank you Rich.

Operator

Your next question comes from the line of Mike Vinciquerra from BMO. Please proceed.

Mike Vinciquerra – BMO

Good morning.

Philip Pendergraft

Hi good morning.

Mike Vinciquerra – BMO

I wanted to ask on the interest spread you guys talked about getting some benefits from the additional capital you raised. So if there was 92 basis points spread with those benefits and I think you've put it in the $1 million a quarter range in terms of savings, what would, is that still the right number and what would the spread have been had you not gotten that cheaper capital in the business?

Kevin McAleer

Mike, actually I don't know of the top of my head. We didn't calculate excluding the increased capital. But I will be happy to get you that number. The – and of course it's not cheaper capital but it's the impact of having more capital in the broker dealer on the – on our ability to manage our cash and cash borrowings affectively and so as we've indicated we thought that would have a meaningful savings for us. It wasn't $1 million in the quarter, we didn't have the capital for the entire quarter, but certainly we anticipate, we did get a benefit there and we anticipate that will continue.

Mike Vinciquerra – BMO

I understand, okay.

Kevin McAleer

We'll get to the specific offline.

Mike Vinciquerra – BMO

Okay and then just also on the $29 million kind of max goal for compensation. I just want to make sure I understand you got two different programs it sounds like where you think it's going to drive $2 million in annual savings, one you've already completed, one will be completed in the third quarter. Is that $4 million, I guess it's called a million dollars a quarter. Is that already factored into the $29 million or that potentially it's the one of the third quarter. But just help me understand how this numbers are going to shake out?

Kevin McAleer

Sure, the 29 includes everything we have planned, I mean essentially what we're doing we're adding $4.5 million in Ridge expense or in compensation expense associated with the Ridge acquisition. We're going to take at least $4 million out of our existing business so that we hold compensation expense flat with the quarter. And then we got – we'll have about $400,000 a month, I mean a quarter, $400,000 a quarter in state pay so that gets us up to about $29 million.

Mike Vinciquerra – BMO

Okay, all right. Great. And then just to understand again the clients loss, I think we talked in this call last quarter about you believe that correspondent numbers were close to stabilization obviously something changed in terms of who you decided you wanted to be doing business with long-term. Just talk about again it's a more house cleaning going on, it sounds like you just looked at these clients and said given the service we're providing them and the amount of money we can generate, it's just not worth our focus when we've got bigger clients like TradeKing and some others who are coming on-board.

Philip Pendergraft

Mike, you're exactly right, I mean we've done a lot of work over the last 90 days in terms of correspondent profitability analysis trying to make as we look our cost and try to and as we bring on 95 new customers, trying to make sure that we – that we'll make it and that we have profitable relationships and our relationship I mean we're a decisive company now, were a relationship that pays us $2000 or $3,000 a month and isn't growing. Lot of way to talk to justify and so we – I mean there were a number of things that. so we made a number of decisions based upon that again in a different environment maybe we might have made different decisions but this is just, we are very focused on cost right now and so as a result we're looking at – we're trying to ensure that on every correspondent that we think would have a positive march.

Mike Vinciquerra – BMO

Got it. Okay, thank you.

Operator

Your next question comes from the line of Howard Chen from Credit Suisse. Please proceed.

Howard Chen – Credit Suisse

Good morning Phil, good morning Kevin.

Philip Pendergraft

Howard, good morning sir.

Kevin McAleer

Hi Howard.

Howard Chen – Credit Suisse

Phil, you focused a lot of your commentary on right sizing the expense base given the challenging top-line conditions, I know these were structuring programs are tough but if I thought about what was incremental to us today, is that $2 million for the second program, $2 million more coming in the third quarter and is that the full extent of it and if so do you think that's enough as it seems like to us a very modest amount of the overall expense base still?

Philip Pendergraft

Well we're looking at non compensation expenses very closely as well, but I don't have a number to give you today in terms of what we think we can take out of non compensation related expenses. We're actually cutting headcount and reducing compensation expense at a time when we grow our revenue base by $50 million. So and its again it is a little bit of a, yes I mean in a clearly if we hadn't just added 100 new correspondents we'd be cutting more than $4 million in compensation expense.

But given the fact that we've just grown the business 20% and we're taking we're still able to take, we're going to still take headcount out of it and frankly if we get done with, if we take $4 million out and but it's not enough, we'll come back and take another look at it, but we are and we're going to take at least $4 million out. That's what we're committing too but certainly to the extent we're able to do more than that in the near term, we will.

But again we're in a transition – this is business is in – we're in a transition. We've grown significantly and while we have to focus on cost control, we got to make sure that we don't overdo it, we have to understand and we have to make sure that we are properly servicing a much bigger customer base today than we had 60 days ago.

Howard Chen – Credit Suisse

That makes sense particularly with Ridge. I just wanted to confirm that we're on kind of on the same page on the numbers. And then on the spread compression, I mean we saw some benefit from an increase in margin lending for the major online brokers during the quarter, I know we talked about in this in past your trends have not always kind of like synced up in any given period of time but could you just give us a broader sense of margin lending trends and your outlook here as you see it within your correspondent base?

Philip Pendergraft

Yes Howard we were largely flat in the quarter versus Q1. We did not see an uptick in margin balances in the second quarter versus the first quarter, we didn't go down but we didn't go up.

Howard Chen – Credit Suisse

Okay, thanks. And then looking forward clearly your top-line outlook is for continued challenging tepid market conditions, that – doest that kind of translate into margin lending balances as well.

Philip Pendergraft

Yes I think we're not forecasting that margin balances are going to grow for the rest of the year, I mean it is because we have concerns about the retail investor for the rest of the year. Now obviously we're going to see growth from the Ridge acquisition so our margin balances will be up next quarter. We – but I don't and we – but I don't think we're going to see really – we don't anticipate a meaningful growth in margin balances for the rest of the year. We do anticipate growing customer balances overall but I think that balance – frankly I think that's going to largely come from additional cash balances, it's not going to come from stock lending or from margin lending.

Howard Chen – Credit Suisse

What impact did the LIBOR expansion have on the business this quarter just outside of the broader macro issues that LIBOR move would imply?

Philip Pendergraft

That really didn't have any impact on us at all. Almost everything we do is fed funds based.

Kevin McAleer

It really had no effect on us financially.

Operator

Your next question comes from the line of Dave Capps from JPMorgan.

Dave Capps – JPMorgan

I was hoping that you guys could go into a little more depth on the cost expectations, specifically you had said that you foresaw from the Ridge acquisition, $50 million of additional revenues and approximately $13 million of additional EBITDA which would imply $37 million of additional expenses. And given that the employee compensation line is staying relatively flat, I was curious where we would see that show up.

Kevin McAleer

Well, approximately $22 million will be in outsourced servicing expense. We will run 44% of the acquired revenues. So that's what we are paying Broadridge to continue to service the business that we purchased. Then there is a component that is believe is going to run around $10 million a year – between $10 million and $12 million that is variable expenses directly associated with that revenue days, and then I think in our model, we had about $4.5 million in compensation expense and that sort of gets us down pretty close to the – I think, well, I am doing the rough math in my head, Dave, that gets us pretty close to $22 million, $35 million – I get pretty close to the EBITDA number.

Now we do think the EBITDA number is going to be a little bit higher than $13 million. We are now forecasting at least $3.5 million in the third quarter, and we are going to take out $4 million or so in compensation expense from our existing business. So we will get a pickup in margin there.

Dave Capps – JPMorgan

Okay, so if I can just go back through that, if you take out – you have mentioned $4 million of compensation, you are taking that back out, that would effectively take that $13 million. I understand that you are – it's coming from the business, the existing business but you could look at almost as that $13 million becomes $17 million. And then on the –

Kevin McAleer

You certainly could look at it that way, in that case, I make it $18 million because we think we are going to be at least $3.5 million this quarter.

Dave Capps – JPMorgan

Okay, and then on the outsourced servicing expenses, is that going to be a new line item.

Philip Pendergraft

We haven't really made a decision on that yet.

Dave Capps – JPMorgan

Okay. And then, you talked earlier about the competitive landscape and especially about the possible increased competition that you could see in Canada. I was just hoping that you could go into a little depth on some of the pricing pressures or lack thereof that you have been seeing in the industry.

Philip Pendergraft

So, we are actually not seeing that significant of price competition in Canada but we are seeing –

Kevin McAleer

The place where we are seeing the most price – nor are we seeing it here in the U.S. in much of our customer base. We have seen pretty significant price pressure in the very high frequency black box space over the past quarter or so. We are not seeing it really anywhere else, so Australia and the UK, we are holding our margins very well, at least from a pricing perspective. And then our futures business, we are actually signing more higher margin futures business as we have – as we continue to focus in the ID marketplace, we are actually winning higher margin business in that company.

Operator

Your next question comes from the line of David Scharf from JMP Securities.

David Scharf – JMP Securities

Couple of specific questions, then I want to maybe touch upon just some sort of market opportunity issues. On the high frequency side, you mentioned it a couple of times as being more than ordinary level of price competition. Can you remind us or give us a little bit of an update of roughly what percent of your transaction mix coming from those types of clients?

Philip Pendergraft

I don't have that number off the top of my head. I think really the more meaningful number would be percentage of revenue rather than transaction because that kind of customer will always influence the transaction mix much more than it will influence –

David Scharf – JMP Securities

Right, right, my mistake, revenue.

Philip Pendergraft

But we are certainly particularly post the Ridge, I think we are going to be down in the high single digits, low double digits but we will get you an exact number on that. I just don't have that off the top of my head.

David Scharf – JMP Securities

No, that's helpful, I mean around 10%, that gives us the sense for what part of the (inaudible) is impacted.

Philip Pendergraft

I think that's the kind of magnitude.

David Scharf – JMP Securities

Can you comment a little bit about the makeup of the pipeline, obviously with TradeKing converted, that was a large significant one I mean. Are there any potential top ten correspondence in the current signed-but-to-be-converted pipeline or is it, at this point not a lot of company that are going to move the needle much?

Philip Pendergraft

I think that in the pipeline, there are not any – outside of TradeKing there is nothing that is going to be a top ten customer in – at least not in the near term. It is interesting in a couple of our markets over the last quarter or two, we have had – they are having conversations with some pretty meaningful – they seem to have stepped up the level of our conversations with very large customers. And we don't have anything really to report but I think perhaps as a – I think the Ridge transaction has given us a lot more visibility and perhaps credibility with some larger accounts. And so, we are having – it's been interesting to note the uptick in significant conversations with very significant customers.

So that's all very amorphous but it is a definite trend that we have seen over the last three to six months.

David Scharf – JMP Securities

Shifting to just more industry wide issues, I know I believe it was last quarter you addressed some of the issues in terms of capital requirements and just in lieu of now FinReg being passed, any regulatory fallout from the latest legislative initiatives that maybe we haven't touched upon that might impact any of your business whether it's from a compliance reporting, ongoing cost standpoint or we largely have all that in the rearview mirror?

Philip Pendergraft

FinReg, we believe will not have a meaningful impact on us directly. There is no telling of what the unintended consequences of a bill of that size are going to be on the marketplace but we haven't seen anything in it that will directly have a negative impact on us. One big regulatory initiative that I know we're underway with is a change in tax reporting; brokers are required to begin reporting cost basis next year or in the 1099s here in the US, which was not previously a requirement; now we're engaged in that effort.

We were actually in Washington this week visiting with folks on the Hill and others in the regulatory community and we are cautiously optimistic that this form should access – some of the sponsored access changes that are going to come out will be limited to non-members and so that will have very little impact on our business, that might be a positive for us. And I don't really see, there's no regulatory capital issues underway that are going to give us concern.

We do have a concern, a little bit of a concern around some of the things we're doing in the foreign exchange space that could have an impact on some things we had hoped to do but nothing that – but now in current revenues.

David Scharf – JMP Securities

Lastly I just want to kind of revisit the issue of the correspondent hearing that's still continuing. Trying to get my arms around it thinking more broadly beyond where we are in the cycle and in the depressed volumes in rate environment but trying to get a better handle on ultimately the target market and whether that's shifting as Penson defined it and what the opportunity is.

I mean we went through obviously a good year in which quite a bit of unprofitable clients were peered. It seemed like on the last call that process came to a conclusion.

Now we learn that there has been another few dozen that didn't meet the threshold and I'm wondering first where those people go to the extent they are still in business. Secondly, emerging from this cycle, which we hopefully will all see, is the message in the market now that is where a lot of companies Penson kind of went after and a lot of the bigger guys ignored, is this the feeling in the marketplace that those are correspondents that are no longer welcomed in Penson or that, Gee, if you sign up with Penson, you better not run into a down market because you'll get dropped pretty quickly.

Has the size of your target customer over the long-haul been changed? Does that say something about how we ought to view your competitive landscape going forward with the Ridge acquisition? Are we moving up market? Is there a greater demand for scale? I know those are a lot of questions but I'm trying to look beyond the current cycle and understand is this unique niche you had shifting it for the long-haul.

Philip Pendergraft

There is some truth to what you said. We're not that interested in a customer that is going to generate $3000 or $4000 a month in revenue for a long period of time. Now I'm not sure we've really been that interested in that customer for a good while because I mean we've certainly been – we have a number of much larger customers and our average customer pays us a million bucks a year.

So a customer that pays us 50 in that universe has not been a great target market for us for some time. I think that we have traditionally perhaps had a reluctance to terminate relationships strictly on a cost basis or strictly from a revenue perspective. We tended to do it more on credit or regulatory, but this is a pretty tough environment, and so we certainly looked at some of our lower ending customer base in it with a more critical eye.

I did think most of that was done but we also thought that the environment was going to be better, sooner and we just don't think it's going to be now. We're preparing the business for a lower interest rate environment for a longer period of time and we have to drive margin in our existing business. It's clear we're not going to get higher interest revenue from – interest rate increases anytime in the near term.

We're still signing startup customers. We're still getting – I mean we're not walking away from markets that we served before but we're not today and really haven't been for sometime a good spot for the $50,000 a year customer. That was a long answer to a short question. Of course, you asked me a bunch of questions, so hopefully I covered them all in that dissertation.

David Scharf – JMP Securities

Yes and I appreciate it and obviously difficult decisions have to be made in this kind of environment. I'm trying to get a handle on emerging from this cycle in a more attractive volume and rate environment. Are these the types of correspondence that you would want to see back in the fold?

Philip Pendergraft

Yes, we have worked really hard to make sure that's not the case. A customer that was paying us $50,000 a year four years ago and is paying us 50 today; that's a pretty good sign they're going to pay us $50,000 in the next cycle too, and that's not a profitable customer really.

David Scharf – JMP Securities

Lastly, just on Canada, another sort of market oriented question. I mean it's obviously about a tenth the size of the market here. We saw Fidelity move into it I mean. What did Pershing see in that market when you look at the overall size and the fact that you've been there for a while. Fidelity entered in, the banks are entrenched, I mean and I know it's difficult to answer the question from your competitors' perspective but as they looked at the size of that market and what's transpired, why do you think they entered there?

Philip Pendergraft

Because I think that what we're hearing is that at least initially it's because of their US customer's interest in Canada. So it's not so much a burning desire to go build a clearing business in Canada as much as it is a desire not to automatically give out that business to somebody like us when it goes northbound.

Now I'm sure that they will be good competitors in that market but clearly we have a pretty good head start and we've actually made a lot of progress as I indicated. Northbound executions over the last year have grown very significantly in that marketplace. A number of the big trading firms have moved up there. We're benefiting from that and I think that particularly Pershing has been concerned about business that they're losing northbound.

Operator

Your next question comes from the line of Jeff Graf from Springhouse Capital.

Jeff Graf – Springhouse Capital

On the clearing volumes, you had mentioned that volumes were weak in the quarter yet the revenue was up 11% sequentially. So, can you just kind of discuss what was driving the sequential rise in clearing revenue?

Philip Pendergraft

Yes, so actually volumes were up in the quarter. They were just really weak in June, and that's what drove the increase. May was a very strong month for volume but June what we saw are a very sharp drop off in June.

Jeff Graf – Springhouse Capital

On the balance sheet, it looks like – I know there is probably some noise with the Ridge acquisition but it looks like short-term bank loans really spiked in the quarter. I think it went from $16 million to about $170 million. Could you just describe what's behind that?

Philip Pendergraft

Actually that is a period versus – the balance sheet is obviously just a snapshot of where we were on June 30 versus March 31. The average debt balance was up completely related with increased debt one day, completely related to actually the closing of the Ridge transaction and we had money moving around during those last three days of the month, and so our balance at that period was up. The average for the quarter was – I'm not sure what it was but it was down sharply quarter-over-quarter as a result of the new capital that we put in business.

Jeff Graf – Springhouse Capital

As we see the third quarter balance sheet next quarter, you would expect that to come down significantly?

Philip Pendergraft

Well, actually I have no way to tell you that. I mean we settled several billion dollars of transaction today and short-term bank loans are at the broker dealer level and our use of short-term bank loans is strictly around our daily settlement needs and our funding obligations in all the markets where we settle.

So it could be zero, it could be $400 million on a given day. The average is what's important and I do expect that the average will remain substantially down as a result of the additional capital in the business.

Operator

There are no further questions at this time. This concludes the question and answer portion of the call. I would now like to turn the call back over to Mr. Pendergraft for closing remarks.

Philip Pendergraft

Thank you for sticking with us for an hour and 17 minutes. We will endeavor not to continue to set new records in terms of lengths of calls. Hopefully we'll have a fewer moving pieces next quarter and we aren't going to tie you up so much during the day. We do appreciate your question and your participation and your interest in Penson.

We look forward to talking to you again when we report our third quarter results. On behalf of the Penson team around the world, we'd like to wish each of a very good day. Thank you for your time.

Operator

Ladies and gentlemen, this concludes the presentation. Thank you for your participation in today's conference. You may now disconnect. Have a great day.

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

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Source: Penson Worldwide, Inc. Q2 2010 Earnings Call Transcript
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