SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

(mark one)

 

ý              QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003

 

or

 

o              TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission file No. 0-30066

 

 

SANDERS MORRIS HARRIS GROUP INC.

(Exact name of registrant as specified in its charter)

 

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  YES  ý          NO  o

 

Indicate by check mark whether registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  YES  ý          NO  o

 

The number of shares of the registrant’s Common Stock, par value $0.01 per share, outstanding as of November 1, 2003, was 17,216,442.

 

 

SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

 

INDEX

 

PART I.  CONDENSED CONSOLIDATED FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheet as of September 30, 2003 (unaudited) and December 31, 2002
	Condensed Consolidated Statement of Income for the Three and Nine Months Ended September 30, 2003 and 2002 (unaudited)
	Condensed Consolidated Statement of Shareholders’ Equity for the Nine Months Ended September 30, 2003 (unaudited)
	Condensed Consolidated Statement of Cash Flows for the Nine Months Ended September 30, 2003 and 2002 (unaudited)
	Notes to Condensed Consolidated Financial Statements (unaudited)
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
PART II.  OTHER INFORMATION
Item 1.	Legal Proceedings
Item 6.	Exhibits and Reports on Form 8-K

 

1

 

PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

 

SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEET

(in thousands, except share and per share amounts)

 

		September 30, 2003			December 31, 2002
		(unaudited)
ASSETS
Cash and cash equivalents		$	31,353		$	34,890
Receivables, net of allowance of $400 and $295, respectively
Broker-dealers		1,398			641
Customers		2,285			2,026
Related parties		6,358			4,489
Other		897			719
Deposits with clearing brokers		1,053			1,000
Securities owned		23,696			16,995
Securities available for sale		2,998			3,064
Furniture and equipment, net		4,135			4,021
Deferred income taxes		397			638
Other assets		2,012			1,167
Goodwill, net of accumulated amortization of $4,268		49,399			47,673
Total assets		$	125,981		$	117,323
LIABILITIES AND SHAREHOLDERS’ EQUITY
Liabilities:
Accounts payable and accrued liabilities		$	13,639		$	15,308
Securities sold, not yet purchased		458			93
Other liabilities		161			190
Total liabilities		14,258			15,591
Commitments and contingencies
Minority interests		150			421
Shareholders’ equity:
Preferred stock, $0.10 par value; 10,000,000 shares authorized; no shares issued and outstanding		—			—
Common stock, $0.01 par value; 100,000,000 shares authorized; 17,920,484 and 17,439,743 shares issued, respectively		179			174
Additional paid-in capital		113,062			109,959
Receivables for shares issued		(949		)	(705		)
Retained earnings (accumulated deficit)		3,520			(3,367		)
Accumulated other comprehensive loss		(177		)	(243		)
Unearned compensation		(779		)	(1,392		)
Treasury stock at cost, 722,503 and 702,849 shares, respectively		(3,283		)	(3,115		)
Total shareholders’ equity		111,573			101,311
Total liabilities and shareholders’ equity		$	125,981		$	117,323

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

2

 

SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF INCOME

(in thousands, except share and per share amounts)

(unaudited)

 

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2002			2003			2002
Revenues:
Commissions		$	12,807		$	11,644		$	38,441		$	32,676
Principal transactions		4,444			1,574			10,393			6,969
Investment banking		2,966			1,318			13,167			9,080
Fiduciary, custodial and advisory fees		2,768			1,850			7,049			5,490
Interest and dividends		621			471			1,830			1,359
Other income		569			562			1,846			1,877
Total revenues		24,175			17,419			72,726			57,451
Expenses:
Employee compensation and benefits		14,380			11,530			44,809			37,415
Floor brokerage, exchange and clearance fees		1,268			1,047			4,169			3,034
Communications and data processing		1,398			1,190			4,135			3,094
Occupancy		1,347			1,114			4,228			3,312
Other general and administrative		2,501			1,958			7,154			5,907
Total expenses		20,894			16,839			64,495			52,762
Income before equity in income (loss) of limited partnerships, income taxes and minority interests		3,281			580			8,231			4,689
Equity in income (loss) of limited partnerships		338			(888		)	3,191			(71		)
		3,619			(308		)	11,422			4,618
(Provision) benefit for income taxes		(1,283		)	90			(4,478		)	(1,743		)
Minority interests in net income (loss) of consolidated companies		(33		)	52			(57		)	30
Net income (loss)		$	2,303		$	(166	)	$	6,887		$	2,905
Earnings (loss) per share:
Basic		$	0.13		$	(0.01	)	$	0.40		$	0.18
Diluted		$	0.13		$	(0.01	)	$	0.39		$	0.17
Weighted average common shares outstanding:
Basic		17,179,476			16,674,678			17,047,891			16,586,483
Diluted		17,669,969			16,674,678			17,575,860			16,812,364

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

3

 

SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

For the nine months ended September 30, 2003

(in thousands, except shares)

(unaudited)

 

 

		Amounts					Shares
Common stock
Balance, beginning of period		$	174				17,439,743
Stock issued pursuant to employee benefit plan		5					480,741
Balance, end of period		179					17,920,484
Additional paid-in capital
Balance, beginning of period		$	109,959
Stock issued pursuant to employee benefit plan		4,139
Dividends		(1,036		)
Balance, end of period		113,062
Receivables for shares issued
Balance, beginning of period		$	(705	)
Issuance of restricted stock		(813		)
Amortization of notes receivable		569
Balance, end of period		(949		)
Retained earnings (accumulated deficit)
Balance, beginning of period		$	(3,367	)
Net income		6,887			6,887
Balance, end of period		3,520			6,887
Accumulated other comprehensive loss
Balance, beginning of period		$	(243	)
Net change in unrealized depreciation on securities available for sale		105			105
Income tax on change		(39		)	(39	)
Balance, end of period		(177		)	66
Comprehensive income					6,953
Unearned compensation
Balance, beginning of period		$	(1,392	)
Net issuance of restricted stock		(58		)
Amortization of unearned compensation		671
Balance, end of period		(779		)
Treasury stock
Balance, beginning of period		$	(3,115	)			(702,849	)
Acquisition of treasury stock		(168		)			(19,654	)
Balance, end of period		(3,283		)			(722,503	)
Total shareholders’ equity and common shares outstanding		$	111,573				17,197,981

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

4

 

SANDERS MORRIS HARRIS GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

For the nine months ended September 30, 2003 and 2002

(in thousands)

(unaudited)

 

		2003			2002
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	6,887		$	2,905
Adjustments to reconcile net income to net cash (used in) provided by operating activities:
Realized gain on securities available for sale		(8		)	(9		)
Depreciation		869			625
Provision for bad debts		190			188
Compensation expense related to amortization of notes receivable and unearned compensation		1,240			844
Deferred income taxes		202			(81		)
Minority interests in income (loss) of consolidated companies		57			(30		)
Changes in operating assets and liabilities:
(Increase) decrease in receivables		(3,086		)	2,461
Increase in securities owned		(6,701		)	(791		)
Increase in other assets		(940		)	(430		)
Increase (decrease) in securities sold, not yet purchased		365			(53		)
Decrease in other liabilities		(29		)	(110		)
(Decrease) increase in accounts payable and accrued liabilities		(1,874		)	229
Net cash (used in) provided by operating activities		(2,828		)	5,748
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures		(955		)	(2,415		)
Acquisition, net of cash acquired of $142		(1,608		)	—
Purchase of securities available for sale		(1,173		)	(2,346		)
Proceeds from sales and maturities of securities available for sale		1,352			480
Net cash used in investing activities		(2,384		)	(4,281		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Purchase of treasury stock		(168		)	(642		)
Collection of receivable for shares issued		—			48
Proceeds from shares issued		3,273			868
Investment by minority interest		38			75
Distributions to minority interests		(432		)	—
Payments of cash dividends		(1,036		)	(834		)
Net cash provided by (used in) financing activities		1,675			(485		)
Net (decrease) increase in cash and cash equivalents		(3,537		)	982
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		34,890			30,410
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	31,353		$	31,392
Noncash investing and financing activities:
Cash paid for income taxes		$	3,736		$	3,377

 

The accompanying notes are an integral part of the condensed consolidated financial statements.

 

5

 

1.              BASIS OF PRESENTATION

 

Nature of Operations

 

Through its operating subsidiaries Sanders Morris Harris Inc. (“SMH”), Salient Capital Management (“Salient/PMT”), and SMH Capital Advisors (“SMCA”), the Company provides a broad range of financial services, including institutional, prime and retail brokerage, investment banking, other investment banking services,  merchant banking, financial advisory, trust related services, investment management and financial planning. The Company serves a diverse group of institutional, corporate and individual clients.

 

The Company merged with and acquired its operating subsidiaries in 2003, 2001, 2000 and 1999.  The acquisitions were accounted for using the purchase method.  All of the operating subsidiaries are 100% owned, (either directly or indirectly) by the Company, except Salient/PMT which is 50% owned by the Company.

 

Consolidation

 

The unaudited condensed consolidated financial statements of the Company include the accounts of its majority owned subsidiaries. All material intercompany transactions and balances have been eliminated in consolidation.

 

In management’s opinion, the unaudited condensed consolidated financial statements include all adjustments necessary for a fair presentation of our consolidated financial position at September 30, 2003, our results of operations for the three and nine months ended September 30, 2003 and 2002, and our cash flows for the nine months ended September 30, 2003 and 2002.  All adjustments are of a normal recurring nature. Interim results are not necessarily indicative of results for a full year.

 

These condensed consolidated financial statements and notes should be read in conjunction with the Company’s annual report on Form 10-K for the year ended December 31, 2002.

 

Effects of Recently Issued Accounting Standards

 

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51.  This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation.  The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31, 2003.  In October 2003, the FASB delayed this Interpretation’s implementation date for entities that existed prior to February 1, 2003.  For such entities that existed prior to February 1, 2003, the effective date is the first interim or annual reporting period ending after December 15, 2003.  The application of this Interpretation is not expected to have a material effect on the Company’s consolidated financial statements.  The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that the Company will consolidate or disclose information about variable interest entities when the Interpretation becomes effective.  The Company has identified one entity that would require consolidation under this Interpretation.  The Company expects consolidation of this entity to increase the Company’s assets and liabilities by approximately $100,000 and have an insignificant effect on the other basic consolidated financial statements.

 

In May 2003, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.  SFAS No. 150 requires certain financial instruments that have characteristics of both liabilities and equity to be classified as a liability on the consolidated balance sheet.  SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first fiscal period beginning after December 15, 2003.  The Company does not have any financial instruments affected by the adoption of SFAS No. 150.

 

6

 

Compensation

 

Statement of Financial Accounting Standards (SFAS) No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment to FASB Statement No. 123, was issued in December 2002.  SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods for transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation.  In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results.  The Company has adopted the disclosure provisions included on SFAS No. 148 in the notes to the consolidated financial statements contained herein.

 

The Company applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations including FASB Interpretation No. 44, Accounting for Certain Transactions involving Stock Compensation an Interpretation of APB Opinion No. 25, issued in March 2000, to account for its fixed plan stock options.  Under this method, compensation expense is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.

 

The following table illustrates the effect on net income (loss) as if the Company had applied the fair value recognition provisions of SFAS No. 123 as amended by SFAS No. 148:

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2002			2003			2002
Net income (loss) as reported		$	2,303		$	(166	)	$	6,887		$	2,905
Deduct: Total stock based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(123		)	(144		)	(361		)	(614		)
Pro forma net income (loss)		$	2,180		$	(310	)	$	6,526		$	2,291
Earnings (loss) per share
Basic-as reported		$	0.13		$	(0.01	)	$	0.40		$	0.18
Basic-pro forma		$	0.13		$	(0.02	)	$	0.38		$	0.14
Diluted-as reported		$	0.13		$	(0.01	)	$	0.39		$	0.17
Diluted-pro forma		$	0.12		$	(0.02	)	$	0.37		$	0.14

 

Reclassifications

 

Certain reclassifications have been made to the 2002 condensed consolidated financial statements to conform them with the 2003 presentation.   The reclassifications had no effect on retained earnings (accumulated deficit), results of operations or cash flows as previously reported.

 

 

2.              ACQUISITIONS

 

On May 2, 2003, the Company acquired a 50% ownership interest in the Salient companies.  Additionally, the Company acquired a 23.15% profits interest in The Endowment Fund, a related entity.  The former owners of Salient and The Endowment Fund received cash payments totaling $1.75 million and may later receive an additional $250,000 cash payment and up to 1,200,000 common shares if Salient/PMT operations exceed specified performance levels.   The Salient companies and Pinnacle Management & Trust

 

7

 

Company (“PMT”) were contributed to Salient/PMT, which entity’s Class A limited partner units are jointly owned by the Company and the former owners of Salient.  Additionally, the Company received Class B limited partner units of Salient/PMT, which in the event of a liquidation or sale of Salient/PMT entitle the Company to first receive proceeds equal to the net asset value of PMT as of May 2, 2003, (approximately $4.4 million) with the remaining proceeds to be divided equally among the owners of the Class A units.  The Salient companies provide investment advisory services to individuals and institutions.  The Endowment Fund is a diversified fund of funds using fund managers that specialize in a variety of investment approaches.  The acquisitions were accounted as a purchase, and accordingly, the financial information of the Salient companies and The Endowment Fund has been included in the Company’s consolidated financial statements from May 2, 2003.  The purchase price of approximately $1.8 million exceeded the fair market value of identifiable net assets by approximately $1.7 million, which has been recorded as goodwill.  The Company uses the consolidation method to account for its investment in Salient/PMT.

 

Proforma financial information is not presented as the acquisition would have had an immaterial impact on the actual historical financial information if completed at the beginning of the periods.

 

3.              SECURITIES OWNED AND SECURITIES SOLD, NOT YET PURCHASED

 

Securities owned and securities sold, not yet purchased as of September 30, 2003 were as follows:

 

		Owned			Sold, Not Yet Purchased
		(in thousands)
Marketable:
U.S. Government and agency (cost $658)		$	658		$	—
Corporate stocks (cost $1,178)		409			458
Corporate bonds and commercial paper (cost $2,383)		3,215			—
		4,282			458
Not readily marketable:
Partnerships (cost $5,490)		12,471			—
Corporate stocks and warrants (cost $2,560)		6,943			—
		$	23,696		$	458

 

Securities not readily marketable include investment securities (a) for which there is no market on a securities exchange or no independent publicly quoted market, (b) that cannot be publicly offered or sold unless registration has been effected under the Securities Act of 1933, or (c) that cannot be offered or sold because of other arrangements, restrictions, or conditions applicable to the securities or to the Company.  Not readily marketable securities consist of investments in limited partnerships, equities, options and warrants.  The investments in limited partnerships are accounted for using the equity method, which approximates fair value, and principally consist of Environmental Opportunities Fund, L.P., Environmental Opportunities Fund II, L.P., Environmental Opportunities Fund II (Institutional), L.P., Corporate Opportunities Fund, L.P., Corporate Opportunities Fund (Institutional), L.P., Sanders Opportunity Fund, L.P., Sanders Opportunity Fund (Institutional), L.P., Tactical Opportunities High Yield Fund, L.P., Life Sciences Opportunity Fund, L.P., Life Sciences Opportunity Fund (Institutional), L.P., Life Sciences Opportunity Fund II, L.P. and Life Sciences Opportunity Fund (Institutional) II, L.P.

 

8

 

4.              SECURITIES AVAILABLE FOR SALE

 

Securities available for sale at September 30, 2003 were as follows:

 

		Amortized			Gross Unrealized						Estimated
		Cost			Gains			Losses			Fair Value
		(in thousands)
U.S. Government and agency obligations		$	1,546		$	20		$	—		$	1,566
Marketable equity securities		1,733			5			(306		)	1,432
Total		$	3,279		$	25		$	(306	)	$	2,998

 

 

The contractual maturities of debt securities available for sale at September 30, 2003, were as follows:

 

Due before 5 years		$	1,261
Due after 25 years through 30 years		305
Total		$	1,566

 

Gross gains on sales of securities available for sale were $36,000 for the nine months ended September 30, 2003 and $23,000 for the nine months ended September 30, 2002.  Gross realized losses on securities available for sale were $28,000 for the nine months ended September 30, 2003 and $14,000 for the nine months ended September 30, 2002.

 

5.              INCOME TAXES

 

The differences between the effective tax rate reflected in the income tax provision (benefit) from operations and the statutory federal rate were as follows:

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2002			2003			2002
		(in thousands)						(in thousands)
Tax computed using the statutory rate		$	1,219		$	(87	)	$	3,864		$	1,580
State income taxes and other		64			(3		)	614			163
Total		$	1,283		$	(90	)	$	4,478		$	1,743

 

6.              COMMITMENTS AND CONTINGENCIES

 

There were no firm underwriting commitments open at September 30, 2003.

 

The Company and its subsidiaries have obligations under operating leases that expire by 2013 with initial noncancelable terms in excess of one year.

 

The Company is a party to various legal proceedings that are of an ordinary or routine nature incidental to its operations.  The Company believes it has adequately reserved for such litigation matters and that they

 

9

 

will not have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.

 

The Company has uncommitted financing arrangements with clearing brokers who finance customer accounts, certain broker-dealer balances and firm trading positions.  Although these customer accounts and broker-dealer balances are not reflected on the consolidated balance sheet for financial accounting and reporting purposes, the Company has generally agreed to indemnify these clearing brokers for losses they may sustain in connection with the accounts, and therefore, retains risk on these accounts.  The Company is required to maintain certain cash or securities on deposit with its clearing brokers.

 

7.              EARNINGS (LOSS) PER COMMON SHARE

 

Basic and diluted earnings per-share computations for the periods indicated were as follows:

 

		Three Months Ended September 30,
		2003			2002
		(in thousands, except share and per share amounts)
Computation of basic and diluted income (loss) per common share for the three months ended September 30:
Net income (loss)		$	2,303		$	(166	)
Weighted average number of common shares outstanding		17,179,476			16,674,678
Common shares issuable under stock option plan		1,056,694			—
Less shares assumed repurchased with proceeds		(566,201		)	—
Weighted average common shares outstanding		17,669,969			16,674,678
Basic income (loss) per common share		$	0.13		$	(0.01	)
Diluted income (loss) per common share		$	0.13		$	(0.01	)

 

		Nine Months Ended September 30,
		2003			2002
		(in thousands, except share and per share amounts)
Computation of basic and diluted income per common share for the nine months ended September 30:
Net income		$	6,887		$	2,905
Weighted average number of common shares outstanding		17,047,891			16,586,483
Common shares issuable under stock option plan		1,051,693			1,253,848
Less shares assumed repurchased with proceeds		(523,724		)	(1,027,967		)
Weighted average common shares outstanding		17,575,860			16,812,364
Basic income per common share		$	0.40		$	0.18
Diluted income per common share		$	0.39		$	0.17

 

 

Outstanding stock options (50,000 for the three months ended September 30, 2003; 55,000 for the nine months ended September 30, 2003; 1,463,848 for the three months ended September 30, 2002; and 210,000 for the nine months ended September 30, 2002) have not been included in diluted earnings (loss) per common share because their inclusion would have been antidilutive for the periods presented.

 

 

8.              BUSINESS SEGMENT INFORMATION

 

The Company’s businesses operate in two reportable business segments.  The Company’s investment banking and brokerage segment includes the operations of SMH.  SMH is an investment banking and

 

10

 

brokerage firm whose activities primarily include securities underwriting,  other investment banking services, private placements, and institutional, prime and retail brokerage.  The Company’s investment management segment includes the operations of Salient/PMT and SMCA.   Salient/PMT is a state chartered trust company which provides investment advisory, investment management, and a variety of trust services to individuals, trusts and institutions.  SMCA provides financial planning services to individuals and asset management services to investors with an emphasis on fixed income securities.  The following summarizes certain financial information of each reportable segment for the three and nine months ended September 30, 2003 and 2002, respectively.

 

(in thousands)		Investment Banking and Brokerage			Investment Management			Corporate and Other			Consolidated Total
Three Months Ended September 30, 2003
Revenues		$	21,280		$	2,145		$	750		$	24,175
Expenses		(18,722		)	(1,674		)	(498		)	(20,894		)
Income before equity in income of limited partnerships, income taxes and minority interests		2,558			471			252			3,281
Equity in income of limited partnerships		221			—			117			338
Income before income taxes and minority interests		$	2,779		$	471		$	369		$	3,619
Three Months Ended September 30, 2002
Revenues		$	15,886		$	1,489		$	44		$	17,419
Expenses		(14,943		)	(1,336		)	(560		)	(16,839		)
Income (loss) before equity in loss of limited partnerships, income taxes and minority interests		943			153			(516		)	580
Equity in loss of limited partnerships		(709		)	—			(179		)	(888		)
Income (loss) before income taxes and minority interests		$	234		$	153		$	(695	)	$	(308	)
Nine Months Ended September 30, 2003
Revenues		$	66,043		$	5,618		$	1,065		$	72,726
Expenses		(58,620		)	(4,525		)	(1,350		)	(64,495		)
Income (loss) before equity in income of limited partnerships, income taxes and minority interests		7,423			1,093			(285		)	8,231
Equity in income of limited partnerships		2,778			—			413			3,191
Income before income taxes and minority interests		$	10,201		$	1,093		$	128		$	11,422
Nine Months Ended September 30, 2002
Revenues		$	53,005		$	4,382		$	64		$	57,451
Expenses		(47,230		)	(3,757		)	(1,775		)	(52,762		)
Income (loss) before equity in income of limited partnerships, income taxes and minority interests		5,775			625			(1,711		)	4,689
Equity in income (loss) of limited partnerships		36			—			(107		)	(71		)
Income (loss) before income taxes and minority interests		$	5,811		$	625		$	(1,818	)	$	4,618

 

(in thousands)		Investment Banking and Brokerage			Investment Management			Corporate and Other			Consolidated Total
Total assets as of September 30, 2003		$	87,483		$	7,362		$	31,136		$	125,981
Total assets as of December 31, 2002		$	80,614		$	6,701		$	30,008		$	117,323

 

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9.              EMPLOYEE BENEFIT PLANS

 

Under its 1998 Incentive Plan, as amended, the Company has reserved 25% of the issued and outstanding Common Stock of the Company, or 4,000,000 shares of Common Stock, whichever is greater, for the purpose of issuing incentive awards under the Incentive Plan.  The Company had 1,554,602 shares of Common Stock available for grant under the Incentive Plan at September 30, 2003.

 

Stock Options

 

The Incentive Plan provides for the issuance to eligible employees of, among other things, incentive and non-qualified stock options, that may expire up to 10 years from the date of grant.   The outstanding options vest over varying periods and have an exercise price equal to the closing price of the Company’s stock on the date of the grant.

 

Restricted and Capital Incentive Plan (“CIP”)

 

Effective January 2, 2001, the Company adopted the CIP under its Incentive Plan in which eligible employees may purchase shares of the Company’s restricted common stock at a discount of up to 33 1/3 % of the 20-day average of the closing sales prices for a share of the Company’s common stock, ending on the day prior to the date the shares are issued.  The CIP was amended effective November 1, 2001 to include eligible consultants as potential participants under the program.

 

All shares issued are valued at the closing price on the date the shares are issued.  Consideration paid through the deferral of salaries, commissions, or discretionary bonuses is recorded as compensation expense on the date the shares are issued.  The difference between the value of the shares issued and the consideration paid is recorded as unearned compensation and is shown as a separate component of shareholders’ equity.  Additionally, shares are issued under the Incentive Plan in conjunction with notes receivable, which are also shown as a separate component of shareholders’ equity. Unearned compensation and the notes receivable are amortized to compensation expense over the three-year vesting periods.

 

The following summarizes certain information related to the CIP for the three and nine months ended September 30, 2003 and 2002.

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2003			2002			2003			2002
		(in thousands, except shares)						(in thousands, except shares)
Number of shares issued		10,077			53,419			102,855			368,954
Value of shares issued		$	89		$	325		$	874		$	2,066
Additions to unearned compensation		1			251			58			966
Additions to notes receivable		85			—			813			519
Amortization of unearned compensation		191			200			671			489
Amortization of notes receivable		185			122			569			355

 

10.       RELATED PARTIES

 

The Company had receivables from related parties totaling $6.4 million at September 30, 2003, consisting primarily of $1.8 million of unpaid management fees earned on the Company’s investments in limited partnerships and $4.3 million of notes receivable from employees and consultants.

 

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

 

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and their related notes.

 

General

 

We provide diversified financial services through our subsidiaries, including institutional, prime and retail brokerage, investment banking, other investment banking services, merchant banking, financial advisory, trust related services, investment management and financial planning. All of these activities are highly competitive and are sensitive to many factors outside our control, including those factors listed under “Factors Affecting Forward-Looking Statements.”

 

We closely monitor our operating environment to enable us to respond promptly to market cycles. In addition, we seek to lessen earnings volatility by controlling expenses, increasing fee-based business and developing new revenue sources. Nonetheless, operating results for any specific period should not be considered representative of future performance.

 

Components of Revenues and Expenses

 

Revenues.                  Our revenues are comprised primarily of (1) commission revenue from retail, prime and institutional brokerage transactions, (2) fees from asset-based advisory services, (3) principal and agent transactions, (4) investment banking revenue from corporate finance fees, public and private offerings, mergers and acquisitions, merchant banking and (5) fees from asset management, financial planning and fiduciary services.  We also earn interest on the cash held and dividends received from the equity securities held by us for our corporate capital accounts and have realized and unrealized gains (or losses) on securities in our inventory account.  Interest income results from interest earned on our inventories of fixed income securities prior to sale, and from interest and dividends earned on investments in our capital accounts.

 

Expenses.                   Our expenses consist of (1) employee compensation and benefits, (2) brokerage and clearing costs, and (3) other expenses.  Compensation and benefits have both a variable component based on revenue production and a fixed component.  The variable component includes institutional and retail sales commissions, bonuses, overrides, and trading desk incentives.  Retail and institutional commissions are based on a competitive commission schedule.  The investment banking group and the research group receive a salary and discretionary bonus as compensation.  The fixed component includes administrative and executive salaries, payroll taxes, employee benefits and temporary employee costs.  Compensation and benefits is our largest expense item and includes wages, salaries and benefits. During the third quarter of 2003, compensation and benefits represented 69% of total expenses, and 59% of total revenues compared to 68% of total expenses, and 66% of total revenues during the comparable period in 2002.   During the first nine months of 2003, compensation and benefits represented 69% of total expenses, and 62% of total revenues compared to 71% of total expenses, and 65% of total revenues during the comparable period in 2002.

 

Brokerage and clearance expenses include clearing and trade execution costs associated with the retail, prime and institutional brokerage business at SMH.  SMH clears its transactions primarily through the Pershing Division of Bank of New York Co. and other clearing brokers.

 

Other expenses include (1) occupancy and equipment expenses, such as rent and utility charges for facilities, and (2) communications and data processing expenses, such as third-party systems, quotes, market data and software program providers.

 

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Results of Operations

 

Three Months Ended September 30, 2003 Compared to Three Months Ended September 30, 2002

 

Total revenues increased 39% to $24.2 million in the third quarter of 2003 from $17.4 million for the same quarter in 2002 mainly due to increases in prime brokerage services and asset management activities.  Total expenses for the same 2003 period increased 24% to $20.9 million from $16.8 million in the same quarter of the previous year mainly from increases in employee compensation and benefits from higher salaries, commissions, and bonuses paid on revenue increases.  Equity in income (loss) of limited partnerships increased from a loss of $888,000 during the third quarter of 2002 to $338,000 during the third quarter of 2003, due to increases in the values of securities held in the investment portfolios of the limited partnerships managed by the Company.  Net income (loss) for the three month period ended September 30, 2003 increased to $2.3 million from a loss of $166,000 in the same period in 2002.  Basic and diluted income per share was $0.13 for the three months ended September 30, 2003 compared to a loss of  $0.01 for the same period in 2002.

 

Commissions revenue increased to $12.8 million in the third quarter of 2003 from $11.6 million in 2002, primarily as a result of increased trading volume related to the growth of both the number and size of prime broker accounts.  Principal transactions revenue totaled $4.4 million for the 2003 period versus $1.6 million in the third quarter of 2002, principally due to increases in revenues from fixed income trading and increases in the values of securities owned by the Company.  Investment banking revenue increased to $3.0 million during the third quarter of 2003 from $1.3 million in the same period of 2002, principally due to an increase in fees earned from private placement and syndicate transactions.  Revenues from fiduciary, custodial and advisory fees increased to $2.8 million in the third quarter of 2003 from $1.9 million in same quarter of 2002 primarily due to increases in the size of investment portfolios we manage.  Interest and dividend income increased to $621,000 in 2003 from $471,000 in the same period last year.

 

During the three months ended September 30, 2003, employee compensation and benefits, increased to $14.4 million from $11.5 million in the same period last year reflecting salaries, commissions and bonuses paid on the revenue increases.  Floor brokerage, exchange and clearance fees increased to $1.3 million in the third quarter of 2003 from $1.0 million in the same quarter of 2002 reflecting increased clearing and execution costs resulting from the additional trading volume attributable to the growth in revenues from prime brokerage services.  Other general and administrative expenses increased to $2.5 million during the third quarter of 2003 from $2.0 million in the third quarter of last year mainly due to the growth in the prime brokerage division.  Occupancy and communication costs increased due to an acquisition, increased personnel and trading volumes.

 

The effective tax rate from operations was 35.8% for the three months ended September 30, 2003 compared to 35.2% (benefit) for the three months ended September 30, 2002.

 

Nine Months Ended September 30, 2003 Compared to Nine Months Ended September 30, 2002

 

Total revenues increased 26% to $72.7 million in the first nine months of 2003 from $57.5 million for the same period in 2002, principally due to increases in prime brokerage services, investment banking and asset management activities.  Total expenses for the same 2003 period increased 22% to $64.5 million from $52.8 million in the same period of the previous year mainly from increases in employee compensation and benefits from higher salaries, commissions, and bonuses paid on revenue increases.  Equity in income of limited partnerships increased from a loss of $71,000 during the first nine months of 2002 to $3.2 million during the first nine months of 2003, due to increases in the values of securities held in the investment portfolios of the limited partnerships managed by the Company.  Net income for the nine month period ended September 30, 2003 increased to $6.9 million from $2.9 million in the same period in 2002.  Basic income per share was $0.40 for the nine months ended September 30, 2003 compared to $0.18 for the same period in 2002.  Diluted income per share was $0.39 for the nine months ended September 30, 2003, compared to $0.17 for the same period in 2002.

 

Commissions revenue increased to $38.4 million in the first nine months of 2003 from $32.7 million in 2002, primarily as a result of increased trading volume related to the growth of both the number and size of prime broker accounts.  Principal transactions revenue totaled $10.4 million for the 2003 period versus $7.0 million in 2002, primarily due to increases in revenues from fixed income trading and to gains in the values of

 

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warrants awarded to the Company for investment banking services.  Investment banking revenue increased to $13.2 million during the first nine months of 2003 from $9.1 million in the same period of 2002, principally due to an increase in fees earned from private placement and syndicate transactions.  Revenues from fiduciary, custodial and advisory fees increased to $7.0 million in the first nine months of 2003 from $5.5 million in same period of 2002 reflecting growth in the amount of assets managed by the Company.  Interest and dividend income increased to $1.8 million in 2003 from $1.4 million in the same period last year.

 

During the nine months ended September 30, 2003, employee compensation and benefits, increased to $44.8 million from $37.4 million in the same period last year, reflecting salaries, commissions and bonuses paid on increased revenues.    Floor brokerage, exchange and clearance fees increased to $4.2 million in the first three quarters of 2003 from $3.0 million in the same period of 2002 reflecting increased clearing and execution costs resulting from the additional trading volume attributable to the growth in revenues from prime brokerage services.  Communication and data processing costs increased to $4.1 million in 2003 from $3.1 million in the same period last year resulting primarily from increased personnel and trading volumes related to the prime brokerage division.   Occupancy costs totaled $4.2 million during the first nine months of 2003, compared to $3.3 million in the prior year period.  Other general and administrative expenses increased to $7.2 million during the first nine months of 2003 from $5.9 million in the first nine months of last year mainly due to the growth in the prime brokerage division.

 

The effective tax rate from operations was 39.4% for the nine months ended September 30, 2003 compared to 37.5% for the nine months ended September 30, 2002.

 

Liquidity and Capital Resources

 

We intend to satisfy a large portion of our funding needs with our own capital resources, consisting largely of internally generated earnings and liquid assets we currently hold.

 

At September 30, 2003, we had approximately $31.4 million in cash and cash equivalents, which together with receivables from broker-dealers, deposits with clearing brokers, marketable securities owned, and securities available for sale represented about 32.6% of our total assets at the end of the third quarter.

 

For the nine months ended September 30, 2003, net cash used in operations totaled $2.8 million versus net cash provided by operations of $5.7 million during the first nine months of 2002.  Accounts receivable increased by $3.1 million during the nine months ended September 30, 2003, principally due to increases in revenues and notes receivable from employees.  Securities owned increased by $6.7 million during the first nine months of 2003 primarily due to increases in the values of the Company’s investments including the limited partnerships managed by the Company and warrants held by the Company that were received as part of investment banking transactions.

 

Capital expenditures for the first nine months of 2003 were $955,000, mainly for the purchase of furniture and computer equipment and software, as well as for leasehold improvements necessary for our growth.  During the first nine months of 2003, we reacquired 19,654 of our common shares at a total cost of approximately $168,000.

 

At September 30, 2003, SMH, our registered broker-dealer subsidiary, was in compliance with the net capital requirements of the Securities and Exchange Commission’s Uniform Net Capital Rules and had capital in excess of the required minimum.  PMT was in compliance with the Texas Department of Banking net capital requirement and had capital in excess of the required minimum.

 

We are a party to various legal proceedings that are of an ordinary or routine nature incidental to our operations.  We believe we have adequately reserved for such litigation matters and that they will not have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

 

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Factors Affecting Forward-Looking Statements

 

This quarterly report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended (the “Acts”). These forward-looking statements may relate to such matters as anticipated financial performance, future revenues or earnings, business prospects, projected ventures, new products, anticipated market performance and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. To comply with the safe harbor, the Company cautions readers that a variety of factors could cause the Company’s actual results to differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. These risks and uncertainties, many of which are beyond the Company’s control, include, but are not limited to (1) trading volume in the securities markets; (2) volatility of the securities markets and interest rates; (3) changes in regulatory requirements, which could affect the demand for the Company’s services or the cost of doing business; (4) general economic conditions, both domestic and foreign, especially in the regions where the Company does business; (5) changes in the rate of inflation and related impact on securities markets; (6) competition from existing financial institutions and other new participants in the securities markets; (7) legal developments affecting the litigation experience of the securities industry; (8) successful implementation of technology solutions; (9) changes in valuations of the Company’s trading and warrant portfolios resulting from mark-to-market adjustments; (10) dependence on key personnel and (11) demand for the Company’s services. The Company does not undertake to publicly update or revise any forward-looking statements.

 

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

 

Market Risks

 

At September 30, 2003, PMT had equity securities under management with a fair value of $539 million.  PMT’s fee income for the nine months ended September 30, 2003 would have been reduced by approximately $152,000 assuming a hypothetical 10% decrease in the value of its equity securities under management.  PMT’s securities available for sale are recorded at a fair value of approximately $3.0 million at September 30, 2003.  These securities are subject to equity price risk.  These securities have an original cost of $3.3 million.  At September 30, 2003, the unrealized decline in market value totaling $281,000, less tax benefit of $104,000, has been included as a separate component of shareholders’ equity.

 

Management evaluates the realizability of securities available for sale to determine if a decline in value is other than temporary.  Such evaluation considers the length of time and the extent to which market value has been less than cost, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in market value.  Management believes the unrealized losses are temporary at September 30, 2003.  However, a write-down accounted for as a realized loss may be necessary in the future.

 

The Company’s trading equity and debt securities are marked to market on a daily basis.  At September 30, 2003, the Company’s trading equity and debt securities were recorded at a fair value of approximately $4.3 million.  These trading equity and debt securities are subject to equity price risk.  This risk would amount to approximately $430,000 based on a potential loss in fair value from a hypothetical 10% decrease in the market value of such equity and debt securities.  The actual equity price risk related to the trading equity and debt securities may differ substantially.

 

 

Item 4.  Controls and Procedures

 

Our management, including our Chief Executive Officer and Chief Financial Officer, have conducted an evaluation of the effectiveness of our disclosure controls and procedures as of the end of the quarter covered by this report.  Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are effective for timely gathering, analyzing and disclosing the information we are required to disclose in our reports filed under the Securities Exchange Act

 

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of 1934, as amended.  There have been no changes in our internal control over financial reporting that occurred during the quarter covered by this report that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II.   OTHER INFORMATION

 

Item 1.  Legal Proceedings              

 

We are a party to various legal proceedings that are of an ordinary or routine nature incidental to our operations.  Certain of our litigation and claims are covered by insurance with a maximum deductible of $50,000.    We believe we have adequately reserved for such litigation matters and that they will not have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

 

Item 6.  Exhibits and Reports on Form 8-K

 

(a) Exhibits

 

 

Exhibit Number		Description
3.1		Articles of Incorporation of the Company, as amended  (filed as Exhibit 3.1 to the Company’s Form 10-K for the year ended December 31, 2001 (File No. 000-30066) and incorporated herein by reference).
3.2		Amended and Restated Bylaws of the Company (filed as Exhibit 3.2 to the Company’s Form 10-K for the year ending December 31, 1998 (File No. 000-30066) and incorporated herein by reference).
*31.1		Certification of Chief Executive Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
*31.2		Certification of Chief Financial Officer Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
*32.1		Certification of the Chief Executive Officer Pursuant to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
*32.2		Certification of the Chief Financial Officer Pursuant to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

* Filed herewith.

 

 

(b) Reports on Form 8-K.

 

On August 13, 2003, the Company filed a current report on Form 8-K relating to (i) the declaration by its board of directors of a cash dividend in the amount of $0.03 per share of common stock, and (ii) the Company’s earnings report for the quarter ended June 30, 2003.

 

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SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

	SANDERS MORRIS HARRIS GROUP INC.
	By	/s/  BEN T. MORRIS
		Ben T. Morris Chief Executive Officer
	By	/s/  RICK BERRY
		Rick Berry Chief Financial Officer
Date:  November 12, 2003

 

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