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KBW, Inc. (NYSE:KBW)

Q2 2010 Earnings Conference Call

July 29, 2010 9:00 AM ET

Executives

Alan Oshiki – IR

John Duffy – Chairman and CEO

Robert Giambrone – CFO

Analysts

Patrick Davitt – Bank of America/Merrill Lynch

Hugh Miller – Sidoti

Steve Stelmach – FBR Capital Markets

Operator

Good day, ladies and gentlemen and welcome to the Second Quarter 2010 KBW Earnings Conference Call. My name is (Keisha) and I will be your operator for today. At this time all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to hand the call over to, Mr. Alan Oshiki, KBW Investor Relations. Please proceed.

Alan Oshiki

Thank you operator and good morning, everyone. Joining us on the call this morning are John Duffy, Chairman and Chief Executive Officer of KBW; and Robert Giambrone, the company’s Chief Financial Officer.

Before we start, I want to briefly remind everyone that some of the statements made during this conference call constitute forward-looking statements within the meaning of the Federal Securities Laws, including such statements as those regarding expectations of future results, general financial performance, future business prospects and strategies.

These statements are based on management’s current expectations and are subject to a number of risks and uncertainties, which could cause actual results to differ materially from those described in the forward-looking statements. Investors are cautioned not to place undue reliance on these statements.

Additional information about factors that could cause our results to differ materially from those in the forward-looking statements can be found in the company’s filings with the U.S. Securities and Exchange Commission.

At this time, I would like to turn the call over to Mr. John Duffy. John?

John Duffy

Thank you Alan. Good morning everyone and thank you for dialing in to this morning’s call. As is described in the press release this morning, our first half revenues were $239 million up 35% from last year. Revenues for the second quarter were basically flat with last year’s second quarter.

Our second quarter 2010 revenues were down from the first quarter and generally that reflects the slowdown and unfavorable markets that I think we experienced in May or June of this year. In summary, in terms of our business lines, our equity capital markets activities were still very busy, but I would say that transactions were more difficult to complete in the second as opposed to earlier in the year. Again because of market conditions.

M&A in terms of our investment banking activities, I would still characterize as quite. Investment banking revenues in total were $131 million for the first half. In terms of our commission business, cash equities business generally the revenue levels were flat compared with the prior year and the second quarter with very comparable for the first quarter. I think our performance display has been better than most of the firms that we would consider our peers and again that’s the flat performance I think is a function of difficult operating environment.

The trading environment clearly in the second quarter was more difficult than the first quarter and we experienced that in both the fixed income and equity areas and also some marks in terms of some of our principal investments. As we mentioned previously we’ve expanded into Asia. We now have one quarter of performance behind us. I would say that we’re very pleased with the progress that we made in our Hong Kong and Tokyo’s office and look forward to expanding that presence.

On the expense line, we kept the compensation expense level at 59.5% of revenues in the second quarter, that was exactly the same number in the first quarter, that percentage excludes the IPO awards that relates to a escrowing public back in November of 2006 and (inaudible) in the fourth quarter of this year.

As I suggested back in February in our fall some of our growth initiatives like the Asia expansion were probably cause our compensation ratio to be 1% to 2% above what it probably would have otherwise been because of the build out of those businesses. Two other items mentioned in our press release that is really new. One we have decided to institute a quarterly cash dividend, the initial payment will be $0.05 per share and I believe the payable date on that dividend is September 15, and the Board also authorized a share repurchase up to $70 million. I think explaining both of those actions in 3.5 years since we’ve gone public; we feel today we have more than enough capital to run our businesses.

We haven’t done any acquisitions since we’ve been public despite some of our expansion moves we frankly have found a cheaper or more efficient to recruit people of rather buying other firms. And we look at the initiation of a cash dividend as partial distribution of our earnings power. The share repurchase movement or the authorization, we decided to take stock as part of our compensation in 2006 and as those shares vest, we’re conscious about the potential diluted impact of those shares, and hence we’ve given ourselves the ability to retire those shares and we think that’s the right move.

Still excited about the opportunities to grow our business and we don’t think that either of these moves or actions the cash dividend or the potential repurchase of shares will impede our ability to take advantage of these growth opportunities that we see in it any way.

In summary, first half revenues were up about 35% and I’d like to point out that our non-comp expenses were up 12.5% and expenses in the second quarter, non-comp expenses in the second quarter were down versus the prior year and the first quarter. So I think we’re starting to achieve some positive earnings leverage. And with that I’d like to turn it over to Bob Giambrone, our CFO to go into a little bit more detail on the numbers. Bob?

Robert Giambrone

Thank you, John. Good morning everyone. As usual, all the numbers I discuss will be on a operating basis which is the GAAP results, adjusted for the compensation expense related to amortization stock awards at the time of the IPO. As John mentioned those restricted shares will fully vest this coming November.

Second significant items in the second quarter of the first half include our record first half total revenues of $239.1 million, including $105.8 million for the second quarter compared to the first quarter’s total revenue of $133.3 million. Last year’s second quarter total revenues amounted to $105.1 million. First half net income was $22.4 million or $0.62 per share.

Investment banking revenue increased $62 million for the first half to $131.1 million. Principal transactions revenue for the first half totaled $22.3 million, an increase of $5.4 million compared to the first half of 2009, reflecting the sharp decline in trading related revenue totaling $3.3 million in this year’s second quarter, compared to $19 million in the first quarter.

Commissions revenue of $71.5 million was essentially flat with the first half – for the first half, with the first half in 2009, and up slightly for the quarter compared to the first quarter this year, which was $36.1 million.

Our capital which is all tangible remains very strong. Our balance sheet leverage remains relatively low at approximately 1.5 times. Book value per share was just over $15 at June 30. Headcount at the end of the second quarter was 533.

Net income for the second quarter was $9.3 million or $0.26 per diluted share, compared to $13.1 million or $0.36 per diluted share for the first quarter. First half 2010 net income was $22.4 million with $0.62 per diluted share compared to a net income of $10.4 million or $0.30 per diluted share for the first half of 2009.

Now I’d like to go into a little more detail on revenue and expense items. Investment banking revenue for the second quarter was $61.2 million, an increase of $18.9 million from the second quarter of 2009. Capital market revenues of $46.7 million increased $10.3 million compared to the second quarter of 2009 although the total number of transactions for 2010 was down. The results included three significant lead managed transactions and a larger than average private placement transaction.

M&A and advisory fees increased $8.6 million to $14.5 million in the second quarter of 2010 compared to the second quarter of 2009, as a result of more completed advisory engagements in the 2010 period. Compared to the first quarter of 2010, investment banking revenue decreased $8.8 million with capital markets revenues down $6.9 million on fewer transactions, and M&A and advisory fees down $1.9 million.

Investment banking revenue for the first half of 2010 was $131.1 million, compared to $69.2 million for 2009’s first half, an increase of $62 million. M&A and advisory fee revenues were $30.9 million for 2010 compared to $15.3 million for 2009, an increase of $15.6 million due to more completed assignments.

Our capital markets revenue for 2010 were $100.2 million compared to $53.8 million for 2009’s first half, an increase of $46.4 million.

On the commissions, equity commissions for the second quarter were relatively flat at $36.1 million compared to the first quarter. Equity commissions for the first half of 2010 was $71.5 million which included $80 million for European equities compared to $71.9 million in total and $17.5 million for European equity for 2009.

Principal transactions revenue of $3.3 million for the second quarter was down $15.8 million from the first quarter total. Fixed income revenue was $6.9 million compared to $12.9 million for the first quarter, a decrease of $6 million, as customer order flow slowed significantly after the strong fixed income rally of the first quarter weakened considerably in the second quarter.

Equity market making losses of $1.1 million compared to $900,000 for the first quarter and other principal transactions resulted in a loss for the quarter of $2.6 million compared to a gain of $7 million in the first quarter due to adverse market conditions as a result of widespread uncertainty and lack of clarity on a number of global issues that prevailed during most of the second quarter.

First half 2010 principal transactions revenue was $22.3 million compared to corresponding 2009 amount of $27.7 million. Fixed income revenue was $19.8 million compared to $22.5 million in the 2009 first half. Other principal transactions gains amounted to $4.5 million compared to $7.7 million in the 2009 period.

Interest and dividend revenue increased $1.6 million and $2.8 million for the second quarter and first half 2010 respectively. We received a special dividend from a private equity investment of approximately $500,000 in the second quarter.

On the expense side, as John mentioned the compensation ratio was 59.5% for the first half compared to 60% in last year’s first half. Non-compensation expenses for the second quarter decreased $5.2 million from the first quarter to a total of $25.9 million reflecting lower professional fees and startup cost for KBW Asia. First half non-compensation expenses were up $6.3 million or 12.5% due primarily to higher communication and data processing expense including KBW Asia’s startup costs.

Those were the items I wanted to point out on our results. And at this point, I am going to turn it back to John Duffy.

John Duffy

Thank you Bob. (Kinesia), can you just line it up, the Q&A. We are prepared to take the questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Patrick Davitt with Bank of America/Merrill Lynch. Please proceed.

Patrick Davitt – Bank of America/Merrill Lynch

The $2.6 million loss in other PT, could you give us some color what kind of securities those were? Is that the legacy (inaudible) portfolio or it was something else?

John Duffy

Well, it’s really everything else, Patrick. As we mentioned before, you could see on the balance sheet, we do own securities. We do have interest in limited partnerships, has the capital in our own hedge funds, and we do trade to an extent for our own account. So, it’s all those things, and essentially all the markets really were down, particularly towards the end of the quarter. And it really caused us to really pull back on trading as well, as customers dealings reflected in our – as is indicated in our commission revenues and even our own (inaudible) business. So, I think caution was the word. And if you owned anything it did not go up. So, it was spread, it includes listed securities, equity securities, private securities, partnerships, it’s really everything else.

Patrick Davitt – Bank of America/Merrill Lynch

Okay great. And there is lot mixed messages about the bank M&A cycle out there, at our conference in June, like John mentioned it. He felt like the ramp up could be delayed for quite some time because of the buyers are just not trusting the target balance sheet. Is that still kind of the feeling you are getting from the meetings you are having?

John Duffy

I think generally yes, Patrick, though I would say, yes the middle Atlantic and New England region, the real estate experience or correction is that has been as severe. And, if you look at where those stocks are trading, most of them have been able to maintain positive earnings, everybody’s reserved building. But generally the paying is up in this quarter of the country are in better shape. I think you could see some activity, because there’s less kind of disruption in terms of loan portfolios here.

Clearly, we’ve got pent-up supply, so I think my basic thesis is correct and that you’ve got to wait until the buyers are more certain about asset pricing levels than they’ve been. My senses are starting to get close to that at least in this geography. I would say that is not the case in a lot of other geographies, whether you’re talking the Southeast or portions in the West, I think we’re still ways there. But – and we’ve still got a lot of FDIC I think opportunities in the pipeline over the course of the next 12 months or so.

So I think the majority of the geography is still focused on the FDIC transactions, though, yes, I think we’re starting to see some level of activity, but it’s principally I think in this quarter of a country.

Patrick Davitt – Bank of America/Merrill Lynch

Okay, that’s helpful. And, finally, the share repurchases, is that going to be kind of sporadic and opportunistic or do you plan to kind of space them out over the next few quarters?

John Duffy

I’m not sure have anything well defined at this point. The Board just authorized us. I think we’ll we may be opportunistic. But, as I mentioned, we have shares vesting from some of the employee program. So I think they’re – eventually there may be more of a systematic approach to make sure the dilution from that share issuance doesn’t become too significant. So this is new for us. So I think over the course of the next couple quarters, we’ll know little better what we’re going to do with respect to that, but we thought that was appropriate to get the authorization now.

Patrick Davitt – Bank of America/Merrill Lynch

Okay, thanks a lot guys.

John Duffy

Okay.

Operator

Your next question comes from the line of Hugh Miller with Sidoti. Please proceed.

Hugh Miller – Sidoti

Yes, I was – just wanted to get your thoughts on kind of the European bank stress tests and kind of the quality of the tests, your thoughts there. And the opportunities I guess that you think there might be in that region they’re going to help out with potential capital raising?

John Duffy

I think, yes, interesting question. I think the results that came out pretty much myriad what our analysts in London were expecting. I think they had maybe a slightly higher number that they go would not test. I think looking at the market reaction, I think there’s still lot of questions on the part of the investors, even though the response generally has been favorable.

You’ve got some countries like Germany and Spain, where I think their equivalent of our savings banks, that sector looks quite weak. And I think the markets, maybe still their breath a little bit in terms of how the cave houses in Spain or the land banks in Germany, what their future is and how their governments deal with that.

Looking at some of the levels and whatnot, I expect that there’s going to be continued capital rising over that side of the pond over the course of the next year or so as market conditions permit.

Hugh Miller – Sidoti

And do you guys – do you feel as though given your focus on research coverage there and the relationships that you have that you see opportunities there to kind of participate in that?

John Duffy

Well, we have most of the activity taking place over there has been in rights offerings and I think the corporate (inaudible) opportunity or margins are not as lucrative as they are on this side on the Atlantic. And I think there is also a potential to do some midcap activity, there is capital needs for companies that are growing and try to take the advantage of some of the dislocation that’s happening with the larger companies.

So it’s – it hasn’t been the most fertile territory in the last couple of years. I think we’re optimistic that future is going to be a little bit brighter for us. But I think in terms of the impact on our consolidated numbers, it’s fairly minor relative to the – what’s going on in the US in our presence here.

Hugh Miller – Sidoti

Okay. I appreciate the color there. And, I guess, if we look at your underwriting activity so far in July, it seems to have picked up a little bit from I guess the anemic pace of the latter part of the second quarter. But just wanted to get a sense of the conversations you are having with your clients and how that may have the dynamics may have changed a little bit from the latter part of the quarter, if at all.

John Duffy

The – we just concluded our two-day community bank conference. We had 83 regional banks present. I started off the conference Tuesday morning by pointing out that last year we had I think 95 companies to present and 38 or 39 of them had issued capital since last year’s conference. We expect that the capital markets activity is going to continue, industry still needs capital.

There are two types of company which is trying to get the market. One, the people that are winning the FDIC transactions, frequently come back to the markets to reload after they would carry – spend some capital on the transaction. So we expect to see almost serial issuers in some cases. And then, there are other people who have the damaged balance sheets that really are trying to get back at the capital compliance. The latter deals are much more difficult to do.

We’re watching a deal today that I would say is on the opportunistic side and I noticed this morning that there was a deal not one of ours that was pulled from a company that I think probably used more in the capital need categories to get one of our deals and whether it was pulled because of price or lack of interest, I don’t know, but the – I say that because clearly the market conditions are more difficult than they were from I’d say last May through October at the first – at the fourth quarter of this year, late January, February, we have a window.

And then I think when Europe went into a bit of a tailspin and some of the economic numbers here are weak, it certainly made the market more difficult in May and June. I think the second quarter earnings that we’ve seen here domestically from the bank sector generally were little bit better that people were expecting, so that’s kind of given the market a little bit of a lift here.

So we’re somewhat more optimistic than we may have been over the last three months or so in terms of ability to achieve deals. But I think the degree of difficulty is gone up, but the pipeline is very full. We spent the last two days talking to 83 bank managements and I don’t think our investment bankers have ever been busier.

Hugh Miller – Sidoti

Okay. It’s certainly great color there. I guess, last question with regards to the fixed income segment there. Can you just talk about the competitive landscape there? Are you seeing some additional challenges given the hiring activities for maybe some of the larger peers and your thoughts on that versus just it being a challenging climate during the second quarter?

John Duffy

I think the level of interest rates and a lot of our fixed income trading is with the banking industry, there’s just not a lot going on I think in terms of portfolio repositioning or new activity, and I think that’s probably the principal reason that revenues were down. I don’t think it’s so much the competitive landscape. I think there’s couple of things happening on the competitive landscape that probably offset each other.

You had some of the large shops or kind of trying to rebuild their efforts, maybe having cut too much late ‘08, early ‘09. But I think some of the other kind of specialty shops that ramped up or were created formed – take the advantage of the opportunity in fixed – in the fixed income space, first half of last year or most of last year. I think those firms are finding the environment quite challenging and I think our level of conversations with potentially recruiting some employees from some of those firms is actually kind of gone up in the last six or eight weeks as people that may have left the big shops that may have went to some of these smaller competitors or finding that the lack of a broader platform is inhibiting their ability to do business. So we may have an opportunity to add some more people there.

Operator

(Operator Instructions) Your next question comes from the line of Steve Stelmach with FBR Capital Markets.

Steve Stelmach – FBR Capital Markets

Just circling back up on principle transactions, obviously a tough quarter for everybody but how should we think about that going forward? Is the capital allocation in that business any different today than it was maybe in 2009 when business was pretty good or is the capital allocations are the same and it’s just a matter of sort of being opportunistic given market conditions.

John Duffy

Yes, we don’t really change the capital allocations dramatically quarter to quarter or maybe even year to year. We’ve got plenty of capital and I think it’s just the trader is not that utilizing, they have the ability to do just because the market being adverse and I think you got to kind of look at several of these businesses or lines together to try to forecast or predict what they’re going to be on a quarterly basis, I think is pretty hazardous I think we’ve all experienced in both the equity and fixed income markets over the last couple of years.

So we don’t view risk taking as really the impetus. We have the capital of taking advantage of opportunities when we see them and if the market is going the wrong way, we’re not going to bet the house due to a fact that I think we have positive numbers there, is more the story than how much the drop was. We’re not betting the house here but we have the capital to take advantage of situations as they present themselves like frankly they did in 2009 where we kind of had an extraordinary league opportunity to make money.

Steve Stelmach – FBR Capital Markets

Just turning to Asia real quick, I know it’s only been about a quarter or so but can you give us just a flavor for the comparative environment there? Are you guys facing more sort of U.S. domicile middle market players in Asia when you compete for business or is it everybody and anybody that’s over there that you’re sort of butting heads with?

John Duffy

Well, on the cash equity business, I think initially our traction is a lot with U.S. and European accounts that do buy Asian equities not that we’re going to ignore the local players but we’ve hired specialized sales (inaudible) in New York and London. I think something like the 12 largest holders of Asian financials are existing customers of ours in the U.S. and in Europe. So I think what we’re really doing is capitalizing on those relationships and leveraging them. We hope to have new clients over in Asia and I think we’re satisfied with the traction in the first quarter. People are embracing the research products. We’ve got about I think about 70% of the companies that we intent going following over there. We’ve already got published research on.

Steve Stelmach – FBR Capital Markets

On the repurchases just to clarify, that’s more than just simply offsetting stock rent in the future. We should actually see share count bleed lower a little bit over time as you utilize that $70 million, is that correct?

John Duffy

I don’t think we’re going to forecast the share count. We’re conscious of, before issuing shares every year to employees that, you kind of get a creeping dilutive impact and I think to the extent it makes financial sense, we want mitigate or eliminate that. So I don’t know if there’s any magic number that we’re looking at in terms of what number of shares outstanding going to be.

Maybe relative to that point we did take a look at what the share ownership is. It was about 74% after the IPO, obviously we’ve had a lot of shares vest over the past three years from the stock that we’ve issued and the employee selling, but we still have almost 40% employee ownership of the current shares outstanding, which I think is very significant and that doesn’t include the unvested shares that we’ve issued to employees.

Operator

(Operator Instructions) There are no further questions in queue at this time. I would now like to turn the call back over to Mr. John Duffy for any closing remarks.

John Duffy

We appreciate everybody’s interest this morning. If you have questions during the day, don’t hesitate to call Bob or myself to give you a little bit more clarity on the numbers and we look forward to speaking with you in another six months. Thanks very much.

Operator

Thank you for your participation in today’s conference. This concludes the presentation, you may now disconnect your lines. Good day.

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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.

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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