SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [ X ] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended May 31, 1998 OR [ ] 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 1-9466 Lehman Brothers Holdings Inc. (Exact Name of Registrant As Specified In Its Charter) Delaware 13-3216325 (State or other jurisdiction of I.R.S. Employer Identification No.) incorporation or organization) 3 World Financial Center New York, New York 10285 (Address of principal (Zip Code) executive offices) Registrant's telephone number, including area code: (212) 526-7000 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 ______ As of June 30, 1998, 118,294,083 shares of the Registrant's Common Stock, par value $.10 per share, were outstanding. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED MAY 31, 1998 INDEX Part I. FINANCIAL INFORMATION Page Number Item 1. Financial Statements - (unaudited) Consolidated Statement of Income - Three and Six Months Ended May 31, 1998 and 1997 ...............................3 Consolidated Statement of Financial Condition - May 31, 1998 and 1997 ...............................5 Consolidated Statement of Cash Flows - Six Months Ended May 31, 1998 and 1997................................7 Notes to Consolidated Financial Statements.............9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..........16 Part II. OTHER INFORMATION Item 1. Legal Proceedings ......................................34 Item 6. Exhibits and Reports on Form 8-K ..................36 Signatures................................................................37 EXHIBIT INDEX ....................................................38 Exhibits LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of INCOME (Unaudited) (In millions, except per share data) Three months ended May 31 May 31 1998 1997 -------------- ------------ Revenues Principal transactions $ 588 $ 326 Investment banking 495 274 Commissions 124 91 Interest and dividends 4,307 3,099 Other 40 16 ------- ------- Total revenues 5,554 3,806 Interest expense 4,081 2,952 ----- ----- Net revenues 1,473 854 ----- ------ Non-interest expenses Compensation and benefits 747 433 Brokerage, commissions and clearance fees 60 61 Professional services 43 47 Occupancy and equipment 38 36 Communications 32 34 Business development 29 26 Depreciation and amortization 22 21 Other 26 24 ------ ------ Total non-interest expenses 997 682 ----- ----- Income before taxes 476 172 Provision for income taxes 152 51 ----- ------ Net income $ 324 $ 121 ===== ===== Net income applicable to common stock $ 268 $ 114 ===== ===== Weighted average shares Basic 120.6 118.0 ===== ===== Diluted 126.3 120.4 ===== ===== Earnings per common share Basic $2.22 $0.97 ===== ===== Diluted $2.12 $0.95 ===== ===== See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT of INCOME (Unaudited) (In millions, except per share data) Six months ended May 31 May 31 1998 1997 --------------- ----------- Revenues Principal transactions $1,011 $ 672 Investment banking 843 514 Commissions 241 188 Interest and dividends 7,981 6,377 Other 58 54 -------- -------- Total revenues 10,134 7,805 Interest expense 7,616 6,026 ------ ------ Net revenues 2,518 1,779 ------ ------ Non-interest expenses Compensation and benefits 1,277 902 Brokerage, commissions and clearance fees 114 118 Professional services 85 88 Communications 74 70 Occupancy and equipment 68 69 Business development 55 51 Depreciation and amortization 44 43 Other 50 47 ----- ----- Total non-interest expenses 1,767 1,388 ----- ----- Income before taxes 751 391 Provision for income taxes 240 126 ----- ----- Net income $ 511 $ 265 ===== ===== Net income applicable to common stock $ 448 $ 252 ===== ===== Weighted average shares Basic 120.6 117.5 ===== ===== Diluted 125.6 119.8 ===== ===== Earnings per common share Basic $3.71 $2.15 ===== ===== Diluted $3.57 $2.11 ===== ===== See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (Unaudited) (In millions) May 31 November 30 ASSETS 1998 1997 ---------- ----------- Cash and cash equivalents $ 5,225 1,685 Cash and securities segregated and on deposit for regulatory and other purposes 1,295 1,149 Securities and other financial instruments owned: Governments and agencies 34,387 33,037 Corporate equities 13,034 10,877 Corporate debt and other 14,968 10,892 Mortgages and mortgage-backed 15,362 11,455 Derivatives and other contractual agreements 9,179 8,353 Certificates of deposit and other money market instruments 2,835 2,248 ------ ------ 89,765 76,862 ------ ------ Collateralized short-term agreements: Securities purchased under agreements to resell 48,927 43,606 Securities borrowed 20,702 14,146 Receivables: Brokers, dealers and clearing organizations 2,206 2,193 Customers 7,808 9,105 Others 1,637 1,540 Property, equipment and leasehold improvements (net of accumulated depreciation and amortization of $766 in 1998 and $735 in 1997) 465 468 Other assets 877 787 Excess of cost over fair value of net assets acquired (net of accumulated amortization of $115 in 1998 and $111 in 1997) 160 164 -------- -------- Total assets $179,067 $151,705 ======== ======== See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT OF FINANCIAL CONDITION (Continued) (Unaudited) (In millions, except share data) May 31 November 30 1998 1997 --------- ------------- LIABILITIES AND STOCKHOLDERS' EQUITY Commercial paper and short-term debt $ 11,148 $ 7,818 Securities and other financial instruments sold but not yet purchased: Governments and agencies 18,387 16,201 Corporate equities 7,849 4,293 Corporate debt and other 2,074 2,219 Derivatives and other contractual agreements 9,054 7,367 -------- -------- 37,364 30,080 ------- ------- Collateralized short-term financings: Securities sold under agreements to repurchase 70,912 63,204 Securities loaned 7,627 7,846 Payables: Brokers, dealers and clearing organizations 3,286 2,155 Customers 12,344 11,702 Accrued liabilities and other payables 4,457 4,116 Long-term debt: Senior notes 23,029 17,049 Subordinated indebtedness 3,816 3,212 --------- --------- Total liabilities 173,983 147,182 ------- ------- Commitments and contingencies STOCKHOLDERS' EQUITY Preferred stock, $1.00 par value; 38,000,000 shares authorized: 5% Cumulative Convertible Voting, 13,000,000 shares authorized; $39.10 liquidation preference per share Series A - shares issued and outstanding: 32,100 in 1998 and 1 1 33,050 in 1997 Series B - shares issued and outstanding: 12,967,900 in 1998 507 507 and 12,966,950 in 1997 5.94% Cumulative, Series C - 500,000 shares issued and outstanding; 250 $500 liquidation preference per share Redeemable Voting, 1,000 shares issued and outstanding; $1.00 liquidation preference per share Common stock, $0.10 par value; 300,000,000 shares authorized; Shares issued: 120,251,742 in 1998 and 119,513,337 in 1997; Shares outstanding: 117,114,203 in 1998 and 116,612,074 in 1997 12 12 Common stock issuable 126 155 Additional paid-in capital 3,462 3,436 Foreign currency translation adjustment (11) 12 Retained earnings 928 498 Common stock in treasury, at cost: 3,137,539 shares in 1998 and 2,901,263 shares in 1997 (191) (98) ------------ ------------ Total stockholders' equity 5,084 4,523 ---------- ---------- Total liabilities and stockholders' equity $179,067 $151,705 ======== ======== See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Unaudited) (In millions) Six months ended May 31 May 31 1998 1997 ---------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 511 $ 265 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 44 43 Provisions for losses and other reserves 22 19 Deferred tax benefit (33) Other adjustments 30 42 Net change in: Cash and securities segregated (146) (660) Securities and other financial instruments owned (12,903) (6,856) Securities purchased under agreements to resell (5,321) (7,753) Securities borrowed (6,556) (1,434) Receivables from brokers, dealers and clearing organizations (13) 1,046 Receivables from customers 1,297 (781) Securities and other financial instruments sold but not yet purchased 7,284 7,927 Securities sold under agreements to repurchase 7,708 1,060 Securities loaned (219) 608 Payables to brokers, dealers and clearing organizations 1,131 226 Payables to customers 642 1,166 Accrued liabilities and other payables 269 342 Other operating assets and liabilities, net (219) (307) ------- ------- Net cash used in operating activities $(6,439) $(5,080) -------- ------- See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Continued) (Unaudited) (In millions) Six months ended May 31 May 31 1998 1997 ------- -------- CASH FLOWS FROM FINANCING ACTIVITIES Proceeds from issuance of senior notes $7,566 $3,120 Principal payments of senior notes (1,534) (1,101) Proceeds from issuance of subordinated indebtedness 600 395 Principal payments of subordinated indebtedness (209) Net proceeds from commercial paper and short-term debt 3,330 2,887 Payments for treasury stock purchases (187) Dividends paid (28) (25) - Issuance of common stock 21 18 Issuance of preferred stock 248 ------- Net cash provided by financing activities 10,016 5,085 ------ ----- CASH FLOWS FROM INVESTING ACTIVITIES Purchase of property, equipment and leasehold improvements (37) (34) ------- ------- Net cash used in investing activities (37) (34) ------- ------- Net change in cash and cash equivalents 3,540 (29) ----- -------- Cash and cash equivalents, beginning of period 1,685 2,149 ----- ----- Cash and cash equivalents, end of period $5,225 $2,120 ====== ====== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (in millions) Interest paid totaled $7,063 and $5,781 for the six months ended May 31, 1998 and 1997, respectively. Income taxes paid totaled $207 and $71 for the six months ended May 31, 1998 and 1997, respectively. See notes to consolidated financial statements. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation: The consolidated financial statements include the accounts of Lehman Brothers Holdings Inc. ("Holdings") and subsidiaries (collectively, the "Company" or "Lehman Brothers"). Lehman Brothers is one of the leading global investment banks serving institutional, corporate, government and high-net- worth individual clients and customers. The Company's worldwide headquarters in New York and regional headquarters in London and Tokyo are complemented by offices in additional locations in North America, Europe, the Middle East, Latin America and the Asia Pacific Region. The Company is engaged primarily in providing financial services. The principal U.S. subsidiary of Holdings is Lehman Brothers Inc. ("LBI"), a registered broker-dealer. All material intercompany accounts and transactions have been eliminated in consolidation. The Company's financial statements have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (the "SEC") with respect to the Form 10-Q and reflect all normal recurring adjustments which are, in the opinion of management, necessary for a fair presentation of the results for the interim periods presented. Pursuant to such rules and regulations, certain footnote disclosures which are normally required under generally accepted accounting principles have been omitted. It is recommended that these consolidated financial statements be read in conjunction with the audited consolidated financial statements included in the Company's Annual Report on Form 10-K for the twelve months ended November 30, 1997 (the "Form 10-K"). The Consolidated Statement of Financial Condition at November 30, 1997 was derived from the audited financial statements. The nature of the Company's business is such that the results of any interim period may vary significantly from quarter to quarter and may not be indicative of the results to be expected for the fiscal year. Certain prior period amounts reflect reclassifications to conform to the current period's presentation. 2. Accounting Policies: In 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per Share," which is effective for fiscal periods ending after December 15, 1997. SFAS No. 128 replaced the presentation of primary and fully diluted earnings per common share ("EPS") with basic and diluted EPS. The Company adopted SFAS No. 128 during the first quarter of 1998 and restated EPS data for the prior periods to conform with the provisions of the Statement. On January 1, 1998, SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" became fully effective. Previously, the FASB had deferred until that date certain provisions of SFAS No. 125 pertaining to repurchase agreements, securities lending and similar financing transactions. As a result of adopting the deferred provisions of SFAS No. 125, the Company recognized approximately $1.0 billion of collateral controlled on certain financing transactions and a corresponding obligation to return such collateral at the termination of such transactions. In March 1998, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use" (the "SOP"). The SOP requires that certain costs incurred in LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS connection with developing or obtaining software for internal use be capitalized. The SOP requires prospective application as of the beginning of an entity's fiscal year without adjustment for costs that would have been capitalized had the SOP been in effect in prior periods. The Company has elected early adoption of this accounting pronouncement effective as of the beginning of its 1998 fiscal year and capitalized approximately $5.6 million of internal use software costs during the first half of 1998. 3. Long-Term Debt: During the six months ended May 31, 1998, the Company issued $8,166 million of long-term debt (comprised of $7,566 million of senior notes and $600 million of subordinated debt). Of the total issuances during the period, $3,027 million were U.S. dollar fixed rate, $4,114 million were U.S. dollar floating rate, $459 million were foreign currency denominated fixed rate, and $566 million were foreign currency denominated floating rate. These issuances were primarily utilized to refinance current and prefund the remaining maturities of long-term debt in 1998 and to increase total capital (stockholders' equity plus long-term debt). The Company's floating rate new issuances contain contractual interest rates based primarily on London Interbank Offered Rates ("LIBOR"). All of the Company's fixed rate new issuances were effectively converted to floating rate obligations through the use of interest rate swaps. Of the foreign currency denominated new issuances totaling $1,025 million, $858 million were effectively swapped to U.S. dollars with the remainder match funding foreign currency denominated capital needs. The Company had $1,534 million of long-term debt mature during the six months ended May 31, 1998. 4. Capital Requirements: The Company operates globally through a network of subsidiaries with several being subject to regulatory requirements. In the United States, LBI, as a registered broker-dealer, is subject to SEC Rule 15c3-1, the Net Capital Rule, which requires LBI to maintain net capital of not less than the greater of 2% of aggregate debit items arising from customer transactions, as defined, or 4% of funds required to be segregated for customers' regulated commodity accounts, as defined. At May 31, 1998, LBI's regulatory net capital, as defined, of $1,435 million exceeded the minimum requirement by $1,307 million. Lehman Brothers International (Europe) ("LBIE"), a United Kingdom registered broker-dealer and subsidiary of Holdings, is subject to the capital requirements of the Securities and Futures Authority ("SFA") of the United Kingdom. Financial resources, as defined, must exceed the total financial resources requirement of the SFA. At May 31, 1998, LBIE's financial resources of approximately $2.3 billion exceeded the minimum requirement by approximately $500 million. Lehman Brothers Japan Inc.'s Tokyo branch, a regulated broker-dealer, is subject to the capital requirements of the Japanese Ministry of Finance and, at May 31, 1998, had net capital of approximately $470 million which was approximately $135 million in excess of the specified levels required. Certain other non-U.S. subsidiaries are subject to various securities, commodities and banking regulations and capital adequacy requirements LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS promulgated by the regulatory and exchange authorities of the countries in which they operate. At May 31, 1998, these other subsidiaries were in compliance with their applicable local capital adequacy requirements. The Company's "AAA" rated derivatives subsidiary, Lehman Brothers Financial Products Inc. ("LBFP"), has established certain capital and operating restrictions which are reviewed by various rating agencies. At May 31, 1998, LBFP had capital which exceeded the requirement of the most stringent rating agency by approximately $95 million. The regulatory rules referred to above, and certain covenants contained in various debt agreements may restrict Holdings' ability to withdraw capital from its regulated subsidiaries, which in turn could limit its ability to pay dividends to shareholders. 5. Derivative Financial Instruments: In the normal course of business, the Company enters into derivative transactions to satisfy the needs of its clients and to manage the Company's own exposure to market and credit risks resulting from its trading activities in cash instruments (collectively, "Trading-Related Derivative Activities"). The Company records its Trading-Related Derivative Activities on a mark-to-market basis with realized and unrealized gains and losses recognized currently in Principal transactions in the Consolidated Statement of Income. Unrealized gains and losses on derivative contracts are recorded on a net basis in the Consolidated Statement of Financial Condition for those transactions with counterparties executed under a legally enforceable master netting agreement and are netted across products and against cash collateral when such provisions are stated in the master netting agreement. Listed in the following table is the fair value and average fair value of the Company's Trading-Related Derivative Activities. Average fair values of these instruments were calculated based upon month-end statement of financial condition values, which the Company believes do not vary significantly from the average fair value calculated on a more frequent basis. Variances between average fair values and period-end values are due to changes in the volume of activities in these instruments and changes in the valuation of these instruments due to variations in market and credit conditions. Average Fair Value* Fair Value* Six Months Ended May 31, 1998 May 31, 1998 ------------------------ -------------------------- (in millions) Assets Liabilities Assets Liabilities - --------------------------------------------------------------------------------------------------------------------------- Interest rate and currency swaps and options (including caps, collars and floors) $4,999 $2,999 $4,685 $2,872 Foreign exchange forward contracts and options 1,620 2,011 1,509 1,658 Options on other fixed income securities, mortgage-backed securities forward contracts and options 244 206 239 221 Equity contracts (including equity swaps, warrants and options) 2,103 3,649 2,379 2,823 Commodity contracts (including swaps, forwards, and options) 213 189 192 178 ------------------------------------------------------- Total $9,179 $9,054 $9,004 $7,752 ------------------------------------------------------- LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS Average Fair Value* Fair Value* Twelve Months Ended November 30, 1997 November 30, 1997 ------------------------- ------------------------ (in millions) Assets Liabilities Assets Liabilities - --------------------------------------------------------------------------------------------------------------------------- Interest rate and currency swaps and options (including caps, collars and floors) $4,704 $3,303 $4,306 $3,224 Foreign exchange forward contracts and options 1,840 1,885 1,236 1,532 Options on other fixed income securities, mortgage-backed securities forward contracts and options 310 297 275 246 Equity contracts (including equity swaps, warrants and options) 1,304 1,696 2,134 1,681 Commodity contracts (including swaps, forwards, and options) 195 186 304 465 ------------------------------------------------------ Total $8,353 $7,367 $8,255 $7,148 ----------------------------------------------------- * Amounts represent carrying value (exclusive of collateral) and do not include receivables or payables related to exchange-traded futures contracts. Assets included in the table above and on the previous page represent the Company's unrealized gains, net of unrealized losses for situations in which the Company has a master netting agreement. Similarly, liabilities represent net amounts owed to counterparties. Therefore, the fair value of assets/liabilities related to derivative contracts at May 31, 1998 represents the Company's net receivable/payable for derivative financial instruments before consideration of collateral. Included within the $9,179 million fair value of assets at May 31, 1998 was $8,659 million related to swaps and OTC contracts and $520 million related to exchange-traded option and warrant contracts. Included within the $8,353 million fair value of assets at November 30, 1997 was $8,016 million related to swaps and OTC contracts and $337 million related to exchange-traded option and warrant contracts. With respect to OTC contracts, including swaps, the Company views its net credit exposure to be $6,014 million at May 31, 1998, representing the fair value of the Company's OTC contracts in an unrealized gain position, after consideration of collateral of $2,645 million. Presented below is an analysis of the Company's net credit exposure at May 31, 1998 for OTC contracts based upon internal designations of counterparty credit quality. Counterparty S&P/Moody's Risk Rating Equivalent Net Credit Exposure - ------------ ------------------------- ------------------- 1 AAA/Aaa 15% 2 AA-/Aa3 or higher 25% 3 A-/A3 or higher 34% 4 BBB-/Baa3 or higher 13% 5 BB-/Ba3 or higher 8% 6 B+/B1 or lower 5% These designations are based on actual ratings made by external rating agencies or by equivalent ratings established and utilized by the Company's Corporate Credit Department. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS The Company is also subject to credit risk related to its exchange-traded derivative contracts. Exchange-traded contracts, including futures and certain options, are transacted directly on the exchange. To protect against the potential for a default, all exchange clearing houses impose net capital requirements for their membership. Additionally, the exchange clearing house requires counterparties to futures contracts to post margin upon the origination of the contract and for any changes in the market value of the contract on a daily basis (certain foreign exchanges provide for settlement within three days). Therefore, the potential for losses from exchange-traded products is limited. For a further discussion of the Company's derivative related activities, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations - Off-Balance Sheet Financial Instruments and Derivatives" and Notes 1 and 11 to the Consolidated Financial Statements, included in the Form 10-K. 6. Other Commitments and Contingencies: In connection with its financing activities, the Company has outstanding commitments under certain lending arrangements of approximately $3.5 billion at May 31, 1998 and $2.4 billion at November 30, 1997. These commitments require borrowers to provide acceptable collateral, as defined in the agreements, when amounts are drawn under the lending facilities. Advances made under the above lending arrangements are typically at variable interest rates and generally provide for over-collateralization based upon the borrowers' creditworthiness. The Company, through its high yield sales and trading activities, makes commitments to extend credit in loan syndication transactions principally to below investment grade borrowers and then participates a significant portion of these commitments. These commitments, net of syndications and participations, totaled $1.9 billion and $1.4 billion at May 31, 1998 and November 30, 1997, respectively, are typically secured against the borrower's assets and have fixed maturity dates. The draw down of these facilities is generally contingent upon certain representations, warranties and contractual conditions of the borrower. Total commitments may not be indicative of actual funding requirements as the Company intends to continue syndicating, selling, and/or participating these commitments. The Company has commitments to invest up to $351 million in partnerships, which in turn will make direct merchant banking related investments. These commitments will be funded as required through the end of the respective partnerships' investment periods, principally expiring in 2004. In June 1998, the Company sponsored a $5 billion interim loan fund, designed to extend financing to clients in connection with a wide range of domestic and international leveraged transactions, including acquisitions, corporate recapitalization and refinancing of existing debt. In connection therewith, the Company intends to provide up to $400 million to be used by the fund. Any draw downs under the facility are expected to be repaid within a short-term period. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS In the normal course of its business, the Company has been named a defendant in a number of lawsuits and other legal proceedings. After considering all relevant facts, available insurance coverage and the advice of outside counsel, in the opinion of the Company such litigation will not, in the aggregate, have a material adverse effect on the Company's consolidated financial position or results of operations. As a leading global investment bank, risk is an inherent part of all of the Company's businesses and activities. The extent to which the Company properly and effectively identifies, assesses, monitors and manages each of the various types of risks involved in its trading (including derivatives), brokerage, and investment banking activities is critical to the success and profitability of the Company. The principal types of risks involved in the Company's activities are market risk, credit or counterparty risk and transaction risk. Management has developed a control infrastructure to monitor and manage each type of risk on a global basis throughout the Company. For further discussion of these matters, refer to Note 13 to the Consolidated Financial Statements, in the Form 10-K. 7. Preferred Stock: On May 11, 1998 the Company issued 5,000,000 Depository Shares (each representing 1/10th of a share) of 5.94% Cumulative Preferred Stock, Series C ("Series C Preferred Stock"), $1.00 par value. These shares have a redemption price of $500 per share, together with accrued and unpaid dividends. Redemption of the Series C Preferred Stock is at the option of the Company for any or all of the outstanding shares after May 31, 2008. The $250 million redemption value of the shares outstanding at May 31, 1998 is classified on the Company's balance sheet as 5.94% Cumulative, Series C Preferred Stock. In 1994, Holdings issued the Redeemable Preferred Stock to American Express and Nippon Life for $1,000. The holders of the Redeemable Preferred Stock are entitled to receive annual dividends through May 31, 2002 in an amount equal to 50% of the amount, if any, by which the Company's net income for the preceding year exceeds $400 million, up to a maximum of $50 million, prorated in the case of the last dividend period, which runs from December 1, 2001 to May 31, 2002. For the six months ended May 31, 1998, the Company's net income of $511 million resulted in the recognition of a $50 million dividend on the Redeemable Voting Preferred Stock, which has been reflected in the Consolidated Statement of Income. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES NOTES to CONSOLIDATED FINANCIAL STATEMENTS 8. Earnings Per Share Earnings per share was calculated as follows (in millions, except for per share data): Three months Six months ended ended May 31 May 31 ----------------- ---------------- Numerator: 1998 1997 1998 1997 ------- ------ ------ -------- Net income $324 $121 $511 $265 Preferred stock dividends (56) (7) (63) (13) ----- ----- ----- ----- Numerator for basic and diluted earnings per share - income available to common stockholders $268 $114 $448 $252 ===== ==== ==== ==== Denominator: Denominator for basic earnings per share - weighted-average shares 121 118 121 118 Effect of dilutive securities: Employee stock options 3 1 3 1 Common stock equivalents 2 1 2 1 ------ ----- ------ ------ Dilutive potential common shares 5 2 5 2 ------ ----- ------ ------ Denominator for diluted Earnings per share - adjusted Weighted-average shares 126 120 126 120 ===== ===== ===== ===== Basic earnings per share $2.22 $0.97 $3.71 $2.15 ===== ===== ===== ===== Diluted earnings per share $2.12 $0.95 $3.57 $2.11 ===== ===== ===== ===== LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Business Environment The principal business activities of the Company are investment banking and securities trading and sales, which by their nature are subject to volatility, primarily due to changes in interest and foreign exchange rates and security valuations, global economic and political trends and industry competition. As a result, the Company's revenues and earnings may vary significantly from quarter to quarter and from year to year. The generally favorable market and economic conditions that characterized fiscal 1997 continued into the first six months of the Company's fiscal year ("fiscal 1998"). During the first six months of fiscal 1998, investor demand in the worldwide debt and equity markets remained strong led by continued growth in the U.S. economy and the favorable interest-rate environment. The pace of underwriting for combined fixed income and equity securities accelerated to record levels. The unabated pace of global merger and acquisition activity fueled financing of all types. Investors continued to focus on worldwide market conditions, particularly with respect to the potential effects of the Asian crisis, as well as any signs of potential weakening in the U.S. economy. In the global fixed income markets, fiscal 1998 began with uncertainty as investors focused on whether the U.S. Federal Reserve Board (the "Fed") would raise the overnight lending rate from 5.5% and whether the crisis which began in the Asian region in the latter half of 1997 would have a negative impact on the U.S. economy. By the end of January, however, the bond markets rallied when the Fed left rates unchanged: interest rates on the 30-year U.S. Treasury bond remained below 6% for most of the first half of fiscal 1998. In Europe, the economic environment remained extremely favorable throughout this period. Low levels of inflation, the continued strength of the U.S. dollar and the prospects of European Monetary Union propelled the European bond markets, especially in some of the smaller markets (e.g., Italy and Spain). In Japan, the weakening economy drove bond yields to historic lows not seen by any modern, industrialized country. In the six months ending May 31, 1998, Japanese 10 year yields fell 50bp to 1.45% as the Yen fell 8% to Y/$ 138.8. U.S. equity markets continued to recover from the 1997 Asian correction, with most equity indices posting successive record highs during this period. However, concerns about earnings weakness related to Asia and an increase in corporate profit warnings, prompted analysts to reduce their earnings expectations. Earnings growth slowed considerably with the turmoil in Asia ; indeed, most of the markets' rise came from an increase in the "price to earnings" multiple for the equity market as a whole. The forward "price to earnings" multiple on the U.S. stock market (measured by the S&P 500) rose from 19 times at the beginning of the fiscal year to above 21 times now. This increase was facilitated by moderate inflation and the 30 year U.S. Treasury bond yield staying below 6% for almost the entire period. Thus, despite slowing profit growth, the S&P 500 returned almost 14% for the first half of 1998. Supported by a favorable bond market environment, together with increasing evidence of a recovery in domestic demand, European equity markets performed very strongly. The FT/S&P European Index gained 28.5% in dollar terms over the period, while trading volumes remained buoyant. By contrast, in late spring, increasing pessimism over Japan's ability to resolve its bad debt and structural problems and the associated weakness in the yen sparked off a wave of negative sentiment towards markets across the Far East and throughout emerging markets LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS globally. In the six months ending May, the FT/S&P Pacific Basin Index fell 11.6% in U.S. dollar terms, and Latin American equities (IFC Investable Index) declined 11.4%. Worldwide underwriting volumes in fixed income products were unprecedented during the first six months of fiscal 1998. U.S. underwriting volumes, while experiencing a slowdown in December 1997 and January 1998, strengthened over the prior year, with heavy issuance of corporate, high yield and asset-backed bonds. Issuers came to market to take advantage of the historically attractive yields as well as favorable pricing in the spread sectors. Equity and equity-related underwriting volumes also increased during fiscal 1998 from the comparable period in fiscal 1997 as increased stock prices and favorable valuations induced capital raising by issuers. However, the actual number of equity and equity-related deals was overshadowed by the significant number of debt transactions, where issuance proceeded at a rate not seen since the fourth quarter of 1990. Corporate Finance Advisory activities continued at record levels during the first six months of fiscal 1998. Coming off a strong pace in 1997, the volume of announced transactions in the first half of 1998 continued to reflect the trend of consolidation, deregulation and globalization across industry sectors as well as the overall strength in the global capital markets. Strong financial markets have characterized fiscal 1998; nevertheless, the financial services industry is cyclical. As a result, the Company's businesses are evaluated across market cycles for operating profitability and their contribution to the Company's long-term strategic objectives. The Company strives to minimize the effects of economic downturns through its diversified product base; stringent cost controls, global presence and risk management practices. Note: Except for the historical information contained herein, this Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are based on current expectations, estimates and projections about the industries in which the Company operates. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. The Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations For the Three Months Ended May 31, 1998 and 1997 The Company reported net income of $324 million for the second quarter ended May 31, 1998 representing an increase of 168% from net income of $121 million for the second quarter ended May 31, 1997. This increase reflected across-the-board strength in the Company's fixed income, equity and investment banking businesses. The Company's earnings momentum and profitability increased significantly throughout the second quarter of 1998. Earnings per common share (diluted) increased to $2.12 for the second quarter of 1998 from $0.95 for the second quarter of 1997. Included in the 1998 earnings per common share computation was the recognition of $50 million in dividends on the Company's Redeemable Voting Preferred Stock. American Express Company and Nippon Life Insurance Company are entitled to receive an annual non-cumulative preferred dividend equal to 50 percent of the amount by which the company's net income for the full fiscal year exceeds $400 million, up to a maximum of $50 million per year, through 2002. In 1997, the Redeemable Voting Preferred Stock dividend was not recognized until the third and fourth quarter, when the Company's year to date net income exceeded the $400 million threshold. Net revenues increased to $1,473 million for the second quarter of 1998 from $854 million for the second quarter of 1997. The increase in net revenues from the second quarter of 1997 resulted from continued strong performance in the global merger and acquisition advisory business, fixed income and equity derivatives, leveraged lending and high yield origination, and real estate and mortgage activities. Compensation and benefits expense as a percentage of net revenues was 50.7% for both 1998 and 1997, reflecting the thirteenth successive quarter of consistent compensation levels relative to net revenues. Nonpersonnel expenses were $250 million in the second quarter of 1998, essentially unchanged from the $249 million in the second quarter of 1997; however, nonpersonnel expenses as a percentage of net revenues decreased to 17.0% in the second quarter of 1998 from 29.2% in the second quarter of 1997. Increased net revenues and unchanged expense levels led to an improvement in the Company's pretax operating margin to 32.4% in the second quarter of 1998 from 20.2% in the second quarter of 1997. The Company, through its subsidiaries, is a market-maker of equity and fixed income products in major domestic and international markets. As part of its market-making activities, the Company maintains inventory positions of varying amounts across a broad range of financial instruments that are marked-to-market on a daily basis and, along with the Company's proprietary trading positions, give rise to principal transactions revenues. The Company utilizes various hedging strategies to minimize its exposure to significant movements in interest and foreign exchange rates and the equity markets. Net revenues from the Company's market-making and trading activities in fixed income and equity products are recognized as either principal transactions or net interest revenues depending upon the method of financing and/or hedging related to specific inventory positions. The Company evaluates its trading strategies on an overall profitability basis which includes both principal transactions revenues and net interest. Therefore, changes in net interest LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS should not be viewed in isolation but should be viewed in conjunction with revenues from principal transactions. Principal transactions and net interest revenues increased 72% to $814 million in the second quarter of 1998 from $473 million in the second quarter of 1997. Principal transactions revenues increased as favorable market conditions characterized by low interest rates and low inflation supported debt markets and helped to spur growth in the equity markets in both the U.S. and Europe. Growth in fixed income revenues was paced by mortgages, foreign exchange, derivatives and high yield, while growth in equities revenue was driven by equity cash trading, derivatives and equity arbitrage. Net interest revenues increased as a result of an increase in inventory and a shift in the composition of the Company's fixed income portfolio. The following table of net revenues by business unit and the accompanying discussion have been prepared in order to present the Company's net revenues in a format that reflects the manner in which the Company manages its businesses. For internal management purposes, the Company has been segregated into four major business units: Fixed Income, Equity, Corporate Finance Advisory, and Merchant Banking. Each business unit represents a grouping of financial activities and products with similar characteristics. These business activities result in revenues that are recognized in multiple revenue categories contained in the Company's Consolidated Statement of Income. Net revenues by business unit contain certain internal allocations, including funding costs, which are centrally managed. Three Months Ended May 31, 1998 Principal Transactions and Investment Net Interest Commissions Banking Other Total - -------------------------------------------------------------------------------- Fixed Income $671 $9 $220 $2 $902 Equity 145 111 122 2 380 Corporate Finance Advisory 104 104 Merchant Banking (3) 49 46 Other 1 4 36 41 - -------------------------------------------------------------------------------- $814 $124 $495 $40 $1,473 - -------------------------------------------------------------------------------- Three Months Ended May 31, 1997 Principal Transactions and Investment Net Interest Commissions Banking Other Total - -------------------------------------------------------------------------------- Fixed Income $358 $11 $ 71 $5 $445 Equity 122 76 41 2 241 Corporate Finance Advisory (3) 83 80 Merchant Banking (4) 80 76 Other 4 (1) 9 12 - -------------------------------------------------------------------------------- $473 $91 $274 $16 $854 - -------------------------------------------------------------------------------- LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Fixed Income. The Company's fixed income net revenues reflect customer flow activities (both institutional and high-net-worth retail), secondary trading, debt underwriting, syndicate and financing activities related to fixed income products. Fixed income products include dollar- and non-dollar government securities, mortgage- and asset-backed securities, money market products, dollar- and non-dollar corporate debt securities, emerging market securities, municipal securities, financing (global access to debt financing sources including repurchase and reverse repurchase agreements), foreign exchange and fixed income derivative products. Fixed income net revenues increased 103% to $902 million for the second quarter of 1998 from $445 million for the second quarter of 1997. The increase in the second quarter results versus the prior year quarter reflected increased revenues from a number of fixed income products including improved performance in both sales and trading and syndicate activities in high yield corporates as well as increased contributions from mortgages, foreign exchange and fixed income derivative products, partially offset by decreased results in government and municipal investments. Investment banking revenues, as a component of fixed income revenues, increased to $220 million for the second quarter of 1998 from $71 million for the second quarter of 1997 due to increased underwriting fees, particularly in high yield corporates. Equity. Equity net revenues reflect customer flow activities (both institutional and high-net-worth retail), secondary trading, equity underwriting, equity finance, equity derivatives and equity arbitrage activities. The Company's equity net revenues increased to $380 million for the second quarter of 1998 from $241 million for the second quarter of 1997. Higher revenues resulted from higher levels of customer flow activities in U.S. and European listed securities, increased underwriting volumes and improved contributions from equity derivatives. Investment Banking revenues, as a component of equity revenues, increased to $122 million for the second quarter of 1998 from $41 million for the second quarter of 1997 due to increased underwriting volumes in U.S. listed and convertible securities. Corporate Finance Advisory. Corporate finance advisory net revenues, classified in the Consolidated Statement of Income as a component of investment banking revenues, result primarily from fees earned by the Company in its role as strategic advisor to its clients. This role consists of advising clients on mergers and acquisitions, divestitures, leveraged buyouts, financial restructurings, and a variety of cross-border transactions. Net revenues from corporate finance advisory activities increased to $104 million for the second quarter of 1998, reflecting a 30% increase from the $80 million recognized in the second quarter of 1997. This increase reflected the closing of several large transactions in the second quarter of 1998 and continued strength in the overall merger and acquisition market environment. The Company ended the second quarter with a strong transaction pipeline which stood at $166 billion in terms of total dollar value based on data supplied by Securities Data Company. Merchant Banking. The Company is the general partner for nine active merchant banking partnerships. Current merchant banking investments held by the partnerships include both publicly traded and privately held companies. Merchant banking net revenues primarily represent the Company's proportionate share of net realized and unrealized gains and losses from the sale and revaluation of investments held by the partnerships. Such amounts are classified in the Consolidated Statement of Income as a component of investment banking revenues. Merchant banking net revenues also reflect the net interest expense relating to the financing of the Company's investment in the partnerships. Merchant banking net revenues were $46 million for the second quarter of 1998 down from $76 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS million in the second quarter of 1997. The second quarter of 1997 reflects the realized gain on the sale of a significant portion of a publicly traded investment held by the partnerships. Non-Interest Expenses. Non-interest expenses were $997 million for the second quarter of 1998 and $682 million for the second quarter of 1997. Compensation and benefits expense as a percentage of net revenues remained unchanged from the prior year quarter at 50.7%. Nonpersonnel expenses were $250 million in the second quarter of 1998 compared to $249 million in the second quarter of 1997; however, nonpersonnel expenses as a percentage of net revenues decreased to 17.0% in the second quarter of 1998 from 29.2% in the second quarter of 1997 despite planned investments in a number of key strategic businesses and increased expense related to a higher volume of business activity. Income Taxes. The Company's income tax provision was $152 million for the second quarter of 1998 compared to $51 million for the second quarter of 1997. The effective tax rate was 32% for the second quarter of 1998 and 30% for the second quarter of 1997. The increase in the effective tax rate relates primarily to a significantly higher level of pretax income (which reduces the impact of permanent differences), and an increase in income subject to state and local taxes, partially offset by an increase in tax benefits attributable to income and transactions subject to preferential tax treatment. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations For the Six Months Ended May 31, 1998 and 1997 The Company reported net income of $511 million for the six months ended May 31, 1998, representing an increase of 93% from net income of $265 million for the six months ended May 31, 1997. Earnings per common share (diluted) increased to $3.57 for the six months of 1998 from $2.11 for the six months of 1997. Included in the 1998 earnings per common share computation was the recognition of $50 million in dividends on the Company's Redeemable Voting Preferred Stock. American Express Company and Nippon Life Insurance Company are entitled to receive an annual non-cumulative preferred dividend equal to 50 percent of the amount by which the company's net income for the full fiscal year exceeds $400 million, up to a maximum of $50 million per year, through 2002. In 1997, the Redeemable Voting Preferred Stock dividend was not recognized until the third and fourth quarter, when the Company's year to date net income exceeded the $400 million threshold. Net revenues increased to $2,518 million for the six months of 1998 from $1,779 million for the six months of 1997. The increase in net revenues from the first half of 1997 resulted from continued strong performances in the global merger and acquisition advisory, fixed income and equity businesses. Compensation and benefits expense as a percentage of net revenues was 50.7% for both the first half of 1998 and 1997. Nonpersonnel expenses increased slightly to $490 million in the six months of 1998 from $486 million in the six months of 1997; however, nonpersonnel expenses declined as a percentage of net revenues to 19.5% for the six months of 1998 from 27.3% for the comparable period in 1997. Increased net revenues and unchanged expense levels led to an improvement in the Company's pretax operating margin to 29.8% in the first half of 1998 from 22.0% in the first half of 1997. Principal transactions and net interest revenues increased to $1,376 million for the six months of 1998 from $1,023 million for the six months of 1997. Principal transactions revenues increased as favorable market conditions characterized by low interest rates and low inflation supported debt markets and helped to spur growth in the equity markets in both the U.S. and Europe. Growth in Fixed Income revenue was paced by mortgages, foreign exchange, derivatives and high yield, while growth in equities revenue was driven by equity cash trading and derivatives. Net interest revenues increased as a result of an increase in inventory and a shift in the composition of the Company's fixed income portfolio. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table of net revenues by business unit and the accompanying discussion have been prepared in order to present the Company's net revenues in a format that reflects the manner in which the Company manages its businesses. Net revenues by business unit contain certain internal allocations, including funding costs, which are centrally managed. Six Months Ended May 31, 1998 Principal Transactions and Investment Net Interest Commissions Banking Other Total - ----------------------------------------------------------------------------- Fixed Income $1,120 $ 17 $376 $ 6 $1,519 Equity 263 216 182 4 665 Corporate Finance Advisory (2) 199 197 Merchant Banking (6) 85 79 Other 1 8 1 48 58 - ----------------------------------------------------------------------------- $1,376 $241 $843 $58 $2,518 - ----------------------------------------------------------------------------- Six Months Ended May 31, 1997 Principal Transactions and Investment Net Interest Commissions Banking Other Total - ----------------------------------------------------------------------------- Fixed Income $ 826 $ 21 $172 $ 8 $1,027 Equity 205 160 106 3 474 Corporate Finance Advisory (3) 149 146 Merchant Banking (8) 84 76 Other 3 7 3 43 56 - ----------------------------------------------------------------------------- $1,023 $188 $514 $54 $1,779 - ----------------------------------------------------------------------------- Fixed Income. Fixed income net revenues increased to $1,519 million for the six months of 1998 from $1,027 million for the six months of 1997. The increase in the six months of 1998 versus the prior year six months reflected increased revenues from a number of fixed income products including improved performance in both sales and trading and syndicate activities in high yield corporates as well as increased contributions from mortgages, foreign exchange and fixed income derivative products partially offset by decreased results in government and municipal investments. Investment banking revenues, as a component of fixed income revenues, increased to $376 million for the six months of 1998 from $172 million for the six months of 1997 due to increased underwriting fees, particularly in high yield corporates. Equity. The Company's equity net revenues increased to $665 million for the six months of 1998 from $474 million for the six months of 1997. Higher revenues resulted from higher levels of customer flow activities in U.S. listed securities, increased underwriting volumes and improved contributions from equity derivatives. Investment banking revenues, as a component of equity revenues, increased to $182 million for the six months of 1998 from $106 million for the six months of 1997 due to increased underwriting volumes in U.S. listed and convertible securities. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Corporate Finance Advisory. Net revenues from corporate finance advisory activities increased to $197 million for the six months of 1998 reflecting a 35% increase from the $146 million recognized in the six months of 1997. This increase reflected continued strength in the overall merger and acquisition market environment. For completed M&A transactions, Lehman has improved its worldwide ranking from number 10 to number 4, increasing its market share from 6% to 15%, in part through participation in 5 of the 15 largest deals in the first half of the 1998 calendar year. Merchant Banking. Merchant banking net revenues were $79 million for the six months of 1998 and $76 million in the six months of 1997. 1998 net revenues reflect the realized gains on the sales of the partnerships' interest in numerous investments as well as net unrealized gains recognized on the publicly traded investments. 1997 net revenues reflect a realized gain on the sale of a significant portion of a publicly traded investment held by the partnerships which was completely divested in the third quarter of 1997. Non-Interest Expenses. Non-interest expenses were $1,767 million for the six months of 1998 and $1,388 million for the six months of 1997. Compensation and benefits expense as a percentage of net revenues remained unchanged from the comparable prior year period at 50.7%. Nonpersonnel expenses increased slightly to $490 million in the six months of 1998 from $486 million in the six months of 1997, however, nonpersonnel expenses declined as a percentage of net revenues to 19.5% for the six months of 1998 from 27.3% for the comparable period in 1997. Income Taxes. The Company's income tax provision was $240 million for the six months of 1998 compared to $126 million for the six months of 1997. The effective tax rate was 32% for the six months of 1998 and 1997. The 1998 effective tax rate, although the same as that of 1997, reflects an increase in tax benefits attributable to income and transactions subject to preferential tax treatment offset by a significantly higher level of pretax income and an increase in income subject to state and local taxes. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources Overview As a leading global investment bank that actively participates in the global capital markets, the Company has large and diverse capital requirements. Many of the businesses in which the Company operates are capital intensive. Capital is required to finance, among other things, the Company's securities inventories, underwriting activities, principal investments, merchant banking activities and investments in fixed assets. The Company's balance sheet is liquid and consists primarily of cash and cash equivalents, securities and other financial instruments owned, and collateralized short-term financing agreements. The liquid nature of these assets provides the Company with flexibility in financing and managing its business. The Company's primary activities are based on the execution of customer-related transactions. This flow of customer business supports the rapid asset turnover rate of the Company's inventory. The Company's total assets increased to $179.1 billion at May 31, 1998 from $151.7 billion at November 30, 1997, reflecting the strategic expansion of certain business lines. The Company's continued focus on growing higher margin businesses resulted in across the board increases in inventory positions at May 31, 1998 compared to November 30, 1997. The Company also positioned itself to benefit from favorable conditions in the worldwide fixed income markets by increasing its secured customer financing activities. Funding and Capital Policies The Company's Finance Committee is responsible for establishing and managing the funding and liquidity policies of the Company. These policies include recommendations for capital and balance sheet size as well as the allocation of capital and balance sheet to product areas. Under the authority of the Finance Committee, members of the Company's treasury department work with Regional Asset and Liability Committees to ensure coordination of global funding efforts and implementation of the funding and liquidity policies. The Regional Asset and Liability Committees are aligned with the Company's geographic funding centers and are responsible for implementing funding strategies for their respective regions. The primary goal of the Company's funding policies is to provide sufficient liquidity and availability of funding sources across a wide range of market environments. There are five key elements of its funding strategy that the Company attempts to achieve: (1) Maintain an appropriate Total Capital structure to support the business activities in which the Company is engaged. Total Capital is defined as long-term debt, preferred stock and common stockholders' equity. (2) Minimize liquidity and refinancing risk by funding the Company's assets on a global basis with secured and unsecured liabilities, which have maturities equal to or exceeding the anticipated liquidation period of the assets. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (3) Maintain sufficient financial resources to enable the Company to meet its obligations in a period of financial stress through a combination of collateralized short-term financings and Total Capital, as well as the implementation of a contingency funding plan. Financial stress is defined as any event which severely constrains the Company's access to unsecured funding sources. (4) Obtain diversified funding through a global investor base which maximizes liquidity and reduces concentration risk. (5) Maintain funding availability in excess of actual utilization. Short-Term Funding The Company strives to maximize the portion of the Company's balance sheet that is funded through collateralized borrowing sources, which in turn minimizes the reliance placed upon unsecured short-term debt. Collateralized borrowing sources include cash market securities and other financial instruments sold but not yet purchased, as well as collateralized short-term financings, defined as securities sold under agreements to repurchase ("repos") and securities loaned. Because of their secured nature, OECD government repos and certain other types of collateralized borrowing sources are less credit-sensitive and have historically been a more stable financing source under adverse market conditions. The amount of the Company's collateralized borrowing activities will vary reflecting changes in the mix and overall levels of securities and other financial instruments owned and global market conditions. The majority of the Company's assets are funded with collateralized borrowing sources. At May 31, 1998 and November 30, 1997, $107 billion and $94 billion, respectively, of the Company's total balance sheet was financed using collateralized borrowing sources. As of May 31, 1998 and November 30, 1997, commercial paper and short-term debt outstanding were $11.1 billion and $7.8 billion, respectively. Of these amounts, commercial paper outstanding as of May 31, 1998 was $5.9 billion with an average maturity of 74 days, compared to $3.9 billion with an average maturity of 73 days as of November 30, 1997. At May 31, 1998, Holdings maintained a Revolving Credit Agreement (the "Credit Agreement") with a syndicate of banks. Under the terms of the Credit Agreement, the banks have committed to provide up to $2 billion for up to 364 days. Any loans outstanding on the commitment termination date may be extended to the first anniversary of the commitment termination date at the option of Holdings. The Credit Agreement contains covenants which require, among other things, that the Company maintain specified levels of liquidity and tangible net worth, as defined. There were no borrowings outstanding under the Credit Agreement at May 31, 1998. The Company may use the Credit Agreement for general corporate purposes from time to time. The Company has maintained compliance with the applicable covenants of the Credit Agreement at all times. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Company is currently negotiating a new $1 billion Committed Securities Repurchase Facility (the "Facility") for LBIE, the Company's major operating entity in Europe. The Facility is expected to provide secured multi-currency financing for a broader range of collateral types than LBIE's previous committed secured credit facility. Under the terms of the Facility, the bank group will agree to provide funding for up to one year on a secured basis. Total Capital In accordance with the Company's liquidity plan, the Company increased its Total Capital base in 1998 to $31.9 billion at May 31, 1998 from $24.8 billion at November 30, 1997. Total Capital increased primarily due to an increase in long-term debt and the retention of earnings. May 31 November 30 (in millions) 1998 1997 - -------------------------------------------------------------------------------- Long-term Debt Senior Notes $23,029 $17,049 Subordinated Indebtedness 3,816 3,212 ------- ------- 26,845 20,261 Stockholders' Equity Preferred Equity 758 508 Common Equity 4,326 4,015 ------- ------- 5,084 4,523 - -------------------------------------------------------------------------------- Total Capital $31,929 $24,784 - -------------------------------------------------------------------------------- During the six months of 1998, the Company issued $8.2 billion in long-term debt, which was $6.6 billion in excess of its maturing debt. Long-term debt increased to $26.8 billion at May 31, 1998 from $20.3 billion at November 30, 1997 with a weighted average maturity of 3.7 years at May 31, 1998 and 4.1 years at November 30, 1997. At May 31, 1998, the Company had approximately $10.1 billion available for the issuance of debt securities under various shelf registrations and debt programs. Capital Resources and Capital Adequacy Balance sheet leverage ratios are one measure used to evaluate the capital adequacy of a company. Leverage ratios are commonly calculated using either total assets or adjusted total assets divided by total stockholders' equity. The Company believes that the adjusted leverage ratio, rather than the gross leverage ratio, is a more effective measure of financial risk when comparing companies in the securities industry. Adjusted total assets represent total assets less the lower of securities purchased under agreements to resell or securities sold under agreements to repurchase. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Due to the nature of the Company's sales and trading activities, the overall size of the Company's assets and liabilities fluctuates from time to time and at specific points in time may be higher than the fiscal quarter ends or the quarterly average. The Company's average gross leverage ratio and average adjusted leverage ratio for the quarter ended May 31, 1998 were 39.6x and 26.9x, respectively and for the year ended November 30, 1997 were 41.3x and 28.9x, respectively. In early 1997, the Company implemented a business performance measurement system. This system is a management reporting tool which charges for capital utilization across the Company's products. It provides detailed profitability and return on equity information for each of the Company's lines of business. The results of charging each of the respective businesses for its capital utilization are that businesses have begun to optimize their use of balance sheet and capital resources, resulting in an improved return on assets and overall decreased levels of both quarterly average gross and adjusted leverage. [GRAPHIC OMITTED] LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Credit Ratings The Company, like other companies in the securities industry, relies on external sources to finance a significant portion of its day-to-day operations. The Company's access to and cost of funding is generally dependent upon its short- and long- term debt ratings. In April 1998, Moody's Investors Services upgraded its ratings outlook on the Company to "positive" from "stable". Additionally, during May 1998, Thomson Bank Watch, upgraded its long-term debt ratings of the Company to "A" from "A-" and the long-term senior and subordinated debt ratings of Lehman Brothers Inc. ("LBI") to "A+" from "A" and "A" from "A-", respectively. As of May 31, 1998, the short- and long-term senior debt ratings of Holdings and LBI were as follows: Holdings LBI -------- --- Short-term Long-term Short-term Long-term** - -------------------------------------------------------------------------------- Duff & Phelps Credit Rating Co. D-1 A D-1 A/A- Fitch IBCA, Inc. F-1 A F-1 A/A- Moody's P2 Baa1 P2 A3*/Baa1 S&P A-1 A A-1 A+*/A Thomson BankWatch TBW-1 A TBW-1 A+/A * Provisional ratings on shelf registration ** Senior/subordinated Insurance Subsidiary The Company has established a new subsidiary to underwrite and accumulate insurance and reinsurance risks. The new subsidiary, Lehman Re Ltd., is a Bermuda licensed Class 4 and Long-Term insurance company and was capitalized in June 1998 at $500 million. Lehman Re Ltd. intends to underwrite property and casualty, as well as life and annuity insurance risks. It expects to focus its business initially in four areas: finite and structured financial products; political risk and trade credit insurance; property catastrophe reinsurance; and life and annuity reinsurance. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS High Yield Securities The Company underwrites, trades, invests and makes markets in high yield corporate debt securities. The Company also syndicates, trades and invests in loans to below investment grade-rated companies. For purposes of this discussion, high yield debt securities are defined as securities or loans to companies rated BB+ or lower, or equivalent ratings by recognized credit rating agencies, as well as non-rated securities or loans which, in the opinion of management, are non-investment grade. Non-investment grade securities generally involve greater risks than investment grade securities due to the issuer's creditworthiness and the liquidity of the market for such securities. In addition, these issuers have higher levels of indebtedness, resulting in an increased sensitivity to adverse economic conditions. The Company recognizes these risks and aims to reduce market and credit risk through the diversification of its products and counterparties. High yield debt securities are carried at market value, and unrealized gains or losses for these securities are reflected in the Company's Consolidated Statement of Income. The Company's portfolio of such securities at May 31, 1998 and November 30, 1997 included long positions with an aggregate market value of approximately $3.7 billion and $3.2 billion, respectively, and short positions with an aggregate market value of approximately $479 million and $172 million, respectively. The portfolio may, from time to time, contain concentrated holdings of selected issues. The Company may also, from time to time, mitigate its net exposure to any single issuer through the use of derivatives and other financial instruments. At May 31, 1998, the Company had no single exposure to an issuer of high yield securities greater than $100 million. Lending Activities The Company, through its high yield sales and trading activities, makes commitments to extend credit in loan syndication transactions principally to below investment grade borrowers and participates a significant portion of these commitments. These commitments, which are net of syndications and participations totaled $1.9 billion at May 31, 1998, are typically secured against the borrower's assets and have fixed maturity dates. The utilization of these facilities is generally contingent upon certain representations, warranties and contractual conditions of the borrower. Total commitments may not be indicative of actual funding requirements as the Company intends to continue syndicating, selling, and/or participating these commitments. . Merchant Banking and Related Lending Activities The Company's merchant banking activities include investments in nine partnerships, for which the Company acts as general partner, as well as direct investments. At May 31, 1998, the investment in merchant banking partnerships was $154 million and direct investments were $204 million. The Company's policy is to carry its investments, including its partnership interests, at fair value based upon the Company's assessment of the underlying investments. The Company has commitments to invest up to $351 million in the partnerships, which in turn will make direct merchant banking related investments. These commitments will be funded as required through the end of the respective partnerships' investment periods, principally expiring in 2004. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In June 1998, the Company sponsored a $5 billion interim loan fund, designed to extend financing to clients in connection with a wide range of domestic and international leveraged transactions, including acquisitions, corporate recapitalization and refinancing of existing debt. In connection therewith, the Company intends to provide up to $400 million to be used by the fund. Any draw downs under the facility are expected to be repaid within a short-term period. In addition, at May 31, 1998, the Company had $727 million direct bridge financings outstanding. Subsequent to May 31, 1998, the Company syndicated a significant portion of these financings. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Risk Management As a leading global investment banking company, risk is an inherent part of the Company's businesses. Global markets, by their nature, are prone to uncertainty and subject participants to a variety of risks. The Company has developed policies and procedures to identify, measure and monitor each of the risks involved in its trading, brokerage and investment banking activities on a global basis. The principal risks of Lehman Brothers are market, credit, liquidity, legal and operational risks. Risk management is considered to be of paramount importance. The Company devotes significant resources across all of its worldwide trading operations to the measurement, management and analysis of risk, including investments in personnel, information technology infrastructure and systems. Market Risk Market risk represents the potential change in value of a portfolio of financial instruments due to changes in market rates, prices, and volatilities. Market risk is present in cash products, derivatives, and contingent claim structures that exhibit linear as well as non-linear profit and loss sensitivity. The Company's exposure to market risk varies in accordance with the volume of client driven market-making transactions, the size of the Company's proprietary and arbitrage positions, and the volatility of financial instruments traded. The Company seeks to mitigate, whenever possible, excess market risk exposures through the use of futures and option contracts and offsetting cash market instruments. The Company participates globally in interest rate, equity, and foreign exchange markets. The Company's fixed income division has a broadly diversified market presence in U.S. and foreign government bond trading, emerging market securities, corporate debt (investment and non-investment grade), money market instruments, mortgages and mortgage-backed securities, asset-backed securities, municipal bonds, and interest rate derivatives. The Company's equity division facilitates domestic and foreign trading in equity instruments, indices, and related derivatives. The Company's foreign exchange businesses are involved in trading currencies on a spot and forward basis as well as through derivative products and contracts. Value at Risk For purposes of Securities and Exchange Commission disclosure requirements, the Company has elected to disclose an entity-wide value at risk analysis of virtually all of the Company's trading activities. The value at risk related to non-trading financial instruments has been excluded from this analysis and not reported separately because the amounts were not material. The value at risk calculation measures potential losses in expected revenues and is based on a methodology which uses a one-day holding period and a 95% confidence level. Value at risk as of each date presented below was measured by analyzing the distribution of actual trading revenues during the preceding one year period and assumed a relatively consistent portfolio mix. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Value at risk is one measurement of potential losses in revenues that may result from adverse market movements over a specified period of time with a selected likelihood of occurrence. Value at risk has substantial limitations, including its reliance on historical performance and data as valid predictors of the future. Consequently, value at risk is only one of a number of tools the Company utilizes in its daily risk management activities. The Company's value at risk for each component of market risk, and in total was as follows (in millions): May 31, 1998 November 30, 1997 ------------ ----------------- Interest rate risk $12.5 $12.2 Equity price risk 10.0 7.1 Foreign exchange risk 2.4 4.5 Diversification benefit (10.5) (9.0) ----- ---- Total Company $14.4 $14.8 ===== ===== The Company utilizes a wide variety of market risk management methods, including: limits for each trading activity; marking all positions to market on a daily basis; daily profit and loss analyses; position reports; aged inventory position analyses; and independent verification of all inventory pricing. The Company believes that these procedures, which stress timely communication between risk, trading and senior management, are critical elements of the risk management process. Other Recent Development On April 17, 1998, the United States District Court for the Northern District of Texas approved the settlement of a class action captioned Warren Chisum, et al. v. Lehman Brothers Inc., et al. The class action alleged violations of the federal securities laws and breaches of fiduciary duty by defendants in connection with the origination, sale and operation of nine E.F. Hutton net lease real estate limited partnerships sold in the early 1980's. The settlement cost of $75 million was charged against existing reserves. LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES PART II - OTHER INFORMATION ITEM 1 Legal Proceedings Lehman Brothers is involved in a number of judicial, regulatory and arbitration proceedings concerning matters arising in connection with the conduct of its business. Such proceedings include actions brought against LBI and others with respect to transactions in which LBI acted as an underwriter or financial advisor, actions arising out of LBI's activities as a broker or dealer in securities and commodities and actions brought on behalf of various classes of claimants against many securities and commodities firms of which LBI is one. Although there can be no assurance as to the ultimate outcome, Lehman Brothers has denied, or believes it has meritorious defenses and will deny, liability in all significant cases pending against it including the matters described below, and intends to defend vigorously each such case. Although there can be no assurance as to the ultimate outcome, based on information currently available and established reserves, the Company believes that the eventual outcome of the actions against it, including the matters described below, will not, in the aggregate, have a material adverse effect on its business or consolidated financial condition. Actions Relating to First Capital Holdings Inc. (Reported in Holdings' Annual Report on Form 10-K and First Quarter Report on Form 10-Q) The Virginia Commissioner of Insurance. On May 21, 1988 after trial, the Court entered a Judgment Order in accord with the jury verdict, ordering that the plaintiffs recover nothing from the defendants and dismissing the complaint. Warren D. Chisum, et al. v. Lehman Brothers Inc. et al. (Reported in Holdings' Annual Report on Form 10-K and First Quarter Report on Form 10-Q) On April 17, 1988, the Court entered a final order approving the settlement of this action. Bamaodah v. E.F. Hutton & Company Inc. (Reported in Holdings' Annual Report on Form 10-K and First Quarter Report on Form 10-Q) The Court has ordered the experts to conduct a review of certain additional documents and has set October 25, 1998 as the next hearing date. AIA Holding SA et al. V. Lehman Brothers Inc. and Bear Stearns & Co., Inc. (Reported in Holdings' Annual Report on Form 10-K and First Quarter Report on Form 10-Q) On July 3, 1998 the Plaintiffs served their First Amended Complaint which contains eighteen causes of action against Lehman Brothers and/or Bear Stearns. In re MobileMedia Securities Litigation. LBI was named as a defendant in several purported class actions filed in December, 1996 in the United States District Court for the District of New Jersey in connection with (i) a November 7, 1995 offering of common stock of MobileMedia Corporation; and (ii) a November 7, 1995 offering of 9-3/8% senior subordinated notes of MobileMedia Communications Inc due in 2007. On November 3, 1997 a consolidated amended class action complaint was filed naming certain of MobileMedia Corporation's officers and directors and the four co-lead underwriters of these offerings, including LBI. MobileMedia filed for Chapter 11 bankruptcy protection on January 30, 1997, and therefore, is not named as a defendant. The complaint alleges that the underwriters violated Sections 11 and 12 of the 1933 Securities Act. Plaintiffs seek rescission and unspecified compensatory damages. ITEM 6 Exhibits and Reports on Form 8-K The following exhibits and reports on Form 8-K are filed as part of this Quarterly Report, or where indicated, were heretofore filed and are hereby incorporated by reference: (a) Exhibits: 11 Computation of Per Share Earnings 12.1 Computation in Support of Ratio of Earnings to Fixed Charges 12.2 Computation in Support of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends 27 Financial Data Schedule (b) Reports on Form 8-K: Form 8-K dated May 13, 1998, Item 7. Form 8-K dated June 18, 1998, Items 5 and 7. SIGNATURES 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. LEHMAN BROTHERS HOLDINGS INC. (Registrant) Date: July 15, 1998 By /s/ Richard S. Fuld Jr. -------------------------- Richard S. Fuld, Jr. Chairman of the Board and Chief Executive Officer (Principal Executive Officer) Date: July 15, 1998 By /s/ Charles B. Hintz -------------------------- Charles B. Hintz Chief Financial Officer (Principal Financial Officer) EXHIBIT INDEX Exhibit No. Exhibit Exhibit 11 Computation of Per Share Earnings Exhibit 12.1 Computation in Support of Ratio of Earnings to Fixed Charges Exhibit 12.2 Computation in Support of Ratio of Earnings to Combined Fixed Charges and Preferred Dividends Exhibit 27 Financial Data Schedule Exhibit 11 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES COMPUTATION of PER SHARE EARNINGS (Unaudited) (In millions, except share data) Three months Six months ended Ended May 31 May 31 ------------------------------------- -------------------------------------- 1998 1997 1998 1997 ---------------- ----------------- ----------------- ----------------- Numerator: Net income $324 $121 $511 $265 Preferred stock dividends (56) (7) (63) (13) ---------------- ----------------- ----------------- ----------------- Numerator for basic and diluted earnings per share - income available to common stockholders $268 $114 $448 $252 ================ ================= ================= ================= Denominator: Denominator for basic earnings per share - weighted-average shares 120,633,663 118,009,833 120,638,259 117,510,139 Effect of dilutive securities: Employee stock options 3,343,693 1,543,642 3,017,385 1,435,395 Common stock equivalents 2,323,903 867,258 1,896,015 811,550 ---------------- ----------------- ----------------- ----------------- Dilutive potential common shares 5,667,596 2,410,900 4,913,400 2,246,945 ---------------- ----------------- ----------------- ----------------- Denominator for diluted earnings per share - adjusted weighted-average shares 126,301,259 120,420,733 25,551,659 119,757,084 ================ ================= ================= ================= Basic earnings per share $2.22 $0.97 $3.71 $2.15 ================ ================= ================= ================= Diluted earnings per share $2.12 $0.95 $3.57 $2.11 ================ ================= ================= ================= Exhibit 12.1 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES COMPUTATION in SUPPORT of RATIO of EARNINGS to FIXED CHARGES (Dollars in millions) (Unaudited) For the For the For the For the For the For the Twelve Months Eleven Months Twelve Months Twelve Months Twelve Months Six Months Ended Ended Ended Ended Ended Ended December 31 November 30 November 30 November 30 November 30 May 31 1993 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- ---- Fixed Charges: Interest expense: Subordinated indebtedness $ 144 $ 158 $ 206 $ 220 $ 240 $ 118 Bank loans and other borrowings* 5,224 6,294 10,199 10,596 12,770 7,498 Interest component of rentals of office and equipment 76 42 44 34 32 16 Other adjustments** 7 4 28 16 9 11 ------ --------- -------- ------- -------- ------- TOTAL (A) $5,451 $6,498 $10,477 $10,866 $13,051 $7,643 ====== ========= ======== ======= ======== ====== Earnings: Pretax income (loss) from continuing operations $ 27 $ 193 $ 369 $ 637 $ 937 $ 751 Fixed charges 5,451 6,498 10,477 10,866 13,051 7,643 Other adjustments*** (6) (4) (28) (14) (8) (11) ------- ------- ------- ------- ------- ----- TOTAL (B) $5,472 $6,687 $10,818 $11,489 $13,980 $8,383 ====== ====== ======= ======= ======= ====== (B / A) 1.00 1.03 1.03 1.06 1.07 1.10 * Includes amortization of long-term debt discount. ** Other adjustments include capitalized interest and debt issuance costs and amortization of capitalized interest. *** Other adjustments include adding the net loss of affiliates accounted for at equity whose debt is not guaranteed by the Company and subtracting capitalized interest and debt issuance costs and undistributed net income of affiliates accounted for at equity. Exhibit 12.2 LEHMAN BROTHERS HOLDINGS INC. and SUBSIDIARIES COMPUTATION in SUPPORT of RATIO of EARNINGS to COMBINED FIXED CHARGES and PREFERRED DIVIDENDS (Dollars in millions) (Unaudited) For the For the For the For the For the For the Twelve Months Eleven Months Twelve Months Twelve Months Twelve Months Six Months Ended Ended Ended Ended Ended Ended December 31 November 30 November 30 November 30 November 30 May 31 1993 1994 1995 1996 1997 1998 ---- ---- ---- ---- ---- ---- Combined Fixed Charges and Preferred Dividends: Interest expense: Subordinated indebtedness $ 144 $ 158 $ 206 $ 220 $ 240 $ 118 Bank loans and other borrowings* 5,224 6,294 10,199 10,596 12,770 7,498 Interest component of rentals of office and equipment 76 42 44 34 32 16 Other adjustments** 7 4 28 16 9 11 --------- --------- --------- --------- ----------- ------- Total fixed charges 5,451 6,498 10,477 10,866 13,051 7,643 Preferred dividends (tax equivalent basis) 48 58 64 58 109 92 -------- -------- --------- --------- -------- ------- TOTAL (A) $5,499 $6,556 $10,541 $10,924 $13,160 $7,735 ====== ====== ======= ======= ======= ====== Earnings: Pretax income (loss) from continuing operations $ 27 $ 193 $ 369 $ 637 $ 937 $ 751 Fixed charges 5,451 6,498 10,477 10,866 13,051 7,643 Other adjustments*** (6) (4) (28) (14) (8) (11) -------- ------- ------- ------- -------- ------ TOTAL (B) $5,472 $6,687 $10,818 $11,489 $13,980 $8,383 ====== ====== ======= ======= ======= ====== (B / A) **** 1.02 1.03 1.05 1.06 1.08 * Includes amortization of long-term debt discount. ** Other adjustments include capitalized interest and debt issuance costs and amortization of capitalized interest. *** Other adjustments include adding the net loss of affiliates accounted for at equity whose debt is not guaranteed by the Company and subtracting capitalized interest and debt issuance costs and undistributed net income of affiliates accounted for at equity. **** Earnings were inadequate to cover fixed charges and preferred dividends and would have had to increase $27 million in 1993 in order to cover the deficiency.