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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549


FORM 10-K

(Mark One)

x                              Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the fiscal year ended December 31, 2004

o                                 Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the transition period from                    to                    

Commission File Number 0-23644


INVESTMENT TECHNOLOGY GROUP, INC.

(Exact name of registrant as specified in its charter)

DELAWARE

95-2848406

(State of incorporation)

(IRS Employer Identification No.)

380 Madison Avenue, New York, New York

(212) 588-4000

(Address of principal executive offices)

(Registrant’s telephone number, including area code)

10017

 

(Zip Code)

 

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:


Common Stock, $0.01 par value

New York Stock Exchange

(Title of class)

(Name of exchange on which registered)

 

SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: None


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 x No o

Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this form 10-K    Yes o No x

Indicate by check mark whether the registrant is an accelerated filer (as defined by Exchange Act Rule 12b-2)

Yes x No o

Aggregate market value of the voting stock held by non-affiliates of the Registrant at June 25, 2004:

Number of shares outstanding of the Registrant’s Class of common stock at March 1, 2005:

$505,579,820

42,024,530

 

DOCUMENTS INCORPORATED BY REFERENCE:

Proxy Statement relating to the 2005 Annual Meeting of Stockholders (incorporated, in part, in Form 10-K Part III).

 




2004 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

 

 

Page

PART I

Item 1.

 

Business

 

1

 

Item 2.

 

Properties

 

17

 

Item 3.

 

Legal Proceedings

 

17

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

18

 

PART II

Item 5.

 

Market for Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchase of Equity Securities

 

19

 

Item 6.

 

Selected Financial Data

 

20

 

Item 7.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

21

 

Item 7A.

 

Quantitative and Qualitative Disclosures About Market Risk

 

42

 

Item 8.

 

Financial Statements and Supplementary Data

 

45

 

Item 9.

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

 

71

 

Item 9A.

 

Controls and Procedures

 

71

 

PART III

Item 10.

 

Directors and Executive Officers of the Registrant

 

73

 

Item 11.

 

Executive Compensation

 

73

 

Item 12.

 

Security Ownership of Certain Beneficial Owners and Management

 

73

 

Item 13.

 

Certain Relationships and Related Transactions

 

73

 

Item 14.

 

Principal Accounting Fees and Services

 

73

 

PART IV

Item 15.

 

Exhibits and Financial Statement Schedules

 

74

 

 

Investment Technology Group, ITG, ITG ACE, ITG/Opt, ITG WebAccess, activePeg, AsiaPOSIT, POSIT, QuantEX, ResRisk, RouteNet, SmartServer, TCA, The Future of Trading, TriAct and VWAP SmartServer are registered trademarks or servicemarks of the Investment Technology Group, Inc. companies. AlterNet, Channel ITG, Full Service Direct Market Access, Hoenig, Horizon SmartServer, ITG Link, ITG PRIME, ITG/Risk, ITG Logic, Radical, ResRisk+, SPI SmartServer, Triton and Where Risk Control Meets Cost Control are trademarks or servicemarks of the Investment Technology Group, Inc. companies.




 

FORWARD-LOOKING STATEMENTS

In addition to the historical information contained throughout this Annual Report on Form 10-K, there are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). All statements regarding our expected future financial position, results of operations, cash flows, dividends, financing plans, business strategies, competitive positions, plans and objectives of management for future operations, and concerning securities markets and economic trends are forward-looking statements. Although we believe our expectations reflected in such forward-looking statements are based on reasonable assumptions, there can be no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from the expectations reflected in the forward-looking statements herein include, among others, the actions of both current and potential new competitors, rapid changes in technology, fluctuations in market trading volumes, financial market volatility, evolving industry regulations, risk of errors or malfunctions in our systems or technology, cash flows into or redemptions from equity funds, effects of inflation, customer trading patterns, the success of our new products and services offerings as well as general economic and business conditions, internationally or nationally, securities, credit and financial market conditions, and adverse changes or volatility in interest rates. Certain of these factors, and other factors, are more fully discussed in Management’s Discussion and Analysis of Financial Condition and Results of Operations—Issues and Uncertainties—in this Annual Report on Form 10-K, which you are encouraged to read.

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PART I

Item 1.                        Business

Investment Technology Group, Inc. (“ITG” or the “Company”) was formed as a Delaware corporation on July 22, 1983. Its principal subsidiaries include: (1) ITG Inc. and AlterNet Securities, Inc. (“AlterNet”), United States (“U.S.”) broker-dealers in equity securities, (2) ITG Execution Services Inc., a New York Stock Exchange floor broker (“ITG Execution Services”), (3) Investment Technology Group Limited (“ITG Europe”), an institutional broker-dealer in Europe, (4) ITG Australia Limited (“ITG Australia”), an institutional broker-dealer in Australia, (5) ITG Canada Corp. (“ITG Canada”), an institutional broker-dealer in Canada, (6) KTG Technologies Corp. (“KTG”), a direct access provider in Canada, which as of April 8, 2004 became a 50% owned joint venture (see Note 4, “Subsidiary Equity Transactions” in the Notes to the Consolidated Financial Statements), (7) ITG Hoenig Limited (“ITG Hong Kong”), an institutional broker dealer in Hong Kong, and (8) ITG Software Solutions, Inc., our intangible property, software development and maintenance subsidiary in the U.S.

We have two reportable segments: U.S. Operations and International Operations. The U.S. Operations segment provides equity trading and quantitative research services to institutional investors, brokers, money managers and alternative investment funds in the U.S. while our International Operations segment includes our brokerage businesses in Europe, Australia, Canada and Hong Kong, as well as a software development and research facility in Israel. Financial information by segment is provided in Note 20, “Segment Reporting”, in Notes to the Consolidated Financial Statements.

We are a full service trade execution firm that uses technology to increase the effectiveness and lower the cost of trading. With an emphasis on ongoing research, we offer the following products and services to our clients:

Execution Services:

·        POSIT: an electronic stock crossing system.

·        TriAct: a continuous intraday trading vehicle.

·        Electronic Trading Desk: an agency trading desk offering clients the ability to efficiently access multiple sources of liquidity.

·        SmartServers: algorithmic systems which implement automated server-based trading strategies.

Client-Site Trading Products:

·        Triton: a Windows-based decision-support, trade management and order routing system.

·        Radical: a Windows-based trading platform targeted for the active trading community.

·        Channel ITG: an integrated link to the trade blotters of popular trade order management systems.

·        QuantEX: a Unix-based decision support, trade management and order routing system.

·        ITG Platform: a Windows-based order routing and trade management system.

·        ITG WebAccess: a browser-based order routing tool.

Analytical Products and Research:

·        TCA: a tool for systematically estimating and measuring transaction costs.

·        ITG Logic: an interactive pre-trade suite of products, offered through an integrated platform:

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·       ITG Risk Models: a set of equity risk models to assist portfolio managers, researchers and traders in measuring, analyzing and managing a variety of risks.

·       ITG ResRisk+: a multifaceted optimizer, enabling portfolio managers and traders to assess and control portfolio risk characteristics through any series of executions.

·        ITG/Opt: a computer-based equity portfolio selection system.

·        ITG Fair Value Model: a research tool to assist mutual funds in making fair value calculations of fund net asset value (“NAV”).

Soft Dollar Programs:

·        Provision of independent third party research and ITG Analytical Products and Research products and services.

·        Directed brokerage and commission recapture arrangements.

We generate commission revenues on a “per transaction” basis for all orders executed. Orders are delivered to us from our “front-end” software products, Triton, QuantEX, ITG Platform, Radical, Channel ITG and ITG WebAccess, as well as other vendors’ front-ends and direct computer-to-computer links to customers. In the U.S., orders may be executed on or through (1) POSIT, (2) TriAct, (3) our SmartServers, (4) the NYSE, (5) the American Stock Exchange, (6) certain regional exchanges, (7) the Nasdaq National Market, (8) market makers, (9) electronic communication networks (“ECNs”), systems which trade equity securities and (10) third party alternative trading systems (“ATSs”). In our International Operations, we generate revenues on a “per transaction” basis on the volume of securities executed or on the contract value of securities traded through POSIT or our Electronic Trading Desk.

Our U.S. trading volumes by product category over the last five years are summarized in the graph below:

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POSIT

POSIT was introduced in 1987 in the U.S. as a technology-based solution to the trade execution needs of quantitative and passive investment managers. It has since grown to also serve the active trading and broker-dealer communities. There are 522 clients currently using POSIT in the U.S., including corporate and government pension plans, insurance companies, bank trust departments, investment advisors, broker-dealers and mutual funds. There are 186, 53 and 3 clients using versions of POSIT in Europe, Australia, and Hong Kong, respectively.

POSIT is an electronic stock crossing system through which clients enter buy and sell orders to trade single stocks and portfolios of equity securities among themselves in a confidential environment. Orders may be submitted to the system directly via Triton, QuantEX, Radical, Channel ITG, POSITalert, ITG Platform, ITG WebAccess or other computer-to-computer links, or indirectly through TriAct, SmartServers or the ITG Electronic Trading Desk personnel. We also work in partnership with vendors of other popular trading systems, allowing users the flexibility to route orders directly to POSIT from trading products distributed by Bridge Information Systems, BRASS, Bloomberg and other trade order management systems (“TOMS”).

U.S. POSIT currently accepts orders for a universe of approximately 30,000 different equity securities, but may be modified, as the need arises, to include additional equity securities. The POSIT algorithm optimizes the maximum possible number of buy and sell orders that match or “cross”. Clients may specify conditions on their orders that must be satisfied, such as the requirement that the net cash resulting from buys and sells remain within specified constraints. A client may also specify a minimum number of shares to be executed for a given order. There are currently eleven scheduled intraday crosses every business day. POSIT prices trades at the midpoint of the best bid and offer for each security at the time of the cross, based on information provided directly to the system by a third-party data vendor. Immediately after each match, clients receive electronic reports showing match results for their orders. Clients then decide whether to keep unmatched orders in the system for future matches or to execute them by other means. POSIT AHC, the after hours cross, was introduced in 2003. This match runs after the close of the intraday trading session. In the POSIT after hours cross, all trades are priced at the day’s closing price.

POSIT provides the following significant benefits to clients:

·        Confidential matching of buy and sell orders eliminates market impact. In contrast, participants in traditional or other open markets are constantly subject to the risk that disclosure of an order will unfavorably affect price conditions.

·        The average execution size in POSIT is significantly larger than the average execution size on ECNs and registered exchanges.

·        Users gain access to the substantial pool of liquidity represented by aggregate POSIT orders in each match.

·        Midpoint pricing allows users to save half the bid/offer spread.

·        Clients pay a low commission on completed transactions relative to the industry average. POSIT generates revenue from commissions charged on each share crossed through the system.

POSIT gives users the option of customizing their trading objectives and specifying additional constraints, while preserving the functionality of the existing POSIT system. This capability is referred to collectively as a “POSIT strategy.” This capability allows orders that might otherwise be ineligible for POSIT to participate in the match. POSIT strategies include ResRisk, which allows users to control the risk of the unexecuted “residual” portfolio, and Pairs, which makes execution of one trade contingent on the execution of another, at or better than a given relative valuation. Clients engaging in portfolio funding,

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liquidation, restructuring and rebalancing transactions often utilize ResRisk. Risk arbitrage, statistical arbitrage and portfolio substitution trades are examples of transactions that can be implemented using the Pairs strategy. We also implement custom applications upon request.

Clients can also access POSIT through our brokerage subsidiary, AlterNet. AlterNet enables clients to execute trades in POSIT on a net basis, i.e. with the commission payable to us for the POSIT trade included in the price at which the client executes their POSIT trade. This feature is particularly attractive to our broker-dealer customers and AlterNet was created in response to broker-dealers’ desires to have net pricing in POSIT.

Clients may also access POSIT using POSITalert, introduced in 2004. POSITalert is a simple to use application that reminds traders of every upcoming POSIT match and allows for rapid entry of orders into the match. POSITalert is an easy to install application that sends orders to POSIT securely over the internet. It is primarily targeted at clients who do not have an ITG front end or a front end capable of sending orders to ITG and have traditionally used the phone to place orders in POSIT.

TriAct

TriAct is a continuous, intraday crossing system offering full anonymity, continuous execution opportunities, no market impact, and access to our POSIT system. TriAct provides price improvement on every transaction and opportunities for size improvement. Participants in TriAct submit orders that may be executed in one of three ways: (a) against the ongoing flow of market bound orders submitted by other ITG clients and our Electronic Trading Desk, (b) against orders from other TriAct participants (liquidity suppliers) and (c) for TriAct orders marked as eligible to participate in POSIT, in one of POSIT’s eleven intraday crosses. Both listed and OTC securities can be traded in TriAct.

An execution in TriAct is priced between the bid/offer spread. When a liquidity supplier interacts with a market-bound order, the supplier receives 75 percent of the spread, when executing against other suppliers, or in POSIT, the supplier receives 50 percent of the spread. TriAct allows traders to control how their orders are traded by offering order expiration time, control of the rate at which orders are traded (during 1, 5, or 15 minute intervals), price protection, and portfolio buy/sell and minimum share constraints. In addition, TriAct enforces the tick/bid test rules for short sales of securities. TriAct is accessible from Triton, Radical, ITG Platform and QuantEX as well as third party TOMS and ITG’s Electronic Trading Desk.

Electronic Trading Desk

The Electronic Trading Desk is a full-service, agency execution group that specializes in lowering transaction costs for our clients through the utilization of our proprietary trading products, including extensive use of POSIT, TriAct and our SmartServers.

Clients use Triton, Radical, QuantEX, ITG Platform and ITG WebAccess to deliver orders electronically to our desk and, as orders are executed by the desk, reports are automatically delivered electronically back to the client. For clients that do not send orders to ITG execution destinations through our Client Site Trading Products, our account executives receive orders by telephone, fax, e-mail or other electronic means. Clients give our active traders single stock orders or program trades to work throughout the day as well as residual trades from unfilled orders in POSIT.

For order completion outside of POSIT, the Electronic Trading Desk utilizes numerous sources of liquidity to complete trades. The Electronic Trading Desk will use Triton and QuantEX to route orders to multiple market destinations, including primary exchanges, regional exchanges, over-the-counter market makers, ECNs and ATSs, or actively seek the contra side of client orders by soliciting interest among other clients.

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The Portfolio Trading Group focuses on agency list or program trading. By employing a step-by-step process that leverages technology and access to multiple sources of liquidity, the Portfolio Trading Group seeks to systematically achieve high quality executions for the client by controlling transaction costs. A client program is evaluated with a pre-trade analysis to determine aggregate portfolio characteristics, estimate market impact, and to quantify risk. The group implements a number of sophisticated trading strategies using QuantEX and Triton to meet execution objectives. After the execution is completed, we provide the client with comprehensive reports analyzing execution results utilizing ITG Research products.

SmartServers

SmartServers are automated trading destinations that accept orders from client workstations and execute them using computerized trading algorithms. All SmartServers are physically located at ITG, and are accessed electronically by clients via the ITG Platform, Radical, Triton or QuantEX, via direct connections or our Electronic Trading Desk. Each SmartServer is an automated trading agent pre-programmed with a particular trading style. By using these agents, traders can focus their attention on a subset of their orders, letting the SmartServer trade the rest of the orders on the list.

Currently, we provide four strategy-based servers: Horizon SmartServer, activePeg SmartServer, SPI SmartServer and the ITG Smart Order Router. The Horizon SmartServer executes orders in a manner designed to closely track a security’s volume-weighted average price, or VWAP, throughout the trading day. The Horizon SmartServer analyzes liquidity and market conditions continuously throughout the day and determines the appropriate order size and order price to approximate the VWAP. Clients may choose to execute relative to the VWAP price for the entire trading day, or for some subset of that trading day.

ITG’s activePeg SmartServer is aimed at traders who are benchmarked to a decision-price (pre-trade) benchmark or who would like to execute as quickly as possible while still minimizing the market impact of their trades. Traders can specify an expiration time to explicitly define the time horizon for a wave of orders, or they can let the strategy choose an appropriate time horizon for each order individually. The trading algorithm uses a blended passive/aggressive style to work orders automatically over the time horizon, supplying liquidity passively with the objective of attracting executions at favorable prices but also issuing carefully timed aggressive orders to keep the trade on schedule. Care is taken by all components of the algorithm to blend in with other orders in the market and minimize the leakage of information to other parties in the marketplace.

The SPI SmartServer is designed to improve trading performance of small- and medium-size orders that are traditionally executed as market orders. The SPI SmartServer analyzes momentum, volatility, and other indicators to decide how and when to trade an order to improve upon the results expected from a market order. Clients may choose a time horizon for each order, anywhere from 5 to 30 minutes, whereby the SPI SmartServer monitors the market and determines the timing, pricing, and size of outgoing orders using real-time market data. The SPI SmartServer is currently being merged into the ActivePeg server to handle short-duration orders and will no longer be sold as a stand-alone product.

The Smart Order Router provides convenient access to the listed and OTC markets by aggregating access through a single connection. Users send market and limit orders to the Smart Order Router and the system routes the orders to the exchange or ECN with the best price. All quantities at the best available price across all trading venues are exhausted before moving to the next level. A proprietary algorithm is used to find all visible, hidden, reserve and discretionary liquidity. All major ECN features are supported by the router by passing the orders through to an ECN that supports the feature.

ITG also provides trading strategies for use by our clients using the Triton execution product. In addition to the strategies described above, ITG provides automated strategies for volume participation, decision price based on the ITG ACE trading cost estimation model and time-weighted average price.

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Since the algorithms are delivered using Triton, they can be highly interactive, allowing very detailed control over execution.

Triton

Triton, released in 2003, is our list-oriented order management and execution system, bringing a complete set of integrated execution and analytical tools to the user’s desktop. Triton was designed to supercede QuantEX and was built using a Windows-based architecture for ease-of-use, easy customization and tight integration with the user’s desktop environment.

Triton provides clients with the functionality to manage every step of the trading process. From the Triton desktop, users can perform trade management functions, make order execution decisions, monitor trading results, access real-time and historical market data, and utilize trading analytics. Orders may be routed to many destinations including POSIT, TriAct, ITG’s agency trading desk, ITG SmartServers, exchanges, ECNs, and certain third party brokers through our RouteNet order routing service. Triton’s blotter supports sophisticated portfolio aggregation and allocation. Triton also provides integrated access to ITG’s proprietary pre- and post-trade products. Finally, Triton is a multi-user system, allowing work groups to share access to portfolios and track trading results.

Triton has numerous facilities for customization and integration into the clients’ trading environment. FIX is used to integrate with most order management systems and proprietary customer environments. Triton provides rich programming interfaces based on the Microsoft .NET development environment for building product customizations, including trading shortcuts, analytics, algorithmic trading strategies and reports.

Triton runs as a stateless thin-client, typically on the client’s primary desktop PC. The balance of the Triton product runs on servers in ITG data centers. Clients may connect to ITG over the Internet or using a private network.

Revenues are generated through commissions and transaction fees charged for each trade electronically routed through Triton and executed on one of the many destinations available from the application. We do not derive royalties from the sale or licensing of the Triton software. As of December 31, 2004, there were 135 installations of Triton at 70 client sites in the U.S.

Radical

Radical, ITG’s desktop application for institutional and hedge fund traders, provides clients connectivity to a variety of liquidity pools and execution venues. Orders may be routed to many destinations including POSIT, TriAct, ITG’s agency trading desk, ITG SmartServers, exchanges, ECNs, and certain third party brokers through our RouteNet order routing service. We continually monitor the evolution of electronic markets and, as appropriate, create links to new liquidity sources and seek to support emerging order types. Radical provides a fast and easy way to enter single orders or list orders for execution. Radical also provides a fully customizable user interface. Radical provides real-time market data from exchanges as well as ECN book data and has full multi-trader capabilities allowing work groups to share access to working orders and track trading results. Radical is Windows based and has a thin-client architecture. Network connectivity is established through the Internet or through a dedicated communication line

As of December 31, 2004, there were 188 installations of Radical at 122 client sites in the U.S.

Channel ITG

Channel ITG, introduced in 2004, provides an integrated link to the trade blotter of popular TOMS. It is a powerful, easy to use tool that sweeps orders from the TOMS blotter, and allows them to be sent to

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POSIT, TriAct, ITG SmartServers and the ITG Trading Desk. Channel ITG allows the user to set sweep criteria and control exactly which orders they would like swept. The user may then review and adjust any orders prior to sending them to an ITG destination. As trades are executed, the positions in the user’s trade blotter are updated in real time. Channel ITG also issues reminders of upcoming POSIT matches. Channel ITG is presently integrated with the MacGregor XIP and EZE Castle TOMS, and integration with other major providers is currently in progress.

QuantEX

QuantEX is our Unix-based, list-oriented order management and execution system. We are actively converting QuantEX clients to Triton and plan to retire QuantEX shortly. QuantEX provides clients with functionality to manage every step of the trading process. From the QuantEX desktop, users can access integrated real-time and historical market data and analytics to perform trade management functions, make order execution decisions and monitor trading results. Orders may be routed to many destinations including POSIT, TriAct, ITG’s agency trading desk, ITG SmartServers, exchanges, ECN’s, and certain third party brokers through our RouteNet order routing service. QuantEX provides integrated access to ITG’s pre- and post-trade products. QuantEX also provides a rules-based programming environment for developing analytics and automated trading strategies.

As of December 31, 2004, there were 47 installations of QuantEX at 18 client sites in the U.S.

ITG Platform

ITG Platform provides clients with seamless connectivity from their desktop to a variety of execution destinations including POSIT, TriAct, ITG’s agency trading desk, ITG SmartServers, exchanges, ECN’s, and certain third party brokers through our RouteNet order routing service. Orders may be corrected or cancelled electronically, and all reports are delivered electronically back to the ITG Platform. We are actively converting ITG Platform users to our Radical and, in some cases, Triton systems. ITG Platform also supports special trading interfaces as needed by POSIT strategies and SmartServers. Allocation information can be associated with executions in the ITG Platform and delivered to us electronically. ITG Platform has access to historical data through the ITG Data Center, including a wide array of analytics. ITG Platform also provides clients enhanced list trading capabilities, access to special ECN order types and, in some cases, access to real time NASDAQ Level II data. ITG Platform has the ability to communicate with ITG via the Internet or through private networks.

As of December 31, 2004, there were 231 installations of ITG Platform at 66 client sites in the U.S.

ITG WebAccess

ITG WebAccess allows users to take advantage of our advanced trading services from anywhere through the Internet. ITG WebAccess is a browser-based order routing tool for sending orders to POSIT and the Electronic Trading Desk.

Analytical Products and Research

ITG’s Analytical Products and Research group (“APR”) has developed an integrated suite of tools that address every stage of the investment process, from portfolio construction to pre-trade analysis, on to trade execution and post-trade cost and performance reporting. These products are available for direct client use, enabling clients to measure, analyze, and control the cost of trading. The guiding principle of research and product development in this area is to increase investment returns by lowering transaction costs, managing risk, and optimizing portfolio decisions. As part of its activities, APR also publishes and distributes studies on topics of interest to our clients. In the same way users of fundamental research

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compensate the brokerage firms that provide such research (i.e., directing commissions to such brokerage firms), our clients reward us for these value-added research services.

In addition to its role in our overall research and development effort, APR provides both sales and consulting services to our clients and prospective clients. Taken together, these activities are key components of our overall relationship development and maintenance activities. Consulting encompasses a set of value-added services for the benefit of our clients. These services break down into four main categories: product support, development of customized pre-trade and post-trade reporting vehicles, customization of analytical software, and provision of quantitative research. In its sales capacity, APR introduces clients and prospective clients to the full range of products and services offered by our company, and provides information about features, pricing and functional specifications. The sales process includes establishment of an in-depth understanding of client practices and requirements, followed by design and presentation of integrated solutions based on our products, described below.

TCA (Post-trade Transaction Cost Analysis Service)

Transaction cost measurement is critical to controlling trading costs and has become a focus of the U.S. and international trading community. TCA, ITG’s web-based transaction cost analysis service, identifies, measures and analyzes trading costs, and delivers prompt daily results. Integrated with our Triton front end, TCA reports are available anytime during the trading day. Clients can generate a large variety of standard reports built into the browser-based application and customized reports can be produced based on specific client requests. The TCA service also supports our own trading desk, with respect to periodic reporting on ITG trading activity, by execution product and by client. The product offerings spanning the service include the core TCA web-based transaction cost tool (“TCA”), the ITG Peer Group Database, a custom reporting facility, and consulting services.

The core TCA post-trade reporting facility allows users to compare actual executed prices to user-selected benchmark prices, in order to help assess trade execution quality. Over 30 benchmarks are available as part of the core product, including the volume-weighted average price, closing price, pre-trade midquote and last trade. Customized benchmarks can be produced based on client requests.

The ITG Peer Group Database provides buyside institutions and their clients with a measure of a firm’s relative trading costs. Rather than comparing costs to a fixed benchmark, the system analyzes a firm’s trading costs relative to the trading costs of its peers, trading similar stocks under similar circumstances. Performance rankings also can be calculated for a firm’s traders, portfolio managers, and brokers. While TCA provides clients with tactical and strategic measures of trading cost measurement, the ITG Peer Group Database provides a context for judging a firm’s performance.

The custom reporting tools and consulting services go hand-in-hand, providing tailored reporting and analysis. Consulting in this area often results in specialized reports, designed in cooperation with the client, and aimed towards specific business process requirements. More general reporting on an ad hoc basis, with respect to industry trends compared to client performance, also is produced, with the aid of a proprietary consulting database, which permits aggregation of trading results and comparison with other investment data and trend analysis.

ITG Logic (Pre-trade Toolkit)

ITG Logic is an interactive pre-trade suite of products, offered through an integrated platform, of use to portfolio managers, traders, and transition managers. This toolkit is designed to assist such market participants with the control of transaction costs, the management of risk, and optimization of the balance between those key concepts and urgency with respect to the capture of market returns. The platform itself permits consolidated reporting and options with respect to delivery mechanisms to the client. In addition to web-based browser delivery, the system includes web-services functionality, allowing swift integration

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with proprietary client and third-party order management systems. Data input and reporting are facilitated through web browsers, real-time dynamic Excel spreadsheet applications, and integration into order management systems. The Logic toolkit is offered both as a standalone set of applications and through our Triton client-site front end. The current set of applications includes ITG ACE, our suite of risk models, and ResRisk+, a list optimization and reporting tool, all described below.

ITG ACE, our pre-trade agency cost analysis tool, is a mathematical model providing transaction cost forecasts for single stock executions or portfolio trades. Among other features, ITG ACE can compute optimal trading strategies that balance price impact and opportunity costs, and is used in this capacity as part of our algorithmic trading strategy offerings, in addition to similar functionality offered through Logic.

ITG ACE is used by investment professionals as a tool for cost analysis at a variety of decision points. Portfolio managers can factor expected transaction costs into portfolio rebalancing decisions, traders can assess trade execution costs before placing orders into the market, and managers can benchmark trading performance, handicapping trades for execution difficulty, post-trade. Given its versatility, the ACE model also is incorporated into TCA, ITG/Opt, ResRisk+, and our Triton client-site front end.

ITG Risk Models are equity risk models that assist portfolio managers, researchers and traders in measuring, analyzing and managing risk in a variety of market environments and applications. ITG Risk Models can be used to estimate tracking error relative to benchmark portfolios, forecast total volatility of long/short portfolios, construct market/sector/industry-neutral trade lists, measure exposure, and decompose risk. The models also are employed to create optimal portfolios in conjunction with an equity portfolio selection system, such as ITG/Opt.

U.S. Equity Risk Models are delivered for daily, weekly, and monthly horizons. Country-specific and Global Risk Models are available as part of the overall suite. Risk models also are offered to clients in file format, outside the Logic platform, for direct integration with client portfolio management and testing systems.

ResRisk+ is a multifaceted optimizer and reporting tool, enabling portfolio managers and traders to assess and control portfolio risk characteristics through any series of executions. ResRisk+ is not an automated trading tool, rather a “power assist” that provides users with intelligently constructed trading scenarios, while preserving full control over executions.

A capability unique to ITG, ResRisk+ allows users to target the portfolio and stock-specific risks of greatest concern, adjusting controls as a portfolio’s composition shifts. It is used to quantify risk levels before and after execution, construct waves of trades to minimize selected costs and risks, and move portfolios progressively closer to their benchmarks and targeted risk characteristics, including liquidity, tracking error, sector balance, and cash imbalance. As such, it is a tool for controlling risk through manager transitions, rebalancings, multiple POSIT matches, or any other transactions requiring meticulous control of portfolio characteristics. ResRisk+ also is offered to clients as a standalone application, when client workflow requirements are best met in that fashion.

ITG/Opt

ITG/Opt is a computer-based equity portfolio selection system, employing advanced optimization techniques to help investors construct portfolios that meet their investment objectives. Special features of the system make it particularly useful to “long/short” and taxable investors, as well as any investor seeking to control transaction costs.

ITG/Opt is usually delivered as a “turnkey” system that includes software and, in some cases, hardware and data. Included in the service is telephone and on-site support to assist in training and integration of the system with the user’s other investment systems and databases, with the goal of tightly coupling ITG/Opt to the client’s workflow. In addition to its core portfolio construction capabilities,

9




ITG/Opt has powerful back testing and batch scheduling features that permit efficient researching of new or refined investment strategies. The system, which is targeted at highly sophisticated investment applications, is offered primarily to our largest clients.

ITG Fair Value Model

Under the Investment Company Act of 1940, mutual funds and their directors/trustees are required to make a good faith determination of the fair value of a fund’s portfolio securities when market quotations are not readily available. The ITG Fair Value Model facilitates such fair value computations.

In most instances, an open-end mutual fund’s NAV is calculated based on the closing price for each security underlying the fund’s portfolio. For mutual funds with foreign or thinly traded assets, however, this practice may raise concerns regarding the “fair value” of a fund’s securities where the underlying securities’ local markets close prior to the close of the U.S. markets and therefore do not account for market events in the U.S. or other subsequent events.

The ITG Fair Value Model is an independent service, which provides fair value adjustment factors to assist in determining whether to adjust securities’ closing prices when market quotations are not readily available. In historical tests of international funds, the ITG Fair Value Model has significantly reduced the opportunity for mutual fund market timing. Covering all major global equity markets, the model supplies a monitoring report for each country, with information on universe coverage and the model’s historic performance. The information is updated daily and made available shortly after the U.S. market close for downloading to the client site.

Soft Dollar Programs

We actively market and distribute independent third-party and our own analytical and research products and services to professional investment managers with the expectation that these managers will generate specified amounts of commission revenues. These types of arrangements are referred to as soft dollar arrangements and are pursued by ITG Europe, ITG Hong Kong and, in the U.S., primarily by the Hoenig division of ITG Inc.

An important aspect of our soft dollar programs involves identifying independent sources of investment research and information that adds value to our customers’ investment decision-making process. We seek research services from private research groups, independent analysts, information services organizations and other entities in the U.S. and overseas and collaborate with these providers to obtain products and services that assist our investment management customers in carrying out their investment management responsibilities.

We obtain research products and services from numerous independent sources and regularly communicate the availability and suitability of these products and services to our customers. Through our relationships with independent research analysts and other service providers, we offer a wide variety of specialized and sophisticated research products and services, including fundamental research, economic research and forecasting, quantitative analysis, global research, quotation, news and database systems, fixed income research, software for securities analysis, portfolio management and performance measurement services. Many of these products and services are available directly from the research analyst or service provider, as well as from other brokerage firms, including specialty firms offering only independent research and firms that also provide proprietary research.

Our relationship with an independent research provider typically is one in which the research organization agrees to supply research products or services to our customers for a specified period of time (generally one year or less), and we agree to pay for such research. All of our research relationships are non-exclusive arrangements.

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In addition, we engage in directed brokerage arrangements with certain institutional investors, particularly hedge funds, private investment funds and investment partnerships, corporations and pension plans. A directed brokerage arrangement is a contractual arrangement between a brokerage firm and its customer whereby the broker pays certain expenses of the customer, such as custodian fees, or refunds to the customer a portion of commissions paid in consideration of the customer directing commission business to the broker. These types of arrangements are commonly known as directed brokerage because the customer instructs its money managers to direct trades for the customer’s account to the broker with whom the customer has a directed brokerage arrangement. In the case of pension plans, directed brokerage arrangements often involve the payment of commission refunds to the pension plan and are often referred to as “commission recapture” programs.

ITG Europe

ITG Europe was founded in 1998 as an institutional broker and provides institutional investors in European equities with most of the products and services provided by ITG Inc. in U.S. equities, including POSIT, Electronic Trading Desk and research products such as TCA and ACE. Eight daily European POSIT matches are currently run dealing in equities from the UK, France, Germany, Switzerland, the Netherlands, Spain, Italy, Belgium, Sweden, Finland and Ireland. A flexible range of electronic connectivity options is provided including through ITG Platform, FIX protocol and other tailored solutions. POSIT’s position as the pre-eminent equities crossing platform in Europe was strengthened on February 28,2005 with the acquisition of the rival crossing business, E-Crossnet Limited. Alongside POSIT, ITG Europe’s other products and services have experienced significant growth in recent years, contributing approximately half of ITG Europe’s product revenues during 2004, when ITG Europe provided services to 234 clients.

ITG Australia

In 1997, we launched ITG Australia Limited, an institutional brokerage firm that applies our cost-saving execution and transaction research technologies to Australian equity trading. ITG Australia provides Institutional investors from Australia, Asia, North America and Europe dealing in Australia many of the products and services provided to our U.S. customer base, including POSIT and certain other research and dealing products such as TCA, automated trading strategies and performance attribution. ITG Australia has achieved a high degree of penetration into the institutional investor base in Australia.

ITG Canada

In April 2000, we formed our Canadian subsidiary, ITG Canada Corp., which functions as an institutional broker-dealer in Canada focusing on Canadian equities. ITG Canada provides institutions access to many of the ITG products provided to our U.S. customer base.

In September 2001, we acquired the KastenNet business of Kasten Chase Applied Research Limited for $4.7 million. KastenNet is a direct access provider that employs proprietary technology to connect its Canadian broker-dealer clients to the Toronto Stock Exchange (“TSX”) and U.S. markets. We acquired the assets of KastenNet via KTG, a wholly-owned subsidiary of ITG.

On April 8, 2004, ITG Canada entered into a joint venture with IRESS Market Technology Limited (“IRESS”), a developer of financial market systems in Australia. As part of the joint venture agreement, we sold 50% of our interest in KTG, to IRESS for C$5.5 million (approximately US$4.1 million) resulting in a gain on sale of approximately US$2.4 million on a pretax basis and $1.5 million on an after-tax basis. Our remaining 50% interest was contributed to the new joint venture, which will continue to operate the existing KTG business (which provides connectivity to the Toronto Stock Exchange) while also designing,

11




developing and marketing a broker-neutral direct access product based upon IRESS technology. Our 50% interest in the new joint venture is accounted for under the equity method of accounting.

ITG Hong Kong

In June 2001, we formed ITG Hong Kong Ltd. ITG Hong Kong is an institutional broker-dealer focusing on applying ITG’s cost saving trading technologies in the Asian markets. POSIT was launched in Hong Kong in June 2002 for the matching of Hong Kong equities. In addition to POSIT, ITG Hong Kong provides a range of research and dealing products such as automated trading strategies and TCA. ITG Hong Kong has continued to increase its client penetration in the Asian markets, with clients from Asia, Australia, North America and Europe.

On September 3, 2002, as a result of the acquisition of Hoenig Group Inc., by ITG, the Hong Kong operations were substantially boosted by the addition of Hoenig (Far East) Limited, a Hong Kong based, wholly-owned broker-dealer subsidiary. Hoenig (Far East) provided trade execution, independent research and other services in Asian markets to alternative investment funds and money managers.

During December 2003, ITG Hong Kong Ltd. changed its name to ITG Hoenig Limited in preparation for the merger of ITG Hong Kong and Hoenig (Far East), which occurred in February 2004.

Hoenig

On September 3, 2002, we acquired Hoenig Group Inc., which, through its operating affiliates, provides trade execution, independent research and other services to alternative investment funds and money managers globally.

Under the terms of the transaction, Hoenig Group Inc. stockholders received approximately $105.0 million, or $11.58 per share, of which approximately $2.4 million, or $0.23 per share, have been placed into an escrow account. Such escrow requirement relates to the pursuit, by the Contingent Payment Rights Committee (“CPRC”) established at the time of acquisition on behalf of Hoenig Group Inc. shareholders, of certain insurance and other claims in connection with the $7.2 million pre-tax loss announced by Hoenig Group Inc. on May 9, 2002 as a result of unauthorized trading in foreign securities, by a former employee of Hoenig & Company Limited, in violation of Hoenig’s policies and procedures.

In December 2004, the CPRC completed its pursuit of these claims on behalf of the former Hoenig shareholders and distributed an additional $3.8 million or approximately $0.374 cents per share in cash to such shareholders. We anticipate that in January 2006, determinations will be available with respect to tax liabilities associated with the amounts recovered by the CPRC. In the event that such tax liabilities are less than the amounts remaining in the escrow, such remaining amounts will be distributed to the former Hoenig Group, Inc. shareholders. While the amount of any such payment remains to be determined, we expect that it will not exceed $.05 per share (or approximately $600,000). In the event a second payment is made, it will represent the full and final distribution from the escrow.

In connection with this acquisition, we incurred transaction costs consisting primarily of professional fees of approximately $2.8 million, which have been included in the purchase price. The purchase price was allocated to those assets acquired and liabilities assumed based on the fair value of Hoenig’s net assets as of September 3, 2002. Approximately $0.5 million was allocated to the “Hoenig” trade name, which is being amortized over three years. The excess of the purchase price over the estimated fair value of the net assets acquired was $56.0 million and has been allocated to goodwill. The results of operations of Hoenig have been included in our results of operations since September 3, 2002.

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License and Relationship with Barra

In 1987, Jefferies & Company, Inc. and BARRA Inc. (“Barra”) formed a joint venture for the purpose of developing and marketing POSIT. In 1993, Jefferies & Company, Inc. assigned all of its rights relating to the joint venture and the license agreement, discussed below, to us.

Prior to the closing of the POSIT Transaction (defined below), the technology used to operate POSIT in the U.S. was licensed to us pursuant to a perpetual license agreement between ITG Inc. and the POSIT Joint Venture. The license agreement granted ITG Inc. the exclusive right to use certain proprietary software necessary to the continued operation of POSIT in the U.S. and a non-exclusive license to use proprietary software that operates in conjunction with POSIT.

In June 2004 Barra was acquired by Morgan Stanley Capital International Inc. (“MSCI”) and on December 15, 2004 we entered into an agreement with MSCI to acquire MSCI and Barra’s ownership interest in the POSIT Joint Venture (the “POSIT Transaction”) for $90 million plus a contingent component payable over 10 years (equal to 1.25% of the revenues from the business of the POSIT Joint Venture). The POSIT Transaction closed on February 1, 2005, at which time we became the owner of all right, title, interest, including all intellectual property rights of the POSIT Joint Venture.

Prior to the closing of the POSIT Transaction, pursuant to license agreements with the POSIT Joint Venture, ITG Inc., ITG Australia, ITG Europe and ITG Hong Kong paid quarterly royalties to the POSIT Joint Venture equal to specified percentages of the transaction fees we charge on each share crossed through POSIT. For the years ended December 31, 2004, 2003, and 2002, we paid aggregate royalties to the POSIT Joint Venture of $13.7 million, $16.7 million, and $19.6 million, respectively, under the license agreements.

Regulation

Certain of our U.S. and non-U.S. subsidiaries are subject to various securities regulations and capital adequacy requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. In the U.S., the Securities and Exchange Commission (“SEC”) is the federal agency responsible for the administration of the federal securities laws, with the regulation of broker-dealers primarily delegated to self-regulatory organizations (“SROs”), principally the National Association of Securities Dealers, Inc. (“NASD”) and national securities exchanges. In addition to federal oversight, securities firms are also subject to regulation by state securities administrators in those states in which they conduct business. Furthermore, our non-US subsidiaries are subject to regulation by central banks and regulatory bodies in those jurisdictions where each subsidiary is authorized to do business. The SROs, central banks and regulatory bodies conduct periodic examinations of our broker-dealers subsidiaries in accordance with the rules they have adopted and amended from time to time.

ITG’s principal regulated subsidiaries are discussed below.

·       ITG Inc. is a U.S. broker-dealer registered with the SEC, NASD, National Futures Association, Pacific Stock Exchange (“PCX”), Ontario Securities Commission (“OSC”), all 50 states, Puerto Rico and the District of Columbia. ITG Inc.’s principal self-regulator is the NASD.

·       AlterNet is a U.S. broker-dealer registered with the SEC, NASD and 12 states. AlterNet’s principal self-regulator is the NASD.

·       ITG Execution Services is a U.S. broker-dealer registered with the SEC, NASD, NYSE, PCX, Boston Stock Exchange (“BSE”), Chicago Stock Exchange (“CHX”), Philadelphia Stock Exchange (“PHLX”) and New York State. ITG Execution Services’ principal self-regulator is the NYSE.

·       ITG Canada is a Canadian broker-dealer registered with the Investment Dealers’ Association (“IDA”), OSC and 6 other Provincial securities authorities (Alberta Securities Commission, British

13




Columbia Securities Commission, Autoritè des marches Financiers, Manitoba Securities Commission, New Brunswick Securities Commission, Saskatchewan Financial Services Commission). ITG Canada is a member of the TSX and TSX Venture Exchange.

·       ITG Australia, an Australian broker-dealer, is a participating organization of the Australian Stock Exchange Limited (“ASX”) and a holder of an Australian Financial Services License issued by the Australian Securities and Investment Commission. ITG Australia’s principal regulator is the ASX.

·       ITG Europe refers to Investment Technology Group Limited (“ITGL”) and/or its wholly owned subsidiary Investment Technology Group Europe Limited (“ITGEL”). ITGL and ITGEL are authorized by the Irish Financial Services Regulatory Authority (“IFSRA”) under Section 10 of the Investment Intermediaries Act, 1995. ITGL’s POSIT business is also regulated by IFSRA under the Committee of European Securities Regulators’ Standards for Alternative Trading Systems. ITGEL London Branch is regulated by the Financial Services Authority for the conduct of investment business in the United Kingdom. ITGL is a member of the London Stock Exchange (“LSE”), Deutsche Boerse and Euronext.

·       ITG Hong Kong refers to ITG Hoenig Ltd. (“ITGHK”) and/or its affiliate ITG Securities (Asia) Limited (“ITG Asia”). ITGHK is a participating organization of the Hong Kong Stock Exchange and a holder of a dealer’s license issued by the Securities and Futures Commission of Hong Kong (“SFC”), with the SFC acting as its principal regulator.

Broker-dealers are subject to regulations covering all aspects of the securities business, including sales methods, trade practices among broker-dealers, use and safekeeping of clients’ funds and securities, capital structure of securities firms, record-keeping and conduct of directors, officers and employees. Additional legislation, changes in the interpretation or enforcement of existing laws and rules may directly affect the mode of operation and profitability of broker-dealers. The SEC, SROs, state securities commissions and foreign regulatory authorities may conduct administrative proceedings, which can result in censure, fine, the issuance of cease-and-desist orders or the suspension or expulsion of a broker-dealer, its officers or employees. The principal purpose of regulation and discipline of broker-dealers is the protection of clients and the securities markets, rather than the protection of creditors and stockholders of broker-dealers.

ITG Inc., AlterNet and ITG Execution Services are required by law to belong to the Securities Investor Protection Corporation. In the event of a U.S. broker-dealer’s insolvency, the Securities Investor Protection Corporation fund provides protection for client accounts up to $500,000 per customer, with a limitation of $100,000 on claims for cash balances. ITG Canada is required by Canadian law to belong to the Canadian Investors Protection Fund (“CIPF”). In the event of a Canadian broker-dealer’s insolvency, CIPF provides protection for client accounts up to 1,000,000 Canadian dollars per customer.

Regulation ATS

From the formation of the POSIT joint venture until the adoption of Regulation ATS, POSIT operated under a “no-action” letter from the SEC staff that it would not recommend that the SEC commence an enforcement action if POSIT were operated without registering as an exchange. We are currently operating POSIT and TriAct as part of our broker-dealer operations in accordance with Regulation ATS. Accordingly, neither POSIT nor TriAct are registered with the SEC as an exchange. There can be no assurance that the SEC will not in the future seek to impose more stringent regulatory requirements on the operation of alternative trading systems such as POSIT or TriAct. In addition, certain of the securities exchanges have actively sought to have more stringent regulatory requirements imposed upon automated trade execution systems. There can be no assurance that Congress will not enact additional legislation applicable to alternative trading systems.

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Net Capital Requirement

ITG Inc., AlterNet and ITG Execution Services are subject to the Uniform Net Capital Rule (Rule 15c3-1) under the Exchange Act, which requires the maintenance of minimum net capital. ITG Inc. has elected to use the alternative method permitted by Rule 15c3-1, which requires that ITG Inc. maintain minimum net capital equal to the greater of $250,000 or 2% of aggregate debit balances arising from customer transactions. AlterNet and ITG Execution Services have elected to use the basic method permitted by Rule 15c3-1, which requires that they maintain minimum net capital equal to the greater of $100,000 for AlterNet and $5,000 for ITG Execution Services, or 6 2¤3% of aggregate indebtedness.

At December 31, 2004, ITG Inc., AlterNet and ITG Execution Services had net capital of $102.7 million, $3.8 million and $1.0 million, respectively, of which $102.4 million, $3.7 million and $1.0 million, respectively, was in excess of required net capital.

In addition, our Canadian, Australian, European and Asian operations had regulatory capital in excess of the minimum requirements applicable to each business as of December 31, 2004 of approximately $10.2 million, $4.2 million, $27.8 million and $7.7 million, respectively.

As of December 31, 2004, ITG Inc. held a $2.9 million cash balance on behalf of its Hoenig division in a segregated deposit account at its clearing broker, Jefferies and Company, Inc., for the benefit of customers under certain directed brokerage arrangements.

As a result of the February 1, 2005 POSIT Transaction, discussed in “License and Relationship with Barra”, ITG Inc.’s excess net capital on February 1, 2005 approximated $25.2 million.

Although we believe that the combination of our existing net regulatory capital and operating cash flows will be sufficient to meet regulatory capital requirements for our subsidiaries, a shortfall in net regulatory capital would have a material adverse effect on our business and our results of operations.

Competition

The automated trade execution and analysis services that we offer compete with services offered by leading brokerage firms and transaction processing firms, and with providers of electronic trading, trade order management systems and financial information services. POSIT also competes with various national and regional securities exchanges and execution facilities, the Nasdaq National Market, ATSs and ECNs, as well as other share matching systems for trade execution services. In addition, the number of trading products that compete with our Client Site Trading Products has been increasing. Many of our competitors have substantially greater financial, research and development and other resources. We believe that our services compete on the basis of access to liquidity, transaction cost and market impact cost reduction, timeliness of execution and probability of trade completion. Although we believe that POSIT, TriAct, Triton, Radical, QuantEX, ITG Platform, SmartServers, the Electronic Trading Desk and our Analytical Products and Research services have established certain competitive advantages, our ability to maintain these advantages will require continued identification of enhancements to our products, investment in the development of our services, additional marketing activities and customer support services. There can be no assurance that we will have sufficient resources to continue to make this investment, that our competitors will not devote significantly more resources to competing services or that we will otherwise be successful in maintaining our current competitive advantages. In addition, we cannot predict the effect that changes in regulations applicable to our business may have on the competitive environment.

Research and Product Development

We devote a significant portion of our resources to the development and improvement of technology-based services. Important aspects of our research and development effort include enhancements of existing software, the ongoing development of new software and services and investment in technology to enhance

15




our efficiency. In our consolidated statements of income, we expensed research and development costs amounting to $23.3 million, $24.1 million, and $23.0 million for the years ended December 31, 2004, 2003, and 2002, respectively.

The development of technology-based services is a complex and time-consuming process. New products and enhancements to existing products can require long development and testing periods. Significant delays in new product releases or significant problems in creating new products could negatively impact our revenues.

Dependence on Proprietary Intellectual Property; Risks of Infringement

Our success is dependent, in part, upon our proprietary intellectual property. We generally rely upon patents, copyrights, trademarks and trade secrets to establish and protect our rights in our proprietary technology, methods and products. A third party may still try to challenge, invalidate or circumvent the protective mechanisms that we select. We cannot assure that any of the rights granted under any patent, copyright or trademark that we may obtain will protect our competitive advantages. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as the laws of the U.S.

In the past several years, there has been a proliferation of so-called “business method patents” applicable to the computer and financial services industries. There has also been a substantial increase in the number of such patent applications filed. Under current law, U.S. patent applications remain secret for 18 months and may, depending upon where else such applications are filed, remain secret until issuance of a patent. In light of these factors, it is not economically practicable to determine in advance whether our products or services may infringe the present or future patent rights of others. We believe that factors such as technological and creative skills of our personnel, new product developments, frequent product enhancements, name recognition and reliable product maintenance are essential to establishing and maintaining a state-of-the-art technological system. There can be no assurance that we will be able to protect our technology from disclosure or that others will not develop technologies that are similar or superior to our technology. It is likely that from time to time, we will receive notices from others of claims or potential claims of intellectual property infringement or we may be called upon to defend a joint venture partner, customer, vendee or licensee against such third party claims. Responding to these kinds of claims, regardless of merit, could consume valuable time, result in costly litigation or cause delays, all of which could have a material adverse effect on us. Responding to these claims could also require us to enter into royalty or licensing agreements with the third parties claiming infringement. Such royalty or licensing agreements, if available, may not be available on terms acceptable to us.

Employees

As of December 31, 2004, we employed 653 personnel globally. Our U.S. Operations employed 484 personnel and our International Operations employed 169 personnel at that date.

Availability of Public Reports

Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K are available without charge on our web site at http://www.itginc.com/investor. You may also obtain copies of our reports without charge by writing to: Investment Technology Group, Inc., 380 Madison Avenue, New York, NY, 10017, attn: Investor Relations.

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Item 2.                        Properties

U.S. Operations

Our principal offices are located at 380 Madison Avenue in New York, New York. We currently lease the entire 4th floor and a portion of the 5th and 7th floors or approximately 83,000 square feet of office space. The fifteen-year lease terms for the 4th and 5th floors and the thirteen-year lease term for the 7th floor expire in January 2013.

We maintain a research, development, sales and technical support services facility in Culver City, California where we occupy approximately 78,000 square feet of office space. 23,500 square feet of usage office located space at 600 Corporate Pointe Drive is pursuant to a lease agreement that expires in December 2005. An additional 54,300 square feet of office space is located at 400 Corporate Pointe Drive pursuant to a lease agreement that expires in December 2016.

Additionally, we have a backup and regional office in Boston, Massachusetts where we occupy approximately 21,000 square feet of office space with a lease expiring in April 2010.

The Hoenig division maintains an office in Rye Brook, New York where we occupy approximately 28,000 square feet of office space. The lease agreement expires in December 2010.

International Operations

ITG Canada has offices in Toronto, Canada where we occupy approximately 7,800 square feet of office space pursuant to two leases expiring in December 2007 and August 2008, respectively.

ITG Europe has offices in Dublin, Ireland and London, England where we occupy approximately 4,000 and 7,000 square feet of office space, respectively. We lease the Dublin space pursuant to a twenty-year lease agreement that expires in August 2018 and we lease the London space pursuant to a nine-year lease agreement that expires in September 2013.

ITG Australia has trading facilities in Melbourne and Sydney, Australia where we occupy approximately 4,600 and 2,700 square feet of office space, respectively. We lease the Melbourne space pursuant to a two-year lease agreement that expires in June 2006 and we lease the Sydney space pursuant to a five-year lease agreement that expires in February 2006.

Our Hong Kong operations occupy approximately 4,200 square feet of office space. The lease agreement expires in June 2007.

We have a research facility in Herzelya Pituach, Israel where we occupy approximately 8,400 square feet of office space. We lease the Israel space pursuant to a seven-year lease agreement that expires in December 2008.

Item 3.                        Legal Proceedings

Except as described below, we are not a party to any pending legal proceedings other than claims and lawsuits arising in the ordinary course of business. We do not believe these proceedings will have a material adverse effect on our financial position or results of operations.

In March 2004, we were served with a complaint by John Wald and Pendelton Trading Systems, Inc. (collectively “Pendelton”) asserting that certain features of ITG ACE and our Limit Order Model infringe Pendelton’s U.S. Patent No. 6,493,682 (the “Pendelton Patent”). In February 2005, Pendelton filed a motion for leave to amend its complaint to add claims that ITG Horizon SmartServer, ITG HorizonPlus, and certain features of QuantEX and Triton infringe the Pendelton Patent. That proposed amendment also contains a federal false advertising claim, state law claims for unfair competition and unjust enrichment and a claim under a New York consumer protection statute. It is our position that we are not

17




infringing the Pendelton Patent and that such claim is without merit. It is also our position that Pendelton’s other claims concerning ITG’s advertising of its products are without merit. We plan to vigorously defend such claims. However, intellectual property disputes are subject to inherent uncertainties and there can be no assurance that such claims will be resolved favorably to us or that they would not have a material adverse effect on us.

We have received a letter from the NASD as part of what we understand to be an industry investigation relating to gifts and gratuities. In addition, we have received a subpoena from the SEC similarly seeking information concerning gifts and entertainment involving a mutual fund company. We believe that other broker-dealers have received similar subpoenas. These investigations are in their early stages and we cannot predict their potential outcomes.

Item 4.                        Submission of Matters to a Vote of Security Holders

There were no matters submitted to a vote of security holders during the fourth quarter ended December 31, 2004.

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PART II

Item 5.                        Market for Registrant’s Common Stock, Related Stockholder Matters and Issuer Purchase of Equity Securities

Common Stock Data

Our common stock trades on the New York Stock Exchange under the symbol “ITG”.

The following table sets forth, for the periods indicated, the range of the high and low closing sales prices per share of our common stock as reported on the New York Stock Exchange.

 

 

High

 

Low

 

2003:

 

 

 

 

 

First Quarter

 

24.27

 

11.06

 

Second Quarter

 

19.29

 

11.51

 

Third Quarter

 

21.12

 

16.50

 

Fourth Quarter

 

20.80

 

15.61

 

2004:

 

 

 

 

 

First Quarter

 

16.37

 

14.30

 

Second Quarter

 

15.95

 

12.34

 

Third Quarter

 

15.30

 

11.98

 

Fourth Quarter

 

20.00

 

14.58

 

 

On March 1, 2005, the closing sales price per share for our common stock as reported on the New York Stock Exchange was $19.16. On March 1, 2005, we believe that our common stock was held by approximately 5,200 stockholders of record or through nominees in street name accounts with brokers.

During 2004, our Board of Directors authorized the repurchase of 5.0 million additional shares of our common stock and we have 2.0 million shares remaining for repurchase under such authorization.

Our dividend policy is to retain earnings to finance the operations and expansion of our businesses. We do not anticipate paying any cash dividends on our common stock at this time.

During the fourth quarter of 2004, we did not repurchase any shares of our common stock.

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Item 6.     Selected Financial Data

The selected consolidated statements of income data and the consolidated statement of financial condition data presented below as of and for each of the years in the five-year period ended December 31, 2004, are derived from our consolidated financial statements, which financial statements have been audited by KPMG LLP, our independent auditors. Earnings per share information prior to 2001 have been retroactively restated to reflect our three-for-two stock split in December 2001. Such selected financial data should be read in connection with the consolidated financial statements contained in this report.

 

 

Year Ended December 31,

 

 

 

2004

 

2003

 

2002

 

2001

 

2000

 

 

 

(In thousands, except per share amounts)

 

Consolidated Statement of Income Data:

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

$

334,486

 

$

333,992

 

$

387,581

 

$

377,407

 

$

310,405

 

Total expenses

 

267,894

 

264,291

 

260,328

 

241,295

 

197,409

 

Income before income taxes

 

66,592

 

69,701

 

127,253

 

136,112

 

112,996

 

Income tax expense

 

25,609

 

27,748

 

53,443

 

57,217

 

49,403

 

Net income

 

$

40,983

 

$

41,953

 

$

73,810

 

$

78,895

 

$

63,593

 

Basic earnings per share

 

$

0.96

 

$

0.89

 

$

1.52

 

$

1.65

 

$

1.37

 

Diluted earnings per share

 

$

0.96

 

$

0.89

 

$

1.51

 

$

1.62

 

$

1.34

 

Basic weighted average number of common shares outstanding (in millions)

 

42.8

 

47.0

 

48.5

 

47.9

 

46.5

 

Diluted weighted average number of common shares outstanding (in millions)

 

42.8

 

47.0

 

49.0

 

48.7

 

47.3

 

Consolidated Statement of Financial Condition Data:(1)

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

612,458

 

$

649,848

 

$

594,254

 

$

418,478

 

$

281,712

 

Total stockholders’ equity

 

$

370,501

 

$

361,303

 

$

356,509

 

$

317,944

 

$

210,416

 

Other Selected Financial Data:

 

 

 

 

 

 

 

 

 

 

 

Revenues per trading day by U.S. Operations
(in thousands)

 

$

1,031

 

$

1,086

 

$

1,373

 

$

1,416

 

$

1,232

 

Revenues per trading day by Non U.S. Operations (in thousands)

 

296

 

239

 

165

 

106

 

 

Shares executed per trading day by U.S. Operations (in millions)

 

82

 

81

 

98

 

91

 

65

 

Average number of employees

 

627

 

617

 

643

 

524

 

368

 

Total number of U.S. customers(2)

 

985

 

991

 

1,085

 

636

 

613

 

POSIT(2)

 

522

 

544

 

559

 

551

 

521

 

Electronic Trading Desk(2)

 

725

 

758

 

449

 

444

 

418

 

Client Site(3)

 

276

 

247

 

290

 

258

 

254

 

Soft Dollar(2)

 

400

 

396

 

423

 

 

 

Total number of Non U.S. customers(2)

 

540

 

517

 

457

 

292

 

34

 

Return on average stockholders’ equity

 

11.5

%

11.5

%

21.2

%

30.4

%

38.1

%

Book value per share(4)

 

$

8.83

 

$

8.08

 

$

7.50

 

$

6.54

 

$

4.44

 

Tangible book value per share(4)

 

$

6.71

 

$

6.25

 

$

5.76

 

$

6.03

 

$

4.34

 

Price to earnings ratio using diluted earnings
per share

 

20.9

 

18.1

 

14.8

 

24.1

 

20.7

 


(1)    Numbers are as of December 31st of each year.

(2)    Total POSIT, Electronic Trading Desk and soft dollar customers include those customers who have generated revenues in excess of $1,000 per annum.

(3)    Client Site customers and customer installations include those customers and installations that have either (a) traded 100,000 shares in the last quarter of such calendar year or (b) traded shares on at least 12 different days during such quarter.

(4)    Share and earnings per share information have been retroactively restated to reflect the Company’s three-for-two stock split in December 2001.

20




Item 7.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations

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

Executive Overview

We have two reportable segments: U.S. Operations and International Operations. The U.S. Operations segment provides equity trading and research services to institutional investors, brokers and alternative investment funds and money managers in the U.S. while our International Operations segment includes our brokerage businesses in Australia, Canada, Europe and Hong Kong, as well as a research facility in Israel.

We generate substantially all of our revenues from the following three products and services (“Product Revenues”):

·       POSIT

·       Electronic Trading Desk

·       Client Site Trading Products

Revenues primarily consist of commissions from customers’ use of our trade execution and analytical and  research services. Because these commissions are paid on a per-transaction basis, revenues fluctuate from period to period depending on (i) the volume of securities traded through our services in the U.S. and Canada, and (ii) the contract value of securities traded in Europe, Australia and Hong Kong.

Expenses consist of compensation and employee benefits, transaction processing, software royalties, occupancy and equipment, telecommunications and data processing services, restructuring charges, and other general and administrative expenses.

Our U.S. operations faced a difficult economic environment in 2004, with continued execution pricing pressure and challenging equity market conditions. The average portfolio turnover rate for equity funds, weighted by fund assets, dropped to 51% (as of October 2004), which was the lowest in over 20 years. Volatility as measured by the VIX index (CBOE Volatility Index) hit its lowest average levels since 1995. In this lackluster environment, program trading as a percentage of NYSE-traded volume continued to rise, averaging 50.6%. This increase in program trading further intensified the competition for execution-only commissions, with the remainder of order flow allocated for fundamental research commitments to full service brokers or soft dollar obligations. In this environment, ITG’s U.S. domestic revenues declined 5%.

Our international operations fared better, achieving record revenues of $74.6 million for 2004, an increase of $14.4 million over 2003. This revenue growth includes a benefit from foreign exchange rate movement of $6.7 million.

According to London Stock Exchange (“LSE”) statistics, the value of U.K. equity customer business grew 18% for the year. Our European business grew at a slower pace with ITG Europe’s market share of LSE customer business for the year decreasing to 1.24% from 1.44% in 2003. However this decrease primarily reflected difficult trading conditions at the start of the year as the business adjusted to the challenges posed to POSIT following the introduction of the LSE’s SETSmm trading service in November 2003. By the second half of 2004 these challenges had been largely addressed and UK market share had increased to 1.46% in the third quarter and 1.53% in the fourth quarter. In addition, the value of continental European equities traded by ITG Europe also increased, up 70% in 2004, compared to 2003. These increases in market share and values traded were attributable to a range of factors including developing our portfolio trading services and winning new clients with TCA. For 2004, revenues from our European business grew $5.5 million, which included a foreign exchange rate benefit of $3.8 million.

21




In Canada, our second largest international business after Europe, the volume of shares traded on the TSX increased to 61.3 billion shares in 2004 (from 55.6 billion in 2003), with ITG Canada increasing its market share to 2.8% of value traded on the TSX from 2.6% in 2003. For 2004, revenues from our Canadian business grew $5.7 million, which included a foreign exchange rate benefit of $1.8 million as well as a $2.4 million gain on our sale of 50% of KTG.

Our 2004 results reflect the following non-recurring items:

i.                   Unrealized gains of $3.3 million, representing the carrying value of shares of common stock that we own in Archipelago Holdings Inc. (“Archipelago”), following its August 2004 initial public offering, are included in other revenues. These shares were acquired via an equity entitlement program.

ii.               A recovery against previous investment write-downs of $0.8 million.

iii.           A $2.4 million gain on our sale of 50% of KTG in April 2004.

iv.             An impairment charge of $0.7 million on our New York Stock Exchange Seats as a result of a decline in value that we determined to be other than temporary.

v.                 Our expenses also included other non-recurring items related to a lease abandonment in California, and employee separation costs. Collectively, these costs were $2.8 million.

The impact of the 2004 non-recurring items was a $3.1 million increase in pretax income and a $1.9 million increase in after-tax net income. Reported earnings per share for the year increased by $0.05 as a result of these non-recurring items.

For comparative purposes, our 2003 results also included certain non-recurring items. Included in our 2003 results are (i) a resolution of an Internal Revenue Service examination of Research and Development tax credits taken on ITG’s federal income tax returns prior to 1996. As a result of this settlement, we reversed approximately $1.9 million of tax reserves into income, together with $454,000 of related interest expense that had been accrued as a pre-tax item within other general and administrative expenses, and (ii) impairment charges of $2.7 million recorded during 2003 relating to certain assets whose fair market value was lower than our cost basis (which included a $2 million write down of our New York Stock Exchange Seats). These 2003 non-recurring items reduced pretax income by $2.3 million and increased after-tax income by $0.3 million.

Certain Factors That May Affect Our Results of Operations

While our management’s long-term expectations are optimistic, we face risks or uncertainties that may affect our results of operations. The following conditions, among others, should be considered in evaluating our business and growth outlook.

Financial Market Conditions and General Economic and Political Conditions

The demand for our securities brokerage and related services is directly affected by factors such as economic and political conditions that may lead to decreased trading activity and prices in the securities markets generally. The future economic environment may be subject to periodic economic downturns, such as recessions, as well as geopolitical unrest, war and acts of terrorism in regions where we do business or otherwise, which could also result in reduced trading volumes and prices, which could materially harm our business, financial condition and operating results. Over the last year, the institutional equities market in the U.S. has also experienced continued pricing pressure on commission revenues. Our business is materially affected by conditions in both domestic and foreign financial markets. We anticipate a continuation of the weak pricing environment in the immediate future.

22




Decreases in Trading Volumes or Market Prices

Declines in the volume of securities trading and in market liquidity generally result in lower revenues from our POSIT, Client Site Trading Products and Electronic Trading Desk products. In addition, our trading commissions outside the U.S. and Canada are based on the value of transactions (rather than volume based), which would be adversely affected by price declines. Our profitability would be adversely affected by a decline in trading revenues because a significant portion of our costs are fixed. For these reasons, decreases in trading volume or securities prices could have a material adverse effect on our operating results.

Regulation

General

The securities markets and the brokerage industry in which we operate are subject to extensive regulation in the United States and other jurisdictions around the world. We face the risk of significant intervention by regulatory authorities in all jurisdictions in which we conduct business. In our case, the impact of regulation extends beyond “traditional” areas of securities regulation, such as disclosure and prohibitions on fraud and manipulation by market participants, to the regulation of the structure of markets.

The securities industry has been subject to several fundamental regulatory changes. In the future, the industry may become subject to new regulations or changes in the interpretation or enforcement of existing regulations, which may adversely affect our business. The markets for equity securities have been subject to the most significant regulatory changes. We cannot predict the extent to which any future regulatory changes can affect our business.

On February 26, 2004, the SEC published proposed “Regulation NMS” for public comment. On December 16, 2004, the SEC published a revised version of proposed “Regulation NMS.”  If adopted in its revised form, Regulation NMS would incorporate four substantive provisions related to the regulatory structure of the U.S. equity markets. Subject to applicable exceptions, Proposed Rule 611 of Regulation NMS would require trading centers (which would include national securities exchanges, national securities associations that operate an SRO trading facility, ATSs (such as POSIT and TriAct), exchange market makers, broker-dealers that execute orders internally by trading as principal, or broker-dealers, such as ITG Inc., that execute orders internally by crossing orders as agent) to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers. To be protected, a quotation must be immediately and automatically accessible. Proposed Rule 610 would require fair and non-discriminatory access to quotations, establish a limit on access fees, and require each national securities exchange and national securities association to adopt and enforce rules that prohibit their members from engaging in a pattern or practice of displaying quotations that lock or cross automated quotations. Proposed Rule 612 generally would prohibit market participants from accepting, ranking or displaying orders, quotations or indications of interest in pricing increments finer than one penny. The proposed rule would not prohibit systems, such as POSIT, that match unpriced orders at the midpoint of the best bid and offer from executing such orders in share prices of less than one cent. Finally, Regulation NMS would amend the various national market system joint industry quotation and trade reporting plans to modify the formulas for allocating net income among the exchanges and national securities associations that are the participants of such plans. ITG cannot predict whether or when any or all of Proposed Regulation NMS, either as currently proposed or as may be later modified by the SEC, ultimately will be adopted by the SEC. As a result, we cannot predict the extent to which any future regulatory changes associated with Regulation NMS would affect our business.

23




Regulation ATS

Before Regulation ATS went into effect on April 21, 1999, we operated POSIT pursuant to a “no-action” letter from the SEC staff which stated that it would not commence an enforcement action if POSIT were operated without registering as an exchange. We are currently operating POSIT and TriAct as part of our broker-dealer operations in accordance with Regulation ATS. Accordingly, neither POSIT nor TriAct is registered with the SEC as an exchange. There can be no assurance that the SEC will not in the future seek to impose more stringent regulatory requirements on the operation of alternative trading systems such as POSIT and TriAct. There can be no assurance that Congress will not enact additional legislation applicable to alternative trading systems. Similarly, the non-U.S. POSIT systems are subject to various regulations in the jurisdictions in which they operate, changes to which can have a negative impact on each POSIT system’s ability to operate.

Net Capital Requirement

Each of our broker-dealer subsidiaries is subject to regulatory capital requirements promulgated by the regulatory and exchange authorities of the countries in which they operate. The failure by any of these subsidiaries to maintain its required regulatory capital may lead to suspension or revocation of its broker-dealer registration and its suspension or expulsion by U.S. or international regulatory bodies, and ultimately could require its liquidation. We do not currently maintain any credit facilities in the event of a regulatory capital shortfall. Historically, all regulatory capital needs of ITG Inc., AlterNet and ITG Execution Services have been provided by cash from operations. While we believe that cash flows from operations will continue to provide ITG Inc., AlterNet and ITG Execution Services with sufficient regulatory capital, we are considering the establishment of a credit facility to supplement our existing regulatory capital, as needed.

Soft Dollars

In the U.S., the provision of research to investment managers in consideration of commissions is conducted in conjunction with the investment manager’s reliance upon the safe harbor provided under Section 28(e) of the Securities Exchange Act of 1934. The safe harbor protections of Section 28(e) apply equally to the provision of independent third-party research, as well as proprietary research.

The SEC from time to time has been urged by competitors of the Company and others to seek Congressional reconsideration of Section 28(e) or alter its scope, including modifying the nature of Section 28(e) from a safe harbor to a mandatory regime for the use of soft dollars applicable to all investment advisors (including those not registered with the SEC). From time to time, other regulatory or governmental entities, as well as industry groups, have issued statements, reports and best practices regarding soft dollars. Any regulatory changes or industry best practices that narrow the definition of research provided in Section 28(e) or limit the scope, or modify the nature, of the Section 28(e) safe harbor, or impose onerous record-keeping, reporting or other obligations regarding soft dollar and directed brokerage arrangements could have a material adverse effect on our operations.

Competition

The financial services industry generally, and the securities brokerage business in which we engage in particular, is extremely competitive, and we expect it to remain so. The brokerage and related services offered by us compete with services provided by leading brokerage firms and transaction processing firms and with providers of electronic trading and trade order management systems and financial information services. POSIT also competes with various national and regional securities exchanges and execution facilities, the Nasdaq National Market, ATSs and ECNs for trade execution services. Many of our competitors have substantially greater financial, technical, marketing and other resources which, among

24




other things, enable them to compete with the services we provide on the basis of price, and a willingness to commit their firms’ capital to service a client’s trading needs on a principal,  rather than on an agency, basis. Many of them offer a wider range of services, have broader name recognition and have larger customer bases than we do. Outside the United States, in addition to our U.S. competitors with international capabilities, we compete with non-U.S. financial service companies that may also have long-standing, well-established relations with their clients, some of which also hold dominant positions in their trading markets. We compete on the basis of a number of factors, including access to liquidity, transaction execution, our products and services, innovation, reputation and price.

Insufficient System Capacity or System Failures

Our business relies heavily on the computer and communications systems supporting our operations. Peak trading times and times of unusual market volatility could cause our systems to operate slowly or even fail for periods of time as could general power or telecommunications failures or natural disasters, despite the contingency plans we have in place. Moreover, we have varying levels of contingency plan coverage among our non-U.S. subsidiaries. The presence of computer viruses can also cause failure of our systems. As our business expands, we will need to expand our systems to accommodate an increasing volume of transactions. If any of our systems do not operate properly or are disabled, we could incur financial loss, liability to clients, regulatory intervention or reputational damage. System failure or degradation could lead our customers to file formal complaints with industry regulatory organizations, initiate regulatory inquiries or proceedings, file lawsuits against us, trade less frequently through us or cease doing business with us.

Rapid Changes in Technology

Due to the high demand for technology-based services in the securities industry, we are subject to rapid technological change and evolving industry standards. Also, customer demands become greater and more sophisticated as the dissemination of information to customers increases. If we are unable to anticipate and respond to the demand for new services, products and technologies in a timely and cost-effective manner and to adapt to the technological advancements and changing standards, we will be less able to compete effectively, which could have a material adverse effect on our business.

Credit Risk

We are exposed to credit risk from third parties that owe us money, securities, or other obligations, including our customers and trading counterparties. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, operational failure or other reasons. Substantially all of the clearing and depository operations for our broker-dealer subsidiaries are performed pursuant to clearing agreements with their clearing brokers, who review the credit risk of trading counterparties, as deemed necessary. Volatile securities markets, credit markets and regulatory changes increase our exposure to credit risk, which could adversely affect our financial condition and operating results.

Infrastructure and Research

In connection with our research and product development activities, as well as capital expenditures to improve other aspects of our business, we incur substantial expenses that do not vary directly, at least in the short term, with fluctuations in securities transaction volumes and revenues. In the event of a material reduction in revenues, we may not be able to reduce such expenses quickly and, as a result, we could experience reduced profitability or losses. Conversely, sudden surges in transaction volumes can result in increased profit and profit margin. To ensure that we have the capacity to process projected increases in transaction volumes, we have historically made substantial capital and operating expenditures in advance of such projected increases, including during periods of low transaction volumes. In the event that such

25




growth in transaction volumes does not occur or we are not able to bring a research or product idea to fruition (or do not accurately forecast the demand for any such product), the expenses related to such investments could cause reduced profitability or losses.

Dependence on Major Customers

Customers may discontinue use of our services at any time. The loss of any significant customers could have a material adverse effect on our results of operations. In addition, the loss of significant POSIT customers could result in lower share volumes of securities submitted to POSIT systems around the world, which may adversely affect the liquidity of the systems, reducing their attractiveness to our customers and adversely affecting our trading volumes, operating results and financial condition.

The chart below sets forth our dependence on our three largest clients individually, as well as on our ten largest clients in the aggregate, expressed as a percentage of total revenues:

 

 

% of Total Consolidated Revenue

 

 

 

    2004    

 

    2003    

 

    2002    

 

Largest customer

 

 

6.1

%

 

 

5.4

%

 

 

4.4

%

 

Second largest customer

 

 

2.2

%

 

 

4.0

%

 

 

3.8

%

 

Third largest customer

 

 

2.2

%

 

 

3.1

%

 

 

3.4

%

 

Ten largest customers

 

 

22.5

%

 

 

28.2

%

 

 

26.8

%

 

 

Employee Misconduct or Errors

Employee misconduct could subject us to financial losses or regulatory sanctions and seriously harm our reputation. It is not always possible to deter employee misconduct, and the precautions we take to prevent and detect this activity may not be effective in all cases. Misconduct by our employees could include hiding unauthorized activities from us, improper or unauthorized activities on behalf of customers or improper use of confidential information.

Similarly, employee errors in recording or executing transactions for customers can cause us to enter into transactions that customers may disavow and refuse to settle. These transactions expose us to risk of loss, which can be material, until we detect the errors in question and unwind or reverse the transactions. As with any unsettled transaction, adverse movements in the prices of the securities involved in these transactions before we unwind or reverse them can increase this risk.

Dependence on Third Party Suppliers for Key Services

We depend on a number of third parties to supply elements of our trading systems, computers, communication infrastructure and other equipment, and related support and maintenance. We cannot be certain that any of these providers will be able to continue to provide these services in an efficient and cost-effective manner or that they will be able to meet our expanding needs. If we are unable to make alternative arrangements for the supply of these services in the event of a disruption in the services, our business, financial condition and operating results could be materially harmed.

Risks of Infringement of our Intellectual Property Rights

We rely upon patents, copyrights, trademarks and trade secrets to establish and protect our rights in our proprietary technology, methods and products. However, a third party may still try to challenge, invalidate or circumvent the mechanisms we select to protect our rights. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as the laws of the U.S.

26




In the past several years, there has been a proliferation of so-called “business method patents” applicable to the computer and financial services industries. Under current law, U.S. patent applications remain secret for 18 months and may, depending upon where else such applications are filed, remain secret until issuance of a patent. Thus it is not economically practicable to determine in advance whether our products or services may infringe the present or future patent rights of others. There can be no assurance that we will be able to protect our technology from disclosure or that others will not develop technologies that are similar or superior to our technology. It is likely that from time to time we may also face claims that use of technology material to our business operations infringes on rights of third parties or we may be called upon to defend a joint venture partner, customer or licensee against such third party claims, which could consume valuable time, result in costly litigation or cause delays, all of which could have a material adverse effect on our business.

Results of Operations

The table below sets forth certain items in the consolidated statements of income expressed as a percentage of revenues for the periods indicated:

 

 

Year Ended December 31,

 

 

 

2004

 

2003

 

2002

 

Revenues:

 

 

 

 

 

 

 

Commissions

 

 

 

 

 

 

 

POSIT

 

30.2

%

37.9

%

40.0

%

Electronic Trading Desk

 

32.5

 

35.7

 

28.8

 

Client Site Trading Products

 

30.6

 

23.2

 

28.7

 

Other

 

6.7

 

3.2

 

2.5

 

Total revenues

 

100.0

 

100.0

 

100.0

 

Expenses:

 

 

 

 

 

 

 

Compensation and employee benefits

 

36.7

 

35.4

 

29.5

 

Transaction processing

 

15.3

 

13.9

 

13.0

 

Software royalties

 

4.1

 

5.1

 

5.1

 

Occupancy and equipment

 

9.1

 

9.3

 

7.2

 

Telecommunications and data processing services

 

5.4

 

5.4

 

4.5

 

Restructuring charges

 

 

 

1.5

 

Other general and administrative

 

9.5

 

10.0

 

6.4

 

Total expenses

 

80.1

 

79.1

 

67.2

 

Income before income tax expense

 

19.9

 

20.9

 

32.8

 

Income tax expense

 

7.6

 

8.3

 

13.8

 

Net income

 

12.3

 

12.6

 

19.0

 

 

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

Earnings Per Share

Basic and diluted earnings per share for 2004 and 2003 were $0.96 and $0.89, respectively, an 8% increase from 2003. Our 2004 and 2003 results included non-recurring items discussed above in “Executive Overview”.

27




The following table sets forth the components of revenues, by segment, included in the statement of income with percent change information for the periods indicated (dollars in thousands):

 

 

Year Ended December 31,

 

 

 

 

 

 

 

2004

 

2003

 

Change

 

% Change

 

U.S. Operations

 

$

259,840

 

$

273,781

 

$

(13,941

)

 

(5

)

 

International Operations

 

74,646

 

$

60,211

 

14,435

 

 

24

 

 

Consolidated

 

$

334,486

 

$

333,992

 

$

494

 

 

 

 

 

Revenues

In 2004, consolidated revenues remained relatively unchanged from 2003, with growth in our international operations offsetting lower revenues in our U.S. operations. There were 252 trading days in both 2004 and 2003.

Revenues by segment—U.S. operations

Key volume and revenue performance indicators for the last two years, as well as percent change information, for our U.S. operations are as follows:

U.S. Operations

 

 

 

2004

 

2003

 

Change

 

% Change

 

Total trading volume (in billions of shares)

 

20.6

 

20.4

 

0.2

 

 

1

 

 

Trading volume per day (in millions of shares)

 

81.9

 

81.0

 

0.9

 

 

1

 

 

Product revenues per trading day ($ million)

 

$

1.0

 

$

1.1

 

$

(0.1

)

 

(9

)

 

Average revenue per share traded ($)

 

$

0.0122

 

$

0.0134

 

$

(0.0012

)

 

(9

)

 

U.S. market trading days

 

252

 

252

 

 

 

 

 

 

Product Revenues per trading day from our U.S. operations decreased 9% from 2003 primarily reflecting a decline in average revenue per share partially offset by an increase in trading volume per day.

Revenues by segment—International operations

In 2004, product revenues from our international operations increased $10.1 million or 20%, which included a $5.3 million benefit from exchange rate fluctuations reflecting a weakened U.S. Dollar relative to the currencies in our international markets. From an operational perspective, product revenues increased $4.8 million. All regions generated operating revenue growth primarily from increases in share volumes in Canada, deeper client penetration and increases in market turnover in Europe, Australia, and Hong Kong, despite declines in pricing.

International Product Revenues ($ millions)

 

 

 

2004

 

2003

 

Change

 

% Change

 

Europe

 

30.0

 

25.4

 

 

4.6

 

 

 

18

 

 

Canada

 

16.4

 

14.1

 

 

2.3

 

 

 

16

 

 

Australia

 

8.2

 

6.1

 

 

2.1

 

 

 

34

 

 

Hong Kong

 

6.4

 

5.3

 

 

1.1

 

 

 

21

 

 

Total Product Revenues

 

61.0

 

50.9

 

 

10.1

 

 

 

20

 

 

Less: Currency Exchange Impact

 

(5.3

)

 

 

(5.3

)

 

 

 

 

 

Total Product Revenues Excluding Currency Exchange Impact

 

55.7

 

50.9

 

 

4.8

 

 

 

9

 

 

 

Revenues by product—POSIT

Consolidated POSIT revenues decreased $25.9 million, or 20% (including a $1.6 million benefit from foreign exchange rate fluctuations), principally reflecting lower U.S. share volume and a decline in the contract value of shares crossed in European POSIT, as indicated in the table below. In Europe

28




commissions are calculated on the basis of the underlying contract value of transactions rather than on a per share basis.

POSIT

 

 

 

2004

 

2003

 

Change

 

% Change

 

U.S. POSIT system:

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares crossed (in billions)

 

5.5

 

6.4

 

 

(0.9

)

 

 

(14

)

 

Average shares per day (in millions)

 

21.8

 

25.3

 

 

(3.5

)

 

 

(14

)

 

European POSIT system:

 

 

 

 

 

 

 

 

 

 

 

 

 

Contract value of shares crossed ($ billions)

 

$

17.6

 

$

20.6

 

 

$

(3.0

)

 

 

(15

)

 

 

Revenues by product—Electronic Trading Desk

Electronic Trading Desk revenues decreased $10.6 million (including a $3.3 million benefit from foreign exchange rate fluctuations) to $108.7 million and on a per trading day basis declined by 9% to approximately $431,500 in 2004. Our U.S. Electronic Trading Desk revenues declined $18.3 million, or 21%, which was partially offset by the $7.7 million growth in our International operations. Our European trading desk business more than doubled to $15.9 million, reflecting a deeper client penetration in both the U.K. and continental Europe. Our Australian trading desk business grew by $1.8 million while our Asian trading desk business grew by $1.1 million. In 2004, we recorded $6.2 million of Canadian direct access trading revenues, which had previously been included in the Electronic Trading Desk (in 2003) within Client Site Trading resulting in a $3.9 million decline in the Canadian trading desk business.

In marketing our program trading services, we package our Electronic Trading Desk services with POSIT. Our clients receive blended pricing for executions as a way to provide a single price for an entire portfolio of equity transactions regardless of the execution venue. In the U.S., our combined POSIT and Electronic Trading Desk rate per share declined $0.0010, or 6%, to $0.0157 in 2004 reflecting competitive pricing in the program trading business.

Revenues by product—Client Site Trading Products

Client Site Trading Product revenues, which are only generated by our U.S. Operations and ITG Canada, increased $24.8 million, or 32%, primarily due to the performance of our Triton and Radical products within our U.S. operations, as well as the inclusion of $6.2 million of Canadian direct access trading revenues in 2004. Client Site Trading Product revenues for our U.S. operations increased $18.6 million, or 24% driven by share volume growth.

Other revenues

Other revenues increased $12.2 million or 118%, to $22.5 million in 2004. This increase is comprised of (i) non-recurring gains of $2.4 million from our sale of 50% of KTG in April 2004, (ii) income of $3.3 million arising from unrealized gains on our holding of Archipelago common stock (which we acquired under an equity entitlement program) following its August 2004 initial public offering, (iii) a recovery against previous investment write-downs of $0.8 million, (iv) increases from our U.S. analytical research and routing products as well as same day Canadian inter-listed arbitrage trading, and (v) a $1.3 million benefit from foreign exchange fluctuation.

29




Expenses

The following table sets forth the components of expenses and income taxes, by segment, included in the statement of income with percent change information for the periods indicated (dollars in thousands):

 

 

Year Ended December 31,

 

 

 

 

 

 

 

2004

 

2003

 

Change

 

% Change

 

Consolidated

 

 

 

 

 

 

 

 

 

 

 

Compensation and employee benefits

 

$

122,833

 

$

118,070

 

$

4,763

 

 

4

 

 

Transaction processing

 

51,080

 

46,316

 

4,764

 

 

10

 

 

Software royalties

 

13,806

 

16,894

 

(3,088

)

 

(18

)

 

Occupancy and equipment

 

30,348

 

31,149

 

(801

)

 

(3

)

 

Telecommunications and data processing services

 

17,978

 

18,334

 

(356

)

 

(2

)

 

Other general and administrative

 

31,849

 

33,528

 

(1,679

)

 

(5

)

 

Income taxes

 

25,609

 

27,748

 

(2,139

)

 

(8

)

 

U.S. Operations

 

 

 

 

 

 

 

 

 

 

 

Compensation and employee benefits

 

92,095

 

88,515

 

3,580

 

 

4

 

 

Transaction processing

 

30,086

 

31,668

 

(1,582

)

 

(5

)

 

Software royalties

 

11,875

 

14,659

 

(2,784

)

 

(19

)

 

Occupancy and equipment

 

24,301

 

24,605

 

(304

)

 

(1

)

 

Telecommunications and data processing services

 

12,313

 

12,768

 

(455

)

 

(4

)

 

Other general and administrative

 

26,593

 

27,305

 

(712

)

 

(3

)

 

Income taxes

 

22,232

 

26,008

 

(3,776

)

 

(15

)

 

International Operations

 

 

 

 

 

 

 

 

 

 

 

Compensation and employee benefits

 

30,738

 

29,555

 

1,183

 

 

4

 

 

Transaction processing

 

20,994

 

14,648

 

6,346

 

 

43

 

 

Software royalties

 

1,931

 

2,235

 

(304

)

 

(14

)

 

Occupancy and equipment

 

6,047

 

6,544

 

(497

)

 

(8

)

 

Telecommunications and data processing services

 

5,665

 

5,566

 

99

 

 

2

 

 

Other general and administrative

 

5,256

 

6,223

 

(967

)

 

(16

)

 

Income taxes

 

3,377

 

1,740

 

1,637

 

 

94

 

 

 

During 2004, consolidated expenses (excluding income taxes) increased by $3.6 million. This reflects higher costs in our international operations, driven by currency exchange rate impact of $6.4 million (as a result of the weakened U.S. Dollar). Excluding the impact from foreign currency fluctuations, international operating expenses decreased by $0.5 million primarily in compensation and other general and administrative costs, offset by an increase in transaction processing costs from the related revenue increases and increases in executions in higher priced international markets, such as continental Europe and Japan. The U.S. operations also had a decline in expenses by $2.3 million primarily from a decrease in costs related to our revenue decrease.

Compensation and employee benefits:   Our higher consolidated compensation expense was mainly driven by employee separation costs ($2.0 million), the impact of foreign currency translation ($2.5 million) and an increase in average headcount in our U.S. operations.

U.S. compensation expense reflects the inclusion of employee separation costs primarily related to the departure of our previous Chief Executive Officer as announced on September 9, 2004, as well higher average headcount. Average U.S. headcount in 2004 was 457 compared to 439 in 2003. The headcount increase is principally related to (i) Sarbanes-Oxley compliance activities, (ii) new product introductions and support, (iii) sales efforts, and (iv) our March 29, 2004 acquisition of the 75% of Radical that we did not already own.

The increase in total international compensation expense was driven by unfavorable exchange rate fluctuations ($2.5 million). This was partially offset by headcount reductions in 2003.

30




Transaction processing:   Our higher consolidated transaction processing expenses were mainly driven by revenue growth and business mix changes in our international operations partially offset by lower costs in the U.S.

Lower U.S. transaction processing costs in 2004 reflect (i) the decline in product revenues, (ii) a reduction in the Hoenig division’s execution costs as a result of their integration into ITG Inc. as of September 2003, and (iii) lower clearing and execution costs primarily due to rate reductions.

Higher International transaction processing costs primarily reflect (i) the increase in business activity in 2004, (ii) the change in the European business mix away from POSIT, (iii) a further change in the European business mix from United Kingdom equity executions to Continental Europe equity executions, where we generally incur significantly higher transaction costs, and (iv) currency exchange rate fluctuations ($1.7 million).

Software royalties:   Software royalties principally relate to POSIT royalties, which are contractually fixed as a percentage of POSIT revenues and reflect a decrease in POSIT revenues in 2004. In 2004, royalties were at a slightly higher rate for ITG Europe than in 2003 (which was consistent with those paid in the U.S.) and also included payments to Radical Corporation, a provider of an equity front-end software-trading platform, for licensing their Radical system prior to our March 29, 2004 purchase of the remaining 75% of Radical that we did not already own.

Occupancy and equipment:   The decrease in consolidated occupancy and equipment costs, which are primarily comprised of fixed costs, reflects lower depreciation costs. This was partially offset by a lease abandonment charge in the U.S. of $0.7 million, representing the loss we expect to incur for our remaining lease obligation for vacated office space in California, and currency exchange rate impact of $0.6 million.

Telecommunications and data processing services:   Consolidated telecommunications and data processing services decreased $0.4 million, or 2% despite higher relative costs related to currency exchange rate impact of $0.5 million in our international operations.

Other general and administrative:   Consolidated general and administrative costs were lower in 2004 due to:

(i)             Cost savings of $1.8 million from our international operations (excluding currency exchange impact of $0.8 million);

(ii)         Lower asset impairment charges. In 2003, asset impairment charges were taken to write down the carrying value of two New York Stock Exchange seats ($2 million) and to write down Stock Exchange Trading Rights in Hong Kong ($0.5 million), both of which were obtained in our 2002 acquisition of Hoenig. In 2004, a further $0.7 million asset impairment charge was recorded relating to our two NYSE exchange seats reflecting a decline in value, which we deemed to be other than temporary;

(iii)     Lower doubtful accounts expense in the U.S;

partially offset by:

(iv)       Higher software amortization ($0.8 million), related to product releases in late 2003 and early 2004;

(v)           Higher intangible amortization reflecting the amortization of Radical proprietary software (acquired in March 2004);

(vi)       Additional audit fees and consulting costs related to meeting the requirements of the Sarbanes-Oxley Act of $1.5 million, and

(vii)   Currency exchange rate fluctuation ($0.8 million).

31




Income Tax Expense

The effective tax rate 38.5% in 2004 reflects a significant reduction in non-deductible international losses in Europe and Hong Kong, the reversal of a valuation allowance relating to utilization of capital losses to offset capital gains, and lower levels of R&D tax credits since, in 2003, we benefited from the reversal of a tax reserve of $1.9 million related to an Internal Revenue Service examination of research and development tax credits taken on our tax returns prior to 1996.  Our consolidated effective tax rate can vary from period to period depending on, among other factors, the geographic and business mix of our earnings.

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

Earnings Per Share

Basic earnings per share for 2003 and 2002 were $0.89 and $1.52, respectively. Diluted earnings per share decreased 41%, from $1.51 to $0.89. Our 2003 and 2002 results included non-recurring items discussed above in “Executive Overview”.

The following table sets forth the components of revenues, by segment, included in the statement of income with percent change information for the periods indicated (dollars in thousands):

 

 

Year Ended December 31,

 

 

 

 

 

 

 

2003

 

2002

 

Change

 

% Change

 

U.S. Operations

 

$

273,781

 

$

346,040

 

$

(72,259

)

 

(21

)

 

International Operations

 

60,211

 

$

41,541

 

18,670

 

 

45

 

 

Consolidated

 

$

333,992

 

$

387,581

 

$

(53,589

)

 

(14

)

 

 

Revenues

Consolidated revenues decreased 14% to $334.0 million despite the 45% increase in revenues achieved by our international operations.

Revenues by segment—U.S. operations

Revenues in our U.S. operations decreased 21% to $273.8 million during 2003 reflecting lower portfolio turnover and the highly competitive environment which continued throughout the year. Our U.S. operations benefited from the full year of Hoenig ownership (following its acquisition on September 3, 2002). In 2003 Hoenig contributed an additional $20.4 million of revenues to our U.S. operations.

Key volume and revenue performance indicators for the last two years, as well as percent change information, for our U.S. operations are as follows:

U.S. Operations, excluding Hoenig(a)

 

 

 

2003

 

2002

 

Change

 

% Change

 

Total trading volume (in billions of shares)

 

18.6

 

24.1

 

(5.5

)

 

(23

)

 

Trading volume per day (in millions of shares)

 

74.0

 

95.7

 

(21.7

)

 

(23

)

 

Product revenues per trading day ($ million)

 

$

0.96

 

$

1.32

 

$

(0.36

)

 

(27

)

 

Average revenue per share traded ($)

 

$

0.0129

 

$

0.0138

 

$

(0.0009

)

 

(7

)

 

U.S. market trading days

 

252

 

252

 

 

 

 

 


(a)           Hoenig excluded for purposes of year-to-year comparability.

There were 252 U.S. trading days in both 2003 and 2002. Product Revenues per trading day from our U.S. operations decreased 27% driven by a volume decrease of 23% coupled with a decline in average revenue per share. Specifically, trading volume fell to 18.6 billion shares from 24.1 billion in 2002, while our average revenue capture decreased almost 7% to $0.0129 per share in 2003.

32




Revenues by segment—International operations

In 2003, product revenues from our international operations grew $16.0 million or 46%, which included a $4.6 million benefit from exchange rate fluctuations as a result of a weakened U.S. Dollar relative to the currencies in our international markets. From an operational perspective, we grew product revenues $11.4 million. This increase included the full year benefit of Hoenig ownership, which added $3.8 million to revenues. Our European product revenue grew $6.9 million, or 38%, to $25.2 million. Our Canadian product revenues increased by $4.3 million, or 44% to $14.1 million, reflecting increased installations of our client-site trading products and analytical products such as ITG ACE and TCA. In Australia, we reported product revenues of $6.2 million, an increase of 22% from 2002. In Hong Kong, we reported product revenues of $5.3 million compared with $1.7 million in 2002. While our Hong Kong operations began generating revenues in June 2002, $3.2 million of the growth was the result of the full year benefit of Hoenig.

Revenues by product—POSIT

Consolidated POSIT revenues decreased $28.3 million, or 18%, principally reflecting lower U.S. share volume, as indicated in the table below. This was partially offset by a 30% increase in European POSIT revenues, resulting from growth in the contract value of shares crossed, since commissions are calculated on the basis of the underlying contract value of transactions rather than on a per share basis.

POSIT

 

 

 

2003

 

2002

 

Change

 

% Change

 

U.S. POSIT system:

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares crossed (in billions)

 

6.4

 

7.7

 

 

(1.3

)

 

 

(17

)

 

Average shares per day (in millions)

 

25.3

 

30.5

 

 

(5.2

)

 

 

(17

)

 

European POSIT system:

 

 

 

 

 

 

 

 

 

 

 

 

 

Contract value of shares crossed ($ billions)

 

$

20.6

 

$

14.8

 

 

$

5.8

 

 

 

39

 

 

 

Revenues by product—Electronic Trading Desk

Electronic Trading Desk revenues increased $7.7 million, or 7% in 2003. Our U.S. Electronic Trading Desk revenues decreased $4.2 million or 5%, despite Hoenig’s U.S. business contributing an additional $18.2 million of U.S. Electronic Trading Desk revenues. In our International Operations, Electronic Trading Desk revenues increased $11.8 million with our Canadian, European and Australian trading desk businesses growing by $4.2 million, $2.8 million and $1.1 million, respectively. Our Asian trading desk business contributed an additional $3.7 million of revenue of which, $3.2 million was added by Hoenig. Electronic Trading Desk revenues per trading day increased by 7%, to $474,000 in 2003.

In marketing our program trading services, we package our Electronic Trading Desk services with POSIT. Our clients receive blended pricing for executions as a way to provide a single price for an entire portfolio of equity transactions regardless of the execution venue. In the U.S., our combined POSIT and Electronic Trading Desk rate per share declined $0.0016, or 9% to $0.0168 in 2003 reflecting competitive pricing in the program trading business.

Revenues by product—Client Site Trading Products

Client Site Trading Product revenues, which in 2003 and 2002 were only generated by our U.S. Operations, decreased 30%. Share volumes decreased 28% while our rates per share decreased 3%. More than 75% of the revenue decline resulted from a reduction in business with several high volume, low commission clients. During the second half of 2003, we began replacing our QuantEX and ITG Platform products with our next generation product offerings, Triton and Radical.

33




Other revenues

Other revenues increased $0.9 million, or 9%, to $10.4 million in 2003 due to higher (i) subscription revenues for routing and other services in the U.S. and (ii) income/loss from positions taken by ITG Canada as customer facilitations (a customary practice in the Canadian marketplace) and income from same day Canadian interlisted arbitrage trading. These increases were partially offset by a decline in our global investment income due to lower interest rates.

Expenses

The following table sets forth the components of expenses and income taxes, by segment, included in the statement of income with percent change information for the periods indicated (dollars in thousands):

 

 

Year Ended December 31,

 

 

 

 

 

 

 

2003

 

2002

 

Change

 

% Change

 

Consolidated

 

 

 

 

 

 

 

 

 

 

 

Compensation and employee benefits

 

$

118,070

 

$

114,402

 

$

3,668

 

 

3

 

 

Transaction processing

 

46,316

 

50,459

 

(4,143

)

 

(8

)

 

Software royalties

 

16,894

 

19,643

 

(2,749

)

 

(14

)

 

Occupancy and equipment

 

31,149

 

28,017

 

3,132

 

 

11

 

 

Telecommunications and data processing services

 

18,334

 

17,453

 

881

 

 

5

 

 

Restructuring charges

 

 

5,874

 

(5,874

)

 

(100

)

 

Other general and administrative

 

33,528

 

24,480

 

9,048

 

 

37

 

 

Income taxes

 

27,748

 

53,443

 

(25,695

)

 

(48

)

 

U.S. Operations

 

 

 

 

 

 

 

 

 

 

 

Compensation and employee benefits

 

88,515

 

89,144

 

(629

)

 

(1

)

 

Transaction processing

 

31,668

 

41,836

 

(10,168

)

 

(24

)

 

Software royalties

 

14,659

 

18,468

 

(3,809

)

 

(21

)

 

Occupancy and equipment

 

24,605

 

22,390

 

2,215

 

 

10

 

 

Telecommunications and data processing services

 

12,768

 

12,459

 

309

 

 

2

 

 

Restructuring charges

 

 

4,631

 

(4,631

)

 

(100

)

 

Other general and administrative

 

27,305

 

19,193

 

8,112

 

 

42

 

 

Income taxes

 

26,008

 

52,848

 

(26,840

)

 

(51

)

 

International Operations

 

 

 

 

 

 

 

 

 

 

 

Compensation and employee benefits

 

29,555

 

25,258

 

4,297

 

 

17

 

 

Transaction processing

 

14,648

 

8,623

 

6,025

 

 

70

 

 

Software royalties

 

2,235

 

1,175

 

1,060

 

 

90

 

 

Occupancy and equipment

 

6,544

 

5,627

 

917

 

 

16

 

 

Telecommunications and data processing services

 

5,566

 

4,994

 

572

 

 

11

 

 

Restructuring charges

 

 

1,243

 

(1,243

)

 

(100

)

 

Other general and administrative

 

6,223

 

5,287

 

936

 

 

18

 

 

Income taxes

 

1,740

 

595

 

1,145

 

 

192

 

 

 

During 2003, foreign exchange rate fluctuations contributed approximately $6 million to the overall increase in expenses for our international operations.

34




Compensation and employee benefits:   Our compensation expense increase of $3.7 million was mainly driven by (i) the full year impact of our acquisition of Hoenig, (ii) the expensing of stock based compensation, and (iii) the impact of exchange rate fluctuations, specifically the weaker U.S. Dollar, increasing the relative costs of compensation in our International operations. These increases were offset by savings achieved in 2003 following our December 2002 restructuring.

U.S. compensation expense decreased $0.6 million despite the inclusion of (i) Hoenig, which added an incremental $8.4 million to U.S. compensation costs in 2003, (ii) the expensing of performance based stock options of $1.2 million in 2003, and (iii) severance costs due to additional headcount reductions in 2003. These additional costs were more than offset by the savings achieved in 2003 from our December 2002 restructuring (approximately $8.4 million), as well as declines in other benefits such as performance based bonuses in 2003. Weighted average U.S. headcount (excluding Hoenig, for comparability) in 2003 was 395 compared to 450 in 2002.

Total international compensation expense increased $4.3 million primarily from (i) the Hoenig acquisition, which accounted for $1.5 million of the increase, (ii) exchange rate fluctuation ($2.6 million), (iii) additional severance for international staffing reductions in 2003, and (iv) increases in compensation in Canada and Europe. These additional costs were partially offset by the headcount reduction as part of the December 2002 restructuring.

Transaction processing:   Consolidated transaction processing expenses decreased $4.1 million in 2003.

U.S. transaction processing costs declined by $10.2 million in 2003 driven primarily by rate decreases from our clearance and settlement, and execution providers, as well as the overall decline in our share volume. These lower rates included ECN costs, which declined $3.2 million reflecting a 32% decrease in our ECN rates in 2003. These savings were offset by the inclusion of additional Hoenig transaction processing costs of $3.5 million.

International transaction processing costs increased $6.0 million in 2003 primarily from (i) the increase in share volume and contract value of transactions in 2003, (ii) exchange rate fluctuation ($1.3 million) and (iii) the inclusion of Hoenig ($1.3 million).

Software royalties:   Software royalties principally relate to POSIT royalties, which are contractually fixed as a percentage of POSIT revenues. Accordingly, declines in our consolidated POSIT revenues resulted in declines in software royalty expense.

Occupancy and equipment:   Consolidated occupancy and equipment costs, which are primarily comprised of fixed costs, increased $3.1 million in 2003 reflecting (i) the inclusion of Hoenig ($1.1 million), (ii) exchange rate impact of $0.6 million, (iii) lease related expenses, including escalation and taxes, and (iv) management expenses for business continuity services.

Telecommunications and data processing services:   Consolidated telecommunications and data processing services increased $0.9 million, or 5% largely due to the inclusion of Hoenig costs ($0.8 million).

Restructuring charges:   In order to align our infrastructure with expected levels of trading volume, we terminated 72 employees in December 2002, including 54 personnel employed in our U.S. operations and 18 personnel employed in our International Operations. As a result of this decision, we recorded a $5.9 million pretax charge consisting of severance and related expenses for the 72 employees. There were no such charges in 2003.

35




Other general and administrative:   Consolidated general and administrative costs increased $9.0 million in 2003 primarily due to:

(i)                   Write down of the carrying value of two New York Stock Exchange seats that we obtained as part of the Hoenig acquisition ($2 million);

(ii)               Write down of Stock Exchange Trading Rights in Hong Kong which we also obtained in the Hoenig acquisition ($0.5 million);

(iii)           The inclusion of a full year of Hoenig costs ($2.9 million) in 2003;

(iv)             Higher software amortization ($2.6 million) primarily due to our releases of new versions of ITG/Opt and Triton in late 2002;

(v)                 Exchange rate fluctuations;

(vi)             Increases in corporate insurance, particularly directors and officers insurance;

(vii)         Higher consulting costs related to business and product marketing, information systems and other non-recurring consulting activities and short-term projects including the mandates of the Sarbanes-Oxley Act; and

(viii)     Write-off of our investment in Inference Group LLC.

These cost increases were partially offset by reversal of accrued interest ($0.5 million) related to the resolution of an Internal Revenue Service examination of research and development tax credits taken on our tax returns prior to 1996.

Income Tax Expense

Our 39.8% effective tax rate includes the reversal of a tax reserve of $1.9 million related to an Internal Revenue Service examination of research and development tax credits taken on our tax returns prior to 1996. Excluding the impact of this item, our effective tax rate would have been 42.5%, compared with 42.0% in 2002.

Critical Accounting Policies and Estimates

Our consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the U.S. In many instances, the application of such principles requires management to make estimates or to apply subjective principles to particular facts and circumstances. A change in the estimates or a variance in the application, or interpretation of accounting principles generally accepted in the U.S. could yield a materially different accounting result. Below is a summary of the Company’s critical accounting policies and estimates where we believe that the estimations, judgments or interpretations that we made, if different, would have yielded the most significant differences in our consolidated financial statements. In addition, for a summary of all of our significant accounting policies, see Note 2, Summary of Significant Accounting Policies, in the Notes to the Consolidated Financial Statements.

Fair Value

Securities owned, at fair value, securities sold, not yet purchased, at fair value, and investments in limited partnerships in the consolidated statements of financial condition are carried at fair value or amounts that approximate fair value, with the related unrealized gains or losses recognized in our results of operations. The fair value of these instruments is the amount at which these instruments could be exchanged in a current transaction between willing parties, other than in a forced liquidation. Where available, we use the prices from independent sources such as listed market prices, or broker or dealer

36




quotations. For investments in illiquid and privately held securities that do not have readily determinable fair values, we use estimated fair values as determined by management.

At December 31, 2004, we held shares of Archipelago Holdings Inc., acquired under an equity entitlement program, which held its initial public offering in August 2004. Prior to its IPO, these shares were held at a fair value of zero as determined by management since a market price had not been observable or measurable. Although a market price was available at December 31, 2004, we were prohibited from selling our shares through February 2005. Accordingly, following the specialized accounting practices available for broker-dealers, the restriction on trading in Archipelago Holdings was considered in arriving at the appropriate fair value of the shares, which value was reduced from the quoted market value of $3.5 million at December 31, 2004, to $3.3 million.

During 2004, a technology venture capital fund in which we had invested $2.7 million in 2000, ceased operations. Based upon our mark-to-market assessment of its portfolio, we wrote off most of this investment in 2002, as most of its portfolio companies had ceased operations. In the latter half of 2004, we received distributions from the fund (as part of its liquidation process) which exceeded our carrying value by $0.8 million.

Stock Based Compensation

Effective January 1, 2003, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, as amended by SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, prospectively to all awards granted, modified, or settled after January 1, 2003. Under this method of adoption, compensation expense will be recognized based on the fair value of stock options, Employee Stock Purchase Plan shares and restricted stock units granted for fiscal 2003 and future years over the related service period. In 2003 and 2004, the Company granted performance based stock options based on a cumulative three-year performance metric and recorded stock based compensation expense for these options. Under the fair value approach, management employs considerable judgment in estimating, on the date of grant, the options expected life and expected volatility. Additionally, management estimates the number of options that are expected to vest based on the expected outcomes of the performance related conditions.

Accounting for Business Combinations, Goodwill and Other Intangibles

Determining the fair value of certain assets and liabilities acquired in a business combination is judgmental in nature and often involves the use of significant estimates and assumptions. For initial valuations, we retain valuation experts to provide us with independent fair value determinations of goodwill and other intangibles. In addition, we perform valuations based on internally developed models. Specifically, a number of different methods are used in estimating the fair value of acquired intangibles as well as testing goodwill and other intangibles for impairment. Such methods include the income approach and the market approach. Significant estimates and assumptions applied in these approaches include, but are not limited to, projection of future cash flows, the applicable discount rate, perpetual growth rates, and adjustments made to assess the characteristics and relative performance of similar assets.

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, which became effective January 1, 2002, we discontinued the amortization of goodwill. SFAS No. 142 requires goodwill to be assessed no less than annually for impairment. As of the most recent impairment test, we determined that the carrying value of goodwill for each reporting unit was not impaired. Other intangibles with definite lives will continue to be amortized over their useful lives and are assessed for impairment on an annual basis (or sooner when events or circumstances indicate a possible impairment) pursuant to the provisions of SFAS No. 142 and SFAS No. 144, Accounting for Long Lived Assets and for Long Lived Assets to be

37




Disposed Of. Amortization expense related to goodwill and other intangibles for the years ended December 31, 2004, 2003, and 2002 was as follows:

 

 

Amortization Expense ($ millions)

 

 

 

  2004  

 

  2003  

 

  2002  

 

Other Intangibles

 

 

$

0.7

 

 

 

$

0.6

 

 

 

$

0.5

 

 

 

38




As is the normal practice in our industry, the values we report for exchange seats, which are included within other assets in our financial statements, are valued at cost or a lesser amount if there is an other-than-temporary impairment in value. During third quarter 2004, we wrote down the carrying value of two NYSE seats that were previously valued at $1.5 million each as a result of the continued reduction in NYSE seat prices. As we believe this decline in value is other-than-temporary in nature, we have taken a $0.7 million write-down to reflect the fair value of these seats at $1.2 million each. The fair value was determined by referencing actual NYSE seat sales occurring during 2004. Our assessment of the nature and extent of impairment of the NYSE seats requires considerable judgment by management with respect to evaluating external factors.

The following table indicates our sensitivity to potential future impairment charges from further declines in market value of our NYSE exchange seats and potential declines in the fair value of our goodwill:

 

 

Potential Future Impairment ($ in millions)

 

 

 

       10%       

 

       25%       

 

       50%       

 

NYSE exchange seats

 

 

$

0.2

 

 

 

$

0.6

 

 

 

$

1.2

 

 

Goodwill:

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. Operations

 

 

6.6

 

 

 

16.6

 

 

 

33.1

 

 

International Operations

 

 

2.0

 

 

 

5.1

 

 

 

10.2

 

 

 

Soft Dollar Programs

We permit institutional customers to allocate a portion of their gross commissions to pay for research products and other services provided by third parties. The amounts so allocated for those purposes are commonly referred to as soft dollar arrangements. We are accounting for the cost of independent research and directed brokerage arrangements on an accrual basis. Commission revenue is recorded when earned on a trade date basis. Our accounting for commission revenues includes the guidance contained in Emerging Issues Task Force (“EITF”) Issue No. 99-19, Reporting Revenues Gross versus Net, and accordingly, payments relating to soft dollars are netted against the commission revenues. Prepaid soft dollar research balances are included in Receivables from Brokers, Dealers and Other and accrued soft dollar research payable balances are classified as Accounts Payable and Accrued Expenses in our consolidated statements of financial condition.

We continuously monitor our customer account balances and maintain an allowance for soft dollar advances which is comprised of a general reserve based on historical collections performance plus a specific reserve for certain known customer issues. If actual bad debts are greater than the reserves calculated based on historical trends and known customer issues, we may be required to record additional bad debt expense, which could have a material adverse impact on our operating results for the periods in which such additional expense would occur. Soft dollar revenues and related prepaid and accrued soft dollar research balances for the years ended December 31, 2004, 2003, and 2002 were as follows:

 

 

$ millions

 

 

 

2004

 

2003

 

2002

 

Net soft dollar commissions

 

$

54.1

 

$

53.2

 

$

33.6

 

Prepaid soft dollar research, gross

 

7.8

 

6.8

 

7.9

 

Allowance for prepaid soft dollar research

 

(1.7

)

(2.0

)

(2.3

)

Prepaid soft dollar research, net of allowance

 

6.1

 

4.8

 

5.6

 

Accrued soft dollar research payable

 

17.6

 

18.8

 

20.9

 

 

38




Income Taxes

SFAS No. 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Fluctuations in the actual outcome of these future tax consequences could materially impact our financial position or results of operations.

Liquidity and Capital Resources

Our liquidity and capital resource requirements result from our working capital needs, primarily consisting of compensation and benefits and transaction processing fees. Historically, cash from operations has met all working capital requirements. We believe that our cash flow from operations and existing cash balances will be sufficient to meet our operating cash requirements.

In Asia, we maintain working capital facilities with a bank relating to our clearing and settlement activities. These facilities are in the form of overdraft protection totaling approximately $18.9 million and are supported by $3.6 million in restricted cash deposits.

A substantial portion of our assets are liquid, consisting of cash and cash equivalents or assets readily convertible into cash. We generally invest our excess cash in money market funds and other short-term investments that mature within 90 days or less. Additionally, securities owned at fair value include highly liquid, variable state and municipal obligations, auction rate preferred stock, mutual fund investments, common stock and warrants. At December 31, 2004, cash and cash equivalents and securities owned, at fair value amounted to $239.0 million and net receivables from brokers, dealers and other due within 30 days totaled $189.5 million. In addition, we held $7.3 million of total cash in restricted or segregated bank or clearing broker accounts at December 31, 2004.

We also invest a portion of our excess cash balances in cash enhanced strategies, which we believe should yield higher returns without significant effect on risk. As of December 31, 2004, we had investments in limited partnerships totaling $20.3 million, all of which were invested in marketable securities.

Cash flows provided by operating activities were $30.8 million in 2004 as compared to $61.9 million in 2003. The $31.1 million decrease was primarily attributable to changes in working capital as well as non-cash gains included in net income. The working capital changes include the impact of a  $12.6 million increase in investments in state and municipal government securities during 2004, which are classified on the consolidated statements of financial condition as securities owned, at fair value, as well as a $45.3 million reduction in payables to brokers, dealers and others, partially offset by a $21.2 million reduction in receivables from brokers, dealers and others.

Net cash used in investing activities reflects (i) completion of our acquisition of Radical Corporation by acquiring the 75% of its outstanding shares that we did not already own, (ii) investments in computer hardware and software, as well as capitalizable software development projects, partially offset by (iii) proceeds from the sale of 50% of our ownership interest in KTG, formerly a wholly-owned subsidiary, to IRESS, an Australia based developer of financial market systems. Our remaining 50% interest was contributed to a new Canadian joint venture with IRESS.

Net cash used in financing activities reflects purchases of 3 million shares of our common stock as part of our share repurchase program, which were funded from our available cash resources. As part of our share repurchase program, our Board of Directors authorizes management to use its discretion to purchase an agreed-upon maximum number of shares of common stock in the open market or in privately negotiated transactions. During 2004, we purchased 3 million shares of our common stock at an average

39




cost of $13.78 per share, totaling $41.3 million. At December 31, 2004, we had the authorization to purchase an additional 2 million shares of our common stock under the share repurchase program.

Historically, all regulatory capital needs of ITG Inc., AlterNet and ITG Execution Services have been provided by cash from operations. Although we believe that cash flows from operations will continue to provide ITG Inc., AlterNet and ITG Execution Services with sufficient regulatory capital, we are considering the establishment of a credit facility to supplement our existing regulatory capital, as needed. At December 31, 2004, ITG Inc., AlterNet and ITG Execution Services had net capital of $102.7 million, $3.8 million and $1.0 million, respectively, of which $102.4 million, $3.7 million and $1.0 million, respectively, was in excess of required net capital.

In addition, our Canadian, Australian, Asian and European operations had regulatory capital in excess of the minimum requirements applicable to each business as of December 31, 2004 of approximately $10.2 million, $4.2 million, $7.7 million, and $27.8 million respectively.

As a result of the February 1, 2005 POSIT Transaction, discussed in “License and Relationship with Barra”, ITG Inc.’s excess net capital on February 1, 2005 approximated $25.2 million

Although we believe that the combination of our existing net regulatory capital and operating cash flows will be sufficient to meet regulatory capital requirements, we are considering the establishment of a credit facility to supplement our existing regulatory capital, as needed, as a shortfall in net regulatory capital would have a material adverse effect on us.

As of December 31, 2004, ITG Inc. held a $2.9 million cash balance on behalf of its Hoenig division in a segregated deposit account with its clearing broker for the benefit of customers under certain directed brokerage arrangements.

Off-Balance Sheet Arrangements and Aggregate Contractual Obligations

Off-Balance Sheet Arrangements

In the normal course of business, we are involved in the execution of various customer securities transactions. Securities transactions are subject to the credit risk of counterparties or customer nonperformance. In connection with the settlement of non-U.S. securities transactions, Investment Technology Group, Inc. has provided third party financial institutions with guarantees in amounts up to a maximum of $144.7 million. In the event that a customer of ITG’s subsidiaries fails to settle a securities transaction, or if the related ITG subsidiaries were unable to honor trades with a customer, Investment Technology Group, Inc. would be required to perform for the amount of such securities up to the $144.7 million cap. However, transactions are collateralized by the underlying security, thereby reducing the associated risk to changes in the market value of the security through settlement date. Therefore, the settlement of these transactions is not expected to have a material effect upon our financial statements. It is also our policy to review, as necessary, the credit worthiness of each counterparty and customer.

40




Aggregate Contractual Obligations

As of December 31, 2004, our contractual obligations and other commercial commitments amounted to $71.2 million in the aggregate and consisted of the following (dollars in thousands):

 

 

Payments due by period ($ thousands)

 

Contractual obligations

 

 

 

Total

 

Less than
1 year

 

1-3 years

 

3-5 years

 

More than
5 years

 

Operating lease obligations

 

$

60,588

 

$

7,488

 

$

14,201

 

$

13,989

 

$

24,910

 

Minimum compensation employment agreements

 

8,565

 

5,745

 

2,820

 

––

 

––

 

Purchase obligations

 

2,031

 

729

 

1,115

 

187

 

 

Total

 

$

71,184

 

$

13,962

 

$

18,136

 

$

14,176

 

$

24,910

 

 

Business Combinations

On September 3, 2002, we acquired Hoenig Group Inc., which, through its operating affiliates, provides trade execution, independent research and other services to alternative investment funds and money managers globally.

Under the terms of the transaction, Hoenig Group Inc. stockholders received approximately $105.0 million, or $11.58 per share, of which approximately $2.4 million, or $0.23 per share, have been placed into an escrow account. Such escrow requirement relates to the pursuit, by the Contingent Payment Rights Committee (“CPRC”) established at the time of acquisition on behalf of Hoenig Group Inc. shareholders, of certain insurance and other claims in connection with the $7.2 million pre-tax loss announced by Hoenig Group Inc. on May 9, 2002 as a result of unauthorized trading in foreign securities, by a former employee of Hoenig & Company Limited, in violation of Hoenig’s policies and procedures.

In December 2004, the CPRC completed its pursuit of these claims on behalf of the former Hoenig shareholders and distributed $3.8 million or approximately $0.374 cents per share in cash to such shareholders. We anticipate that in January 2006, determinations will be available with respect to tax liabilities associated with the amounts recovered by the CPRC. In the event that such tax liabilities are less than the amounts remaining in the escrow, such remaining amounts will be distributed to the former Hoenig Group, Inc. shareholders. While the amount of any such payment remains to be determined, we expect that it will not exceed $.05 per share (or approximately $600,000). In the event a second payment is made, it will represent the full and final distribution from the escrow.

In connection with this acquisition, we incurred transaction costs consisting primarily of professional fees of approximately $2.8 million, which have been included in the purchase price. The purchase price was allocated to those assets acquired and liabilities assumed based on the fair value of Hoenig’s net assets as of September 3, 2002. Approximately $0.5 million was allocated to the “Hoenig” trade name, which is being amortized over three years. The excess of the purchase price over the estimated fair value of the net assets acquired was $56.0 million and has been allocated to goodwill.

On March 29, 2004, we acquired the remaining 75% of Radical Corporation (“Radical”) that we did not already own for $12.2 million in cash. The Radical business augments our product offerings for the active trading community. The total purchase price of $13.2 million is subject to a potential purchase price adjustment (not to exceed $5.8 million) based upon performance over the one year period following our February 27, 2004 call option exercise.

The consolidated financial statements include the results of operations of the above businesses from their respective dates of acquisition.

On November 1, 2002, Inference Group LLC, our former asset management subsidiary, was reorganized. In connection with this reorganization, we sold 81% of Inference Group LLC to the Inference

41




Group management team and retained a 19% minority ownership interest. In the fourth quarter of 2003, Inference Group LLC ceased substantially all asset management operations. Accordingly, we took an asset impairment charge of $223,000 representing the full cost basis of our investment.

Recent Accounting Pronouncements

In December 2004, the FASB issued a revision to SFAS No. 123, Accounting for Stock-Based Compensation, titled Share-Based Payment. As a result, the fair value based method of accounting for stock-based payments will be required on a modified prospective basis, meaning any previously granted but unvested awards will be recorded as an expense on a prorated basis over the remaining vesting period. We voluntarily adopted the fair value method approach January 1, 2003 on a prospective basis and therefore, the impact the revised Statement will have on our results of operations, financial position and cash flows will be minimal. SFAS No. 123R is effective for interim and annual periods beginning after June 15, 2004.

Subsequent Events

In 1987, Jefferies & Company, Inc. and BARRA Inc. (“Barra”) formed a joint venture for the purpose of developing and marketing POSIT. In 1993, Jefferies & Company, Inc. assigned all of its rights relating to the joint venture and the license agreement to us. On December 16, 2004 we signed an agreement with Morgan Stanley Capital International Inc. (“MSCI”) to acquire the 50% interest in the POSIT Joint Venture we did not own from BARRA POSIT Inc., a subsidiary of MSCI. This transaction was completed on February 1, 2005 giving us sole ownership of the POSIT Joint Venture. The purchase price consisted of an initial payment of $90 million, paid at the closing of the transaction, and a contingent component payable over the ten years following closing equal to 1.25% of the revenues from the business of the POSIT Joint Venture. At our discretion, we have the right to accelerate these contingent payments at any time during the ten-year period. This transaction will result in significant savings from decreased royalty payments partially offset by (i) amortization costs related to the intellectual property, (ii) forgone investment income on the $90 million outlay, and (iii) the cost of additional headcount.

On February 28, 2005, we acquired E-Crossnet, to offer professional investors in Europe an integrated equities crossing system with access to an expanded liquidity pool.

We are in the process of applying to register as a foreign company securities corporation with the Japanese Financial Service Agency under the Foreign Securities Company Law of Japan and become a member firm of the Japan Securities Dealers Association and the Japan Investor Protection Fund in order to commence trading activity in Japan in 2005.

Item 7A.                Quantitative and Qualitative Disclosures About Market Risk

Market risk refers to the potential for adverse changes in the value of a company’s financial instruments as a result of changes in market conditions. We are exposed to market risk associated with changes in interest rates, foreign currency exchange rates and equity prices to the extent we own such instruments in our portfolio. We do not engage in speculative or leveraged transactions, nor do we hold or issue financial instruments for trading purposes. We continually evaluate our exposure to market risk and oversee the establishment of policies, procedures and controls to ensure that market risks are identified and analyzed on an ongoing basis.

We have performed sensitivity analyses on different tests of market risk as described in the following sections to estimate the impacts of a hypothetical change in market conditions on the fair value of securities owned and the U.S. dollar value of non-U.S. dollar-based revenues associated with our international operations. Estimated potential losses assume the occurrence of certain adverse market conditions. Such estimates do not consider the potential effect of favorable changes in market factors and also do not represent management’s expectations of projected losses in fair value. We do not foresee any

42




significant changes in the strategies used to manage interest rate risk, foreign currency risk or equity price risk in the near future.

Interest Rate Risk

Our exposure to interest rate risk relates primarily to interest-sensitive financial instruments in our investment portfolio. Interest-sensitive financial instruments will decline in value if interest rates increase. Our interest-bearing investment portfolio primarily consists of short-term, high-credit quality money market funds, highly liquid variable rate municipal securities, auction rate preferred stock and treasury notes. The aggregate fair market value of our portfolio was $180.8 million and $191.0 million as of December 31, 2004 and 2003, respectively. Our interest-bearing investments are not insured and because of the short-term high quality nature of the investments are not likely to fluctuate significantly in market value. For the years ended December 31, 2004 and 2003 we estimated that a hypothetical 100 basis point adverse change in interest rates would have resulted in a $1.8 million and $2.0 million decline in the value of our portfolio, respectively.

Foreign Currency Risk

We currently operate and continue to expand globally in a variety of ways, including through our operations in Canada, Australia, Europe and Hong Kong, and through the development of specially tailored versions of our services. Additionally, we maintain development facilities in Israel. Our investments and development activities in these countries expose us to currency exchange rate fluctuations primarily between the U.S. Dollar and the British Pound Sterling, Euro, Australian Dollar, Canadian Dollar, Hong Kong Dollar and Israeli New Shekel. When the U.S. dollar strengthens against these currencies, the U.S. dollar value of non-U.S. dollar-based revenue decreases. To the extent that our international activities recorded in local currencies increase in the future, our exposure to fluctuations in currency exchange rates will correspondingly increase. We have not engaged in derivative financial instruments as a means of hedging this risk. Non-U.S. dollar cash balances held overseas are generally kept at levels necessary to meet current operating and capitalization needs.

Approximately 22% and 18% of our revenues for the years ended December 31, 2004 and 2003 were denominated in non-U.S. dollar currencies. For the years ended December 31, 2004 and 2003, we estimated that a hypothetical 10% adverse change in foreign exchange rates would have resulted in a decrease in net income from our international operations of $0.3 million and $0.2 million, respectively.

Equity Price Risk

Equity price risk results from exposure to changes in the prices of equity securities. At times, we do hold positions overnight due to client or Company errors. Equity price risk can arise from liquidating such positions. Accordingly, we maintain policies and procedures regarding the management of our errors and accommodations proprietary trading accounts. It is our policy to attempt to trade out of all positions arising from errors and accommodations immediately while balancing our exposure to market risk. Certain positions may therefore be liquidated over a period of time in an effort to minimize market impact.

We manage equity price risk associated with open positions through the establishment and monitoring of trading policies and through controls and review procedures that ensure communication and timely resolution of trading issues. Our operations and trading departments review all open trades daily. Additionally, our clearing broker notifies us of all known trade discrepancies on the day following the trade date. We have also established approval policies that include review by a Supervisory Principal of any proprietary trading activity.

Our cash management strategy seeks to optimize excess liquid assets by preserving principal, maintaining liquidity to satisfy capital requirements, minimizing risk and maximizing our after tax rate of

43




return. Our policy is to invest in high quality credit issuers, limit the amount of credit exposure to any one issuer and invest in tax efficient strategies. Our first priority is to reduce the risk of principal loss. We seek to preserve our invested funds by limiting default risk, market risk, and re-investment risk. We attempt to mitigate default risk by investing in high quality credit securities that we believe to be low risk and by positioning our portfolio to respond appropriately to reductions in the credit rating of any investment issuer or guarantor that we believe is adverse to our investment strategy.

For working capital purposes, we invest only in money market instruments. Cash balances that are not needed for normal operations are invested in a tax efficient manner in instruments with appropriate maturities and levels of risk to correspond to expected liquidity needs. We currently have investments in municipal bonds, auction rate preferred bonds and, to a lesser extent, common stock. To the extent that we invest in marketable equity securities, we ensure portfolio liquidity by investing in marketable securities with active secondary or resale markets. We do not use derivative financial instruments in our investment portfolio. At December 31, 2004 and 2003, our cash and cash equivalents and securities owned were approximately $239.0 million and $263.2 million, respectively.

Our investments in limited partnership funds require approval of executive management and/or the board of directors. As of December 31, 2004, we had investments in limited partnerships totaling $20.3 million, all of which were invested in marketable securities. The limited partnerships employ either a hedged convertible strategy or a long/short strategy to capitalize on short term price movements.

44




 

Item 8.                        Financial Statements and Supplementary Data

 

Pages

Independent Auditors’ Report

 

46

 

Consolidated Statements of Financial Condition

 

47

 

Consolidated Statements of Income

 

48

 

Consolidated Statements of Changes in Stockholders’ Equity

 

49

 

Consolidated Statements of Cash Flows

 

50

 

Notes to Consolidated Financial Statements

 

51

 

 

45




 

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Investment Technology Group, Inc.:

We have audited the accompanying consolidated statements of financial condition of Investment Technology Group, Inc. (the Company) as of December 31, 2004 and 2003, and the related statements of income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2004. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Investment Technology Group, Inc. as of December 31, 2004 and 2003, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.

As discussed in Note 2 to the consolidated financial statements, in 2003 the Company changed its method of accounting for stock-based compensation.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Investment Technology Group, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

/s/ KPMG LLP

New York, New York

March 15, 2005

 

46




INVESTMENT TECHNOLOGY GROUP, INC.
Consolidated Statements of Financial Condition
(In thousands, except share amounts)

 

 

December 31,

 

 

 

2004

 

2003

 

Assets

 

 

 

 

 

Cash and cash equivalents

 

$

206,465

 

$

239,013

 

Cash restricted or segregated under regulations and other

 

7,287

 

11,892

 

Securities owned, at fair value

 

32,530

 

24,174

 

Receivables from brokers, dealers and other, net

 

198,642

 

219,860

 

Investments in limited partnerships

 

20,311

 

19,529

 

Premises and equipment

 

24,023

 

25,088

 

Capitalized software

 

8,926

 

6,575

 

Goodwill

 

86,550

 

77,143

 

Other intangibles

 

2,657

 

4,747

 

Deferred taxes

 

10,226

 

12,147

 

Other assets

 

14,841

 

9,680

 

Total assets

 

$

612,458

 

$

649,848

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Liabilities:

 

 

 

 

 

Accounts payable and accrued expenses

 

$

82,821

 

$

82,554

 

Payables to brokers, dealers and other

 

142,446

 

187,764

 

Software royalties payable

 

3,350

 

4,209

 

Securities sold, not yet purchased, at fair value

 

30

 

1,264

 

Income taxes payable

 

13,310

 

12,754

 

Total liabilities

 

241,957

 

288,545

 

Commitments and contingencies (Note 19)

 

 

 

 

 

Stockholders’ Equity:

 

 

 

 

 

Preferred stock, par value $0.01 1,000,000 shares authorized; no shares issued or outstanding

 

 

 

Common stock, par value $0.01; 100,000,000 shares authorized; 51,327,388 and 51,262,743 shares issued at December 31, 2004 and 2003, respectively; and 41,950,670 and 44,740,279 shares outstanding at December 31, 2004 and 2003, respectively

 

513

 

513

 

Additional paid-in capital

 

161,169

 

157,319

 

Retained earnings

 

374,961

 

333,978

 

Common stock held in treasury, at cost; shares: 9,376,718 and 6,522,464 at December 31, 2004 and 2003, respectively

 

(177,095

)

(138,641

)

Accumulated other comprehensive income:

 

 

 

 

 

Currency translation adjustment

 

10,953

 

8,134

 

Total stockholders’ equity

 

370,501

 

361,303

 

Total liabilities and stockholders’ equity

 

$

612,458

 

$

649,848

 

 

The accompanying Notes to these Consolidated Financial Statements
are integral parts of these statements.

47




INVESTMENT TECHNOLOGY GROUP, INC.
Consolidated Statements of Income
(In thousands, except per share amounts)

 

 

Year Ended December 31,

 

 

 

2004

 

2003

 

2002

 

Revenues:

 

 

 

 

 

 

 

Commissions

 

 

 

 

 

 

 

POSIT

 

$

100,858

 

$

126,729

 

$

155,060

 

Electronic Trading Desk

 

108,733

 

119,355

 

111,703

 

Client Site Trading Products

 

102,369

 

77,554

 

111,333

 

Other

 

22,526

 

10,354

 

9,485

 

Total revenues

 

334,486

 

333,992

 

387,581

 

Expenses:

 

 

 

 

 

 

 

Compensation and employee benefits

 

122,833

 

118,070

 

114,402

 

Transaction processing

 

51,080

 

46,316

 

50,459

 

Software royalties

 

13,806

 

16,894

 

19,643

 

Occupancy and equipment

 

30,348

 

31,149

 

28,017

 

Telecommunications and data processing services

 

17,978

 

18,334

 

17,453

 

Restructuring charges

 

 

 

5,874

 

Other general and administrative

 

31,849

 

33,528

 

24,480

 

Total expenses

 

267,894

 

264,291

 

260,328

 

Income before income tax expense

 

66,592

 

69,701

 

127,253

 

Income tax expense

 

25,609

 

27,748

 

53,443

 

Net income

 

$

40,983

 

$

41,953

 

$

73,810

 

Earnings per share:

 

 

 

 

 

 

 

Basic

 

$

0.96

 

$

0.89

 

$

1.52

 

Diluted

 

$

0.96

 

$

0.89

 

$

1.51

 

Basic weighted average number of common shares outstanding

 

42,811

 

46,996

 

48,464

 

Diluted weighted average number of common shares outstanding

 

42,841

 

47,016

 

49,003

 

 

The accompanying Notes to these Consolidated Financial Statements
are integral parts of these statements.

48




 

INVESTMENT TECHNOLOGY GROUP, INC.
Consolidated Statements of Changes in Stockholders’ Equity
For the Years Ended December 31, 2004, 2003 and 2002
(In thousands, except share amounts)

 

 

Preferred
Stock

 

Common
Stock

 

Additional
Paid-In 
Capital

 

Retained
Earnings

 

Common 
Stock Held 
in Treasury

 

Accumulated 
Other 
Comprehensive 
Income (Loss)

 

Total 
Stockholders’ 
Equity

 

Balance at December 31, 2001

 

 

 

 

 

$ 512

 

 

 

$ 146,131

 

 

$ 218,215

 

 

$ (45,939

)

 

 

$   (975

)

 

 

$ 317,944

 

 

Issuance of common stock for the employee stock option plan (759,146 shares), the employee stock unit award plan (99,230 shares), and the directors’ retainer fee subplan (614 shares)

 

 

 

 

 

 

 

 

6,460

 

 

 

 

17,141

 

 

 

 

 

 

23,601

 

 

Issuance of common stock for the employee stock purchase plan (35,712 shares)

 

 

 

 

 

 

 

 

1,188

 

 

 

 

 

 

 

 

 

 

1,188

 

 

Purchase of common stock for treasury (2,005,400 shares)

 

 

 

 

 

 

 

 

 

 

 

 

(63,673

)

 

 

 

 

 

(63,673

)

 

Exchange of Hoenig stock options for ITG stock options

 

 

 

 

 

 

 

 

1,306

 

 

 

 

 

 

 

 

 

 

1,306

 

 

Net income

 

 

 

 

 

 

 

 

 

 

73,810

 

 

 

 

 

 

 

 

73,810

 

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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