Piper Sandler Companies (PIPR) 2004 Q2 法說會逐字稿

Welcome to the Piper Jaffray conference call to discuss 2004 second-quarter results. Chairman and CEO Andrew Duff and Chief Financial Officer Sandra Sponem are your hosts for the call. (OPERATOR INSTRUCTIONS). As informed earlier, individual shareholders and members of the media who have questions are invited to contact Piper Jaffray after this call to have their questions addressed.

Now, I'll turn the call over to Jennifer Olson-Goude, Director of Investor Relations.

Good morning, and welcome to the Piper Jaffray second-quarter conference call. Statements made on this call that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements that involve inherent risks and uncertainties. Factors that could cause actual results to differ materially from those anticipated are identified in our reports on file with the SEC, and are available at our website at www.PiperJaffray.com and at the SEC's website at www.SEC.gov.

Now, I'll turn the call over to Andrew Duff. Andrew?

Thank you, Jennifer. We'll cover four topics on today's call. I'll start with a quick recap of the general market conditions during the second quarter, then I'll give an overview for each of our businesses. Sandy will cover the second-quarter financial results, and I'll finish with an outlook for the rest of the year. Then we'll take questions.

We faced a more challenging market environment compared to the first-quarter results, resulting in mixed performance from our business. Concerns about inflation, rising interest rates and geopolitical events created uncertainties in the markets. All major indices were flat to up only slightly for the quarter. Industry equity trading volumes declined during the quarter. We believe we reported respectable results for the quarter; however, we recognize we have room for improvement going forward.

Let me talk specifically about what we saw for each of our businesses during the quarter. First, Capital Markets, which is comprised of fixed income and equities and investment banking. The second quarter continued to be challenging for our fixed income business. We said at the end of the first quarter that we experienced softness in sales and trading, and that we expected the sluggishness to continue, and it did. Uncertainties around rising interest rates led to substantially reduced institutional client flow and trading profits. Our fixed income business achieved record revenues in the second quarter of last year, driven by high-yield corporate bonds, in which we have proprietary research.

The other important component of our fixed income business is public finance underwriting. We have moved past the robust refinancing activity, as reflected by the 4 million revenue decline from the last year. However, this business is on par with the sequential first quarter. Despite higher interest rates, cities and counties still need to issue debt to fund infrastructure or deficits. We believe the transition to higher rates will continue to impact our fixed income sales and trading business, and we have taken several steps to address this new market environment.

First, we continue to diversify our fixed income sales and trading business. Let me be specific. We added a mortgage capability about two years ago. We expect this business to continue to grow long-term, as it is relatively early in its maturity. We added a new team in the first quarter, to broaden our corporate capability beyond Piper's high-yield niche and deepen our product offering for our clients. This team focuses on investment-grade corporate products. Like mortgages, this new business may take a couple of years to mature.

Second, we continue to expand our sales and distribution capability. We added 14 middle-market salespeople in late 2003 and early 2004, to deepen our penetration of the middle-market segment.

Third, we believe we have the appropriate risk management strategies in place for this tougher market environment. We have reduced our value at risk, both in absolute levels and the average quarter over quarter. We believe these long-term investments are appropriate, despite a more challenging environment near-term. We will continue to evaluate and execute appropriate actions to support our strategy of targeting middle-market clients in the fixed income business.

Now let me turn to equities and investment banking. This quarter, M&A revenue doubled from last year and this year's first quarter. Equity underwriting revenue rose from the last year, but declined from the first quarter of this year, due to timing of some deals. In both businesses, we completed substantially more deals than one year ago. During the quarter, we closed a significant healthcare M&A transactions, and were very pleased with the results for our client. This transaction was the primary driver of the year-over-year increase in revenue. Our M&A announced deal backlog is looking good at nine transactions, which is up from the six at the end of the first quarter.

For equity underwriting for the quarter, we ranked 13th, based on 25 completed equity offerings, ranking us as the number-two middle-market investment bank behind the bulge bracket firms. Year to date, we are leading middle-market investment bank with 50 completed transactions. Our equity backlog also remains strong at 27 filed deals, representing all of our four industry sectors.

Now, let me cover our Private Client Services segment. Revenues in this business were even with last year, but softened from a strong first quarter. Private clients were less active in the second quarter, given the uncertainties in the financial markets. We believe we have stabilized this business over the last 12 months, and are now laying the foundation to improve revenue growth and profitability. We believe we have the right strategy for our private client business to become the primary financial advisor to our clients. In this capacity, we would determine a client's needs, develop and implement a plan and monitor the results.

To support this strategy, we are executing on three initiatives. First, train and recruit to our advisory process and culture. We are emphasizing hiring candidates to develop into financial advisors. We believe we have improved the quality of our candidates, and we are ahead of where we expected to be with hiring at this point in the year. Recruiting is slow, and we expect that it will take time for this pipeline to rebuild. On the training front, our new head of business development we announced last quarter has developed a comprehensive training plan to align our training with our primary advisory strategies.

The second initiative is to expand profitable relationships. We are developing tools for financial advisors to use on their desktops to improve relationship and business decisions. We are in the pilot stage with these tools, and expect to roll them out more broadly by the end of the year.

Third, drive key growth markets to build out our franchise from our strong midwestern base. In the second quarter, we hired new leaders for two key markets, San Francisco and Kansas City. Both individuals will provide strong leadership in growing these important markets. The foundation is being laid, and we believe improved financial results will follow, but they will take time.

Let me turn to investment research, which we believe is critical to both Capital Markets and Private Client Services. We continue to add subsectors to expand our research coverage. During the quarter, we extended our financial and consumer equity research platforms with new coverage in specialty finance and insurance companies and also specialty retailer. We're very pleased to see the quality of our research recognized by two well-known surveys during the quarter. Our research was ranked seventh overall by Forbes, Top Equity Analyst for 2003, based on earning estimates and stockpicking; ranked 10th overall by Wall Street Journal, Best on the Street for 2003 based on stockpicking; and four Piper analysts received a top-five ranking in their section.

In summary, we believe we are taking the right steps to address the new market environment for our fixed income business. Our equities business is performing well, and we believe we continue to advance the right strategy for Private Client Services. The financial results will take time to realize.

Now, I'll ask Sandy to provide a detailed look at our financial results for the second quarter. Sandy?

Thank you, Andrew. Second-quarter net income of $13 million and fully diluted earnings per share of 67 cents were up approximately 50 percent versus the year-ago quarter, on only slightly increased revenue. Our second-quarter pretax operating margin of 10 percent increased over last year's 6.5 percent, and was about even with the preceding quarter.

For the first six months, net income and fully diluted earnings per share doubled from the prior year, at 26.8 million and $1.38 respectively. Net revenues of 416.7 million year to date represent an 11 percent increase over the prior year, primarily due to significantly improved equity investment banking revenues.

Pretax operating margin for the first six months grew to 10.3 percent, compared to 5.5 percent last year. Second-quarter net revenues were essentially unchanged compared to the year-ago period; however, we did see the mix of revenue shift significantly to equity-related products from fixed-income-related products. A $10.5 million increase in investment banking revenue was offset by a $10 million decrease in principal transactions, primarily due to a decline in fixed income institutional sales and trading. Commissions and fees remained virtually flat compared to last year, but declined 3.7 million or 5 percent from the first quarter, driven by softer individual investor activity.

For the quarter, non-interest expenses totaled 186.6 million, down 3 percent from the prior year. Compensation expense was relatively unchanged from last year; however, non-compensation expenses of 58.9 million were down 5.6 million or 9 percent versus the prior year. Last year's second quarter included an $8.8 million loan loss reserve for anticipated attrition related to implementing a new compensation plan for our financial advisors. If non-compensation expenses were adjusted for the additional reserve and the royalty fee paid to U.S. Bancorp, these expenses actually rose by $4 million or 8 percent year over year. Much of this increase was anticipated and planned for, particularly in four main areas -- new public company costs, which had been previously estimated at $5 million for the year; costs related to the cash award program, also estimated at $5 million annually; investments in technology; and, lastly, expansion of our research coverage. In addition, we experienced higher variable costs, such as travel, that are associated with increased equity deal activity.

Now, let me cover our segment results. Capital Markets recorded 113.6 million in net revenues for the quarter, relatively unchanged to the prior year. Segment pretax operating income for the quarter decreased 5.6 million or 22 percent from last year, but was relatively flat on a sequential quarter basis.

Equity investment banking and particularly M&A remained healthy and ahead of the prior year. However, compared to the previous quarter, equity underwriting declined by $6 million, due to timing of some deals. Also compared to the first quarter, equity trading volumes declined, resulting in a $4.2 million decrease in equity institutional sales.

Our fixed income institutional sales business declined compared to a record prior-year quarter. We began to experience softer fixed income results in the first quarter of 2004. Concerns about rising interest rates really took hold during the second quarter, with substantially reduced institutional client order flow and trading profits compared to a year ago. Our fixed income business had achieved record revenues in the second quarter of last year, driven by high-yield corporate bonds, where we have proprietary research.

Operating expenses for the Capital Markets segment were 93.6 million for the quarter, a 4 percent increase over the prior-year period. The higher expenses stemmed from investments in technology, including the new fixed-income trading system implemented late last year, and other technology investments to support Capital Markets; expansion of our depth and breadth of research coverage; and then additional costs, such as travel, associated with stronger equity deal activity. Segment pretax operating margin of 17.6 percent for the quarter was in line with the stable annual historical margins in this business.

Turning to our Private Client Services segment, this segment recorded 88.1 million in net revenues for the quarter, which was flat to the last year, despite 74 fewer financial advisors. Private clients were more active in the first quarter of 2004, but less so in the second quarter, amidst concerns over inflation, rising interest rates and geopolitical events. Segment pretax operating income was 11.8 million, up significantly from the 0.8 million recorded in the year-ago period.

Operating expenses for the Private Client segment of 76.3 million were 13 percent below the prior year, primarily due to lower loan losses related to certain forgivable employee loans. Segment pretax operating margin was 13.4 percent for the quarter, compared to 0.9 percent last year and 12.8 percent in the first quarter of this year.

Finally, corporate support and other. Corporate support and other pretax operating loss narrowed to 9.9 million for the second quarter, compared to a loss of 12 million in the prior year. Second-quarter results included a $1 million net gain on a venture capital investment in a company we recently took public.

In summary, for the quarter, we continued to see the slowdown in fixed income sales and trading that began in the first quarter. Equities continued to perform well. Private Client was softer, following a strong first quarter, and we remain vigilant on costs, making sure any incremental investments are supporting our strategy and are in line with revenue.

Now, let me turn it back to Andrew for a few final comments.

I'll wrap up our prepared remarks with a few comments about the rest of the year, and then we would like to take your questions. We expect the trend of the first six months on fixed income institutional sales and trading to continue. Equity underwriting and M&A backlogs continue to be healthy. As long as the markets remain active, we'll participate. This is a lumpy business, and a few deals shifting to another quarter can have a material impact on our bottom line.

We entered the traditional summer slowdown in Q3, and the presidential elections in Q4 may create uncertainty, so equity trading and private client revenues could continue to be softer.

That concludes our prepared comments. Now, I'll ask the operator to facilitate Q&A.

(OPERATOR INSTRUCTIONS). Steven Eisman, Frontpoint.

Can you just talk about the cost side -- what you are doing there relative to the business? You seem to be wanting to build the base of the Company, and yet the business, at least right now, seems to be slow. Are you going to adjust your cost structure or just wait for the business to get better?

Yes; we are continuing (ph) to make some targeted investments. These are items that we had planned for. Some of the increase in the cost structure were items that were related to being a public company, and we have disclosed that to a certain extent in the Form 10 (ph) as part of the spinoff, about $5 million annually in things like D&O insurance, (indiscernible) important things like that. But if you look at some of the other cost items, which are more variable in nature, such as outside services and travel, those are the increases that are primarily related to increased deal activity. So there's nothing structurally going on.

Riley Tierney, Level Global Investors.

I'd like to ask a couple of questions regarding the private client business. If you had to describe how the sequential performance of commissions played out during the quarter, would that kind of have reflected the general market conditions of kind of a steadily declining into June? And if maybe you could give us some idea of how things are going in July?

We actually don't disclose our monthly results. I would say that July had some of the tenor of June.

Now let me ask you about the equity backlog. You completed a very large transaction recently. You said that the backlog is actually stronger now than it was at the beginning of the quarter. How would you characterize the deals in the backlog? Do you think these are the kind of deals that have a high probability of being completed, or are there a mix of kind of income-related deals that might be less attractive in an environment were interest rates are higher? Could you just give us some kind of feel for what's in there?

Yes. The Company, I think, is it's well diversified across all four of our verticals, which again are consumer, financial, institutions, technology and healthcare. And at any given time, I think some portions of that might be less successful, but it's very well diversified.

And then the last thing I would ask is -- the M&A revenues were very strong during the quarter. Do you think the current level of M&A revenues is sustainable, given what you have in the pipeline for completion? Or was that just an unusually strong quarter?

We did complete one large transaction during the quarter, and that primarily drove the year-over-year and quarter-over-quarter increase. We've said before that business can be lumpy, depending on timing of transactions. That said, entering the third quarter here, we've got nine transactions in backlog versus six in the first quarter.

Is that on the M&A side?

That's on the M&A side.

Justin Hughes, Philadelphia Financial.

First of all, on the PCS side, in the last quarter, you guys talked about increasing your headcount there and hiring, and yet your financial advisors were down from quarter to quarter. Was that due to just not hiring, or just more attrition than you expected?

Our plan, I would reiterate, which is twofold to grow our financial advisors, to train and develop our own, essentially taking people with what we believe is relevant experience, primarily around relationship building, and train them into our primary advisory model. We are actually ahead of our plans for that hiring. Our pipeline of hiring seasoned people, recruiting them to the firm, is slightly slower. Refilling the pipeline could take some work on our part. Having said that, our attrition has slowed down substantially, and I believe it's reflective of the industry.

And then, following up on Riley's questions on M&A, the fact that you guys disclosed one large transaction is kind of unusual to see a broker mention a specific transaction. So I was wondering -- I'm assuming that was a fairly significant deal in the quarter. Can you quantify, on a pre-tax basis, the contribution that had this quarter?

No; we don't disclose pre-tax contribution for an individual deal.

Okay. Is there a level of significance in which you would point out a particular deal? Would it have to be better than 20 percent on pre-tax or something like that?

No; we wouldn't. We are not going to disclose the bottom-line profit on any individual deal. But again, we felt it was important for folks to notice or to understand that there was a significant transaction during the quarter, because the increase was so large.

And secondly, I would just ask add to that on this call a quarter ago, we had a number of questions about it because it had been announced and was a very large, billion-dollar transaction. So we also thought it was consistent to acknowledge that that had been completed this quarter.

And then you said there's nine deals that have been announced but not yet closed at the end of the quarter, and there were six the prior quarter. The fees are on a volume basis, so can you give us the deal value in those six versus those nine?

No; we are not going to announce the pipeline on M&A.

Deal just announce the number of pipeline, not the value?

Yes.

The number of announced transactions, not the expected economics.

And then, last question -- your corporate revenues from quarter to quarter went from 2 million to 6 million, and year over year from less than 1 million to 6 million. You said there was an equity gain on that, but I think you said that was only 2 million?

Actually, the net gain was $1 million. This investment was held in a partnership that's consolidated into the Company, and so you have consolidation accounting. So we recorded the full revenue gain on the investment, which was $4 million during the quarter. But then there was an additional 3 million of minority interest expense.

I see. So it was only a 1 million contribution to pre-tax?

Yes, net. So both revenue (multiple speakers).

And has that investment been completely exited, or will we see marks to market going forward?

The Company recently went public, so there is a lockup period on the stock. But we have a small number of firm investments that we hold -- that particular investment, as well as others. And we don't disclose -- they are not significant, and we don't disclose individual details of them except when you have an unusual gain like the one we did in the quarter.

So we should see marks on this going forward?

As well as other venture investments that we own.

Chuck Cree (ph), Atlas Capital.

Just a quick question. I was curious -- there seems to be, based on your announcement and kind of some of your larger peers based in New York, somewhat of a deceleration as well as some seasonality, pretty much across business lines, maybe with the exception of M&A. Given the fact that consensus shows much higher earnings for the second half of the year relative, to what you've reported in what seems to be a fairly strong first half of the year, I'm just curious if you can give us a little more comfort as to how you get to the back-half guidance, which I think for the last two quarters is $1.52 versus your $1.38 that you earned in the first half.

There's a very straightforward answer to that, which is we give no guidance. Those are models that several firms have created, and you can speak to them, but we give no guidance.

Adrian McKay (ph), Freestyle Fund Management (ph).

Can you talk a little bit about your entry into the fixed income business, which seems to be at a time when you would expect the payoff from those types of investments to decline in a rising interest rate environment? And can you talk about the impact of that expansion on your cost structure, because it seems like you've made some significant hires in that area?

Yes. It's core to our long-term middle-market strategy. We continue to believe that that's the foundation of our opportunity in both our equities and fixed income business, and we will continue to make some of those investments we recognized and articulated last quarter. I think we were amongst the first to point to the softening fixed income environment that we expect to continue.

The bulk of that is consistent with our long-term strategy, which is increased distribution. While the distribution may not achieve its original plans, it is a commission sales force, so the expenses related to the revenues. And, secondly, some product enhancements we think is appropriate, such as our new on-the-run (ph) investment-grade capability to increase our penetration with existing clients, even in a softer environment. We believe, while that may have some modest short-term pressure for us, the long-term benefits are squarely there.

In order to be competitive, won't you have to take some pretty significant principal risk in order to maintain (ph) inventory in that business?

That's part of the reason I commented on our VAR. We do not run a proprietary book in either of our capital markets, but our inventories do reflect our client flow and our intention of facilitating that to the best of our ability. But that's specifically why our VAR, which is relatively modest at about 0.5 million, declined by 50 percent quarter over quarter and is now about 250,000, specifically because our flow is down and our inventories are down, as well. That's correlated, directly correlated (inaudible).

Lauren Smith, Keefe.

Just a couple of questions. Just to follow up on the hiring issue, certainly you've added some key people, managers in some regional offices on the private client side, and you certainly have broadened on certain sector groups in research. Where would you say we are, you are, in that process with respect to your goals? Are we close to the end? Is there meaningfully more amount of hiring that you envision in the near term?

The bulk of our hiring, Lauren, has been accomplished. Collectively, we had hired what I call essentially sales roles, whether it's a financial advisor on the private client side or increased distribution on the fixed income side. Other than that, our hiring is largely done.

So it's a lot on the producing side. And I believe there was a fair amount in the current quarter, so it's probably not even up and running its full capacity yet? One could look at it that way?

Yes.

And then on the private client side, you mentioned -- well, I guess firstly, is your thought process still a 3-to-1 ratio of training to hire?

Yes.

So no change there. And then on the recruiting front, you said -- you noted it has slowed some for you. Is that more because of specifics to the competitive dynamic of the environment right now? I mean, I'm hearing from some of our other companies that things have heated up again, so that some of these up-front payout packages are getting lofty again, and you just don't want to go there.

Lauren, let me clarify that. Perhaps I wasn't as clear as I can be. Our pipeline is taking longer to fill up. It's not slowing. It's actually increasing. But it's a slower ramp coming from a standstill for a year and a half, two years, and it's taking a while. We do have a very clear model on the trans comp (ph) that we'll offer that we intend to be very disciplined to. We have some signs of what you're suggesting, which is some markets are offering substantially more than we are, at which point those people will select other firms. We are not going to change our discipline.

And then on the comp side, the ratio trended down a little bit. Is that to 61.6, I think it was, in the quarter. Are we kind of stabilizing here, or might there be a lower trend?

This is a very common pattern to what you'd see to it (ph) pretty much the last through history (ph) here is that our first quarter tends to be our highest compensation rate quarter. Again, that's because we reset all the benefit plans such as 401(k) match and payroll taxes, et cetera. So this was natural and expected that our comp would tend downward.

It's going to vary from quarter to quarter, I will tell you, by the mix of our business because, if you remember, our Capital Markets business has a lower payout ratio than the Private Client business. So, as business mix changes from quarter to quarter, you might get some fluctuation. But generally it trends down from the first quarter. And we've really been fairly stable the last couple of years now on our comp ratio overall.

And then, just looking at the segment data, and just drilling down into the institutional sales, on the equity front, just using one of your competitors who reported this week, as well, I was looking at the equity side, and yours was down pretty meaningfully quarter on quarter and then down also year on year. And again, just using comps, they were flat sequentially and up pretty big, 20 percent, year on year. And I'm just wondering if there was anything unusual that you can point to that might have affected those results, or anything specific to you guys. I just thought that disparity was pretty marked.

What I'm looking at here for the second quarter -- we were a little bit softer. But year to date, equity institutional sales are up just under 10 percent year over year. But anyway, second quarter was a little bit softer. I think trading volumes declined industrywide, and our volumes were a little bit softer because of that. So I don't know the particular competitor you are speaking to, and what went on in that individual firm, but we tended to have -- we had a pretty decent first quarter, a little bit softer in the second quarter.

Justin Hughes, Philadelphia Financial.

Just one more question. In the past, you guys had given your targeted return on equity, or at least you said that you wanted to be in the upper segment of your peers' return on equity?

Right.

Actually, I think it was tangible return on equity?

Yes.

When I look at kind of my comp group, I think they're at about a 20 percent ROE. Is that still your target on tangible equity?

Well, maybe you've got a different comp group than we do. Our comp group is AG Edwards, Raymond James and Jefferies.

Okay. And they are still not quite (multiple speakers) --

We are quite competitive with that group.

So you are targeting -- I'm just guessing. I think those guys are all like a low, like 12 to 13 percent ROE type of target?

I think, a blended average, they are in kind of the midteens.

And that's on tangible or on stated book?

That's on tangible.

So you would be targeting something like $3 a share (multiple speakers)?

No. We are not issuing guidance for any specific targets. We just want to be a top performer amongst that group.

No, I wasn't saying specifically for this year, but over time do you think you can get to a run rate of $3 a share?

We are not giving targets or long-term goals on a per-share basis.

At this time, there no further questions.

Well, let me wrap up. Thank you all for joining us on today's call. We continue to work to ensure that Piper Jaffray is positioned appropriately in the current market environment and, very importantly, focus on executing what we believe are the right strategic actions to ensure the long-term growth of our firm. Thank you for joining us, and we look forward to updating your next quarter.