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PLCC > SEC Filings for PLCC > Form 10-Q on 8-Nov-2012All Recent SEC Filings

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Form 10-Q for PAULSON CAPITAL CORP


8-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations

FORWARD-LOOKING STATEMENTS AND RISK FACTORS

This report, including, without limitation, Item 2. "Management's Discussion and Analysis of Financial Condition and Results of Operations," contains or incorporates both historical and "forward-looking" statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Words such as "anticipates," "believes," "expects," "intends," "future" and similar expressions identify forward-looking statements. Any such forward-looking statements in this report reflect our current views with respect to future events and financial performance and are subject to a variety of factors that could cause our actual results to differ materially from historical results or from anticipated results expressed or implied by such forward-looking statements. Because of such factors, we cannot assure you that the results anticipated in this report will be realized. As noted elsewhere in this report, various aspects of our business are subject to extreme volatility, often as a result of factors beyond our ability to anticipate or control. In particular, factors, such as the condition of the securities markets, which are in turn based on popular perceptions of the health of the economy generally, can be expected to affect the volume of our business as well as the value of the securities maintained in our trading and investment accounts. Other factors that may affect our future financial condition or results of operations include the following:

Aspects of our business are volatile and affected by factors beyond our control.

Our ability to attract and retain customers may be affected by our reputation.

We are subject to extensive regulation that could result in investigations, fines or other penalties.

We face intense competition in our industry.

Our future success depends on retaining existing management and hiring and assimilating new key employees, and our inability to attract or retain key personnel would materially harm our business and results of operations.

We are subject to the risk of legal proceedings, which may result in significant losses to us that we cannot recover. Claimants in these proceedings may be customers, employees, investors or regulatory agencies, among others, seeking damages for mistakes, errors, negligence or acts of fraud by our employees.

As a public company, we are subject to complex legal and accounting requirements that require us to incur substantial expense and expose us to risk of non-compliance.

Our directors and executive officers control approximately 47% of our common stock and may have interests differing from those of other stockholders.

OVERVIEW

Substantially all of our business has historically consisted of the securities brokerage and corporate finance activities of our wholly-owned subsidiary, Paulson Investment Company, Inc. ("PIC"), which has operations in four principal categories, all of them in the financial services industry. These categories are:

corporate finance revenues consisting principally of underwriting discounts and underwriter warrants;

securities trading from which we record profit or loss, depending on trading results;

investment income resulting from earnings on, and increases or decreases in the value of, our investment portfolio; and

securities brokerage activities for which we earn commission revenues.

During the second quarter of fiscal 2012 ended June 30, 2012, the Company sold substantially all PIC's retail brokerage business to JHS Capital Advisors, LLC and is focusing its operations on boutique investment banking.

In addition, Paulson Capital Properties, LLC, a 100% owned subsidiary, was established for the purpose of purchasing, improving and remarketing underappreciated real estate. Through September 30, 2012, we had not purchased any real estate.


Because we operate in the financial services industry, our revenues and earnings are substantially affected by general conditions in financial markets. Further, past performance is not necessarily indicative of results to be expected in future periods. In our securities brokerage business, the amount of our revenues depends on levels of market activity requiring the services we provide. Our corporate finance activity, which consists of acting as the managing underwriter of initial and follow-on public offerings, private investments in public equity ("PIPEs") and private placements for smaller companies, is similarly affected by the strength of the market for new equity offerings, which has historically experienced substantial cyclical fluctuation. During the first nine months of 2012, the number of global IPO's fell by approximately 47% to 142, which raised proceeds of $70.7 billion, compared to the first nine months of 2011 when 269 IPO's were completed for total proceeds of $113 billion. Fewer initial public offerings from China and continued economic weakness in Europe contributed to the declines. In the United States, the number of IPO's was up slightly to 99 during the current nine-month period, compared to 96 in the first nine months of 2011. Total proceeds for the US IPO's increased to $35.0 billion from $29.2 billion raised in the first nine months of 2011. The outlook for the remainder of 2012 is encouraging globally. Although many companies delayed their initial public offerings due to continued concerns about weak economic growth rates internationally, the number of companies in the global IPO pipeline continues to increase to near historic high levels. Although we attempt to match operating costs with activity levels, many of our expenses are either fixed or difficult to change on short notice. Accordingly, fluctuations in corporate finance revenues tend to result in sharper fluctuations, on a percentage basis, in net income or loss.

Our investment and trading income or loss is affected by changes in market valuation of securities generally and, in particular, by changes in valuation of the equity securities of microcap companies in which our investments and trading activities tend to be concentrated. Equity markets in general, and microcap equity markets in particular, have always experienced significant volatility and this volatility has, in recent years, been extreme. As a result, the value of our investment portfolio and securities held in connection with our trading and investment activities has experienced large quarterly fluctuations in income or loss, and our net worth has substantially increased or decreased as our securities holdings are marked to market.

A substantial portion of our corporate finance business consists of acting as managing underwriter of initial and follow-on public offerings for microcap and smallcap companies. As a part of our compensation for these activities, we typically receive warrants exercisable to purchase securities similar to those that we offer and sell to the public. The warrants generally have a five-year expiration date and are subject to a restricted period of six months to one-year during which we cannot exercise. The exercise price is typically 120% of the price at which the securities were initially sold to the public. Accordingly, unless there is at least a 20% increase in the price of these securities at some time more than six months and less than five years after the offering, the warrants will remain "under water" and will ultimately expire unexercised. We also receive warrants in connection with PIPEs, which have varying terms and conditions.

CRITICAL ACCOUNTING POLICIES AND USE OF ESTIMATES

We reaffirm the critical accounting policies and estimates as reported in our Annual Report on Form 10-K for the year ended December 31, 2011, which was filed with the Securities and Exchange Commission on March 8, 2012.

SALE OF RETAIL BROKERAGE OPERATIONS

In February 2012, the Company announced it had reached an agreement with JHS Capital Advisors, LLC (JHS) of Tampa, Florida to sell substantially all of its retail brokerage operations, including many of its branch and non-branch offices as well as registered personnel (employees and independent contractors), to JHS. Under the transaction, Paulson advisors became registered representatives of JHS and, through JHS, will continue to use RBC Correspondent Services, a division of RBC Capital Markets, LLC, for custody of client assets and securities, trade execution and portfolio reporting.


The sale closed on April 16, 2012. Under the agreement, the Company is to be paid approximately $1,653,247 net of certain deductions for compensation expenses. $1,107,741 was received on closing on April 16, 2012, and the balance is to be paid over three installments on July 16, 2012, October 15, 2012 and January 11, 2013. During the three- and nine-month periods ended September 30, 2012, the Company received $165,183 as the first installment payment. Subsequent to September 30, 2012, the Company received the second installment payment of $153,666. The final purchase price is subject to recalculation after six months based upon the aggregate gross dealer commissions for the twelve month period ended at that time. The agreement also requires twelve directors, officers and employees of the Company to enter into non-solicitation and non-competition agreements pursuant to which they are prohibited from soliciting employees and registered representatives of JHS for two years from the closing date and, subject to a limited exception, engaging in the retail brokerage business for one year from the closing date.

The Company continues to operate independently as a broker/dealer focused on its core competencies in boutique investment banking activities, and continues as a public company under the symbol "PLCC" on the NASDAQ Exchange.

RESULTS OF OPERATIONS

Our revenues and operating results are influenced by fluctuations in the equity markets as well as general economic and market conditions, particularly conditions in the NASDAQ and over-the-counter markets, where our investment and trading positions and the underlying stock for the underwriter warrants are heavily concentrated. Significant fluctuations can occur in our revenues and operating results from one period to another. Our results of operations depend upon many factors, such as the number of companies that are seeking financing, the quality and financial condition of those companies, market conditions in general, the performance of our previous underwritings and interest in certain industries by investors. As a result, revenues and income derived from these activities may vary significantly from period to period. Our revenues include the following:

Corporate finance revenues, which are a function of total proceeds from offerings done during the period, compensation per offering and the fair value of underwriter warrants received;

Investment income (loss), which includes (i) the unrealized appreciation and depreciation of securities held based on quoted market prices, (ii) the unrealized appreciation and depreciation of securities held that are not readily marketable, based upon our estimate of their fair value,
(iii) realized gains and losses on the sale of securities with quoted market prices and securities that are not readily marketable, (iv) income on the exercise of underwriter warrants, and (v) the unrealized appreciation and depreciation of underwriter warrants held;

Trading income (loss), which is the gain or loss from trading positions before commissions paid to the representatives in the trading department; and

Commissions, which represent amounts earned from our retail securities brokerage activities.


The following tables set forth the changes in our operating results in the three- and nine month periods ended September 30, 2012 compared to the three- and nine-month periods ended September 30, 2011 (dollars in thousands):

                                             Three Months Ended              Favorable
                                               September 30,               (Unfavorable)       Percentage
                                           2012              2011             Change             Change
Revenues:
Commissions                            $         68       $     3,487     $        (3,419 )          (98.0 )%
Corporate finance                                22                78                 (56 )          (71.8 )
Investment income                               141                59                  82            139.0
Trading loss                                   (132 )            (393 )               261             66.4
Interest and dividends                          400               125                 275            220.0
Gain (loss) on sale of assets                   (24 )               -                 (24 )         (100.0 )
Other                                            45                45                   -                *
Total revenues                                  520             3,401              (2,881 )          (84.7 )
Expenses:
Commissions and salaries                        279             3,514               3,235             92.1
Underwriting expenses                             4                 1                  (3 )         (300.0 )
Rent and utilities                               40               144                 104             72.2
Communication and quotation services             49               136                  87             64.0
Professional fees                               161                76                 (85 )         (111.8 )
Travel and entertainment                          4                30                  26             86.7
Advertising and promotion                         -                 4                   4            100.0
Settlement expense                               74               (25 )               (99 )         (396.0 )
Clearing expenses                                10                80                  70             87.5
Bad debt expense                                  -                 4                   4            100.0
Depreciation and amortization                     -                 5                   5            100.0
Licenses, taxes and insurance                   170               110                 (60 )          (54.5 )
Other                                            58               131                  73             55.7
Total expenses                                  849             4,210               3,361             79.8
Loss before income taxes               $       (329 )     $      (809 )   $           480             59.3 %


*Not meaningful.

                                            Nine Months Ended              Favorable
                                              September 30,              (Unfavorable)       Percentage
                                           2012            2011             Change             Change
Revenues:
Commissions                            $      3,725     $    11,797     $        (8,072 )          (68.4 )%
Corporate finance                                70             256                (186 )          (72.7 )
Investment loss                                (438 )          (154 )              (284 )         (184.4 )
Trading income (loss)                           810          (1,529 )             2,339            153.0
Interest and dividends                          561             392                 169             43.1
Loss on asset disposition                        (1 )             -                  (1 )         (100.0 )
Gain on sale of assets                        1,596               -               1,596            100.0
Other                                           140             136                   4              2.9
Total revenues                                6,463          10,898              (4.435 )          (40.7 )
Expenses:
Commissions and salaries                      4,368          11,893               7,525             63.3
Underwriting expenses                            42              12                 (30 )         (250.0 )
Rent and utilities                              255             429                 174             40.6
Communication and quotation services            266             401                 135             33.7
Professional fees                               590             463                (127 )          (27.4 )
Travel and entertainment                         50              92                  42             45.7
Advertising and promotion                         9              20                  11             55.0
Settlement expense                               74               -                 (74 )         (100.0 )
Clearing expenses                               175             298                 123             41.3
Bad debt expense                                232               4                (228 )        (5700.0 )
Depreciation and amortization                     5              14                   9             64.3
Licenses, taxes and insurance                   437             349                 (88 )          (25.2 )
Other                                           307             473                 166             35.1
Total expenses                                6,810          14,448               7,638             52.9
Loss before income taxes               $       (347 )   $    (3,550 )   $         3,203             90.2 %


Revenues
The United States markets had a strong third quarter of 2012, with the NASDAQ Composite rising 6.2%. For the first nine months of 2012, the NASDAQ increased by 19.6%, The Dow Jones Industrial Average was up 4.3% in the third quarter and increased 10% for the nine month period. Third quarter performance was driven by international government stimulus programs and moderate economic growth in the United States, particularly in manufacturing and housing.

Commissions declined 98% during the third quarter ended September 30, 2012 compared to the third quarter of 2011 and declined 68.4% for the first nine months of 2012 compared to the first nine months of 2011. The declines were largely due to the sale of substantially all the Company's retail brokerage business to JHS effective April 16, 2012. As of September 30, 2012, the Company had 5 registered representatives, which were included in the Company's 17 employees, compared to 98 registered representatives as of September 30, 2011.

Corporate finance income in the third quarter of 2012 was down 71.8% from the third quarter of 2011, and declined 72.7% for the nine month period ended September 30, 2012 compared to the nine month period ended September 30, 2011. The Company participated in a smaller private placement for The Patron Company in the first nine months of 2012, while we completed a larger private placement for The Patron Company in the third quarter of 2011.

Investment income (loss) included the following (in thousands):

                                        Three months Ended                Nine months Ended
                                          September 30,                     September 30,
                                       2012            2011             2012             2011
Net unrealized appreciation
(depreciation) related to
underwriter warrants               $        141     $        44     $        (51 )    $      (176 )
Net unrealized appreciation
(depreciation) of securities
held based on quoted market
prices or, for securities that
are not readily marketable, our
estimate of their fair value                  -              15             (253 )             22
Net realized loss on the sale of
securities with quoted market
prices and securities that are
not readily marketable                        -               -             (134 )              -
                                   $        141     $        59     $       (438 )    $      (154 )

We did not exercise any underwriter warrants in the first three quarters of 2012 or 2011. Generally, when we exercise a warrant to obtain the underlying common stock, the common stock is subsequently sold in the near term and the related gain is reflected as a component of investment income.

Investment income (loss) is volatile from period to period due to the fact that it is driven by the fair value of the securities and underwriter warrants held. In addition, the performance of the securities in which we have a concentration can significantly affect our investment income from period to period.

Trading loss decreased by 66.4% to $132 thousand in the third quarter of 2012 compared to $393 thousand in the third quarter of 2011. For the first nine months of 2012, trading income was $810 thousand compared to a trading loss of $1.529 million for the first nine months of 2011. The trading income was positively affected by the market value of certain securities in which we make a market. Our focus is on very small capitalization issues, especially those tied to our corporate finance clients.


Expenses
Total expenses decreased by $3.361 million in the third quarter of 2012 compared to the third quarter of 2011, and decreased by $7.638 million for first nine months of 2012 compared to the first nine months of 2011. The decline in both periods was primarily due to the sale of the Company's retail brokerage operations in April 2012, which resulted in lower commissions and salaries, as well as related expenses including rent and utilities, and communications and quotation services. Bad debt expense decreased by $4,000 in the third quarter and increased by $228,000 in the nine-month period as the Company reserved the full amount of two notes receivable. Professional fees increased by $85,000 in the third quarter and increased $127,000 in the nine month period of 2012 compared to the same periods in 2011 primarily due to the sale of the Company's retail brokerage operations on April 16, 2012. Underwriting expenses increased by $3,000 in the third quarter of 2012 compared to the third quarter of 2011 and increased by $30,000 in the first nine months of 2012 compared to the first nine months of 2011. Expenses vary due to the timing and level of investment banking activity. Licenses, taxes and insurance increased by $60,000 in the third quarter and increased $88,000 in the nine month period of 2012 compared to the same periods in 2011 primarily due to higher insurance costs.

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity include our cash and receivables from our clearing organization, offset by payables to our clearing organization.

In addition, our sources of liquidity include, to a certain extent, our trading positions, borrowings on those positions and profits realized upon the sale of the securities underlying underwriter warrants exercised. The liquidity of the market for many of our securities holdings, however, varies with trends in the stock market. Since many of the securities we hold are thinly traded, and we are, in many cases, a primary market maker in the issues held, any significant sales of our positions could adversely affect the liquidity of the issues held. In general, falling prices in NASDAQ and over-the-counter securities (which make up most of our trading positions) lead to decreased liquidity in the market for these issues, while rising prices in NASDAQ and over-the-counter issues tend to increase the liquidity of the market for these securities.

We believe our cash and receivables from our clearing organization at September 30, 2012 are sufficient to meet our cash and regulatory net capital needs for at least the next twelve-month period from September 30, 2012. Our liquidity could be negatively affected by protracted unfavorable market conditions.

As a securities broker-dealer, we are required by SEC regulations to meet certain liquidity and capital standards. We believe we were in compliance with these standards at September 30, 2012.

Following the lapse of restrictions upon issuance, capital available from the sale of the underlying securities of underwriter warrants exercised can fluctuate significantly from period to period as the value of the underlying securities fluctuates with overall market and individual company financial condition or performance. There is no public market for the underwriter warrants. The securities receivable upon exercise of the underwriter warrants cannot be resold unless the issuer has registered these securities with the SEC and with the states in which the securities will be sold unless exemptions are available. Any delay or other problem in the registration of these securities would have an adverse impact upon our ability to obtain funds from the exercise of the underwriter warrants and the resale of the underlying securities.

At September 30, 2012, we owned 11 underwriter warrants from 8 issuers, all but 1 of which were exercisable. None of the warrants had an exercise price below the September 30, 2012 market price of the securities receivable upon exercise. There is little or no direct relationship between the intrinsic value of our underwriter warrants at the end of any given period and the fair value calculated using the Black-Scholes option pricing model. The prices of the securities underlying the underwriter warrants are very volatile, and substantial fluctuations in their fair value can be expected in the future.

Cash used by operating activities totaled $791,000 in the first nine months ended September 30, 2012, which included our net loss of $347,000 as well as changes in our operating assets and liabilities as discussed in more detail below.


Our net receivable from our clearing organization totaled $3.4 million at September 30, 2012 and $5.1 million at December 31, 2011. Our net receivable from our clearing organization is affected by the results of the activity in our trading and investment accounts, as well as the timing of general corporate expenditures and cash flow requirements.

During the second quarter of 2012, we sold substantially all our retail brokerage business to JHS Capital Advisors, LLC and recorded a gain on sale of assets, after adjustments, of $1.596 million. Notes and other receivables net of allowances for doubtful accounts increased $581,000 to $1.188 million at September 30, 2012 from $607,000 at December 31, 2011, primarily due to the remainder of the note receivable from JHS for the remaining installment payments due under the sale of the Company's retail brokerage operations.

Changes in our trading and investment securities owned are dependent on the purchase and sale of securities during the period, as well as changes in their fair values during the period.

A summary of activity related to the fair value of our underwriter warrants was as follows (in thousands):

Balance, December 31, 2011                 $ 1,395
Receipt of underwriter warrants                  -
Net unrealized loss on value of warrants        51
Warrants exercised or expired                    -
Balance, September 30, 2012                $ 1,344

Deferred revenue of $157,000 at September 30, 2012 was primarily related to amounts received from our clearing firm pursuant to a five-year agreement with three, one-year extensions, and is being amortized at the rate of $14,881 per . . .

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