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Executives

Phil Pendergraft – Chief Executive Officer

Kevin McAleer – Executive Vice President & Chief Financial Officer

Analysts

Mike Vinciquerra - BMO

Ken Worthington – J.P. Morgan

Patrick O’Shaughnessy – Raymond James

Howard Chen – Credit Suisse

Dave Katz – J.P. Morgan

Chris Connor – Sandler O’Neill

Kevane Wong – JMP Securities

Mark Lane – William Blair

Scott Appleby – Appleby Capital

Penson Worldwide (OTC:PNSN) 3Q 2010 Earnings Call November 2, 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’s Securities and Exchange Commission filings. Actual results could differ materially from those currently anticipated and we disclaim any obligation to update information disclosed in this call as a result of developments which occur afterwards. At this time, all participants have been placed on a listen-only mode and the floor will open for questions and comments following the presentation. During the question-and-answer session, please do not use cell phones or blackberries as they can cause loud static on the line. I would now like to turn the floor over to Mr. Phil Pendergraft, Chief Executive Officer. Mr. Pendergraft, you may begin.

Phil Pendergraft

Good morning and thank you for joining us today. I am here with Kevin McAleer, our Chief Financial Officer, as usual. We have a presentation that accompanies our remarks and provides other information. It can be found on the Penson investor relations page events calendar. Look for the .pdf connected to this conference call.

Last night we released our third quarter results. We reported an after-tax net loss of $8 million from operations equal to $0.28 per share, an after-tax severance charge of $1.4 million equal to $0.05 per share, totaling a GAAP net loss of $9.4 million equal to $0.33 per share. These results include $8 million in non-cash expenses that have an after-tax effect of $5 million. This quarter’s loss was larger than anticipated, due almost entirely to significantly lower trading volumes at our U.S. securities clearing and execution company. However, revenues from correspondent contracts acquired from Ridge did hold up well and performed fairly close to the expectations we discussed on our last earnings call. Our business expansion and cost saving programs are on track and since the end of the third quarter, industry activity has improved and our volumes have begun to rebound. Company-wide, net revenues total just under $70 million. That included more than $12 million from former Ridge correspondents, but a decline of $13 million from other businesses. That decrease was primarily due to 22% lower non-inertest revenues in Penson businesses excluding Ridge. In general, this fall off was in-line with the sharply reduced average daily volumes experienced industry-wide, which were off more than 27% in equities and 21% in options. As you know, our non-interest revenues are closely tied to volumes. Since the end of the quarter, however, industry activity has improved and, in fact, it began to improve in the middle of September and our volumes have begun to rebound just as industry volumes have. Average daily trades for the company, including Ridge, are up 19% in equities and 26% in options, October versus September. We anticipate that this volume increase will have a corresponding impact on all non-interest revenue categories including other revenues, much of which is tied to our execution services business, in one way or another. Net interest income was up 18% on a quarter-over-quarter basis, due entirely to the business acquired from Ridge. Average interest earning balances increased by 12% to a record $6.75 billion. Net interest spread was unchanged at 92 basis points. We have continued to see improvements in interest revenues in October with stock lending net revenues estimated to be up 25% and total net interest revenues up between 10% and 15%, in both cases, compared with our September numbers. Third quarter expenses totaled approximately $85 million, approximately $11.4 million of these expenses related to the Ridge correspondents, which included amortization and interest expense on long-term debt associated with the acquisition. Excluding Ridge and severance costs, total expenses declined by $1.5 million, reflecting the impact of lower volumes and our cost-control measures. During the quarter, but not reflected in the quarter’s results, we reduced annual compensation by an additional $4 million. We will begin to see these savings in the fourth quarter. Expenses included $1.2 million in technology conversion costs related to our just-completed conversion at our futures company and our upcoming conversion to Broadridge in the U.S. We expect these expenses to decline substantially in the fourth quarter. As I mentioned earlier, as a part of the third quarter expenses, there were $8 million of non-cash items. About $44.5 million for depreciation and more than $1 million each for amortization, non-cash interest expenses, and stock-based compensation. Looking at the $13 million net revenue decline in Penson businesses excluding Ridge, about $7.4 million came from lower clearing and commission fees. Most of that was at PFSI, our U.S. securities clearing business. Most of that came from our active trader base. That is the black box and direct market access or DMA correspondents that cater to high-volume, institutional and professional clients and the online correspondents that serve active retail clients. Revenues from these groups of correspondents were down approximately 40% as compared to PFSI’s other correspondents categories which were off an average of 20%. This makes sense because the customers of our more active trader correspondents thrive off of market volume and volatility, both of which were lower during the third quarter. Of the $13 million, approximately $4.2 million was due to a 34% drop in other revenues. This was primarily in our execution services business which includes trade aggregation and execution, which we provide to our correspondents (“inaudible”). Again, this was principally volume-related in what, for us, is a very high margin business. The balance of the decline, about $700,000.00 was in net interest revenues. Interest earning customer balances grew by 1%, while the net interest spread fell by six basis points to 86 basis points, due primarily to changes in a our balance mix. All of our other businesses, the former Ridge correspondents, futures, London, Canada, and technology held up fairly well, with our Australian business continuing to make good progress toward profitability.

Turning now to just the block of business acquired from Ridge. As I noted earlier, the correspondent businesses acquired from Ridge performed, generally, in line with what we had anticipated going into this quarter, given the lower-than-expected volumes. We anticipate that this business should perform ahead of our original expectation in the fourth quarter. During the third quarter, revenues came in at $12.2 million compared to our $12 million to $13 million plan, and EBIDA came in at $3.2 million compared to our $3.5 million plan. Volumes were only off 8% from the second quarter. We were able to make up most of the effect of that volume decline in net interest revenues through the expansion of the Ridge stock lending business. As a result, we had originally planned for revenues to be split 80/20 between non-interest and interest. Revenues from this block of business came in at about 70/30. Overall, we averaged $665 million in customer interest-earning balances from the former Ridge clients with a net interest spread of a 159 basis points. Now, we do not plan to break out Ridge correspondent results going forward, but we believed that it was important to do so this time in order to help you understand what happened during the quarter.

We have talked a lot about Penson Australia. It was much improved in the third quarter as many of our new correspondents began trading. Our Australian volumes actually increased more than 40% in the quarter, although from a small base. This enabled us to significantly improve operating leverage and to cut Australia’s losses by half to approximately $670,000.00. Year-to-date, we have incurred approximately $2.9 million in pre-tax losses in getting this start-up off the ground. We anticipate further improvements in their performance in the fourth quarter.

We are also making progress with our cost saving program. As I indicated earlier, excluding costs associated with the Ridge clients and one-time costs, primarily severance, total expenses declined by $1.5 million when compared with the second quarter, despite a $1 million incremental increase in conversion related expenses.

During the second quarter, we reduced annual compensation expenses by approximately $2 million and indicated that we would seek an equal reduction in the third quarter. We actually achieved twice that amount or more than $4 million during the third quarter, which we should begin to see in the fourth quarter. This reduces our target compensation number to $28 million per quarter, although, that could fluctuation slightly depending on performance-based compensation. The Broadridge conversions remain on schedule. Canada is scheduled to convert at the end of the year. The U.S. conversions will be staged beginning in the second quarter of 2011 and completed by the end of the third quarter. Our target remains $7 million in base technology savings, savings of up to $3 million more of other outsourced functions. Canada will generate about 40% of the base savings, the U.S. between 50% and 55%, and the U.K. the balance.

As we indicated during our last conference call, we had hoped to return to profitability on an operating basis in the second half of the year. With our third quarter results and current industry conditions, we now believe that that is unlikely. Due to uncertain market conditions, we do not want to be in the guidance business, but I can tell that our internal planning anticipates steadily improving our operating results going forward on a sequential quarter basis. This assumes, of course, industry conditions generally stay at the current levels.

Looking at the fourth quarter, what do we think is going to change going into the fourth quarter? We anticipate, among other things, that volume should be better than the third quarter, certainly if present levels are any indication. Margin lending and our stock lending businesses have already improved with good current momentum. Compensation and other expenses should be lower, including a reduction in conversion-related expenses. Our Australian business should continue to improve and move into the black. In terms of correspondents, we completed the TradeKing conversion in late September and we have one of our strongest new business pipelines going into the fourth quarter. I believe we have 36 correspondent firms in the pipeline currently.

Moving into 2011, we should begin to see initial cost savings from the Broadridge technology and outsourcing agreement in the first quarter, when we transition our Canadian business. As we move through the year, those saving should increase sequentially as the U.S. securities clearing business moves in stages to the Broadridge platform. Although, trading volumes have increased as of late, the market still presents challenges. However, we do believe that our strategies, designed to increase revenues and reduce costs, will enable us to steadily improve results even in a generally softer trading environment.

To wrap up, this has definitely been a tough quarter. Similar to that experience by almost everybody in the industry, businesses principally based on generating revenue from creating volumes and interest rates. Having said that, I want to be clear that we consider this performance to be unacceptable. We are dedicated to getting through this period and coming out of it a stronger and leaner company. On our last call, we explained that we are focused on four key areas. First, on aggressively adjusting our cost structure in line with the current operating environment. Second, on building relationships with our new Ridge correspondents and providing them with additional services and products. Third, in seeking new revenue opportunities from new clients and products. And fourth, on driving toward fully implementing the technology and outsourcing agreements from Broadridge. On each of these fronts we are making significant progress which we believe will positively impact our financial performance as we move forward including in the near-term.

That concludes our formal remarks and at this time we would be please to take questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Our first question comes from the line of Mike Vinciquerra with BMO. Please proceed.

Mike Vinciquerra - BMO

Good morning guys.

Phil Pendergraft

Good morning Mike.

Fist, I just want to ask on the comp. looking at the reconciliation you guys gave between Ridge and Penson, itself. Looks like this quarter we were about $29 million in comps. Essentially, what you are saying is the $4 million in annualized savings, you will get the $1 million savings to get to that $28 million run-rate on a quarterly basis?

Phil Pendergraft

Yes Sir.

Mike Vinciquerra - BMO

Second thing, stock-based comp this quarter, $1.14 million, I am curious when you allocate that to employees, what is the primary driver to put aside bonus comp? Because, obviously the last couple quarters have been rough on the bottom line and I want to understand what they are being paid for.

Phil Pendergraft

Well, Mike, actually stock-based compensation, this quarter, is almost exclusively from stock-based compensation that has been granted over the past two or three years. I am not aware that we made any new stock compensation awards in either the second or third quarters. Any previous awards are amortized over the term of their vesting.

Mike Vinciquerra - BMO

I understand. Then I want to ask on the top line, and you went into some detail on the clearing revenues, and I certainly understand that the industry was down. Historically, you guys have been much more stable both up and down versus, what I will call the broad discount brokers, and obviously this quarter you are more in-line. I think it is because of your diversification across industries and across geographies, but the main difference this quarter was just all in that high-frequency trading group. Did you get any balance at all from some of the other markets, year-end or the futures space, or anything like that?

Phil Pendergraft

Certainly, our futures business actually performed well this quarter. The segregated balances there are at an all-time high. They are about $700 million as of the last week or two. I think you are right. We have historically seen a little lower beta, shall we say, in the way our customers have performed, but this quarter was different. We saw, particularly in our U.S. business, we saw the biggest drop-off that we really, I think, have seen in our history on a quarter-over-quarter basis in terms of our active trader participation. Everything was down but the active component was down the most. I think a lot of it had to do with just really a decline in volatility and volume overall. They just did not participate at the level that we have seen in previous, even in previous downturns. We didn’t lose any customers. There is no change. It really is apples to apples. It is just all about lower volume.

Mike Vinciquerra - BMO

Okay. Thank you.

Operator

Your next question comes from the line of Ken Worthington with J.P. Morgan. Please proceed.

Ken Worthington – J.P. Morgan

Hi. Good morning.

Phil Pendergraft

Ken, good morning sir.

Ken Worthington – J.P. Morgan

First, on the correspondent pipeline, again, seems very strong, not seeing the conversion that we would have expected. Did the Ridge acquisition impact conversions and now that that is completed and long-completed, what is the likely timing of conversion for the 36 new correspondents?

Phil Pendergraft

Well, Ken, they will convert anywhere from, in general, they should convert anywhere from this quarter, the fourth quarter, up through the second quarter of next year. We are going to be somewhere between three and nine months depending on the level of integration required. There are two key factors, I think, that impacted the third quarter. One, in Canada, we are not converting anybody. We have locked all that down given our pending conversion to Broadridge over year end. Our Canadian subsidiary, we are not actually moving anybody out of the pipeline. Here in the U.S., truthfully, we were really focused on TradeKing in the third quarter. It was a big conversion for us. It slipped a couple of times due to technology issues on our side and on the TradeKing side and we were actually very focused on making sure that we got that converted properly in the quarter and that impacted some other transitions.

Ken Worthington – J.P. Morgan

Great. Thank you. Then on rates, short-term rates did increase kind of on an average basis in 3Q as LIBOR rose and you saw this on the interest-earning assets, and that is kind of what we expected. But, the yield on the interest-paying liabilities rose about the same amount. What are the dynamics that played out here? I guess the reason I ask is that when rates rise, we expect a positive impact. I think you guys expect a positive impact and no rates just blipped and it was just really LIBOR, but we didn’t see spreads expand at all with the temporary blip-up in rates and I just wanted to see what, if anything, led to that dynamic this quarter?

Phil Pendergraft

So Ken, actually our rate structure is based around Fed funds, generally, rather than LIBOR. We did not see really any meaningful increase in, let me say this a different way. I want to be a little clearer. On our existing business, we actually saw a six-basis-point decline and that was largely because of mix this quarter. Although, we continue to see pressure on our FDIC deposit program because of the banking environment, because the banks are getting healthier and they are less competitive, being less competitive for rates in that program. We actually saw really the six-basis-point decline on our existing business was really largely around mix. We held our spread pretty well in the FDIC side. We had 149 or 159, I can’t remember which. I think it was 159-basis-point spread on the Ridge side and that averaged in to hold our overall spread at 92 basis points. That is sort of a long answer to say that the changes in LIBOR really had no impact at all and our spread, largely, was impacted by changes in mix in our existing business and by the layering in of the Ridge business on top of it.

Great. Thank you very much.

Phil Pendergraft

Yes sir.

Operator

Your next question comes from the line of Patrick O’Shaughnessy with Raymond James. Please proceed.

Patrick O’Shaughnessy – Raymond James

Hey, good morning guys.

Phil Pendergraft

Patrick, good morning sir.

Good morning Patrick.

Patrick O’Shaughnessy – Raymond James

A question for you about your capital base. Obviously, you guys raised some capital in conjunction with the Broadridge deal and, I think, at that time you felt pretty comfortable with it. Now, after a couple quarters of some losses and potentially, depending on what volumes do, a relatively murky net income picture for the next two quarters. How do you feel about your capital position? Does it still provide you enough room to grow you correspondent base? And perhaps, more importantly, in the near-term, how do correspondents feel when their clearing firm has been posting losses for a few quarters?

Phil Pendergraft

Okay, that is two or three questions. Let me kind of divide them up. First, from a capital perspective, the last two quarters we have actually generated cash. Our cash losses, the non-cash component of our losses has actually exceeded the cash portion. The last two quarters have really had no impact on our overall capital perspective, on the capital in the businesses. We will see at our U.S. subsidiary, our capital ratios will be lower than normal at the end of the third quarter. That has really nothing to do with our losses. We had some unusual and temporary customer balance increases over quarter end. We had a customer that increased his balance by about $300 million for a week over quarter-end. We had some unusually high option requirements due to quarterly option expiration. Our numbers will be down slightly at our U.S. subsidiary and were down for about a week. But other than that, we have had really no impact; I mean our capital is virtually unchanged from where it was a quarter ago or two quarters ago. Now, that is capital. Turning to correspondents, I think our clients are certainly not going to be surprised that we are struggling in this environment because they are struggling too. Fundamentally, we are an agency business and we process our customers’ business. We had a tough quarter because they had a tough quarter. I do not think it will have any impact on our customer base, the majority of which are under long-term contracts anyway. I think that we will have no impact there. I think you had three questions, I think I answered them all.

Patrick O’Shaughnessy – Raymond James

I think you covered it. Thank you. My next question would be around your cost base and I think that you provided a fair amount of detail today, stuff that you can take to lower. Let’s assume that we stay in a volume environment, kind of like we have been in the last few months and certainly we saw some improvement in October. The seasonality would suggest maybe it dips a little bit towards the end of the year. But, let’s say that we stay in this environment and rates stay zero to 25 basis points that is on-target for the next year or so. Do you guys feel like your cost structure as it is now and will be improving as you get some of the synergies from Ridge, is it in a place where you are comfortable with a profitability that can drive given the headwinds that you might be facing or might you, at some point, have to take further steps to say okay, the headwinds are just too severe, maybe we need to address this further.

Phil Pendergraft

Patrick, we are going to address it every quarter. We are very focused on costs and to the extent we see places where we can further reduce our expense base, we are going to do it. I do think that at the volume levels that we are seeing in the fourth quarter coupled with the savings, the $7 million to $10 million in savings that we will begin to see next year, and the stronger performance of Ridge, the Ridge acquired business that we are seeing, and in Australia, I think those factors will allow us to remain profitable even in this very depressed environment. I am actually hopeful that we might see some further volume improvements as we go into next year after some of the election uncertainties are out of the way. But even if we don’t, I think those other factors will allow us to be profitable, but we are not going to make a lot of money in this environment. But, I also do not expect that we will see a repeat of the third quarter. We will take additional steps on the cost side, as necessary.

Patrick O’Shaughnessy – Raymond James

Alright, fair enough. Thank you very much.

Operator

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

Howard Chen – Credit Suisse

Hi. Good morning Phil, Good morning Kevin.

Phil Pendergraft & Kevin McAleer

Good morning sir. Good morning Howard.

Howard Chen – Credit Suisse

Could you just remind us of any differences as you think about them amongst your legacy U.S. clients and those that you acquired with Ridge, even if you exclude the really active traders in the legacy of business, would you provide a lot of color on? It still seems like there is a meaningful gap in what happened to volumes during the quarter. I am hoping to get any thoughts you have there.

Phil Pendergraft

The Ridge base, the differences are really two major differences. One is, and they are sort of at either end of the spectrum, the more traditional retail brokerage, where we have not traditionally been strong. The other is in the more tradition, institutional business, the underwriting, research, the firms that provide the really traditional backside institutional support. Those are both areas where we have not been strong. Both of those held up much more strongly than the more technology-based, self-directed customer that had been the core of our traditional U.S. business.

Howard Chen – Credit Suisse

Just as a follow-up to that, Phil, could you just give us pro-forma for Ridge and maybe what you see in the current environment? How you think about the revenue or volume break-down between the different U.S. client segments, the traditional, institutional, high-frequency, other?

Phil Pendergraft

Howard, I would be pleased to do that. I don’t have that. Please do that offline. I don’t have those numbers at my fingertips. I will tell you that, as I indicated during the previous quarter’s call, we believe that the Ridge transaction is going to run 10% to 15% ahead of our original plan. We have seen some pretty meaningful improvement in volume there. It is currently running ahead of our acquisition plan on the volume side and we are doing meaningfully better than we had anticipated in the stock lending and execution services cross-over between our two businesses. We are actually, you cannot see it a lot because of the other moving pieces this quarter, we are actually very pleased with what is going on with them.

Howard Chen – Credit Suisse

Just following up on the high-frequency client segment, I know, Phil you have touched on a couple times in terms of just the market declines and the activity levels, but is this primarily from the legacy Penson side or Legacy Schonfeld side from a few years ago.

Phil Pendergraft

It is both. We certainly saw declines in some of the business that came from the Schonfeld acquisition, but we saw it in the core Penson technology-focused customers as well. I think it was more about that kind of customer than any specific acquisition or block of business.

Howard Chen – Credit Suisse

Okay, and then how about just follow-up in terms of competitive landscape in that client, is there anything competitively that you would point to or not point to that is changing that would sort of shift volume from you to someone else, etc?

Phil Pendergraft

No. I don’t think that competitive pressure really had any impact on the performance in the quarter. I think it was about volume. We did not lose any customers. We did not have any customers shift volume. We have actually had a pretty good customer acquisition quarter. I do not see anything on, nothing on the competitive front really had an impact.

Howard Chen – Credit Suisse

Thanks for taking all of the questions. My final one, just again, related to this high-frequency stuff, with the step down in volumes, do you anticipate any impact on future Schonfeld earn outs? I cannot completely recall where we are in terms of just realizing all of those.

Phil Pendergraft

We actually have one to go, next summer. It is based on revenue and earnings. I think it is fair to assume that the current performance will have an impact on that.

Howard Chin – Credit Suisse

Great. Many thanks for taking the questions.

Phil Pendergraft

Sure.

Operator

Your next question comes from the line of Dave Katz with J.P. Morgan. Please proceed.

Dave Katz – J.P. Morgan

Hi Gentleman.

Phil Pendergraft

Hey, good morning.

Dave Katz – J.P. Morgan

I was hoping that you, I know you provided some guidance in terms, or at least an indication of what you are seeing in terms of October. On the interest revenue side of it, I was hoping you could define exactly what, because one would assume it would not be growth and spread that would be driving that.

Phil Pendergraft

Actually Dave, it is. Part of it is, I think we have seen a little bit of balanced growth in October. We are seeing improvements in our mix and we are seeing strong growth in our stock lending business, which is one of the more profitable segments of our interest-earning balances. Those earnings are up about 25% in October versus September. That will have a positive impact on spread. In our core Penson business, we saw a six-basis-point decline in the third quarter versus the second quarter, and that was actually largely around mix, an unfavorable mix shift. I think that we are seeing some of that reversed and I would expect us to have a more favorable mix in the fourth quarter if current indications hold true.

Dave Katz – J.P. Morgan

Okay, and then where do you guys stand currently in terms of your net regulatory capital, I guess, in relation to the covenant?

Phil Pendergraft

We are in compliance with our bank covenants. Our net regulatory capital, I do not think, has changed materially over the quarter.

Dave Katz – J.P. Morgan

Okay, the bank covenant includes a maximum consolidated leverage ratio, would you be able to define what the max ratio is?

Phil Pendergraft

Dave, I don’t have that number with me or in front of me. But, we are in compliance with our bank covenants. We did amend our bank facility over the past month. I think the actual covenants contained in that are filed under confidential treatment, but we are in compliance. We do not have anything drawn on it, we have never drawn on it. But, we are incompliance with it and we do have availability under the facility.

Dave Katz – J.P. Morgan

Okay, two follow-up questions then. On the amendments, did those amendments change or give you more leeway in terms of complying with the financial covenants themselves?

Phil Pendergraft

Yes.

Dave Katz – J.P. Morgan

Okay.

Phil Pendergraft

Given the current operating environment, we worked with our banks to make sure that we had some more flexibility in the facility.

Dave Katz – J.P. Morgan

Okay, the second question was on the, I know that you guys have nothing drawn on it at present, but my reading of it indicates that anything drawn on it has to be matched, at least, by cash on hand , which would mean that the $75 million facility could not be used to address cash needs of the business. Is that correct?

Phil Pendergraft

No. That is not correct.

Dave Katz – J.P. Morgan

Okay. The entire $75 million could be used for the business, if needed?

Phil Pendergraft

There is no cash corresponding or compensating cash balance requirement on it. We do have availability on the line. We do not currently have availability of the full $75 million based on a couple of our ratios, but we do have meaningful availability on the line. There is no compensating balance requirement.

Dave Katz – J.P. Morgan

Excellent. Thank you very much for the clarification.

Phil Pendergraft

Thanks Dave.

Operator

Your next question comes from the line of Chris with Sandler O’Neill. Please proceed.

Chris Connor – Sandler O’Neill

Good morning Phil, good morning Kevin.

Phil Pendergraft & Kevin McAleer

Good morning Chris.

Chris Connor – Sandler O’Neill

Maybe to ask this question a little different way, I know you have talked a lot about costs and your expense base and what you can do. I am just wondering, as we look at this environment, and if it persists for a while, if maybe pricing or how you think about pricing and if you think you are actually pricing your services appropriately given the volumes we are seeing. Particularly, do you have floors for some clients? Maybe as an ancillary question, would you be willing to give up some of the upside of higher rates to your correspondent clients in exchange for getting some volume-based floors?

Phil Pendergraft

Volume-based floors.

Chris Connor – Sandler O’Neill

Basically, like a guaranteed payment from certain brokers even if volume slows down, that they would pay you something. Is that ever part of your contracts with them?

Phil Pendergraft

Yes. Almost all of our contracts have minimum payments built in. Those tended to be more substantial off-shore than they are on-shore, particularly in the U.K. and many of the acquired Ridge correspondent clients’ contracts have more meaningful minimums built into them. Most our deals are volume. That volume is not all monthly volume, some of it is annual volume, some of it is average volume. To the extent volume stays down for a meaningful period of time, that will actually result in higher per unit revenue, as we sort of move back up the scale, if that makes sense.

Chris Connor – Sandler O’Neill

Yes. That was one thing I was wondering about because seeing the Roughly 20% - 25% reduction in volume, depending on which metric you are looking at, I thought you might end up a little less on the impact to your revenues.

Phil Pendergraft

I think, over time, we would see some of that. We did not see that materially in the quarter because not all of the contracts are just month-to-month volume.

Chris Connor – Sandler O’Neill

Okay. I might have missed it in all the disclosures, but do you have a number for intangible assets at quarter end?

Phil Pendergraft

I don’t have it in front of me, but we will get it for you.

Okay. I will follow up on that one. The last one from me, you mentioned not doing any conversions in Canada through the end of the year because of the lock-down with Broadridge. Will you have a similar sort of setup in the U.S. next year as you go through those transitions to the Broadridge technology, is that going to slow the pace of some conversions or will you try to get them through certain windows and then close it down for a while?

Phil Pendergraft

No actually, we are in a very different place here in the U.S. than we are in Canada. We are already running a hundred clients from the Broadridge technology. Those are the clients that we acquired as a part of the deal.

Chris Connor – Sandler O’Neill

Right.

Phil Pendergraft

We are already beginning to convert new business onto the Broadridge platform. Right now, we are still in a place where we are converting firms under the SunGard platform and under the Broadridge platform, sort of depending on the mix of business, but toward the end of the year we will stop converting to SunGard and all new conversions will go under Broadridge. It should not hold us up at all.

Chris Connor – Sandler O’Neill

Got it. Okay. Thanks very much.

Kevin McAleer

Sir, the difference in Canada is Canada is not running on two platforms today. We are only running on one and we are converting to a new one. Whereas today, in the U.S., we are running on both already.

Chris Connor – Sandler O’Neill

Right. Got it.

Operator

Your next question comes from the line of Kevane Wong with JMP Securities. Please proceed.

Kevane Wong – JMP Securities

Hey, good morning guys.

Phil Pendergraft

Good morning.

Kevane Wong – JMP Securities

Guess a few things. First, conduit business, you mentioned how Ridge got some benefit on conduit, but when you look at the average volumes, sequentially down in the spread on that business, really dropped out. I know it tends to be pretty jumpy, how that number can be. Can you give us any sort of insight on how we should think on that? Is there some point where you might be able to somehow get some more stability on there, or is it just really going to continue to jump and just be a highly variable component of the business?

Phil Pendergraft

Okay. There are actually two answers to that question. First, the Ridge, the impact on our net interest revenue related to the Ridge stock lending business, is not the conduit piece. It is the in-house piece. It is more effectively utilizing the Ridge inventory for in-house stock lending. It is not the conduit piece.

Kevane Wong – JMP Securities

Okay.

Phil Pendergraft

The conduit piece will continue to be volatile. It is a function of marketplace volumes, marketplace volatility and the value of our box. In the third quarter, volume and volatility were low and the value of our box was unusually low. We had the lowest spread we have had in a number of quarters and, I think, slightly lower average balances. I wish I had a good way to predict that for you. It is subject to some volatility based on those factors each quarter.

Kevane Wong – JMP Securities

Has that also shown an improvement so far in October or has it remained as depressed as it was in the third quarter?

Phil Pendergraft

We have seen an improvement of, I think, between 10% and 15% in the conduit book in the fourth quarter. We have seen a stronger overall improvement but that is primarily from our in-house stock lending business as opposed to conduit. But, conduit is up double digits in the quarter.

Kevane Wong – JMP Securities

Got you. And then, on other revenues. You sort of touched on it. I know what is in there is GHCO, commissions, other calls, FX, etc. How are those products doing within there? I think you mentioned GHCO was doing well. I was sort of curious how FX is doing. Just trying to parse that out a little more between products that are really within that.

Phil Pendergraft

Our foreign exchange business was weak in the quarter, but had a very nice month in October. We have been disappointed in our retail expansion in that business. That is generating somewhere between $1 million and $2 million a year in revenue, which is about somewhere between 30% and 50% of where we wanted to be. Our institutional business there was weaker in the third quarter, but has seen a nice recovery, was really very strong in October. Our execution services business is actually the biggest component in that other revenue column. That was weak in the third quarter, partly, because in our trade aggregation program we essentially share savings and additional revenue generated by hitting certain volume tiers on certain of the exchanges. When overall industry volume is down, that actually has a bigger impact on our aggregation program because we are not hitting the tiers that generate the savings. Revenue from that program was off very sharply in the third quarter.

Kevane Wong – JMP Securities

Maybe just to help quantify it a little bit. How much was the execution services as a percentage of other revenues in third quarter versus second quarter? Just to give us some sort of sense on how much that can swing.

Phil Pendergraft

Execution services revenue is north of 50% of total other revenue. I do not have the exact number in front of me, but we would be happy to share that with you offline.

Kevane Wong – JMP Securities

Do you have any sort of left-field on how that was? Was it over 50% in the third quarter or is that more normal basis if it has to be over 50%?

Phil Pendergraft

On a more normal basis, it is over 50%.

Kevane Wong – JMP Securities

Okay, and then lastly, I know it is a smaller line, but the technology revenues took a sequential drop there too. Is there simply, people pulled back in the quarter or do you think things that you had that were possibly going to be sold, just dropped off? Has there been a shift in people’s spending for these technology products that you have? Just a little comment there please.

Phil Pendergraft

The decline, quarter-over-quarter, is all volume related. We earn more than, about two-thirds of our revenue and our technology is related to transactions. With volume being down, technology revenue is down. Having said that, we certainly have seen over the last two years, we have seen a significant decline in the level of development revenue. As our clients, particularly our big enterprise-level clients have been pretty reluctant to spend meaningful development dollars in this economic environment. We are seeing a little bit of change in that as we look at 2011. We have had at least one of our major enterprise customers come to us and begin discussions about a significant upgrade in their technology base. Maybe we are going to see some dollars begin to free up, but certainly the last couple of years we have not seen that.

Kevane Wong – JMP Securities

Great. Thank you.

Operator

Your next question comes from the line of Mark Lane with William Blair. Please proceed.

Mark Lane – William Blair

Good morning. Just a couple of quick ones. I apologize if I missed this, but on Ameritrade, the sink-or-swim business, you had given some insight as to the transition of certain balances and the impact on the net interest margin last quarter. Can you update us on that now?

Phil Pendergraft

Mark, I don’t have updated numbers. I am not aware that that has changed materially, but I will certainly update those and be happy to provide them to you.

Mark Lane – William Blair

But the transition has not started yet, I would assume?

Phil Pendergraft

No. We now anticipate the transition somewhere in the first or second quarter of next year.

Mark Lane – William Blair

Okay. I think last quarter you mentioned that it could start as early as late this quarter.

Phil Pendergraft

Yes, there was some discussion of a November date, but now I believe the earliest will be some time at the end of February and could extend as late, under current thinking, somewhere into late in the second quarter.

Mark Lane – William Blair

Again, maybe I missed this, but the pipeline, the customer movement, 385to 386 pipeline, 24 to 36, I know you were frank about the slower pace of conversions, but how many clients were converted during the quarter and did you continue your pruning process at all?

Phil Pendergraft

No. I think we are largely done with the, let me say it a different way. I think we are largely done with the pruning process. I will say that we are, based upon really what is going on in the marketplace, what had one on over the last couple of years and what is going on now, we are certainly much more aggressive at regular review of correspondent activity. I think the more formalized review that we have been engaged in over the last year or so, is largely over. We did add, we converted eight customers in the quarter and had seven that left or closed. I think the revenue impact of those that closed, of the seven, was something less than $0.5 million a year. It was pretty nominal.

Mark Lane – William Blair

So where does that pipeline coming from? It is a pretty strong sequential improvement. I think in this environment you would not see that sort of growth.

Phil Pendergraft

We actually picked up, I believe, ten or eleven firms as a part of the Ridge transition. A bunch of the growth this quarter and the pipeline came from adding customers that were in the Ridge pipeline.

Mark Lane – William Blair

Got it. Okay. They were not in the number last quarter.

Phil Pendergraft

That’s correct.

Mark Lane – William Blair

Thank you.

Operator

Your next question comes from the line of Scott Appleby with Appleby Capital. Please proceed.

Scott Appleby – Appleby Capital

Hey Phil.

Phil Pendergraft

Good morning Scott.

Scott Appleby – Appleby Capital

Just trying to get an understanding. This is really a follow-up on the last question. What is the profile of the new correspondent customer in your pipeline?

Phil Pendergraft

Scott, the truth is I am not sure that there is an average. They range everywhere from Macquarie Holdings U.S. business, which we converted in October, to z start-up firm like Hewlands, that we talked about last quarter, to a Brazilian-based IB that is entering into an IB agreement with Pesnon GHCO. It ranges from the start-up to the large institutional player and really everything in between.

Scott Appleby – Appleby Capital

Are there any geographies that look particularly promising?

Phil Pendergraft

The majority of our pipeline is in our U.S. business, which makes sense because our U.S. business is the largest business we have. We are seeing some pretty meaningful opportunities in Brazil. We have done quite a bit work down there over the last year and have begun to sign some pretty good pieces of business either directly out of that market or through a U.S.-based intermediary. I would say, if I was looking at pipeline from an actual geography, that would be the thing that would jump out a little bit outside of just the normal U.S. business that we are signing.

Scott Appleby – Appleby Capital

Okay. And just a quick question for Kevin. On page 7 for your results, you have got a severance cost number in here of $1.4 million. Is this the only one-time cost in the quarter?

Kevin McAleer

Yes. It is. Severance was the only one-time charge.

Scott Appleby – Appleby Capital

Okay. That’s it. Thanks guys.

Phil Pendergraft & Kevin McAleer

Thank you, Scott. Good to talk to you.

Operator

Your next question is a follow-up from Patrick O’Shaughnessy with Raymond James. Please proceed.

Patrick O’Shaughnessy - Raymond James

Hey guys. I wanted to dig in a little bit more on the volume sensitivity of the technology and other revenue line items. The reason why I ask that is because, in the past, you have had quarters with great volume. For example, the June quarter, you had pretty elevated volumes, great clearing commission fees and we did not see an upward spike in those line items. But, then we have a quarter with bad volume and we see the drop. Was there something different about the volume dynamics this quarter that we saw that sensitivity?

Phil Pendergraft

Patrick, I do not think so. We certainly saw a meaningful decline in our trade aggregation program, for reasons I have already shared. I think we also had an impact, certainly had an impact over the last two or three quarters, maybe four quarters in terms of declines on revenue associated with our option execution business. Obviously, payment for order flow in that business has largely vanished and that has been an outside factor that has impacted us over the last two or three quarters. I think, this quarter the amount of execution revenue associated with option execution, or at least associated with payment for option execution, is fairly nominal. I think, over the last year all of that has gone away. That would be the only other outside factor that I am aware of other than volume and the trade aggregations things I have talked about.

Patrick O’Shaughnessy - Raymond James

I appreciate the detail and then, one last quick question. Dublin, that dark pool you guys were going to start up last originally and then you put it on hold as the market structure issues were being dealt with. I assume that continues to be on hold at this point?

Phil Pendergraft

Patrick, it does, even though it is something that we remain really interested in. We just have our plate pretty full right now with Broadridge related issues and opportunities and think that our dollars and our time are better spent in that area right now.

Patrick O’Shaughnessy - Raymond James

Thanks again.

Operator

There are no additional questions at this time. I would now like to hand the presentation back over to Mr. Pendergraft for closing remarks.

Phil Pendergraft

I want to thank you all for attending this morning. I want to thank the San Francisco contingent for being kind to the Texas contingent. We do appreciate you joining us. We do appreciate your interest in Penson. We take very seriously our obligation to improve our operations and we are very focused on that. We look forward to talking to you again when we report the fourth quarter and annual results in late January or early February. On behalf of all the Penson team around the world, we would like to wish you all a very good day.

Thank you.

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Source: Penson Worldwide 3Q 2010 Earnings Call Transcript
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