XNYS:KBW Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

Table of Contents

 

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2012

 

OR

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from          to          

 

Commission File Number: 001-33138

 

KBW, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

 

13-4055775

(State or Other Jurisdiction of Incorporation or Organization)

 

(I.R.S. Employer Identification No.)

 

787 Seventh Avenue, New York, New York 10019

(Address of principal executive offices)

 

Registrant’s telephone number: (212) 887-7777

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x  No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

The number of shares of the Registrant’s common stock, par value $0.01 per share, outstanding as of April 30, 2012 was 34,728,954, which number includes 4,596,136 shares representing unvested restricted stock awards and excludes 255,936 shares underlying vested restricted stock units.

 

 

 



Table of Contents

 

TABLE OF CONTENTS

 

Available Information

 

1

 

 

 

PART I-FINANCIAL INFORMATION

 

2

 

 

 

 

Item 1. Financial Statements

 

2

 

 

 

 

 

Consolidated Statements of Financial Condition-March 31, 2012 (unaudited) and December 31, 2011

 

2

 

 

 

 

 

Consolidated Statements of Operations-Three Months ended March 31, 2012 and 2011 (unaudited)

 

3

 

 

 

 

 

Consolidated Statements of Comprehensive Income-Three Months ended March 31, 2012 and 2011 (unaudited)

 

4

 

 

 

 

 

Consolidated Statement of Changes in Stockholders’ Equity-Three Months ended March 31, 2012 (unaudited)

 

5

 

 

 

 

 

Consolidated Statements of Cash Flows-Three Months ended March 31, 2012 and 2011 (unaudited)

 

6

 

 

 

 

 

Notes to Consolidated Financial Statements

 

7

 

 

 

 

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

22

 

 

 

 

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

32

 

 

 

 

 

Item 4. Controls and Procedures

 

33

 

 

 

PART II-OTHER INFORMATION

 

34

 

 

 

 

Item 1. Legal Proceedings

 

34

 

 

 

 

 

Item 1A. Risk Factors

 

34

 

 

 

 

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

34

 

 

 

 

 

Item 3. Defaults Upon Senior Securities

 

34

 

 

 

 

 

Item 4. Mine Safety Disclosures

 

34

 

 

 

 

 

Item 5. Other Information

 

35

 

 

 

 

 

Item 6. Exhibits

 

35

 

 

 

SIGNATURES

 

36

 

 

 

EXHIBIT INDEX

 

37

 

 

 

EX-31.1: CERTIFICATION

 

 

 

 

 

EX-31.2: CERTIFICATION

 

 

 

 

 

EX-32.1: CERTIFICATION

 

 

 

 

 

EX-32.2: CERTIFICATION

 

 

 

 

 

EX-101: INTERACTIVE DATA

 

 

 



Table of Contents

 

Available Information

 

We are required to file current, annual and quarterly reports, proxy statements and other information required by the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with the Securities and Exchange Commission (the “SEC”).  You may read and copy any document we file with the SEC at the SEC’s Public Reference Room located at 100 F Street, N.E., Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an internet website at http://www.sec.gov, from which interested persons can electronically access our SEC filings.

 

We will make available, free of charge through our internet site http://www.kbw.com, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy statements, Forms 3, 4 and 5 filed by or on behalf of directors, executive officers and certain large stockholders, and any amendments to those documents filed or furnished pursuant to the Exchange Act.  These filings will become available as soon as reasonably practicable after such material is electronically filed with or furnished to the SEC.

 

We also make available, on the Investor Relations page of our website, our (i) Corporate Governance Guidelines, (ii) code of Business Conduct and Ethics, (iii) Supplement to Code of Business Conduct and Ethics for CEO and Senior Financial Officers and (iv) the charters of the Audit, Compensation, and Corporate Governance and Nominations Committees of our Board of Directors.  You will need to have Adobe Reader software installed on your computer to view these documents, which are in the PDF format.  These documents will also be available in print without charge to any person who requests them by writing or telephoning:  KBW, Inc., Office of the General Counsel, 787 Seventh Avenue, New York, New York, 10019, U.S.A., telephone number (212) 887-7777.  These documents, as well as the information on our website, are not a part of this report.

 

1



Table of Contents

 

PART I—FINANCIAL INFORMATION

 

Item 1.  Financial Statements.

 

KBW, INC. and SUBSIDIARIES

Consolidated Statements of Financial Condition

(Dollars in thousands)

 

 

 

March 31, 2012
(unaudited)

 

December 31, 2011

 

ASSETS

 

 

 

 

 

Cash and cash equivalents

 

$

144,724

 

$

136,582

 

Financial instruments owned, at fair value:

 

 

 

 

 

Equities

 

133,698

 

81,068

 

Corporate and other debt

 

66,313

 

28,985

 

Mortgage and other asset-backed securities

 

14,668

 

25,690

 

Other investments

 

41,961

 

58,758

 

Total financial instruments owned, at fair value:

 

256,640

 

194,501

 

Receivables from clearing brokers

 

17,152

 

95,383

 

Accounts receivable

 

22,045

 

8,368

 

Income taxes receivable

 

15,979

 

19,293

 

Fixed assets, at cost, less accumulated depreciation and amortization of $37,306 in 2012 and $36,016 in 2011

 

14,097

 

14,952

 

Other assets

 

51,477

 

50,020

 

Total assets

 

$

522,114

 

$

519,099

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Liabilities:

 

 

 

 

 

Financial instruments sold, not yet purchased, at fair value:

 

 

 

 

 

Equities

 

$

74,709

 

$

51,453

 

Corporate debt

 

13,916

 

7,909

 

U.S. Government and agency securities

 

14,471

 

5,234

 

Total financial instruments sold, not yet purchased, at fair value:

 

103,096

 

64,596

 

Accrued compensation and benefits

 

5,622

 

36,097

 

Income taxes payable

 

10,217

 

9,539

 

Accounts payable, accrued expenses and other liabilities

 

22,330

 

25,714

 

Total liabilities

 

141,265

 

135,946

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock

 

 

 

Common stock

 

301

 

289

 

Paid-in capital

 

145,864

 

147,888

 

Retained earnings

 

245,668

 

246,939

 

Accumulated other comprehensive loss

 

(10,984

)

(11,963

)

Total stockholders’ equity

 

380,849

 

383,153

 

Total liabilities and stockholders’ equity

 

$

522,114

 

$

519,099

 

 

See accompanying notes to consolidated financial statements.

 

2



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Consolidated Statements of Operations

(unaudited)

(Dollars in thousands, except per share information)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

Revenues:

 

 

 

 

 

Investment banking

 

$

27,029

 

$

37,648

 

Commissions

 

29,219

 

34,429

 

Principal transactions, net

 

10,506

 

17,340

 

Interest and dividend income

 

1,785

 

3,204

 

Other

 

702

 

2,562

 

Total revenues

 

69,241

 

95,183

 

 

 

 

 

 

 

Expenses:

 

 

 

 

 

Compensation and benefits

 

42,929

 

56,634

 

Occupancy and equipment

 

4,700

 

5,659

 

Communications and data processing

 

7,736

 

8,695

 

Brokerage and clearance

 

3,362

 

4,916

 

Business development

 

3,191

 

4,624

 

Professional services

 

1,842

 

3,702

 

Interest

 

192

 

309

 

Restructuring charges

 

2,244

 

 

Other

 

2,343

 

2,852

 

Total expenses

 

68,539

 

87,391

 

Income before income taxes

 

702

 

7,792

 

Income tax expense

 

236

 

3,151

 

Net income

 

$

466

 

$

4,641

 

 

 

 

 

 

 

Earnings per common share:

 

 

 

 

 

Basic

 

$

0.01

 

$

0.13

 

Diluted

 

$

0.01

 

$

0.13

 

 

 

 

 

 

 

Dividends declared per common share

 

$

0.05

 

$

0.05

 

 

 

 

 

 

 

Weighted average number of common shares outstanding:

 

 

 

 

 

Basic

 

30,211,667

 

33,122,382

 

Diluted

 

30,211,667

 

33,122,382

 

 

See accompanying notes to consolidated financial statements.

 

3



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(unaudited)

(Dollars in thousands)

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Net income

 

$

466

 

$

4,641

 

Other comprehensive income:

 

 

 

 

 

Currency translation adjustments

 

979

 

888

 

Total other comprehensive income

 

979

 

888

 

Comprehensive income

 

$

1,445

 

$

5,529

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

 

KBW, INC. and SUBSIDIARIES

Consolidated Statement of Changes in Stockholders’ Equity

Three Months Ended March 31, 2012

(unaudited)

(Dollars in thousands, except per share information)

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

 

 

Other

 

Total

 

 

 

Preferred

 

Common

 

Paid-in

 

Retained

 

Comprehensive

 

Stockholders’

 

 

 

Stock

 

Stock

 

Capital

 

Earnings

 

(Loss) / Income

 

Equity

 

Balance at December 31, 2011

 

$

 

$

289

 

$

147,888

 

$

246,939

 

$

(11,963

)

$

383,153

 

Net income

 

 

 

 

466

 

 

466

 

Other comprehensive income, currency translation adjustment

 

 

 

 

 

979

 

979

 

Dividends on common stock

 

 

 

 

(1,737

)

 

(1,737

)

Amortization of stock-based compensation

 

 

 

12,966

 

 

 

12,966

 

Cancellation of 820,721 shares of restricted stock in satisfaction of withholding tax requirements

 

 

(8

)

(14,499

)

 

 

(14,507

)

Issuance of 2,077,929 shares of common stock

 

 

20

 

38,857

 

 

 

38,877

 

Restricted stock units converted

 

 

 

(3,505

)

 

 

(3,505

)

Stock-based awards vested

 

 

 

(35,339

)

 

 

(35,339

)

Net tax shortfall related to stock-based awards

 

 

 

(504

)

 

 

(504

)

Balance at March 31, 2012

 

$

 

$

301

 

$

145,864

 

$

245,668

 

$

(10,984

)

$

380,849

 

 

Description of preferred stock and details:

 

 

 

 

 

Number of Shares

 

 

 

Par Value

 

Authorized

 

Issued

 

Outstanding

 

March 31, 2012

 

$

0.01

 

10,000,000

 

 

 

December 31, 2011

 

$

0.01

 

10,000,000

 

 

 

 

Description of common stock and details:

 

 

 

 

 

Number of Shares

 

 

 

Par Value

 

Authorized

 

Issued*

 

Outstanding*

 

March 31, 2012

 

$

0.01

 

140,000,000

 

30,132,818

 

30,132,818

 

December 31, 2011

 

$

0.01

 

140,000,000

 

28,875,610

 

28,875,610

 

 


(*) These share amounts exclude vested restricted stock units.

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

 

 

KBW, INC. and SUBSIDIARIES

Consolidated Statements of Cash Flows

(unaudited)

(Dollars in thousands)

 

 

 

Three Months Ended
March 31,

 

 

 

2012

 

2011

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

466

 

$

4,641

 

Adjustments to reconcile net income to net cash provided by / (used in) operating activities:

 

 

 

 

 

Amortization of stock-based compensation

 

12,966

 

19,423

 

Depreciation and amortization

 

1,219

 

1,409

 

Deferred income tax expense

 

7,769

 

4,386

 

(Increase) decrease in operating assets:

 

 

 

 

 

Financial instruments owned, at fair value

 

(62,139

)

(149,067

)

Receivables from clearing brokers

 

78,393

 

134,794

 

Accounts receivable

 

(13,632

)

1,886

 

Income taxes receivable

 

3,333

 

340

 

Other assets

 

(9,190

)

(7,602

)

Increase (decrease) in operating liabilities:

 

 

 

 

 

Financial instruments sold, not yet purchased, at fair value

 

38,500

 

85,626

 

Accrued compensation and benefits

 

(30,501

)

(106,155

)

Payable to clearing brokers

 

 

2,471

 

Income taxes payable

 

678

 

(975

)

Accounts payable, accrued expenses and other liabilities

 

(3,357

)

1,429

 

Net cash provided by / (used in) operating activities

 

24,505

 

(7,394

)

Cash flows from investing activities:

 

 

 

 

 

Purchase of furniture, equipment and leasehold improvements

 

(369

)

(1,347

)

Net cash used in investing activities

 

(369

)

(1,347

)

Cash flows from financing activities:

 

 

 

 

 

Cash dividends paid

 

(1,737

)

(1,861

)

Issuance of shares of common stock

 

33

 

51

 

Cancellation of restricted stock in satisfaction of withholding tax requirements

 

(14,507

)

(17,707

)

Cancellation of shares of common stock related to the stock repurchase program

 

 

(12,941

)

(Shortfall) excess net tax benefit related to stock-based awards

 

(504

)

3,538

 

Repayment of notes receivable from stockholders

 

 

100

 

Net cash used in financing activities

 

(16,715

)

(28,820

)

Currency adjustment:

 

 

 

 

 

Effect of exchange rate changes on cash

 

721

 

685

 

Net increase / (decrease) in cash and cash equivalents

 

8,142

 

(36,876

)

Cash and cash equivalents at the beginning of the period

 

136,582

 

162,272

 

Cash and cash equivalents at the end of the period

 

$

144,724

 

$

125,396

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Income taxes

 

$

36

 

$

813

 

Interest

 

$

27

 

$

374

 

 

See accompanying notes to consolidated financial statements.

 

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Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements

(unaudited)

(Dollars in thousands, except per share information)

 

(1)                                 Organization and Basis of Presentation

 

The consolidated financial statements include the accounts of KBW, Inc., and its wholly owned subsidiaries (the “Company”), Keefe, Bruyette & Woods, Inc. (“Keefe”), Keefe, Bruyette & Woods Limited (“KBWL”), Keefe, Bruyette & Woods Asia Limited (“KBW Asia”), KBW Asset Management, Inc. and KBW Ventures, Inc. Keefe is a regulatory member of the Financial Industry Regulatory Authority (“FINRA”) and is principally a broker-dealer in securities and a market-maker in certain financial services stocks and bonds in the United States.  KBWL is authorized and regulated by the U.K. Financial Services Authority (“FSA”) and a member of the London Stock Exchange.  KBW Asia is a securities firm licensed and regulated by the Securities and Futures Commission in Hong Kong.  Keefe’s, KBWL’s and KBW Asia’s customers are predominantly institutional investors including other brokers and dealers, commercial banks, asset managers and other financial institutions. Keefe has a clearing arrangement with Pershing LLC on a fully disclosed basis.  KBWL has a clearing arrangement with Pershing Securities Limited on a fully disclosed basis and is responsible for clearance and settlement for both KBWL and KBW Asia.

 

(2)                                 Summary of Significant Accounting Policies

 

(a)               Principles of Consolidation

 

The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include the accounts of the Company and its consolidated subsidiaries.  All intercompany transactions and balances have been eliminated.

 

The Company consolidates entities for which it has a controlling financial interest as defined in Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 810, Consolidation.  The usual condition for a controlling financial interest is ownership of a majority voting interest.  As a result, the Company generally consolidates entities when they have ownership, directly or indirectly, of over 50 percent of the outstanding voting shares of another entity.  Since a controlling financial interest may be achieved through arrangements that do not involve voting interest, the Company also evaluates entities for consolidation under the “variable interest model” in accordance with ASC 810.  The Company consolidates variable interest entities when it has determined to hold the power that most significantly impacts the entity’s economic performance or a right to absorb a majority of the entity’s expected losses, or expected residual returns, or both.  The Company had no variable interest entities that required consolidation at March 31, 2012 and December 31, 2011.

 

In addition, the Company evaluates its investments in limited partnerships under ASC 810.  Under ASC 810, the general partners in limited partnerships are presumed to have control unless the limited partners have either a substantial ability to dissolve the limited partnership or otherwise can remove the general partner without cause or have substantial participating rights.  There were no limited partnership interests that required consolidation at March 31, 2012 and December 31, 2011.

 

(b)               Use of Estimates

 

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the Company’s financial statements and footnotes including securities valuations, compensation accruals and other matters.  Management believes that the estimates used in preparing the Company’s consolidated financial statements are reasonable.  Actual results may differ from these estimates.

 

(c)                Cash and Cash Equivalents

 

Cash equivalents include investments with an original maturity of three months or less.  Due to the short-term nature of these instruments, carrying value approximates their fair value.

 

(d)               Fair Value of Financial Instruments

 

The Company accounts for financial instruments that are being measured and reported on a fair value basis in accordance with ASC 820, Fair Value Measurements and Disclosures.  ASC 820 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements.  ASC 820 defines fair value as “the price that would be

 

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Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

received to sell an asset or paid to transfer a liability in an ordinary transaction between current market participants at the measurement date.”

 

Fair value is generally based on quoted market prices.  If quoted market prices are not available, fair value is determined based on other relevant factors, including dealer price quotations, price activity for equivalent instruments and valuation pricing methods.  Among the factors considered by the Company in determining the fair value of financial instruments for which there are no current quoted market prices are credit spreads, the terms and liquidity of the instrument, the financial condition, operating results and credit ratings of the issuer or underlying company, the quoted market price of publicly traded securities with similar duration and yield, assessing the underlying investments, market-based information, such as comparable company transactions, performance multiples and changes in market outlook as well as other measurements.  Financial instruments owned and financial instruments sold, not yet purchased are stated at fair value, with related changes in unrealized appreciation or depreciation reflected in principal transactions, net in the accompanying consolidated statements of operations.  Financial assets and financial liabilities carried at contract amounts may include receivables from clearing brokers, securities purchased under resale agreements, short-term borrowings and securities sold under repurchase agreements.  See Note 3 of the Notes to Consolidated Financial Statements for additional discussion of ASC 820.

 

ASC 825, Financial Instruments, provides entities the option to measure certain financial assets and financial liabilities at fair value with changes in fair value recognized in earnings each period.  ASC 825 permits the fair value option election, on an instrument-by-instrument basis, either at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.  Such election must be applied to the entire instrument and not only a portion of the instrument.  The Company applied the fair value option for certain eligible instruments, including all private equity securities and limited partnership interests, as these financial instruments had been managed on a fair value basis by the Company prior to the fair value option electionGenerally, the fair values of these financial instruments have been determined based on company performance and, in those instances where market values are readily ascertainable, by reference to recent significant events occurring in the marketplace or quoted market prices.  ASC 820 permits, as a practical expedient, the use of the net asset value per share, or its equivalent, of an entity to estimate its fair value.  The Company’s partnership interests are recorded at fair value, determined by using net asset values or capital statements provided by the general partner, updated for capital contributions and distributions, and changes in market conditions up to the reporting date.

 

(e)                Receivables From and Payable to Clearing Brokers

 

Receivables from and payable to clearing brokers include the net proceeds from securities sold, including financial instruments sold not yet purchased, commissions related to securities transactions, margin loans and related interest and deposits with clearing brokers.  Proceeds related to financial instruments sold, not yet purchased may be restricted until the securities are purchased.  Balances are presented net when the right of set-off exists.

 

(f)                  Fixed Assets

 

Furniture and other equipment, computer equipment and software are carried at cost and depreciated on a straight-line basis using estimated useful lives of the related assets, generally two to five years.  Leasehold improvements are amortized on a straight-line basis over the lesser of the economic useful life of the improvement or the term of the respective leases.

 

(g)               Revenue Recognition

 

Investment Banking

 

The Company earns fees for providing strategic advisory services in mergers and acquisitions (“M&A”) and other transactions which are predominantly composed of fees based on a successful completion of a transaction, and from capital markets, which is comprised of underwriting securities’ offerings and arranging private placements.

 

Strategic advisory revenues are recorded when earned, the fees are determinable and collection is reasonably assured.  Non-refundable upfront fees are generally deferred and recognized as revenue ratably over the expected period in which the related services are rendered.  Upon successful completion of a transaction or termination of an engagement, the recognition of revenue would be accelerated.

 

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Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

Capital markets revenue consists of:

 

·                        Underwriting revenues, which are recognized on trade date, net of related syndicate expenses, at the time the underwriting is completed. In syndicated underwritten transactions, management estimates the Company’s share of transaction-related expenses incurred by the syndicate, and the Company recognizes revenue net of such expense.  On final settlement, the Company adjusts these amounts to reflect the actual transaction-related expenses and resulting underwriting fee.

 

·                        Private placement revenues, net of related expenses, which are recorded when the services related to the underlying transaction are completed under the terms of the engagement.  This is generally the closing date of the transaction.

 

Since the Company’s investment banking revenues are generally recognized at the time of completion of each transaction or when the services are performed, these revenues typically vary between periods and may be considerably affected by the timing of the closing of significant transactions.

 

Commissions

 

The Company’s sales and trading business generates revenue from equity securities’ trading commissions paid by institutional investor customers.  Commissions are recognized on a trade date basis.

 

Principal transactions

 

Financial instruments owned, at fair value and financial instruments sold, not yet purchased, at fair value are recorded on a trade-date basis with realized and unrealized gains and losses reflected in principal transactions, net in the consolidated statements of operations.

 

Interest and dividend income

 

The Company recognizes contractual interest on financial instruments owned at fair value on an accrual basis as a component of interest and dividend income.  Dividend income is recognized on the ex-dividend date.

 

(h)            Stock-Based Compensation

 

Stock-based compensation is measured at fair value on the date of grant and amortized to compensation expense over the requisite service period, net of estimated forfeitures.  Compensation expense for awards with performance conditions is recognized over the requisite service period based on the probable outcome of the performance condition at each reporting date.  At the end of the performance period, the total compensation cost recognized will be the grant-date fair value of all units that actually vest based on the outcome of the performance conditions.  Stock-based awards that do not require future service (i.e. vested awards and certain awards granted to retirement eligible employees) are expensed immediately on the date of grant.  Withholding tax obligations may be satisfied by the repurchase of shares by the Company.  Such shares are cancelled upon repurchase.

 

(i)            Income Taxes

 

Deferred tax assets and liabilities are recognized for the future tax effect of differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.  In the event it is more likely than not that a deferred tax asset will not be realized, a valuation allowance is recorded.

 

The Company applies ASC 740, Income Taxes, which prescribes a single, comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on its tax returns.  Income tax expense is based on pre-tax accounting income, including adjustments made for the recognition or derecognition related to uncertain tax positions.

 

9



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

(j)                  Earnings Per Common Share (“EPS”)

 

Basic EPS is computed by dividing net income applicable to common shareholders, which represents net income reduced by the allocation of earnings to participating securities, by the weighted average number of common shares.  Losses are not allocated to participating securities.  The weighted average number of common shares outstanding includes restricted stock units for which no future service is required as a condition to the delivery of the underlying common stock.  Diluted EPS includes the determinants of basic EPS and, in addition, gives effect to potentially dilutive common shares related to Company stock compensation plans.

 

ASC 260, Earnings Per Share, addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting and therefore need to be included in the earnings allocation in calculating EPS under the two-class method. Accordingly, the Company treats unvested share-based payment awards that have non-forfeitable rights to dividend or dividend equivalents as a separate class of securities in calculating EPS.

 

The Company has granted performance equity awards (“Performance Awards”) that vest and convert to shares of common stock only if the Company achieves predetermined performance goals.  Since the issuance of the shares is contingent upon the satisfaction of certain conditions, the Performance Awards are included in diluted EPS based on the number of shares (if any) that would be issuable if the end of the reporting period were the end of the contingency period.

 

(k)               Foreign Currency Translation

 

The Company translates the statements of financial condition of the Company’s foreign subsidiaries at the exchange rates in effect as of the end of each reporting period.  The consolidated statements of operations are translated at the average rates of exchange during the period.  The resulting translation adjustments of the Company’s foreign subsidiaries are recorded directly to other comprehensive income (loss) in the consolidated statements of comprehensive income.  Gains or losses resulting from foreign currency transactions are included in net income.

 

(l)                          Reclassifications

 

Certain amounts from prior periods have been reclassified to conform to the current period presentation.

 

(3)                                 Financial Instruments

 

The Company accounts for financial instruments that are being measured and reported on a fair value basis in accordance with ASC 820.  This includes those items currently reported in financial instruments owned, at fair value and financial instruments sold, not yet purchased, at fair value on the consolidated statements of financial condition.

 

As defined in ASC 820, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In determining fair value, the Company uses various methods, primarily market and income approaches. Based on these approaches, the Company utilizes assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and/or the risks inherent in the inputs to the valuation technique. These inputs can be readily observable, market corroborated, or generally unobservable firm inputs. The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs. Based on the observability of the inputs used in the valuation techniques, the Company is required to provide the information set forth below according to the fair value hierarchy. The fair value hierarchy ranks the quality and reliability of the information used to determine fair values. Financial instrument assets and liabilities carried at fair value have been classified and disclosed in one of the following three categories:

 

Level 1

 

Quoted market prices in active markets for identical assets or liabilities.

Level 2

 

Observable market based inputs or unobservable inputs that are corroborated by market data.

Level 3

 

Unobservable inputs that are not corroborated by market data.

 

Level 1 primarily consists of listed financial instruments whose value is based on quoted market prices, such as listed equities, equity options and warrants, and preferred stock.  This category also includes U.S. Government securities for which the Company typically receives independent external valuation information.  There were no transfers in or out of Level 1 during the three

 

10



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

months ended March 31, 2012.

 

Level 2 includes those financial instruments that are valued using multiple valuation techniques, primarily the market and income approaches.  The valuation methodologies utilized are calibrated to observable market inputs.  The Company considers recently executed transactions, market price quotations and various assumptions, including credit spreads, the terms and liquidity of the instrument, the financial condition, operating results and credit ratings of the issuer or underlying company, the quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, as well as other measurements. In order to be classified as Level 2, substantially all of these assumptions would need to be observable in the marketplace or can be derived from observable data or supported by observable levels at which transactions are executed in the marketplace.  Financial instruments in this category include certain corporate debt, collateralized debt obligations (“CDOs”) primarily collateralized by company trust preferred and capital securities, certain convertible preferred stock, residential and commercial mortgage-backed securities and other asset-backed securities.  There were no transfers in or out of Level 2 during the three months ended March 31, 2012.

 

Fair value of corporate debt, certain convertible preferred stock, residential and commercial mortgage-backed securities and other asset-backed securities classified as Level 2 was determined by using quoted market prices, broker or dealer quotes, or alternate pricing sources with reasonable levels of price transparency.  Fair value of CDOs primarily collateralized by banking and insurance company trust preferred and capital securities was determined primarily by considering recently executed transactions of similar securities and certain assumptions, including the financial condition, operating results and credit ratings of the issuer or underlying companies.

 

Level 3 is comprised of financial instruments whose fair value is estimated based on multiple valuation techniques, primarily market and income approaches.  The valuation methodologies utilized may include significant inputs that are unobservable from objective sources.  The Company considers various market inputs and assumptions, such as recently executed transactions, market price quotations, discount margins, market spreads applied, the terms and liquidity of the instrument, the financial condition, operating results and credit ratings of the issuer or underlying company, the quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, default rates, as well as other measurements.  Included in this category are private equity securities and other investments including limited and general partnership interests.

 

Fair value of private equity securities classified as Level 3 was determined by assessing market-based information, such as performance multiples, comparable company transactions, changes in market outlook and the terms and liquidity of the instrument. Fair value of limited and general partnership interests classified as Level 3 was determined by using net asset values or capital statements provided by the general partner, updated for capital contributions and distributions and changes in market conditions, if significant, up to the reporting date.  Private equity securities and limited and general partnership interests generally trade infrequently.

 

The following table provides information related to financial instruments where a practical expedient was used as the basis to measure the fair value of certain entities that calculate a net asset value per share (or equivalent) as of March 31, 2012:

 

Type of Investment

 

Fair Value

 

Unfunded
Commitments

 

Redemption
Frequency

 

Notice
Period

 

Public/private equity funds (a)

 

$

38,931

 

$

12,244

 

n/a

 

n/a

 

 


(a)          This category includes several funds that invest primarily in domestic public and private companies operating in the financial services sector.  Management of these funds also have the ability to invest in foreign public and private equities, debt financial instruments, warrants, hybrid securities and membership interests in the financial services sector.  The fair values of investments in this category have been estimated using asset values based on capital statements provided by the general partner, updated, as necessary, for capital contributions and distributions and changes in market conditions up to the reporting date.  These investments generally cannot be redeemed, unless approved by the general partners.  Upon liquidation of the underlying investments prior to the life expectancy / maturity of the funds, management of the funds can elect to make distributions to the limited partners.  The time horizon for such distributions is at the discretion of the general partners but should not exceed the time horizon of the fund’s life expectancy.  It is estimated that these investments would be liquidated approximately ten years following the initial investment date, some with options to extend for up to a two year period, ranging from 2013 — 2020.  Additional expenses, such as legal and administrative associated with the final liquidation can be

 

11



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

incurred.  Therefore, it is possible that upon final liquidation of the investments, the final funds distributed could be different from the estimated value of the investment.  However, these differences are not expected to be material.

 

In determining the appropriate levels, the Company performed a detailed analysis of the assets and liabilities that are subject to ASC 820.  At each reporting period, all assets and liabilities for which the fair value measurement is based on significant unobservable inputs are classified as Level 3.

 

Assets at Fair Value as of March 31, 2012

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Financial instruments owned, at fair value:

 

 

 

 

 

 

 

 

 

Equities

 

$

88,532

 

$

21,894

 

$

22,570

 

$

132,996

 

Corporate and other debt:

 

 

 

 

 

 

 

 

 

Corporate debt

 

389

 

61,546

 

 

61,935

 

CDOs

 

 

4,378

 

 

4,378

 

Total corporate and other debt

 

389

 

65,924

 

 

66,313

 

Mortgage and other asset-backed securities:

 

 

 

 

 

 

 

 

 

Non-agency residential mortgage-backed securities

 

 

3,688

 

 

3,688

 

Commercial mortgage-backed securities

 

 

10,816

 

 

10,816

 

Asset-backed securities

 

 

164

 

 

164

 

Total mortgage and other asset-backed securities

 

 

14,668

 

 

14,668

 

Other investments(1)

 

 

 

41,961

 

41,961

 

Total non-derivative trading assets

 

88,921

 

102,486

 

64,531

 

255,938

 

Equity options/warrants

 

543

 

159

 

 

702

 

Total financial instruments owned

 

$

89,464

 

$

102,645

 

$

64,531

 

$

256,640

 

 


(1)          Consists of limited and general partnership interests.

 

Liabilities at Fair Value as of March 31, 2012

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Financial instruments sold, not yet purchased, at fair value:

 

 

 

 

 

 

 

 

 

Equities

 

$

74,640

 

$

 

$

 

$

74,640

 

Corporate debt

 

 

13,916

 

 

13,916

 

U.S. Government and agency securities

 

14,471

 

 

 

14,471

 

Total non-derivative trading liabilities

 

89,111

 

13,916

 

 

103,027

 

Equity options/warrants

 

69

 

 

 

69

 

Total financial instruments sold, not yet purchased

 

$

89,180

 

$

13,916

 

$

 

$

103,096

 

 

12



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

Assets at Fair Value as of December 31, 2011

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Financial instruments owned, at fair value:

 

 

 

 

 

 

 

 

 

Equities

 

$

61,280

 

$

2,418

 

$

16,422

 

$

80,120

 

Corporate and other debt:

 

 

 

 

 

 

 

 

 

Corporate debt

 

332

 

23,527

 

 

23,859

 

CDOs

 

 

5,126

 

 

5,126

 

Total corporate and other debt

 

332

 

28,653

 

 

28,985

 

Mortgage-backed securities:

 

 

 

 

 

 

 

 

 

Agency residential mortgage-backed securities

 

 

22,783

 

 

22,783

 

Non-agency residential mortgage-backed securities

 

 

2,907

 

 

2,907

 

Total mortgage-backed securities

 

 

25,690

 

 

25,690

 

Other investments(1)

 

 

 

58,758

 

58,758

 

Total non-derivative trading assets

 

61,612

 

56,761

 

75,180

 

193,553

 

Equity options/warrants

 

948

 

 

 

948

 

Total financial instruments owned

 

$

62,560

 

$

56,761

 

$

75,180

 

$

194,501

 

 


(1)          Consists of limited and general partnership interests.

 

Liabilities at Fair Value as of December 31, 2011

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Financial instruments sold, not yet purchased, at fair value:

 

 

 

 

 

 

 

 

 

Equities

 

$

51,392

 

$

 

$

 

$

51,392

 

Corporate debt

 

 

7,909

 

 

7,909

 

U.S. Government and agency securities

 

5,234

 

 

 

5,234

 

Total non-derivative trading liabilities

 

56,626

 

7,909

 

 

64,535

 

Equity options/warrants(2)

 

61

 

 

 

61

 

Total financial instruments sold, not yet purchased

 

$

56,687

 

$

7,909

 

$

 

$

64,596

 

 


(2)          To-be-announced securities are accounted for as derivative transactions and the unrealized losses were reported in accounts payable, accrued expenses and other liabilities on the consolidated statements of financial condition.  The associated payable of $43 has been excluded from the above table. These to-be-announced securities would be classified as Level 2.

 

The non-derivative trading assets/liabilities categories were reported in financial instruments owned, at fair value and financial instruments sold, not yet purchased, at fair value on the Company’s consolidated statements of financial condition.

 

The derivative financial instruments were reported on a gross basis by level.  The Company’s derivative activities included in financial instruments owned and financial instruments sold, not yet purchased consist of writing and purchasing listed equity options and warrants.

 

The following table provides quantitative information about significant unobservable inputs for Level 3 fair value measurements:

 

13



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

Instrument

 

Fair Value at
3/31/12

 

Technique

 

Input

 

Range (W/Avg.)

 

Equities: Financial Services

 

$

22,570

 

Market Comparable Companies

 

Book value multiple (a)

 

0.8 - 1.3 (0.9)

 

 

 

 

 

 

 

Tangible book value multiple (a)

 

0.6 - 1.4 (1.0)

 

 

 

 

 

 

 

Marketability Discount (b)

 

3% - 12% (4)%

 

 

 

 

 

 

 

 

 

 

 

Limited Partnership: Financial Services

 

$

3,030

 

Market Comparable Companies

 

Book value multiple (a)

 

1.7

 

 

 

 

 

 

 

Earnings multiple (a)

 

13.0 - 16.8

 

 


(a) Represents amounts used when the reporting entity has determined that market participants would use such multiples when measuring the fair value of these investments.

 

(b) Represents amounts used when the reporting entity has determined that market participants would take these discounts into account in a fair value measurement.

 

Sensitivity of Level 3 Inputs to Fair Value Measurements

 

The significant unobservable inputs used in the fair value measurement of the Company’s Level 3 private equity securities included in the table above are market comparable company performance multiples, including book value and tangible book value multiples, and marketability discounts.  Significant increases (decreases) in any of the market comparable performance multiple inputs in isolation would result in a significantly higher (lower) fair value measurement.  Significant increases (decreases) in the marketability discount input in isolation would result in a significantly lower (higher) fair value measurement.

 

The significant unobservable inputs used in the fair value measurement of the Company’s Level 3 limited partnership investment included in the table above (excludes financial instruments where a practical expedient was used as a basis to measure fair value) are market comparable company performance multiples of the underlying investments, including book value and earnings multiples.  Significant increases (decreases) in any of the market comparable performance multiple inputs in isolation would result in a significantly higher (lower) fair value measurement.

 

The following table provides a reconciliation of the beginning and ending balances for the non-derivative trading assets measured at fair value using significant unobservable inputs (Level 3) for the three months ended March 31, 2012 and 2011:

 

Level 3 Financial Assets

 

Three Months Ended
March 31, 2012

 

Balance as of
December 31,
2011

 

Total gains
and (losses)
(realized and
unrealized)

 

Purchases

 

(Sales)

 

Transfers
in/(out) of
Level 3

 

Balance as
of
March 31,
2012

 

Changes in
unrealized
gains and
(losses)
included in
earnings
related to
assets still held
at reporting
date

 

Equities

 

$

16,422

 

$

(986

)

$

7,257

(a)

$

(123

)

$

 

$

22,570

 

$

(947

)

Other investments

 

58,758

 

757

 

2,977

(a)

(20,531

)

 

41,961

 

766

 

Total Level 3 financial assets

 

$

75,180

 

$

(229

)

$

10,234

 

$

(20,654

)

$

 

$

64,531

 

$

(181

)

 


(a)          Equities include $7,249 and other investments include $2,918 of financial instruments received from a distribution-in-kind from the redemption of the KBW Financial Services Fund, L.P., see Note 10 of the Notes to Consolidated Financial Statements for additional information.

 

14



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

Three Months Ended
March 31, 2011

 

Balance as of
December 31,
2010

 

Total gains
and (losses)
(realized
and
unrealized)

 

Purchases

 

(Sales)

 

Transfers
in/(out)of
Level 3

 

Balance as of
March 31, 2011

 

Changes in
unrealized gains
and (losses)
included in
earnings related
to assets still
held at reporting
date

 

Equities

 

$

16,654

 

$

172

 

$

 

$

 

$

 

$

16,826

 

$

172

 

Corporate and other debt:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

CDOs

 

1

 

30

 

 

(30

)

 

1

 

 

Other debt obligations

 

11,806

 

460

 

 

(2,063

)

 

10,203

 

235

 

Total corporate and other debt

 

11,807

 

490

 

 

(2,093

)

 

10,204

 

235

 

Other investments

 

51,336

 

902

 

7,408

 

(704

)

 

58,942

 

562

 

Total Level 3 financial assets

 

$

79,797

 

$

1,564

 

$

7,408

 

$

(2,797

)

$

 

$

85,972

 

$

969

 

 

Total gains and losses represent the total gains and/or losses (realized and unrealized) recorded for the Level 3 financial assets and were reported in principal transactions, net in the accompanying consolidated statements of operations.  Additionally, the change in the unrealized gains and losses may be offset by realized gains and losses during the period.

 

Purchases and sales represent the amount of purchases and/or sales of Level 3 financial assets during the period.  The amounts were recorded on the transaction dates at the transaction amounts.

 

Transfers in/(out) of Level 3 represent existing financial assets that were previously categorized at a higher/lower level. Transfers in or out of Level 3 result from changes in the observability of inputs used in determining fair values for different types of financial assets.  Transfers were reported at their fair value as of the actual date in which such changes in the fair value inputs occurred.

 

The amount of unrealized gains and losses included in earnings attributable to the change in unrealized gains and losses relating to Level 3 assets still held at the end of the period were reported in principal transactions, net in the accompanying consolidated statements of operations.  The change in unrealized gains and losses may be offset by realized gains and losses during the period.

 

(4)                                 Short-Term Borrowings

 

From time to time, the Company obtains secured short-term borrowings primarily through bank loans.  There were no short-term borrowing obligations outstanding during the three month period ended March 31, 2012.

 

(5)                                 Commitments and Contingencies

 

(a)              Leases

 

As of March 31, 2012, there were no significant changes in the Company’s lease agreements since December 31, 2011.

 

(b)              Litigation

 

In the ordinary course of business, the Company may be a defendant or codefendant in legal proceedings.  At December 31, 2011, the Company believes, based on currently available information, that the results of such proceedings, in the aggregate, will not have a material adverse effect on the Company’s financial condition.  The results of such proceedings could be material to the Company’s operating results for any particular period, depending, in part, upon additional developments affecting such matters and the operating results for such period.  Legal reserves have been established in accordance with ASC 450, Contingencies. Once established, reserves are adjusted when there is more information available or when an event occurs requiring a change.

 

15



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

(c)               Investment Commitments

 

As of March 31, 2012, the Company had approximately $12,244, including $7,400 to an affiliated fund which is limited to additional investments in existing portfolio holdings, in outstanding commitments for additional funding to limited partnership investments.

 

(6)                                 Financial Instruments with Off-Balance-Sheet Risk

 

In the normal course of its principal trading activities, the Company enters into transactions in financial instruments with off-balance-sheet risk.  These financial instruments, such as options, warrants, futures and mortgage-backed to-be-announced (“TBA”) securities, contain off-balance-sheet risk inasmuch as ultimate settlement of these transactions may have market and/or credit risk in excess of amounts which are recognized in the consolidated financial statements.  Transactions in listed options and warrants are conducted through regulated exchanges, which clear and guarantee performance of counterparties.

 

Also, in connection with its principal trading activities, the Company has sold securities that it does not currently own and will, therefore, be obligated to purchase such securities at a future date.  The Company has recorded this obligation in the financial statements at market values of the related securities and will record a trading loss if the market value of the securities increases subsequent to the purchase date.

 

(a)              Broker-Dealer Activities

 

The Company clears securities transactions on behalf of customers through its clearing brokers.  In connection with these activities, customers’ unsettled trades may expose the Company to off-balance-sheet credit risk in the event customers are unable to fulfill their contracted obligations.  The Company seeks to control the risk associated with its customer activities by monitoring the creditworthiness of its customers.

 

(b)              Derivative Financial Instruments

 

The Company’s derivative activities consist of writing and purchasing listed equity options and/or warrants and, from time to time, futures on interest rate, currency and equity products and mortgage-backed TBA securities for trading for our own account. Options and warrants are included in financial instruments owned, at fair value and financial instruments sold, not yet purchased, at fair value in the accompanying consolidated statements of financial condition.  See also Note 3 of the Notes to Consolidated Financial Statements for additional details.  As a writer of options, the Company receives a cash premium at the beginning of the contract period and bears the risk of unfavorable changes in the fair value of the financial instruments underlying the options.  Options written do not expose the Company to credit risk since they obligate the Company (not its counterparty) to perform.

 

In order to measure derivative activity, notional or contract amounts are frequently utilized.  Notional contract amounts, which are not included on the consolidated statements of financial condition, are used as a basis to calculate contractual cash flows to be exchanged and generally are not actually paid or received.

 

A summary of the Company’s listed options, warrants, futures contracts and TBA securities is as follows:

 

 

 

Current

 

Average

 

End of

 

 

 

Notional

 

Fair

 

Period

 

 

 

Value

 

Value

 

Fair Value

 

March 31, 2012:

 

 

 

 

 

 

 

Purchased options/warrants

 

$

10,171

 

$

1,044

 

$

702

 

Written options/warrants

 

$

3,854

 

$

55

 

$

69

 

Short agency mortgage-backed TBA securities

 

$

 

$

2

 

$

 

 

 

 

 

 

 

 

 

December 31, 2011:

 

 

 

 

 

 

 

Purchased options/warrants

 

$

18,398

 

$

3,694

 

$

948

 

Written options/warrants

 

$

2,756

 

$

388

 

$

61

 

Short agency mortgage-backed TBA securities

 

$

21,960

 

$

28

 

$

43

 

 

16



Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

The following table summarizes the net gains from trading activities included in principal transactions, net with respect to the consolidated statements of operations for the three months ended March 31, 2012 and 2011:

 

 

 

Three Months Ended

 

 

 

March 31,

 

Type of Instrument

 

2012

 

2011

 

Equities

 

$

1,134

 

$

 5,400

 

Corporate and other debt

 

5,215

 

5,962

 

Mortgage and other asset-backed securities

 

3,168

 

5,076

 

Other investments

 

989

 

902

 

Total

 

$

10,506

 

$

 17,340

 

 

The revenue related to the equities and mortgage and other asset-backed securities categories included realized and unrealized gains and losses on both derivative instruments and non-derivative instruments.  Corporate and other debt and other investments included realized and unrealized gains and losses on non-derivative instruments.

 

(7)                                 Concentrations of Credit Risk

 

The Company is engaged in various securities trading and brokerage activities servicing primarily domestic and foreign institutional investors.  Nearly all of the Company’s transactions are executed with and on behalf of institutional investors, including other brokers and dealers, commercial banks, mutual funds, and other financial institutions.  The Company’s exposure to credit risk associated with the non-performance of these customers in fulfilling their contractual obligations pursuant to securities transactions can be directly impacted by volatile securities markets.

 

A substantial portion of the Company’s marketable securities are common stock and debt of financial institutions.  The credit and/or market risk associated with these holdings can be directly impacted by factors that affect this industry such as volatile equity and credit markets and actions of regulatory authorities.

 

(8)                                 Stockholders’ Equity

 

Dividends Declared on Common Stock

 

During the three months ended March 31, 2012, the Company’s board of directors declared and the Company paid dividends of $0.05 per share totaling $1,753.

 

Stock Repurchase Program

 

On July 28, 2010, the Company’s board of directors approved a stock repurchase program, authorizing the Company to repurchase in the aggregate up to $70,000 of its outstanding common stock.  On October 26, 2011, the Company’s board of directors authorized an additional $50,000 for its stock repurchase program.  Purchases by the Company under this program may be made from time to time at prevailing market prices in open market purchases, privately negotiated transactions, block purchase techniques or otherwise, as determined by the Company’s management.  There was no activity during the three months ended March 31, 2012.

 

This program does not obligate the Company to acquire any particular amount of common stock.  The timing, frequency and amount of repurchase activity will depend on a variety of factors such as levels of cash generation from operations, cash requirements for investments in the Company’s business, current stock price, market conditions and other factors.  The stock repurchase program may be suspended, modified or discontinued at any time and has no set expiration date.

 

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KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

(9)                                 Stock-Based and Other Incentive Compensation

 

Stock-Based Compensation

 

At March 31, 2012, the Company had one effective incentive compensation arrangement under the 2009 Incentive Compensation Plan (the “Plan”).  The Plan permits the Company to issue shares of common stock pursuant to the grant or exercise of stock options, stock appreciation rights, restricted stock awards (“RSAs”), restricted stock units, performance unit awards and performance share awards, as well as grant cash-based awards and other awards to directors, officers, employees and consultants.

 

Restricted Stock Awards

 

As part of the 2011 year-end performance award process the Company granted 2,471,786 RSAs under the Plan to certain employees in March 2012 (“2011 Bonus Awards”).  The aggregate fair value of the RSAs granted in connection with the 2011 Bonus Awards in March 2012 was $40,290.  This value was based upon the grant date share price of $16.30.  RSAs are actual shares of common stock issued to the participant that are restricted.  The stock granted in connection with the 2011 Bonus Awards generally vests over a three year period.  Vesting would accelerate on a change in control, death or permanent disability.  Unvested RSAs are eligible to receive dividends but are subject to forfeiture upon termination of employment.

 

For 2011 Bonus Awards that were granted to retirement-eligible employees, the Company recognized the grant date fair value as compensation expense for such awards on the date of grant instead of over the service period specified in the award terms. For employees who will be retirement-eligible prior to vesting of the 2011 Bonus Awards, the Company recognizes compensation expense ratably from the grant date to the retirement eligibility date.  The Company recorded accelerated non-cash incremental compensation expense of $6,162 in the first quarter of 2012 related to 2011 Bonus Awards granted to retirement-eligible employees.

 

Long Term Incentive Program

 

In February 2010, the Company adopted a Long Term Incentive Program (the “LTIP”) under the 2009 Plan.  The LTIP allows the Company to make awards under the Plan to selected employees, which awards will provide for payments of such amounts pursuant to such terms and conditions as the Company shall determine.  The LTIP provides that amounts specified or calculated pursuant to awards may be earned during a performance cycle established for such an award upon the achievement of specified performance goals.

 

During the first quarter of 2010, the Company approved awards under the Plan to three members of senior management.  The LTIP awards have established performance cycles (2010, 2010 through 2011 and 2010 through 2012) and amounts payable based on the achievement of certain levels of cumulative growth in adjusted earnings per share during the performance cycle.  For the 2010 through 2011 performance cycle, LTIP awards were not earned as the cumulative growth in adjusted earnings per share was below the established minimum level.  As of March 31, 2012, there was no accrual for the 2010 through 2012 performance cycle as the cumulative growth in adjusted earnings per share is expected to be below the established minimum level.

 

Performance Equity Awards

 

In March 2011, the Company granted Performance Equity Awards to three members of senior management.  The Performance Equity Awards provide for the issuance of up to 120,240 shares of Common Stock to the recipients in the aggregate, contingent upon achievement of a target level of “Return on KBW Average Equity” as defined in the Performance Equity Awards.  The share price of the Performance Equity Awards on grant date was $24.93.  The three year performance period began on January 1, 2011 and ends on December 31, 2013.  The range of possible Performance Equity Awards vesting is between 0% and 200% of the target, so that the minimum number of shares that may be awarded to the recipients in the aggregate is zero and the maximum number is 240,480.  In addition, these Performance Equity Awards contain “clawback” provisions that provide for repayment of all or a portion of shares issued in the event of certain accounting restatements, thereby creating at-risk performance units for these executives.  Unvested Performance Equity Awards are subject to forfeiture upon termination of employment.  Under the Performance Equity Award agreements, in the event of (i) termination by us without “cause,” (ii) termination by the employee for “good reason” or (iii) the employee’s death, “disability,” or “retirement,” (as each such term is defined in the Plan) during any performance cycle or period, such employee will be entitled to payment of a pro-rata portion (based on the portion of such performance cycle or period that such employee was actively employed by us) of such employee’s award with respect to such performance cycle or period, provided that the performance goals with respect to such performance cycle or period are achieved.  In the event of a change in control, as defined in the

 

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Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

Plan, the target performance goals applicable to any outstanding Performance Equity Awards shall be deemed to have been attained in full (unless actual performance exceeds the target performance goal, in which case actual performance shall be used) and all of the applicable shares will be deemed vested and subject to payment as provided in the Plan.  As of March 31, 2012, there was no accrual for Performance Equity Awards based on the probable outcome of the performance condition.

 

(10)                          Transactions with Affiliated Funds

 

The Company is in the process of exiting its asset management business.  The Company completed the full redemption of investors in the KBW Financial Services Funds (KBW Financial Services Master Fund, Ltd., KBW Financial Services Fund, L.P., KBW Financial Services Fund, Ltd.) and ended the capital commitment period of the KBW Capital Partners I, L.P (“Capital Partners”).  In January 2012, the Company received cash and securities totaling $19,379 upon full redemption of the KBW Financial Services Fund, L.P.  Capital Partners is a nonconsolidated investment fund that was formed by the Company with third-party investors and has been externally managed beginning January 2012.  The realization phase of Capital Partners is expected to be completed in the next few years, which is not expected to materially impact the Company’s financial statements.  The aggregate carrying value of the Company’s interest in Capital Partners was $4,863 and $4,948 as of March 31, 2012 and December 31, 2011, respectively.  The Company elected to apply the fair value option to this affiliated fund.  See Note 5 of the Notes to Consolidated Financial Statements for the Company’s commitments related to this affiliated fund.

 

(11)                          Restructuring Charges

 

Commencing in the third quarter of 2011, the Company undertook steps to reduce the Company’s workforce and certain other costs to better align its resources to the current business environment. These efforts continued through the first quarter of 2012 with further headcount reductions.  As a result of the workforce reduction, the Company has also consolidated office workspace in New York City and terminated several market data contracts.  These actions resulted in restructuring charges to earnings relating to severance, lease obligation accruals for vacant office space and contract termination costs in 2011.  This workforce reduction program was completed in the first quarter of 2012 resulting in additional severance costs of $2,244 in the first quarter of 2012.  The cumulative amount of severance costs incurred from this workforce reduction program was $9,243.  The accrual related to severance was included in accrued compensation and benefits and the accruals related to the consolidation of space in our New York office and the termination of several market data services contracts were included in accounts payable, accrued expenses and other liabilities on the accompanying statements of financial condition.

 

The following table provides a reconciliation of the beginning and ending balances of accruals related to restructuring charges through March 31, 2012:

 

 

 

Severance

 

Lease
Obligations

 

Market Data
Service
Contracts

 

Total

 

Accrual for restructuring charges, balance at December 31, 2011

 

$

2,369

 

$

7,553

 

$

375

 

$

10,297

 

Additional accrual for restructuring charges

 

2,244

 

 

 

2,244

 

Costs paid or settled

 

(4,464

)

(849

)

(51

)

(5,364

)

Accrual for restructuring charges, balance at March 31, 2012

 

$

149

 

$

6,704

 

$

324

 

$

7,177

 

 

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Table of Contents

 

KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

(12)                          Earnings Per Share

 

The computations of basic and diluted earnings per share are set forth below:

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

Net income

 

$

466

 

$

4,641

 

Less: Dividends and allocation of undistributed earnings to participating securities(1)

 

219

 

477

 

Net income applicable to common shareholders

 

$

247

 

$

4,164

 

 

 

 

 

 

 

Weighted average number of common shares outstanding(1)(2):

 

 

 

 

 

Basic

 

30,211,667

 

33,122,382

 

Effect of dilutive securities - restricted stock

 

 

 

Diluted

 

30,211,667

 

33,122,382

 

Earnings per common share:

 

 

 

 

 

Basic

 

$

0.01

 

$

0.13

 

Diluted

 

$

0.01

 

$

0.13

 

 


(1)         Participating securities in the form of unvested share based payment awards amounted to weighted average shares of 3,598,607, and 3,768,302, for the three months ended March 31, 2012 and 2011, respectively.  Dividends declared on participating securities amounted to $219 and $193, net of estimated forfeitures, for the three months ended March 31, 2012 and 2011, respectively.

 

(2)         Basic and diluted common shares outstanding were equal for the periods presented under the two-class method.

 

(13)                          Income Taxes

 

The Company applies the provisions of ASC 740, which prescribes the recognition and measurement criteria related to tax positions taken or expected to be taken in a tax return.  For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities.  In addition, the following information required by ASC 740 is provided:

 

·                  The Company’s gross unrecognized tax benefits, excluding interest and penalties, has not changed significantly since December 31, 2011.

 

·                  The Company classifies interest and penalties, if any, related to tax uncertainties as income tax expense.  This amount has not changed significantly since December 31, 2011.

 

·                  The Company and its subsidiaries file consolidated federal and various state, local and foreign tax returns.  The federal income tax returns have been audited and/or closed through 2005.  Various state, local and foreign returns are subject to audits by tax authorities beginning with the 2008 tax year.  The settlement of any outstanding audits within the next 12 months, if any, is not anticipated to have a significant impact on the Company’s financial position.

 

(14)                          Industry Segment Data

 

The Company follows the provisions of ASC 280, Segment Reporting, in disclosing its business segments.  Pursuant to that guidance, an entity is required to determine its business segments based on the way management organizes the segments within the enterprise for making operating decisions and assessing performance.  Based upon these criteria, the Company has determined that its entire business should be considered a single segment.

 

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KBW, INC. and SUBSIDIARIES

Notes to Consolidated Financial Statements—(Continued)

(unaudited)

(Dollars in thousands, except per share information)

 

(15)                          Net Capital Requirement

 

Keefe is a registered U.S. broker-dealer that is subject to the Uniform Net Capital Rule (SEC Rule 15c3-1 or the Net Capital Rule) administered by the SEC and FINRA, which requires the maintenance of minimum net capital. Keefe has elected to use the basic method to compute net capital as permitted by the Net Capital Rule, which requires Keefe to maintain minimum net capital, as defined, of $2,053 as of March 31, 2012. These rules also require Keefe to notify and sometimes obtain approval from FINRA for significant withdrawals of capital. The Company’s net capital and net capital in excess of requirement were as follows:

 

 

 

March 31, 2012

 

Net Capital

 

$

82,674

 

Net Capital in Excess of Requirement

 

$

80,621

 

 

KBWL is an investment firm authorized and regulated by the FSA in the United Kingdom and is subject to the capital requirements of the FSA.  As of March 31, 2012, KBWL was in compliance with its local capital requirements.  At March 31, 2012, KBWL’s capital resources of $33,118 exceeded the capital resources requirement by $25,640.

 

(16)                          Recent Accounting Developments

 

In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income (Topic 220). ASU 2011-05 eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. An entity can elect to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements.  ASU 2011-05 was effective for interim and annual periods beginning after December 15, 2011. The Company adopted ASU 2011-05 in the first quarter of 2012 and elected the two-statement method.

 

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurements and Disclosure Requirements in U.S. GAAP and IFRSs.   ASU 2011-04 clarifies how a principal market is determined, addresses the fair value measurement of instruments with offsetting market or counterparty credit risks and the concept of valuation premise and highest and best use, extends the prohibition on blockage factors to all three levels of the fair value hierarchy and requires additional disclosures, including quantitative information about the significant unobservable inputs used for all Level 3 measurements and a qualitative discussion about the sensitivity of recurring Level 3 measurements to changes in the unobservable inputs.  ASU 2011-04 was effective for interim and annual periods beginning after December 15, 2011. The adoption of ASU 2011-04 in the first quarter of 2012 did not impact the Company’s results of operations or financial position, but did impact the Company’s disclosures about fair value measurements.  See Note 3 of the Notes to Consolidated Financial Statements.

 

(17)                          Subsequent Events

 

Declaration of Quarterly Dividend

 

On April 25, 2012, the Company’s board of directors declared a quarterly dividend of $0.05 per share on its outstanding common stock.  The dividend is payable on June 15, 2012 to shareholders of record on June 1, 2012.

 

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Table of Contents

 

Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following discussion should be read in conjunction with our audited consolidated financial statements and the related notes included elsewhere in this report.

 

Cautionary Statement Regarding Forward-Looking Statements

 

We have made statements in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in other sections of this report that are forward-looking statements. In some cases, you can identify these statements by forward-looking words such as “may,” “might,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential” or “continue,” the negative of these terms and other comparable terminology.  These forward-looking statements, which are based on various underlying assumptions and expectations and are subject to risks, uncertainties and other unknown factors, may include projections of our future financial performance based on our growth strategies and anticipated trends in our business.  These statements are only predictions based on our current expectations and projections about future events.  There are or may be important factors that could cause our actual results, level of activity, performance or achievements to differ materially from the historical or future results, level of activity, performance or achievements expressed or implied by such forward-looking statements.  These factors include, but are not limited to, those discussed in the section entitled “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011.

 

Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy or completeness of any of these forward-looking statements. You should not rely upon forward-looking statements as predictions of future events. We are under no duty to update any of these forward-looking statements after the date of filing of this report to conform such statements to actual results or revised expectations.

 

Overview

 

We are a leading full service investment bank specializing in the financial services industry.  Our principal activities are: (i) investment banking, including mergers and acquisitions and other strategic advisory services (“M&A”), equity and fixed income securities offerings, and mutual thrift conversions, (ii) equity and fixed income sales and trading, and (iii) research that provides fundamental, objective analysis that identifies investment opportunities and helps our investor customers make better investment decisions.

 

Within our full service business model, our focus includes bank and thrift holding companies, banks, thrifts, insurance companies, broker-dealers, mortgage banks, asset management companies, mortgage and equity real estate investment trusts, and other real estate components, consumer and specialty finance firms, financial processing companies and securities exchanges.  We emphasize serving investment banking clients in the small and mid cap segments of the financial services industry although our clients also include many large-cap companies.  Our sales customers are primarily institutional investors.

 

Most revenues with respect to our services provided are primarily determined as a result of active competition in the marketplace.  Our revenues are primarily generated through advisory, underwriting and private placement fees earned through our investment banking activities, commissions earned on equity sales and trading activities, interest and dividends earned on our securities’ inventories and profit and losses from trading activities related to the securities’ inventories.

 

Our largest expense is compensation and benefits.  Our performance is dependent on our ability to attract, develop and retain highly skilled employees who are motivated to provide quality service and guidance to our clients.

 

Many external factors affect our revenues and profitability. Such factors include equity and fixed income trading prices and volumes, the volatility of these markets, the level and shape of the yield curve, political events and regulatory developments, including recent government participation in providing capital to financial institutions, and competition.  These factors influence our investment banking operations in that such factors affect the number and timing of equity and fixed income securities issuances and M&A activity within the financial services industry.  These same factors also affect our sales and trading business by impacting equity and fixed income trading prices and volumes and valuations in secondary financial markets.  Commission rates, market volatility and other factors also affect our sales and trading revenues.  These market forces may cause our revenues and earnings to fluctuate significantly from period to period and the results of any one period should not be considered indicative of future results.  See “—Business Environment.”

 

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Table of Contents

 

A significant portion of our expense base is variable, including employee compensation and benefits, brokerage and clearance, communication and data processing and business development expenses.  Our remaining costs generally do not directly relate to the service revenues earned.

 

Certain data processing systems that support equity and fixed income trading, research, payroll, human resources and employee benefits are service bureau based and are operated in the vendors’ data centers.  We believe that this stabilizes our fixed costs associated with data processing.  We also license vendor information databases to support investment banking, sales and trading and research.  Vendors may, at the end of contractual terms, terminate our rights or modify or significantly alter product and service offerings or related fees, which may affect our ongoing business activities or related costs.

 

Business Environment

 

Global economic and financial market conditions can materially affect our financial performance.  The Company’s principal sources of revenue are derived from financial services sector capital markets, M&A and sales and trading of equity and fixed income securities.  Economic uncertainties in the U.S. and global markets, continue to cause reduced capital raising activity.  While there are signs in the U.S. banking sector of improved credit quality and earnings, and greater confidence in asset values, we have not yet seen a significant trend towards consolidation or an increase in capital raising transactions.

 

The ongoing uncertain investor sentiment regarding the financial services industry has resulted in continued investor caution, despite improvements in share prices.  In the U.S., the KBW Bank Index increased by 26% for the three months ended March 31, 2012 while the KBW Regional Banking Index increased by 14%.  In Europe, the KBW European Large-Cap Banking Index increased by 14% and the KBW European Mid & Small-Cap Banking Index increased by 17% for the three months ended March 31, 2012.

 

It is difficult to predict how long these conditions will continue to impact our overall revenues.  We believe that we remain well capitalized and well positioned to assist our clients in raising capital and in providing needed advice in M&A and other transactions for the financial services industry in the U.S., Europe and Asia.

 

Results of Operations

 

Three Months Ended March 31, 2012 Compared with Three Months Ended March 31, 2011

 

Overview

 

Total revenues were $69.2 million for the three months ended March 31, 2012 compared with $95.2 million for the same period in 2011, a decrease of $25.9 million, or 27.3%.  This decrease was primarily due to decreases in investment banking revenues of $10.6 million and principal transactions, net revenue of $6.8 million.

 

Total expenses decreased $18.9 million, or 21.6%, to $68.5 million for the three months ended March 31, 2012, which included $2.2 million of restructuring charges, compared with $87.4 million for the same period in 2011, primarily due to a decrease in compensation and benefits expense of $13.7 million, or 24.2%.

 

We recorded net income of $0.5 million, or $0.01 per diluted share, for the three months ended March 31, 2012 compared with net income of $4.6 million, or $0.13 per diluted share, for the three months March 31, 2012.  Our non-GAAP operating net income, which excludes restructuring charges related to the workforce reduction program was $2.0 million, or $0.06 per diluted share, for the three months ended March 31, 2012.  See “—Non-GAAP Financial Measures” for a reconciliation of our non-GAAP measures to their corresponding GAAP amounts.

 

Restructuring

 

Commencing in the third quarter of 2011, we undertook significant steps to reduce our workforce and certain other costs to better align our resources to the current business environment.  These efforts continued through the first quarter of 2012 with further headcount reductions including those related to our decision to exit the asset management business.  These workforce reductions were completed early in the first quarter of 2012 resulting in restructuring charges of $2.2 million (see “Non-GAAP Financial Measures” below).

 

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Table of Contents

 

The following table provides a comparison of our revenues and expenses for the periods presented (dollars in thousands):

 

 

 

Three Months Ended

 

 

 

 

 

 

 

March 31,

 

Period-to-Period

 

 

 

2012

 

2011

 

$ Change

 

% Change

 

 

 

(unaudited)

 

Revenues:

 

 

 

 

 

 

 

 

 

Investment banking

 

$

27,029

 

$

37,648

 

$

(10,619

)

(28.2

)%

Commissions

 

29,219

 

34,429

 

(5,210

)

(15.1

)

Principal transactions, net

 

10,506

 

17,340

 

(6,834

)

(39.4

)

Interest and dividend income

 

1,785

 

3,204

 

(1,419

)

(44.3

)

Other

 

702

 

2,562

 

(1,860

)

(72.6

)

Total revenues

 

69,241

 

95,183

 

(25,942

)

(27.3

)

 

 

 

 

 

 

 

 

 

 

Expenses:

 

 

 

 

 

 

 

 

 

Compensation and benefits

 

42,929

 

56,634

 

(13,705

)

(24.2

)

Occupancy and equipment

 

4,700

 

5,659

 

(959

)

(16.9

)

Communications and data processing

 

7,736

 

8,695

 

(959

)

(11.0

)

Brokerage and clearance

 

3,362

 

4,916

 

(1,554

)

(31.6

)

Business development

 

3,191

 

4,624

 

(1,433

)

(31.0

)

Professional services

 

1,842

 

3,702

 

(1,860

)

(50.2

)

Interest

 

192

 

309

 

(117

)

(37.9

)

Restructuring charges

 

2,244

 

 

2,244

 

100.0

 

Other

 

2,343

 

2,852

 

(509

)

(17.8

)

Total expenses

 

68,539

 

87,391

 

(18,852

)

(21.6

)

Income before income taxes

 

702

 

7,792

 

(7,090

)

(91.0

)

Income tax expense

 

236

 

3,151

 

(2,915

)

(92.5

)

Net income

 

$

466

 

$

4,641

 

$

(4,175

)

(90.0

)%

 

Non-GAAP Financial Measures

 

We are reporting our total expenses, net income and diluted earnings per share for the three months ended March 31, 2012 on a non-GAAP basis (“Non-GAAP Financial Measures”) in our 2012 first quarter Form 10-Q.  The Non-GAAP Financial Measures for the three months ended March 31, 2012 exclude restructuring charges related to the workforce reduction program.

 

Our management utilized non-GAAP calculations in understanding and analyzing our financial results.  Specifically, our management believes that these Non-GAAP Financial Measures provided useful information by excluding the restructuring charges, related to the workforce reduction program which may not be indicative of our core operating results and business outlook.  Our management believes that these Non-GAAP Financial Measures will allow for a better evaluation of the operating performance of our business and facilitate meaningful comparison of our results in the current period to those in prior periods and future periods. Such periods did not and likely will not include the impact of significant restructuring charges.  Our reference to these Non-GAAP Financial Measures should not be considered as a substitute for results that are presented in a manner consistent with GAAP. These Non-GAAP Financial Measures are provided to enhance investors’ overall understanding of our current financial performance.

 

A limitation of utilizing these Non-GAAP Financial Measures is that the GAAP accounting effects of these events do in fact reflect the underlying financial results of our business and these effects should not be ignored in evaluating and analyzing our financial results.  Therefore, management believes that our GAAP measures of total expenses, net income and diluted earnings per share and the same respective Non-GAAP Financial Measures of our financial performance should be considered together.

 

The following provides details with respect to reconciling total expenses, net income and diluted earnings per share on a GAAP basis for the three months ended March 31, 2012 to the aforementioned captions on a non-GAAP basis:

 

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Table of Contents

 

 

 

Three Months Ended
March 31, 2012

 

Three Months Ended
March 31, 2011

 

 

 

(dollars in thousands, except per share information)

 

 

 

(unaudited)

 

 

 

 

 

 

 

Total expenses:

 

 

 

 

 

Total expenses - GAAP basis

 

$

68,539

 

$

87,391

 

Adjustment to exclude restructuring charges

 

(2,244)

(a)

 

Non-GAAP operating total expenses (b)

 

$

66,295

 

$

N/A

 

 

 

 

 

 

 

Net income:

 

 

 

 

 

Net income - GAAP basis

 

$

466

 

$

4,641

 

Adjustment to exclude restructuring charges, net of tax benefit

 

1,488

(a)

 

Non-GAAP operating net income (b)

 

$

1,954

 

$

N/A

 

 

 

 

 

 

 

Diluted earnings per share:

 

 

 

 

 

Diluted earnings per share - GAAP basis

 

$

0.01

 

$

0.13

 

Adjustment to exclude restructuring charges, net of tax benefit

 

0.05

(a)

 

Non-GAAP operating diluted earnings per share (b) 

 

$

0.06

 

$

N/A

 

 


(a)          The adjustment represents the exclusion of restructuring charges, which includes compensation expense related to the workforce reduction program.

 

(b)         A non-GAAP financial measure that management believes provides the most meaningful comparison between historical, present and future periods.

 

Revenues

 

Investment Banking

 

Investment banking revenue was $27.0 million for the three months ended March 31, 2012 compared with $37.6 million for the same period in 2011, a decrease of $10.6 million, or 28.2%.  M&A and advisory revenue increased $11.0 million, or 115.8%, to $20.5 million for the three months ended March 31, 2012 compared with $9.5 million for the same period in 2011, primarily due to the completion of several larger than average advisory engagements completed in 2012.  Capital markets revenue was $6.5 million for the three months ended March 31, 2012 compared with $28.2 million for the same period in 2011, a decrease of $21.7 million, primarily due to a lower number of equity capital market transactions for the three months ended March 31, 2012 compared with the same period in 2011.

 

Commissions

 

Commissions revenue was $29.2 million for the three months ended March 31, 2012 compared with $34.4 million for the same period in 2011, a decrease of $5.2 million, or 15.1%.  U.S. equity commissions were $20.9 million for the three months ended March 31, 2012 compared with $23.8 million for the same 2011 period, a decrease of $2.9 million, or 12.2%, and non-U.S. equity commissions were $8.3 million for the three months ended March 31, 2012 compared with $10.6 million for the same period in 2011, a decrease of $2.3 million, or 21.7%, reflecting lower market volumes in financial services companies’ stocks in 2012.

 

Principal Transactions, Net

 

Principal transactions, net revenue was $10.5 million for the three months ended March 31, 2012 compared with $17.3 million for the same period in 2011, a decrease of $6.8 million, or 39.4%.  Fixed income revenue was $8.8 million for the three months ended March 31, 2012 compared with $12.3 million for the same period in 2011, a decrease of $3.5 million, or 28.4%,

 

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primarily due to reduced client activity.  Trading for our own account, including firm investments, resulted in revenue of $3.4 million for the three months ended March 31, 2012 compared with revenue of $5.5 million for the same period in 2011, a decrease of $2.1 million and equity market making resulted in negative revenue of $1.8 million for the three months ended March 31, 2012 compared with negative revenue of $1.2 million for the same period in 2011.  The realized gains and change in the fair value of our trust preferred backed collateralized debt obligations and related securities owned remained relatively unchanged for the three months ended March 31, 2012 compared with a gain of $0.8 million for the same period in 2011.

 

Interest and Dividend Income

 

Interest and dividend income was $1.8 million for the three months ended March 31, 2012 compared with $3.2 million for the same period in 2011, a decrease of $1.4 million, or 44.3%.  The decrease was primarily due to lower levels of interest bearing assets.

 

Other

 

Other revenues were $0.7 million for the three months ended March 31, 2012 compared with $2.6 million for the same period in 2011, a decrease of $1.9 million, or 72.6%.  The decrease was primarily due to lower fees earned on loan portfolio valuation and transaction services in 2012 compared with the same period in 2011.

 

Expenses

 

Compensation and Benefits

 

Compensation and benefits expense decreased $13.7 million, or 24.2%, to $42.9 million for the three months ended March 31, 2012 compared with $56.6 million for the same period in 2011.  The compensation ratio (compensation and benefits expense as a percentage of total revenue) was 62.0% for the three months ended March 31, 2012 compared with 59.5% for the same period in 2011.

 

Communications and Data Processing

 

Communications and data processing expense decreased $1.0 million, or 11.0%, to $7.7 million for the three months ended March 31, 2012 compared with $8.7 million for the same period in 2011.  The decrease was primarily due to lower market data costs for the three months ended March 31, 2012 compared with the same period in 2011.

 

Brokerage and Clearance

 

Brokerage and clearance expense decreased $1.6 million, or 31.6%, to $3.4 million for the three months ended March 31, 2012 compared with $4.9 million for the same period in 2011.  The decrease was primarily due to lower clearance costs for the three months ended March 31, 2012 compared with the same period in 2011.

 

Business Development

 

Business development expense decreased $1.4 million, or 31.0%, to $3.2 million for the three months ended March 31, 2012 compared with $4.6 million for the same period in 2011.  The decrease was primarily due to lower travel and entertainment expenses for the three months ended March 31, 2012 compared with the same period in 2011.

 

Professional Services

 

Professional services expense decreased $1.9 million, or 50.2%, to $1.8 million for the three months ended March 31, 2012 compared with $3.7 million for the same period in 2011.  The decrease was primarily due to lower legal costs for the three months ended March 31, 2012 compared with the same period in 2011.

 

Income Tax Expense

 

Income tax expense was $0.2 million for the three months ended March 31, 2012, which resulted in an effective tax rate of 33.6%, compared with income tax expense of $3.2 million for the same period in 2011, which resulted in an effective tax rate of 40.4%.

 

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Critical Accounting Policies and Estimates

 

The preparation of our consolidated financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and of revenues and expenses during the reporting periods.  We base our estimates and assumptions on historical experience and on various other factors that we believe are reasonable under the circumstances.  The use of different estimates and assumptions could produce materially different results.  For example, if factors such as those described in Item 1A under “Risk Factors” cause actual events to differ from the assumptions we used in applying the accounting policies, our results of operations, financial condition and liquidity could be materially adversely affected.

 

Our significant accounting policies are summarized in Note 2 of the Notes to Consolidated Financial Statements.  On an ongoing basis, we evaluate our estimates and assumptions, particularly as they relate to accounting policies that we believe are most important to the presentation of our financial condition and results of operations.  We regard an accounting estimate or assumption to be most important to the presentation of our financial condition and results of operations where the nature of the estimate or assumption is material due to the level of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, as well as the impact of the estimate or assumption on our financial condition or operating performance is material.

 

Based on these criteria, we believe the following to be our critical accounting policies:

 

Fair Value of Financial Instruments

 

We account for financial instruments that are being measured and reported on a fair value basis in accordance with FASB Accounting Standards Codification (“ASC”) 820, Fair Value Measurements and Disclosures. ASC 820 defines fair value, establishes a framework for measuring fair value and requires enhanced disclosures about fair value measurements. ASC 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an ordinary transaction between current market participants at the measurement date.”  See Note 3 of the Notes to Consolidated Financial Statements for a more detailed discussion of fair value of financial instruments.

 

ASC 825, Financial Instruments, provides entities the option to measure certain financial assets and financial liabilities at fair value with changes in fair value recognized in earnings each period.  ASC 825 permits the fair value option election, on an instrument-by-instrument basis, either at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.  Such election must be applied to the entire instrument and not only a portion of the instrument.  We applied the fair value option for certain eligible instruments, including all private equity securities and limited partnership interests, as these financial instruments had been managed on a fair value basis prior to the fair value option election.

 

Financial instruments are valued at quoted market prices, if available.  For financial instruments that do not have readily determinable fair values through quoted market prices, the determination of fair value is based upon consideration of available information, including types of financial instruments, current financial information, restrictions on dispositions, fair values of underlying financial instruments and quotations for similar instruments.

 

The valuation process for financial instruments may include the use of valuation models and other techniques.  Adjustments to valuations derived from valuations models may be made when, in management’s judgment, either the size of the position in the financial instrument in a nonactive market or other features of the financial instrument such as its complexity, or the market in which the financial instrument is traded (such as counterparty, credit, concentration or liquidity) require that an adjustment be made to the value derived from the models.  An adjustment may be made if a financial instrument is subject to sales restrictions that would result in a price less than the quoted market price.  Adjustments from the price derived from a valuation model reflects management’s judgment that other participants in the market for the financial instrument being measured at fair value would also consider in valuing that same financial instrument and are adjusted for assumptions about risk uncertainties and market conditions.  Results from valuation models and valuation techniques in one period may not be indicative of future period fair value measurements.

 

Fair Value Hierarchy

 

In determining fair value, we utilize various methods including the market and income approaches.  Based on these approaches, we utilize assumptions that market participants would use in pricing the asset or liability, including assumptions about risk and or the risks inherent in the inputs to the valuation technique.  These inputs can be readily observable, market corroborated, or generally unobservable firm inputs.  We utilize valuation techniques that maximize the use of observable inputs and minimize the use

 

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of unobservable inputs.  Based on the observability of the inputs used in the valuation techniques, we are required to provide the following information according to the fair value hierarchy.  The fair value hierarchy ranks the quality and reliability of the information used to determine fair values.  Financial instrument assets and liabilities carried at fair value have been classified and disclosed in one of the following three categories:

 

Level 1

 

Quoted market prices in active markets for identical assets or liabilities.

Level 2

 

Observable market based inputs or unobservable inputs that are corroborated by market data.

Level 3

 

Unobservable inputs that are not corroborated by market data.

 

Level 1 primarily consists of listed financial instruments whose value is based on quoted market prices, such as listed equities, equity options and warrants, and preferred stock.  This category may also include U.S. Government and agency securities for which we typically receive independent external valuation information.

 

Level 2 includes those financial instruments that are valued using multiple valuation techniques, primarily market and income approaches.  The valuation methodologies utilized are calibrated to observable market inputs.  We consider recently executed transactions, market price quotations and various assumptions, such as credit spreads, the terms and liquidity of the instrument, the financial condition, operating results and credit ratings of the issuer or underlying company, the quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, as well as other measurements. In order to be classified as Level 2, substantially all of these assumptions would need to be observable in the marketplace or can be derived from observable data or supported by observable levels at which transactions are executed in the marketplace.  Financial instruments in this category include certain corporate debt, CDOs primarily collateralized by banking and insurance company trust preferred and capital securities, certain convertible preferred stock, residential and commercial mortgage-backed securities and other asset-backed securities.

 

Fair value of corporate debt, certain convertible preferred stock, residential and commercial mortgage-backed securities and other asset-backed securities classified as Level 2 was determined by using quoted market prices, broker or dealer quotes, or alternate pricing sources with reasonable levels of price transparency.  Fair value of CDOs primarily collateralized by banking and insurance company trust preferred and capital securities was determined primarily by considering recently executed transactions of similar securities and certain assumptions, including the financial condition, operating results and credit ratings of the issuer or underlying companies.

 

Level 3 is comprised of financial instruments whose fair value is estimated based on multiple valuation techniques, primarily market and income approaches.  The valuation methodologies utilized may include significant inputs that are unobservable from objective sources.  We consider various market inputs and assumptions, such as recently executed transactions, market price quotations, discount margins, market spreads applied, the terms and liquidity of the instrument, the financial condition, operating results and credit ratings of the issuer or underlying company, the quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, default rates, as well as other measurements.  Included in this category are private equity securities and other investments including limited and general partnership interests.

 

Fair value of private equity securities was determined by assessing market-based information, such as performance multiples, comparable company transactions, changes in market outlook and the terms and liquidity of the instrument.  Fair value of limited and general partnership interests was determined by using net asset values or capital statements provided by the general partner, as a practical expedient, updated for changes in market conditions, if significant, up to the reporting date.  Private equity securities and limited and general partnership interests generally trade infrequently.

 

The variables affecting fair value estimates of these financial instruments can change rapidly and unexpectedly, which could have a significant impact on the fair value estimates of these financial instruments.  Results from valuation techniques in one period may not be indicative of future period fair value measurements.

 

Our Level 3 assets were $64.5 million as of March 31, 2012, which represented approximately 12% of total assets and approximately 25% of total assets measured at fair value.

 

The availability of observable inputs can vary from product to product and is affected by a wide variety of factors, including, for example, the type of product, whether the product is new and not yet established in the marketplace, and other characteristics particular to the transaction.  To the extent that valuation is based on models or inputs that are less observable or unobservable in the market, the determination of fair value requires more judgment.  Accordingly, the degree of judgment exercised by management in determining fair value is greatest for instruments categorized in Level 3. In certain cases, the inputs used to measure fair value may

 

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fall into different levels of the fair value hierarchy.  In such cases, for disclosure purposes, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement in its entirety.

 

Fair value is a market-based measure considered from the perspective of a market participant who holds the asset or owes the liability rather than an entity-specific measure.  When market assumptions are not readily available, management’s assumptions are set to reflect those that market participants would use in pricing the asset or liability at the measurement date.  We use prices and inputs that are current as of the measurement date, including during periods of market dislocation. In periods of market dislocation, the observability of prices and inputs may be reduced for many instruments.  This condition could cause an instrument to be reclassified from Level 1 to Level 2, or from Level 2 to Level 3.

 

Fair Value of Financial Instruments Control Process

 

We employ a variety of control processes to validate the fair value of our financial instruments, including those derived from utilizing valuation techniques.  Individuals outside of the trading departments obtain independent prices, as appropriate.  Where a valuation technique is used to determine fair value, recently executed comparable transactions and other observable market data are considered for purposes of validating assumptions underlying the valuation technique.  These control processes are designed to assure that the values used for financial reporting are based on observable inputs wherever possible.  In the event that observable inputs are not available, the control processes are designed to assure that the valuation approach utilized is appropriate and consistently applied and that the assumptions are reasonable.  These control processes include reviews by personnel with relevant expertise who are independent from the trading desks, including involvement by senior management.

 

Income Taxes

 

Deferred tax assets and liabilities are recognized for the future tax attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date.  In the event it is more likely than not that a deferred tax asset will not be realized, a valuation allowance will be recorded.

 

We apply ASC 740, Income Taxes, which prescribes a single, comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the Company has taken or expects to take on its tax returns.  Income tax expense is based on pre-tax accounting income, including adjustments made for the recognition or derecognition related to uncertain tax positions.

 

Contractual Obligations

 

As of March 31, 2012, our contractual obligations with respect to operating leases have not significantly changed since December 31, 2011.  Investment commitments were $12.2 million, including $7.4 million to an affiliated fund, as of March 31, 2012.

 

Off-Balance Sheet Arrangements

 

In the normal course of our principal trading activities, we may enter into transactions in financial instruments with off-balance-sheet risk.  These financial instruments, such as options, warrants, futures contracts and mortgage-backed to-be-announced securities, contain off-balance-sheet risk inasmuch as ultimate settlement of these transactions may have market and/or credit risk in excess of amounts which are recognized in the consolidated financial statements.  Transactions in listed options and warrants are conducted through regulated exchanges, which clear and guarantee performance of counterparties.  As described in Item 3 — “Quantitative and Qualitative Disclosures About Market Risk — Credit Risk,” through indemnification provisions in our clearing agreements with our clearing brokers, customer activities may expose us to off-balance sheet credit risk, which we seek to mitigate through customer screening and collateral requirements.

 

We are a member of various exchanges that trade and clear securities, options, warrants and/or futures contracts. As a member of these exchanges, we may be required to pay a proportionate share of the financial obligations of another member who may default on its obligations to the exchange.  To mitigate these performance risks, the exchanges often require members to post collateral as well as meet minimum financial standards.  While the rules governing different exchange memberships vary, our guarantee obligations generally would arise only if the exchange had previously exhausted its resources.  In addition, any such guarantee

 

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obligation would be apportioned among the other non-defaulting members of the exchange.  Any potential contingent liability under these membership agreements cannot be estimated.  We have not recorded any contingent liability in our consolidated financial statements for these agreements and currently believe that any potential requirement to make payments under these agreements is remote.

 

Liquidity and Capital Resources

 

We are the parent company of Keefe, KBWL, KBW Asia and KBW Ventures, Inc.  Dividends and other transfers from our subsidiaries are our primary source of funds to satisfy our capital and liquidity requirements.  Applicable laws and regulations, primarily the net capital rules discussed below, restrict dividends and transfers from Keefe, KBWL and KBW Asia to us.  Our rights to participate in the assets of any subsidiary are also subject to prior claims of the subsidiary’s creditors, including customers and trade creditors of Keefe, KBWL and KBW Asia.

 

We monitor and evaluate the composition and size of our assets and operating liabilities.  As a result of our market making, customer and principal activities, the overall size of total assets and operating liabilities fluctuate from period to period.  Our assets generally consist of cash and cash equivalents, financial instruments, resale agreement balances and receivables.

 

Our operating activities in the period generate and use cash resulting from net income or loss and fluctuations in our current assets and liabilities.  The most significant fluctuations in current assets and liabilities have resulted from changes in the level of customer activity, changes in the types of and value of the financial instruments owned on a principal basis and shifts in our investment positions in response to changes in our trading strategies or prevailing market conditions.  We have not relied significantly on leverage.  Our moderate use of leverage does not expose us to potential requirements to sell assets as a result of margin calls due to decreases in the fair value of financial instruments.

 

We have historically satisfied our capital and liquidity requirements through capital from our stockholders and internally generated cash from operations.  As of March 31, 2012, we had liquid assets of $161.9 million, consisting of cash and cash equivalents and receivables from clearing brokers.  From time to time, we may obtain a short term subordinated loan from our U.S. clearing broker or others to support underwriting activity over a very short time.  We may also finance fixed income positions with securities sold under repurchase agreements as well as utilizing margin borrowing from the clearing brokers.

 

Although we believe such sources remain available, we do not currently plan to obtain such short-term subordinated financing from any outside source.  We do not currently have any long term debt obligations and therefore, are not exposed to the breach of any debt covenants.

 

We have a “universal” shelf registration statement on form S-3 on file with the SEC.  This shelf registration statement would enable us to sell, from time to time, the securities covered by the registration statement in one or more public offerings.  The securities covered by the registration statement include common stock, preferred stock, depositary shares, senior debt securities, subordinated debt securities, warrants, stock purchase contracts, and stock purchase units.  We may offer any of these securities independently or together in any combination with other securities and may consummate such offerings in rapid fashion and with little notice.

 

The timing of cash bonus payments to our employees may significantly affect our cash position and liquidity from period to period.  While our employees are generally paid salaries semi-monthly during the year, cash bonus payments, which make up a larger portion of total compensation, are generally paid once a year.  Cash bonus payments for a given year are generally paid in February of the following year.  We continually monitor our liquidity position and believe our available liquidity will be sufficient to fund our operations over the next twelve months.

 

Our dividend policy currently contemplates the payment of a quarterly cash dividend.  On February 22, 2012, our board of directors declared a cash dividend of $0.05 per share of common stock (equaling an aggregate payment of $1.8 million based on 35.1 million total shares outstanding on March 5, 2012, including shares underlying vested restricted stock units), which cash dividend was paid on March 15, 2012 to stockholders of record as of the close of business on March 3, 2012.  On April 25, 2012, our board of directors declared a cash dividend of $0.05 per share of common stock (equaling an aggregate payment of approximately $1.7 million based on approximately 35.0 million total shares outstanding on April 30, 2012, including shares underlying vested restricted stock units), which cash dividend will be paid on June 15, 2012 to stockholders of record as of the close of business on June 1, 2012.

 

On July 28, 2010, our board of directors authorized management to repurchase in the aggregate up to $70.0 million worth of shares of our common stock from time to time at prevailing market prices in open market purchases, in private negotiated transactions,

 

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in block purchases or otherwise, as may be determined by management.  On October 26, 2011, the Company’s board of directors authorized an additional $50.0 million for its stock repurchase program.  There was no activity with respect to the stock repurchase program during the three months ended March 31, 2012.

 

The dividend to be paid on June 15, 2012 and any additional purchases under our share repurchase program are expected to be funded from available cash resources.  Our board of directors may, in its sole discretion, amend or repeal our dividend policy at any time and decrease or eliminate dividend payments and our management may terminate the share repurchase program at any time.  If we had insufficient cash to pay dividends in the amounts set forth in our dividend policy or to buy back shares, we would need either to reduce or eliminate such programs or fund a portion of them with borrowings or financings from other sources.  Shares of common stock repurchased are expected to be cancelled immediately and therefore reduce common stock and paid-in capital.

 

As a registered broker-dealer and member firm of FINRA, as successor to the NYSE, Keefe is subject to the uniform net capital rule of the SEC. We use the basic method permitted by the uniform net capital rule, which generally requires that the ratio of aggregate indebtedness to net capital cannot exceed 15 to 1. FINRA, as successor to the NYSE, may prohibit a member firm from expanding its business or paying dividends if resulting net capital would be below the regulatory minimum required capital. We do not expect that these requirements will materially impact our ability to meet our current and future obligations.

 

At March 31, 2012, Keefe’s net capital under the SEC’s Uniform Net Capital Rule was $82.7 million, or $80.6 million in excess of the minimum required net capital.

 

KBWL is subject to the capital requirements of the U.K. Financial Services Authority. KBWL’s total capital resources of $33.1 million exceeded the capital resources requirement by approximately $25.6 million at March 31, 2012.

 

Cash Flows

 

Three months ended March 31, 2012.  Cash increased $8.1 million for the three months ended March 31, 2012, primarily due to cash flows provided by operating activities of $24.5 million, partially offset by cash used in financing activities of $16.7 million.

 

Net income, after adjusting for non-cash expense and revenue items of $22.0 million, provided cash of $22.4 million.  The non-cash items consisted of expenses of $13.0 million resulting from the amortization of stock-based compensation expenses, $1.2 million related to depreciation and amortization expense and $7.8 million related to a deferred income tax expense.  Cash of $3.2 million was used as a result of an increase in operating assets, primarily attributable to increases in financial instruments owned, at fair value of $62.1 million and accounts receivable of $13.6 million, partially offset by a decrease in receivables from clearing brokers of $78.4 million.  Cash of $5.3 million was provided as a result of a decrease in operating liabilities, primarily attributable to an increase in financial instruments sold, not yet purchased, at fair value of $38.5 million, partially offset by a decrease in accrued compensation and benefits of $30.5 million.

 

We used $0.4 million in our investing activities for the purchase of fixed assets.  Cash used in financing activities was $16.7 million primarily as a result of the cancellation of restricted stock in satisfaction of withholding tax requirements.

 

Three months ended March 31, 2011.  Cash decreased $36.9 million for the three months ended March 31, 2011, primarily due to cash flows used in financing and operating activities.

 

Net income, after adjusting for non-cash expense and revenue items of $25.2 million, provided cash of $29.9 million.  The non-cash items consisted of expenses of $19.4 million resulting from the amortization of stock-based compensation expenses, $1.4 million related to depreciation and amortization expense and $4.4 million related to deferred income tax expense.  Cash of $19.6 million was used as a result of an increase in operating assets, primarily attributable to increases related to financial instruments owned, at fair value of $149.1 million, partially offset by a $134.8 million decline in receivables from clearing brokers.  Cash of $17.6 million was used as a result of a decrease in operating liabilities, primarily attributable to a decrease in accrued compensation and benefits of $106.2 million, partially offset by an increase in financial instruments sold, not yet purchased, at fair value of $85.6 million.

 

We used $1.3 million in our investing activities for the purchase of fixed assets.  Cash used in financing activities was $28.8 million primarily as a result of the cancellation of restricted stock in satisfaction of withholding tax requirements and the cancellation of shares of common stock related to the stock repurchase program.

 

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Item 3.                    Quantitative and Qualitative Disclosures About Market Risk.

 

Market Risk

 

Market risk represents the risk of loss that may result from the change in value of a financial instrument due to fluctuations in its market price.  Market risk may be exacerbated in times of trading illiquidity when market participants refrain from transacting in normal quantities and/or at normal bid-offer spreads.  Our exposure to market risk is directly related to our role as a financial intermediary in customer trading and to our market making and investment activities.  Market risk is inherent in financial instruments.

 

We trade in equity and debt securities as an active participant in both listed and over the counter markets.  We typically maintain securities in inventory to facilitate our market making activities and customer order flow.  We may use a variety of risk management techniques and hedging strategies in the ordinary course of our trading business to manage our exposures.

 

In connection with our sales and trading business, management also reviews reports appropriate to the risk profile of specific trading activities.  Management monitors risks in its trading activities by establishing and periodically reviewing limits for each trading desk and reviewing daily trading results, inventory aging, securities concentrations and ratings.  Typically, market conditions are evaluated and transaction details and securities positions are reviewed.  These activities seek to ensure that trading strategies are within acceptable risk tolerance parameters.  Activities include price verification procedures, position reconciliations and reviews of transaction bookings.  We believe these procedures, which stress timely communications between traders, trading management and senior management, are important elements of the risk management process.

 

The following table sets forth our monthly high, low and average long/short financial instruments owned, including the market value of listed options and warrants, for the three months ended March 31, 2012:

 

 

 

High

 

Low

 

Average

 

 

 

(dollars in thousands)

 

Long Value:

 

 

 

 

 

 

 

Equities

 

$

133,698

 

$

81,068

 

$

105,213

 

Corporate and other debt

 

$

66,313

 

$

28,985

 

$

49,385

 

Mortgage and other asset-backed securities

 

$

35,127

 

$

14,668

 

$

23,087

 

Other investments

 

$

58,758

 

$

41,299

 

$

45,872

 

Short Value:

 

 

 

 

 

 

 

Equities

 

$

74,709

 

$

51,453

 

$

63,232

 

Corporate and other debt

 

$

13,916

 

$