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Executives

Phil Pendergraft – CEO

Kevin McAleer – CFO

Terry Bourne – CEO of Penson Canada

Analysts

Richard Repetto – Sandler O'Neill

David Scharf – JMP Securities

Howard Chen – Credit Suisse

Tim Shea – JP Morgan

Mike Vinciquerra – BMO Capital Markets

Patrick O'Shaughnessy – Raymond James

Penson Worldwide Inc. (OTC:PNSN) Q2 2008 Earnings Call Transcript July 24, 2008 5:00 PM ET

Operator

Good morning and welcome to the Penson Worldwide conference call. Before we begin, I’d like to read Penson’s Safe Harbor statements.

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 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 discussed 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 be opened for questions and comments following the presentation. 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. Thank you for joining us. I’m here today with Kevin McAleer, our Chief Financial Officer. Also with us is Terry Bourne, Chief Executive Officer of Penson Canada. Terry will provide us with an overview of our activities north of the border. And all three of us will be available to answer questions after our presentation.

As you know, last night we released our second quarter results. We’re very pleased to report that we earned $0.23 per share on net revenues that were 6% from the first quarter to $74.6 million. Several factors contributed to our strong performance. We converted new correspondents and introducing brokers faster than expected. This benefited our securities and futures businesses from both trading and customer balance perspectives. We ended the quarter with 295 correspondents for a net gain of 11 during the period.

Now while US equity volumes were weaker than in the first quarter, we had a record quarter in US option volumes. As our market share grew to 4.5% of this asset class. In addition, market volumes in Canada remained strong, which benefited our business there.

We’ve been taking steps to improve our securities lending businesses, including adding new personnel and enhancing the technology employed in these areas. We saw meaningful results from these efforts this quarter, especially in May and June.

In the future space, our segregated customer funds have grown to more than $400 million as we have benefited from new client acquisitions and increases in exchange margin requirements. The combination of improvement in securities lending and increased customer segregated funds produced the first positive mix shift in our interest earning balances in six quarters. As a result, we experienced only an eight basis-point decline in our net interest spread from the first quarter. This was significantly less than we had anticipated given the 114 basis-point decline in the average federal funds rate between the two quarters.

From a timing perspective, April came in as originally anticipated. Positive trends began to build in May and continued to strengthen through June. And I am pleased to report that early results indicate that July should be even better than any month of the second quarter.

However, not everything went our way during the quarter. In our UK business, for the first time since 2006, we operated at a loss. Factors causing this included soft securities lending business, reduced business from an important client, and continued slowness in our CFT product offering. We’re in the process of launching an enhanced technology offering in the third quarter, which we believe will further our new client acquisition efforts. And we are confident that the UK will return to the block before the end of the year.

Now while the operations of our futures business had been strong, we have been disappointment with some developments in the Sentinel bankruptcy case. As you will recall, Sentinel was a money manager, which filed bankruptcy last summer. Our futures companies had funds under management by Sentinel. Last year, by order of the bankruptcy court, we received approximately 70% of our funds back from the estate. It now appears that we may become involved in litigation with the Sentinel bankruptcy trustee related to the amount of funds that we received or believe that we are entitled to receive in the future. We believe that the court was correct in ordering the distribution last year. And if necessary, we intend to vigorously defend our right to those funds and to those that we believe are still owed to us.

Otherwise, our new business opportunity in the US and Canada is doing very well. As of the end of June, we had 26 signed correspondents and introducing brokers in the pipeline. As these firms come online, we should exceed 300 correspondents for the first time during the third quarter.

In addition, it now appears that the interest cycle is at or very near the bottom with some possibility of an increase in rates later this year. All in all, we are much more optimistic about the rest of the year than we were at the beginning of this quarter.

Turning to an analysis of our revenues, each line item contributed to our second quarter results. Clearing and commission revenues were up 2% on a sequential quarter basis. This is very favorable considering that volume on the major US equity exchanges was off a meaningful 15% to 20%.

There are a number of reasons for our strong performance in this area. First, we are diversified in terms of the markets we serve. Our Canadian business, for example, continued to be strong primarily due to the commodity orientation of the equity business there. Second, as noted, is our continuing new client growth particularly in the US and Canada. Third, we continue to see a number of our correspondents outperform the market in terms of volume growth. And fourth, as I mentioned, we saw strong growth in our US options business.

Technology revenues were up 6% quarter-over-quarter. And Nexa was back in the Black with a small profit versus a small loss in the first quarter. The improvement was due primarily to better development revenue. Last call, we explained that some clients had placed development projects on hold due to market conditions. This situation improved in the second quarter.

We also had a very strong quarter at Nexa’s Tick Data unit. Tick Data supplies quantitative trading firms with historical intra-day data on equities, futures, and options. We have recently rolled out some new products, including certain Asia markets, which had been very well received. Two of the three months in quarter were record months for Tick Data. The increase to development revenue and strong Tick Data sales, plus a smaller recurring revenue increase pushed Nexa into the Black in the quarter.

In addition, after the end of the quarter, Nexa signed a licensing agreement with a major new client. This contract is expected to generate over $4 million in high margin licensing revenues over the next five to six quarters. We were confident that Nexa would be in the Black for the remainder of the year even without this contract, but with this contract, 2008 should be Nexa’s best year ever.

Other revenue was up 15% quarter-over-quarter rebounding to more than $11 million. This is in line to what we have said previously. While other revenue was not going to snap back immediately to the strong $13 million level we saw in the fourth quarter, we were confident we’re going to improve from the first quarter, and it did.

There were four major factors. First, we’ve continued growth in our options executions business due to increased contract volume, which more than offset the declining yield due to $0.01 pricing. Second, we had a strong quarter in equity execution services as well. Third, we had a very strong quarter in our fixed income business in Canada generating near record commissions for the quarter. And fourth, we did a little better in our foreign exchange and trading businesses. Overall, we feel that we are back on track with a more normal run rate in this area.

Turning to net interest revenue, we had another record quarter in our conduit stock lending business. Our net revenue from conduit lending increased more than 16% from the first quarter to nearly $3 million. The spread continue to be in the 70-plus basis points range that began in the March-ending quarter. We’ve added new professionals to this desk whose trading volumes are growing. At this time, it looks like the third quarter will be another strong quarter for this business.

And finally, turning to net interest from customer assets, this was 8% from the first quarter. This was driven by growth in interest earning assets – interest earning balances up 17% in the quarter. And for the first time in six quarters, we also saw a positive shift in balance mix. So as we mentioned earlier, we had an eight basis points decline in our spread from the first quarter despite 114 basis points drop in the average funds rate enabling us to bring much of our growth in balances for the bottom line.

This successful performance was driven by expansion of our house stock lending business and the addition of new correspondent businesses and their balances. We also deployed new technology in the first quarter, which has allowed us to optimize the collateral available for loan. We’ve benefited from that significantly in the quarter.

And lastly, seg funds from the futures business were up more up more than 41% from the end of the first quarter largely due to new business, the growth of introducing brokers and their customers.

Looking at our results on an operating unit basis, Pension Financial Services, our US clearing and execution firm did well during the second quarter. Clearing and commission revenues were up 5% and our options business was especially strong. Net interest revenue was good due to both conduit and house stock lending improvements. And both clearing and interest benefited from the impact of new correspondents.

So why is business so strong? Well first, we are winning new business in the market place because of our high volume capacity and our multi-asset, multi-currency, multi-market capabilities. Second, very clearly, our sales team had a homerun court. We launched our expanded sales effort about a year ago. This year, we added to that sales team and we are benefiting from these moves. Third, while we have not experienced a direct impact from what happened with Bear Sterns and North American Clearing, we believe that in this environment, our independent, non-conflicted model has become even more attractive.

I mentioned earlier that we have 26 firms in the pipeline signed, but not yet producing revenues. Included in this total is Van der Moolen. They’ve chosen us to clear their institutional and options business here in the US. Also included is Scottrade. We will begin clearing for customers using their new advanced option trading technology to be launched later this year. We mentioned this business on our first quarter call, but did not have permission to identity the correspondent at that time.

Our portfolio margin business continues to grow, and is now up to 293 accounts. Although the debit balances grew only slightly in the quarter to a $154 million average. Overall, our US business is performing very strongly and is entering the third quarter with a lot of momentum.

Penson GHCO, our futures business, also had a solid quarter. While transaction volumes were down, we did very well in interest revenues because of the in the increase in segregated funds. We’ve said that we believe there’s a lot of growth in the futures business, and that is what we’re delivering. Seg funds have nearly tripled in the size over the last 18 months. Penson GHCO had approximately $149 million is seg funds when we acquired it in the fall of 2006. We now have more than $400 million and continue to see meaningful growth opportunities.

Turning to Penson Asia, during the second quarter, we focused on preparing an online US securities offering for MONEX clients in – MONEX clients in Japan, which should launch within the next few weeks. As we mentioned on the last call, we have reached an agreement with MONEX, one of the leading securities firms in Japan, with more than 750,000 accounts.

And our Canadian business did very well. It continues to exceed plan. And to tell you more about Canada, I’d like to introduce Terry Bourne. He’s the Chief Executive Officer of our Canadian operations, Terry.

Terry Bourne

Thank you, Phil. And we appreciate the opportunity to share some information about Penson Financial Services Canada. While I’ve had the opportunity to meet with some of those on today’s call, for those I have not met, my name is Terry Bourne. I am the CEO of Penson Canada. I’ve been with the company since 2003, and previously held the position of Chief Operating Officer. I’ve been in the financial services business here in Canada for 27 years. And I’ve been actively involved with the clearing business, both at Merrill Lynch Canada and the Toronto Dominion Bank.

For those of you joining us today, we’d like to provide you with some – a little background regarding Penson Canada. We were founded in Montreal in 1999, and today, the largest independent clearing firm in Canada. We are members of the TSX, the ME, and IIROC, in addition to both CDS and CDCC, the Canadian clearing depositories. We have offices located across Canada including Montreal, Toronto, Calgary, and Vancouver. We have 250 dedicated team members who service our customers. We also have one of the most experienced management teams in Canada.

We service a broad range of firms within the financial services community including retail, the discount brokerage, full service, institutional, and DMA. We service over 41 broker dealers and 41 ICPMs. We have client assets of over 13 billion Canadians. And our balance is in excess of 1 billion Canadian dollars. Our core service is the clearing business, but we also provide the dealer community with trade execution services, foreign exchange services, international trading, option trading, futures, and fixed income, a complete range of products and services.

One of our fastest customer growing segments is our ICPM division. This client base provides managed investment services to wealthy investors, pension funds, globe funds, et cetera. In some ways, this is somewhat two IRAs in the US.

As Phil mentioned, the second quarter was another strong quarter for Penson Canada. We processed record levels of clearing volume with more than 3.4 million trades. This was 14% ahead of the first quarter volumes, and 10% above the year ago quarter. As a result, we have reported very strong revenues in clearing services. The contributing factors include favorable Canadian market conditions, the increase in new ATS’s in Canada, our continued growth across our customer base, and the impact of our new customers that joined us in late 2007.

Other revenue contributors included our fixed income desk, which reported another strong quarter of revenues. For the first six months of 2008, our fixed income dollar volume traded was up 63% and revenue was up 137% compared to a year ago. This is due to a number of reasons including a growing demand from both our clearing and non-clearing customers.

As we mentioned, our ICPM business continues to increase and is continuing to our revenue growth. In the second quarter, we added 120 Canadian dollars in new assets, a 5% increase over the first quarter. We now have a total of 856 Canadian dollars in ICPM assets, and service over 41 firms across Canada. We are very excited about the long term opportunities to Penson Canada in servicing this customer base.

Looking ahead, I’m sure everybody have heard about that the Bank of Nova Scotia is buying E*TRADE Canada, one of our correspondents. As mentioned assumed, that E*TRADE would leave to go soft clearing in 2008 and had targeted this for June this year. E*TRADE had elected to go soft clearing in 2006, and had become to soft clear some of their business late last year. So from our point of view, we have planned accordingly and this news is a non-event.

Meanwhile, we are very confident of our growth plans. We currently have four broker dealers signed, two of which have just received regulatory approval. We have a diversified customer base, a diversified revenue stream, a strong product and service offering, and strong sales team that has a created a very healthy sales pipeline. We have recently added another sales trader to our fixed income business. And we’ll be adding a dedicated business development position to our FX team.

We continue to work very closely with our associates in the US to develop sales opportunities. With the introduction of new electronic markets to Canada, we are witnessing increased interest from current and potential clients in both DMA and across the board arbitrage from the US. And we are very well positioned to capitalize on this.

In closing, we’d like to extend all of you an invitation to drop by and meet with us the next time you find yourself north of the border. Now, back to Kevin.

Kevin McAleer

Thanks, Terry, and good morning, everyone. I just want to comment on and touch on a few other items. First, our non-interest revenue, our clearing and commissions technology and other revenue in the quarter was a record $840,000 per trading day versus $838,000 per day in the first quarter, which was itself a record. The June quarter had 64 trading days and the March quarter had 61. Our non-interest revenues, a percent of total revenues, were virtually the same as in the prior quarter, approximately 72%.

With regard to expenses, this is the highest quarter seasonally for floor brokers and clearing fees. As a percent of clearing and commission revenues, however, these expenses were lower this year at 23% versus 27% in the year-ago quarter. First quarter, traditionally, has a rebate from the DTCC. Our second quarter is traditionally the highest, with the third and fourth quarters benefiting from increasingly discounted pricing from the DTCC and OCC.

Now the DTCC recently announced that this year, they have plans to issue rebates back to customers faster based on a formula of any remaining rebate balance to be issued in March of the next year. We’re still examining the details, but we do anticipate that these changes will positively affect our cost of processing in 2008. We previously said that we expect such per unit cost to be the lowest in history this year. And this news is further evidence of that fact. The move to lower monthly fees versus waiting until the end of the year or next for a big rebate will be good news for us this year. Next year, they’re likely to reduce the amount of rebates in Q1.

Our other expenses were also higher in the quarter on a sequential and year-over-year basis. As we mentioned in the news release, we continue to invest in expanded capacity. With all the business we are taking on, we want to ensure our availability to service existing and new customers as volume and balances continue to grow. Other than that, there were no meaningful variances in expenses.

Now our operating margin was 12.8% in the second quarter of 2008, compared to 18.4% in the first quarter of this year. This decrease is attributable to lower floor brokerage and exchange clearing fees in the first quarter due to the large rebate we received, and higher other expenses in the second quarter due primarily to increased cost for capacity expansion. In the year-ago quarter, operating margin was 18.6%. A year-over-year decline was almost exclusively associated with the 33 basis points decline in our interest spread caused by the significant reduction in federal fund rate between the two periods. If our interest spread had been the same this quarter as the year ago quarter, our operating margins would have been approximately 19.5%.

With regard to our share repurchases, we’ve continued to buy a small amount during the quarter. We purchased approximately 236,000 shares, for a total of $2.4 million, or an average price of $10.24 per share. That will leave us approximately $4.8 million in share repurchase authorized by the Board.

With regard to our performance payment for Schonfeld acquisition, we’ll make the first annual payment in August in cash.

And lastly, as regards to acquisitions, we are having many conversations, but nothing conclusive. Given the price of the stock, our hurdles are a little higher as we didn’t want to use our shares at this time as part of an acquisition package.

And now, here’s Phil to wrap it up.

Phil Pendergraft

Thanks, Kevin. Now I’d like to update you on our interest rate sensitivity. Remember, this is based upon our quarter-ending balances, both the absolute numbers and the mix of these balances. Based upon these factors and the current federal funds rate of 2%, we believe that a 25 basis points change in either direction will impact us by approximately $750,000 per quarter in net interest revenues from customer balances. This is lower in the last couple of quarters due to our current mix and level of balances, which makes sense. We didn’t see the expected impact of lower rates this rates this quarter. So we don’t expect to see quite the same impact as we had anticipated on the way up either.

So in conclusion, we’re very pleased with where we are. The second quarter numbers were the result of many factors, which are still in place. And it should positively impact the third quarter and the rest of the year. We are seeing strong growth in non-interest revenues and customer balances, and continued strength in our conduit book. We’re continuing to see growth from existing clients or adding new correspondents at a fast pace, and we signed a major new technology contract. Because of these and other factors mentioned earlier, we now believe that the second quarter will be the lowest quarter of the year for earnings unless we see a very significant seasonal slowdown this quarter.

All in all, while we do have some challenges, we are very pleased with our positioning. The business is strong and growing even in this interest rate environment. We are doing exactly what we said we would do, which is to focus on what we can control and continue to grow the business. We appreciate your support, confidence, and interest in the company. With that, we’d be pleased to open the call up for questions and answers.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) And our first question comes from the line of Richard Repetto with Sandler O'Neill. Please proceed.

Richard Repetto – Sandler O'Neill

Yes. Good morning, Phil, and good morning, Kevin.

Phil Pendergraft

Good morning, Rich.

Kevin McAleer

Good morning, sir.

Richard Repetto – Sandler O'Neill

Congratulations. Excellent quarter here.

Phil Pendergraft

Thank you.

Richard Repetto – Sandler O'Neill

I guess my question is trying to get – you surprised everybody with the net interest. And I’m just trying to see whether that’s as a result of seven new clients you got in the first quarter, or was it the 11 in the second quarter? I’m just trying to see how much in a flat interest rate environment you could expect it to grow late in Q3.

Phil Pendergraft

So Rich, it’s sort of broken down into two pieces. The absolute dollar gain is the result of the growth and balances. We have a 17% growth and balances quarter-over-quarter. The relatively flat spread is as a result of changes in mix, some of which is associated with those new balances, and some of which is associated with growth in our stock lending business and growths in segregated funds, and in deposited mix shift within our existing customers. Does that make sense?

Richard Repetto – Sandler O'Neill

Yes. Well I guess the question is, you offset what should have been or what you guided to a $6 million and $6.5 million decline in net interest from the sensitivity. Next quarter, if all other things have been – be in this thing, if rates stayed the same, would you expect net interest to be flat? Do we still get the impact of new clients bringing in new balances?

Phil Pendergraft

Yes. So Rich, I believe that based upon where we are today again and based upon the mix and makeup of our balances, we actually do not expect – we expect a pretty stable spread this quarter, in the third quarter. And so, growth in net interest revenues will come primarily from growth in balances, either from existing customers or new customers. And so would certainly expect them to grow because we have a very strong pipeline.

Richard Repetto – Sandler O'Neill

Got you. Okay. And then you mentioned the wind on Nexa, $4 million, I heard – I thought you said that $4 million in licensing revenue over the next four to five quarters. I’m just trying to see what is there – what type of expenses are tied to that?

Phil Pendergraft

Rich, it’s pretty – in essence, we’ve licensed existing technology that will have relatively low costs associated with that contract. So it should be a very high margin contract for us.

Richard Repetto – Sandler O'Neill

And I got it right, it was over the four to five quarters?

Phil Pendergraft

Yes. That’s correct.

Richard Repetto – Sandler O'Neill

Okay. Lastly, Kevin mentioned a little bit the Schonfeld sales in cash. Could you tell us what the impact – you’ve done a little bit of a buyback this past quarter, and I guess we could probably expect – we can assume what the buyback is? But this would be an incremental impact to the shift. Could you sort of help us figure that out or understand it?

Kevin McAleer

No, Rich. Actually, in the second quarter – I mean in the first quarter, we announced that we’ve continued to make this payment in cash. And therefore, we made the adjustment to our share count in the first quarter. So there will be no impact to the share count in the second quarter or the third quarter related to this – related to this payment. If we’ve chosen to make it in stock, then there would have been a difference.

Richard Repetto – Sandler O'Neill

Understood. Go ahead, sorry.

Kevin McAleer

Yes. However, if we elect, we could in the third quarter forecast a stock payment solely based on where we would expect stock price today. Right now, it’s cash.

Phil Pendergraft

Yes. So the point is we’re not starting the ’09 payment cycle related to Schonfeld. And we would currently anticipate that we would make that payment in stock. And so we will begin incurring [ph] a payment related to Schonfeld in the third quarter. And so you could expect an impact in the third quarter share count related to next year’s payment.

Richard Repetto – Sandler O'Neill

Understood. My mistake, I should have gotten the 1Q. But congratulations. Excellent quarter. You're down with a $15 stock handle now to do those calculations. Thanks.

Phil Pendergraft

Thanks, Rich.

Operator

And now our next question comes from the line of David Scharf with JMP Securities. Please proceed.

David Scharf – JMP Securities

Hey, good morning, gentlemen.

Phil Pendergraft

Dave, good morning, sir.

David Scharf – JMP Securities

Obviously, a lot has been covered already in your prepared remarks. I’m wondering you can comment with a little more color on the correspondents that you’re adding. First off, did I hear you correctly? Did you say that of the 26 in the pipeline, practically none or perhaps none of them were take-aways from the North American failure or from Bear.

Phil Pendergraft

That’s correct.

David Scharf – JMP Securities

Okay. So any expectations that there maybe even additional winds in the back half from correspondents from North American and they’d be looking for a new home?

Phil Pendergraft

That’s certainly possible. The profile of correspondents at North American was generally pretty different from our core – from our core customer. And they tended to be much, much smaller. And so I would not expect any really meaningful impact from new correspondents’ signings from North American.

David Scharf – JMP Securities

Okay. Good, good. And as far as the concentration or the size of what’s in the pipeline, obviously, you just mentioned Scottrade, which I suspect was the prior one, that potential 10% customer you had previously referenced. Anyone in the – in these new 26 that have the potential to be a top 15, 20 correspondent.

Phil Pendergraft

Yes.

David Scharf – JMP Securities

Okay. Good.

Phil Pendergraft

It’s sort of – candidly, it’s all over the board. There are going to be some that will be good solid contributors that we wouldn’t anticipate will be – have the potential to hit the – to crack the top 15 or 20. But there certainly are some in that mix that will be meaningful customers.

David Scharf – JMP Securities

Got you. And lastly, switching to the conduit spread, you got the same question three months ago about the sustainability of the spread that you’re delivering now. Now you had remarked that the 70 odd – 77 basis points last quarter was not sustainable. We saw a similar figure this year. Are you rethinking that? I mean is there anything about the product mix, the type of securities you’re brokering that tell you that maybe – maybe 65 to 70 is a sustainable level? Or should we be modeling something lower in the future?

Phil Pendergraft

Well, I mean I think what we said in the first quarter was that we were raising – we were raising our anticipated spread. I think we’ve been to 25 or 45 basis points range. We’re raising our anticipated spread to more like 50 to 70 basis points. I think 70 basis points is on the high side. I would not forecast that we can hold that on a permanent basis. But I do think, based upon our current mix of business, that 50 to 70 basis points range is probably reasonable.

David Scharf – JMP Securities

Okay. Great. Thanks a lot.

Phil Pendergraft

Sure.

Operator

And now our next question comes from the line of Howard Chen with Credit Suisse. Please proceed.

Howard Chen – Credit Suisse

Hi. Good morning, everyone.

Phil Pendergraft

Howard, good morning, sir.

Kevin McAleer

Hi, Howard.

Howard Chen – Credit Suisse

Thanks for taking the questions.

Phil Pendergraft

Sure.

Howard Chen – Credit Suisse

Phil, your comment at the end of the prepared remarks that you anticipated the second quarter to be the lowest quarter of 2008 in terms of earnings per share. Did you expect that lift in the back half to be primarily driven by revenue growth, operating leverage, or capital management effort. (inaudible) in the last –?

Phil Pendergraft

Okay. So I mean we certainly anticipate continued revenue growth. We have a very strong pipeline and strong momentum. And July, as I indicated, July is off to a very strong start. We would anticipate improved operating leverage because the second half of the year, just from a structural perspective, is – the second quarter from a structural perspective is the highest cost quarter. And so we would expect improving leverage from that as well as operating leverage from the growth and revenue.

And I think we are doing – Ray Carli, who joined us as Global Treasurer, has certainly hit the ground running, and has made a meaningful impact in a short period of time. And so I guess the answer – the short answer to your question is, yes.

Howard Chen – Credit Suisse

Okay. That’s helpful. On the balance sheet growth this quarter, is it possible to break out the 17% sequential interest earning as a growth from existing customers versus new organic business installation, versus any effects from acquisitions during the quarter?

Phil Pendergraft

We didn’t do acquisitions on the quarter. So on a sequential quarter basis, there would be no impact related to acquisition. I don’t have the numbers, a breakdown between new and existing customers, but we can try to come up with that.

Howard Chen – Credit Suisse

Great. Thanks, Phil. That’d be a –

Phil Pendergraft

Yes. Sure.

Operator

As of now, our next question comes from the line of Ken Worthington with JP Morgan. Please proceed.

Tim Shea – JP Morgan

Hi, good morning. This is Tim Shea filling in for Ken.

Phil Pendergraft

Sure. Tim, good morning.

Tim Shea – JP Morgan

The first question that we have is how did the new short sale rolls impact you?

Phil Pendergraft

They’re a lot of work. We got, I guess, about four days’ notice to implement the changes. And so we’ve got a lot of folks working a lot of hours, primarily in our stock lending and technology groups trying to make sure we do those properly. We don’t anticipate any impact on our business once we get – once we get the proper development done on the technology front. Although frankly, we’re only three days into it, and so it’s perhaps a little early to judge the full impact of it. But at this point, we don’t anticipate any meaningful impact.

Tim Shea – JP Morgan

Okay. And then the only other thing that we’ve got is on the technology revenue. You may have already gone through this, but would you be able to break out what would be recurring and what would just be one-time development revenue?

Phil Pendergraft

I don’t actually have those numbers in front of me. The development revenue – our recurring revenue for Nexa is now well over 50%. And if you’ll give me a minute, I can give you that number. We’ll look it up for you here in just a minute.

Tim Shea – JP Morgan

Okay. We can just hold on until you get that. And then that’s it for now then.

Phil Pendergraft

All right. Thank you.

Operator

And our next question comes from the line of Mike Vinciquerra with BMO Capital Markets. Please proceed.

Mike Vinciquerra – BMO Capital Markets

Good morning. Congratulations, guys.

Phil Pendergraft

Good morning, Mike.

Kevin McAleer

Hi, Mike.

Mike Vinciquerra – BMO Capital Markets

I wanted to ask – just go back to Rich’s first question, just talking about the balances and the mix and how you stabilize your yield. Can you give us a little more detail behind – when you say that the seg funds were off, you said there was some new balances, and then securities lending? Can you talk about the dynamics of each of those components as to why you get better margins, say for instance, on the seg funds than you would on an equity client?

Phil Pendergraft

Sure. Let me answer – I think it was Tim’s question. Nexa’s development revenue was 25% of total technology revenue. So 75% was recurring. Stock lending and the – and our futures business both have higher margins than – let me step back and say it a different way. The lowest margin business we have on the interest rate side – on the customer interest – in our customer interest book is re-investment of excess customer funds. And the next would come our stock lending business, and third would come margin and our segregated assets on the futures side. And so what we’ve seen is a lot of strong growth in stock lending and in the segregated – in our seg funds. And that has – because those are high yielding assets, we have seen – we saw a much stronger yield over all than we had in business (inaudible). So it is primarily a – it is both a shift in existing balances as well as growth in new balances in higher yielding areas.

Mike Vinciquerra – BMO Capital Markets

That color’s helpful. Thank you, Phil. I don’t want to let Terry off without asking him a couple of questions, if I might. One on the E*TRADE Canada, I just want to make sure I understand any impact. I know that they were only doing about 10,000 darts a day, but I was told that they had about over 900 million Canadian dollars in customer cash. I’m just curious, how much of that actually was sitting with Penson versus, say, with their party money markets.

Terry Bourne

Yes. E*TRADE, in the Canadian correspondent model, slightly different than the US, in Canada, E*TRADE was what we consider or what we call a type four clearing customer, which meant that they manage their own treasury. So from our perspective, E*TRADE always retained all their own cash balances and managed that internally. So this impact, with regard to E*TRADE and their cash balances, really has had no impact on us because they didn’t contribute to our interest revenue.

Mike Vinciquerra – BMO Capital Markets

I understand. Okay. Thank you. And then also, the ICPM market, can you gauge for us approximately the size of that market in terms of both assets and total number of ICPM’s author.

Terry Bourne

We do have that information. I don’t have it on my fingertips so I don’t want to give you misleading information. But the ICPM market in Canada is actually bigger than the broker-dealer market in Canada, so both in size of assets and number of firms, so. But we can get that information to you.

Mike Vinciquerra – BMO Capital Markets

So you’re still a very small player at this time, is that a fair to put it?

Mike Vinciquerra – BMO Capital Markets

Yes. We are new to this servicing, this business segment. It has been the domicile of really the trust companies, if you will. But like I said, the potential is huge. And we think we have a very dynamic offering. And we’re very happy with our growth here.

Mike Vinciquerra – BMO Capital Markets

Great. Thank you, Terry. And then one more thing for you, Phil. Historically you’ve told us in terms of pricing that when you renew your contracts, you’re typically looking at 8% to 10% per year type of decline. Any difference in the competitive dynamics or that type of kind of run rate when you bring on new clients or renew your current clientele?

Phil Pendergraft

Mike, I think we generally look at something between 5% and 10%. I don’t think anything’s really changed. The marketplace, from a pricing perspective, is about the same as it’s been. We’re not seeing any meaningful change.

Mike Vinciquerra – BMO Capital Markets

Okay. Very good. Congratulations again.

Phil Pendergraft

Thanks, Mike. Good to talk to you.

Operator

And now our next question comes from the line of Patrick O'Shaughnessy with Raymond James. Please proceed.

Patrick O'Shaughnessy – Raymond James

Hey, guys. Good morning.

Phil Pendergraft

Good morning, Patrick.

Kevin McAleer

Good morning, Patrick.

Patrick O'Shaughnessy – Raymond James

So your average balances of – your average interest earning asset balances went up pretty substantially from the first quarter. And I was curious, how much of that was due to increased margin requirements in the futures business? And I guess what I’m trying to get to is, how much of that increase is sustainable versus how much is kind of a function of the recent volatility?

Phil Pendergraft

So we saw a 41% – I think it was a 41% increase quarter-over-quarter in seg funds. And in the futures business, the majority of that increase, it’s 41%, the majority of that increase came from new customers, not from increased margin requirements. So I don’t believe – so we believe that the majority – a significant majority of the increase in interest earnings balances is sustainable. And of course, we don’t – even the portion that is due only to exchange margins, we don’t see changing in the foreseeable future. There continues to be significant volatility in the futures space.

Patrick O'Shaughnessy – Raymond James

Got you. I would definitely agree with that. Next question I had was, if I’m looking at the pipeline of new correspondents that you guys have, correspondents that you’ve signed up aren’t revenue generating yet. If I remember correctly, it was 14 at the end of the first quarter, and 26 at the end of the second quarter. And I know you talked a little bit about your sales guys. So I’ll just kind of kick in from Taylor’s quarter, but if you can kind of give a little bit more background on maybe what are some of the themes that they’re seeing out there, which is why you’re also signed up so many correspondents?

Kevin McAleer

I think one of it is just really a lot of hard work. Our team has worked extraordinarily hard in building opportunities over the last year. And this is not a short sale cycle product. And so we’re starting to benefit from seeds we planted last year. So there’s sort of a momentum thing going on there. But there’s no question that the – that our competitive positioning is well received in the marketplace. We’re seeing a lot of interest in the multiple product capability that we have as well as the multiple market capability that we have. We’re signing business.

There’s a lot of interest right now in Canada and in Europe that’s from some – from the active retail and the active professional firms in the US because of the new trading venues in those marketplaces, the proliferation of ATS’s and MTS in those markets. It’s creating a lot of interest from the US active trading community. And even for customers that we don’t clear for in the US, we’re seeing interest in those markets. So product is definitely one.

But it’s also, I think, the fact that we are really an independent – that independent, non-conflictive provider is really resonating in this troubled marketplace.

Patrick O'Shaughnessy – Raymond James

Very good. And one last quick question that I have is, your clearing commission fees, can you kind of give us a sense of – if it hadn’t been for your new customers, would we have seen those get down in the second quarter, and that was the new customers that led to that growth? Or kind of give a breakdown of where that growth came from.

Kevin McAleer

So I don’t have the exact numbers, but most of the growth that we saw in the quarter was actually from existing customers as opposed to new customer contributions.

Patrick O'Shaughnessy – Raymond James

Got it. Thanks guys.

Phil Pendergraft

Yes. Sure.

Operator

And our next question comes as a follow-up question from Howard Chen with Credit Suisse. Please proceed.

Howard Chen – Credit Suisse

Hi again.

Phil Pendergraft

Yes, sir.

Howard Chen – Credit Suisse

Just more broadly, aside from revenues and earnings growth targets, Phil and Kevin, you’ve had longer term targets of 20% pretax margins and 20% returns on equity. Clearly, revenue momentum is solid. But what’s the path to achieve those margin targets since, Kevin, in your prepared remarks to a bit of investment spending on the horizon.

Phil Pendergraft

Yes. Howard, I think the biggest issue is we set those targets when seg funds were $5.25. And we’re going to have a hard time getting there with seg funds at $2. We should see – we would expect to see improved margin growth over the rest of the year. But we’re going to have a hard time hitting those targets with that – or at this point of the interest rate cycle.

Kevin McAleer

And Howard, I think you will recall that the margin is a longer term objective of the company versus our 15% to 25% sales objective. And to be very clear since we had changed the metric or the way we’re measuring revenue from a gross interest basis to a net interest basis, that target is actually 28%. So we’re a good ways away from it.

Howard Chen – Credit Suisse

Okay. And then just finally, how did the ex-conduit net interest spread end in the quarter? You’ve been really helpful in providing this over the past three quarters as the rates have moved around.

Kevin McAleer

It’s in the press release.

Howard Chen – Credit Suisse

No. How did it end the quarter? What was the ending – what was the spread in June?

Phil Pendergraft

I’ll get that for you, Howard. Let me make one – let me make one clarification on the earlier comment I made. There was a question about the SEC and the new stock lending rules. There’s a lot of swirl around those rules right now. There’s a lot of question about what the longer term plan or what the longer term changes might actually happen. Clearly, it’s way too early to make long term predictions about the impact on our business, or frankly, anybody’s business. What we’ve seen – the changes thus far, we don’t believe will have any material impact on our business. And I don’t want to mislead anybody that our – that we’re making long term predictions on what is really short term data base, data points at this point.

So Howard, back to your question specifically, we did not see – we went out to – we don’t actually provide month-by-month data, but we went out the quarter not meaningfully different than our averages for the quarter.

Howard Chen – Credit Suisse

Okay. Great. Thanks.

Phil Pendergraft

Yes, sir.

Operator

And our next question comes as a follow-up question from Richard Repetto with Sandler O'Neill. Please proceed.

Richard Repetto – Sandler O'Neill

One last question, Phil. On a typical trade, and let’s just say not a high frequency, not really super quant high frequency, but say an online broker, what could we use as modeling on what you make in clearing these per a typical online trade?

Phil Pendergraft

Yes. Rich, that’s not information that we disclose for competitive reasons. So I’m sorry. I can’t answer that.

Richard Repetto – Sandler O'Neill

Okay. Well then I’ll do another question. You mentioned last quarter about a quant trading firm that you thought would be, I guess, a top ten client, is how you phrase it I believe.

Phil Pendergraft

Yes.

Richard Repetto – Sandler O'Neill

Okay. Now are they on board in contributing.

Phil Pendergraft

They are on board, but just slowly ramping up.

Richard Repetto – Sandler O'Neill

Okay. And then the other online broker you mentioned earlier that you have a commitment and that will start in the third quarter, is that –? Okay. Go ahead.

Phil Pendergraft

The MONEX, which is the big Japanese firm, starts in the third quarter. Scottrade was the big online broker that we mentioned – we did not mention by name in the first quarter, and they will start in the second half of the year.

Richard Repetto – Sandler O'Neill

Okay. So do we know – second half, that’s pretty broad. We think that’s more a 3Q event or really a 4Q event?

Phil Pendergraft

Rich, I don’t think it will have any contribution in 3Q.

Richard Repetto – Sandler O'Neill

Okay. But this is a signed – you are mentioning by name this in a public format. So this is a signed, firmly committed agreement.

Phil Pendergraft

We have a signed agreement with Scottrade. They’re launching – they have already announced that they are launching an advanced option trading platform, and they’ve selected us to clear that – clear the customers that use that trading system.

Richard Repetto – Sandler O'Neill

Okay. Just the options trade and not the equity trade.

Phil Pendergraft

Actually, we will clear all of the business for customers that use that trading platform, whether equity or options.

Richard Repetto – Sandler O'Neill

Okay. Okay. Thank you very much.

Phil Pendergraft

Thank you.

Operator

And our next question also comes as a follow-up from Patrick O'Shaughnessy with Raymond James. Please proceed.

Patrick O'Shaughnessy – Raymond James

Hey. A quick follow-up about options trading volumes, I guess following that Scottrade comment. Are you guys looking for options to maybe be a bigger source of your growth going forward than maybe it has in the past? It’s not really any secret that (inaudible) is a big client of yours. You have Scottrade coming online. Is that really where you see a pretty big growth area?

Phil Pendergraft

Well we certainly – I think if you just look at options volumes in the marketplace, they’re growing very quick. They continue to be very strong. And we have – and so we would – we certainly would anticipate, at a minimum, holding our market share. And we hope to grow with market share in that business. So I think options and futures, the derivative spaces are growing faster than the equity markets. And we’re well positioned to benefit from that growth.

Patrick O'Shaughnessy – Raymond James

Thank you much.

Phil Pendergraft

Yes, sir.

Operator

And there are no additional questions at this time. I would now like to turn the call over to Mr. Pendergraft for any closing remarks.

Phil Pendergraft

Well again, thank you for joining us today. We appreciate your interest in Penson. We look forward to chatting with you again when we will be reporting third quarter results in the latter part of October. We’d like to wish you all – on behalf of all the Penson team around the world, we’d like to wish you all a good day. And we look forward to be seeing you again soon.

Operator

This concludes our presentation. You may now disconnect, and have a great day.

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Source: Penson Worldwide Inc. Q2 2008 Earnings Call Transcript
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