-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, AVbb2MY7fIwtrknlaSr0qwBLgyBF8WY5+70Hp+gJY2aXjuxk0zcJa8SgNMXAuBBx nH7UrKXlaIBOXB3ITMDUGw== 0000930661-99-001030.txt : 19990507 0000930661-99-001030.hdr.sgml : 19990507 ACCESSION NUMBER: 0000930661-99-001030 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990326 FILED AS OF DATE: 19990506 FILER: COMPANY DATA: COMPANY CONFORMED NAME: SOUTHWEST SECURITIES GROUP INC CENTRAL INDEX KEY: 0000878520 STANDARD INDUSTRIAL CLASSIFICATION: SECURITY BROKERS, DEALERS & FLOTATION COMPANIES [6211] IRS NUMBER: 752040825 STATE OF INCORPORATION: DE FISCAL YEAR END: 0628 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-19483 FILM NUMBER: 99611712 BUSINESS ADDRESS: STREET 1: SUITE 3500 STREET 2: 1201 ELM STREET CITY: DALLAS STATE: TX ZIP: 75270 BUSINESS PHONE: 2146511800 MAIL ADDRESS: STREET 1: SUITE 3500 STREET 2: 1201 ELM STREET CITY: DALLAS STATE: TX ZIP: 75270 10-Q 1 FORM 10-Q (QE 3-26-99) 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 26, 1999 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 SOUTHWEST SECURITIES 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 May 3, 1999, there were 10,713,820 shares of the registrant's common stock, $.10 par value, outstanding. SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Index PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Statements of Financial Condition March 26, 1999 and June 26, 1998 Consolidated Statements of Income and Comprehensive Income For the three and nine months ended March 26, 1999 and March 27, 1998 Consolidated Statements of Cash Flows For the nine months ended March 26, 1999 and March 27, 1998 Notes to Consolidated Financial Statements 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 SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Financial Condition March 26, 1999 and June 26, l998 (In thousands, except par values and share amounts)
March June (Unaudited) ------------------- ---------------- Assets Cash $ 10,451 $ 13,706 Assets segregated for regulatory purposes 278,152 130,728 Marketable equity securities, at market value 95,257 - Receivable from brokers, dealers and clearing organizations 2,515,199 2,365,635 Receivable from clients, net 689,861 648,464 Securities owned, at market value 69,151 32,144 Other assets 35,148 29,429 ------------------- ----------------- $ 3,693,219 $ 3,220,106 =================== ================= Liabilities and Stockholders' Equity Short-term borrowings $ 55,500 $ - Payable to brokers, dealers and clearing organizations 2,421,619 2,293,731 Payable to clients 866,533 720,813 Securities sold not yet purchased, at market value 28,185 1,662 Drafts payable 45,600 41,688 Other liabilities 72,023 36,745 ------------------- ----------------- 3,489,460 3,094,639 Minority interest in consolidated subsidiary 100 - Stockholders' equity: Preferred stock of $1.00 par value. Authorized 100,000 shares; none issued - - Common stock of $.10 par value. Authorized 20,000,000 shares; 10,701,177 issued and outstanding at March 26, 1999; 10,687,583 issued and 10,678,406 shares outstanding at June 26, 1998 1,070 1,069 Additional paid-in capital 69,874 69,462 Accumulated other comprehensive income - unrealized holding gain, net of tax 61,636 - Retained earnings 71,090 55,022 Receivable from employees under the Employee Stock Purchase Plan (11) (12) Treasury stock (9,177 shares, at cost, at June 26, 1998) (74) ------------------- ----------------- Total stockholders' equity 203,659 125,467 Commitments and contingencies ------------------- ----------------- $ 3,693,219 $ 3,220,106 =================== =================
See accompanying Notes to the Consolidated Financial Statements. SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Income and Comprehensive Income For the three and nine months ended March 26, 1999 and March 27, 1998 (In thousands, except per share and share amounts) (Unaudited)
Three Months Ended Nine Months Ended 1999 1998 1999 1998 ---------------------------------------------------------------------- Net revenues from clearing operations $ 10,521 $ 6,243 $ 28,030 $ 19,324 Commissions 16,428 14,791 46,946 44,045 Interest 34,623 33,825 106,286 104,738 Investment banking, advisory and administrative fees 6,372 8,143 21,193 19,071 Net gains on principal transactions 18,580 2,313 29,508 8,625 Other 3,518 3,526 10,572 8,799 ------------------------------------------------------------------- 90,042 68,841 242,535 204,602 ------------------------------------------------------------------- Commissions and other employee compensation 36,182 22,849 90,268 64,878 Interest 23,596 23,612 71,736 73,599 Occupancy, equipment and computer service costs 5,605 4,586 15,149 12,581 Communications 3,405 2,943 9,768 9,076 Floor brokerage and clearing organization charges 1,572 1,263 4,391 3,724 Other 7,976 6,219 22,810 17,185 ------------------------------------------------------------------- 78,336 61,472 214,122 181,043 ------------------------------------------------------------------- Income before income taxes 11,706 7,369 28,413 23,559 Income taxes 4,173 2,506 10,055 8,261 ------------------------------------------------------------------- Net income 7,533 4,863 18,358 15,298 Other comprehensive income - unrealized holding gains arising during period, net of tax 35,858 - 61,636 - ------------------------------------------------------------------- Comprehensive income $ 43,391 $ 4,863 $ 79,994 $ 15,298 =================================================================== Earnings per share - basic $ .70 $ .46 $ 1.72 $ 1.43 =================================================================== Earnings per share - diluted $ .70 $ .45 $ 1.71 $ 1.43 =================================================================== Weighted average shares outstanding - basic 10,696,211 10,678,485 10,683,949 10,673,954 =================================================================== Weighted average shares outstanding - diluted 10,775,321 10,701,566 10,725,042 10,695,356 ===================================================================
See accompanying Notes to Consolidated Financial Statements. SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows For the nine months ended March 26, 1999 and March 27, 1998 (In thousands) (Unaudited)
1999 1998 -------------------- -------------------- Cash flows from operating activities: Net income $ 18,358 $ 15,298 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 2,316 2,505 Provision for doubtful accounts 355 975 Deferred income taxes (1,242) (426) Deferred compensation expense 31 - Decrease (increase) in assets segregated for regulatory purposes (147,424) 160,740 Net change in broker, dealer and clearing organization accounts (21,676) 30,738 Net change in client accounts 103,968 (235,897) Increase in securities owned (37,007) (12,493) Increase in other assets (10,665) (1,660) Increase (decrease) in securities sold not yet purchased 26,523 (2,472) Increase in drafts payable 3,912 18,881 Increase in other liabilities 7,746 4,506 -------------------- -------------------- Net cash used in operating activities (54,805) (19,305) -------------------- -------------------- Cash flows from investing activities: Purchase of furniture, equipment and leasehold improvements (2,044) (1,437) -------------------- -------------------- Net cash used in investing activities (2,044) (1,437) -------------------- -------------------- Cash flows from financing activities: Proceeds from short term borrowings 55,500 19,950 Payment on liabilities subordinated to the claims of general creditors - (1,400) Net change in receivable from employees for Employee Stock Purchase Plan 1 69 Net proceeds from exercise of stock options 100 225 Payment of cash dividend on common stock (2,107) (1,830) Proceeds from issuance of stock of consolidated subsidiary 100 - -------------------- -------------------- Net cash provided by financing activities 53,594 17,014 -------------------- -------------------- Net decrease in cash (3,255) (3,728) Cash at beginning of period 13,706 10,745 -------------------- -------------------- Cash at end of period $ 10,451 $ 7,017 ==================== ====================
See accompanying Notes to the Consolidated Financial Statements. SOUTHWEST SECURITIES GROUP, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements (Unaudited) GENERAL AND BASIS OF PRESENTATION The interim consolidated financial statements include the accounts of Southwest Securities Group, Inc. ("Parent") and its consolidated subsidiaries listed below (collectively, the "Company"): Southwest Securities, Inc. "Southwest" SWS Financial Services, Inc. "SWSFS" (formerly Brokers Transaction Services, Inc.) Southwest Investment Advisors, Inc. "Advisors" Westwood Trust "Trust" Westwood Management Corporation "Westwood" SW Capital Corporation "Capital" SWS Technologies Corporation "Technologies" Mydiscountbroker.com, Inc. "MDB" (formerly Sovereign Securities, Inc.) NorAm Investment Services, Inc. "NorAm" Southwest Clearing Corporation "Clearing"
Southwest, SWSFS, MDB and NorAm are registered broker/dealers under the Securities Exchange Act of 1934 ("1934 Act"). Advisors and Westwood are registered investment advisors under the Investment Advisors Act of 1940. Although not yet active, Clearing was incorporated in the State of Delaware on September 30, 1998 and is a fully consolidated subsidiary. All significant intercompany balances and transactions have been eliminated. The consolidated financial statements as of March 26, 1999, and for the three and nine month periods ended March 26, 1999 and March 27, 1998, 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 26, 1998 filed on Form 10-K. Amounts included for June 26, 1998 are from the audited consolidated financial statements as filed on Form 10-K. CASH FLOW REPORTING Cash paid for interest was $72,285,000 and $72,820,000 for the nine month periods ended March 26, 1999 and March 27, 1998, respectively. Cash paid for income taxes was $7,425,000 and $7,175,000 in 1999 and 1998, respectively. In a non-cash transaction, the Parent received approximately 1.7 million common shares of Knight/Trimark Group, Inc. ("Knight") subsequent to Knight's initial public offering completed July 10, 1998. In conjunction with the Company's Stock Purchase Plan, 9,177 treasury shares were reissued and 6,380 new shares were issued in January 1999. Deferred compensation expense totaling $248,000 was recorded and will be amortized over a period of two years. ASSETS SEGREGATED FOR REGULATORY PURPOSES At March 26, 1999, the Company had reverse repurchase agreements of $262,863,000 and U.S. Treasury securities with a market value of $15,289,000 segregated in a special reserve bank account for the exclusive benefit of customers under Rule 15c3-3 of the 1934 Act. The reverse repurchase agreements were collateralized by U.S. Government securities with a market value of approximately $291,502,000. At June 26, 1998, the Company had U.S. Treasury securities with a market value of $59,515,000 and reverse repurchase agreements of $71,213,000 in this account. The reverse repurchase agreements were collateralized by U.S. Government securities with a market value of approximately $71,871,000 at June 26, 1998. MARKETABLE EQUITY SECURITIES The investment in Knight is classified as marketable equity securities available for sale, and the unrealized holding gains, net of tax, are recorded as a separate component of stockholders' equity on the consolidated statements of financial condition. The Knight shares are subject to the provisions of Securities and Exchange Commission Rule 144 and are currently subject to a 90- day sales restriction that ends May 27, 1999. The following table summarizes the cost and market value of the investment in Knight at March 26, 1999 (in thousands):
Gross Gross Unrealized Unrealized Market Cost Gains Losses Value ---------------------------------------------------- Marketable equity securities $ 432 94,825 - $ 95,257 ====================================================
Knight declared a two-for-one stock split payable to shareholders of record as of the close of business on April 30, 1999, to be paid on or about May 14, 1999. RECEIVABLE FROM AND PAYABLE TO BROKERS, DEALERS AND CLEARING ORGANIZATIONS At March 26, 1999 and June 26, l998, 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 $ 36,176 $ 18,880 Securities borrowed 2,403,609 2,229,587 Correspondent broker/dealers 34,430 62,673 Clearing organizations 1,620 1,245 Other 39,364 53,250 -------------------- ------------------- $ 2,515,199 $ 2,365,635 ==================== =================== Payable Securities failed to receive $ 36,586 $ 45,956 Securities loaned 2,359,043 2,227,874 Correspondent broker/dealers 11,390 11,300 Other 14,600 8,601 -------------------- ------------------- $ 2,421,619 $ 2,293,731 ==================== ===================
SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED At March 26, 1999 and June 26, 1998, the Company held securities owned and securities sold, not yet purchased as follows (in thousands):
March 26, June 26, 1999 1998 ----------------- --------------- Securities owned Corporate equity securities $ 12,888 $ 5,220 Municipal obligations 26,207 13,633 U.S. Government and Government agency obligations 16,829 8,696 Corporate obligations 8,745 1,479 Commercial paper - 446 Other 4,482 2,670 ----------------- --------------- $ 69,151 $ 32,144 ================= =============== Securities sold, not yet purchased Corporate equity securities $ 18,886 $ 1,208 Municipal obligations 1,238 124 U.S. Government and Government agency obligations 5,328 175 Corporate obligations 983 98 Commercial paper - 50 Other 1,750 7 ----------------- --------------- $ 28,185 $ 1,662 ================= ===============
SHORT-TERM BORROWINGS The Company has credit arrangements with commercial banks, which include broker loan lines up to $192,500,000. 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 26, 1999, the amount outstanding under these secured arrangements was $55,500,000 which was collateralized by securities held for Correspondent broker/dealer accounts valued at $52,764,000 and by marketable equity securities owned valued at $21,693,000. There were no amounts outstanding at June 26, 1998 on these credit arrangements. In addition to the broker loans 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. There were no amounts outstanding under this line of credit at March 26, 1999 and June 26, 1998. At March 26, 1999 and June 26, 1998, the Company had no repurchase agreements outstanding. NET CAPITAL REQUIREMENTS 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. Southwest 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. At March 26, 1999, Southwest had net capital of $77,308,000, or approximately 9% of aggregate debit balances, which is $60,893,000 in excess of its minimum net capital requirement of $16,415,000 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 26, 1999, Southwest had net capital of $36,271,000 in excess of 5% of aggregate debit items. SWSFS, MDB and NorAm follow the primary (aggregate indebtedness) method under Rule 15c3-1, which requires the maintenance of minimum net capital of $250,000. At March 26, 1999, the net capital and excess net capital of these companies was as follows:
Net Capital Excess Net Capital ------------------------------------------------ SWSFS $317,000 $ 67,000 MDB 536,000 286,000 NorAm 621,000 371,000
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 $2,659,000, which is $1,659,000 in excess of its minimum capital requirement at March 26, 1999. EARNINGS PER SHARE A reconciliation between the weighted average shares outstanding used in the basic and diluted EPS computations is as follows (in thousands, except share and per share amounts):
Three Months Ended Nine Months Ended March 26, 1999 March 27, 1998 March 26, 1999 March 27, 1998 ------------------------------------- ------------------------------------ Net income $ 7,533 $ 4,863 $ 18,358 $ 15,298 ===================================== ==================================== Weighted average shares outstanding - basic 10,696,211 10,678,485 10,683,949 10,673,954 Effect of dilutive securities: Assumed exercise of stock options 79,110 23,081 41,093 21,402 ------------------------------------- ------------------------------------ Weighted average shares outstanding - diluted 10,775,321 10,701,566 10,725,042 10,695,356 ===================================== ==================================== Earnings per share - basic $ .70 $ .46 $ 1.72 $ 1.43 ===================================== ==================================== Earnings per share - diluted $ .70 $ .45 $ 1.71 $ 1.43 ===================================== ====================================
At March 26, 1999, the Company had two stock option plans, the Southwest Securities Group, Inc. Stock Option Plan (the "1996 Plan") and the Southwest Securities Group, Inc. 1997 Stock Option Plan (the "1997 Plan"). At March 26, 1999, there were approximately 430,000 options outstanding under the 1996 Plan and approximately 20,000 options outstanding under the 1997 Plan. The Company also has approximately 17,000 options outstanding that were granted in conjunction with the acquisition of Barre & Company, Inc. ("Barre Options"). As of March 26, 1999, all outstanding options were dilutive and were included in the calculation of weighted average shares outstanding - diluted. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations FACTORS AFFECTING FORWARD-LOOKING STATEMENTS From time to time, Southwest Securities 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) changes in the rate of inflation and related impact on securities markets; (7) competition from existing financial institutions and other new participants in the securities markets; (8) legal developments affecting the litigation experience of the securities industry; (9) successful implementation of technology solutions; and (10) changes in federal and state tax laws which could affect the popularity of products sold by the Company. The Company does not undertake any obligation to publicly update or revise any forward-looking statements. The Company's discussion of the issues surrounding the Year 2000 contain forward-looking statements as defined in the Acts. These forward-looking statements could relate to, but are not limited to (1) the financial impact of the Year 2000 project; (2) the Company's estimated timetables for completion of each phase of the project; (3) the Company's estimates of the availability of vendor software upgrades and consulting services; (4) the readiness of third- party service providers; and (5) contingency plans. The Company cautions that many factors, including those outside of the control of the Company, could cause actual results to be materially different than those anticipated and expressed in the 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. 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 investment banking and securities brokerage 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. RESULTS OF OPERATIONS During the third quarter of fiscal 1999, net income totaled $7,533,000, an increase of $2,670,000, or 55%, from the third quarter of fiscal 1998. For the nine months ended March 26, 1999, net income increased 20% to $18,358,000 over the comparable prior year period. 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 26, 1999 and March 27, 1998 (in thousands):
Three Month Change Nine Month Change Amount Percent Amount Percent -------------------- ------------------- Net revenues Net revenues from clearing operations $ 4,278 69% $ 8,706 45% Commissions 1,637 11% 2,901 7% Net interest 814 8% 3,411 11% Investment banking, advisory and administrative fees (1,771) (22%) 2,122 11% Net gains on principal transactions 16,267 703% 20,883 242% Other (8) - 1,773 20% -------------------- ------------------- 21,217 47% 39,796 30% -------------------- ------------------- Operating expenses Commissions and other employee compensation 13,333 58% 25,390 39% Occupancy, equipment and computer service costs 1,019 22% 2,568 20% Communications 462 16% 692 8% Floor brokerage and clearing organization charges 309 24% 667 18% Other 1,757 28% 5,625 33% -------------------- ------------------- 16,880 45% 34,942 33% -------------------- ------------------- Income before income taxes $ 4,337 59% $ 4,854 21% ==================== ===================
Net Revenues from Clearing Operations. Net revenues from clearing increased primarily as a result of an increase in total transaction volumes in the three and nine month periods ended March 26, 1999 over the same periods in the prior year. Total transactions processed in the third quarter of fiscal 1999 increased to approximately 6.2 million from approximately 1.7 million in the third quarter of fiscal 1998. Transactions processed in the first nine months of fiscal 1999 totaled 13.9 million versus 4.5 million in the first nine-months of fiscal 1998. Turbulent market conditions thus far during fiscal 1999 and high trading volumes in the internet and technology sectors lead to heavy trading volume in securities markets. The rate of increase in transactions processed has outpaced the increase in revenues from clearing, because, in recent years, the Company has increased the number of high-volume trading Correspondents in its customer base, and a substantial portion of the increase in transactions processed were related to these Correspondents. These customers use a relatively low level of clearing services and, accordingly, are charged substantially discounted clearing fees from the Company's standard clearing schedule. As transaction volumes increase, revenue per clearing transaction tends to decrease as Correspondents take advantage of volume discounts. Commissions. Commissions from the Company's client transactions in the three and nine months ended March 26, 1999 increased when compared with revenues in the comparable prior year periods. This increase is primarily attributable to an increase in fixed income sales, as well as an increase in the number of brokers in the Company's independent contractor network. Fixed income sales increased 45% and 73% over the three and nine month periods, respectively. The number of independent contractor sales representatives increased to 703 at March 26, 1999 from 683 at March 27, 1998. Also contributing to the increase were increased commissions from MDB, the Company's on-line investing subsidiary which began offering on-line trading in the March quarter of fiscal 1998. Commissions at MDB increased approximately 287% and 210% for the three and nine months ended March 26, 1999 over the comparable periods in the prior year. 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 rate it earns on those assets compared with the cost of funds. In the three and nine month periods ended March 26, 1999, net interest income accounted for 17% and 20% of the Company's net revenue, respectively. Net interest income was 23% and 24%, respectively, of net revenue in the three and nine month periods ended March 27, 1998. Interest revenue from customer margin balances and interest expense from customer funds on deposit have fluctuated in relation to average balances over the three and nine month periods ended March 26, 1999 and March 27, 1998. Net interest revenue generated from securities lending activities has remained relatively stable in the current fiscal year versus the prior fiscal year. Average customer balances and average balances from securities lending activities are as follows (in thousands):
Three Months Ended Nine Months Ended March 26, 1999 March 27, 1998 March 26, 1999 March 27, 1998 ---------------------------------- ---------------------------------- Average customer margin balances $ 645,000 $ 494,000 $ 565,000 $ 458,000 Average customer funds on deposit 719,000 563,000 582,000 529,000 Average stock borrowed 2,182,000 2,154,000 2,090,000 2,085,000 Average stock loaned 2,152,000 2,130,000 2,061,000 2,057,000
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. Securities lending activities are conducted out of the Company's New York office using a highly specialized sales force. Competition for these individuals is intense and there can be no assurance that the Company will be able to retain these individuals. Investment Banking, Advisory and Administrative Fees. Investment banking, advisory and administrative fees include revenues derived from the underwriting and distribution of corporate and municipal securities, unit trusts and money market and other mutual funds. Investment banking, advisory and administrative fees decreased in the third quarter of fiscal 1999 when compared to the same period in fiscal 1998 due to decreases in fees from both municipal finance and corporate finance businesses. This decrease was, however, offset slightly by increased fees from investment advisory services in the third quarter of fiscal 1999 over the third quarter of fiscal 1998. Advisory fees earned on investment management increased as assets under management at March 26, 1999 were approximately $3.8 billion versus $3.4 billion at March 27, 1998. The number and offering amount of senior and co-managed municipal finance offerings in which the Company participated decreased 15% for the three month period ended March 26, 1999 over the comparable period of the prior year. Investment banking, advisory and administrative fees for the nine months ended March 26, 1999 were higher than the comparable period of the prior year due to increases in fees from municipal finance and investment advisory services, offset by decreases in corporate finance fees. Although the number of senior and co-managed public finance deals decreased 8% over the comparable prior year period, the total dollar amount of the offerings increased 35%, resulting in increased revenues. Net Gains on Principal Transactions. Net gains on principal transactions have experienced significant growth over prior year in both the three and nine month periods ended March 26, 1999 and March 27, 1998. This growth is due to the expansion of the Company's equity trading area. The number of market makers employed in this area has increased to 23 at March 26, 1999 from nine at March 27, 1998, while coverage from market making activities has increased to 567 over-the-counter securities in which the Company makes a market. Revenue in this area can fluctuate significantly from quarter to quarter based on market conditions. 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. During the three and nine months ended March 26, 1999, commissions and other employee compensation expense increased over the same periods in the prior year. This was principally due to (1) increased commissions and benefits paid to revenue-producing employees generating higher levels of operating revenues; (2) as previously discussed, increased headcount among the independent contractor network; and (3) the addition of 118 full-time employees. The number of employees increased to 877 at March 26, 1999 compared to 759 at March 27, 1998. Approximately 36% of the increased employee count relates to those employed in the information technology area. Occupancy, Equipment and Computer Service Expenses. Occupancy, equipment and computer service expenses increased for both three and nine month periods presented primarily due to upgrades in computer processing equipment as the Company continues to focus its resources on the implementation of its new brokerage software, Comprehensive Software Systems, Ltd. ("CSS") (see YEAR 2000 discussion below). In addition, the Company accrued approximately $325,000 for one-time programming expenses related to customer statement processing in the third quarter of fiscal 1999. Other Expenses. Other expenses have increased primarily due to increases in contract labor, professional services and promotional expenses. Contract labor and professional service expenses relate to, among other things, the Company's involvement in developing Year 2000 compliant software (see YEAR 2000 discussion below). FINANCIAL CONDITION The Parent owned a minority interest in Roundtable Partners, LLC, the predecessor of Knight/Trimark Group, Inc. ("Knight"), which filed an S-1 registration statement with the U.S. Securities and Exchange Commission on May 1, 1998 for an initial public offering of stock. Subsequent to the offering, which closed on July 10, 1998, the Parent owned approximately 1.7 million shares of Knight. The shares are classified as marketable equity securities available for sale, and the unrealized holding gain, net of tax, is recorded as a separate component of stockholders' equity on the consolidated statements of financial condition in accordance with Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities." Knight filed an S-1 registration statement for a secondary offering on February 1, 1999. The Parent did not sell any of its shares in conjunction with the offering. The shares owned by the Parent are subject to a 90-day sales restriction agreement that ends May 27, 1999. Knight declared a two-for-one stock split payable to shareholders of record as of the close of business on April 30, 1999, to be paid on or about May 14, 1999. LIQUIDITY AND CAPITAL RESOURCES 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 $192,500,000. 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 credit arrangements are provided on an "as offered" basis and are not committed lines of credit. Outstanding balances under these credit arrangements are due on demand, bear interest at rates indexed to the federal funds rate and are collateralized by securities of the Company and its clients. At March 26, 1999, the amount outstanding under these secured arrangements was $55,500,000 which was collateralized by securities held for Correspondent broker/dealer accounts valued at $52,764,000 and by marketable equity securities owned valued at $21,693,000. In the opinion of management, these credit arrangements are adequate to meet the short-term operating capital needs of the Company. In addition to the broker loan lines, the Company also 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. There were no amounts outstanding at March 26, 1999 under this unsecured line of credit. Net cash used in operating activities during the nine month period ended March 26, 1999 was $54,805,000. The use of cash was due to the increase in securities owned and was adequately financed by the short-term borrowings mentioned above. 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. 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 issuers credit rating or credit perception could affect the value of financial instruments. Equity Price Risk. The Company is exposed to equity price risk as a result of making markets 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. 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. 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. 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. Market Risk Analysis. The Company has performed an analysis of the Company's financial instruments and has assessed the related risk and materiality in accordance with the rules. Based on this analysis, in the opinion of management, the market risk associated with the Company's financial instruments at March 26, 1999 will not have a material adverse effect on the consolidated statements of financial position or operating results of the Company. YEAR 2000 The widespread use of computer programs that rely on two-digit date programs to perform computations and decision-making functions may cause information technology ("IT") systems to malfunction in the Year 2000 and may lead to significant business delays in the U.S. and internationally. The Year 2000 problem has the potential to impact the securities industry since information is moved to and from the exchanges and trading partners on a real-time basis from computer system to computer system with little human interaction. In addition to potential problems from computer systems, potential problems could arise from equipment with embedded chips, such as vaults, elevators and other non-IT systems. The Company has defined a Year 2000-compliant system as one capable of correct identification, manipulation and calculation when processing data in connection with the year change from December 31, 1999 to January 1, 2000. A Year 2000- compliant system is also capable of correct identification, manipulation and calculation using leap years both alone and in conjunction with other dates. Not all of the Company's systems are compliant under the above definition; however, the Company is addressing the issues with this problem in the following manner. In the first stage, the Company prepared an inventory of all IT and non-IT systems, as well as equipment that could have embedded chips, whether or not critical to the operation of the business. The Company also compiled a listing of material relationships with third parties. These relationships include various exchanges, clearing houses, banks, telecommunications companies and public utilities. This stage of the Year 2000 process is 100% complete. The Company continues to review various areas of the business to identify any items overlooked in the initial inventories. In stage two, results from the inventory discussed above are being assessed to determine the Year 2000 impact and what actions need to be taken to obtain Year 2000 compliance. For the Company's internal systems, actions needed range from obtaining vendor certification of Year 2000 compliance, remediation of internal systems or replacement of systems and equipment that cannot be remediated. This stage is 100% complete. The Company has determined a course of action for remediation or replacement of all critical internal systems. The Company is surveying and obtaining information about Year 2000 readiness of its material third-party relationships. Contingency plans have been developed for those third parties who cannot satisfactorily demonstrate Year 2000 compliance. The plans are continually refined, updated and tested as changes in third-party readiness occurs. The third stage includes the repair, replacement or retirement of systems. This stage of the Year 2000 process is ongoing and is dependent upon the availability of upgrades from our IT vendors, technician time to implement the upgrades and notification from other third parties of Year 2000 compliance. The Company has been upgrading packaged software throughout the organization. Desktop system updates are complete and upgrade of the communications infrastructure is ongoing. The main telephone switch and critical branch office switches have been upgraded where necessary, and upgraded network operating systems have been loaded into place. The rollout of the Year 2000 compliant version of the BRASS Equity Trading System has also been completed. The primary financial system used for financial reporting purposes for the Company was replaced during fiscal 1998 to prepare for Year 2000 as well as to derive other benefits from the financial reporting system. Updates to this system were installed in the second quarter of fiscal 1999 and testing was completed in the third quarter of fiscal 1999. The financial system itself is certified by the vendor as Year 2000 compliant. The Company's primary operational system is the Securities Industry Software ("SIS") application, which provides both front and back office services to Correspondents, customers and our internal users. For several years, the Company has self-supported the SIS application. The Company has been pursuing a replacement strategy for SIS and is implementing a new client-service based information system ("CSS"). CSS is being developed by Comprehensive Software Systems, Ltd., an entity in which several securities firms own interests, including the Company, which owns an 8.18% interest. While replacement of the SIS system with CSS is our primary solution for Year 2000 issues associated with the SIS system, in September 1998 the Company engaged an independent consulting firm to begin remediation of the SIS system. As of March 31, 1999, 100% of the SIS code was remediated and unit tested by the consulting firm. The Company is currently testing the remediated code in-house and is installing the code into production after testing. The Company currently anticipates that 100% of the remediated code will be installed on or about June 30, 1999. The Company has been working on the CSS project since 1992, as implementation of this system was in process before the Company began assessment of critical Year 2000 issues. In fiscal 1997, the Company accelerated the pace of the CSS project so that it would be available as the Year 2000 solution for the SIS system. Through fiscal 1997 and 1998, costs associated with the joint venture, including personnel, hardware, software and related costs, were approximately $4 million. During fiscal 1997 and 1998, the Company incurred an additional $1 million in costs related to the Year 2000 project primarily related to compensation and benefits, software upgrades and hardware replacement for financial and other systems. In the third quarter of fiscal 1999, the Company has incurred an additional $2.4 million in expenses related to the CSS project and other Year 2000 initiatives, bringing the total spent in fiscal 1999 to $5.3 million. The Company expects to incur additional costs in the remainder of fiscal 1999 for the implementation of the CSS software, as well as costs to remediate and replace other systems, totaling approximately $2.3 million. In the first half of fiscal 2000, the Company expects to incur an additional $4 million related to the implementation of the CSS software and other Year 2000 project costs. These costs will be funded out of working capital and substantially all will be expensed. The budgeted expenditures include compensation and benefits for IT and other operational staff, consulting services, software purchases and other remediation costs. Implementation of the CSS system should result in the reduction of certain existing hardware and software lease, maintenance and licensing costs. The Company is also heavily dependent upon the power and telecommunications infrastructure within the United States and would be subject to business interruptions as a result of the failure of those systems. Additionally, the Company would experience disruption in certain of its businesses if the various exchanges, clearing houses or banks used by the Company reported a system failure. The Company is communicating with these third parties in order to obtain assurances regarding Year 2000 readiness. The Company's contingency plans also address potential failure of these systems. The last stage of the implementation process includes testing all of the changes implemented individually and integrating those changes with all of the Company's systems and those of its customers and trading partners. Testing takes on various forms depending on the type of change implemented. Each upgrade, to the extent economically feasible, is run through a test environment before it is implemented. It is then tested to see how well it integrates into the Company's overall IT environment. The Company is also engaging in point-to-point testing with various exchanges, clearing houses and utilities and has established a future date environment for testing the CSS application. The Company recently participated in the Securities Industry Association's industry-wide point-to- point testing which occurred over a series of weekends and simulated the first trading cycle to settle in the Year 2000. While final reconciliation of data from these tests is ongoing, the Company believes it has successfully completed each phase of the testing. Additional tests are planned with vendors not included in the industry-wide test as well as with Correspondent customers. The Company has prepared contingency plans that deal with a variety of failures that could potentially be caused by Year 2000 or other problems. These plans range from global issues like the loss of a major stock exchange or utility, to infrastructure issues like the loss of the primary data communications carrier or regional electrical power supplier, to failures within the Company's facilities like the loss of an owned telephone switch or the failure of an internally maintained application. The Company will continue to refine these plans over the next several months. Testing related to contingency plans will begin with those failures we assume are more likely to occur because of incomplete work or inadequate information on the part of mission critical vendors. The potential impact of the Year 2000 problem on the securities industry as a whole could be material, as virtually every aspect of the sales of securities and processing of transactions will be affected. Due to the size of the task facing the securities industry and the interdependent nature of securities transactions, the Company may be adversely affected by this problem, depending on whether it and the entities with which it does business address this issue successfully. 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 (229.103) Item 2. Changes in Securities and Use of Proceeds None Reportable (Per Instructions to Form 10-Q) Item 3. Defaults upon Senior Securities None Reportable (Per Instructions to Form 10-Q) Item 4. Submission of Matters to a Vote of Security Holders None Reportable (Per Instructions to Form 10-Q) Item 5. Other Information None Reportable (Per Instructions to Form 10-Q) Item 6. Exhibits and Reports on Form 8-K EXHIBITS 10.1 Executive Compensation The information required by this item regarding Executive compensation is incorporated by reference to pages 8 through 11 of the Company's Proxy Statement dated September 24, 1998 which was filed with the Commission pursuant to Regulation 240.14a-6 (c) prior to October 24, 1998. 27 Financial Data Schedule REPORTS ON FORM 8-K None. 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. Southwest Securities Group, Inc. ---------------------------------------- (Registrant) May 5, 1999 /S/ David Glatstein - --------------- ---------------------------------------- Date (Signature) David Glatstein President and Chief Executive Officer (Principal Executive Officer) May 5, 1999 /S/ Stacy M. Hodges - --------------- ---------------------------------------- Date (Signature) Stacy M. Hodges Treasurer and Chief Financial Officer (Principal Financial Officer) May 5, 1999 /S/ Laura Leventhal - --------------- ---------------------------------------- Date (Signature) Laura Leventhal Controller (Principal Accounting Officer) EX-27 2 ARTICLE BD-FINANCIAL DATA SCHEDULE
BD 3-MOS 9-MOS JUN-25-1999 JUN-25-1999 JAN-01-1999 JUN-27-1999 MAR-26-1999 MAR-26-1999 10,451 10,451 3,205,060 3,205,060 262,343 262,343 2,403,609 2,403,609 69,151 69,151 10,416 10,416 3,693,219 3,693,219 55,500 55,500 3,288,152 3,288,152 0 0 2,359,043 2,359,043 28,185 28,185 0 0 0 0 0 0 1,070 1,070 202,589 202,589 3,693,219 3,693,219 18,580 29,508 34,623 106,286 16,428 46,946 6,372 21,193 10,521 28,030 23,596 71,736 36,182 90,268 11,706 28,413 11,706 28,413 0 0 0 0 7,533 18,358 .70 1.72 .70 1.71
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