Summary of KBW, INC. - Yahoo! Finance

ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with our unaudited consolidated financial statements and the related notes included elsewhere in this report.
Cautionary Statement Regarding Forward-Looking Statements We have made statements in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and in other sections of this report that are forward-looking statements. In some cases, you can identify these statements by forward-looking words such as "may," "might," "will," "should," "expect," "plan," "anticipate," "believe," "estimate," "predict," "potential" or "continue," the negative of these terms and other comparable terminology. These forward-looking statements, which are based on various underlying assumptions and expectations and are subject to risks, uncertainties and other unknown factors, may include projections of our future financial performance based on our growth strategies, the identification of market opportunities and anticipated trends in our business. These statements are only predictions based on our current expectations and projections about future events. There are or may be important factors that could cause our actual results, level of activity, performance or achievements to differ materially from the historical or future results, level of activity, performance or achievements expressed or implied by such forward-looking statements. These factors include, but are not limited to, those discussed in the section entitled "Risk Factors" in Part II, Item 1A of this report and the section entitled "Risk Factors" in our Annual Report on Form 10-K for the year ended December 31, 2007.
Although we believe the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, level of activity, performance or achievements. Moreover, neither we nor any other person assumes responsibility for the accuracy or completeness of any of these forward-looking statements. You should not rely upon forward-looking statements as predictions of future events. We are under no duty to update any of these forward-looking statements after the date of filing of this report to conform such statements to actual results or revised expectations. Overview
We are a full service investment bank specializing in the financial services industry. Our principal activities are: (i) investment banking, including mergers and acquisitions ("M&A") and other strategic advisory services, equity and fixed income securities offerings and mutual thrift conversions, (ii) equity and fixed income sales and trading, with an emphasis on institutional customers investing in the small and mid-cap segments, and a wide range of fixed income securities, (iii) research that provides fundamental, objective analysis that identifies investment opportunities and helps our investor customers make informed investment decisions, and (iv) asset management, including investment management and other advisory services to institutional clients and private high net worth clients, as well as various investment vehicles.
Within our full service business model, our focus includes bank and thrift holding companies, banks and thrifts, insurance companies, broker-dealers, mortgage banks, asset management companies, REITs, consumer and specialty finance firms, financial processing companies and securities exchanges. We emphasize serving investment banking clients in the small and mid-cap segments of the financial services industry although our clients also include many large-cap companies. Our sales customers are primarily institutional investors.
Most revenues with respect to our services provided are primarily determined as a result of active competition in the marketplace. Our revenues are primarily generated through advisory, underwriting and private placement fees earned through our investment banking activities, commissions earned on equity sales and trading activities, interest and dividends earned on our securities' inventories and profit and losses from trading activities related to those securities' inventories.
Compensation and benefits comprise the most significant component with respect to our expenses. Our performance is dependant on our ability to attract, develop and retain highly skilled employees who are motivated to provide quality service and guidance to our clients.
Many external factors affect our revenues and profitability. Such factors include equity and fixed income trading prices and volumes, the volatility of those markets, the level and shape of the yield curve, political events and regulatory developments and competition. These factors impact our investment banking operations, including the number and timing of equity and fixed income securities issuances and M&A activity within the financial services industry. These same factors also affect our sales and trading business by impacting equity and fixed income trading prices and volumes and valuations in secondary financial markets. Commission rates, market volatility and other factors also affect our sales and trading revenues. These market forces may cause our revenues and earnings to fluctuate significantly from period to period, and the results of any one period should not be considered indicative of future results. See "-Business Environment."

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A significant portion of our expense base is variable, including employee compensation and benefits, brokerage and clearance, communication and data processing and travel and entertainment expenses. Our remaining costs generally do not directly relate to the service revenues earned.
Certain data processing systems that support equity and fixed income trading, research, payroll, human resources and employee benefits are service bureau-based and are operated in the vendors' data centers. We believe that this stabilizes our fixed costs associated with data processing. We also license vendor information databases to support investment banking, sales and trading and research. Vendors may, at the end of contractual terms, terminate our rights or modify or significantly alter product and service offerings or related fees, which may affect our ongoing business activities or related costs. Business Environment
Our business activities focus on the financial services sector. This financial services industry remains one of the largest sectors of the U.S. and European economies. As of September 30, 2008 the market capitalization of financial companies accounted for 15.8% of all companies in the S&P 500 Index, 19.2% or the S&P MidCap 400 Index, and 19.1% of the S&P SmallCap 600 Index. In the UK, financials accounted for 25.3% of the FTSE Eurofirst Index. In the U.S. this sector remains highly fragmented. There are approximately 1,400 publicly traded banks and thrifts and 8,400 different banking entities in the U.S. Because of our focus, we are particularly impacted by economic and market conditions affecting this sector. Trends in the global economy and domestic and international financial markets have a significant impact on the outlook for financial services, including the market prices for our securities and the securities of other companies in the sector.
Currently, U.S. market and economic conditions have experienced unprecedented volatility and change. In recent months, the landscape of the U.S. financial services industry changed dramatically. In September 2008, the U.S. federal government assumed a conservatorship role in two government sponsored entities ("GSEs"), Federal Home Loan Mortgage Corporation and Federal National Mortgage Association, in response to liquidity and capitalization issues affecting the GSEs and the potential impact of further deterioration in the GSEs on the global financial system. In September 2008, Lehman Brothers Holdings Inc. declared bankruptcy, the Bank of America Corp. announced and signed an agreement to acquire Merrill Lynch & Co., Inc. and the U.S. federal government provided a loan to American International Group Inc. ("AIG") in exchange for an equity interest in AIG. Several large bank holding companies have been sold, in whole or in part, as a result of the intervention of federal bank regulators, including Washington Mutual Inc. and Wachovia Corporation. Major investment banks, Morgan Stanley and Goldman Sachs Group, Inc., received approval from the Federal Reserve to become federal bank holding companies.
The U.S. government has begun the implementation under the Emergency Economic Stabilization Act of 2008 ("EESA"), enacted in October 2008, of a $250 billion Capital Purchase Program ("CPP") implemented under authority provided by the EESA, as well as new senior debt guarantee and non-interest bearing deposit guarantee programs. Under the CPP, the U.S. Department of Treasury ("Treasury") will provide capital to qualifying financial institutions by purchasing non-voting preferred securities representing at least 1% of the qualifying institution's risk-weighted assets, but limited to the lesser of 3% of the qualifying institution's risk-weighted assets or $25 billion. We believe that many institutions will utilize this attractive source of capital. The securities may only be redeemed during the first three years following issuance from the proceeds of an offering of Tier 1 perpetual preferred or common stock. The Treasury will also receive warrants to purchase common equity on favorable terms which may be transferable, subject to certain limitations.
Additional relief will be provided by the FDIC under its Temporary Liquidity Guarantee Program ("TLGP") which will guarantee newly-issued senior unsecured debt obligations issued by banks, thrifts, and qualifying bank and thrift holding companies on or before June 30, 2009. Guarantees under the TLGP would remain in effect, regardless of the term of the underlying obligation, until June 30, 2012. Participation in the TLGP would be mandatory for the first 30 days. The Treasury announced that it is also working on a program that would govern assistance to failing institutions that are deemed to be systemically significant, such as the assistance originally agreed to be issued by the FDIC in connection with Wachovia Corporation.
Coordinated global action by various government agencies and central banks has been implemented with a view to restoring capital, creating market liquidity and opening credit sources. Several large international financial institutions have been closed, required to enter into mergers or broken up into various components.
While there have been some signs that the efforts by the U.S. government, in coordination with certain international efforts may open credit flows and stabilize markets, it is difficult to predict how long these conditions will continue or whether additional deteriorations in asset quality, further credit market dislocations or sustained market downturns may exacerbate the impact of these factors on our overall revenues. Even the successful implementation of some of these initiatives may influence the number, size and structure of capital markets and mergers and acquisitions transactions and our ability to participate in these transactions. The availability of capital from the Treasury could be a significant source of competition for traditional private capital markets transactions. However, it is also possible that many companies will consider capital markets transactions to supplement capital raised

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from the Treasury or to redeem securities and reduce the dilutive effect of the warrants issued to the Treasury. The addition of capital made available by the Treasury may provide sufficient strength and stability for certain institutions to pursue attractive mergers or other business acquisitions. We believe that we are well capitalized and have no plans to seek government assistance or change our business model.
Results of Operations
Three Months Ended September 30, 2008 Compared with Three Months Ended September 30, 2007
Overview
Total revenues were $53.6 million for the three months ended September 30, 2008, a decrease of $47.5 million compared with $101.1 million for the same period in 2007. This decrease was primarily due to the increase in the net losses in principal transactions, net of $38.9 million in 2008 over the same period in 2007 and a decrease in investment banking revenues of $14.1 million, partially offset by an increase in commissions revenue of $10.1 million.
Total expenses were $91.8 million for the three months ended September 30, 2008, compared with $91.3 million for the same period in 2007. The increase was primarily due to increases in compensation and benefits expense and communications and data processing expense.
We recorded a net loss of $23.0 million, or $0.75 per diluted share, for the three months ended September 30, 2008, compared with net income of $5.5 million, or $0.18 per diluted share, for the same period in 2007. After adjusting for the stock compensation expense with respect to the 2006 one-time restricted stock awards granted to employees in connection with our initial public offering ("IPO"), our non-GAAP operating net loss was $21.3 million, or $0.69 per diluted share for the three months ended September 30, 2008, compared with net income of $7.3 million, or $0.23 per diluted share in the same period in 2007. See "- Three Month Non-GAAP Financial Measures" for a reconciliation of our non-GAAP measures to their corresponding GAAP amounts.
The following table provides a comparison of our revenues and expenses for the periods presented (dollars in thousands):

                                                  Three Months Ended
                                                    September 30,                    Period-to-Period
                                                2008             2007           $ Change          % Change
                                                                       (unaudited)
Revenues:
Investment banking                            $  46,042        $  60,132        $ (14,090 )           (23.4 )%
Commissions                                      54,527           44,457           10,070              22.7
Principal transactions, net                     (53,836 )        (14,943 )        (38,893 )             N/M
Interest and dividend income                      5,891           10,317           (4,426 )           (42.9 )
Investment advisory fees                            222              436             (214 )           (49.1 )
Other                                               789              736               53               7.2

Total revenues                                   53,635          101,135          (47,500 )           (47.0 )


Expenses:
Compensation and benefits                        60,318           58,658            1,660               2.8

Non-compensation expenses:
Occupancy and equipment                           5,297            4,922              375               7.6
Communications and data processing                7,290            6,205            1,085              17.5
Brokerage and clearance                           6,039            6,361             (322 )            (5.1 )
Interest                                            871            4,610           (3,739 )           (81.1 )
Business development                              5,054            5,105              (51 )            (1.0 )
Other                                             6,902            5,412            1,490              27.5

Total non-compensation expenses                  31,453           32,615           (1,162 )            (3.6 )

Total expenses                                   91,771           91,273              498               0.5

(Loss) / income before income tax
(benefit) / expense                             (38,136 )          9,862          (47,998 )             N/M
Income tax (benefit) / expense                  (15,136 )          4,327          (19,463 )             N/M

Net (loss) / income                           $ (23,000 )      $   5,535        $ (28,535 )             N/M %

N/M= Not Meaningful

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Three Month Non-GAAP Financial Measures We adopted SFAS No. 123(R), Share-Based Payment, in January 2006, which requires the measurement of compensation cost for stock-based awards at fair value on the date of grant and recognition of compensation expense generally over the service period for awards expected to vest. Such grants are recognized as expenses over the requisite service period, net of estimated forfeitures.
We have reported our net (loss) / income, compensation and benefits expense, (loss) / income before income tax (benefit) / expense, income tax (benefit) / expense, and basic and diluted (loss) / earnings per share on a non-GAAP basis for the three months and nine months ended September 30, 2008 in our October 22, 2008 press release. The non-GAAP amount excluded compensation expense related to the amortization of IPO restricted stock awards granted in November 2006.
The following table provides details with respect to reconciling compensation and benefits expense, (loss) / income before income tax (benefit) / expense, income tax (benefit) / expense, net (loss) / income, and basic and diluted earnings per share on a GAAP basis for the three months ended September 30, 2008 and 2007 to the aforementioned captions on a non-GAAP basis in the same respective periods.

(Dollars in thousands, except per share information)

Three Months Ended September 30, 2008
                                                                            Reconciliation
                                                            GAAP                Amount                   Non-GAAP
Compensation and benefits expense                       $     60,318        $        (2,843 ) (a)      $     57,475

(Loss) / income before income tax (benefit) /
expense                                                 $    (38,136 )      $         2,843  (a)       $    (35,293 )
Income tax (benefit) / expense                          $    (15,136 )      $         1,145  (b)       $    (13,991 )

Net (loss) / income                                     $    (23,000 )      $         1,698  (c)       $    (21,302 )


Earnings per share (d):
Basic                                                   $      (0.75 )      $          0.06            $      (0.69 )
Diluted                                                 $      (0.75 )      $          0.06            $      (0.69 )

Weighted average number of common shares
outstanding (d):
Basic                                                     30,794,738                      -  (e)         30,794,738
Diluted                                                   30,794,738                      -  (e)         30,794,738

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Three Month Non-GAAP Financial Measures (Continued)

Three Months Ended September 30, 2007
                                                                               Reconciliation
                                                               GAAP                Amount                   Non-GAAP

Compensation and benefits expense                          $     58,658        $        (3,128 ) (a)      $     55,530

Income before income tax expense                           $      9,862        $         3,128  (a)       $     12,990
Income tax expense                                         $      4,327        $         1,372  (b)       $      5,699

Net income                                                 $      5,535        $         1,756  (c)       $      7,291


Earnings per share:
Basic                                                      $       0.18        $          0.06            $       0.24
Diluted                                                    $       0.18        $          0.05            $       0.23

Weighted average number of common shares outstanding:
Basic                                                        30,665,945                      -  (e)         30,665,945
Diluted                                                      31,546,276                      -  (e)         31,546,276

(a) The non-GAAP adjustment represents the pre-tax expense with respect to the amortization of the IPO restricted stock awards granted to employees in November 2006.

(b) The non-GAAP adjustment with respect to income tax (benefit) / expense represents the elimination of the tax (benefit) / expense resulting from the amortization of the IPO restricted stock awards in the period.

(c) The non-GAAP adjustment with respect to net income was the after-tax amortization of the IPO restricted stock awards in the period.

(d) In accordance with Statement of Financial Accounting Standards No. 128, basic and diluted common shares outstanding are equal for the quarter ended September 30, 2008.

(e) Both the basic and diluted weighted average number of common shares outstanding were not adjusted.

Our management utilizes these non-GAAP calculations in understanding and analyzing our financial results. Our management believes that the non-GAAP measures provide useful information by excluding certain items that may not be indicative of our core operating results and business outlook. Our management believes that these non-GAAP measures will allow for a better evaluation of the operating performance of our business and facilitate meaningful comparison of our results in the current period to those in prior periods and future periods. Our reference to these non-GAAP measures should not be considered as a substitute for results that are presented in a manner consistent with GAAP. These non-GAAP measures are provided to enhance investors' overall understanding of our current financial performance.
A limitation of utilizing these non-GAAP measures is that the GAAP accounting effects of these events do in fact reflect the underlying financial results of our business and these effects should not be ignored in evaluating and analyzing our financial results. Therefore, management believes that our GAAP measures of net (loss) / income, compensation and benefits expense, (loss) / income before income tax (benefit) / expense, income tax (benefit) / expense, and basic and diluted (loss) / earnings per share and the same respective non-GAAP measures of our financial performance should be considered together.
We expect to grant restricted stock awards and other share-based compensation in the future. We do not expect to make any such substantial grants to employees outside of our regular compensation and hiring process, as we did when we granted IPO restricted stock awards. Revenues
Investment Banking
Investment banking revenue was $46.0 million for the three months ended September 30, 2008, a decrease of $14.1 million, or 23.4%, compared with $60.1 million for the same period in 2007. This decrease was primarily due to a $13.4 million decrease in M&A and advisory fees to $10.6 million for the three months ended September 30, 2008 compared with $24.0 million in the same

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period in 2007, reflecting fewer transactions in 2008 in addition to a larger-than-average M&A and advisory fee which was recorded during the third quarter of 2007. Capital markets revenue was $35.4 million for the three months ended September 30, 2008, a slight decrease of $0.7 million, or 1.9%, compared with $36.1 million for the same period in 2007. The decrease in capital markets revenue was primarily due to fewer underwriting transactions for the three months ended September 30, 2008 compared with the same period in 2007, substantially offset by a significantly larger-than-average private placement transaction which closed during the third quarter of 2008. Commissions
Commissions revenue increased $10.0 million, or 22.7%, to $54.5 million for the three months ended September 30, 2008 compared with $44.5 million for the same period in 2007. This overall increase was due to increases of $8.7 million and $1.4 million in commissions revenue on U.S. and European equity securities, respectively. The increase in commissions revenue was primarily a result of higher volume in equity trading for customers as a result of the especially volatile market for U.S. financial services stocks. Principal Transactions, Net
Principal transactions resulted in a net loss of $53.8 million for the three months ended September 30, 2008 compared to a net loss of $14.9 million for the same period of 2007. The net loss in principal transactions was primarily a result of a loss of $26.7 million related to trust preferred and other capital securities issued by banking and insurance companies and a loss of $23.9 million related to CDOs primarily collateralized by banking and insurance company trust preferred and capital securities for the three months ended September 30, 2008 compared to net losses of $9.2 million and $4.5 million, respectively, for the same 2007 period. Fixed income sales and trading, excluding the aforementioned CDO positions, resulted in a net gain of $2.5 million for the three months ended September 30, 2008, compared to a net loss of $0.7 million for the same period of 2007. Other investments comprised of strategic principal investments of a long term nature resulted in net losses of $5.2 million for the three months ended September 30, 2008, compared to a net loss of $0.9 million for the same period of 2007. Equity market making and trading of equity securities for our own account resulted in a net loss of $0.6 million for the three months ended September 30, 2008, compared with a net gain of $0.3 million for the same period of 2007.
The net loss in the quarter was predominantly a result of market value adjustments on PreTSL� related securities and reflects the unprecedented decline in the market value of most financial services industry securities and in particular the securities of U.S. banking companies during the third quarter of 2008. Trust preferred and other capital securities of banking and insurance companies, all of which were performing, were carried at an aggregate fair value of approximately $35 million (or 42% of original par value and an unrealized loss of approximately $48 million) at September 30, 2008. Trust preferred backed CDOs, including PreTSL� securities, were carried at an aggregate fair value of approximately $27 million (or 42% of original cost and an unrealized loss of approximately $37 million) at September 30, 2008. All rated CDO securities were performing at September 30, 2008.
Adverse market conditions, as described in "-Business Environment," continued during the quarter. Investor demand continued to diminish for many classes of fixed income securities as the deteriorating credit markets experienced dislocation, illiquidity and wider credit spreads. As a result, the fair value of our fixed income financial instruments was impacted by these market fluctuations.
Interest and Dividend Income
Interest and dividend income was $5.9 million for the three months ended September 30, 2008, a decrease of $4.4 million, or 42.9%, compared with $10.3 million for the same period in 2007. This decrease was primarily due to lower average holdings of fixed income financial instruments and securities purchased under resale agreements in the third quarter of 2008 compared with the same period in 2007.
Expenses
Compensation and Benefits
Compensation and benefits expense was $60.3 million for the three months . . .