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SWS Group Inc. (NYSE:SWS)

Q3 2014 Earnings Conference Call

May 7, 2014 10:00 AM ET

Executives

Misty Dierking - Corporate Staff

Jim Ross - President and CEO

Mike Edge - Interim CFO

Analysts

Mike Needham - KBW

Presentation

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 of future quarterly calls, please contact us at 214-859-6351214-859-6351. This conference call is being webcast live on the Internet along with the accompanying 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 borrowings 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 and in our other reports filed with and available from the Securities and Exchange Commission.

This conference also contains references to non-GAAP financial information which is being presented to provide additional information regarding the Company’s operations and should not be used in place of GAAP measures. Today’s slides include reconciliations of these non-GAAP measures with the Company’s GAAP results.

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

Jim Ross

Thanks Misty and good morning everyone. First let me introduce my co-presenter Mr. Mike Edge, CFO of SWS Group. On Slide 5, our agenda, first I’ll touch on the consolidated results for the third quarter and highlight other important developments for SWS Group since our last earnings call. And then Mike 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 is star 1 on the telephone.

Turing to Slide 6, as you know we announced in April that we’ve entered into a definitive merger agreement with Hilltop Holdings. Under the terms of the agreement SWS shareholders will receive consideration of 0.2496 shares of Hilltop common stock and $1.94 of cash for every share of SWS stock they own on the record date.

Based on Hilltop’s March 31 closing price this equates to $7.88 per share, a 30% premium to SWS’s pre-announced market price on January 9, 2014. The merger of our two companies will create a leading Texas based broker dealer and the fourth largest Texas based bank by deposits. Hilltop’s and SWS Group’s businesses are very complementary and we believe the merger provides a compelling opportunity for SWS stock holders to participate in the significant upside potential of a larger more diversified organization that is strongly capitalized and better positioned to compete in the marketplace.

Hilltop has a strong reputation and proven track record of successfully integrating acquisitions. This gives us confidence that this combination will lead to additional opportunities to accelerate operating initiatives already underway. We expect to close the transaction by the end of the calendar year, subject to customary closing conditions, including regulatory approvals and approval of SWS Group shareholders and we will communicate events as they develop through our public filings and press releases.

In the meantime, as we pursue the completion of the merger, we’re conducting our business as usual and remain focused on increasing revenues, controlling costs and improving and operation results. These are the topics we will discuss on today’s call. And with that I’ll turn back to our third quarter results.

Now each of our four operating segments reported pre-tax profits in the third quarter, and they also showed improved pre-tax results as compared to last year’s quarter. The retail segment continued to demonstrate improved performance as it increased pre-tax income to 2.4 million from $308,000 last year. And while revenues remained consistent with last year’s quarter, advisory fees were up in all areas of this business as assets under management increased by 22%. At the same time operating expenses in this segment decreased by 8% and that was primarily due to decreases in commissions and other employee compensation expenses.

The institutional segment showed improvement in both net revenues and pre-tax income as compared to last year’s quarter. Net revenues were up 6%, driven by an increase and net gains on principle transactions, primarily in the municipal finance business. A 42% increase on taxable fixed income commissions as compared to last year was offset by decreases in both portfolio trading in municipal finance commissions.

Our clearing segments net revenues in the third quarter increased to $5.1 million from $4.5 million in last quarter while net income in this segment increased to $979,000 from a net loss of $617,000. Our bank reported a 74% increase in pretax income to $2.1 million, despite lower revenues. We continue to strengthen the bank with classified assets decreasing to $40.9 million or 22.9% of capital plus allowance for loan loss at the end of the quarter from $78.5 million or 41.4% at the same time last year.

The bank also recorded a $1.6 million loan loss recapture in the quarter, contributing to a 33% decrease in operating expenses as compared to last year. Other drivers of the decreases were declines in commissions and other employee compensation, as well as a decrease in REO related expenses as REO balances were $5.9 million at the end of the quarter, as compared to $23.7 million at the end of last year’s quarter.

On Slide 7, net revenues were $65.7 million in the quarter, off slightly from $66.8 million last year. For the quarter we reported a pre-tax loss of $8.2 million compared to a pretax loss of $9.6 million last year. Net loss after tax was $8.8 million or $0.27 per diluted share in the third quarter, compared to a net loss of 5.7 million or $0.17 per diluted share last year. We closed the March quarter with book value per share of $9.37 versus $10.85 per share in the prior year. Assuming full exercise of the outstanding warrants, current book value per share would be $8.33.

On Slide 8, in order to better understand the company’s performance we believe it’s helpful to compare our quarterly results after adjusting for the warrant valuation, the bank’s loan loss recapture and expenses associated with the proposed merger. The fiscal 2014 third quarter included a $6.7 million unrealized loss from the warrant valuation adjustment as compared to a $3.8 million unrealized loss in the same period last year. In addition this year’s quarter included $2.4 million in expenses related to the proposed merger as well as a loan loss recapture of $1.6 million neither of which were included in last year’s third quarter. After adjusting both periods for these items, the adjusted pretax loss for the fiscal 2014 third quarter was $648,000 compared to an adjusted pretax loss of $5.7 million last year.

On Slide 9, as we previously discussed, our core priorities remain focused on improving operating results through both revenue and cost control initiatives. Our broker dealer business segments are well positioned to capitalize on the continued strength in the equity markets with retail and clearing posting year-to-date improvements in fiscal 2014 versus the same period last fiscal year. And while the current low interest rate environment and market volatility pose challenges for our institutional businesses, the segment continues to drive a significant share of our revenues and pretax results.

We’ll continue to monitor developments and enhance our risk management strategies in response to these conditions. We also have continued to reduce classified assets at the bank and have made tremendous progress on those efforts with total classified assets down 48% at the end of the third quarter from the same time last year.

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

Mike Edge

Thanks Jim and good morning everyone. Turing to Slide 11, we provide detail on net revenues in the quarter. Net revenues that is total revenues less interest expense were down 2% from last year, primarily on lower net interest revenue, while operating revenues were flat. Commission revenues were up $1 million from last year with net reductions in both the retail and institutional segments. Investment banking and advisory fees increased $500,000 from last year. Retail advisory fee revenue drove the improvement with an increase of $1.1 million on a 22% increase in assets under management and municipal finance fees also increased by $300,000 on a more favorable mix of business. Taxable fixed income fees however fell $800,000 on weaker government agency under-writing activity. Net gains on principle transactions increased $2.7 million from last year on improvements in both fixed income units. I will provide more detail on this revenue line item on the following slide.

Other revenues fell $2.3 million from last year. This included a $1.2 million reduction in gains on SBA loan sales, $1 million decline in insurance revenue within our retail segment and a $700,000 decrease in deferred compensation revenue. Servicing fees received from a third party administrator increased $500,000 in the quarter offsetting some of the impact of these items. Net interest was up 9% versus last year, primarily due to a reduction in the size of the bank’s loan portfolio and compression in the bank’s net interest margin.

Turning to Slide 12, we provide more detail on net gains on principle transactions revenue line. We recorded total net gains on principle transactions of $8.2 million in the quarter, an improvement of 49% versus last year. Municipal finance trading gains improved substantially on more robust market activity, characterized by improved liquidity, as fears related to large scale municipal defaults and potential changes to the U.S. tax code subsided.

Taxable fixed income trading gains also improved versus last year on reduced market volatility. In addition management continues to emphasize turnover on its inventory of security zone. Trading gains also improved 10% from the December quarter with better performance in both of our fixed income units.

On the next Slide, Slide 13, you can see the breakdown of expenses for the quarter. Total non-provision operating expenses were down 5% from last year. Compensation expense, which was down $3.3 million was the primary driver of the cost savings. This improvement included a reduction of compensation and benefits of $2.5 million mainly related to headcount reductions we made in the first quarter of the fiscal year. In addition we saw an $800,000 decline in expense associated with the value of the Company’s deferred compensation plan assets.

Advertising and promotional expense was down $500,000 on lower travel and entertainment expense, particularly in the retail segment. Other expenses were down slightly, as ongoing legal and professional services fees and REO related expense savings helped to offset deal fees of $2.4 million related to the merger proposal. We recorded a loan loss recapture of $1.6 million in the quarter. Given the continued improvement of the loan book the reduction in historical losses and further classified asset reductions, we felt that the additional recapture was warranted. Lastly I’ll touch on the warrant valuation adjustment, which contributed $2.9 million of additional expense in the quarter as we recorded a loss in the warrant of $6.7 million compared to a loss of $3.8 million last year.

Now turning to Slide 14, we detailed components of the compensation ratio. Since our most significant cost typically relates to employees, we feel that our compensation ratio is a good metric to track the efficiency of our operations. On a GAAP basis, the compensation ratio was 74.2% for the quarter versus 71.2% last quarter and 78% 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 net interest expense associated with the $100 million loan from Hilltop and Oak Hill, the adjusted compensation ratio for the quarter was 70.7%, versus 68% in the prior quarter and 74.5% last year.

Given our current levels of revenue, we believe that a blended compensation ratio in the low 70s is appropriate at this time. While compensation expense was relatively unchanged from the previous quarter, reductions in certain revenue lines that do not impact compensation led to a higher blended ratio. These non-production related line items included reductions in revenue associated with the bank’s equity investments and interest rate swap transactions as well as lower deferred compensation revenue. The improvement from last year was primarily due to headcount reductions in the first quarter of the current fiscal year.

Moving on to Slide 15, you will see the key assumptions underlying the warrant valuation. The $1.40 per share increase in our stock price from December was the primary driver of the $6.7 million increase in the value of the warrant, which resulted in the corresponding unrealized loss on our financials for the quarter. Derived volatility was lower in the quarter due to the pending merger proposals.

Moving on to Slide 16, we breakout net revenues and pretax income for each of the four business segments. All business segments were profitable and all showed improved pretax results versus the year ago quarter. However pretax profits were down from the prior quarter in all businesses except the institutional segment. Pretax profits in the clearing segment were up $1.6 million from a year ago. Clearing fees were up 4% on improved general securities ticket volumes and third party servicing fees increased by $300,000. In addition operating expenses were down $1 million from a year ago due to a 17% decrease in operations and technology expenses as well as compensation related savings.

Profits were down from the prior quarter primarily due to a decline in third party servicing fees. Retail segment profitability improved significantly compared to last year. While net revenues were relatively flat, lower expenses accounted for most of the improvement. Reduced salaries and benefits in the segment combined with lower payout within our independent contractor division on lower revenues resulted in compensation expense savings of $1.2 million. Additional savings in travel and entertainment expense further contributed to cost savings in the quarter.

Profits were down from the prior quarter primarily due to seasonality in retail productions and a decline in third party servicing fees. Institutional segment profitability improved 26% from last year. Net revenue gains of $1.7 million contributed significantly to the improvement. Trading gains improved $2.9 million from last year as we saw improvement in both our taxable and tax exempt trading divisions as a result a more robust market conditions and continued attention to turnover of securities out.

Investment banking and advisory fees were down $600,000 compared to last year, while municipal finance fees improved due to a more profitable mix of deal flow; weaker government agency underwriting activity in our taxable fixed income division offset these gains. Commission revenues were down $600,000 as well, due to weaker volumes in both our portfolio trading and municipal finance businesses. Taxable fixed income however offset most of these declines with a 42% improvement in taxable commissions. Operating expenses increased 2% primarily due to a 1% increase in compensation expense, in line with stronger revenues and high recurring fees related to recent technology upgrades in portfolio trading.

The bank recorded a $900,000 increase in pretax versus last year despite a $2.2 million reduction in net revenues. The net revenue decline included a $1.2 million reduction in net gain on SBA loan sales and the $599,000 increase in losses related to the bank’s equity investments. These declines were partially offset by $462,000 increase in the fair value of REO as well as $301,000 improvement in net gains on the sale of REO. Net interest revenue dropped $900,000 due to a 21% reduction in average loan balances and a 20 basis point reduction in net interest margin.

Non-interest operating expenses were lower in the quarter, offsetting the decline in net revenues, as we recorded a loan loss recapture of $1.6 million in the quarter compared to no provision or recapture last year. Excluding the recapture other operating expenses decreased 17% from last year due to a 12% reduction in compensation as well we lower REO and other problem asset related costs. The decline in profitability from the prior quarter was primarily related to smaller loan loss recapture and losses related to the value of the bank’s equity investments.

Moving on to Slide 17, we display a number of key metrics from the quarter. Clearing volumes decreased 29% from last year due an 88% decline in tickets processed on behalf of high volume correspondence. General securities ticket volume however increased 9% from last year and 2% from December. Employee headcount is down 1% from December and down 13% from a year ago.

Most of this change is due to headcount reductions in September and positions eliminated through attrition. Retail client assets increased 1% from December and 5% from last year. Net capital of the broker-dealer remained strong at $148 million.

Moving to Slide 18, we provide detail on the bank’s classified assets. We continue to reduce classified assets in the quarter as total non-performing assets were down 7% from December and down 45% from last year. In addition current classified assets fell 25% during the quarter and 52% from last year. Total classified assets of $41 million improved 15% from December and 48% from last year. The classified asset ratio of 22.9% continued to improve from 27.2% in December and 41.4% last year.

Now turning to Slide 19, we highlight some key bank statistics. As mentioned earlier, this quarter included a loan loss recapture of $1.6 million on continued improvement and the performance of the loan book, bringing the reserve to loan ratio down to 1.83%. While we believe that the current level of reserves is appropriate and more in line with our peer group, we will continue to re-evaluate the allowance in light of overall loan growth, historical losses and macro-economic trends. The bank’s overall net interest margin of 2.79% 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 20, we highlight a few key balances at the bank. The bank’s investment portfolio ended March at $597 million. Gross loans held for investment of $566 million were up $28.4 million from December. And while challenges remain in the mortgage purchase business due to the refinance market, other gross loans excluding mortgage purchase were up $45.5 million or 10% from December, largely due to our purchase of two loan pools in the quarter totaling $40.

While we do not anticipate making additional purchases of this size in the near future, we believe these purchases were prudent and provide an opportunity to offset weakness that we continue to face in the mortgage purchase business. The bank ended the quarter with core capital of 13.9% and risk-based capital of 27.4%. The broker-dealer continues to provide 88% of the bank's deposits.

Now turning to Slide 21, we provide detail on categories of bank loans. Mortgage purchase balances were down $17 million from December 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 and increased competition to present ongoing challenges in this business. One of the four family loans increased $37.2 million from the end of December as we purchased two loan pools in the quarter totaling approximately $40 million as previously mentioned.

We also continue to see strength in the multi-family portfolio with balances up $10.5 million from December where competition remains the factor in this business. We believe our pipeline is strong and we expect to continue to show modest loan growth in the coming quarters.

And with that I'll turn it back over to you, Jim.

Jim Ross

Thanks Mike. And in closing I’d like to reemphasize our core priorities. As we pursue completion of the merger with Hilltop Holdings, we will continue our efforts to improve operating results by pursuing revenue initiatives across our business lines while controlling expenses. We’re focused on maintaining prudent hedging and risk management strategies in order to ensure that we’re well positioned in the current market environment and we will continue our successful efforts to reduce classified assets and strengthen the bank as we pursue a conservative strategy to grow the loan book and expand our business.

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’d like to remind our listeners that the purpose of today’s call is to discuss our quarterly financial results and we’ll thank you in advance for limiting your question this topic. And with that I’ll open it up for questions. Star 1 on the telephone.

At this time it appears we have no questions. We’d to thank everybody for joining us this morning and good bye.

Question-And-Answer Session

Operator

We do have one question sir. Mike Needham with KBW is on line.

Mike Needham - KBW

So looks like you guys are starting to see bit of a pickup in municipal finance, despite pretty weak industry volumes. So I guess if you could just provide some color on what you’re seeing that’s different. And perhaps if the slowdown in refinancing is having less of an impact?

Jim Ross

Your question is why did we have a reasonably good quarter in municipal finance?

Mike Needham - KBW

Right.

Jim Ross

I think that we’ve got a very talented team in that area. We are very strong in particularly the Texas markets. There were issuance that came to market and we got I guess disproportionately more than our share. Now your second question on are we seeing the refinance slowdown impact, Mike?

Mike Edge

No not, particularly.

Mike Needham - KBW

Okay, that’s fair. And can you comment on maybe your deal pipeline?

Jim Ross

Deal pipeline in which area?

Mike Needham - KBW

Municipal finance.

Jim Ross

I think that in talking to the folks there and the guy that runs that, he’s encouraged in what we see out there in that deal pipeline. Texas has a good strong economy. That’s our primary area for underwriting. We have expanded into other markets. We’re becoming more and more involved in the California markets over in Kentucky, North Carolina, South Carolina. So I think that what you’re seeing today is a lot of work that’s gone into that department over the last two or three years, that’s really starting to pay off. Richard has added some people. He’s really tightened up his process and procedures on his inventory controls. He’s got his cost control and that’s always been a very well-run department for us and I think you’re just starting to see efficiencies and they are competing hard and winning.

Mike Needham - KBW

Fair enough. And within the institutional business, taxable commissions, it looked like you had a nice pickup in the fiscal third quarter. Can you just give us some color on what’s driving that and whether it is just the lower volatility issue or if you’re seeing bit if an improvement there?

Jim Ross

Well I think, I’m going to say a lot of same things I just finished saying about taxable. That’s an area where we’ve added some talents, we’ve restructured some things and what they are doing in there. They have had, it’s still secret there has been a lots of volatility in those markets compared to the previous years. These guys were adapting to kind of the new norm and doing it very well. I don’t think there is any one thing I can point to and say, shazam, this has happened. It’s just working hard and it’s paying off.

Operator

And we have no more questions.

Jim Ross

You’re sure?

Operator

I’m sure.

Jim Ross

All right. Thank you everybody, we appreciate it.

Operator

That concludes today’s conference. Thank you for participating. Please disconnect your lines at this time. Thank you.

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Source: SWS Group's (SWS) CEO Jim Ross On Q3 2014 Results - Earnings Call Transcript
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