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ITG > SEC Filings for ITG > Form 10-Q on 12-Nov-2013All Recent SEC Filings

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Form 10-Q for INVESTMENT TECHNOLOGY GROUP, INC.


12-Nov-2013

Quarterly Report


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

The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements, including the notes thereto.

Overview

ITG is an independent execution and research broker that partners with global portfolio managers and traders to provide innovative financial technology and unique data-driven insights throughout the investment process. From investment decision through settlement, ITG helps clients understand market trends, improve performance, mitigate risk and navigate increasingly complex markets. A leader in electronic trading since launching the POSIT crossing network in 1987, ITG takes a consultative approach in delivering the highest quality institutional liquidity, execution services, analytical tools and proprietary research. ITG is headquartered in New York with offices in North America, Europe and the Asia Pacific region.


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Our business is organized into four reportable operating segments: U.S. Operations, Canadian Operations, European Operations and Asia Pacific Operations (see Note 14, Segment Reporting, to the consolidated financial statements). Our four operating segments provide products and services from each of the following product groups:

Electronic Brokerage - includes self-directed trading using algorithms, smart routing and matching through POSIT in cash equities (including single stocks and portfolio lists), futures and options

Research Sales and Trading - includes (a) unbiased, data-driven equity research through the use of innovative data mining and analysis, as well as detailed analysis of energy asset plays, and (b) portfolio trading and high-touch trading desks providing execution expertise and trading ideas based on ITG Investment Research

Platforms - includes trade order and execution management software applications in addition to network connectivity

Analytics - includes (a) tools enabling portfolio managers and traders to improve pre-trade and real-time execution performance, (b) portfolio construction and optimization decisions and (c) securities valuation

Sources of Revenues

Revenues from the product groups are generated from commissions and fees, recurring (subscriptions) and other sources.

Commissions and fees are derived primarily from (i) commissions charged for trade execution services (including those to compensate for research services),
(ii) income generated on net executions, whereby equity orders are filled at different prices within or at the National Best Bid and Offer ("NBBO") and
(iii) commission sharing arrangements between ITG Net (our private value-added FIX-based financial electronic communications network) and third-party brokers and alternative trading systems (ATSs) whose trading products are made available to our clients on our order management system ("OMS") and execution management system ("EMS") applications in addition to commission sharing arrangements for our ITG Single Ticket Clearing Service. Because commissions are earned on a per-transaction basis, such revenues fluctuate from period to period depending on (a) the volume of securities traded through our services in the U.S. and Canada, (b) the contract value of securities traded in Europe and the Asia Pacific region and (c) our commission rates. Certain factors that affect our volumes and contract values traded include: (i) macro trends in the global equities markets that affect overall institutional equity trading activity,
(ii) competitive pressure, including pricing, created by a proliferation of electronic execution competitors and (iii) potential changes in market structure in the U.S. and other regions. In addition to share volume, revenues from net executions are also impacted by the width of spreads within the NBBO. Trade orders are delivered to us from our OMS and EMS products and other vendors' products, direct computer-to-computer links to customers through ITG Net and third-party networks and phone orders from our customers.

Recurring revenues are derived from the following primary sources:
(i) connectivity fees generated through ITG Net for the ability of the sell-side to receive orders from, and send indications of interest to, the buy-side,
(ii) software and analytical products and services, (iii) maintenance and customer technical support for our OMS and (iv) subscription revenue generated from providing investment research.

Other revenues include: (i) income from principal trading in Canada, including arbitrage trading, (ii) the net spread on foreign exchange transactions executed to facilitate equity trades by clients in different currencies, (iii) the net interest spread earned on securities borrowed and loaned matched book transactions, (iv) non-recurring consulting services, such as one-time implementation and customer training related activities, (v) investment and interest income, (vi) interest income on securities borrowed in connection with customers' settlement activities and (vii) market gains/losses resulting from temporary positions in securities assumed in the normal course of our agency trading business (including client errors and accommodations).

Expenses

Compensation and employee benefits, our largest expense, consists of salaries and wages, incentive compensation, including cash and deferred share-based awards, as well as employee benefits and taxes. Incentive compensation fluctuates based on revenues, profitability and other measures, taking into account the landscape for key talent. Incentive compensation includes a combination of cash and deferred share-based awards, with only the cash portion, representing a lesser portion of our total compensation costs, expensed in the current period. As a result, our ratio of compensation expense to revenues may fluctuate from period to period based on revenue levels.


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Transaction processing expense consists of costs to access various third-party execution destinations and to process, clear and settle transactions. These costs tend to fluctuate with share and trade volumes, the mix of trade execution services used by clients and the rates charged by third parties.

Occupancy and equipment expense consists primarily of rent and utilities related to leased premises, office equipment and depreciation and amortization of fixed assets and leasehold improvements.

Telecommunications and data processing expenses primarily consist of costs for obtaining market data, telecommunications services and systems maintenance.

Other general and administrative expenses primarily include software amortization, consulting, business development, professional fees and intangible amortization.

Interest expense consists primarily of costs associated with outstanding debt and credit facilities.

Executive Summary for the Quarter Ended September 30, 2013

Consolidated Overview

Our operating environment remains difficult with third quarter U.S. cash equity volumes dropping to their lowest level in more than six years. In this environment, we continue to focus on rationalizing our cost structure, expanding our products and services globally and better monetizing the variety of services we provide to clients in each of our four product groups. Our overall third quarter revenue grew 7% compared to the third quarter of 2012 to $127.6 million, driven by market share gains in our European Operations, while consolidated expenses of $116.9 million were down 2%, reflecting the expense discipline we have maintained across the firm.

There is little visibility as to when we will see a rebound in institutional trading activity in the U.S. While there has been some redirection of fixed income assets into international equity funds, to date we have not yet seen the widely expected large scale rotation out of fixed income investments into equities. During the third quarter, domestic equity funds saw net inflows of less than $3 billion (according to the Investment Company Institute), capturing little of the $58 billion in net outflows from fixed income funds during the third quarter, which followed $43 billion of net outflows from fixed income funds in the second quarter. Domestic equity funds flows remain slightly positive for the year on a net basis, in strong contrast to the historic net outflows of $153 billion in 2012.

Our initiatives to grow POSIT as a liquidity center in Europe while continuing to reduce fixed costs across all regions have been successful. During the quarter, we earned net income of $7.7 million, or $0.20 per diluted share, a significant portion of which came from our European Operations where we have seen strong growth in the use of POSIT. These results were a substantial improvement over the $0.2 million, or $0.01 per diluted share earned in the third quarter of 2012.

Given the continued uncertainty surrounding the equity trading environment in the foreseeable future, we will continue to build operating leverage into our business model through rigorous expense discipline while still pursuing selected growth opportunities. We believe this approach will position us well for any future cyclical or secular rises in equity volumes.

Segment Discussions

Our U.S. average daily executed volume was 154.6 million shares per day, down 10% versus the third quarter of 2012 compared with the 6% decline in the overall combined average daily market volume of NYSE- and NASDAQ-listed securities during the same period. Despite the lower volume, our U.S. revenues were down only 1% compared to the third quarter of 2012 as we mitigated the impact of the challenging volume environment with continued improvements in our average revenue per share through increased use of our POSIT Alert block crossing system as well as more clients paying for research through trading at a higher bundled rate. Our average U.S. revenue per share rose to 49 mils in the third quarter, the third straight quarter of improvement and the highest level since the second quarter of 2011. This rate improvement was achieved despite the higher proportion of lower rate sell-side volume, which rose from 49% in the second quarter to 51% in the third quarter. We are also continuing to focus on expense management in the U.S. to further enhance profitability, with total U.S. expenses down 6% compared to the third quarter of 2012.

In Canada, revenues were down 1% against a backdrop of generally flat overall market activity amid persistently difficult market conditions. Commissions and fees declined 6% compared to the third quarter of 2012, driven by declines in average daily volumes and rates from clients using our high-touch desk trading services, as well as unfavorable currency translation.


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Investor sentiment towards European equities has continued to improve and led to an 18% rise in market-wide trading activity over the same quarter last year. In addition to the impact of more favorable market conditions, our European revenues also benefitted from the investments we made in our infrastructure and our products, helping us expand our client base and grow our liquidity pool in POSIT. Through these initiatives, our European commissions and fees increased 67% compared to the third quarter of 2012, far outpacing the growth in market-wide trading activity. We witnessed higher activity from institutional and sell-side accounts using our electronic brokerage offerings including our trading algorithms and POSIT and from buy-side accounts using our POSIT Alert block crossing system. Average daily value traded in POSIT more than doubled, while the average daily value traded in POSIT Alert jumped approximately 250%. ITG now represents more than 13% of total European dark trading, up from less than 10% in the third quarter of 2012. Our revenue gains coupled with improved margins from a higher crossing rate in POSIT and our efforts to reduce settlement and clearing costs significantly improved our reported results in the region.

Revenues from our Asia Pacific Operations were up 13% from the third quarter of 2012, reducing our pre-tax loss by 68%. Market conditions have improved with the higher levels of investor confidence. Overall market-wide trading activity in the markets we participate in increased 33%, with increases in Japan, Hong Kong and Australia of 118%, 17% and 15%, respectively. Our average daily value traded in the region rose 14% versus the third quarter of 2012 driven by strong order flow by local and U.S. clients trading into Japan and Korea. Our lower share of the incremental market activity was largely attributable to the outsized growth in Japanese trading, which represents a lower portion of our activity relative to other countries in the region.

Capital Resource Allocation

In the third quarter, we returned $6.1 million to stockholders through the repurchase of 370,000 shares at an average price of $16.38. We intend to continue to use share repurchases to return capital to shareholders opportunistically, depending on market conditions and the prevailing price per share of our common stock.

Results of Operations - Three Months Ended September 30, 2013 Compared to Three
Months Ended September 30, 2012



U.S. Operations



                                         Three Months Ended September 30,
$ in thousands                              2013                  2012             Change      % Change
Revenues:
Commissions and fees                  $          56,056     $          55,784    $      272            -
Recurring                                        18,982                20,174        (1,192 )         (6 )
Other                                             1,805                 1,843           (38 )         (2 )
Total revenues                                   76,843                77,801          (958 )         (1 )

Expenses:
Compensation and employee benefits               31,304                30,906           398            1
Transaction processing                           10,115                10,894          (779 )         (7 )
Other expenses                                   30,353                34,482        (4,129 )        (12 )
Interest expense                                    593                   678           (85 )        (13 )
Total expenses                                   72,365                76,960        (4,595 )         (6 )
Income before income tax expense      $           4,478     $             841    $    3,637          432

Commissions and fees rose slightly as a 10% reduction in our daily trading volumes was more than offset by an 11% increase in our average revenue per share to $0.0049. This represents the third consecutive quarter of improved average revenue per share and was primarily attributable to increased use of our POSIT Alert block crossing system as well as more clients paying for research through trading at a higher bundled rate. The proportion of our total volume from sell-side clients remained relatively constant at 51% for both the current quarter and the third quarter of 2012.

                                           Three Months Ended September 30,
U.S. Operations: Key Indicators*              2013                  2012             Change        % Change
Total trading volume (in billions of
shares)                                               9.9                  10.9           (1.0 )          (9 )
Trading volume per day (in millions
of shares)                                          154.6                 172.3          (17.7 )         (10 )

Average revenue per share $ 0.0049 $ 0.0044 $ 0.0005 11 U.S. market trading days 64 63 1 2


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* Excludes activity from ITG Derivatives and ITG Net commission sharing arrangements.

Recurring revenues decreased 6% reflecting the impact of client attrition from our OMS product, resulting in lower OMS subscription revenues and lower connectivity fees.

Compensation and employee benefits rose slightly as an increase in incentive based compensation associated with improved profitability offset reductions in salaries and stock-based compensation from our restructuring plan in December 2012.

Transaction processing costs decreased due to the lower level of volumes. As a percentage of commissions and fees, transaction processing has declined due primarily to the increased revenue per share described above, offset in part by the impact of a lower percentage of our volume crossed in POSIT.

Other expenses decreased $4.1 million primarily due to savings from lower market data and connectivity charges resulting from our cost reduction initiatives, as well as, lower software amortization and a reduction of bad debt reserves from improved collection efforts. These decreases were partially offset by higher depreciation and amortization largely from the build-out of our new headquarters in lower Manhattan.

Interest expense incurred in 2013 and 2012 primarily relates to interest cost on our term debt and commitment fees relating to the Credit Agreement, including debt issuance cost amortization.

Canadian Operations



                                         Three Months Ended September 30,
$ in thousands                              2013                  2012             Change      % Change
Revenues:
Commissions and fees                  $          13,376     $          14,227    $     (851 )         (6 )
Recurring                                         2,324                 2,122           202           10
Other                                             1,875                 1,378           497           36
Total revenues                                   17,575                17,727          (152 )         (1 )

Expenses:
Compensation and employee benefits                5,968                 5,336           632           12
Transaction processing                            1,950                 2,623          (673 )        (26 )
Other expenses                                    6,908                 8,131        (1,223 )        (15 )
Total expenses                                   14,826                16,090        (1,264 )         (8 )
Income before income tax expense      $           2,749     $           1,637    $    1,112           68

Currency translation decreased total Canadian revenues and expenses by $0.7 million and $0.6 million, respectively, resulting in a decrease of $0.1 million to pre-tax income.

Canadian commissions and fees declined 6%, primarily due to lower revenue from high-touch desk trading services, as well as unfavorable currency translation, offset in part by an increase in activity from clients using our electronic brokerage services.

Recurring revenues increased primarily due to our billing for market data consumed by clients.

Other revenues increased as a result of an increase in income earned on foreign exchange transactions and lower trading errors and client trade accommodations.

Compensation and employee benefits costs increased due to an increase in share-based compensation, which fluctuates for our Canadian operations based on the changes in the market price of our stock, partially offset by decreases from reduced headcount.

Transaction processing costs decreased as an accrual for sales tax on exchange fees was eliminated. This more than offset higher clearing and settlement charges, primarily from an increase in the number of tickets cleared.

The decrease in other expenses was primarily driven by lower data center related costs following our migration to a new location and lower consulting and market data costs from our cost reduction efforts.


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European Operations



                                       Three Months Ended September 30,
$ in thousands                            2013                  2012             Change      % Change
Revenues:
Commissions and fees                $          19,766     $          11,840    $    7,926           67
Recurring                                       3,103                 3,150           (47 )         (1 )
Other                                            (206 )                (197 )          (9 )         (5 )
Total revenues                                 22,663                14,793         7,870           53

Expenses:
Compensation and employee
benefits                                        7,883                 5,918         1,965           33
Transaction processing                          5,141                 3,718         1,423           38
Other expenses                                  5,524                 5,443            81            1
Total expenses                                 18,548                15,079         3,469           23
Income (loss) before income tax
expense (benefit)                   $           4,115     $            (286 )  $    4,401           NA

Currency translation decreased total European revenues and expenses by $0.5 million and $0.2 million, respectively, resulting in a decrease of $0.3 million to pre-tax income.

Commissions and fees increased 67%, far outpacing the 18% growth in market-wide trading activity due primarily to the impact of investments we made in our infrastructure and our products, helping us expand our client base. This has led to increased activity from buy-side and sell-side clients using our electronic brokerage offerings including our trading algorithms, POSIT and from buy-side clients using our POSIT Alert block crossing system.

Compensation and employee benefits increased due to an increase in incentive-based compensation related to improved performance.

Transaction processing costs increased due to higher value traded, but fell as a percentage of commissions and fees due to the impact of a higher percentage of our value traded crossed in POSIT and our initiatives to reduce settlement and clearing costs.

Other expenses remained relatively flat as an increase in facilities costs relating to our new London office, which we occupied in the third quarter, was offset by lower research and development costs.

Asia Pacific Operations



                                         Three Months Ended September 30,
$ in thousands                              2013                  2012             Change      % Change
Revenues:
Commissions and fees                  $          9,180     $            7,944    $    1,236           16
Recurring                                        1,352                  1,261            91            7
Other                                              (55 )                   91          (146 )       (160 )
Total revenues                                  10,477                  9,296         1,181           13

Expenses:
Compensation and employee benefits               4,509                  4,975          (466 )         (9 )
Transaction processing                           2,584                  2,101           483           23
Other expenses                                   4,036                  4,231          (195 )         (5 )
Total expenses                                  11,129                 11,307          (178 )         (2 )
Loss before income tax benefit        $           (652 )   $           (2,011 )  $    1,359           68

Currency translation decreased both total revenues and expenses in Asia Pacific by $0.5 million.

Asia Pacific commissions and fees increased 16% primarily due to strong order flow by local Asian clients and U.S. clients trading into Japan and Korea.

The growth in recurring revenues primarily reflects growth in the number of billable network connections through ITG Net.

Compensation and employee benefits decreased due to lower headcount and severance.

Transaction processing costs increased due to the higher value of securities traded and a higher mix of our trades executed in Japan and Korea where costs are higher.

The decrease in other expenses is due to lower market data and connectivity costs offset by higher rental expenses for our Hong Kong office.


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Consolidated income tax expense

Our effective tax rate was 27.8% in the third quarter of 2013 compared to a small tax benefit in the third quarter of 2012. The benefit in the third quarter of 2012 reflects the impact of a net reduction to income tax reserves of $1.3 million following the resolution of a state tax contingency. The impact of this reserve reduction on our overall effective tax rate in 2012 was offset by the impact of higher pre-tax losses in the Asia Pacific region where we are not recording any tax benefits. Our current quarter effective tax rate reflects the lower loss in Asia Pacific and higher profitability in Europe, where we have a lower effective tax rate. Our consolidated effective tax rate can vary from period to period depending on, among other factors, the geographic and business mix of our earnings.

Results of Operations - Nine Months Ended September 30, 2013 Compared to Nine
Months Ended September 30, 2012



U.S. Operations



                                       Nine Months Ended September 30,
$ in thousands                            2013                2012             Change      % Change
Revenues:
Commissions and fees                $        179,815    $         175,638    $    4,177            2
Recurring                                     56,975               62,535        (5,560 )         (9 )
Other                                          5,897                6,132          (235 )         (4 )
Total revenues                               242,687              244,305        (1,618 )         (1 )

Expenses:
Compensation and employee
benefits                                      93,993               97,704        (3,711 )         (4 )
Transaction processing                        32,929               33,298          (369 )         (1 )
Other expenses                               100,356              105,935        (5,579 )         (5 )
Goodwill impairment                                -              245,103      (245,103 )       (100 )
Restructuring charges                         (1,264 )                  -        (1,264 )          -
Interest expense                               1,894                1,980           (86 )         (4 )
Total expenses                               227,908              484,020      (256,112 )        (53 )
Income (loss) before income tax
expense (benefit)                   $         14,779    $        (239,715 )  $  254,494          106

Commissions and fees rose 2% as a 4% reduction in our daily trading volumes was more than offset by a 7% increase in our average revenue per share to $0.0047. The increase in our average revenue per share was primarily attributable to increased use of our POSIT Alert block crossing system as well as more clients paying for research through trading at a higher bundled rate. The proportion of . . .

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