SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 28, 2002
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 0-19483
SWS GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware 75-2040825
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1201 Elm Street, Suite 3500, Dallas, Texas 75270
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (214) 859-1800
(Former name, former address and former fiscal year, if changed since last
report)
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 April 26, 2002, there were 17,236,446 shares of the registrant's common
stock, $.10 par value, outstanding.
SWS GROUP, INC. AND SUBSIDIARIES
Index
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Financial Condition
March 28, 2002 (unaudited) and June 29, 2001
Consolidated Statements of Income and Comprehensive Income (Loss)
For the three and nine months ended March 28, 2002 and March 30, 2001
(unaudited)
Consolidated Statements of Cash Flows
For the nine months ended March 28, 2002 and March 30, 2001 (unaudited)
Notes to Consolidated Financial Statements (unaudited)
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
SWS GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Financial Condition
March 28, 2002 and June 29, 2001
(In thousands, except par values and share amounts)
March June
(unaudited)
----------- -----------
Assets
Cash $ 21,346 $ 31,224
Assets segregated for regulatory purposes 439,733 362,071
Marketable equity securities available for sale 5,220 9,687
Receivable from brokers, dealers and clearing organizations 1,952,408 2,221,253
Receivable from clients, net 592,908 437,620
Loans held for sale, net 118,007 155,025
Loans, net 348,826 319,949
Securities owned, at market value 116,834 146,074
Other assets 105,832 101,854
----------- -----------
$ 3,701,114 $ 3,784,757
=========== ===========
Liabilities and Stockholders' Equity
Short-term borrowings $ 169,050 $ --
Payable to brokers, dealers and clearing organizations 1,909,599 2,233,207
Payable to clients 760,842 657,955
Deposits 291,147 336,281
Securities sold, not yet purchased, at market value 19,994 28,650
Drafts payable 29,941 29,620
Advances from Federal Home Loan Bank 155,400 113,477
Other liabilities 66,219 74,831
Exchangeable subordinated notes 7,473 8,568
----------- -----------
3,409,665 3,482,589
Minority interest in consolidated subsidiaries 1,779 2,729
Stockholders' equity:
Preferred stock of $1.00 par value. Authorized 100,000 shares; none issued -- --
Common stock of $.10 par value. Authorized 60,000,000 shares, issued
17,588,027 and outstanding 17,230,566 shares at March 28, 2002; issued
17,509,771 and outstanding 17,247,914 shares at June 29, 2001 1,758 1,751
Additional paid-in capital 257,475 252,225
Retained earnings 20,559 21,269
Accumulated other comprehensive income - unrealized holding gain, net of tax
of $8,090 at March 28, 2002 and $15,075 at June 29, 2001 15,024 27,997
Deferred compensation, net 1,434 1,141
Treasury stock (357,461 shares at March 28, 2002 and 261,857 shares at June 29,
2001, at cost) (6,580) (4,944)
----------- -----------
Total stockholders' equity 289,670 299,439
Commitments and contingencies
----------- -----------
$ 3,701,114 $ 3,784,757
=========== ===========
See accompanying Notes to Consolidated Financial Statements.
1
SWS GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Income and Comprehensive Income (Loss)
For the three and nine months ended March 28, 2002 and March 30, 2001
(In thousands, except per share and share amounts)
(Unaudited)
For the three months ended For the nine months ended
fiscal 2002 fiscal 2001 fiscal 2002 fiscal 2001
--------------------------------------------------------------
Net revenues from clearing operations $ 8,247 $ 11,974 $ 24,931 $ 39,560
Commissions 19,477 16,960 55,597 48,129
Interest 26,996 58,093 98,530 202,158
Investment banking, advisory and administrative fees 10,352 8,722 30,651 26,467
Net gains on principal transactions (including net gains on the
sale of Knight Trading Group, Inc. ("Knight") common stock) 8,968 11,829 34,047 32,264
Other 3,479 3,370 12,118 19,518
--------------------------------------------------------------
77,519 110,948 255,874 368,096
--------------------------------------------------------------
Commissions and other employee compensation 32,554 36,766 103,473 110,721
Interest 12,748 39,963 54,499 140,755
Occupancy, equipment and computer service costs 12,456 8,973 35,474 25,430
Communications 5,226 4,290 14,482 11,800
Floor brokerage and clearing organization charges 2,225 1,715 6,159 5,006
Advertising and promotional 1,065 4,184 6,749 11,926
Other 8,850 9,277 25,150 34,154
--------------------------------------------------------------
75,124 105,168 245,986 339,792
--------------------------------------------------------------
Income before income taxes and minority interest in consolidated
subsidiaries 2,395 5,780 9,888 28,304
Income taxes 920 1,874 4,782 9,366
--------------------------------------------------------------
Income before minority interest in consolidated subsidiaries 1,475 3,906 5,106 18,938
Minority interest in consolidated subsidiaries (428) (349) (352) (1,934)
--------------------------------------------------------------
Income before cumulative effect of a change in accounting principle 1,047 3,557 4,754 17,004
Cumulative effect of a change in accounting principle, net of tax
of $1,548 -- -- -- (2,874)
--------------------------------------------------------------
Net income 1,047 3,557 4,754 14,130
Other comprehensive income (loss):
Holding gain (loss) arising during period, net of tax (1,482) 317 (971) (14,752)
Reclassification for hedging activities, net of tax 942 (167) 862 24,118
Reclassification adjustment for gains realized in net income
on the sale of Knight common stock, net of tax (2,803) (2,064) (12,863) (5,484)
--------------------------------------------------------------
Net gain (loss) recognized in other comprehensive income (loss),
net of tax (3,343) (1,914) (12,972) 3,882
--------------------------------------------------------------
Comprehensive income (loss) $ (2,296) $ 1,643 $ (8,218) $ 18,012
==============================================================
Earnings per share - basic
Income before cumulative effect of a change in accounting
principle $ .06 $ .20 $ .28 $ .97
Cumulative effect of a change in accounting principle, net of tax -- -- -- (.16)
--------------------------------------------------------------
Net income $ .06 $ .20 $ .28 $ .81
==============================================================
Weighted average shares outstanding - basic 17,225,307 17,479,065 17,208,497 17,478,261
==============================================================
Earnings per share - diluted
Income before cumulative effect of a change in accounting
principle $ .06 $ .20 $ .28 $ .96
Cumulative effect of a change in accounting principle, net of tax -- -- -- (.16)
--------------------------------------------------------------
Net income $ .06 $ .20 $ .28 $ .80
==============================================================
Weighted average shares outstanding - diluted 17,312,879 17,553,818 17,276,365 17,582,891
==============================================================
See accompanying Notes to Consolidated Financial Statements.
2
SWS GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the nine months ended March 28, 2002 and March 30, 2001
(In thousands)
(Unaudited)
Fiscal 2002 Fiscal 2001
--------------- ----------------
Cash flows from operating activities:
Net income $ 4,754 $ 14,130
Adjustments to reconcile net income to net cash provided by (used in) operating
activities:
Depreciation and amortization 3,582 3,938
Provision for doubtful accounts 1,881 2,230
Deferred income taxes 5,912 (6,634)
Deferred compensation expense (59) (478)
Gain on sale of marketable equity securities (19,788) (8,437)
Gain on sale of First Consumer Credit LLC (1,163) --
Compensation expense on spin-off of the Westwood Group 3,298 --
Compensation expense on stock options 294 --
Net change in minority interest in consolidated subsidiaries (414) 1,103
Cumulative effect of change in accounting principle, net of tax -- 2,874
Reclassification from other comprehensive income for SFAS No. 133 231 2,006
Change in operating assets and liabilities:
Increase in assets segregated for regulatory purposes (77,662) (5,749)
Net change in broker, dealer and clearing organization accounts (54,763) (19,160)
Net change in client accounts (53,121) 128,157
Net change in loans held for sale 35,611 (36,900)
Decrease (increase) in securities owned 28,893 (21,857)
Increase in other assets (6,145) (1,626)
Increase (decrease) in drafts payable 321 (4,375)
Decrease in securities sold, not yet purchased (8,656) (5,037)
Decrease in other liabilities (6,999) (11,605)
--------------- ----------------
Net cash provided by (used in) operating activities (143,993) 32,580
--------------- ----------------
Cash flows from investing activities:
Purchase of fixed assets (4,759) (5,601)
Net change in loans (30,113) (56,959)
Cash received from sale of First Consumer Credit LLC 1,050 --
Cash paid for O'Connor & Company Securities, Inc., net of cash acquired (1,243) --
Cash acquired in purchase of May, net of payment for purchase -- 584
Cash received for sale of minority interest in Westwood Holdings Group, Inc. 4,093 --
Proceeds from sale of marketable equity securities 4,442 8,488
--------------- ----------------
Net cash used in investing activities (26,530) (53,488)
--------------- ----------------
Cash flows from financing activities:
Increase (decrease) in short-term borrowings, net of effect from purchase of May 169,050 (79,255)
Increase (decrease) in deposits (45,134) 70,614
Increase in advances from Federal Home Loan Bank 41,923 13,866
Payment to repurchase 5% exchangeable subordinated notes -- (16,981)
Proceeds from issuance of stock in consolidated subsidiary 50 150
Payment of cash dividends on common stock - parent (5,163) (4,290)
Net proceeds from exercise of stock options 1,292 386
Proceeds related to Deferred Compensation Plan 288 593
Purchase of treasury stock (1,661) (853)
--------------- ----------------
Net cash provided by (used in) financing activities 160,645 (15,770)
--------------- ----------------
Net decrease in cash (9,878) (36,678)
Cash at beginning of period 31,224 72,479
--------------- ----------------
Cash at end of period $ 21,346 $ 35,801
=============== ================
See accompanying Notes to Consolidated Financial Statements.
3
SWS GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(Unaudited)
GENERAL AND BASIS OF PRESENTATION
The interim consolidated financial statements include the accounts of SWS Group,
Inc. ("Parent") and its consolidated subsidiaries listed below (collectively,
the "Company"):
Brokerage Group
SWS Securities, Inc. "SWS, Inc."
SWS Financial Services, Inc. "SWSFS"
Mydiscountbroker.com, Inc. "MDB"
Southwest Clearing Corp. "Clearing"
May Financial Corporation "May"
Asset Management Group
Westwood Holdings Group, Inc. (80.18%) "Westwood Group"
Westwood Management Corporation "Management"
Westwood Trust "Trust"
SWS Capital Corporation "Capital"
Southwest Investment Advisors, Inc. "Advisors"
Banking Group
First Savings Bank, FSB "FSB"
FSBF, LLC (75%) "FSBF LLC"
FSB Financial, LTD (73.5%) "FSBF LTD"
FSB Development, LLC "FSB Development"
Other
SWS Technologies Corporation "Technologies"
Brokerage Group. SWS, Inc. is a New York Stock Exchange ("NYSE") registered
broker/dealer, and SWSFS, MDB, Clearing and May are National Association of
Securities Dealers ("NASD") registered broker/dealers under the Securities
Exchange Act of 1934 ("1934 Act"). O'Connor & Company Securities, Inc. ceased
operation in the third quarter of fiscal 2002.
Asset Management Group. Advisors and Management are registered investment
advisors under the Investment Advisors Act of 1940. Trust is chartered and
regulated by the Texas Department of Banking.
In conjunction with the December 2001 announcement of the Company's intention to
spin-off the Westwood Group, the Westwood Group filed its Form 10 with the
Securities and Exchange Commission ("SEC") on February 8, 2002. For every four
shares of the Company's common stock owned, stockholders will receive one share
of the Westwood Group's common stock. The Company's Board of Directors will set
a record date and a distribution date of the Westwood Group's common stock to
the Company's stockholders once the SEC has completed its review of the proposed
transaction.
Banking Group. FSB is a federally chartered savings association regulated by the
Office of Thrift Supervision.
Consolidated Financial Statements. The interim consolidated financial statements
as of March 28, 2002, and for the three- and nine-month periods ended March 28,
2002 and March 30, 2001, are unaudited; however, in the opinion of management,
these interim statements include all adjustments, consisting only of normal
recurring adjustments, necessary for a fair presentation of the financial
position, results of operations and cash flows. These financial statements
should be read in conjunction with the audited consolidated financial statements
and related notes as of and for the year ended June 29, 2001 filed on Form 10-K.
Amounts included for June 29, 2001 are from the audited consolidated financial
statements as filed on Form 10-K.
4
All significant intercompany balances and transactions have been eliminated.
Other comprehensive income (loss) for the three- and nine-month periods ended
March 30, 2001 has been restated to reflect the reclassification of changes in
the value of the hedged Knight stock, net of tax, of ($167,000) and $24,118,000,
respectively. The amount previously reported as comprehensive loss for the
three- and nine-month periods ended March 30, 2001 was $1,810,000 and
($6,106,000), respectively.
CASH FLOW REPORTING
Cash paid for interest was $58,454,000 and $143,749,000 for the nine-month
periods ended March 28, 2002 and March 30, 2001, respectively. Cash paid for
income taxes was $3,600,000 and $8,615,000 for the nine-month periods ended
March 28, 2002 and March 30, 2001, respectively.
ASSETS SEGREGATED FOR REGULATORY PURPOSES
At March 28, 2002, the Company had U.S. Treasury securities with a market value
of approximately $292,538,000, reverse repurchase agreements of approximately
$130,000,000, cash of $51,000 and related accrued interest of approximately
$39,000 segregated in special reserve bank accounts for the exclusive benefit of
customers under Rule 15c3-3 of the 1934 Act. These reverse repurchase agreements
were collateralized by U.S. Government securities with a market value of
approximately $132,623,000. The Company also had approximately $17,104,000 in
reverse repurchase agreements, related accrued interest of approximately $1,000
in special reserve bank accounts for the Proprietary Accounts of Introducing
Brokers ("PAIB") at March 28, 2002. These reverse repurchase agreements in the
PAIB accounts were collateralized by U.S. Government securities with a market
value of approximately $17,450,000.
At June 29, 2001, the Company had U.S. Treasury securities with a market value
of approximately $124,363,000, reverse repurchase agreements of approximately
$216,690,000, cash of $19,000 and related accrued interest of approximately
$130,000 segregated in the special reserve bank accounts for the exclusive
benefit of customers. These reverse repurchase agreements were collateralized by
U.S. Government securities with a market value of approximately $220,490,000.
The Company also had approximately $20,862,000 in reverse repurchase agreements,
cash of $1,000 and related accrued interest of approximately $6,000 in special
reserve bank accounts for the PAIB at June 29, 2001. The reverse repurchase
agreements in the PAIB accounts were collateralized by U.S. Government
securities with a market value of approximately $21,101,000.
MARKETABLE EQUITY SECURITIES
The investments in Knight and U.S. Home Systems, Inc. ("USHS") common stock are
classified as marketable equity securities available for sale, and the
unrealized holding gains (losses), net of tax, are recorded as a separate
component of stockholders' equity on the consolidated statements of financial
condition. The following table summarizes the cost and market value of the
investments at March 28, 2002 and June 29, 2001 (dollars in thousands):
Gross Gross
Shares Unrealized Unrealized Market
Held Cost Gains Losses Value
-----------------------------------------------------------------------------
March 28, 2002
Knight 480,184 $ 62 3,367 -- $ 3,429
USHS 365,723 936 855 -- 1,791
------------------------------------------------------------
Marketable equity securities $ 998 4,222 -- $ 5,220
============================================================
June 29, 2001
Marketable equity securities - Knight 906,184 $ 117 9,570 -- $ 9,687
============================================================
5
The "specific identification" method is used to determine the cost of marketable
securities sold. In the three- and nine-month periods ended March 28, 2002, the
Company sold approximately 100,000 and 426,000 shares of Knight, respectively,
with proceeds from the sales totaling $710,000 and $4,442,000, respectively.
Realized gains on these sales totaled approximately $697,000 and $4,387,000 for
the three- and nine-month periods ended March 28, 2002, respectively. In the
three- and nine-month periods ended March 30, 2001, the Company sold
approximately 200,000 and 394,300 shares of Knight, respectively, with proceeds
from the sales totaling $3,201,000 and $8,488,000, respectively. Realized gains
on these sales totaled approximately $3,175,000 and $8,437,000 for the three-
and nine-month periods ended March 30, 2001, respectively. These gains were
reclassified from accumulated other comprehensive income (loss) net of tax of
$244,000 and $1,535,000 for the three- and nine-month periods ended March
28, 2002, respectively, and $1,111,000 and $2,953,000 for the three- and
nine-month periods ended March 30, 2001, respectively.
The holding gain (loss) arising during period presented on the consolidated
statements of income and comprehensive income (loss) is shown net of tax of
$770,000 and $336,000 for the three- and nine-month periods ended March 28,
2002, respectively, and ($423,000) and $7,300,000 for the three- and nine-month
periods ended March 30, 2001, respectively.
As of March 28, 2002 and June 29, 2001, 373,550 shares of this stock are hedged
by the Company's 5% Exchangeable Subordinated Notes ("the Notes"). In December
2000, the Company repurchased and retired 640,782 Notes. A like number of Knight
shares were released from the hedging provisions of SFAS No. 133. Upon final
disposition of these previously hedged shares of Knight stock, the Company will
recognize a non-cash gain of approximately $23.50 per share, net of tax, equal
to the decrease in the value of Knight stock from the hedging date (June 16,
1999), to the termination date of hedge accounting (December 20, 2000). The
Company disposed of 100,000 shares and 426,000 shares of this previously hedged
stock in the three- and nine-month periods ended March 28, 2002, respectively;
therefore, non-cash gains of $3,616,000 and $15,402,000 on the sale of stock
were recorded in net gains from principal transactions in the accompanying
consolidated statements of income and comprehensive income (loss). These
non-cash gains were reclassified from accumulated other comprehensive income
(loss) on the consolidated statements of income and comprehensive income (loss)
net of tax of $1,265,000 and $5,390,000 for the three- and nine-month
periods ended March 28, 2002. There were no such gains in fiscal 2001.
RECEIVABLE FROM AND PAYABLE TO BROKERS, DEALERS AND CLEARING ORGANIZATIONS
At March 28, 2002 and June 29, 2001, the Company had receivable from and payable
to brokers, dealers and clearing organizations related to the following (in
thousands):
March June
------------------ ------------------
Receivable
Securities failed to deliver $ 67,028 $ 25,825
Securities borrowed 1,847,955 2,162,467
Correspondent broker/dealers 22,205 16,353
Clearing organizations 5,026 1,776
Other 10,194 14,832
------------------ ------------------
$ 1,952,408 $ 2,221,253
================== ==================
Payable
Securities failed to receive $ 42,931 $ 22,596
Securities loaned 1,823,827 2,166,165
Correspondent broker/dealers 28,116 31,660
Other 14,725 12,786
------------------ ------------------
$ 1,909,599 $ 2,233,207
================== ==================
6
LOANS AND ALLOWANCE FOR POSSIBLE LOAN LOSSES
Loans receivable, excluding loans held for sale, at March 28, 2002 and June 29,
2001 are summarized as follows (in thousands):
March June
----------------- -----------------
First mortgage loans (principally conventional):
Real estate $ 168,880 $ 153,573
Construction 119,697 116,195
----------------- -----------------
288,577 269,768
----------------- -----------------
Consumer and other loans:
Commercial 25,033 18,757
Other 42,275 35,640
----------------- -----------------
67,308 54,397
----------------- -----------------
Factored receivables 8,639 11,021
----------------- -----------------
364,524 335,186
Unearned income (11,783) (11,957)
Allowance for possible loan losses (3,915) (3,280)
----------------- -----------------
$ 348,826 $ 319,949
================= =================
Impairment of loans with a recorded investment of approximately $8,435,000 and
$4,084,000 at March 28, 2002 and June 29, 2001, respectively, has been
recognized in conformity with SFAS No. 114 as amended by SFAS No. 118. An
analysis of the allowance for possible loan losses for the three- and nine-month
periods ended March 28, 2002 and March 30, 2001 is as follows (in thousands):
Three months ended Nine months ended
fiscal 2002 fiscal 2001 fiscal 2002 fiscal 2001
-------------------------------- --------------------------------
Balance at beginning of period $ 3,445 $ 2,778 $ 3,280 $ 3,699
Provision for loan losses 580 539 1,162 1,327
Loans charged to the allowance, net (110) (129) (527) (1,838)
-------------------------------- --------------------------------
Balance at end of period $ 3,915 $ 3,188 $ 3,915 $ 3,188
================================ ================================
SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED
At March 28, 2002 and June 29, 2001, the Company held securities owned and
securities sold, not yet purchased as follows (in thousands):
March June
--------------- ---------------
Securities owned
Corporate equity securities $ 9,590 $ 28,279
Municipal obligations 36,137 28,280
U.S. Government and Government agency obligations 17,177 26,361
Corporate obligations 33,255 40,240
Funds and trusts 20,675 22,914
--------------- ---------------
$ 116,834 $ 146,074
=============== ===============
Securities sold, not yet purchased
Corporate equity securities $ 2,804 $ 3,690
Municipal obligations 5,839 2,731
U.S. Government and Government agency obligations 4,506 19,150
Corporate obligations 6,181 2,904
Commercial paper 358 --
Funds and trusts 306 175
--------------- ---------------
$ 19,994 $ 28,650
=============== ===============
7
At March 28, 2002, the Company has pledged firm securities valued at $315,000 in
conjunction with securities lending activities.
SHORT-TERM BORROWINGS
The Company has credit arrangements with commercial banks, which include broker
loan lines up to $350,000,000. These lines of credit are used primarily to
finance securities owned, securities held for Correspondent broker/dealer
accounts and receivables in customers' margin accounts. These lines may also be
used to release pledged collateral against day loans. These credit arrangements
are provided on an "as offered" basis and are not committed lines of credit.
These arrangements can be terminated at any time by the lender. Any outstanding
balance under these credit arrangements is due on demand and bears interest at
rates indexed to the federal funds rate. At March 28, 2002, there was
$153,050,000 outstanding under these secured arrangements which were fully
collateralized by client securities valued at $207,194,000, firm securities
valued at $40,144,000 and non-client securities valued at $32,569,000. There
were no amounts outstanding under these secured arrangements at June 29, 2001.
In addition to the broker loan lines, the Company has a $20,000,000 unsecured
line of credit that is due on demand and bears interest at rates indexed to the
federal funds rate, $16,000,000 of which was outstanding at March 28, 2002.
There were no amounts outstanding under this line of credit at June 29, 2001.
The Company has an irrevocable letter of credit agreement aggregating
$55,000,000 and $80,000,000 at March 28, 2002 and June 29, 2001, respectively,
pledged to support its open options positions with an options clearing
organization. The letter of credit bears interest at the brokers' call rate, if
drawn, and is renewable annually. This letter of credit is fully collateralized
by marketable securities held in client and non-client margin accounts with a
value of $83,214,000 and $129,677,000 at March 28, 2002 and June 29, 2001,
respectively. The Company also has an unsecured letter of credit agreement
aggregating $4,595,000 at March 28, 2002 and June 29, 2001, pledged to support
its open positions with a securities clearing organization. The unsecured letter
of credit bears interest at the prime rate plus 3%, if drawn, and is renewable
semi-annually.
In addition to using customer securities to finance bank loans as mentioned
above, the Company also pledges client securities as collateral in conjunction
with the Company's securities lending activities. At March 28, 2002, the Company
has approximately $711,642,000 of client securities under customer margin loans
that are available to be pledged, of which the Company has repledged
approximately $13,521,000 under securities loan agreements. Also, the Company
has received collateral of approximately $1,847,955,000 under securities lending
agreements, of which the Company has repledged approximately $1,807,406,000 at
March 28, 2002.
At March 28, 2002 and June 29, 2001, the Company had no repurchase agreements
outstanding.
DEPOSITS
Deposits at March 28, 2002 and June 29, 2001 are summarized as follows (dollars
in thousands):
March June
Amount Percent Amount Percent
------------------------ -------------------------
Noninterest bearing demand accounts $ 15,268 5.2 % $ 22,406 6.6 %
Interest bearing demand accounts 15,371 5.3 5,088 1.5
Savings accounts 699 0.2 560 0.2
Limited access money market accounts 13,934 4.8 14,008 4.2
Certificates of deposit, less than $100,000 139,321 47.9 179,681 53.4
Certificates of deposit, $100,000 and greater 106,554 36.6 114,538 34.1
------------------------ -------------------------
$ 291,147 100.0 % $ 336,281 100.0 %
======================== =========================
8
The weighted average interest rate on deposits was approximately 3.81% at March
28, 2002 and 5.5% at June 29, 2001. At March 28, 2002, scheduled maturities of
certificates of deposit were as follows (in thousands):
2002 2003 2004 Thereafter Total
-------- -------- -------- ---------- --------
Certificates of deposit, less
than $100,000 $102,632 $ 16,936 $ 4,779 $ 14,974 $139,321
Certificates of deposit,
$100,000 and greater 94,236 3,909 2,623 5,786 106,554
-------- -------- -------- -------- --------
$196,868 $ 20,845 $ 7,402 $ 20,760 $245,875
======== ======== ======== ======== ========
ADVANCES FROM THE FEDERAL HOME LOAN BANK ("FHLB")
At March 28, 2002 and June 29, 2001, advances from the FHLB were due as follows
(in thousands):
March June
----------- -----------
Maturity:
Due within one year $ 142,085 $ 101,456
Due within two years -- 1,517
Due within five years 3,283 3,164
Due within seven years 551 223
Due within ten years 3,703 1,411
Due within twenty years 5,778 5,706
----------- -----------
$ 155,400 $ 113,477
=========== ===========
Pursuant to collateral agreements, the advances from the FHLB, with interest
rates ranging from 2.0% to 7.7%, are collateralized by approximately
$205,000,000 of collateral value (as defined) in qualifying first mortgage loans
at March 28, 2002. At June 29, 2001, advances with interest rates from 3.9% to
7.7% were collateralized by approximately $145,116,000 of collateral value in
qualifying first mortgages.
EXCHANGEABLE SUBORDINATED NOTES
The Company adopted Statement of Financial Accounting Standards No. 133 (SFAS
No. 133) "Accounting for Derivative Instruments and Hedging Activities", as
amended, effective July 1, 2000. SFAS No. 133 is applicable to the Notes due in
2004. The Company issued the Notes in June 1999 in the form of DARTS/SM/, or
Derivative Adjustable Ratio Securities/SM/. As mentioned above, 373,550 DARTS,
with a face value of $21.2 million, remain outstanding as of March 28, 2002 and
June 29, 2001. SFAS No. 133 requires fair value recognition of the Notes'
embedded derivative in the consolidated statements of financial condition.
Changes in the fair value of the embedded derivative are required to be
recognized in earnings, along with the change in fair value of the Knight
shares. Additionally, the change in the time value of the embedded equity option
in the DARTS must be recognized in earnings on a quarterly basis. For the three-
and nine-month periods ended March 28, 2002, the Company recognized losses of
$108,000 and $231,000, respectively, for the change in the time value of the
embedded equity option. The Company recognized losses of $12,000 and $2,006,000
in the three- and nine-month periods ended March 30, 2001 for the change in the
time value of the embedded equity option.
Recognition of the change in fair value of the embedded derivative requires
adjustment of the value of the embedded derivative on the consolidated
statements of financial condition. As of March 28, 2002, the Company decreased
the Notes' liability by approximately $1,341,000 in the third quarter of fiscal
2002, a net $1,095,000 decrease over June 29, 2001. The Company also
reclassified losses of $942,000 and $862,000, respectively, from other
comprehensive income (loss), net of tax of $507,000 and $464,000, respectively,
to earnings to record the value of the hedged Knight shares in the three- and
nine-month periods ended March 28, 2002. The Company reclassified a gain of
$167,000 and a net loss of
9
$24,118,000, respectively, from other comprehensive income (loss), net of tax of
$90,000 and $11,438,000, respectively, to earnings to record the value of the
hedged Knight shares in the three- and nine-month periods ended March 30, 2001.
The following table reflects the activity in the Notes' liability account for
the quarterly periods ended March 28, 2002 and March 30, 2001 (in thousands):
Fiscal 2002 Fiscal 2001
------------- -------------
Balance at beginning of fiscal year $ 8,568 $ 57,500
Change in value of embedded derivative (1,095) (12,297)
Adoption of SFAS No. 133 -- (17,956)
Repurchase of DARTS -- (17,402)
------------- -------------
Balance at end of third quarter $ 7,473 $ 9,845
============= =============
NET CAPITAL REQUIREMENTS
Brokerage Group. The broker/dealer subsidiaries are subject to the Securities
and Exchange Commission's Uniform Net Capital Rule (the "Rule"), which requires
the maintenance of minimum net capital. SWS, Inc. has elected to use the
alternative method, permitted by the Rule, which requires that it maintain
minimum net capital, as defined in Rule 15c3-1 under the 1934 Act, equal to the
greater of $1,500,000 or 2% of aggregate debit balances, as defined in Rule
15c3-3 under the 1934 Act. Clearing is a guaranteed affiliate of SWS, Inc.;
consequently, the excess net capital of Clearing is included in the consolidated
capital calculation of SWS, Inc. At March 28, 2002, SWS, Inc. had net capital of
$93,899,000, or approximately 20.6% of aggregate debit balances, which is
$84,792,000 in excess of its minimum net capital requirement of $9,107,000 at
that date. Additionally, the net capital rule of the New York Stock Exchange,
Inc. (the "Exchange") provides that equity capital may not be withdrawn or cash
dividends paid if resulting net capital would be less than 5% of aggregate debit
items. At March 28, 2002, SWS, Inc. had net capital of $71,130,000 in excess of
5% of aggregate debit items.
The broker/dealer subsidiaries are subject to a provision of Rule 15c3-1 which
requires that a broker-dealer notify the SEC prior to the withdrawal of equity
capital by a parent company if the withdrawal would exceed the greater of
$500,000 or 30 percent of the broker/dealer's excess net capital.
Clearing and May also follow the alternative method. At March 28, 2002, Clearing
had net capital of $28,185,000, or approximately 11% of aggregate debit
balances, which is $23,271,000 in excess of its minimum net capital requirement
of $4,914,000 at that date. At March 28, 2002, Clearing had net capital of
$15,901,000 in excess of 5% of aggregate debit items. May had net capital of
$916,000, which is $666,000 in excess of its net capital requirement of $250,000
at March 28, 2002.
SWSFS and MDB follow the primary (aggregate indebtedness) method under Rule
15c3-1, which requires the maintenance of minimum net capital of $250,000. At
March 28, 2002, the net capital and excess net capital were $319,000 and
$69,000, respectively, for SWSFS and $2,763,000 and $2,513,000, respectively,
for MDB.
Asset Management Group. Trust is subject to the capital requirements of the
Texas Department of Banking, and has a minimum capital requirement of
$1,000,000. Trust had total stockholder's equity of approximately $3,721,000,
which is $2,721,000 in excess of its minimum capital requirement at March 28,
2002.
Banking Group. FSB is subject to various regulatory capital requirements
administered by Federal agencies. Quantitative measures, established by
regulation to ensure capital adequacy, require the maintaining of minimum
amounts and ratios (set forth in the table below) of total and Tier I capital
(as defined in the regulations) to risk-weighted assets (as defined), and of
Tier I capital (as defined) to average assets (as defined). Management believes,
as of March 28, 2002, that FSB meets all capital adequacy requirements to which
it is subject.
10
As of March 28, 2002 and June 29, 2001, FSB is considered "well capitalized"
under the regulatory framework for prompt corrective action. To be categorized
as "well capitalized," FSB must maintain minimum total risk-based, Tier I
risk-based, Tier I leverage ratios as set forth in the table.
FSB's actual capital amounts and ratios are presented in the following tables
(in thousands):
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
Amount Ratio Amount Ratio Amount Ratio
----------------------- ---------------------- ----------------------
March 28, 2002:
Total capital (to risk weighted assets) $ 45,978 10.9 % $ 33,638 8.0 % $ 42,047 10.0 %
Tier I capital (to risk weighted assets) 43,716 10.4 16,819 4.0 25,228 6.0
Tier I capital (to adjusted total assets) 43,716 8.8 19,774 4.0 24,718 5.0
June 29, 2001:
Total capital (to risk weighted assets) $ 43,095 10.7 % $ 32,222 8.0 % $ 40,277 10.0 %
Tier I capital (to risk weighted assets) 42,020 10.4 16,111 4.0 24,166 6.0
Tier I capital (to adjusted total assets) 42,020 8.4 19,993 4.0 24,991 5.0
EARNINGS PER SHARE
A reconciliation between the weighted average shares outstanding used in the
basic and diluted EPS computations is as follows for the three- and nine-month
periods ended March 28, 2002 and March 30, 2001 (in thousands, except share and
per share amounts):
Three months ended Nine months ended
fiscal 2002 fiscal 2001 fiscal 2002 fiscal 2001
-------------------------------------------------------
Income before cumulative effect of a change in accounting
principle $ 1,047 $ 3,557 $ 4,754 $ 17,004
Cumulative effect of a change in accounting principle -- -- -- (2,874)
-------------------------------------------------------
Net income $ 1,047 $ 3,557 $ 4,754 $ 14,130
=======================================================
Weighted average shares outstanding - basic 17,225,307 17,479,065 17,208,497 17,478,261
Effect of dilutive securities:
Assumed exercise of stock options 87,572 74,753 67,868 104,630
-------------------------------------------------------
Weighted average shares outstanding - diluted 17,312,879 17,553,818 17,276,365 17,582,891
=======================================================
Earnings per share - basic
Income before cumulative effect of a change in accounting
principle $ .06 $ .20 $ .28 $ .97
Cumulative effect of a change in accounting principle -- -- -- (.16)
-------------------------------------------------------
Net income $ .06 $ .20 $ .28 $ .81
=======================================================
Earnings per share - diluted
Income before cumulative effect of a change in accounting
principle $ .06 $ .20 $ .28 $ .96
Cumulative effect of a change in accounting principle -- -- -- (.16)
-------------------------------------------------------
Net income $ .06 $ .20 $ .28 $ .80
=======================================================
11
At March 28, 2002, the Company had two stock option plans, the SWS Group, Inc.
Stock Option Plan (the "1996 Plan") and the SWS Group, Inc. 1997 Stock Option
Plan (the "1997 Plan"). At March 28, 2002, there were approximately 1,357,000
options outstanding under the 1996 Plan and approximately 72,000 options
outstanding under the 1997 Plan. As of March 28, 2002, 678,000 options were
antidilutive and therefore were not included in the calculation of weighted
average shares outstanding-diluted.
SEGMENT REPORTING
The Company operates three principal segments within the financial services
industry: the Brokerage Group, the Asset Management Group and the Banking Group.
The category "other consolidated entities" includes the Parent and Technologies.
The Parent is a holding company that owns various investments, including the
investment in Knight common stock. Technologies provides Internet design and
marketing strategies and other Internet-related services, as well as disaster
recovery services. There are no material reconciling adjustments included in
this category.
Asset other Consolidated
Brokerage Management Banking Consolidated SWS
(in thousands) Group Group Group Entities Group, Inc.
- -----------------------------------------------------------------------------------------------------------------------------------
Three months ended March 28, 2002
Net revenues from external sources $ 57,003 $ 5,806 $ 10,129 $ 4,581 $ 77,519
Net intersegment revenue (expense) (1,262) 205 -- 1,057 --
Income (loss) before income taxes and
minority interest in consolidated
subsidiaries (4,189) 2,134 2,009 2,441 2,395
Net income (loss) (2,219) 1,035 1,203 1,028 1,047
Nine months ended March 28, 2002
Net revenues from external sources $ 186,645 $ 16,323 $ 36,051 $ 16,855 $ 255,874
Net intersegment revenue (expense) (3,946) 598 (22) 3,370 --
Income (loss) before income taxes and
minority interest in consolidated
subsidiaries (12,870) 1,905 9,435 11,418 9,888
Net income (loss) (6,708) 240 5,639 5,583 4,754
Three months ended March 30, 2001
Net revenues from external sources $ 93,719 $ 5,126 $ 12,743 $ (640) $ 110,948
Net intersegment revenue (expense) (1,616) 149 (6) 1,473 --
Income (loss) before income taxes and
minority interest in consolidated
subsidiaries 3,689 2,001 3,241 (3,151) 5,780
Net income (loss) 3,029 1,234 1,887 (2,593) 3,557
Nine months ended March 30, 2001
Net revenues from external sources $ 308,458 $ 14,764 $ 39,710 $ 5,164 $ 368,096
Net intersegment revenue (expense) (5,294) 428 (53) 4,919 --
Income (loss) before income taxes and
minority interest in consolidated
subsidiaries 17,961 6,354 13,011 (9,022) 28,304
Net income (loss) 13,703 3,948 7,121 (10,642) 14,130
On the consolidated statements of income and comprehensive income (loss), the
cumulative effect of a change in accounting principle and other comprehensive
income (loss) are solely related to the Parent, which is included in the other
category. Minority interest is attributable to the Parent and the Bank. The
12
Parent's minority interest resulted from the sale of 19.82% of the Westwood
Group to members of Westwood Group's management in the second quarter of fiscal
2002.
COMMITMENTS AND CONTINGENCIES
The Company has issued a line of credit to FSBF LTD for $35 million, expiring
January 22, 2003. The line of credit bears interest at a rate of prime plus
1.5%, if drawn. At March 28, 2002, there were no amounts outstanding on the line
of credit.
On October 21, 1999, the Company filed an arbitration claim with the NASD
against a former correspondent broker dealer and its principal for
non-performance under the correspondent clearing agreement relating to a $5.7
million margin loan. On January 22, 2001, the Company was notified that it was
successful in obtaining a $4.7 million award against the correspondent
broker/dealer but was unsuccessful in its cause against the individual principal
of the correspondent firm. The Company is pursuing collection of the award. The
Company has fully reserved for this margin loan.
In the general course of our brokerage business and the business of clearing for
other brokerage firms, we have been named as defendants in various pending
lawsuits and arbitration proceedings. These claims allege violation of Federal
and state securities laws. FSB is also involved in certain claims and legal
actions arising in the ordinary course of business. We believe that resolution
of these claims will not result in any material adverse effect on our business,
consolidated financial condition or operating results.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
FACTORS AFFECTING FORWARD-LOOKING STATEMENTS
From time to time, SWS Group, Inc. (the "Parent") and subsidiaries
(collectively, the "Company") may publish "forward-looking statements" within
the meaning of section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities and Exchange Act of 1934, as amended, (the "Acts")
or make oral statements that constitute forward-looking statements. These
forward-looking statements may relate to such matters as anticipated financial
performance, future revenues or earnings, business prospects, projected
ventures, new products, anticipated market performance and similar matters. The
Private Securities Litigation Reform Act of 1995 provides a safe harbor for
forward-looking statements. In order to comply with the terms of the safe
harbor, the Company cautions readers that a variety of factors could cause the
Company's actual results to differ materially from the anticipated results or
other expectations expressed in the Company's forward-looking statements. These
risks and uncertainties, many of which are beyond the Company's control,
include, but are not limited to (1) transaction volume in the securities
markets; (2) volatility of the securities markets; (3) fluctuations in interest
rates; (4) changes in regulatory requirements which could affect the cost of
doing business; (5) general economic conditions, both domestic and foreign; (6)
state of the housing market; (7) changes in the rate of inflation and related
impact on financial markets; (8) competition from existing financial
institutions and other new participants in the financial markets; (9) legal
developments affecting the litigation experience of the financial services
industry; (10) successful implementation of technology solutions; (11) changes
in Federal and state tax laws which could affect the popularity of products sold
by the Company and (12) acts of terrorism and other acts of war. The Company
does not undertake any obligation to publicly update or revise any
forward-looking statements.
GENERAL
The Company is primarily engaged in securities execution and clearance,
securities brokerage, investment banking, securities lending and borrowing and
trading as a principal in equity and fixed income securities. The Company also
engages in full-service banking and asset management activities. All of these
activities are highly competitive and are sensitive to many factors outside the
control of the Company, including volatility of securities prices and interest
rates; trading volume of securities; economic conditions in the regions where
the Company does business; income tax legislation; and demand for financial
services. While revenues are dependent upon the level of trading and
underwriting volume, which may fluctuate significantly, a large portion of the
Company's expenses remain fixed. Consequently, net earnings can vary
significantly from period to period.
13
Westwood Spin-Off. In conjunction with the December 2001 announcement of the
Company's intention to spin-off the Westwood Group, the Westwood Group filed its
Form 10 with the Securities and Exchange Commission ("SEC") on February 8, 2002.
For every four shares of the Company's common stock owned, stockholders will
receive one share of the Westwood Group's common stock. The Company's Board of
Directors will set a record date and a distribution date of the Westwood Group's
common stock to the Company's stockholders once the SEC has completed its review
of the proposed transaction.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions that
affect reported amounts and disclosures. Actual results may differ from these
estimates under different assumptions or conditions. The following policies
involve a higher degree of judgment than do our other significant accounting
policies detailed in the Company's Annual Report Form 10-K as of June 29, 2001.
Contingencies. Accounting for contingencies requires the use of judgment and
estimates in assessing the magnitude and likely outcome. In many cases, the
outcome of such matters will be determined by third parties, including
governmental and judicial bodies. The provisions made in the consolidated
financial statements, as well as the related disclosures, represent management's
best estimates of the current status of such matters and their potential outcome
based on a review of the facts and in consultation with outside legal counsel.
Management evaluates and revises its estimates on a quarterly basis. Resolution
of these matters in amounts different from what has been accrued in the
consolidated financial statements could materially impact the Company's
financial position and results of operations.
Investments. The Company generally classifies its investment in debt instruments
(including corporate, government and municipal bonds), mortgage-backed
securities and marketable equity securities as either available-for-sale or
trading. The Company has not classified any investments as held-to-maturity. The
fair value of these securities is determined by obtaining quoted market prices.
Unrealized gains and losses on available-for-sale securities are included in
other comprehensive income and are excluded from earnings. Realized gains and
losses and declines in fair value judged to be other than temporary are included
in earnings.
The Company also holds investments in several privately-held companies, which
are recorded at cost on the Company's consolidated statements of financial
condition. Generally accepted accounting principles require that these holdings
be evaluated for declines in market value below cost that may be other than
temporary. Determination of the market value for these privately-held companies
requires the use of judgment. General market conditions, as well as
company-specific events, could indicate a decline in value. The consolidated
financial statements could be materially impacted should a write-down from cost
be necessitated.
Long-Lived Assets and Goodwill. The Company periodically assesses the impairment
of its long-lived assets and goodwill using judgment as to the effects of
external factors, including market conditions. Judgment is also required in
projecting future operating results. If actual external conditions and future
operating results differ from the Company's judgments, impairment charges may be
necessary to reduce the carrying value of these assets to the appropriate market
value.
Allowance for Possible Loan Losses. The Company provides an allowance for
possible loan losses, which is increased by charges to income and decreased by
charge-offs, net of recoveries. Management regularly reviews this allowance
based on past loan loss experience, known and inherent risks in the loan
portfolio, adverse situations that may affect the borrower's ability to repay,
the estimated value of any underlying collateral and current economic
conditions. Should actual losses differ from management's estimates, the
consolidated financial statements could be materially impacted.
RESULTS OF OPERATIONS
Net income for the three- and nine-month periods ended March 28, 2002 was
$1,047,000 and $4,754,000, respectively, representing decreases over comparable
prior year periods of $2,510,000, or 71%, and $9,376,000, or 66%, respectively.
SFAS No. 133. The adoption of Statement of Financial Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities", as amended,
("SFAS No. 133") in the first quarter of fiscal 2001 created a non-cash earnings
impact in the first quarters of both fiscal 2002 and 2001. SFAS No. 133 is
applicable to the Company's 5% Exchangeable Subordinated Notes, issued in the
form of DARTS/SM/ (or, "Derivative Adjustable Ratio Securities/SM/"). The DARTS
contain an equity-based derivative designed to hedge changes in fair value of
the Company's investment in Knight Trading Group, Inc. ("Knight") common stock.
The embedded derivative has been designated as a fair value hedge of the
Company's investment in Knight shares.
SFAS No. 133 requires fair value recognition of the DARTS' embedded derivative
in the consolidated statements of financial condition. Changes in the fair value
of the embedded derivative are required to be recognized in earnings, along with
the change in fair value of the Knight shares. Under SFAS No. 133, the Company
recognized a net transition loss in the first quarter of fiscal 2001, which
includes gains on the change in the value of the embedded derivative, net of
losses on the change in value of the corresponding Knight common stock
reclassified from other comprehensive income (loss). The net transition loss
represents the differences in the time value of money related to the embedded
derivative.
14
For the three- and nine-month periods ended March 28, 2002, the Company
recognized losses of $108,000 and $231,000, respectively, in the consolidated
statements of income and comprehensive income (loss), representing the change in
the time value of money in the embedded derivative. In the three- and nine-month
periods ended March 30, 2001, the Company recognized losses of $12,000 and
$2,006,000, respectively. Under SFAS No. 133, the related change in the time
value of money in the embedded derivative and the changes in the fair value of
the embedded derivative, along with the change in fair value of the hedged
Knight shares, will be calculated on a quarterly basis and recognized in the
consolidated statements of income and comprehensive income (loss) until such
time as the fair value hedge ceases to exist.
In December 2000, the Company repurchased and retired 640,782 DARTS. A like
number of Knight shares were released from the hedging provisions of SFAS No.
133. Upon final disposition of these previously hedged shares of Knight stock,
the Company will recognize a non-cash gain of approximately $23.50 per share,
net of tax, equal to the decrease in the value of Knight stock from the hedging
date (June 16, 1999), to the termination date of hedge accounting (December 20,
2000). The Company disposed of 100,000 shares and 426,000 shares of this
previously hedged stock in the three- and nine-month periods ended March 28,
2002, respectively. Therefore, non-cash gains of $3,616,000 and $15,402,000 on
the sale of stock were recorded in net gains from principal transactions in the
accompanying consolidated statements of income and comprehensive income (loss).
These non-cash gains were reclassified from accumulated other comprehensive
income net of tax of ($1,265,000) and ($5,390,000) for the three- and nine-month
periods ended March 28, 2002. There were no such gains in fiscal 2001.
Sale of Knight Stock. The cash gains on the 100,000 Knight shares sold in the
third quarter of fiscal 2002 totaled $697,000. These shares were sold to reduce
the Company's position and relative risk in Knight.
MJK Clearing. On October 2, 2001, a bankruptcy court awarded SWS Securities,
Inc. ("SWS, Inc.") the accounts of Minneapolis-based MJK Clearing ("MJK"). The
Securities Investor Protection Corporation assumed responsibility for the
accounts when MJK reported that it was in violation of minimum capital
requirements. The accounts of MJK Clearing were transferred to the Company's
wholly-owned subsidiary, Southwest Clearing Corp. ("Clearing"). On April 8,
2002, these accounts, which represent $12 billion in assets and 47
correspondents, were converted to SWS, Inc.
Net Income from Operating Activities. A calculation of the Company's brokerage,
asset management and banking income, excluding the aforementioned and other
non-recurring non-cash items for fiscal 2002 and 2001 follows (in thousands):
Three months ended Nine months ended
fiscal 2002 fiscal 2001 fiscal 2002 fiscal 2001
-----------------------------------------------------------
Net income $ 1,047 $ 3,557 $ 4,754 $ 14,130
Cash gain on sale of 100,000 shares of Knight stock (453) -- (453) --
SFAS No. 133:
Non-cash gain on sale of Knight stock released
from hedge under SFAS No. 133, net of tax (2,350) -- (10,011) --
Cumulative effect of a change in accounting
principal, net of tax -- -- -- 2,874
Loss on hedging activities, net of tax 70 8 151 1,304
Westwood Group spin-off:
Compensation charge, net of minority interest -- -- 2,741 --
Loan discount, net of tax and minority interest -- -- 290 --
Gain on sale of First Consumer, net of tax -- -- (780) --
-----------------------------------------------------------
$ (1,686) $ 3,565 $ (3,308) $ 18,308
===========================================================
15
After adjusting for the items mentioned above, net income decreased $5,251,000,
or 147%, and $21,616,000, or 118%, in the three- and nine-month periods ended
March 28, 2002 over the comparable prior year periods. These decreases are
attributed to reduced stock loan balances and tightened margins and reduced
volume in the clearing business. Additionally, the Company's operations were
impacted by the closure of the U.S. financial markets in the wake of the
tragedies of September 11. There were 182 trade days in the first nine months of
fiscal 2002 versus 188 trade days in the first nine months of fiscal 2001.
The following is a summary of increases (decreases) in categories of net
revenues and operating expenses for the three- and nine-month periods ended
March 28, 2002 and March 30, 2001 (dollars in thousands):
Three months ended Nine months ended
Amount Percent Amount Percent
----------------------- ------------------------
Net revenues:
Net revenues from clearing operations $ (3,727) (31%) $(14,629) (37%)
Commissions 2,517 15% 7,468 16%
Net interest (3,882) (21%) (17,372) (28%)
Investment banking, advisory and administrative fees 1,630 19% 4,184 16%
Net gains on principal transactions (2,861) (24%) 1,783 6%
Other 109 3% (7,400) (38%)
------------------------ ------------------------
$ (6,214) (9%) $(25,966) (11%)
------------------------ ------------------------
Operating expenses:
Commissions and other employee compensation $ (4,212) (11%) $ (7,248) (7%)
Occupancy, equipment and computer service costs 3,483 39% 10,044 39%
Communications 936 22% 2,682 23%
Floor brokerage and clearing organization charges 510 30% 1,153 23%
Advertising and promotional (3,119) (75%) (5,177) (43%)
Other (427) (5%) (9,004) (26%)
------------------------ ------------------------
(2,829) (4%) (7,550) (4%)
------------------------ ------------------------
Income before income taxes and minority interest $ (3,385) (59%) $(18,416) (65%)
======================== ========================
Net Revenues from Clearing Operations. Net revenues from clearing decreased as a
result of a decrease in transaction volumes and lower clearing fees per
transaction. Total transactions processed in the third quarter of fiscal 2002
decreased 7% to approximately 15 million from approximately 16.1 million in the
third quarter of fiscal 2001. For the nine-month period, transactions decreased
8% to approximately 42.1 million from 45.8 million in the same period of the
prior year. Margin pressure impacted net clearing revenues in the three- and
nine-month periods ended March 28, 2002 as average revenue per trade declined to
$.55 and $.59, respectively, for both periods from $.75 and $.86 for the three-
and nine-month periods ended March 30, 2001, respectively. Trade volume was
reduced due to fewer trading days in the first nine months of fiscal 2002 as
well as general market conditions. Clearing added approximately 248,000
transactions and $.7 million in clearing revenue in the third quarter of fiscal
2002 and 584,000 transactions and $1.9 million in the nine months ended March
28, 2002.
Commissions. In the three- and nine-month periods ended March 28, 2002,
commission revenue increased. This increase comes despite fewer trading days in
the first nine months of fiscal 2002 over the first nine months of fiscal 2001.
Increased commissions generated by the Company's fixed income, institutional
sales and program trading departments were offset by decreased commissions from
the SWS Financial Services, Inc. ("SWSFS") independent contractor network.
16
Commission revenue by type of representative is as follows (dollars in
thousands):
March 28, 2002 March 30, 2001
---------------------------------------- -------------------------------------------
Three months Nine months No. Three months Nine months No.
ended ended of reps ended ended of reps
---------------------------------------- ------------------------------------------
SWS, Inc. brokers $10,467 $29,822 135 $ 8,828 $24,199 116
Independent contractors 4,739 13,610 411 5,260 16,316 473
Other 4,271 12,165 2,872 7,614
------- ------- ------- -------
$19,477 $55,597 $16,960 $48,129
======= ======= ======= =======
Net Interest Income. The Company's net interest income is dependent upon the
level of customer and stock loan balances as well as the spread between the
rates it earns on those assets compared with the cost of funds. Net interest is
the primary source of income for FSB and represents the amount by which interest
and fees generated by earning assets exceed the cost of funds, primarily
interest paid to FSB's depositors on interest-bearing accounts. The components
of interest earnings are as follows (in thousands) for the three- and nine-month
periods ended March 28, 2002 and March 30, 2001:
Three months ended Nine months ended
fiscal 2002 fiscal 2001 fiscal 2002 fiscal 2001
--------------------------------- ----------------------------------
Interest revenue:
Customer margin accounts $ 7,240 $ 11,277 $ 22,938 $ 43,699
Assets segregated for
regulatory purposes 1,991 4,578 7,209 13,360
Stock borrowed 6,239 28,023 30,468 102,079
Loans 9,885 11,089 32,149 33,444
Other 1,641 3,126 5,766 9,576
--------------------------------- ----------------------------------
$ 26,996 $ 58,093 $ 98,530 $202,158
--------------------------------- ----------------------------------
Interest expense:
Customer funds on deposit $ 2,807 $ 9,340 $ 11,911 $ 33,096
Stock loaned 4,656 25,000 24,779 90,580
Deposits 3,172 4,472 11,493 13,140
Other 2,113 1,151 6,316 3,939
--------------------------------- ----------------------------------
12,748 39,963 54,499 140,755
--------------------------------- ----------------------------------
Net interest $ 14,248 $ 18,130 $ 44,031 $ 61,403
================================= ==================================
Brokerage Group. For both the three- and nine-month periods ended March 28,
2002, net interest income accounted for 13% of the Company's net revenue versus
17% and 19% for the three- and nine-month periods ended March 30, 2001. Average
balances of interest-earning assets and interest-bearing liabilities are as
follows (in thousands):
Three months ended Nine months ended
fiscal 2002 fiscal 2001 fiscal 2002 fiscal 2001
------------------------------------------------------------
Average interest-earning assets:
Customer margin balances $ 596,000 $ 499,000 $ 531,000 $ 632,000
Stock borrowed 1,875,000 2,356,000 1,941,000 2,653,000
Average interest-bearing liabilities:
Customer funds on deposit 791,000 738,000 776,000 824,000
Stock loaned 1,845,000 2,358,000 1,915,000 2,654,000
17
Average margin balances for the third quarter of fiscal 2002 are higher than for
the nine-month period ended March 28, 2002 due to an average of $248 million in
margin accounts at Clearing. Rates on customer margin balances and funds on
deposit are influenced by changes in leading market interest rates and
competitive factors. Spreads on securities lending transactions are influenced
by the types of securities borrowed or loaned, market conditions and
counter-party risk.
Banking Group. Net interest revenue generated by the Bank accounted for
approximately 9% of net revenue for both the three- and nine-month periods ended
March 28, 2002 and 8% for both the three- and nine-month periods ended March 30,
2001. At the Bank, changes in net interest revenue are generally attributable to
the timing of loan payoffs and volume.
The following table sets forth an analysis of the Bank's net interest income by
each major category of interest-earning assets and interest-bearing liabilities
for the three-month periods ended March 28, 2002 and March 30, 2001 (dollars in
thousands):
Three months ended
fiscal 2002 fiscal 2001
------------------------------------------------------------------
Interest Interest
Average Income/ Yield/ Average Income/ Yield/
Balance Expense Rate Balance Expense Rate
------------------------------- ----------------------------------
Assets:
Interest-earning assets:
Real estate - mortgage $151,827 $ 2,779 7.3% $105,465 $ 2,914 11.1%
Real estate - construction 119,394 2,112 7.1% 99,108 2,482 10.0%
Commercial 115,988 2,403 8.3% 89,370 2,596 11.6%
Individual 35,026 1,977 22.6% 33,194 2,019 24.3%
Land 39,691 614 6.2% 38,938 1,078 11.1%
Investments 11,067 72 2.6% 12,494 174 5.6%
-------------------- -------------------
472,993 $ 9,957 8.4% 378,569 $ 11,263 11.9%
Noninterest-earning assets:
Cash and due from banks 1,662 2,818
Other assets 13,818 9,416
-------- --------
$488,473 $390,803
======== ========
Liabilities and Stockholders' Equity:
Interest-bearing liabilities:
Certificates of deposit $287,160 $ 3,083 4.3% $259,697 $ 4,320 6.7%
Money market accounts 14,251 60 1.7% 10,322 116 4.5%
Interest-bearing demand accounts 7,542 27 1.4% 3,724 32 3.4%
Savings accounts 757 2 1.1% 548 4 2.9%
Federal Home Loan Bank ("FHLB") advances 107,070 717 2.7% 49,579 668 5.4%
Notes payable 2,596 40 6.2% 6,867 160 9.3%
-------------------- -------------------
419,376 3,929 3.7% 330,737 5,300 6.4%
Noninterest-bearing liabilities:
Non interest-bearing demand accounts 17,988 13,247
Other liabilities 6,344 8,956
-------- --------
443,708 352,940
Stockholders' equity 44,765 37,863
-------- --------
$488,473 $390,803
======== ========
-------- --------
Net interest income $ 6,028 $ 5,963
======== ========
Net yield on interest-earning assets 5.1% 6.3%
==== ====
18
The following table sets forth an analysis of the Bank's net interest income by
each major category of interest-earning assets and interest-bearing liabilities
for the nine-month periods ended March 28, 2002 and March 30, 2001 (dollars in
thousands):
Nine months ended
fiscal 2002 fiscal 2001
------------------------------------------------------------------
Interest Interest
Average Income/ Yield/ Average Income/ Yield/
Balance Expense Rate Balance Expense Rate
-------------------------------- --------------------------------
Assets:
Interest-earning assets:
Real estate - mortgage $ 158,998 $ 9,617 8.1% $ 95,871 $ 8,584 11.9%
Real estate - construction 120,627 6,689 7.4% 93,276 7,700 11.0%
Commercial 112,059 8,025 9.6% 85,830 8,135 12.6%
Individual 32,724 5,668 23.1% 27,746 5,689 27.3%
Land 38,354 2,150 7.5% 38,310 3,336 11.6%
Investments 10,167 317 4.2% 11,813 546 6.2%
---------------------- ----------------------
472,929 $ 32,466 9.2% 352,846 $ 33,990 12.8%
Noninterest-earning assets:
Cash and due from banks 2,947 3,561
Other assets 12,244 7,807
---------- -----------
$ 488,120 $ 364,214
========== ===========
Liabilities and Stockholders' Equity:
Interest-bearing liabilities:
Certificates of deposit $ 285,193 $ 11,095 5.2% $ 255,926 $ 12,654 6.6%
Money market accounts 15,862 288 2.4% 11,562 395 4.6%
Interest-bearing demand accounts 6,804 102 2.0% 3,221 80 3.3%
Savings accounts 707 8 1.5% 526 11 2.8%
FHLB advances 107,661 2,567 3.2% 32,752 1,477 6.0%
Notes payable 1,733 126 9.7% 3,638 328 12.0%
---------------------- ----------------------
417,960 14,186 4.5% 307,625 14,945 6.5%
Noninterest-bearing liabilities:
Non interest-bearing demand accounts 18,188 13,159
Other liabilities 8,657 7,769
---------- -----------
444,805 328,553
Stockholders' equity 43,315 35,661
---------- -----------
$ 488,120 $ 364,214
========== ===========
-------- --------
Net interest income $ 18,280 $ 19,045
======== ========
Net yield on interest-earning assets 7.7% 10.8%
===== ======
Interest rate trends, changes in the economy and the scheduled maturities and
interest rate sensitivity of the investment and loan portfolios and deposits
affect the spreads earned by FSB. For the three- and nine-month periods ended
March 28, 2002, net interest revenue has fluctuated little over the prior year
despite higher loan balances. Although average loan balances have increased, the
decline in interest rates has reduced spreads at the Bank, causing a decline in
net interest revenue in the three- and nine-month periods ended March 28, 2002.
19
The following table sets forth a summary of the changes in the Bank's interest
earned and interest paid resulting from changes in volume and rate for the
three- and nine-month periods ended March 28, 2002 and March 30, 2001 (dollars
in thousands):
Three months ended Nine months ended
fiscal 2002 vs. 2001 fiscal 2002 vs. 2001
------------------------------------------------ ----------------------------------------------
Total Attributed to Total Attributed to
----------------------------------- ----------------------------------
Change Volume Rate Mix Change Volume Rate Mix
------------------------------------------------ ----------------------------------------------
Interest income:
Real estate - mortgage $ (135) $ 1,280 $ (983) $ (432) $ 1,033 $ 5,732 $ (2,776) $ (1,923)
Real estate - construction (370) 508 (729) (149) (1,011) 2,293 (2,545) (759)
Commercial (193) 773 (744) (222) (110) 2,486 (1,996) (600)
Individual (42) 112 (146) (8) (21) 1,053 (890) (184)
Land (464) 21 (476) (9) (1,186) 3 (1,183) (6)
Investments (102) (23) (111) 32 (229) (76) (187) 34
------------------------------------------------ ----------------------------------------------
$ (1,306) $ 2,671 $ (3,189) $ (788) $ (1,524) $ 11,491 $ (9,577) $ (3,438)
------------------------------------------------ ----------------------------------------------
Interest expense:
Certificates of deposit $ (1,237) $ 457 $ (1,532) $ (162) $ (1,559) $ 1,441 $ (2,722) $ (278)
Money market accounts (56) 44 (73) (27) (107) 147 (186) (68)
Interest-bearing demand
accounts (5) 33 (19) (19) 22 88 (33) (33)
Savings accounts (2) 1 (2) (1) (3) 3 (4) (2)
Federal Home Loan Bank
advances 49 731 (286) (396) 1,090 3,440 (521) (1,829)
Notes payable (120) (100) (53) 33 (202) (91) (48) (63)
------------------------------------------------ ----------------------------------------------
(1,371) 1,166 (1,965) (572) (759) 5,028 (3,514) (2,273)
------------------------------------------------ ----------------------------------------------
Net interest income
(expense) $ 65 $ 1,505 $ (1,224) $ (216) $ (765) $ 6,463 $ (6,063) $ (1,165)
================================================ ==============================================
Investment Banking, Advisory and Administrative fees. Fees for the three- and
nine-month periods ended March 28, 2002 have increased over the comparable prior
year periods primarily due to growth in the Westwood Group. Average assets under
management have increased to $4 billion from $3.5 billion in the third quarters
of fiscal 2002 and 2001, respectively, and to $3.9 billion from $3.4 billion in
the first nine months of fiscal 2002 and 2001, respectively. Also contributing
to the increase were increased revenues from money market fees from Clearing.
Net Gains on Principal Transactions. For the three- and nine-month periods ended
March 28, 2002, net gains on principal transactions includes $.7 million and
$4.4 million, respectively, of gains realized on the sale of Knight common
stock. The shares sold in the first six months of fiscal 2002 of were used to
fund advertising commitments of Mydiscountbroker.com, Inc. ("MDB"), the
Company's on-line brokerage subsidiary, while shares were sold in the third
quarter of fiscal 2002 to reduce the Company's Knight exposure. For the three-
and nine-month periods ended March 30, 2001, $3.2 million and $8.4 million,
respectively, represent the gains on sales to fund MDB's advertising
commitments. Net gains also include the previously mentioned $3.6 million and
$15.4 million gains related to SFAS No. 133 in the three- and nine-month periods
ended March 28, 2002, respectively.
Excluding these gains, net gains on principal transactions from the Company's
trading operations were $4.7 million and $14.2 million for the three- and
nine-month periods ended March 28, 2002, respectively, and $8.6 million and
$23.9 million for the three- and nine-month periods ended March 30, 2001,
respectively. The decrease is attributed to a weakened trading environment in
the equity markets in the first nine months of fiscal 2002. Fewer trading days
as a result of the closure of the U.S. financial markets following September 11
also impacted the nine-month results.
Coverage from market making activities has increased to 943 over-the-counter
securities and 638 exchange-listed securities from 655 over-the-counter
securities and 508 listed securities. Revenue in this area can fluctuate
significantly from quarter to quarter based on market conditions.
20
Other Revenue. Other revenue decreased in the nine months ended March 28, 2002
from the same period of the prior fiscal year in part due to a one-time gain in
fiscal 2001. The Company received a net distribution of earnings of $2.2 million
from JAWS Trading LLC, a designated primary market maker on the Chicago Board
Options Exchange. The Company no longer owns the investment in JAWS Trading LLC.
Additionally, FSB had higher gains on the sale of assets and SWSFS had higher
revenue from insurance products in fiscal 2001.
Commissions and Other Employee Compensation. Commissions and other employee
compensation are generally affected by the level of operating revenues, earnings
and the number of employees. Excluding $4 million in non-cash compensation
charges incurred by the Westwood Group in the second quarter of fiscal 2002 as a
result of the announced spin-off, compensation expense decreased $4.2 million
and $11.2 million in the three- and nine-month periods ended March 28, 2002 over
the comparable prior year periods.
The decrease in compensation was principally due to decreased commissions and
benefits paid to revenue-producing employees generating lower levels of
operating income and due to the decrease in headcount in both operations and
information technology areas. Additionally, accruals for profit sharing and
incentive compensation decreased over the prior year due to the operating
performance of the Company. The number of full-time employees decreased to 1,080
at March 28, 2002 compared to 1,164 at March 30, 2001.
Occupancy, Equipment and Computer Service Costs. Occupancy, equipment and
computer service costs increased for both the three- and nine-month periods
ended March 28, 2002 over the same period of the prior year due to the cost of
operating the systems at Clearing, as well as rent and other occupancy costs for
the new Michigan and New Jersey equity trading offices.
Communications. The increase in communications expense for both the three- and
nine-month periods ended December 31, 2001 is due to costs incurred by Clearing,
as well as the expansion of the equity trading division.
Floor Brokerage. The additional clearing business at Clearing resulted in
increased floor brokerage expense during for both the three- and nine-month
periods ended March 28, 2002.
Advertising and Promotional. Advertising and promotional expense decreased in
the third quarter of fiscal 2002, as MDB completed its advertising campaign in
the second quarter. No shares of Knight were sold to fund MDB's expenses in the
quarter ended March 28, 2002, but 326,000 shares of Knight common stock were
sold to offset advertising commitments in the nine-month period ended March 28,
2002 (see Net Gains on Principal Transactions). MDB core accounts were 21,420 at
March 28, 2002 and 22,728 at March 30, 2001.
Other Expense. Other expense decreased due to reduced use of contract labor and
professional consulting services in the Dallas operations and information
systems areas in the three- and nine-month periods ended March 28, 2002 over the
comparable period of the prior year, as well a reduction in legal and
professional service fees. Additionally, the second quarter of the prior fiscal
year included approximately $3 million in non-cash charges related to SFAS No.
133. Offsetting these decreases is an increase in contract labor related to
processing the Clearing's business in Minneapolis, MN.
21
FINANCIAL CONDITION
Loans and Allowance for Possible Loan Losses. The Bank grants loans to customers
primarily within the Dallas/Fort Worth, Texas metropolitan area. Also, the Bank
purchases loans, in the ordinary course of business, which have been originated
in various other areas of the United States. Although the Bank has a diversified
loan portfolio, a substantial portion of its debtors' ability to honor their
contracts is dependent upon the general economic conditions of the area.
Substantially all of the Bank's loans are collateralized with real estate or
automobiles. Loans receivable at March 28, 2002 and June 29, 2001 are summarized
as follows (in thousands):
March June
-----------------------------
Real estate - mortgage $ 149,590 $ 187,967
Real estate - construction 122,165 126,771
Commercial 119,611 92,855
Individuals 37,163 31,982
Land 38,304 35,399
------------ ------------
$ 466,833 $ 474,974
============ ============
The following table shows the expected life of certain loans at March 28, 2002,
and segregates those loans with fixed interest rates from those with floating or
adjustable rates (in thousands):
1 year 1-5 Over 5
or less years years Total
-------------------------------------------- --------------
Commercial $ 28,845 $ 30,192 $60,574 $ 119,611
Real estate - construction 118,377 1,348 2,440 122,165
-------------------------------------------- --------------
Total $ 147,222 $ 31,540 $ 63,014 $ 241,776
============================================ ==============
Amount of loans based upon:
Fixed interest rates $ 3,576 $ 10,057 $ 31,658 $ 45,291
Floating or adjustable interest rates 143,805 21,431 31,249 196,485
-------------------------------------------- --------------
Total $ 147,381 $ 31,488 $ 62,907 $ 241,776
============================================ ==============
Loans are classified as non-performing when they are 90 days or more past due as
to principal or interest or when reasonable doubt exists as to timely
collectibility. A standardized review process exists to determine which loans
should be placed on non-accrual status. At the time a loan is placed on
non-accrual status, previously accrued and uncollected interest is reversed
against interest income. Interest income on non-accrual loans is credited to
income on a cash basis. Non-performing assets as of March 28, 2002 and June 29,
2001 are as follows (dollars in thousands):
March June
-----------------------------
Loans accounted for on a non-accrual
basis $ 8,435 $ 4,084
============= ============
Non-performing loans as a percentage
of total loans 1.8% 0.9%
============= ============
Loans past due 90 days or more, not
included above $ 2,067 $ 608
============= ============
Troubled debt restructurings $ 950 $ 446
============= ============
22
An analysis of the allowance for possible loan losses for the three- and
nine-month periods ended March 28, 2002 and March 30, 2001 is as follows
(dollars in thousands):
Three months ended Nine months ended
fiscal 2002 fiscal 2001 fiscal 2002 fiscal 2001
---------------------------------------------------------------
Balance at beginning of period $ 3,445 $ 2,778 $ 3,280 $ 3,699
Charge-offs:
Commercial 5 -- 8 --
Real estate - mortgage -- 9 29 27
Individuals 154 178 819 2,072
------------- ------------ ------------- ------------
159 187 856 2,099
Recoveries:
Real estate - mortgage -- 3 -- 6
Individuals 49 55 329 255
------------- ------------ ------------- ------------
49 58 329 261
------------- ------------ ------------- ------------
Net charge-offs (110) (129) (527) (1,838)
Additions charged to operations 580 539 1,162 1,327
------------- ------------ ------------- ------------
Balance at end of period $ 3,915 $ 3,188 $ 3,915 $ 3,188
============= ============ ============= ============
Ratio of net charge-offs during the
period to average loans outstanding
during the period 0.02% 0.04% 0.11% 0.54%
============= ============ ============= ============
The allowance for possible loan losses is applicable to the following types of
loans as of March 28, 2002 and June 29, 2001 (dollars in thousands):
March June
--------------------- -----------------------
Percent Percent
of loans of loans
to total to total
Amount loans Amount loans
-------------------------------------------------
Commercial $ 713 25.6 % $ 462 19.6 %
Real estate - construction 1,171 26.2 837 26.7
Real estate - mortgage 989 32.0 439 39.6
Individuals 709 8.0 797 6.7
Land 333 8.2 250 7.4
Unallocated -- -- 495 --
--------------------- -----------------------
$3,915 100.0 % $3,280 100.0 %
===================== =======================
Deposits. Average deposits and the average interest rate paid on the deposits
for the three- and nine-month periods ended March 28, 2002 and March 30, 2001
can be found in the discussion of the Banking Group's Net Interest Income.
Certificates of deposit of $100,000 or greater were $106,554,000 and
$114,538,000 at March 28, 2002 and June 29, 2001, respectively.
23
Advances from Federal Home Loan Bank. The Bank finances its short-term borrowing
needs through advances from the FHLB. This table represents advances from the
FHLB which were due within one year, generally 1-7 days, during the three- and
nine-month periods ended March 28, 2002 and March 30, 2001 (dollars in
thousands):
Three months ended Nine months ended
fiscal 2002 fiscal 2001 fiscal 2002 fiscal 2001
--------------------- --------------------- --------------------- --------------------
Interest Interest Interest Interest
Amount Rate Amount Rate Amount Rate Amount Rate
----------- --------- -- ----------- --------- -- ----------- --------- --- ----------- --------
At end of period $ 142,085 2.1 % $ 45,090 5.1 % $ 142,085 2.1 % $ 45,090 5.1 %
Average during period 93,742 2.2 % 37,790 5.1 % 94,526 3.2 % 22,900 5.8 %
Maximum month-end balance
during period 142,085 -- 88,000 -- 144,000 -- 88,000 --
LIQUIDITY AND CAPITAL RESOURCES
Brokerage Group. The Company's assets are substantially liquid in nature and
consist mainly of cash or assets readily convertible into cash. These assets are
financed by the Company's equity capital, short-term bank borrowings, interest
bearing and non-interest bearing client credit balances, Correspondent deposits
and other payables. The Company maintains an allowance for doubtful accounts
which represents amounts, in the judgment of management, that are necessary to
adequately absorb losses from known and inherent risks in receivables from
clients, clients of Correspondents and Correspondents.
The Company has credit arrangements with commercial banks, which include broker
loan lines up to $350,000,000. These lines of credit are used primarily to
finance securities owned, securities held for Correspondent broker/dealer
accounts and receivables in customers' margin accounts. These lines may also be
used to release pledged collateral against day loans. These credit arrangements
are provided on an "as offered" basis and are not committed lines of credit.
These arrangements can be terminated at any time by the lender. Any outstanding
balance under these credit arrangements is due on demand and bears interest at
rates indexed to the federal funds rate. At March 28, 2002, there was
$153,050,000 outstanding under these secured arrangements which were fully
collateralized by client securities valued at $207,194,000, firm securities
valued at $40,144,000 and non-client securities valued at $32,569,000.
In addition to the broker loan lines, the Company has a $20,000,000 unsecured
line of credit that is due on demand and bears interest at rates indexed to the
federal funds rate, $16,000,000 of which was outstanding at March 28, 2002.
The Company has an irrevocable letter of credit agreement aggregating
$55,000,000 at March 28, 2002 pledged to support its open options positions with
an options clearing organization. The letter of credit bears interest at the
brokers' call rate, if drawn, and is renewable annually. This letter of credit
is fully collateralized by marketable securities held in client and non-client
margin accounts with a value of $83,214,000 at March 28, 2002. The Company also
has an unsecured letter of credit agreement aggregating $4,595,000 at March 28,
2002, pledged to support its open positions with a securities clearing
organization. The unsecured letter of credit bears interest at the prime rate
plus 3%, if drawn, and is renewable semi-annually.
The Company has issued $57.5 million of Notes due June 30, 2004. At maturity,
the principal of the Notes will be paid in shares of the Class A common stock of
Knight or, at the option of the Company, their cash equivalent. The Notes, which
are in the form of DARTS/SM/ (or, "Derivative Adjustable Ratio Securities/SM/"),
were issued in denominations of $56.6875, the closing bid price of Knight on
June 10, 1999. At maturity, Noteholders are entitled to one share of Knight
common stock for each DARTS if the average price for the 20 days immediately
preceding the Notes' maturity is equal to or less than the DARTS issue price.
Noteholders are entitled to .833 shares of Knight common stock for each DARTS if
the average price of Knight's common stock is 20% or more greater than the
DARTS' issue price. If the average price of the Knight common stock is between
the Notes' issue price and 20% greater than the
24
issue price, the exchange rate will be determined by a formula. At March 28,
2002, the Company had 373,550 DARTS outstanding with a face value of $21.2
million. After adjusting for the impact of SFAS No. 133, the DARTS are recorded
at $7.5 million on the consolidated statements of financial condition at March
28, 2002.
The Company's broker/dealer subsidiaries are subject to the requirements of the
Securities and Exchange Commission relating to liquidity, capital standards and
the use of client funds and securities. The Company has historically operated in
excess of the minimum net capital requirements.
Banking Group. FSB's asset and liability management policy is intended to manage
interest rate risk. FSB accomplishes this through management of the repricing of
its interest-earning assets and its interest-bearing liabilities. Overall
interest rate risk is monitored through reports showing both sensitivity ratios,
a simulation model, and existing "gap" data.
Liquidity is monitored daily to ensure the ability to support asset growth, meet
deposit withdrawals, lending needs, maintain reserve requirements, and otherwise
sustain operations. FSB's liquidity is maintained in the form of readily
marketable loans, balances with the FHLB, vault cash, and advances from the
FHLB. In addition, FSB has significant borrowing capacity with the FHLB for the
purpose of purchasing short-term funds should additional liquidity be needed.
Management believes that FSB's present position is adequate to meet its current
and future liquidity needs.
FSB is subject to extensive capital standards imposed by regulatory bodies,
including the Office of Thrift Supervision and the Federal Deposit Insurance
Corporation. FSB has historically met all the capital adequacy requirements to
which it is subject.
Cash Flow. Net cash used in operating activities during the nine-month period
ended March 28, 2002 was $143,993,000. The use of cash is primarily attributable
to the increase in assets segregated for regulatory purposes and the net change
in the receivable from brokers, dealers and clearing organizations.
MARKET RISK
Market risk generally represents the risk of loss that may result from the
potential change in value of a financial instrument as a result of fluctuations
in interest rates, equity prices, and changes in credit ratings of the issuer.
The Company's exposure to market risk is directly related to its role as a
financial intermediary in customer-related transactions and to its proprietary
trading activities.
Interest Rate Risk. Interest rate risk is a consequence of maintaining inventory
positions and trading in interest-rate-sensitive financial instruments. The
Company does not maintain material positions in interest-rate-sensitive
financial instruments. The Company's fixed income activities also expose it to
the risk of loss related to changes in credit spreads. Credit spread risk arises
from the potential that changes in an issuer's credit rating or credit
perception could affect the value of financial instruments. At FSB, interest
rate risk arises when an interest-earning asset matures or when its rate of
interest changes in a timeframe different from that of the supporting
interest-bearing liability.
Equity Price Risk. The Company is exposed to equity price risk as a result of
making markets and taking proprietary positions in equity securities. Equity
price risk results from changes in the level or volatility of equity prices,
which affect the value of equity securities or instruments that derive their
value from a particular stock, a basket of stocks or a stock index.
25
In accordance with the Securities and Exchange Commission's risk disclosure
requirements, the following table categorizes securities owned, net of
securities sold, not yet purchased which are in the Company's trading portfolio,
as well as marketable equity securities in the Company's available-for-sale
portfolio, which are subject to interest rate and equity price risk (in
thousands):
Years to Maturity
1 or less 1 to 5 5 to 10 Over 10 Total
- ----------------------------------------------------------------------------------------------------------------------
Trading securities, at fair value
Municipal obligations $ 205 $ 1,220 $ 9,514 $ 19,359 $ 30,298
U.S. Government and Government agency
obligations 6,556 4,137 1,419 559 12,671
Corporate obligations 2,184 10,411 3,709 10,770 27,074
----------------------------------------------------------------------
Total debt securities 8,945 15,768 14,642 30,688 70,043
Corporate equity -- -- -- 6,786 6,786
Other 20,011 -- -- -- 20,011
----------------------------------------------------------------------
$ 28,956 $ 15,768 $ 14,642 $ 37,474 $ 96,840
======================================================================
Weighted average yield
Municipal obligations 2.0% 3.6% 4.5% 4.9% 4.7%
U.S. Government and Government agency
obligations 3.9% 3.5% 5.5% 6.7% 5.0%
Corporate obligations 8.9% 7.5% 7.3% 10.7% 8.9%
Available-for-sale securities, at fair value
Marketable equity securities $ -- $ -- $ -- $ 5,220 $ 5,220
======================================================================
Exchangeable Subordinated Debt. In addition to the financial instruments
included in the above table, the Company has 373,550 DARTS outstanding with a
face value of $21.2 million. These Notes mature June 30, 2004 and bear a fixed
coupon of 5%. Market risks associated with the DARTS include equity price risk,
in that the amount that the Company will pay at maturity depends on the value of
Knight common stock. As such, these Notes contain an embedded equity derivative
which is subject to accounting treatment under SFAS No. 133. SFAS No. 133
requires fair value recognition of the DARTS' embedded derivative in the
consolidated statements of financial condition. Changes in the fair value of the
embedded derivative are required to be recognized in earnings, along with the
change in fair value of the Knight shares.
Credit Risk. Credit risk arises from the potential nonperformance by
counterparties, customers or debt security issuers. The Company is exposed to
credit risk as a trading counterparty to dealers and customers, as a holder of
securities and as a member of exchanges and clearing organizations. Credit
exposure is also associated with customer margin accounts, which are monitored
daily. The Company monitors exposure to industry sectors and individual
securities and performs sensitivity analysis on a regular basis in connection
with its margin lending activities. The Company adjusts its margin requirements
if it believes its risk exposure is not appropriate based on market conditions.
Managing Risk Exposure. The Company manages risk exposure through the
involvement of various levels of management. Position limits in trading and
inventory accounts are well established and monitored on an ongoing basis.
Current and proposed underwriting, banking and other commitments are subject to
due diligence reviews by senior management, as well as professionals in the
appropriate business and support units involved. FSB seeks to reduce the risk of
significant adverse effects of market rate fluctuations by minimizing the
difference between rate-sensitive assets and liabilities, referred to as "gap",
by maintaining an interest rate sensitivity position within a particular
timeframe. Credit risk related to various financing activities is reduced by the
industry practice of obtaining and maintaining collateral. The Company monitors
its exposure to counterparty risk through the use of credit exposure
information, the monitoring of collateral values and the establishment of credit
limits.
26
NEW ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board has recently issued the following
Statements of Financial Accounting Standards ("SFAS"), which are applicable to
the Company:
SFAS No. 144, "Accounting for the Impairment and Disposal of Long-Lived Assets".
Issued in August 2001, this statement address financial accounting and reporting
for the impairment or disposal of long-lived assets. SFAS No. 144 supercedes
SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to be Disposed of" and the accounting and reporting provisions
of Accounting Principles Board ("APB") Opinion No. 30, "Reporting the Results of
Operations -- Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions," for
the disposal of a segment of the business previously defined in that opinion.
SFAS No. 144 also amends Accounting Research Bulletin No. 51, "Consolidated
Financial Statements" to eliminate the exception to consolidation for a
subsidiary for which control is likely to be temporary. The Company will adopt
the provisions of SFAS No. 144 in the first quarter of fiscal 2003, and has not
yet determined the impact of adoption.
SFAS No. 145,"Rescission of FASB Statements 4, 44, and 64, Amendment of FASB
Statement 13, and Technical Corrections". Issued in April 2002, this statement
updates, clarifies and simplifies existing accounting pronouncements with
respect to the accounting for gains and losses from the extinguishments of debt.
SFAS No. 4 required all gains and losses from extinguishments of debt to be
aggregated and, if material, classified as an extraordinary item, net of related
tax effect. As a result of the rescission of SFAS No. 4, the criteria in APB
Opinion No. 30 will now be used to classify those gains and losses. The
provisions of this statement are applicable to transactions occurring after May
15, 2002. The Company does not believe that SFAS No. 145 will have a material
impact on its consolidated financial statements.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The information required by this item is incorporated in Item 2. Management's
Discussion and Analysis of Financial Condition and Results of Operations under
the caption Market Risk.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None Reportable.
Item 2. Changes in Securities and Use of Proceeds
None Reportable.
Item 3. Defaults upon Senior Securities
None Reportable.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None Reportable.
Item 6. Exhibits and Reports on Form 8-K
On February 11, 2002, the Company filed a Report on Form 8-K to announce its
plan to spin-off its majority owned subsidiary, Westwood Holdings Group, Inc.
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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.
SWS Group, Inc.
--------------------------------------
(Registrant)
May 9, 2002 /s/ Don Buchholz
- --------------------- --------------------------------------
Date (Signature)
Don Buchholz
Chief Executive Officer
(Principal Executive Officer)
May 9, 2002 /s/ Stacy M. Hodges
- --------------------- --------------------------------------
Date (Signature)
Stacy M. Hodges
Treasurer and Chief Financial Officer
(Principal Financial Officer)
May 9, 2002 /s/ Laura Leventhal
- --------------------- --------------------------------------
Date (Signature)
Laura Leventhal
Controller
(Principal Accounting Officer)
28