UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C. 20549
FORM 10-Q
ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2005
o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 0-18188
PAULSON CAPITAL CORP.
(Exact name of small business issuer as specified in its charter)
Oregon
(State or other jurisdiction of incorporation or organization)
93-0589534
(IRS employer identification number)
811 S.W. Naito Parkway
Portland, OR 97204
(Address of principal executive offices)
(503) 243-6000
(Issuer’s telephone number)
Indicate by check mark whether the issuer (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 issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ý No o
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act): Yes o No ý
Number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date:
Common stock, no par value 3,121,946 as of May 10, 2005
Transitional Small Business Disclosure Format (check one): Yes o No ý
PAULSON CAPITAL CORP.
INDEX TO FORM 10-Q
2
PART I — FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
PAULSON CAPITAL CORP. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
|
| 03/31/05 |
| 12/31/04 |
| ||
|
| (unaudited) |
|
|
| ||
ASSETS |
|
|
|
|
| ||
|
|
|
|
|
| ||
Cash and cash equivalents |
| $ | 137,265 |
| $ | 132,845 |
|
Receivable from clearing organization |
| 7,489,014 |
| 7,856,254 |
| ||
Notes and other receivables |
| 698,651 |
| 442,934 |
| ||
Income taxes receivable |
| 851,000 |
| 851,000 |
| ||
Trading securities, at market value |
| 1,747,202 |
| 3,029,326 |
| ||
Investment securities, at market value |
| 21,444,935 |
| 20,774,645 |
| ||
Underwriter warrants, at estimated fair value |
| 11,000,000 |
| 9,416,000 |
| ||
Prepaid and deferred expenses |
| 1,450,943 |
| 1,583,346 |
| ||
Furniture and equipment, net |
| 233,959 |
| 239,028 |
| ||
|
|
|
|
|
| ||
Total assets |
| $ | 45,052,969 |
| $ | 44,325,378 |
|
|
|
|
|
|
| ||
LIABILITIES AND SHAREHOLDERS’ EQUITY |
|
|
|
|
| ||
|
|
|
|
|
| ||
LIABILITIES |
|
|
|
|
| ||
Accounts payable and accrued liabilities |
| $ | 446,382 |
| $ | 2,138,856 |
|
Dividends payable |
| 4,457 |
| — |
| ||
Payable to clearing organization |
| 64,664 |
| 1,021,860 |
| ||
Compensation, employee benefits and payroll taxes |
| 1,736,731 |
| 2,108,056 |
| ||
Securities sold, not yet purchased, at market value |
| 119,701 |
| 50,144 |
| ||
Deferred income taxes |
| 7,147,930 |
| 5,436,000 |
| ||
|
|
|
|
|
| ||
Total liabilities |
| 9,519,865 |
| 10,754,916 |
| ||
|
|
|
|
|
| ||
SHAREHOLDERS’ EQUITY |
|
|
|
|
| ||
Preferred stock, no par value; authorized, 500,000 shares; issued and outstanding, no shares |
| — |
| — |
| ||
Common stock, no par value; authorized, 10,000,000 shares; issued and outstanding, 3,174,590 at 03/31/05 and 3,190,300 at 12/31/04 |
| 1,740,005 |
| 1,745,824 |
| ||
Retained earnings |
| 33,793,099 |
| 31,824,638 |
| ||
|
|
|
|
|
| ||
Total shareholders’ equity |
| 35,533,104 |
| 33,570,462 |
| ||
|
|
|
|
|
| ||
Total liabilities and shareholders’ equity |
| $ | 45,052,969 |
| $ | 44,325,378 |
|
The accompanying notes are an integral part of these statements.
3
PAULSON CAPITAL CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
|
| Three months ended |
| ||||
|
| 03/31/05 |
| 03/31/04 |
| ||
|
|
|
|
|
| ||
Revenues |
|
|
|
|
| ||
Commissions |
| $ | 4,141,057 |
| $ | 5,237,631 |
|
Corporate finance |
| 119,985 |
| 4,009,488 |
| ||
Investment income (loss) |
| 5,152,499 |
| (2,001,275 | ) | ||
Trading income |
| 702,004 |
| 444,195 |
| ||
Interest and dividends |
| 7,691 |
| 4,798 |
| ||
Other |
| 11,169 |
| 915 |
| ||
|
|
|
|
|
| ||
|
| 10,134,405 |
| 7,695,752 |
| ||
Expenses |
|
|
|
|
| ||
Commissions and salaries |
| 4,254,004 |
| 5,662,749 |
| ||
Underwriting expenses |
| — |
| 252,458 |
| ||
Rent, telephone and quotation services |
| 306,498 |
| 303,543 |
| ||
Interest expense |
| — |
| 73 |
| ||
Professional fees |
| 442,766 |
| 264,139 |
| ||
Bad debt expense |
| — |
| 40,000 |
| ||
Travel and entertainment |
| 60,146 |
| 55,066 |
| ||
Settlement expense |
| 262,168 |
| 9,590 |
| ||
Depreciation and amortization |
| 23,057 |
| 30,865 |
| ||
Other |
| 505,977 |
| 501,404 |
| ||
|
|
|
|
|
| ||
|
| 5,854,616 |
| 7,119,887 |
| ||
|
|
|
|
|
| ||
Income before income taxes |
| 4,279,789 |
| 575,865 |
| ||
|
|
|
|
|
| ||
Income tax expense (benefit) |
|
|
|
|
| ||
Current |
| — |
| 274,548 |
| ||
Deferred |
| 1,711,930 |
| (56,295 | ) | ||
|
| 1,711,930 |
| 218,253 |
| ||
|
|
|
|
|
| ||
Net Income |
| $ | 2,567,859 |
| $ | 357,612 |
|
|
|
|
|
|
| ||
Basic and diluted earnings per share |
| $ | 0.81 |
| $ | 0.11 |
|
|
|
|
|
|
| ||
Weighted average number of shares outstanding: |
|
|
|
|
| ||
Basic |
| 3,178,847 |
| 3,161,322 |
| ||
Diluted |
| 3,182,953 |
| 3,187,743 |
|
The accompanying notes are an integral part of these statements.
4
PAULSON CAPITAL CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
For the year ended December 31, 2004
and the three month period ended March 31, 2005
|
| Common Stock |
| Retained |
| ||||
|
| Shares |
| Amount |
|
| |||
|
|
|
|
|
|
|
| ||
Balance at December 31, 2003 |
| 3,124,811 |
| $ | 1,173,045 |
| $ | 28,421,863 |
|
|
|
|
|
|
|
|
| ||
Stock options exercised and income tax benefit from stock option exercise |
| 78,500 |
| 577,518 |
| — |
| ||
|
|
|
|
|
|
|
| ||
Redemption of common stock |
| (13,011 | ) | (4,739 | ) | (86,825 | ) | ||
|
|
|
|
|
|
|
| ||
Net income for the year |
| — |
| — |
| 3,489,600 |
| ||
|
|
|
|
|
|
|
| ||
Balance at December 31, 2004 |
| 3,190,300 |
| 1,745,824 |
| 31,824,638 |
| ||
|
|
|
|
|
|
|
| ||
Redemption of common stock (unaudited) |
| (15,710 | ) | (5,819 | ) | (122,834 | ) | ||
|
|
|
|
|
|
|
| ||
Dividends to common shareholders (unaudited) |
| — |
| — |
| (476,564 | ) | ||
|
|
|
|
|
|
|
| ||
Net earnings for the year to date (unaudited) |
| — |
| — |
| 2,567,859 |
| ||
|
|
|
|
|
|
|
| ||
Balance at March 31, 2005 (unaudited) |
| 3,174,590 |
| $ | 1,740,005 |
| $ | 33,793,099 |
|
The accompanying notes are an integral part of this statement.
5
PAULSON CAPITAL CORP. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
|
| Three months ended |
| ||||
|
| 03/31/05 |
| 03/31/04 |
| ||
|
|
|
|
|
| ||
Cash flows from operating activities |
|
|
|
|
| ||
Net earnings |
| $ | 2,567,859 |
| $ | 357,612 |
|
Adjustments to reconcile net earnings to net cash provided by (used in) operating activities: |
|
|
|
|
| ||
Receipt of underwriter warrants |
| — |
| (2,858,966 | ) | ||
Unrealized (appreciation) depreciation/expiration of underwriter warrants |
| (1,584,000 | ) | 1,670,636 |
| ||
Noncash compensation associated with underwriter warrants |
| — |
| 659,930 |
| ||
Depreciation and amortization |
| 23,057 |
| 30,865 |
| ||
Deferred income taxes |
| 1,711,930 |
| (56,295 | ) | ||
Change in assets and liabilities |
|
|
|
|
| ||
Receivables |
| (255,717 | ) | 154,934 |
| ||
Receivables from/payable to clearing organization |
| (589,956 | ) | (1,698,145 | ) | ||
Trading and investment securities |
| 611,834 |
| 2,043,999 |
| ||
Prepaid and deferred expenses |
| 132,403 |
| 131,816 |
| ||
Accounts payable and accrued liabilities |
| (2,059,342 | ) | (765,504 | ) | ||
Securities sold, not yet purchased |
| 69,557 |
| 139,730 |
| ||
Income taxes payable/receivable |
| — |
| 108,494 |
| ||
|
|
|
|
|
| ||
Net cash provided by (used in) operating activities |
| 627,625 |
| (80,894 | ) | ||
|
|
|
|
|
| ||
Cash flows from investing activities |
|
|
|
|
| ||
Additions to furniture and equipment |
| (17,988 | ) | (35,783 | ) | ||
|
|
|
|
|
| ||
Cash flows from financing activities |
|
|
|
|
| ||
Proceeds from exercise of stock options and tax benefit from stock option exercise |
| — |
| 446,843 |
| ||
Dividends paid to common shareholders |
| (476,564 | ) | (312,481 | ) | ||
Payments to retire common stock |
| (128,653 | ) | — |
| ||
|
|
|
|
|
| ||
Net cash provided by (used in) financing activities |
| (605,217 | ) | 134,362 |
| ||
|
|
|
|
|
| ||
NET INCREASE IN CASH AND CASH EQUIVALENTS |
| 4,420 |
| 17,685 |
| ||
|
|
|
|
|
| ||
Cash and cash equivalents at beginning of period |
| 132,845 |
| 155,314 |
| ||
|
|
|
|
|
| ||
Cash and cash equivalents at end of period |
| $ | 137,265 |
| $ | 172,999 |
|
|
|
|
|
|
| ||
Cash paid during the period for: |
|
|
|
|
| ||
|
|
|
|
|
| ||
Interest |
| $ | — |
| $ | — |
|
Income taxes |
| $ | 19,527 |
| $ | 5,162 |
|
The accompanying notes are an integral part of these statements.
6
PAULSON CAPITAL CORP. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation
These financial statements are those of the Company and its wholly owned subsidiary. In the opinion of management, the accompanying unaudited consolidated financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission and include all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the Company’s financial position as of March 31, 2005 and its results of operations and cash flows for the three months ended March 31, 2005 and 2004. The nature of the Company’s business is such that the results of any interim period are not necessarily indicative of results for a full fiscal year. The accompanying unaudited financial statements and related notes should be read in conjunction with the audited financial statements and Form 10-KSB of the Company for the fiscal year ended December 31, 2004.
2. Dividend
On January 27, 2005, the Company announced the authorization by the Board of Directors of a $0.15 special cash dividend to shareholders of record on February 10, 2005. The dividend was paid on March 3, 2005.
3. Securities Owned
Gains and losses from the disposition of trading securities are reflected as trading revenues in the income statement for the period. Gains and losses from the disposition of investment securities are reflected as investment revenues in the income statement for the period.
4. Commitments and Contingencies
In March 2002, the Company’s wholly owned subsidiary, Paulson Investment Company (“PIC”), and one of its registered representatives, Marvin Cox, were named as defendants in a lawsuit filed by Louis Barinaga, a former PIC customer. Barinaga’s claims related to purchases of convertible notes of E.com, which were purchased directly from E.com. Claimant abated his lawsuit and refiled his claims before the NASD. Subsequently, Barinaga amended his arbitration statement of claim to include claims for breach of fiduciary duty, violations of federal and state securities laws, fraud and negligence relating to transactions in stock of e.Digital. Barinaga’s amended statement of claim also named UBS PaineWebber, Inc. as a respondent. Barinaga claimed that Cox, PIC and UBS PaineWebber, Inc.’s actions prevented him from realizing in excess of $12 million on sales of e.Digital stock. Barinaga sought over $18 million plus interest and fees on the e.Digital claims. The e.Digital stock in question was subject to an agreement entered into between Barinaga and UBS PaineWebber, Inc. An arbitration hearing was set to begin on January 24, 2005. The claim of Barinaga relating to E.com notes was settled prior to the start of the arbitration. The remaining claim of Barinaga relating to e.Digital stock also was settled between PIC and Barinaga prior to the start of the arbitration. The settlement has been consummated with Barinaga. However, PIC’s insurance carrier, after previously providing settlement authorization to PIC, has now withdrawn that authorization because of a dispute between Cox and Barinaga. PIC believes that the insurance carrier is obligated to provide the settlement authorization to which it previously agreed. PIC has filed suit against the insurance carrier and intends to pursue the insurance proceeds vigorously. As of December 31, 2004, the Company has recorded the total amount of the settlement expense in its financial statements.
In October 2002, PIC was named as a defendant in a lawsuit filed by Special Situations Fund III, LP and Special Situations Cayman Fund, LP. The lawsuit was filed in U.S. District Court for the District of New Jersey. It asserts various federal securities law claims and common law fraud and negligence against numerous defendants, including PIC, arising out of two follow-on offerings of Suprema Specialties, Inc. PIC participated in one of the two offerings, the August 25, 2000 follow-on offering of Suprema Specialties, Inc., as a member of the underwriting syndicate, underwriting 75,000 shares in total. The stock was sold in the August 25, 2000 offering at a price of $8.00 per share. Plaintiffs seek damages for the purchase of 399,151 shares of Suprema Specialties, Inc. stock between August 25, 2000 and November 14, 2001. The federal district court has dismissed the claims against PIC. Plaintiffs have appealed and the case currently is pending before the United States Third Circuit Court of Appeals. PIC believes it has meritorious defenses and intends to defend this matter vigorously.
7
On April 12, 2005, the NASD sent a letter to PIC’s outside counsel indicating that the NASD Department of Enforcement had made a preliminary determination to recommend that disciplinary action be brought against PIC, and certain other PIC employees and former employees, for violations of NASD Rules of Conduct 2110, for mutual fund market-timing, and 3010, for failure to supervise the firm’s mutual fund market-timing business. The NASD also has made a similar preliminary determination with respect to PIC’s president, apparently for failure to supervise as he did not participate in any of the trades identified by the NASD as rule violations. The NASD has proposed to resolve the action with PIC in return for a payment by PIC of $341,000 in restitution and $525,000 in fines. The conduct at question relates to activities undertaken in August and September of 2003 by employees in PIC’s New York City office. Paulson believes that none of the activities violated any state or federal laws or regulations. Accordingly, PIC believes it has meritorious defenses and intends to defend this matter vigorously. PIC is to file a response to the NASD’s preliminary determination on May 17, 2005. If this matter is not settled, it will proceed to a hearing before the NASD, either in 2005 or 2006.
An adverse outcome in certain of the matters described above could have a material adverse effect on PIC or the Company. PIC also has been named in certain other legal proceedings and has received notice that certain customers may commence legal proceedings against PIC. The Company has no additional legal proceedings other than through PIC. The Company believes, based upon information received to date and, where the Company believes it appropriate, discussions with legal counsel, that resolution of this additional pending or threatened litigation will have no material adverse effect on the consolidated financial condition, results of operations, or business of the Company.
5. Stock Options
The Company has a stock-based employee compensation plan. As allowed under SFAS No. 123 “Accounting for Stock-Based Compensation,” the Company continues to account for stock options for employees under APB No. 25, “Accounting for Stock Issued to Employees,” and has adopted the disclosure only requirements of SFAS No. 123. There were no stock option grants in the three month periods ended March 31, 2005 or 2004. Accordingly, no pro forma income effect is shown.
6. Earnings Per Share
The following table is a reconciliation of the numerators and denominators of the basic and diluted per share computations for each of the three months ended March 31, 2005 and March 31, 2004.
|
| Income |
| Weighted |
| Per Share |
| ||
|
| (Numerator) |
| (Denominator) |
|
|
| ||
|
|
|
|
|
|
|
| ||
Three Months Ended March 31, 2005 Income available to common stockholders |
| $ | 2,567,859 |
| 3,178,847 |
| $ | 0.81 |
|
|
|
|
|
|
|
|
| ||
Effect of dilutive securities – options |
| — |
| 4,106 |
|
|
| ||
|
|
|
|
|
|
|
| ||
Diluted earnings per share |
| $ | 2,567,859 |
| 3,182,953 |
| $ | 0.81 |
|
|
|
|
|
|
|
|
| ||
Three Months Ended March 31, 2004 Income available to common stockholders |
| $ | 357,612 |
| 3,161,322 |
| $ | 0.11 |
|
|
|
|
|
|
|
|
| ||
Effect of dilutive securities – options |
| — |
| 26,421 |
|
|
| ||
|
|
|
|
|
|
|
| ||
Diluted earnings per share |
| $ | 357,612 |
| 3,187,743 |
| $ | 0.11 |
|
8
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
FORWARD-LOOKING STATEMENTS
This report, including, without limitation, “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains or incorporates both historical and “forward-looking” statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as “anticipates”, “believes”, “expects”, “intends”, “future” and similar expressions identify forward-looking statements. Any such forward-looking statements in this report reflect our current views with respect to future events and financial performance and are subject to a variety of factors that could cause our actual results to differ materially from historical results or from anticipated results expressed or implied by such forward-looking statements. Because of such factors, we cannot assure you that the results anticipated in this report will be realized. As noted elsewhere in this report, various aspects of our business are subject to extreme volatility often as a result of factors beyond our ability to anticipate or control. In particular, factors, such as the condition of the securities markets, which are in turn based on popular perceptions of the health of the economy generally, can be expected to affect the volume of our business as well as the value of the securities maintained in our trading and investment accounts. Other factors that may affect our future financial condition or results of operations include the following:
• The performance of companies whose securities we have underwritten or otherwise sold to our customers may affect our reputation with other potential syndicate and selling group members and institutional and other retail accounts and may also affect the amount of money in our customers’ portfolios available for the kinds of investments that we offer.
• The value of our investment portfolio, including the value of securities without a readily ascertainable market value, that we have estimated for the purpose of reporting on our financial condition and results of operations, may be significantly and adversely affected by changes in the value of the companies themselves or of comparable companies whose stock values we use in estimating the value of our portfolio securities.
• We are subject to a very high degree of regulation and are responsible for compliance with applicable regulations by all of our personnel. A significant regulatory infraction by us or any of our registered representatives could result in significant penalties, including the loss of our license to conduct securities business in one or more jurisdictions.
• Alternatives available to our customers to transact securities trades could affect our ability to continue to execute our brokerage customers’ transactions.
• The loss of our Chairman, Chester Paulson, could have a material adverse impact on our business.
9
Overview
Substantially all of our business consists of the securities brokerage and investment banking activities of our wholly owned subsidiary, Paulson Investment Company, Inc., or PIC. PIC has operations in four principal categories, all of them in the financial services industry. These categories are:
• securities brokerage activities for which PIC earns commission revenues;
• corporate finance revenues consisting principally of underwriting discounts and underwriter warrants;
• securities trading from which PIC records profit or loss, depending on trading results; and
• investment income resulting from earnings on, and increases or decreases in the value of, PIC’s investment portfolio.
Because we operate in the financial services industry, our revenues and earnings are substantially affected by general conditions in financial markets. In our securities brokerage and corporate finance business, the amount of our revenues depends on levels of market activity requiring the services we provide. Our investment banking activity, which consists primarily of acting as the managing underwriter of initial and follow-on public offerings for smaller companies, is similarly affected by the strength of the market for new equity offerings, which has historically experienced substantial cyclical fluctuation. Although we attempt to match operating costs with activity levels, many of our expenses are either fixed or difficult to change on short notice. Accordingly, fluctuations in brokerage and investment banking revenues tend to result in sharper fluctuations, on a percentage basis, in net income or loss.
Our investment income or loss and, to a lesser extent, our trading income or loss are affected by changes in market valuation of securities generally and, in particular, by changes in valuation of the equity securities of microcap companies in which our investments and trading activities tend to be concentrated. Equity markets in general, and microcap equity markets in particular, have always experienced significant volatility and this volatility has, in recent years, been extreme. The results of this volatility on the value of our investment portfolio and securities held in connection with our trading and investment activities include large quarterly fluctuations in income or loss and substantial increases or decreases in our net worth as our securities holdings are marked to market. The securities in the investment account are held for investment, not actively traded, and not deemed part of operations in accordance with management intentions.
A substantial portion of our investment banking business consists of acting as managing underwriter of initial and follow-on public offerings for microcap companies. As a part of our compensation for this activity, we typically receive warrants exercisable to purchase securities identical to those that we offer and sell to the public. Generally, the warrants are not exercisable for the first year after the offering in which they are earned and are thereafter exercisable for four years, after which they expire. The exercise price is typically 120% of the price at which the securities are initially sold to the public. Accordingly, unless there is at least a 20% increase in the price of these securities at some time more than one and less than five years after the offering, the warrants will remain “under water” and will ultimately expire unexercised.
Critical Accounting Policies
The following discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with US GAAP. In preparing our consolidated financial statements, we must make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities at the date of our financial statements. Actual results are likely to differ from these estimates under different assumptions and conditions.
The critical accounting policies described below include those that reflect significant judgments and uncertainties, which potentially could produce materially different results under different assumptions and conditions. We believe our critical accounting policies are limited to those described below.
10
Use of Estimates. We are required to estimate the value of securities that we hold at the date of any financial statements and to include that value, and changes in such value, in those financial statements. Accordingly, the aggregate estimated value of securities, including warrants, as of the date of any balance sheet is recorded as an asset on that balance sheet. When a new warrant is received as a result of our investment banking activity, its estimated value is included in corporate finance revenue on the date on which it is earned. Subsequently, any change in estimated value is recorded as investment income or loss. When a warrant is exercised, the book value is adjusted to reflect the value of the securities purchased, net of the exercise price, and the adjustment amount is recorded as income or loss for the relevant period. If the warrant expires unexercised, the book value is adjusted to zero and the decrease is recorded as a loss in the relevant period.
We estimate the value of our underwriter warrants using the Black-Scholes Option Pricing Model. The Black-Scholes model requires us to use historical price data combined with certain assumptions and judgments as inputs for the model. The most influential factor in this model is price volatility, which we calculate for each issuing company’s warrants based on the respective company’s own historical stock price movements as well as an index of historical prices for comparable companies. When we initially receive a new underwriter warrant from an initial public offering, its calculated volatility factor is entirely based on the volatility of an index of comparable companies, since there is no price history for a new publicly traded company. As each underwriter warrant approaches its expiration date, its volatility factor is derived primarily from the historical prices of its underlying common stock. We cannot assure you that we will ultimately be able to exercise any of our warrants in a way that will realize the value that we attribute to them in our financial statements based on this model. As of March 31, 2005, our underwriter warrants, based on the Black-Scholes Option Pricing Model, were valued at approximately $11.0 million, up from the estimated value of $9.4 million as of December 31, 2004.
In addition to our underwriter warrants, we hold other securities, some of which have very limited liquidity and some of which do not have a readily ascertainable market value. We are required to carry these securities at estimated fair value.
As a result of the factors described above, our revenues and earnings are subject to substantial fluctuation from period to period based on circumstances, many of which are beyond our control. An increase in financial market activity generally, and/or an increase in equity valuations generally, will normally result in increases in our revenues, earnings and net worth as our activity levels and the value of our investment portfolio increase. Conversely, a general market retrenchment will typically lead to decreased revenues, earnings and net worth as a result both of decreased activity and the need to adjust high investment portfolio values to lower levels. Accordingly, results for any historical period are not necessarily indicative of similar results for any future period.
Results of Operations
PIC’s revenues and operating results are influenced by fluctuations in the equity underwriting markets as well as general economic and market conditions, particularly conditions in the over-the-counter market, where PIC’s investment account, trading inventory positions and underwriter warrants are heavily concentrated. Significant fluctuations can occur in PIC’s revenues and operating results from one period to another. PIC’s results of operations depend upon many factors, such as the number of companies that are seeking public financing, the quality and financial condition of those companies, market conditions in general, the performance of previous PIC underwritings and interest in certain industries by investors. As a result, revenues and income derived from these activities may vary significantly from year to year. In the tables below, “Corporate Finance” revenues are a function of total proceeds from offerings done during the period, compensation per offering, and the fair value of underwriter warrants received. “Investment Income” includes realized gains from the exercise of underwriter warrants, gains and losses from the sales of investment securities, and unrealized gains and losses from underwriter warrants and other investment securities. “Trading Income” is the net gain or loss from trading positions before commissions paid to the representatives in the trading department.
11
Summary of Changes in Major Categories
of Revenues and Expense
Three Months Ended March 31, 2005 v. March 31, 2004
|
|
|
|
|
| Three Months Ended |
| |||||
|
| Increase/(Decrease) |
| Percent Change |
| March 31, 2005 |
| March 31, 2004 |
| |||
Revenues: |
|
|
|
|
|
|
|
|
| |||
Sales Commissions |
| $ | (1,096,574 | ) | (20.9 | ) | $ | 4,141,057 |
| $ | 5,237,631 |
|
Corporate Finance |
| (3,889,503 | ) | (97.0 | ) | 119,985 |
| 4,009,488 |
| |||
Investment Income |
| 7,153,774 |
| N/A |
| 5,152,499 |
| (2,001,275 | ) | |||
Trading Income |
| 257,809 |
| 58.0 |
| 702,004 |
| 444,195 |
| |||
Other |
| 13,147 |
| 230.1 |
| 18,860 |
| 5,713 |
| |||
|
|
|
|
|
|
|
|
|
| |||
Total |
| 2,438,653 |
| 31.7 |
| 10,134,405 |
| 7,695,752 |
| |||
|
|
|
|
|
|
|
|
|
| |||
Expenses: |
|
|
|
|
|
|
|
|
| |||
Commissions and Salaries |
| (1,408,745 | ) | (24.9 | ) | 4,254,004 |
| 5,662,749 |
| |||
Underwriting Expenses |
| (252,458 | ) | N/A |
| — |
| 252,458 |
| |||
Rent, Telephone & Quotes |
| 2,955 |
| 1.0 |
| 306,498 |
| 303,543 |
| |||
Other |
| 392,977 |
| 43.6 |
| 1,294,114 |
| 901,137 |
| |||
|
|
|
|
|
|
|
|
|
| |||
Total |
| (1,265,271 | ) | (17.8 | ) | 5,854,616 |
| 7,119,887 |
| |||
|
|
|
|
|
|
|
|
|
| |||
Pretax Income |
| $ | 3,703,924 |
| 643.2 |
| $ | 4,279,789 |
| $ | 575,865 |
|
Three Months Ended March 31, 2005 vs. Three Months Ended March 31, 2004
Revenues
Total revenues for the first quarter of 2005 increased $2.4 million. As shown in the table above, sales commissions—which are commissions generated from the retail stock brokerage business—decreased $1.1 million as a result of lackluster market performance and the lack of commissions associated with corporate finance transactions. Sales commissions are also directly related to the number of brokers engaged by the Company. The Company had 92 stock brokers as of March 31, 2005, as compared to 110 as of March 31, 2004, a decrease of 16 percent.
Corporate finance revenue decreased $3.9 million, from the first quarter of 2004 to the first quarter of 2005. The Company completed two corporate finance transactions in the first quarter of 2004, with no comparable transactions in the first quarter of 2005. During the first quarter of 2005, the Company had a small private placement and participated in a few small transactions in which another investment banking firm was the lead underwriter resulting in approximately $120,000 in corporate finance revenues.
Investment income increased $7.2 million in the first quarter of 2005 as compared to the first quarter of 2004. Investment income can be volatile period-over-period based on the fact it is driven by the market value or fair value of the securities and underwriter warrants held by the Company. Investment income consists of (1) the unrealized and realized appreciation and depreciation of securities held based on quoted market prices, (2) the unrealized appreciation and depreciation of securities held that are not readily marketable, based upon the Company’s estimate of their fair value, (3) the realized gain and loss on the sale of securities that are not readily marketable, and (4) the unrealized appreciation and depreciation of underwriter warrants held by the Company. The appreciation of underwriter warrants totaled $1.6 million during the first quarter of 2005, as compared to the depreciation and expiration of underwriter warrants of $1.7 million for the first quarter of 2004. In addition, the Company’s holdings of Charles & Colvard, Ltd., in its investment account increased in value over $1.5 million during the first quarter of 2005. The remainder of the total investment income is the result of the unrealized and realized depreciation of securities with quoted market prices. There was no change in the estimated fair value of securities not readily marketable during the first quarter of 2005.
12
Trading income increased $257,809 in the first quarter or 2005 as compared to the first quarter of 2004, as a result of exceptional performance from a couple of the Company’s market making securities. PIC’s focus is on very small capitalization issues, especially those tied to PIC’s corporate finance clients.
Expenses
Total expenses decreased by $1.3 million in the first quarter of 2005 from the first quarter of 2004, a decrease of 17.8 percent. The largest dollar decrease was in commissions and salaries with a decrease of $1.4 million in the first quarter of 2005 as compared to the first quarter of 2004. Commission expense decreased approximately $626,000 as a result of lower sales commissions paid on lower commission revenue. Administrative salary expense decreased approximately $783,000 primarily as a result of first quarter 2004 compensation expense associated with underwriter warrants and no corresponding expense in the first quarter of 2005. Underwriting expenses decreased by approximately $252,000 from the first quarter of 2004 as a result of no corporate finance transactions in first quarter 2005 compared to two corporate finance transactions in the first quarter of 2004. Other expenses increased approximately $392,977, or 43.6 percent. The increase in other expenses is primarily attributable to an approximate $179,000 increase in professional fees associated with legal activity related to settlements and fees associated with Sarbanes-Oxley compliance and an estimated $250,000 in settlement expense. The remainder of the net increase in other expenses consists of increases and decreases in various expense categories.
Income
The Company had pretax income of $4.3 million (42.2 percent of revenues) in the first quarter of 2005 compared to pretax income of approximately $576,000 (7.5 percent of revenues) in the first quarter of 2004. Profitability, as a percentage of revenues, generally increases when a significant portion of the Company’s revenues is derived from investment income because fewer expenses are associated with investment income relative to the other revenue sources. Independent of the change in the Black-Scholes value of the underwriter warrants and the income and expense associated with the receipt of the underwriter warrants, the Company would have had pretax income totaling $2.7 million for the first quarter of 2005, compared to pretax income of approximately $48,000 for the first quarter of 2004. Because of the Black-Scholes value of underwriter warrants and other factors, significant fluctuations often occur in PIC’s revenues and operating results from one period to another.
Liquidity and Capital Resources
The majority of PIC’s assets are cash and assets readily convertible to cash. PIC’s securities inventory is stated at market value for the securities that are readily marketable and estimated fair value for the securities that are not readily marketable. The liquidity of the market for many of PIC’s securities holdings, however, varies with trends in the stock market. Since many of the securities held by PIC are thinly traded, and PIC is in many cases a primary market maker in the issues held, any significant sales of PIC’s positions could adversely affect the liquidity of the issues held. In general, falling prices in OTC securities (which make up most of PIC’s trading positions) lead to decreased liquidity in the market for these issues, while rising prices in OTC issues tend to increase the liquidity of the market for these securities.
13
PIC borrows money from National Financial Services, its clearing firm, in the ordinary course of its business, pursuant to an understanding under which the clearing firm agrees to finance PIC’s trading accounts. As of March 31, 2005, no net loans were outstanding pursuant to this arrangement. PIC and the Company are generally able to meet their compensation and other obligations out of current liquid assets.
Another source of capital to PIC and the Company has been the underwriter warrants issued to PIC in connection with its corporate finance activities and the sale of the underlying securities. There is no public market for the underwriter warrants. The securities receivable upon exercise of the underwriter warrants cannot be resold unless the issuer has registered these securities with the SEC and with the states in which the securities will be sold unless exemptions are available. Any delay or other problem in the registration of these securities would have an adverse impact upon PIC’s ability to obtain funds from the exercise of the underwriter warrants and the resale of the underlying securities. At March 31, 2005, PIC owned 14 underwriter warrants, all but three of which were then exercisable; five had an exercise price below the March 31, 2005 market price of the securities receivable upon exercise. The intrinsic value of these five warrants is $2.4 million. There is little or no direct relationship between the intrinsic value of PIC’s underwriter warrants at the end of any given period and the fair value calculated using the Black-Scholes pricing model, as described more fully in Critical Accounting Policies above. The prices of these securities are influenced by general movements in the prices of OTC securities as well as the success of the issuers of the underwriter warrants. The prices of the securities underlying the underwriter warrants are very volatile, and substantial fluctuations in the Company’s estimate of their value can be expected in the future.
In the three months ended March 31, 2005, approximately $628,000 of net cash was provided by operating activities. The major adjustments to reconcile this result to the Company’s net income include the following items that are positive adjustments to or provided cash to operating activities: an increase in deferred income taxes of $1.7 million and a decrease in trading and investment securities of approximately $612,000. The following items are negative adjustments to or a use of cash for operating activities: appreciation of underwriter warrants totaling $1.6 million and a decrease in accounts payable and accrued liabilities of $2.1 million. Net cash used in investing activities in the first three months of 2005 was for additions to furniture and equipment of approximately $18,000. Net cash used in financing activities in the first three months of 2005 approximated $605,000, resulting from approximately $477,000 in dividends paid to common shareholders and approximately $129,000 in payments to retire common stock.
As a securities broker-dealer, PIC is required by SEC regulations to meet certain liquidity and capital standards. We believe we are in compliance with these standards.
At March 31, 2005, the Company had no material commitments for capital expenditures.
In general, the primary sources of PIC’s, and therefore the Company’s, liquidity include PIC’s trading positions, borrowings on those positions and profits realized upon the exercise of underwriter warrants. All of these sources depend in large part on the trend in the general markets for OTC securities. Rising OTC price levels will tend to increase the value and liquidity of PIC’s trading positions, the amount that can be borrowed from National Financial Services based upon those positions, and the value of PIC’s underwriter warrants. The Company believes its liquidity is sufficient to meet its needs for both the short and long term horizon. The Company’s liquidity could be affected by protracted unfavorable market conditions.
Inflation
Because PIC’s assets are primarily liquid, they are not significantly affected by inflation. The rate of inflation affects PIC’s expenses, such as employee compensation, office leasing and communications costs. These costs may not readily be recoverable in the price of services offered by the Company. To the extent inflation results in rising interest rates and has other adverse effects in the securities markets and the value of securities held in inventory or PIC’s investment account, it may adversely affect the Company’s financial position and results of operations.
14
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE OF MARKET RISK
Market risk is the risk of loss to the Company resulting primarily from changes in equity prices and to a significantly lesser extent, interest rates and foreign currency rates. The Company has exposure to market risk through the market-making and trading operations of PIC, its broker-dealer subsidiary. In connection with these activities, PIC maintains inventories in order to ensure availability of securities and to facilitate client transactions as well as trading for its own proprietary equity investment account. PIC was a market-maker for 46 equity securities from 40 different issuers and no tax exempt and taxable debt obligations at March 31, 2005.
|
| March 31, 2005 |
| December 31, 2004 |
| ||||||||
|
| Trading and |
| Securities sold but |
| Trading and |
| Securities sold but |
| ||||
Marketable equity and other securities at fair value |
| $ | 23,114,013 |
| $ | 119,701 |
| $ | 23,583,728 |
| $ | 50,144 |
|
|
|
|
|
|
|
|
|
|
| ||||
Marketable debt securities |
| 78,124 |
| — |
| 220,243 |
| — |
| ||||
|
|
|
|
|
|
|
|
|
| ||||
Total marketable equity, debt and other securities at fair value |
| $ | 23,192,137 |
| $ | 119,701 |
| $ | 23,803,971 |
| $ | 50,144 |
|
Changes in the value of PIC’s trading inventories and its proprietary investment accounts result primarily from fluctuations in equity prices as well as changes in interest rates and general market and economic conditions. PIC’s primary method of controlling risk in its trading inventories and investment accounts is through daily monitoring and use of position limits. PIC’s trading inventories consist primarily of Nasdaq equity securities: as of March 31, 2005, the equity trading inventory limit was $2 million and the fixed income limit was $500,000. PIC’s trading activities were within these limits at March 31, 2005. Position limits in trading inventory accounts are monitored on a daily basis as are limit exceptions. Debt obligation trading inventories are relatively small, since, for the most part, these securities are purchased only upon orders from customers. Consolidated positions and exposure reports are prepared and reviewed monthly by the Senior Vice President of Trading. Trading also monitors inventory levels and trading results on a monthly basis, with particular focus on position concentration, liquidity and volatility. Trading prepares summary results every month to record each position at fair market value, which can require adjustments for lack of liquidity, high concentration or other reasons.
Equity Price Risk
PIC is exposed to significant equity price risk as a result of its customer transactions and market-making activity in equity securities and its concentrations in a limited number of equities, many of which are related to its investment banking projects. PIC’s broker-dealer activities are client-driven, with the objective of meeting its clients’ needs while earning a trading profit to compensate for the risk associated with carrying inventories in equities, many of which are volatile, and some of which are illiquid, micro and small cap securities. PIC attempts to reduce the risk of loss inherent in this activity by monitoring these securities positions continuously throughout each day. The average aggregate inventory held in PIC’s proprietary investment account during the quarter ended March 31, 2005 was approximately $18.6 million. Prices of the marketable equities held in these accounts are readily available and monitored on a continuous basis.
15
Interest Rate Risk
PIC has very little direct exposure to interest rate risk. A relatively minor amount of PIC’s trading inventory consists of debt obligations, and any of these positions PIC might have occasionally are in its trading inventory for only a very short time. However, to the extent that interest rate fluctuations affect general market conditions and cause investors to shift away from or more heavily into equity investing, interest rates can have an effect on the value of PIC’s equity positions.
Foreign Currency Risk
PIC does not deal in securities denominated in foreign currencies and only trades foreign equities upon receipt of an order from customers, so it does not have any significant exposure to foreign currency risk in its trading inventory or investment accounts.
ITEM 4. CONTROLS AND PROCEDURES
(a) Our management, with the participation of our President and Chief Financial Officer, conducted an evaluation of our disclosure controls and procedures, as such terms are defined under Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. Based on their evaluation, our President and Chief Financial Officer concluded that our disclosure controls and procedures were effective.
(b) For the quarter ended March 31, 2005, there have been no changes in our internal control over financial reporting that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.
16
PART II
OTHER INFORMATION
Item 1. Legal Proceedings.
See Note 4 to Condensed Consolidated Financial Statements in Part I.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
Small Business Issuer Purchases of Equity Securities
Period |
| Paulson Capital |
| Paulson Capital Corp. |
| Total Number of |
| Maximum Number of |
| |
01/01/05 to 01/31/05 |
| 13,210 |
| $ | 8.22 |
| 13,210 |
| 209,024 |
|
02/01/05 to 02/28/05 |
| None |
| N/A |
| N/A |
| 209,024 |
| |
03/01/05 to 03/31/05 |
| 2,500 |
| $ | 8.05 |
| 2,500 |
| 206,524 |
|
Total |
| 15,710 |
| $ | 8.19 |
| 15,710 |
| 206,524 |
|
All of the shares purchased were open-market transactions as part of a corporate plan for stock repurchase. The stock repurchase plan, approved by the board of directors on September 17, 2001, authorizes the repurchase of up to 300,000 shares. There is no expiration date on the stock repurchase plan.
Item 3. Defaults upon Senior Securities.
None
Item 4. Submission of Matters to a Vote of Security Holders.
None
Item 5. Other Information.
None
Item 6. Exhibits
31.1 |
| Certification of Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically. |
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|
|
31.2 |
| Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically. |
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|
|
32.1 |
| Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically. |
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|
|
32.2 |
| Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Filed herewith electronically. |
17
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| PAULSON CAPITAL CORP. | |
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Date: May 17, 2005 | By: | /s/ CHESTER L.F. PAULSON |
|
| Chester L.F. Paulson |
|
| President |
|
|
|
Date: May 17, 2005 | By: | /s/ CAROL RICE |
|
| Carol Rice |
|
| Chief Financial Officer |
18