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Stifel Financial Corp. (NYSE:SF)

Q2 2008 Earnings Call Transcript

August 12, 2008 10:00 am ET

Executives

Jim Zemlyak – SVP, Treasurer, and CFO

Ron Kruszewski – Chairman, President and CEO

Analysts

Joel Jeffrey – KBW

Operator

Good morning. My name is Yaazi and I will be your conference operator today. At this time I would like to welcome everyone to the Stifel Financial second quarter earnings 2008 conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator instructions) Thank you. Mr. Jim Zemlyak, Chief Financial Officer, you may begin your conference.

Jim Zemlyak

Thank you, operator. Good morning, everyone. This is Jim Zemlyak, CFO of Stifel Financial Corp. I would like to welcome everyone to our conference call today to discuss our second quarter 2008 fiscal results. Please note that this conference call is being recorded. If you’d like a copy of today's presentation you may download the slides from our website, www.stifel.com.

Before we begin today's call, I would like to remind listeners that this presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not statements of fact or guarantees of performance. They are subject to risks, uncertainties, and other factors that may cause actual future results to differ materially from those discussed in the statements.

To supplement our financial statements presented in accordance with GAAP, we use certain non-GAAP measures of financial performance and liquidity. These non-GAAP measures should only be considered together with the company's GAAP results. And finally, for a discussion of risks and uncertainties in our business, please see the business factors affecting the company and the financial services industry in the company's Annual Report on Form 10-K and MD&A of results in the company's quarterly report on Form 10-Q.

Let me begin the call by going over our second quarter business highlights. Net revenues of $209 million, down slightly from the prior year second quarter and the first quarter of 2008. We reported GAAP net income of $12.3 million, or $0.45 per diluted share, a 752% increase over the prior year second quarter and a 14% decrease from the first quarter of 2008. Core net income of $16.3 million, or $0.60 per diluted share, a 13% decrease from the prior year second quarter and a 11% decrease from the first quarter of 2008, again core is after acquisition related charges, which were adjusted, which Ron will discuss later in the presentation.

Commission and principal transactions revenue increased $34.8 million, 31% over the previous year second quarter. Investment banking revenue declined 67% to $20.9 million from the prior year second quarter. Asset management and service fee revenue increased 17% to $30 million as compared to the prior year second quarter. For the three months ending June 30, 2008, utilizing Core earnings, pretax margin was 13%. And for the three months ended June 30th of 2008, utilizing Core earnings, annualized return on average equity was 14%. The Fixed Income Capital Markets segment recorded net revenue of $34.7 million, a 231% increase over the second quarter of ‘07. And lastly, we had a 3-for-2 stock split distributed on June 12th of 2008 to shareholders of record as of May 29, 2008.

We move forward to our next slide, which is our year-to-date business highlights. Net revenue of $420.4 million, a 14% increase for the six months as compared to ‘07. Our GAAP net income of $26.7 million, or $0.99 per diluted share, a 160% increase for the six months. Book value per common share increased to $19.75 as of June 30, a 14% increase from 12/31/07. Core net income of $34.6 million, or $1.29 per diluted share, an 8% increase for the year as compared to 2007.

Our Private Client Group and Fixed Income Capital Markets net revenue increased 16% and 213% respectively in the first six months as compared to the prior year. Commission and principal transactions revenue increased 49% to $301 million from the prior year months. Investment banking revenue declined 60% to $42.8 million from the prior year six months. Again the prior year six months and second quarter results include the firm's largest investment banking transaction, which contributed $24.7 million in Q2 of ’07.

Asset management and service fee revenue increased 34% to $60.2 million from the prior year six months. For the six months ending June 30 of ‘08, utilizing Core earnings, pretax margin was 14%. And for the six months ending June 30, ‘08, utilizing Core earnings, return on average equity was 16%.

I’d like to turn the call over to our Chairman and CEO, Ron Kruszewski.

Ron Kruszewski

Thank you, Jim. What I’d like to talk about, first of all, as I’ve said, given the difficult market conditions, we are pleased to report what I think was a very strong quarter. The quarter would be characterized by balance, balance in our businesses as the investment banking, which was weak across the industry but was offset by strong Private Client business, actually record Private Client business, a very strong Fixed Income Capital Markets, and within Equity Capital Markets, our cash equities business or our slow business has been very strong and something that we are gratified that we are getting traction on our business model, our research driven business model.

But this environment – certainly one of the things I want to talk about, maybe focus on this call is that this environment provides us the opportunity to continue to build our franchise. Unlike what many people are reading in the industry, which are the thousands and thousands of jobs that are being either eliminated or, according to today’s paper, being shipped abroad, we are adding people almost at a very fast pace. And so I have a slide here, which talks about recent growth and talk about why I think this adds significantly to our franchise and our shareholder value, but also as I cautioned in the press release, there were startup costs always associated when any time you – when you add people. And that can have a pressing impact on short-term results. But we are not running the firm for short-term results, we are running it for long-term value.

If you look at this in our Private Client Group, we’ve hired 89 financial advisors. This is all since the 1st of 2008. We’ve opened 16 new offices, a lot of offices out west, but offices all around. The startup costs year-to-date in excess of $2 million in some of these offices for the quarter in excess of $1 million. I’ll come back to that in a moment.

Equity Capital Markets, in sales and trading, hired 21 professionals since the 1st of the year. Of note, we associated with Bear Stearns, 11 people in New York, sales and trading, made an immediate positive impact to our firm. It was a great association for us. On the investment banking side, we’ve added 18 professionals, including a number of managing directors that also includes a nine-person energy team that is already beginning to add to our pipeline.

On the Fixed Income side, we’ve added 25 sales and trading professionals, including 12 in an aircraft leasing group. Public finance, 57% increase in our professional staff in public finance by adding 20 professionals, including two new offices; one is Lansing, Michigan, the other in San Antonio, Texas. And on the bank, people [ph] bank, not just professionals but across the infrastructure of the bank we’ve added 63 people to support the growth initiatives of the bank, which is again to primarily service our clientele in the brokerage firm. So this growth has been – probably we have been as active in hiring and adding quality people as we have ever been, certainly in my tenure at the firm. It continues into the third quarter and I’m very excited about the prospects for the future. I do not believe the world is coming to an end. It might stagger along for longer than a lot of anticipate, but in the end we are certainly adding to the capabilities of this firm.

If we go quickly – Jim went through a lot of the numbers. I don’t want to be redundant on the income statement, but I will point out if you look at – the slide we are looking at shows core net income of $0.60 and GAAP at $0.45. I’ll just point a couple things out for the quarter. Our margins were I think 12.8%, call it 13% margins for the quarter. We look at – we manage to 15% margins. The difference between the 13% and the 15% is about $1 million in the quarter for startup costs in our Private Client Group. We had about $500,000 markdown in our investment portfolio. And we had about $2 million and what I would say would be additional comp accruals to make sure that were adequately reserved for comp. We don’t want to be in a position where in the fourth quarter we have to ramp our comp accruals up significantly because – I mean, you still have to pay people even though the market is difficult.

So when you look at our ratios and you see comp and benefits at 66% of net revenue, I wouldn’t get too excited about that. That’s higher than we certainly target, but we want to be conservative in our comp accruals. And so that’s at 66% and operating expenses at 21. There is a point to a point and a half in the startup costs. So that gets this margin of 13%. But we have our arms around why that is. The difference between 13% and 15% is $0.08 to $0.09 a share, so if you want to understand the magnitude of that.

If you look at the slide and just look at the source of revenues, the two things that really kind of jump out is again principal transactions up some 97% although relatively flat from the first quarter, again primarily driven by strong fixed income results would be the primary reason for that. And then investment banking for the quarter down 67%, a combination of weak industry-wide environment, which we are not immune, coupled with the fact that last year in the second quarter we did the people’s transaction of the carryover from our Ryan Beck merger and that transaction added significantly almost $25 million in investment banking. So the combination of those two results in a 67% decline in investment banking, which – again that will carry through almost all the slides, the weakness in the calendar and then in the M&A is true across the industry and for us.

If you look at the segments, again despite a lot that we are hearing about, I’m pleased to report that our Private Client Group had a record quarter in terms of revenue, all-time record and an all-time record in terms of profitability despite some of these additional startup costs for all these new branches. Fixed Income Capital Markets had their second best quarter, both in terms of revenue and profitability. Again Equity Capital Markets, a strong performance in the cash equities business, offset by weakness in investment banking. And then I’ll get to the bank.

So if you look – let’s look at the Private Client Group quickly. Again, a record quarter, record profitability, really nothing to comment. Comp and benefits of 60%, operating expenses of 15%, pretax margins of 25%. Pleased with the results of the Private Client Group for the quarter.

Equity Capital Markets, you’ll note net margins not where we want them to be, driven by a 69% comp to net revenue ratio, which is again – us making sure that we are adequately reserved. If you look at the sources of revenue, again, I’ve said this, but our model is based upon the fact that we are research-driven. We drive our results – we drive our business through quality research, the goal of which would add alpha to our clients. We think we are getting traction, as you can see, quarter-over-quarter, a 22% increase in the flow of business, 30% for the year. So when I compare that to what’s going on in the Street, I feel that we’re certainly gaining market share and everyday it seems that we continue to gain new clients.

On the investment banking front, again as you can see, a very difficult comparison to last year’s quarter, again because of people. So within Equity Capital Markets, banking is down 76%. It’s down 17% sequentially. But we do see we have a very good pipeline and we believe that when the markets rebound we will participate accordingly. So while it’s been difficult, the core underpinnings of our business is very good in Equity Capital Markets.

Fixed Income Capital Markets, simply a fantastic performance again. Margins at 34%. As I said last quarter, I did not believe the revenue run rate of $44 million was sustainable. We felt that we had about $100 million business at that time. So it was interesting that that actually prediction seems to have come out as we had revenues of $34 million, but annualized it’s at about $100 million. I will say that the tax exempt public finance business has been slow that usually is for the – using the first six months of the year, that’s slow. It’s just the way our business works. We generally most of that business in the second half of the year. But a very good performance across the board in Fixed Income sales, trading, and you have it. We feel we’ve added a lot of good people and that business is humming along.

On the Bank, probably the only real thing of noteworthy at the Bank is the provision for loan loss that went up from $135,000 to $935,000. Included in that provision for loan loss was approximately $500,000 of net charge-offs, which then in turn causes our non-performing loans as a percentage of loans to go from 1.4% down to 0.7%. So net-net, we wrote off a loan of about $0.5 million. But you can see our non-performers are at 0.73. Again the Bank is small. You will see that there has not been a lot of growth in the bank. Certainly we are growing as fast as we could grow it, but that’s on purpose. Probably I don’t need to say anything more about that.

Other segment, again, we’ll talk about acquisition related. The other segment, which was primarily the overhead of the firm is up as you would expect it to be as our net revenues are up 14% year-over-year and our overhead is also accordingly although we think we think we have operating leverage across that.

If you look at GAAP to Core earnings as we do every quarter, you will see that slide 14 shows a reconciliation from Core to GAAP. $0.60 in Core income, down to $0.15 of acquisition related. I’ll remind everyone that while – everyone has seen we had 750% increase in net income, GAAP net income. That’s the result of last year in the second quarter when we took the large acquisition related charge related to Ryan Beck. So that’s why we always focus on Core net income. But you could see the reconciliation.

And I always like to talk about, if you look at slide 15, it’s where we do project our acquisition related expenses, you will see that we had for the second quarter on a pretax basis $6.514 million. We’ve been projecting $6.5 million a quarter. That’s what we estimate for Q3 and Q4. It’s about $0.14 to $0.15 a share. But again the important thing is, in 2009 we will no longer have these charges as they are primarily stock-based compensation expenses related primarily to the Legg Mason transaction, which is going to be coming on its third anniversary, and a little bit to the Ryan Beck.

On the balance sheet side, we remain well capitalized with $560 million in capital, $465 million in equity, $95 million in very attractive trust-preferred security. That’s against assets of $1.7 billion, book value per share $19.75. Book value up both because of earnings and the amortization of that stock-based comp, offset by the fact that we bought back 572,000 shares at a premium to book. So that’s dilutive to our book value. Net-net, book value is at $19.75 a share.

If you look at Level 3 assets, again probably underscores why we have not had a lot of difficulties. Our total Level 3 assets are $44 million, which is less than 1% of our equity. Of that $44 million, $27 million of it we classify auction-rate securities in the Level 3 for purposes of this. So, $27 million of it. So, almost all of our Level 3 assets are auction-rate securities primarily closed-end preferreds and some student – the student loan auction-rate securities. We are confident that that market is beginning to clear up in whatever manner it takes here. It’s been in the press every day, but we don’t think that that’s going to resolve. And then we have about $17 million, which is really investments, investments and partnerships and other things that simply have no observable inputs to value. But this is not what everyone has been reading about. So again, that’s our Level 3 assets.

Capital, I’ve already spoke about, in that we are very well capitalized. Equity to assets 28%, our total capitalization of 33%, and our trust to equity are only at 20%. So we feel very good about our capital structure. Finally, if you look at our other financial data, you will see the Bank quarter-over-quarter did not really grow that much, from $290 million to $300 million. The broker-dealer state relatively flat. So total assets really didn’t change quarter-to-quarter; some of our [ph] equity did. Net-net, a very good quarter, but I’m mostly excited about the capabilities that we added to allow us to continue to not only gain market share, but to continue to be a great investment for our shareholders.

So with that, operator, I’ll be glad to take any questions. Hello?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from KBW. Your line is open.

Joel Jeffrey – KBW

Hi guys, this is Joel Jeffrey.

Ron Kruszewski

Hi, Joel.

Joel Jeffrey – KBW

Quick question. In your 10-Q, you talk about a transfer from the available for sale securities of about $10 million at the held for maturity. Can you give us a little color on that?

Ron Kruszewski

Sure. That is a position that we have in a bank TRUP [ph] CLO. And there have been a lot of discussions about the accounting for that. If you look, Joel, a lot of firms have moved that into held to maturity. We believe we are going to hold this thing for a while. You certainly – the market to sell these things is very difficult if there is a market at all. So we felt that we should move it into held to maturity at the bank and effectively take some of the volatility out of other comprehensive income.

Joel Jeffrey – KBW

Okay. And then in terms of your auction-rate securities, how much exposure do your clients have to that?

Ron Kruszewski

It’s in total – it depends on how you classify auction-rate securities. There’s a whole bunch in terms of whether they are BVRNs [ph] or whatever. But let’s talk about our primary one that we look at the most of the closed end funds. And that would be about $260 million – $265 million the clients own.

Joel Jeffrey – KBW

Okay.

Ron Kruszewski

Let me add one other thing to that. I think it’s important for people on the call to understand. There is a lot going on and people are reading about a lot of the developments in this area. One of the things that’s of note is – and we’re continuing to analyze is, of that $265 million, about more than half, maybe 60% to 65% of that total was transferred to our front through our recruiting efforts. So that’s some of these issues that people have to understand that how is this all going to get resolved. I mean, it’s securities that just transferred into us that we’re holding. So it will – it’s a complex situation.

Joel Jeffrey – KBW

Okay. And then just finally at the Bank, it looks like the loan portfolio grew primarily in the residential and home equity lines. Is that part of your plan to sort of move this portfolio to a more residential-focused or was that just where the sort of best opportunities were?

Ron Kruszewski

I think that’s where – as we are marketing to our clientele and putting in a – what we are trying to have a combined collateral securities home equity, the home equity portfolio for our clients is where we see opportunity as hard as that is to believe today.

Joel Jeffrey – KBW

In the home equity lines, were those people exercising existing lines or were these new lines that were initiated?

Ron Kruszewski

I’m not sure I have – I don’t know if I have the data for that, Joel. I’m sure it’s a little above.

Joel Jeffrey – KBW

Okay, great. Thanks very much.

Ron Kruszewski

Yes.

Operator

(Operator instructions) I show no questions in queue.

Ron Kruszewski

Our questions keep getting less and less, so hopefully that’s good. Anyway, everyone, thank you. We look forward to – appreciate your interest in the company and look forward to talking to you after the third quarter. Take care. Bye.

Operator

This concludes today’s conference call. You may now disconnect your lines.

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