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SWS Group (NYSE:SWS)

Q4 2014 Earnings Conference Call

September 3, 2014 10:00 am ET

Executives

Jim Ross – Chief Executive Officer

Mike Edge – Chief Financial Officer

Lisa Conatser – Human Resources Administrative Coordinator

Analysts

Lisa Conatser

Good morning everyone and welcome to the SWS Group quarterly conference call and webcast. This is Lisa Conatser 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 214-859-6351.

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. During the question and answer session, call participants may access the queue to submit a question by pressing star, one on their telephone.

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 intents, beliefs 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 broker loan lines, credit agreements and credit facilities, customer margin loan activity, credit worthiness of 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, the ability to meet regulatory capital requirements, the failure to consummate or delay in consummating the proposed transaction with Hilltop Holdings Inc. for other reasons, the risk that a regulatory approval that may be required for the proposed transaction is delayed, is not obtained or is obtained subject to conditions that are not anticipated, 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 Lisa and good morning everyone. Turning to Slide 5, my first task is to introduce my co-producer, Mr. Mike Edge, CFO of SWS Group. On Slide 6, our agenda – first, I’ll touch on the consolidated results for the fourth quarter and highlight other important developments for the company since our last earnings call, 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 will be star, one on the telephone.

Turning to Slide 7, last month we announced that the close of business on Friday, September 5 has been set as the record date for the special meeting of shareholders to consider and vote on the merger with Hilltop Holdings Inc. Following the record date, we will file with the SEC definitive proxy materials related to the proposed merger as soon as is reasonably possible. The definitive proxy materials will include the special meeting date, which we expect will be approximately six weeks after the record date. Subject to stockholder and regulatory approvals, we still anticipate completing the merger by the end of 2014 calendar year.

While we pursue the completion of the merger, we remain committed to improving our operating results through both cost cutting and revenue initiatives, and today’s call will focus solely on the results of these efforts for the fourth quarter and fiscal 2014. We will not discuss specifics of the current transaction.

Now, each of our four business segments reported pre-tax profits for the fourth quarter and for the fiscal year. Retail assets under management increased 14% from last June, which helped to replace lower commission revenues while controlled costs and improved efficiencies helped to improve pre-tax results. Institutional results improved considerably as we did not experience the disruption in the bond markets that we did last year and portfolio trading volumes improved. Clearing results improved in the quarter as cost cutting and increased revenues helped to offset a decline in ticket volumes, and core results at the bank showed continued improvement as the reduction in the loan loss recapture was the primary factor in lower pre-tax results. Our team at the bank has done a wonderful job addressing asset quality over the last few years, and we believe we’re well positioned for conservative growth.

On Slide 18, we see that the fourth fiscal quarter net revenues were $63.2 million, an increase of $7.8 million from last year. We reported pre-tax income of $637,000 for the quarter as compared to a pre-tax loss of $3.7 million for the same period last year and a net loss after tax of $304,000 or $0.01 per diluted share on this year’s quarter. For the fiscal 2013 fourth quarter, the net loss was $32.5 million or $0.99 per diluted share. For the fiscal year, net revenues were down 1.9% to $266.4 million from $271.7 million in fiscal 2013. We narrowed the pre-tax loss to $6.1 million for the year from $6.7 million in fiscal 2013. Net loss for fiscal 2014 was $7.1 million or $0.21 per diluted share compared to a net loss of $33.4 million for fiscal 2013. Last fiscal year’s results included a $30 million increase in our deferred tax asset valuation allowance recorded in the fiscal 2013 fourth quarter.

We closed the fiscal year with book value per share of $9.46 versus $9.66 per share in the prior year. Assuming the exercise of all the outstanding warrants, we estimate tangible book value per share would be $8.16 versus $8.18 last year.

Turning to Slide 9, in order to better understand the company’s performance, we believe it is helpful to compare our quarterly results after adjusting for the warrant valuation adjustment, expenses associated with the proposed merger, and the bank’s loan loss recapture. The fiscal 2014 fourth quarter included a $3.2 million unrealized gain from the warrant valuation adjustment as compared to a $3.9 million unrealized gain in the same period last year. In addition, this year’s quarter included $1.4 million in expenses related to the proposed merger as well as a loan loss recapture of $492,000. Obviously there were no merger related expenses in last year’s quarter and the loan loss recapture was $6.3 million in last year’s quarter. After adjusting both periods for these items, the adjusted pre-tax loss was $1.7 million for the fiscal 2014 fourth quarter as compared to the $13.9 million for last year’s fourth quarter. For the fiscal year, the adjusted pre-tax loss was $4.1 million compared to $18 million for fiscal 2013.

On Slide 10, as we begin our fiscal 2015 we remain focused on increasing profitability across our business lines through both revenue and cost cutting initiatives, and while we made progress in many areas and improved our consolidated financial results over the past fiscal year, challenges remain. Current economic and regulatory uncertainty will require our continued diligence as we enhance our risk management strategies and pursue a return to profitability. We successfully reduced our bank’s classified assets and non-performing loans during the fiscal year, and we’ll work and build on our efforts to conservatively grow the bank’s loan book in fiscal 2015.

With that, I’ll turn it over to Mike for a review of our financial results for the quarter.

Mike Edge

Thanks Jim, and good morning everyone. Turning to Slide 12, we provide detail on net revenues in the quarter. Net revenues – that is total revenues less interest expense – were up 14% from last year. Commission revenues were down $1.7 million from last year as weaker results in the retail segment offset improvement in our portfolio trading business. Investment banking and advisory fees declined $5 million from last year as we exited the corporate finance business and experienced less robust underwriting activity in our taxable fixed income and municipal finance divisions. Retail advisory fees, however, improved on a 14% increase in assets under management.

Net gains on principal transactions improved $13.6 million from last year as both fixed income units benefited from more a stable rate environment than we saw a year ago. Other revenues were up $1.6 million from last year. This included a $700,000 improvement in the holding company’s venture capital fund investment, a $600,000 increase in third party servicing fees, and a $500,000 increase in gains related to the valuation adjustment for the firm’s deferred compensation plan. Other revenues in the banking segment were down $600,000, offsetting some of these improvements. Net interest was up 5% versus last year primarily due to an 8 basis point reduction in the bank’s net interest margin.

Turning to Slide 13, we provide more detail on net revenues for the full fiscal year. Net revenues declined 2% from last year primarily due to lower net interest revenues. Commission revenues were down by $6.1 million due to a $4.4 million decline in the institutional segment driven by lower portfolio trading volumes. Retail commissions were also off by $1.7 million primarily due to weaker results in our independent contractor business. Investment banking and advisory fees were down $5.2 million due to a decline in taxable fixed income underwriting fees and our exit from the corporate finance business. Retail advisory fees improved $3.6 million as assets under management increased 14%, offsetting a portion of the decline.

Net gains on principal transactions improved $12.3 million on relative strength in our fixed income businesses in this year’s fourth quarter. Other revenues increased $2.4 million on a $2 million increase in third party servicing fees and a $1 million improvement related to the value of the firm’s deferred compensation plan investments. Other revenues at the bank were down $700,000. Net interest was up $8.7 million from last year mainly due to the banking segment, as average loan balances declined 24% and our net interest margin narrowed by 50 basis points.

On the next slide, Slide 14, you can see the breakdown of expenses for the quarter. Total non-provision operating expenses were down 4% from last year. Compensation expense, which was down $2.5 million, was the primary driver of the cost savings. Excluding the $400,000 increase of expense related to the value of the firm’s deferred compensation plan investment, compensation expense fell $2.9 million. The bulk of these savings came from a reduction in retail compensation related to a decrease in customer activity, our exit from the corporate finance business, and headcount reductions made earlier in the year. We also recorded a loan loss recapture of $492,000 in the quarter compared to a recapture of $6.3 million last year as the quality of our loan book continues to improve. The valuation adjustment for the warrants resulted in a benefit of $3.2 million in the quarter compared to a benefit of $3.9 million last year.

On to Slide 15, we provide more detail on operating expenses for the full fiscal year. Total non-provisioned operating expenses were down 5% in fiscal 2014 from last year. Compensation expense, which was down $10.8 million, was the primary driver of the cost savings. Excluding a $700,000 increase in expense related to the value of the firm’s deferred compensation plan investments, total compensation expense fell $11.5 million. The bulk of these savings came from firm-wide headcount reductions made in the first quarter of fiscal 2014, our exit from the corporate finance business last June, and lower compensation expense in our independent contractor business.

Other expenses were down $3.9 million primarily as a result of lower OREO-related expenses, regulatory fees, and other outside service expense at the bank. Ongoing legal and professional services fees declined $3.1 million as well, which partially offset $3.8 million in deal fees associated with the proposed merger. We also recorded a loan loss recapture of $5.4 million for the year compared to a recapture of $7.7 million last year as our bank team has continued to diligently address problem assets in the legacy portfolio. The warrant valuation adjustment contributed a net increase in expense of $7.2 million as we recorded net expense of $3.6 million for the year compared to a net benefit of $3.6 million last year.

On to Slide 16, we detail the components of the compensation ratio. On a GAAP basis, the compensation ratio was 73.4% for the quarter versus 74.2% last quarter and 88.2% last year. While these numbers are appropriate, we believe that it is helpful to make some adjustments to these percentages in order to compare the ratios between periods and to our peer group. Excluding the interest expense associated with the $100 million loan from Hilltop and Oak Hill, the adjusted compensation ratio was 69.7% for the quarter versus 70.7% in the prior quarter and 83.4% in the fiscal 2013 fourth quarter. Given our current levels of revenue, we believe that a blended compensation ratio in the low 70’s is appropriate at this time. The improvement from last year was due to the combined effects of both headcount reductions in the first quarter and a 14% improvement in net revenues.

Moving on to Slide 17, you’ll see the key assumptions underlying the warrant valuation. The $0.20 per share decline in our stock price from March combined with lower volatility and a loss of time value all worked to decrease the value of the warrant by $3.2 million, resulting in a corresponding unrealized gain for the quarter.

On to Slide 18, we break out net revenues and pre-tax income for each of our four business segments. All business segments were profitable in the fourth quarter and for the full year. Pre-tax profits improved versus the year-ago quarter and for the full year in all of our broker-dealer related segments, and the bank segment showed improvement in its core results for both the quarter and the full year. For the quarter, pre-tax profits in the clearing segment were up $1.1 million from a year ago on a combination of increased revenues and cost reductions. Third party servicing fees increased by $400,000 while operating expenses were down $700,000 from last year due to lower operations and technology expenses and compensation-related savings. Retail segment profitability improved by approximately $640,000 in the fourth quarter compared to last year. Improved advisory fees, third party servicing fees, and insurance revenues helped to offset a decline in commission revenues as assets under management increased 14% from last year. Compensation expense was down $1.7 million compared to last year and occupancy and travel and entertainment expenses declined as well.

Net revenues in the institutional segment were up 54% while profitability improved $8.5 million in the quarter compared to last year. Net gains on principal transactions improved $13.6 million as fixed income markets were much calmer than they were last year. In addition, commission revenues were up $1.1 million on improved volumes in our portfolio trading business. Offsetting these improvements, investment banking and advisory fees were lower by $5.7 million as we exited the corporate finance business and experienced less robust underwriting activity in our taxable municipal finance positions than we saw a year ago.

The bank’s pre-tax results were down $5.1 million in the quarter compared to last year. While net revenues declined approximately $1 million, the reduction in loan loss recapture accounted for most of the change. The bank’s other revenues for the quarter were down $600,000 from a year ago as declining gains on SBA loan sales and a reduction in gains recognized on the bank’s equity method investments offset improvements on OREO sales.

Net interest also decreased by approximately $400,000 as average loan balances declined 8% and net interest margin contracted by 8 basis points. Excluding the loan loss recapture, operating expenses decreased 17% from last year due to a 14% reduction in compensation as well as lower OREO expenses and other problem asset-related costs. In addition, the bank recorded a $492,000 loan loss recapture in the quarter compared to $6.3 million last year.

On to Slide 19, we display a number of key metrics from the quarter. Employee headcount ended the fiscal year down 3% from March and down 16% from a year ago. Most of this change was due to headcount reductions in September of 2013 and eliminating positions through attrition. Retail client assets increased 3% from March and 8% from last year. Net capital at the broker-dealer remains strong at $156 million.

Next on Slide 20, we provide detail on the bank’s classified assets. We continue to focus on reducing classified assets as total non-performing assets were down 9% from March and down 40% from last year. Total classified assets of $41 million were roughly in line with March quarter and improved 39% from a year ago. We ended fiscal ’14 with a classified asset ratio of 22.7% compared to 37.4% last year.

Turning to Slide 21, we highlight some key bank statistics. We finished the year with a reserve to loan ratio of 1.82%, in line with the March quarter. We believe that the current level of reserves is appropriate and more aligned with our peer group than a year ago directly as a result of the improved quality of the portfolio. That said, we will continue to evaluate the allowance in light of overall loan growth, historical losses, and macroeconomic trends. The bank’s overall net interest margin of 2.91% reflects a 12 basis point increase from the prior quarter due to improved mortgage purchase activity and less reliance on a lower yielding investment portfolio.

Moving on to Slide 22, we highlight a few key balances at the bank. The bank’s investment portfolio ended June at $515 million and gross loans held for investment of $622 million were up $56.2 million from March. The bank ended the quarter with core capital of 14.1% and risk-based capital of 25.5%.

On to Slide 23, we provide detail on our categories of bank loans. Mortgage purchase balances were up $61 million from March as new home purchase activity improved and new business initiatives took effect. While we saw some improvement from the prior quarter, we expect increased competition and soft refinancing activity to continue to represent headwinds going forward. Gross loans, excluding mortgage purchase, were down slightly from March but relatively stable.

With that, I’ll turn it back over to you, Jim.

Jim Ross

Thanks Mike. In closing, I’d like to highlight our core priorities once more as we begin the new fiscal year. While we pursue the merger with Hilltop Holdings, we are focused on improving operating results across our business lines and returning to consistent profitability. We expect the uncertainty of the current market environment to persist for the foreseeable future and will continue to engage in effective risk management strategies to address these challenges. In addition, we will pursue conservative growth in our banking segment while maintaining our past success in reducing problem assets.

With that, 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. Before I 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. We thank you in advance for limiting your questions to this topic.

With that, I’ll open it up for questions – star, one on the phone.

Question and Answer Session

Jim Ross

As we have no questions in the queue, we’d like to thank everybody once more for joining us. Good morning.

Operator

That concludes today’s conference. Thank you for participating. You may now disconnect.

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