UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

 

ý

 

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

 

 

 

 

 

For the quarterly period ended June 30, 2005

 

 

 

 

 

OR

 

 

 

 

 

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 001-13913

 

WADDELL & REED FINANCIAL, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

51-0261715

(State or other jurisdiction

 

(I.R.S. Employer

of incorporation or organization)

 

Identification No.)

 

6300 Lamar Avenue

Overland Park, Kansas

66202

(Address of principal executive offices)

(Zip Code)

 

(913) 236-2000

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes ý  No o

 

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

 

Shares outstanding of each of the registrant’s classes of common stock as of the latest practicable date:

 

Class

 

Outstanding as of July 22, 2005

 

Class A common stock, $.01 par value

 

83,650,841

 

 

 



 

Waddell & Reed Financial, Inc.

 

Form 10-Q

Quarter Ended June 30, 2005

 

Index

 

 

Part I.

Financial Information

 

 

 

 

Item 1.

 

Financial Statements

 

 

 

 

 

 

 

 

 

Consolidated Balance Sheets at June 30, 2005 and December 31, 2004

 

 

 

 

 

 

 

 

 

Consolidated Statements of Operations for the three months and six months ended June 30, 2005 and June 30, 2004

 

 

 

 

 

 

 

 

 

Consolidated Statements of Comprehensive Income for the three months and six months ended June 30, 2005 and June 30, 2004

 

 

 

 

 

 

 

 

 

Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2005

 

 

 

 

 

 

 

 

 

Consolidated Statements of Cash Flows for the six months ended June 30, 2005 and June 30, 2004

 

 

 

 

 

 

 

 

 

Notes to Unaudited Consolidated Financial Statements

 

 

 

 

 

 

 

Item 2.

 

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

 

 

 

 

 

 

 

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

 

 

 

 

 

 

 

Item 4.

 

Controls and Procedures

 

 

 

 

 

Part II.

Other Information

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

 

 

 

 

 

 

Item 2.

 

Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities

 

 

 

 

 

 

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

 

 

 

 

 

 

Item 6.

 

Exhibits and Reports on Form 8-K

 

 

 

 

 

 

 

 

 

Signatures

 

 

 

2



 

PART I.  FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

 

WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(in thousands)

 

 

 

June 30,

 

December 31,

 

 

 

2005

 

2004

 

 

 

(unaudited)

 

 

 

Assets

 

 

 

 

 

 

 

 

 

 

 

Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

118,453

 

83,900

 

Investment securities

 

52,523

 

125,275

 

Receivables:

 

 

 

 

 

Funds and separate accounts

 

26,864

 

24,751

 

Customers and other

 

38,134

 

38,651

 

Income taxes receivable

 

2,072

 

 

Deferred income taxes

 

27

 

24

 

Prepaid expenses and other current assets

 

7,212

 

6,469

 

 

 

 

 

 

 

Total current assets

 

245,285

 

279,070

 

 

 

 

 

 

 

Property and equipment, net

 

53,858

 

54,429

 

Deferred sales commissions, net

 

16,115

 

15,029

 

Goodwill

 

195,309

 

195,309

 

Intangible assets

 

54,999

 

54,984

 

Other assets

 

18,377

 

21,086

 

Total assets

 

$

583,943

 

619,907

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

Accounts payable

 

$

46,180

 

56,744

 

Accrued sales force compensation

 

13,684

 

13,035

 

Accrued other compensation

 

12,308

 

10,767

 

Short-term notes payable

 

214,609

 

35,000

 

Income taxes payable

 

 

8,210

 

Other current liabilities

 

48,502

 

38,761

 

 

 

 

 

 

 

Total current liabilities

 

335,283

 

162,517

 

 

 

 

 

 

 

Long-term debt

 

 

202,899

 

Accrued pensions and postretirement costs

 

17,456

 

15,899

 

Deferred income taxes

 

13,032

 

13,438

 

Other

 

5,846

 

6,277

 

 

 

 

 

 

 

Total liabilities

 

$

371,617

 

401,030

 

 

 

 

 

 

 

Stockholders’ equity :

 

 

 

 

 

Common stock - $0.01 par value: 250,000 shares authorized; 99,701 shares issued; 83,653 shares outstanding (82,798 at December 31, 2004)

 

997

 

997

 

Additional paid-in capital

 

235,526

 

236,313

 

Retained earnings

 

373,717

 

383,155

 

Deferred compensation

 

(46,333

)

(31,400

)

Cost of 16,048 common shares in treasury (16,903 at December 31, 2004)

 

(346,996

)

(365,892

)

Accumulated other comprehensive income

 

(4,585

)

(4,296

)

 

 

 

 

 

 

Total stockholders’ equity

 

$

212,326

 

218,877

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

583,943

 

619,907

 

 

See accompanying notes to unaudited consolidated financial statements.

 

3



 

WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

(Unaudited, in thousands, except for per share data)

 

 

 

For the three months
ended June 30,

 

For the six months
ended June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Revenues:

 

 

 

 

 

 

 

 

 

Investment management fees

 

$

64,533

 

59,261

 

128,115

 

119,557

 

Underwriting and distribution fees

 

65,874

 

62,306

 

133,219

 

128,523

 

Shareholder service fees

 

20,320

 

19,101

 

40,130

 

38,068

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

150,727

 

140,668

 

301,464

 

286,148

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Underwriting and distribution

 

73,468

 

66,651

 

147,757

 

134,824

 

Compensation and related costs

 

19,796

 

18,024

 

39,614

 

36,276

 

Equity compensation

 

6,248

 

3,396

 

9,038

 

4,636

 

Subadvisory fees

 

4,145

 

1,301

 

7,666

 

2,482

 

General and administrative

 

49,867

 

9,535

 

60,103

 

19,021

 

Depreciation

 

2,409

 

2,249

 

4,784

 

4,477

 

 

 

 

 

 

 

 

 

 

 

Total operating expenses

 

155,933

 

101,156

 

268,962

 

201,716

 

 

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

(5,206

)

39,512

 

32,502

 

84,432

 

 

 

 

 

 

 

 

 

 

 

Investment and other income

 

1,455

 

2,494

 

2,819

 

3,098

 

Interest expense

 

(3,685

)

(2,415

)

(6,939

)

(4,725

)

 

 

 

 

 

 

 

 

 

 

Income (loss) before provision for income taxes

 

(7,436

)

39,591

 

28,382

 

82,805

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

(349

)

14,387

 

12,719

 

29,720

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(7,087

)

25,204

 

15,663

 

53,085

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share:

 

 

 

 

 

 

 

 

 

Basic

 

($0.09

)

0.31

 

0.19

 

0.66

 

Diluted

 

($0.09

)

0.31

 

0.19

 

0.65

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

80,810

 

80,487

 

80,865

 

80,585

 

Diluted

 

80,810

 

81,755

 

81,872

 

82,001

 

 

 

 

 

 

 

 

 

 

 

Dividends declared per common share

 

$

0.1500

 

0.1500

 

0.3000

 

0.3000

 

 

See accompanying notes to unaudited consolidated financial statements.

 

4



 

WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss)

(Unaudited, in thousands)

 

 

 

For the three months
ended June 30,

 

For the six months
ended June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

(7,087

)

25,204

 

15,663

 

53,085

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

Net unrealized appreciation (depreciation) of investments during the period, net of income taxes of $331, $(1,482), $211 and $(1,160), respectively

 

563

 

(2,523

)

359

 

(1,803

)

Reclassification adjustment for amounts included in net income, net of income taxes of $0, $720, $(381), and $720, respectively

 

 

1,226

 

(648

)

1,226

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

(6,524

)

23,907

 

15,374

 

52,508

 

 

See accompanying notes to unaudited consolidated financial statements.

 

5



 

WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

 

Consolidated Statement of  Stockholders’ Equity

 

For the Six Months Ended June 30, 2005

(Unaudited, in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

Additional

 

 

 

 

 

 

 

other

 

Total

 

 

 

Common stock

 

paid-in

 

Retained

 

Deferred

 

Treasury

 

comprehensive

 

stockholders’

 

 

 

Shares

 

Amount

 

capital

 

earnings

 

compensation

 

stock

 

income

 

equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2004

 

99,701

 

$

997

 

$

236,313

 

$

383,155

 

$

(31,400

)

$

(365,892

)

$

(4,296

)

$

218,877

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

15,663

 

 

 

 

15,663

 

Recognition of equity compensation

 

 

 

1,443

 

 

7,592

 

 

 

9,035

 

Issuance of restricted shares and other

 

 

 

(2,083

)

 

(22,525

)

24,608

 

 

 

Dividends accrued

 

 

 

 

(25,101

)

 

 

 

(25,101

)

Exercise of stock options

 

 

 

(394

)

 

 

1,388

 

 

994

 

Tax benefit from equity awards

 

 

 

247

 

 

 

 

 

247

 

Other stock transactions

 

 

 

 

 

 

(1,103

)

 

(1,103

)

Treasury stock purchases

 

 

 

 

 

 

(5,997

)

 

(5,997

)

Reclassification for amounts included in net income

 

 

 

 

 

 

 

(648

)

(648

)

Unrealized gain on investment securities

 

 

 

 

 

 

 

359

 

359

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at June 30, 2005

 

99,701

 

$

997

 

$

235,526

 

$

373,717

 

$

(46,333

)

$

(346,996

)

$

(4,585

)

$

212,326

 

 

See accompanying notes to unaudited consolidated financial statements.

 

6



 

WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited, in thousands)

 

 

 

For the six months
ended June 30,

 

 

 

2005

 

2004

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

15,663

 

53,085

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

5,439

 

5,305

 

Recognition of equity compensation

 

9,038

 

4,636

 

(Gain)/loss on sale of available-for-sale investments

 

(1,029

)

3

 

Net purchases and sales of trading securities

 

1,691

 

 

Gain on trading securities

 

(121

)

(1,948

)

Loss on sale and retirement of fixed assets

 

92

 

65

 

Capital gains and dividends reinvested

 

(67

)

(45

)

Deferred income taxes

 

(239

)

1,969

 

Changes in assets and liabilities:

 

 

 

 

 

Receivables from funds and separate accounts

 

(2,113

)

(224

)

Other receivables

 

(98

)

(2,300

)

Other assets

 

(1,638

)

(797

)

Accounts payable

 

(10,564

)

(8,925

)

Other liabilities

 

2,894

 

(10,101

)

 

 

 

 

 

 

Net cash provided by operating activities

 

$

18,948

 

40,723

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchases of available-for-sale investment securities

 

 

(1,123

)

Proceeds from sales of available-for-sale investment securities

 

66,464

 

31

 

Proceeds from maturity of available-for-sale investment securities

 

5,541

 

8,740

 

Additions to property and equipment

 

(4,306

)

(3,921

)

Cash paid for acquisitions

 

(15

)

 

 

 

 

 

 

 

Net cash provided by investing activities

 

$

67,684

 

3,727

 

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Net short-term borrowings (repayments)

 

(21,000

)

2,000

 

Cash dividends

 

(24,973

)

(24,683

)

Purchase of treasury stock

 

(5,997

)

(21,766

)

Exercise of stock options

 

994

 

4,130

 

Other stock transactions

 

(1,103

)

 

 

 

 

 

 

 

Net cash used in financing activities

 

$

(52,079

)

(40,319

)

 

 

 

 

 

 

Net increase in cash and cash equivalents

 

34,553

 

4,131

 

 

 

 

 

 

 

Cash and cash equivalents at beginning of period

 

83,900

 

71,466

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

118,453

 

75,597

 

 

See accompanying notes to unaudited consolidated financial statements.

 

7



 

WADDELL & REED FINANCIAL, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

 

1.              The Company and Significant Accounting Policies

 

Waddell & Reed Financial, Inc. and Subsidiaries

 

Waddell & Reed Financial, Inc. and subsidiaries (hereinafter referred to as the “Company,” “we,” “us,” or “our”) derive revenues primarily from investment management, investment product underwriting and distribution, and shareholder services administration provided to the Waddell & Reed Advisors Group of Mutual Funds (the “Advisors Funds”), W&R Target Funds, Inc. (the “Target Funds”), Ivy Funds, Inc. and the Ivy Funds portfolios (collectively, the “Ivy Funds”), and Waddell & Reed InvestEd Portfolios, Inc. (“InvestEd”) (collectively, the “Funds”), and institutional and separately managed accounts.  The Funds and the institutional and separately managed accounts operate under various rules and regulations set forth by the United States Securities and Exchange Commission (the “SEC”). Services to the Funds are provided under contracts that set forth the fees to be charged for these services. The majority of these contracts are subject to annual review and approval by each Fund’s board of directors/trustees and shareholders. Our revenues are largely dependent on the total value and composition of assets under management, which include mainly domestic equity securities, but also include debt securities and international equities.  Accordingly, fluctuations in financial markets and composition of assets under management impact revenues and results of operations.

 

Basis of Presentation

 

We have prepared the accompanying unaudited consolidated financial statements included herein pursuant to the rules and regulations of the SEC.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures are adequate to enable a reasonable understanding of the information presented.  The information in this Quarterly Report on Form 10-Q should be read in conjunction with Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2004. Certain amounts in the prior years’ financial statements may have been reclassified for consistent presentation.

 

The accompanying unaudited consolidated financial statements have been prepared consistently with the accounting policies described in Note 2 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2004, which include the following: use of estimates, investment securities, property and equipment, software developed for internal use, goodwill and intangible assets, deferred sales commissions, revenue recognition, advertising and promotion, stock-based compensation, income taxes, derivatives and hedging activities, litigation contingencies, and disclosures about fair value of financial instruments.

 

In our opinion, the accompanying unaudited consolidated financial statements reflect all adjustments (consisting of only a normal and recurring nature) necessary to present fairly our financial position at June 30, 2005 and December 31, 2004 and the results of operations and cash flows for the three and six months ended June 30, 2005 and 2004, in conformity with accounting principles generally accepted in the United States.

 

8



 

Revenue Recognition

 

We recognize investment management fees as earned over the period in which services are rendered. We charge the Funds daily based upon average daily net assets under management in accordance with management advisory contracts between the Funds and the Company. In general, the majority of investment management fees earned from institutional and separate accounts are charged quarterly based upon an average of net assets under management at the end of the months within the quarter in accordance with management advisory contracts.

 

Shareholder service fees are recognized monthly and are calculated based on the number of accounts or assets under management, as applicable. Other administrative service fee revenues are recognized as contractual obligations are fulfilled or as services are provided.

 

Underwriting and distribution commission revenues resulting from the sale of investment products are recognized on the trade date.

 

As previously disclosed, the Company collects Rule 12b-1 service and distribution fees under sales and servicing plan agreements (compensatory and/or reimbursement) with the mutual funds, predominantly the Advisors Funds Class A reimbursement plan.  This plan allows for reimbursement to us of certain Rule 12b-1 eligible expenses, not to exceed a maximum of 25 basis points of average daily net assets under management.  Rule 12b-1 service and distribution fees are collected for costs related to the distribution and servicing of mutual fund shares such as sales commissions paid to financial advisors, advertising, sales brochures and costs for providing ongoing services to mutual fund shareholders.  Effective as of the second quarter of 2005, the Company has changed its method of reporting Rule 12b-1 service fee revenue to the gross basis of presentation. Previously, the Company used the net basis of presentation, whereby such service fee revenue was recorded as an offset against related underwriting and distribution expenses and presented as a reduction of expenses in “Underwriting and distribution expenses.”

 

Using the revised presentation, Rule 12b-1 revenues and associated distribution expenses are reported on a gross basis, as “Underwriting and distribution fees” and “Underwriting and distribution expenses” in the Consolidated Statements of Operations. Prior period amounts have been reclassified to be consistent with the 2005 presentation. These reclassifications did not impact our gross margin dollars, net income, cash flows, working capital, or shareholders’ equity amounts for each period presented.  Refer to Note 8 “Change in Method of Reporting Rule 12b-1 Service Fees” for additional information about this reclassification and reasons therefor.

 

Certain other prior year amounts have been reclassified to conform to current year presentation.

 

We also recognize certain distribution revenues monthly on certain types of investment products, primarily variable annuity products, which are generally calculated based on average daily net assets under management.

 

Stock-Based Compensation

 

Recent Accounting Developments in Stock-Based Compensation

 

The Company currently applies Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and related interpretations, in accounting for its stock-based compensation plans.  Accordingly, no compensation expense has been recognized for employee stock-based compensation plans other than for restricted stock and instances where vesting of option awards have been accelerated.  The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” (“SFAS 148”)

 

9



 

an amendment of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,”  (“SFAS 123”); therefore, no compensation expense has been recognized for the Company’s employee stock options.

 

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment, (revised 2004)” (“SFAS 123R”). SFAS 123R requires entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award, normally the vesting period. This revised statement allows entities to restate previously issued financial statements or adopt the provisions on a prospective basis. If restatement is chosen, the expense shown for prior periods will be the same amounts previously calculated and reported in their pro forma disclosures that had been required by SFAS 123.  The provisions of SFAS 123R are effective for our 2006 fiscal year beginning January 1, 2006. We will continue to apply the accounting provisions of APB 25 in accounting for our stock-based compensation plans until the effective date of SFAS 123R.  On March 30, 2005, the SEC released Staff Accounting Bulletin No. 107, “Share Based Payments,” (“SAB 107”), which expresses the staff’s views regarding the application of SFAS 123R.  The impact of adopting SFAS 123R and SAB 107 cannot be accurately estimated at this time, as it is dependent on the amount of share based awards in future periods.  However, had the Company adopted SFAS 123R and SAB 107 in a prior period, the impact would approximate the pro forma impact to net income (loss) and earnings (loss) per share under SFAS 123’s fair value method of accounting for employee stock plans as presented in the tables within this footnote.  SFAS 123R also requires that tax benefits received in excess of recognized compensation cost be reclassified from an operating cash flow to a financing cash flow in the Consolidated Statement of Cash Flows.  This change in classification will reduce net operating cash flows and increase net financing cash flows in the periods after adoption.

 

On April 25, 2005, the Compensation Committee of the Board of Directors approved the accelerated vesting of all then outstanding unvested options to purchase common stock of the Company previously awarded to employees, financial advisors, officers and directors.  This resulted in the accelerated vesting of options to purchase 624,267 shares of common stock of the Company.  Of these options, 447,497 were “in-the-money” options having an exercise price less than the then current market price of the Company’s common stock and a weighted average exercise price of $13.90 per share.  In order to prevent unintended personal benefits to directors and executive officers with such options, the Board imposed restrictions on any shares received through the exercise of accelerated options held by those individuals.  These restrictions prevent the sale of any stock obtained through exercise of an accelerated option prior to its original vesting date, other than the disposition of stock in the payment for the exercise price of options and associated income taxes, if any.

 

The Board of Directors (the “Board”) approved the accelerated vesting of these options based on the belief that it was in the best interest of the stockholders to reduce future compensation expense that the Company would otherwise be required to report in its statement of operations upon adoption of SFAS 123R in the first quarter of 2006.  Subsequent to the Board’s decision to accelerate the vesting of these options, the separation of employment of our former CEO triggered the remeasurement of compensation cost under current accounting standards and as a result we incurred compensation expense of $1.4 million during the second quarter of 2005.  We anticipate that all other “in-the-money” accelerated vesting option holders will remain employed with the Company throughout the original vesting term of such options, and therefore, in accordance with existing accounting standards, no expense will be recorded for these options, unless option holders are able to exercise an option that would have expired unexercisable pursuant to its original terms.  Stock-based employee compensation expense under the fair value method presented in our pro forma tables below includes pre-tax expense of approximately $1.9 million for the second quarter of 2005 as a result of accelerated stock option vesting.

 

10



 

The following table illustrates the effect on reported net income (loss) and earnings (loss) per share for the three and six months ended June 30, 2005 and 2004 as if we had applied the fair value method of accounting for employee stock plans as required by SFAS 123.

 

 

 

 

Three months ended
June 30,

 

Six months ended
June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

(in thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

Net income (loss), as reported

 

$

(7,087

)

25,204

 

15,663

 

53,085

 

Add:

 

 

 

 

 

 

 

 

 

Total stock-based compensation employee expense included in reported net income (loss), net of related tax effects

 

910

 

 

910

 

 

Deduct:

 

 

 

 

 

 

 

 

 

Total stock-based employee compensation expense determined under fair-value based method for all awards, net of related tax effects

 

(1,158

)

(442

)

(1,346

)

(1,066

)

 

 

 

 

 

 

 

 

 

 

Pro forma net income (loss)

 

$

(7,335

)

24,762

 

15,227

 

52,019

 

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share

 

 

 

 

 

 

 

 

 

As reported

 

$

(0.09

)

0.31

 

0.19

 

0.66

 

Pro forma

 

$

(0.09

)

0.31

 

0.19

 

0.65

 

Diluted earnings per share

 

 

 

 

 

 

 

 

 

As reported

 

$

(0.09

)

0.31

 

0.19

 

0.65

 

Pro forma

 

$

(0.09

)

0.30

 

0.19

 

0.63

 

 

The weighted-average fair value of each stock option included in the preceding pro forma amounts was estimated using a Black-Scholes option-pricing model and is amortized over the vesting period of the underlying options.

 

The Board approved grants of restricted shares of the Company’s Class A common stock in lieu of stock options beginning in 2002.  As of June 30, 2005, a total of 2,814,897 shares of unvested restricted stock were outstanding.  Grants of restricted stock are valued on the date of grant, have no purchase price, and are expensed using the straight-line method over a four year vesting period.  These grants vest over four years in one-third increments annually beginning on the second anniversary of the grant date.  Depending on the circumstances of termination, unvested shares of restricted stock may be forfeited upon the termination of employment with the Company.  Except for restrictions placed on the transferability of the restricted stock, holders of restricted stock have full stockholders rights during the term of restriction, including voting rights and the right to receive cash dividends.

 

2.              Cash and Cash Equivalents

 

Cash and cash equivalents include cash on hand and short-term investments.  We consider all highly liquid investments with original or remaining maturities of 90 days or less at the date of purchase to be cash equivalents.  Cash and cash equivalents at June 30, 2005 and December 31, 2004 include amounts of $17.4 million and $22.6 million, respectively, for the benefit of customers in compliance with applicable securities industry regulations.  Substantially all cash balances are in excess of federal deposit insurance limits.

 

As of June 30, 2005 and December 31, 2004, we had pledged a portion of our commercial paper holdings with a combined market value of $26.4 million and $21.5 million, respectively, as collateral for performance of our obligations to a bank under a letter of credit.  On July 21, 2005, the bank was released of

 

11



 

its obligation under the letter of credit agreement, and as such, these holdings have been released from their restriction.

 

3.              Fair Value Hedge

 

On March 12, 2002, our $200.0 million 7.5% fixed rate senior notes maturing in January 2006 (the “Notes”) were effectively converted to variable rate debt by entering into an interest rate swap agreement. The difference in floating rate interest paid and 7.5% fixed rate interest received is recorded as an adjustment to interest expense during the period that the related debt is outstanding.  As short-term interest rates fall, our interest expense declines and vice versa.  As of June 30, 2005, the floating rate being paid was 5.79%.  The change in the fair value of the swap is recorded on the consolidated balance sheet by adjusting the carrying amounts of the Notes by an offsetting amount for the swap.

 

Under Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities,” (“SFAS 133”) we account for the swap as a fair value hedge of the Notes.  The swap is considered 100% effective in hedging the changes in the fair value of the Notes arising from changes in interest rates, and accordingly, there has been no impact on earnings resulting from any ineffectiveness associated with this transaction.  As a result of the hedge, the Company realized interest expense savings of approximately $0.9 million and $2.1 million for the three and six months ended June 30, 2005, respectively.  For the three and six months ended June 30, 2004, we realized interest expense savings of $1.9 million and $3.8 million, respectively.  As of June 30, 2005, we have recorded a cumulative increase in “Other assets” of $0.9 million to reflect the fair value of the swap and a cumulative increase in “Short term notes payable” of $0.9 million to reflect the fair value of the Notes.  As of December 31, 2004, we recorded a cumulative increase in “Other assets” of $3.4 million to reflect the fair value of the swap and a cumulative increase in “Long-term debt” of $3.4 million to reflect the fair value of the Notes.

 

4.            Investments

 

Investments are as follows:

 

 

Market Value

 

 

 

June 30,

 

December 31,

 

 

 

2005

 

2004

 

 

 

(in thousands)

 

 

 

 

 

 

 

Available-for-sale securities:

 

 

 

 

 

United States government-backed mortgage securities

 

$

276

 

$

315

 

Municipal bonds

 

15,865

 

17,415

 

Certificates of deposit

 

 

56,753

 

Corporate bonds

 

979

 

5,067

 

Affiliated mutual funds

 

27,167

 

35,964

 

 

 

$

44,287

 

$

115,514

 

 

 

 

 

 

 

Trading securities:

 

 

 

 

 

Affiliated mutual funds

 

8,236

 

9,761

 

 

 

 

 

 

 

Total investments

 

$

52,523

 

$

125,275

 

 

12



 

Certain information related to our available-for-sale securities is as follows:

 

 

 

June 30,

 

December 31,

 

 

 

2005

 

2004

 

 

 

(in thousands)

 

Cost - available-for-sale securities

 

$

37,510

 

$

108,278

 

Gross unrealized gains

 

7,426

 

8,128

 

Gross unrealized losses

 

(649

)

(892

)

 

 

 

 

 

 

Market value - available-for-sale securities

 

$

44,287

 

$

115,514

 

 

Effective June 30, 2004, the Company began matching investments to the funding obligations created by our deferred compensation plans.  These plans allow employees to choose investment vehicles, which are primarily Company sponsored mutual funds.  At that time, certain mutual fund holdings classified as available-for-sale totaling $10.0 million were transferred to the trading portfolio.  The transfer resulted in the recognition of an unrealized gain of $1.9 million as investment and other income in 2004.  Gross purchases and sales of trading securities for the six months ended June 30, 2005 were $408 thousand and $2.1 million, respectively.

 

On June 8, 2005, a cash appeal bond of $56.3 million plus accrued interest of $1.1 million was returned to us as part of the resolution of outstanding legal issues with Torchmark Corporation.  For additional information regarding this matter refer to Note 9 “Contingencies” below.  Also, as of June 30, 2005 and December 31, 2004, investment securities, which exclude cash and cash equivalents, with a combined market value of $15.9 million and $21.2 million, respectively, were pledged as collateral for performance of our obligations to a bank under a letter of credit pending the outcome of legal matters. On July 21, 2005, as ordered by the NY Supreme Court on January 28, 2004 as a result of the legal award being reversed and vacated, the bank was released of its obligation under the letter of credit agreement, and as such, all securities have been released from their restriction. Refer to Note 9 “Contingencies” for more information on this matter.

 

A summary of debt securities with market values below carrying values for twelve months or longer at June 30, 2005 is as follows:

 

 

 

Fair value

 

Unrealized
(losses)

 

 

 

(in thousands)

 

 

 

 

 

 

 

Municipal bonds

 

$

4,513

 

(487

)

Corporate bonds

 

979

 

(162

)

Total temporarily impaired securities

 

$

5,492

 

(649

)

 

We assess the carrying value of investments in debt and equity securities each quarter to determine whether an other than temporary decline in market value exists.  We consider factors affecting the issuer, the industry the issuer operates in, general market trends including interest rates, and our ability and intent to hold an investment until it has recovered. Consideration is given to the length of time an investment’s market value has been below carrying value and prospects for recovery to carrying value. At June 30, 2005, we had one municipal security and one asset-backed security with market values below their carrying values.  Both have maturities that exceed nine years.  Based upon our assessment of these bonds and our history of holding bonds until maturity, we determined that a write-down was not appropriate at this time.

 

13



 

5.              Stockholders’ Equity

 

Earnings (Loss) per Share

 

The components of basic and diluted earnings (loss) per share were as follows:

 

 

 

Three months ended
June 30,

 

Six months ended
June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

 

 

(in thousands, except per share data)

 

 

 

 

 

 

 

 

 

 

 

Net income (loss), as reported

 

$

(7,087

)

25,204

 

$

15,663

 

53,085

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding - basic

 

80,810

 

80,487

 

80,865

 

80,585

 

Dilutive potential shares from stock options and restricted stock awards, computed under the treasury stock method

 

 

1,268

 

1,007

 

1,416

 

Weighted average shares outstanding -diluted

 

80,810

 

81,755

 

81,872

 

82,001

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.09

)

$

0.31

 

$

0.19

 

$

0.66

 

Diluted

 

$

(0.09

)

$

0.31

 

$

0.19

 

$

0.65

 

 

Anti-dilutive Securities

 

Anti-dilutive potential common shares resulting from options to purchase shares of common stock that were excluded from the diluted earnings per share calculation were 2.84 million shares for the six months ended June 30, 2005, and 2.84 million shares and 2.79 million shares for the three and six months ended June 30, 2004, respectively. Excluded from the diluted earnings per share calculation were 37,397 shares of anti-dilutive unvested restricted stock for the six months ended June 30, 2005, and 1,104,733 shares and 517,069 shares for the three and six months ended June 30, 2004, respectively.  Diluted earnings per share is the same as basic earnings per share for the three month period ended June 30, 2005 as the impact of stock options and restricted stock awards would have been anti-dilutive.  The number of diluted shares outstanding had the company had net income for the three months ended June 30, 2005 would have been 81,493 million shares.

 

Dividends

 

On April 27, 2005 our Board approved a dividend in the amount of $0.15 per share to stockholders of record as of July 11, 2005 to be paid on August 1, 2005.  The total dividend to be paid is approximately $12.5 million.

 

Common Stock Repurchases

 

Our Board has authorized the repurchase of our common stock in the open market and/or private purchases. The acquired shares may be used for corporate purposes, including shares issued to employees in our stock based compensation programs.  There were no common shares repurchased on the open market for the three months ended June 30, 2005 and June 30, 2004.  Common shares repurchased on the open market for the six months ended June 30, 2005 and June 30, 2004 were 292,600 shares and 865,900 shares, respectively.

 

14



 

6.              Goodwill and Identifiable Intangible Assets

 

Goodwill

 

Goodwill represents the excess of the purchase price over the tangible assets and identifiable intangible assets of an acquired business.  At June 30, 2005 and December 31, 2004, gross goodwill was $234.0 million and accumulated amortization was $38.6 million.  There were no changes to the carrying amount of goodwill during the six months ended June 30, 2005.  Our goodwill is not deductible for tax purposes.

 

In accordance with guidelines set forth under Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets,” (“SFAS 142”), a detailed valuation was performed as of June 30, 2005 to measure both the fair value and the carrying value of each business unit for possible impairment.  The determination of possible impairment is primarily measured by reference to various valuation techniques used in the investment management industry, quoted market values, and future cash flows.  As a result of the valuation analysis, it was determined that no impairment of goodwill existed because the fair value of each business unit exceeded its carrying value.

 

Identifiable Intangible Assets

 

Identifiable intangible assets (all considered indefinite lived) are summarized as follows:

 

 

 

June 30,

 

December 31,

 

 

 

2005

 

2004

 

 

 

(in thousands)

 

Unamortized intangible assets:

 

 

 

 

 

Mutual fund management advisory contracts

 

$

38,699

 

$

38,684

 

Subadvisory management contracts

 

16,300

 

16,300

 

 

 

 

 

 

 

Total

 

$

54,999

 

$

54,984

 

 

In accordance with guidelines set forth in SFAS 142, we evaluated the useful life of our identifiable intangible assets as of June 30, 2005 and determined that there was no change.

 

15



 

7.              Pension Plan and Postretirement Benefits Other Than Pension

 

We provide a non-contributory retirement plan that covers substantially all employees of the Company and certain vested former employees of our former parent company.  Benefits payable under the plan are based on years of service and compensation during the final ten years of employment.  We also sponsor an unfunded defined benefit postretirement medical plan that covers substantially all employees of the Company, including our financial advisors and retirement advisors of the Legend group of subsidiaries (“Legend”).  This medical plan is contributory with retiree contributions adjusted annually.  The following table presents the components of net periodic benefit cost related to these plans.

 

 

 

 

 

 

 

Other
Postretirement

 

 

 

 

 

Other
Postretirement

 

 

 

Pension Benefits

 

Benefits

 

Pension Benefits

 

Benefits

 

 

 

Three months
ended June 30,

 

Three months
ended June 30,

 

Six months
ended June 30,

 

Six months
ended June 30,

 

 

 

2005

 

2004

 

2005

 

2004

 

2005

 

2004

 

2005

 

2004

 

 

 

(in thousands)

 

(in thousands)

 

Components of net periodic benefit cost:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Service cost

 

$

1,434

 

1,062

 

105

 

118

 

2,799

 

2,332

 

211

 

236

 

Interest cost

 

1,242

 

1,037

 

77

 

85

 

2,412

 

2,136

 

153

 

169

 

Expected return on plan assets

 

(1,218

)

(1,299

)

 

 

(2,604

)

(2,599

)

 

 

Actuarial loss amortization

 

413

 

68

 

22

 

43

 

717

 

212

 

44

 

86

 

Prior service costs amortization

 

109

 

109

 

6

 

6

 

218

 

218

 

12

 

12

 

Transition obligation amortization

 

1

 

1

 

 

 

2

 

2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

1,981

 

978

 

210

 

252

 

3,544

 

2,301

 

420

 

503

 

 

As disclosed in our financial statements for the year ended December 31, 2004, we anticipate that our contribution to the pension plan for 2005 will range from $0 to $10 million.  During the six month period ending June 30, 2005, we did not make a contribution to the pension plan.

 

8.              Change in Method of Reporting for Rule 12b-1 Service Fees

 

Effective as of the second quarter 2005, the Company changed its method for reporting Rule 12b-1 service fee revenue to the gross basis of presentation based upon EITF 99-19, which first became effective in 2000.   Previously, the Company presented Rule 12b-1 service fee revenue for both compensatory and reimbursement plans on a net basis.  Although our reimbursement plans, which represent a significant portion of our total Rule 12b-1 service fee revenue, have indicators of both net and gross reporting under EITF 99-19, we have reconsidered the basis of our treatment under EITF 99-19 due to the growth in Rule 12b-1 service fee revenue under our compensatory plans, which have stronger indicators of gross reporting.  As a result of this evaluation, we determined that additional weight should be given to our role as primary obligor in transactions between mutual funds and their shareholders for our Rule 12b-1 reimbursement plans.  Further, we believe that with this change our presentation reflects the predominate industry practice for reporting Rule 12b-1 service fee revenue.

 

16



 

As discussed in Note 1 under the heading “Revenue Recognition,” the Company previously presented Rule 12b-1 service fee revenues as a reduction of associated expenses in “Underwriting and distribution” expense in our Consolidated Statements of Operations. The following table presents the gross method of presentation as reclassified.

 

 

 

Underwriting &
Distribution
Revenue

 

Total
Operating
Revenue

 

Underwriting &
Distribution
Expense

 

Total
Operating
Expenses

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

For the three months ended March 31,

 

 

 

 

 

 

 

 

 

2005

 

$

67,345

 

$

150,737

 

$

74,289

 

$

113,029

 

2004

 

66,215

 

145,478

 

68,171

 

100,559

 

2003

 

55,742

 

117,433

 

57,444

 

114,013

 

 

 

 

 

 

 

 

 

 

 

For the three months ended June 30,

 

 

 

 

 

 

 

 

 

2005

 

65,874

 

150,727

 

73,468

 

155,933

 

2004

 

62,306

 

140,668

 

66,651

 

101,156

 

2003

 

56,875

 

122,936

 

58,330

 

88,182

 

 

 

 

 

 

 

 

 

 

 

For the three months ended September 30,

 

 

 

 

 

 

 

 

 

2004

 

59,325

 

136,667

 

63,866

 

97,568

 

2003

 

55,369

 

126,047

 

58,575

 

119,505

 

 

 

 

 

 

 

 

 

 

 

For the year ended December 31,

 

 

 

 

 

 

 

 

 

2004

 

252,884

 

569,688

 

268,800

 

406,329

 

2003

 

231,656

 

506,252

 

239,293

 

417,555

 

2002

 

240,473

 

492,201

 

242,372

 

344,428

 

2001

 

272,475

 

546,098

 

262,711

 

362,096

 

2000

 

279,676

 

586,886

 

260,019

 

354,963

 

 

9.              Contingencies

 

The Company and/or certain of our subsidiaries are involved from time to time in various legal proceedings and claims incident to the normal conduct of business. During the second quarter of 2005, the Company recorded a charge of $35.0 million to recognize liabilities related to settlements of outstanding litigation in the resolution of legal matters with the NASD and United Investors Life Insurance Company (“UILIC”) litigation as set forth under the headings “NASD Enforcement Action” and “Alabama and California Proceedings” below.  Previously, during the third quarter of 2003, the Company recorded a charge of $32.0 million to recognize liabilities for estimated damages and legal costs for both the third quarter of 2003 and future legal costs in connection with the UILIC litigation, the NASD Enforcement Action, and ongoing disputes with former sales personnel in our Advisors channel, including the Sawtelle Arbitration.  In addition to legal costs incurred in the third quarter of 2003, this charge included estimated damages and future legal costs assuming these matters are resolved in a manner that is unfavorable after exhausting all reasonable legal remedies.  As a result of the settlements in the second quarter of 2005, the Sawtelle Arbitration is the only outstanding matter from the 2003 charge that is still unresolved.  As an estimate, it is possible that the ultimate amount of damages and legal costs could be higher or lower than the Company’s recorded liability.  As a result, any changes could have a material effect on the results of operations in a particular quarter or year as the Company evaluates this liability in future periods.

 

17



 

NASD Enforcement Action

 

See Note 16 of the Notes to Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004 for a description and discussion of this litigation.   As previously disclosed on April 29, 2005, the Company reached a settlement agreement with the NASD regarding this matter.  This settlement consisted of a non-deductible fine payable to the NASD in the amount of $5 million and the establishment of an $11 million restitution fund for certain variable annuity clients. In agreeing to the terms of the settlement, Waddell & Reed, Inc. neither admitted nor denied the NASD’s allegations.

 

State Variable Annuity Settlements

 

As previously announced on April 29, 2005, in conjunction with the settlement of the NASD Enforcement Action referenced above, the Company agreed to a settlement in principal with a consortium of states regarding the same variable annuity sales practices that were the subject of the NASD Enforcement Action.  The $2 million non-deductible fine agreed to by the Company with the states will be apportioned among those states participating.  Each state participating will receive (a) a base amount of $20,000 per state, and (b) a pro rata share of the remainder based on the number of variable annuity exchanges in each state.  The penalty amounts for any state not joining the multi-state settlement will be distributed among the participating states on the same basis as described in (b) above sometime before the end of the year.  At the time of this filing, the Company had signed definitive settlement documents (and made payments) with/to the states of California, Kansas, Minnesota, Missouri, New Jersey, Nevada and Wyoming.  The Company anticipates signing definitive settlement documents with a significant number of other states before the expiration of the deadline.  In agreeing to the terms of the multi-state settlement, the Company neither admitted nor denied the states’ allegations.

 

The Company anticipates that a few states may not accept the multi-state settlement offer and may institute separate proceedings against the Company.  Currently, the State Auditor and Commissioner of Securities of the State of Montana have such a proceeding on file (Case No. 03-31-05).  It alleges multiple violations of the Montana Securities Act and the Montana Insurance Code in connection with variable annuity exchanges and seeks unspecified fines and restitution.  As a result of the acceptance of the multi-state agreement by the State of Missouri, the enforcement action instituted by the State of Missouri as described in the Company’s first quarter Quarterly Report on Form 10-Q dated April 26, 2005 was resolved with the Company neither admitting nor denying the state’s allegations.

 

As a separate condition to the multi-state settlement, the Company agreed to identify all customers who had a decrease in minimum guaranteed death benefit from an exchange of an UILIC Advantage II variable annuity for a Nationwide variable annuity and to reimburse that customer upon their death for the reduction in death benefit, if any, at that time.

 

Sawtelle Arbitration

 

See Note 16 of the Notes to Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004 for a description and discussion of this litigation and its possible impact on the financial position and results of operations of the Company. There were no material developments in this matter since the filing of the above referenced Form 10-K.  However, the surety released the original appeal bond related to this case in the amount of $28.7 million on July 21, 2005.  See additional discussion in the “Liquidity and Capital Resources” section of Management’s Discussion and Analysis for additional information related to the release of the bond.  The release of the bond does not and will not have an impact on the ultimate resolution of this arbitration.

 

18



 

Waddell & Reed Financial, Inc. vs. Torchmark Corporation/United Investors

 

Tax Proceedings

 

See Note 16 of the Notes to Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004 for a description and discussion of this litigation and its possible impact on the financial position and results of operations of the Company. There were no material developments in this matter since the filing of the above referenced Form 10-K.

 

Alabama and California Proceedings

 

See Note 16 of the Notes to Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004 for a description and discussion of this litigation.  As previously disclosed on April 29, 2005, during the second quarter the Company agreed to pay $14.5 million to Torchmark Corporation to settle all outstanding litigation between the companies and their subsidiaries and affiliates, including actions in Alabama, Kansas and California, with the exception of the tax case between the companies regarding income tax refunds received from the state of Kansas.  In addition, both companies executed a full general mutual release to resolve any and all claims or causes of action arising or occurring at any time in the past. As a result, upon the completion of the formal settlement proceedings, the Alabama courts released to the Company its $56 million cash bond, plus interest, that was posted at the time of the Alabama verdict.

 

SEC/New York Attorney General

 

During the third quarter of 2003, the Company received a subpoena from the New York Attorney General’s office and requests for information from the Securities and Exchange Commission in regard to their investigations of late trading and market-timing transactions within the mutual fund industry.  The Company’s efforts to resolve these matters with both offices are continuing. These requests, investigations, and settlement discussions are ongoing and the Company is continuing to cooperate fully. In the opinion of management, the ultimate resolution and outcome of this matter is uncertain.  An ultimate resolution of this matter, or an adverse determination against the Company, could have a material adverse impact on the financial position and results of operations of the Company. However, the possible impact is unknown and not reasonably determinable; therefore, no liability has been recorded in the consolidated financial statements of Waddell & Reed Financial, Inc.

 

Williams Excessive Fee Litigation

 

See Note 16 of the Notes to Consolidated Financial Statements of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004 for a description and discussion of this litigation and its possible impact on the financial position and results of operations of the Company. There were no material developments in this matter since the filing of the above referenced Form 10-K.

 

19



 

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

 

Certain statements contained in this Quarterly Report on Form 10-Q constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding our expectations, hopes, beliefs, intentions or strategies regarding the future.  All statements, other than statements of historical fact included in this Form 10-Q regarding our financial position, business strategy and other plans and objectives for future operations are forward-looking statements.  All forward-looking statements included in this Form 10-Q are based on information available to us on the date hereof, and we assume no obligation to update such forward-looking statements, whether as a result of new information, future events or otherwise.  Although we believe that the assumptions and expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to have been correct or that we will take any actions that may presently be planned and neither us nor any other person will be responsible for the accuracy or completeness of any such forward-looking statements.  Certain important factors that could cause actual results to differ materially from our expectations are disclosed in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2004, which include, without limitation, a risk that the expected benefits from the expansion of our distribution channels may not be as beneficial as expected, the adverse effect from a decline in securities markets or if our products’ performance declines, failure to renew investment management agreements, our ability to retain key personnel and financial advisors, adverse results of litigation and/or arbitration judgments or settlements, acts of terrorism and/or war, competition, changes in government regulation, availability and terms of capital, regulatory enforcement actions or settlements, changes in the regulatory environment, less favorable economic and market conditions, including our cost to finance the Company, and other risks as set out in the reports filed by us with the Securities and Exchange Commission.   Should one or more of these risks materialize or should the underlying assumptions prove incorrect, actual results could differ materially from those forecasted or expected.  All subsequent written or oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by such factors.

 

The information contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in this Form 10-Q and the audited financial statements and notes thereto in our 2004 Annual Report on Form 10-K, as well as a more detailed explanation of risk factors at the end of this Item 2 under the heading entitled “Forward Looking Information.”

 

Overview

 

The Company’s earnings and cash flows are heavily dependent on financial market conditions.  Significant increases or decreases in the various securities markets, particularly equity markets, can have a material impact on the Company’s results of operations, financial condition and cash flows.  We derive our revenues primarily from providing investment management, investment product underwriting and distribution, and administrative services to the Funds and institutional and separately managed accounts.  Investment management fees, our most substantial source of revenues, are based on the amount of average assets under management and are affected by sales levels, financial market conditions, redemptions, and the composition of assets.  Underwriting and distribution revenues, another substantial source of revenues, consist of sales charges and commissions derived from sales of investment and insurance products, distribution and/or service fees on certain variable products and mutual fund share classes, and fees earned on fee-based asset allocation products, as well as advisory services.  The products sold have various commission structures and the revenues received from sales of products vary based on the type and amount sold.  Our products are distributed through either our sales force of registered financial advisors (the “Advisors channel”) or non-proprietary distribution methods including other broker-dealers, other registered investment advisors (including the Legend retirement advisors), and 401(k) platforms (the “Wholesale channel”).  Rule 12b-1 distribution and/or service fees earned for distributing and/or servicing certain mutual fund shares are based upon a

 

20



 

percentage of assets and fluctuate based on sales, redemptions, and financial market conditions.  Shareholder service fees include transfer agency fees, custodian fees for retirement plan accounts, and portfolio accounting fees.

 

Company Developments

 

The second quarter of 2005 was marked with considerable change for the Company, paving the way for future growth.  During this year’s second quarter, we settled various legal matters and announced significant changes to our executive management, including a new Chief Executive Officer and Chief Investment Officer, as well as a new independent Chairman of the Board of Directors.  Our broker-dealer subsidiaries also appointed a Chief Regulatory Officer.  We intend to move forward sharpening our focus on our core business and renewing our commitment to the values of service, quality and leadership.

 

Effective May 25, 2005, Keith A. Tucker, the Company’s Chief Executive Officer and Chairman of the Board resigned after serving thirteen years with the Company.  Consistent with emerging best practices in corporate governance, the Company separated the position of Chairman of the Board of Directors from that of the Chief Executive Officer.  The Company’s President and former Chief Investment Officer, Henry J. Herrmann, a thirty-four year veteran of the Company, was named Chief Executive Officer, while the position of independent, non-executive Chairman of the Board was filled by Alan W. Kosloff, an independent member of the Board.  Mr. Tucker will continue to serve the Company as a consultant for a period of eight years.  On June 20, 2005, Michael L. Avery, a twenty-four year veteran of our investment management team was appointed Chief Investment Officer.  Mr. Avery succeeds Mr. Herrmann in leading an investment management team of over 50 professionals; with Mr. Herrmann remaining chairman of the Investment Policy Committee.  Also during the second quarter, Terry L. Lister was hired as Chief Regulatory Officer for our two broker-dealer subsidiaries, Waddell & Reed, Inc. and Ivy Funds Distributor, Inc.  Mr. Lister has nearly thirty years experience in the securities regulatory field and will manage the compliance process in both our Advisors distribution channel and the non-proprietary sales within our Wholesale channel.

 

Of particular importance in this year’s second quarter, is our settlement of outstanding legal matters with the NASD and a consortium of states relating to variable annuity sales practices, and with Torchmark Corporation for outstanding litigation for actions in Alabama, California, and Kansas with the exception of an outstanding tax case between the companies described further in Note 9 “Contingencies” of the Notes to the Unaudited Consolidated Financial Statements.   Total expenses incurred in the second quarter of 2005 for these settlements were $35.0 million, pre-tax, and are discussed in further detail at Note 9 “Contingencies” of the Notes to the Unaudited Consolidated Financial Statements.

 

As announced last quarter, we are implementing a number of changes in the Advisors channel to revitalize sales growth.  We began this effort by appointing a new National Sales Manager and Associate National Sales Manager in conjunction with expanding the responsibility of the Chief Marketing Officer to also include distribution efforts through the Advisors channel.  During the second quarter of 2005, the Advisors channel support network in the home office underwent organizational restructuring implementing some common industry practices to better align with our financial advisors’ needs, including sales support and services.  For example, we have established a home office sales desk for use by our financial advisors, making experts available to answer any questions regarding our investment products in a prompt manner.  As a part of this restructuring, we incurred pre-tax charges of $504 thousand during the second quarter of 2005, primarily in the form of employee severance.  We have sharpened our focus on recruiting additional quality financial advisors; to this end we are developing a home office organization of internal recruiters designed to assist our field managers.  While these activities add costs to the Advisors distribution channel, they are designed to generate higher sales and productivity levels from our financial advisors.

 

On a year to date basis, total gross sales were $345 million higher than last year while the overall dollar value of redemptions was down $222 million.  The non-proprietary distribution component of the Wholesale

 

21



 

channel continues to grow, with gross sales up $502 million, or 82% higher than last year, accounting for 43% of total sales across all distribution lines.  Redemptions in the Advisors channel declined $200 million, or 11%, year to date, contributing to the 38% decrease in the net outflows of this channel.

 

Recent Accounting Developments

 

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123R, “Share-Based Payment, (revised 2004)” (“SFAS 123R”). SFAS 123R requires entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide service in exchange for the award, normally the vesting period. This revised statement allows entities to restate previously issued financial statements or adopt the provisions on a prospective basis. If restatement is chosen, the expense shown for prior periods will be the same amounts previously calculated and reported in their pro forma disclosures that had been required by Statement of Financial Accounting Standards No. 123,”Accounting for Stock-Based Compensation,” (“SFAS 123”).  The provisions of SFAS 123R are effective for our 2006 fiscal year beginning January 1, 2006. We will continue to apply the accounting provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” in accounting for our stock-based compensation plans until the effective date of SFAS 123R.

 

On March 30, 2005, the SEC released Staff Accounting Bulletin No. 107, “Share Based Payments,” (“SAB 107”), which expresses the staff’s views regarding the application of SFAS 123R.  The impact of adopting SFAS 123R and SAB 107 cannot be accurately estimated at this time, as it is dependent on the amount of share based awards in future periods.  However, had the Company adopted SFAS 123R and SAB 107 in a prior period, the impact would approximate the pro forma impact to net income and earnings per share under SFAS 123’s fair value method of accounting for employee stock plans as described in the disclosure of pro forma net income (loss) and earnings (loss) per share in Note 1 in the Notes to our Unaudited Consolidated Financial Statements in this report.  SFAS 123R also requires that tax benefits received in excess of compensation cost recognized be reclassified from an operating cash flow to a financing cash flow in the Consolidated Statement of Cash Flows.  This change in classification will reduce net operating cash flows and increase net financing cash flows in the periods after adoption.

 

On April 25, 2005, the Compensation Committee of the Board of Directors approved the accelerated vesting of all then outstanding unvested options to purchase common stock of the Company previously awarded to employees, financial advisors, officers and directors.  This resulted in the accelerated vesting of options to purchase 624,267 shares of common stock of the Company.  Of these options, 447,497 were “in-the-money” options having an exercise price less than the then current market price of the Company’s common stock and a weighted average exercise price of $13.90 per share.  In order to prevent unintended personal benefits to directors and executive officers with such options, the Board imposed restrictions on any shares received through the exercise of accelerated options held by those individuals.  These restrictions prevent the sale of any stock obtained through exercise of an accelerated option prior to its original vesting date, other than the disposition of stock in the payment for the exercise price of options and associated income taxes, if any.

 

The Board of Directors (the “Board”) approved the accelerated vesting of these options based on the belief that it was in the best interest of the stockholders to reduce future compensation expense that the Company would otherwise be required to report in its statement of operations upon adoption of SFAS 123R in the first quarter of 2006.  Subsequent to the Board’s decision to accelerate the vesting of these options, the separation of employment of our former CEO triggered the remeasurement of compensation cost under current accounting standards and as a result we incurred compensation expense of $1.4 million during the second quarter of 2005.  We anticipate that all other “in-the-money” accelerated vesting option holders will remain employed with the Company throughout the original vesting term of such options, and therefore, in accordance with existing accounting standards, no expense will be recorded for these options, unless option

 

22



 

holders are able to exercise an option that would have expired unexercisable pursuant to its original terms.

 

Change in Method of Reporting for Rule 12b-1 Service Fees

 

The Company changed its method for reporting Rule 12b-1 service fee revenues to the gross basis of presentation based upon Emerging Issues Task Force Issue No. 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent” (“EITF 99-19”) which first became effective in 2000.   Previously, the Company presented Rule 12b-1 service fee revenue for both compensatory and reimbursement plans on a net basis, whereby such service fee revenue was recorded as an offset against related underwriting and distribution expenses and presented as a reduction of expenses in “Underwriting and distribution expenses.”  Although our reimbursement plans, which represent a significant portion of our total Rule 12b-1 service fee revenue, have indicators of both net and gross reporting under EITF 99-19, we have reconsidered the basis of our treatment under EITF 99-19 due to the growth in Rule 12b-1 service fee revenue under our compensatory plans, which have stronger indicators of gross reporting.  As a result of this evaluation, we determined that additional weight should be given to our role as primary obligor in transactions between mutual funds and their shareholders for our Rule 12b-1 reimbursement plans.  Further, we believe that with this change our presentation reflects the predominate industry practice for reporting Rule 12b-1 service fee revenue.

 

Under the Company’s revised presentation, Rule 12b-1 service fee revenue will no longer be presented as a reduction of Rule 12b-1 related expenses, and will result in an increase to both our underwriting and distribution revenue and expenses by the same amount. The revised presentation has no effect on gross margin dollars, net income, cash flows, working capital or shareholders’ equity amounts previously reported, and will not affect such amounts in future periods.  Refer to Note 8 “Change in Method of Reporting for Rule 12b-1 Service Fees” of the Notes to the Unaudited Consolidated Financial Statements for revised presentation of revenues and expenses for the quarterly reporting periods during the years 2005, 2004, and 2003 and the years ended December 31, 2004, 2003, 2002, 2001, and 2000.

 

Results of Operations — Three Months Ended June 30, 2005 as Compared with Three Months Ended June 30, 2004

 

Net Loss

 

The Company reported net loss of $7.1 million, or ($0.09) per diluted share, for the second quarter of 2005 compared to net income of $25.2 million, or $0.31 per diluted share, for the second quarter of 2004.  This year’s second quarter included several charges totaling $41.3 million pre-tax ($28.8 million net of tax) that are not considered typical ongoing operating expenses of the Company.  Included in the aggregate pre-tax charges of $41.3 million were $35.0 million related to settlements of outstanding litigation, and charges aggregating $6.3 million, primarily for costs relating to the separation of employment of our former CEO, and to a significantly lesser extent, various other separation and restructuring charges related to leadership changes made in the Advisors channel.  These charges are included as components of compensation expense, equity compensation expense, underwriting and distribution expense, and general and administrative expenses.  A discussion of the various components of net income follows.

 

Investment Management Fee Revenues

 

Investment management fee revenues were $64.5 million, an increase of $5.3 million, or 9%, from last year’s second quarter.  Total average assets under management for the current quarter were $38.2 billion compared to $36.1 billion for the second quarter of 2004, up 6%.

 

Revenues from management services provided to our retail mutual funds, which are distributed both through the Advisors channel and through non-proprietary distribution in the Wholesale channel, increased $5.1 million, or 11%, while the related retail average assets increased 7% to $30.0 billion.  Compared to last

 

23



 

year’s second quarter, the average assets in the Ivy Funds family grew 68% to $5.2 billion due primarily to significant sales growth in the non-proprietary segment of the Wholesale channel.   Because of the slightly higher management fee rate, the significant growth in Ivy Funds average assets resulted in a larger management fee increase for combined retail mutual funds than the increase to combined retail average assets.  Institutional and separate account revenues increased 1% while related average assets increased 2% over last year’s second quarter.

 

The following tables provide information regarding the composition of our average assets under management by asset class and distribution channel (in millions).

 

 

 

Second Quarter 2005

 

 

 

Advisors
Channel

 

Wholesale Channel

 

 

 

Non-proprietary

 

Institutional

 

Total

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Asset Class:

 

 

 

 

 

 

 

 

 

Equity

 

$

20,252

 

4,762

 

7,606

 

$

32,620

 

Fixed Income

 

3,933

 

313

 

621

 

4,867

 

Money Market

 

670

 

56

 

 

726

 

Total

 

$

24,855

 

5,131

 

8,227

 

$

38,213

 

 

 

 

Second Quarter 2004

 

 

 

Advisors
Channel

 

Wholesale Channel

 

 

 

Non-proprietary

 

Institutional

 

Total

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Asset Class:

 

 

 

 

 

 

 

 

 

Equity

 

$

19,336

 

3,662

 

7,406

 

$

30,404

 

Fixed Income

 

3,884

 

268

 

693

 

4,845

 

Money Market

 

739

 

63

 

 

802

 

Total

 

$

23,959

 

3,993

 

8,099

 

$

36,051

 

 

24



 

Change in Assets Under Management

 

The following tables summarize the changes in our assets under management.  All sales are net of commissions.  The activity includes all Funds (by channel of distribution) including money market funds and net asset value accounts for which we receive no commissions, and institutional business. 

 

 

 

Second Quarter 2005

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Institutional

 

Total

 

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Beginning Assets

 

$

24,921

 

5,022

 

8,242

 

$

38,185

 

 

 

 

 

 

 

 

 

 

 

Sales (net of commissions)

 

560

 

503

 

123

 

1,186

 

Redemptions

 

(824

)

(286

)

(349

)

(1,459

)

Net Sales

 

(264

)

217

 

(226

)

(273

)

 

 

 

 

 

 

 

 

 

 

Net Exchanges

 

(14

)

11

 

0

 

(3

)

Reinvested Dividends & Capital Gains

 

53

 

16

 

30

 

99

 

Net Flows

 

(225

)

244

 

(196

)

(177

)

 

 

 

 

 

 

 

 

 

 

Market Appreciation

 

696

 

101

 

269

 

1,066

 

Ending Assets

 

$

25,392

 

5,367

 

8,315

 

$

39,074

 

 

 

 

Second Quarter 2004

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Institutional

 

Total

 

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Beginning Assets

 

$

24,276

 

4,048

 

8,336

 

$

36,660

 

 

 

 

 

 

 

 

 

 

 

Sales (net of commissions)

 

532

 

280

 

192

 

1,004

 

Redemptions

 

(861

)

(263

)

(531

)

(1,655

)

Net Sales

 

(329

)

17

 

(339

)

(651

)

 

 

 

 

 

 

 

 

 

 

Net Exchanges

 

(12

)

11

 

0

 

(1

)

Reinvested Dividends & Capital Gains

 

38

 

9

 

26

 

73

 

Net Flows

 

(303

)

37

 

(313

)

(579

)

 

 

 

 

 

 

 

 

 

 

Market Appreciation

 

200

 

10

 

67

 

277

 

Ending Assets

 

$

24,173

 

4,095

 

8,090

 

$

36,358

 

 

The second quarter of 2005 yielded overall gross sales of $1.2 billion, comparing favorably to the same period last year.  Overall net flows improved 69% compared to last year’s second quarter.  Subadvised assets under management have grown significantly to $3.3 billion at June 30, 2005 compared to $1.2 billion at June 30, 2004.  During the second quarter of 2005, gross sales of subadvised funds were $414.2 million, representing 39% of total retail mutual fund gross sales and 35% of total gross sales.  Gross mutual fund sales through non-proprietary distribution improved 80% to $503 million.  Net flows of non-proprietary distribution were $244 million positive, resulting in over a 100% increase from last year’s second quarter.  Gross mutual fund sales of the Advisors channel improved 5% to $560 million, while net outflows of the

 

25



 

Advisors channel were reduced by 26% from last year’s second quarter.  Advisor productivity level increased 7% to $188 thousand per advisor in this year’s second quarter.  Productivity levels of veteran advisors (advisors with the company two years or more) increased 12% from last year’s second quarter to $289 thousand per veteran advisor.

 

Redemption rates were lower in this year’s second quarter compared to the same period last year for both distribution channels.  The combined long-term redemption rate, which includes our Funds and institutional and separate accounts but excludes money market fund redemptions, was 13.5% down from 16.4% in last year’s second quarter.

 

Underwriting and Distribution Fee Revenues and Expenses

 

Underwriting and distribution fee revenues were $65.9 million, an increase of $3.6 million, or 6%, due to a higher investment product sales and higher asset-based fees in this year’s second quarter. Underwriting and distribution fee expenses were $73.5 million, an increase of $6.8 million, or 10%, from last year’s second quarter.  Direct underwriting and distribution expenses increased approximately $3.8 million over last year’s second quarter, due primarily to higher commissions and a $0.7 million increase in amortization of deferred selling costs from sales of Class B and Class C shares.  Indirect expenses climbed $3.0 million over last year’s second quarter.  Of the $3.0 million increase to indirect expense, approximately $0.4 million was due to employee severance and restructuring costs in the Advisors channel resulting from changes in leadership made to revitalize sales.  For further discussion on the underwriting and distribution results, refer to the applicable distribution channel discussion below.

 

The following tables illustrate our underwriting and distribution fee revenues and expenses segregated by the method of distribution within the respective Advisors or Wholesale channel:

 

 

 

Second Quarter 2005

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Legend

 

Total

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

49,465

 

5,473

 

10,936

 

$

65,874

 

Expenses

 

 

 

 

 

 

 

 

 

Direct

 

32,910

 

7,890

 

7,398

 

48,198

 

Indirect

 

18,659

 

3,603

 

3,008

 

25,270

 

 

 

51,569

 

11,493

 

10,406

 

73,468

 

Net Underwriting & Distribution

 

$

(2,104

)

(6,020

)

530

 

$

(7,594

)

 

 

 

Second Quarter 2004

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Legend

 

Total

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

48,448

 

3,425

 

10,433

 

$

62,306

 

Expenses

 

 

 

 

 

 

 

 

 

Direct

 

31,498

 

5,855

 

7,045

 

44,398

 

Indirect

 

17,107

 

2,679

 

2,467

 

22,253

 

 

 

48,605

 

8,534

 

9,512

 

66,651

 

Net Underwriting & Distribution

 

$

(157

)

(5,109

)

921

 

$

(4,345

)

 

26



 

Distribution Margin

 

Our consolidated distribution margin declined to -11.5% in this year’s second quarter compared to -7.0% in last year’s comparative period.  The Advisors channel distribution margin, which excludes our non-proprietary distribution efforts and better reflects only the activity of our sales force, decreased to -4.3% in this year’s second quarter compared to -0.3% for last year’s comparative period.   The Advisors channel second quarter distribution margin calculation includes approximately $0.4 million of costs for employee severance and restructuring; excluding those costs the Advisors channel distribution margin would have been
-3.4%.

 

Advisors Channel

 

Underwriting and distribution revenues earned in the Advisors channel in this year’s second quarter increased $1.0 million, or 2%, from the comparative period last year to $49.5 million.  Commissions received from the sale of front-end load products, which include mutual fund Class A shares (those sponsored by the Company and those underwritten by other non-proprietary mutual fund companies), financial plans and various variable annuity products, were $23.1 million, up $1.2 million, or 6%, from last year’s second quarter in direct correlation with front-end load product sales, which were up 5%. Financial planning fee revenue was $0.8 million higher than last year’s second quarter as the number of financial plans sold increased 25%.

 

The following table illustrates commissionable proprietary investment product sales by our financial advisors, including sales of our InvestEd portfolios.  Sales are shown gross of commissions and exclude sales by Legend retirement advisors, money market funds, other non-proprietary mutual funds, insurance products, and mutual funds sold at net asset value for which we receive no commission.

 

 

 

 

 

 

 

Variance

 

 

 

2Q 2005

 

2Q 2004

 

Amount

 

Percentage

 

 

 

(amount in millions, except percentage data)

 

 

 

 

 

 

 

 

 

 

 

Front-end load sales (Class A)

 

$

316

 

295

 

21

 

7

%

Variable annuity products

 

79

 

84

 

(5

)

-6

%

Front-load product total

 

395

 

379

 

16

 

4

%

 

 

 

 

 

 

 

 

 

 

Deferred-load sales (Class B&C)

 

56

 

58

 

(2

)

-3

%

Allocation products

 

6

 

 

6

 

nm

 

Total proprietary sales

 

$

457

 

437

 

20

 

5

%

 

Revenues earned on the sale of insurance products increased slightly to $0.1 million, or 3%, compared with last year’s second quarter.  Asset-based distribution fee revenues earned on Class B and Class C shares were essentially flat with last year’s second quarter, increasing $0.1 million to $3.5 million. Rule 12b-1 asset-based fees earned from assets sold through the Advisors channel increased $0.3 million, or 2%, from last year’s second quarter to $14.3 million.  Asset-based fees earned on our allocation products were down $0.7 million, or 22%, from the second quarter last year corresponding to a 25% decline in average assets in asset allocation products.

 

Underwriting and distribution expenses in the Advisors channel increased $3.0 million, or 6%, to $51.6 million for the second quarter of 2005. Direct expenses were up $1.4 million, or 4%, to $32.9 million primarily due to higher commission expenses.  Front-load commission expenses, excluding commissions paid on financial plan sales, increased $0.4 million, or 4%, while the corresponding sales increased 5%.  Commission expenses from the sale of financial plans, which are considered a front-end load product but are not included in the front-end load sales volume, increased $0.7 million.  Also, commission expenses from insurance sales, which are not considered front-end load investment products, increased $0.1 million, or 3%, directly corresponding to the 3% increase in insurance commission revenues due to slightly higher sales of

 

27



 

these products in this year’s second quarter.  Asset-based Rule 12b-1 service fee commission expenses, which are paid to our financial advisors, increased $0.4 million, or 4%, from last year to $11.0 million.  Commissions paid on our asset allocation products were down $0.3 million, or 25%, due to the decline in average assets in asset allocation products.

 

Indirect expenses of the Advisors channel increased $1.6 million, or 9%, from last year’s second quarter to $18.7 million.  In this year’s second quarter, we incurred approximately $0.4 million in organizational restructuring costs, primarily in the form of employee severance.  Additionally, increased costs for sales program initiatives, marketing and sales brochures, relocation assistance related to leadership changes, and increased compensation and benefit expense associated with the addition of home office financial advisors support personnel led to the overall increase in indirect expenses.  We are in the process of implementing changes to revitalize this distribution channel with a focus on advisor recruiting and providing internal wholesaling resources for our advisors to improve sales levels and advisor productivity.

 

Wholesale Channel

 

Underwriting and distribution revenues and expenses in the Wholesale channel are generated by non-proprietary distribution of our mutual funds through other broker dealers, other registered investment advisors, 401(k) platforms and through distribution of various investment products by Legend retirement advisors.  Revenues earned in the Wholesale channel increased $2.6 million, or 18%, to $16.4 million. Revenues at Legend increased 5%, or $0.5 million, to $10.9 million from last year’s second quarter due to increases in advisory fees and commissions received on sales.  Rule 12b-1 asset-based fees earned from assets sold through non-proprietary distribution increased $0.9 million, or 33%, from last year to $3.5 million.  Asset-based distribution revenue earned from assets sold through non-proprietary distribution increased $0.9 million, or 40%, corresponding to 40% growth in the related Class B and Class C average assets, while commissions received for certain mutual fund sales through non-proprietary distribution that are not load-waived increased $0.5 million to $0.8 million.

 

Underwriting and distribution expenses of the Wholesale channel increased $3.9 million, or 21%, to $21.9 million in the second quarter of 2005. Direct expenses increased $2.4 million, or 19%, to $15.3 million due primarily to increased amortization of Class B and Class C share deferred selling costs and higher wholesaler commission expense.  Amortization of deferred selling costs for Class B and Class C shares increased $0.8 million from last year’s second quarter to $1.5 million in the current period.  Wholesaler commissions on sales of the Ivy Funds through non-proprietary distribution increased $0.6 million as our gross mutual fund sales through this segment of the Wholesale channel increased 80% to $503 million for the second quarter of 2005.  Asset-based Rule 12b-1 service fee commission expenses increased $0.3 million, or 11%, from last year to $3.5 million.  Commissions paid to Legend retirement advisors increased $0.3 million, or 5%.

 

Indirect expenses increased $1.5 million, or 28%, from last year’s second quarter to $6.6 million.  With the addition of several full-time internal and external wholesalers compared to last year’s second quarter and increased headcount at Legend, related compensation expense increased approximately $0.4 million in the Wholesale channel.  An increase in business meetings and travel costs of approximately $0.4 million also contributed to the rise in indirect expenses.

 

Shareholder Service Fee Revenue

 

Shareholder service fee revenues from transfer agency, custodian, and accounting services were $20.3 million, an increase of $1.2 million, or 6%, from the second quarter of 2004.  The average number of shareholder accounts, one of the primary drivers of service fee revenue, also increased 6% to 2.51 million at June 30, 2005 compared with 2.36 million at June 30, 2004.

 

28



 

Compensation and Related Costs

 

In this year’s second quarter, compensation and related costs (excluding equity compensation discussed below), increased by $1.8 million, or 10%, to $19.8 million.  Salaries, wages, and related payroll taxes were up $1.3 million, or 11%.  A charge of $0.5 million related to the resignation of our former CEO also contributed to the increase in the current period.  Average employee headcount increased 5% from last year’s second quarter, primarily in our information technology services department.  Changes in the discount rate and expected return on plan asset assumptions resulted in an increase in pension expense of  $0.3 million from last year’s second quarter.

 

Equity Compensation

 

Equity compensation expense in the second quarter of 2005 was $6.2 million compared to $3.4 million in the second quarter of 2004, an increase of 84%.  The increase is due in part to increased amortization expense of approximately $0.9 million associated with our annual grant of restricted stock on April 2, 2005 discussed below, and in part to $2.2 million in charges related to the resignation of our former CEO - $1.4 million relating to certain stock options for which vesting had previously been accelerated, and the remaining balance taken to reflect a change in the amortization of restricted stock from the straight-line method to a graded vesting method due to the change in employment status.  We expect to continue experiencing increased stock compensation expense from annual restricted stock grants.

 

On April 2, 2005, we granted 1,107,533 shares of restricted stock with a fair market value of $19.75 per share under the Company’s Stock Incentive Plan, as amended and restated (the “SIP”).  These shares vest over four years in one-third increments annually beginning on the second anniversary of the grant date.  Under the SIP, unvested shares of restricted stock may be forfeited upon the termination of employment with the Company, dependent upon the circumstances of termination.  Except for restrictions placed on the transferability of the restricted stock, holders of restricted stock have full stockholders rights during the term of restriction, including voting rights and the rights to receive cash dividends.  Based on the market value of these restricted shares on the grant date, we recorded deferred compensation totaling $21.9 million during the second quarter of 2005.  Deferred compensation is included as a component of stockholders’ equity and is recognized as expense over the four-year vesting period.

 

Subadvisory Fees

 

Subadvisory fees represent fees paid to other asset managers who provide advisory services for certain Ivy mutual fund portfolios obtained in the acquisition of Mackenzie Investment Management, Inc. and certain assets from the strategic alliance with Securian Financial Group, Inc.  In most cases, these other asset managers were subadvising the assets prior to our acquisition and specialize in investment styles not offered by the Company.  Subadvisory fees for the second quarter of 2005 were $4.1 million, an increase of $2.8 million from last year’s second quarter, due to substantial growth in the average assets of certain subadvised funds.  In the second quarter of 2005, approximately 40% of total retail mutual fund gross sales were of funds managed by subadvisors.  Gross management fees earned from these assets are included as part of management fee revenues discussed above.

 

29



 

General and Administrative Costs

 

General and administrative expenses increased by $40.3 million to $49.9 million in the second quarter of 2005.  Of the $40.3 million increase, $38.2 million were charges not typical of ongoing operations of the Company.  As a result of the settlement of outstanding legal matters with Torchmark Corporation for actions in Alabama, California, and Kansas (with the exception of the outstanding tax case between the companies described further in Note 9 “Contingencies” of the Notes to the Unaudited Consolidated Financial Statements) we incurred a charge of $14.5 million.   Additionally, as a result of the settlement of outstanding legal matters with the NASD and a consortium of states relating to variable annuity sales practices, we incurred a charge of $20.5 million.  Also included as a charge in the overall $40.3 million increase to general and administrative expenses was a $3.0 million payment to our former CEO pursuant to his resignation and the entry into an eight year consulting agreement for ongoing managerial and advisory services.  Under this agreement, he will continue to receive $0.4 million per year for rendered services.  We also incurred approximately $0.2 million for legal and consulting fees related to the separation.

 

Excluding the aforementioned charges, general and administrative expenses increased $2.2 million, or 23%, from last year’s second quarter.  Increased costs for space rent, computer services, dealer services, regulatory shareholder filings, and audit and consulting fees aggregated to approximately $1.5 million over last year’s second quarter. We also had non-recurring expenses of $0.4 million related to a change in home office expansion plans.

 

Investment and Other Income, Interest Expense and Taxes

 

Investment and other income decreased $1.0 million from last year’s second quarter to $1.4 million for the second quarter of 2005.  Last year’s second quarter included a realized gain on trading securities of  $1.9 million which resulted from the change in classification for certain mutual fund holdings from available-for-sale to trading.  The change in classification was made to hedge our exposure to market volatility created by our deferred compensation liabilities.  The current period’s realized gain on this portfolio was $0.3 million.  Interest on short-term investments received during the second quarter of 2005 was $0.5 million higher than the comparative period last year due to higher average balances and interest rates.

 

Interest expense increased $1.3 million, or 53%, from last year’s second quarter due to a combination of higher average short-term borrowings and rates, and a $1.0 million decrease in the benefit from the interest rate swap on our senior notes compared to last year’s second quarter.  Higher average borrowings on short-term loans in the current year coupled with higher average interest rates, 3.19% compared to 1.35%, resulted in higher interest of $0.3 million on short-term loans.  The remainder of the increase was attributed to higher interest expense on our 7.5% senior notes between periods as a result of higher variable rates paid on the interest rate swap.  As of June 30, 2005, the floating rate being paid was 5.79% compared to 3.81% as of June 30, 2004.

 

In this year’s second quarter, the effective tax rate was impacted by the non-deductible charges recorded in connection with the settlement of litigation with the NASD and a consortium of states related to variable annuity sales practices.

 

Results of Operations – Six Months Ended June 30, 2005 as Compared with Six Months Ended June 30, 2004

 

Net Income

 

The Company reported net income of $15.7 million, or $0.19 per diluted share, for the first six months of 2005 compared to net income of $53.1 million, or $0.65 per diluted share, in the same period last year.  In this year’s second quarter, we incurred several charges totaling to $41.3 million ($28.8 million net of tax) that are not considered typical ongoing operating expenses of the Company.  Included in the aggregate

 

30



 

charges of $41.3 million were $35.0 million related to settlements of outstanding litigation, and charges aggregating $6.3 million, pre-tax, primarily for costs relating to the separation of employment of our former CEO, and to a significantly lesser extent various other separation and restructuring charges related to leadership changes made in the Advisors channel.  These charges are included as a component of compensation expense, equity compensation expense, underwriting and distribution expense, and general and administrative expenses.  A discussion of the various components of year to date net income follows.

 

Investment Management Fee Revenues

 

Investment management fee revenues were $128.1 million, an increase of $8.6 million, or 7%, from the first six months last year.  Total average assets under management for the year to date were $38.3 billion compared to $36.5 billion for the first six months of 2004, up 5%.

 

Revenues from management services provided to our retail mutual funds, which are distributed both through the Advisors channel and through non-proprietary distribution in the Wholesale channel, increased $8.5 million, or 9%, while the related retail average assets increased 6% to $29.9 billion.  Compared to last year’s first six months, the average assets in the Ivy Funds family grew 63% to $4.9 billion due to significant sales growth in the non-proprietary segment of the Wholesale channel.   The average assets in the Advisors Funds family contracted 2%, due in part to net asset outflows, some of which moved into the Ivy Funds family.  Because of the slightly higher management fee rate, the significant growth in Ivy Funds average assets resulted in a larger management fee increase for combined retail mutual funds than the increase to combined retail average assets.  Institutional and separate account business was flat compared with the first six months of 2004.

 

The following tables provide information regarding the composition of our average assets under management by asset class and distribution channel (in millions).

 

 

 

Year to Date 2005

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Institutional

 

Total

 

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Asset Class:

 

 

 

 

 

 

 

 

 

Equity

 

$

20,303

 

4,622

 

7,737

 

$

32,662

 

Fixed Income

 

3,962

 

318

 

630

 

4,910

 

Money Market

 

682

 

55

 

 

737

 

Total

 

$

24,947

 

4,995

 

8,367

 

$

38,309

 

 

 

 

Year to Date 2004

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Institutional

 

Total

 

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Asset Class:

 

 

 

 

 

 

 

 

 

Equity

 

$

19,518

 

3,657

 

7,579

 

$

30,754

 

Fixed Income

 

3,968

 

273

 

704

 

4,945

 

Money Market

 

767

 

61

 

 

828

 

Total

 

$

24,253

 

3,991

 

8,283

 

$

36,527

 

 

31



 

Change in Assets Under Management

 

The following tables summarize the changes in our assets under management.  All sales are net of commissions.  The activity includes all Funds (by channel of distribution) including money market funds and net asset value accounts for which we receive no commissions, and institutional business. 

 

 

 

Year to Date 2005

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Institutional

 

Total

 

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Beginning Assets

 

$

25,297

 

4,702

 

8,659

 

$

38,658

 

 

 

 

 

 

 

 

 

 

 

Sales (net of commissions)

 

1,142

 

1,114

 

361

 

2,617

 

Redemptions

 

(1,558

)

(588

)

(855

)

(3,001

)

Net Sales

 

(416

)

526

 

(494

)

(384

)

 

 

 

 

 

 

 

 

 

 

Net Exchanges

 

(31

)

25

 

0

 

(6

)

Reinvested Dividends & Capital Gains

 

92

 

17

 

63

 

172

 

Net Flows

 

(355

)

568

 

(431

)

(218

)

 

 

 

 

 

 

 

 

 

 

Market Appreciation

 

450

 

97

 

87

 

634

 

Ending Assets

 

$

25,392

 

5,367

 

8,315

 

$

39,074

 

 

 

 

Year to Date 2004

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Institutional

 

Total

 

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

Beginning Assets

 

$

24,337

 

3,805

 

8,431

 

$

36,573

 

 

 

 

 

 

 

 

 

 

 

Sales (net of commissions)

 

1,169

 

612

 

491

 

2,272

 

Redemptions

 

(1,758

)

(501

)

(964

)

(3,223

)

Net Sales

 

(589

)

111

 

(473

)

(951

)

 

 

 

 

 

 

 

 

 

 

Net Exchanges

 

(62

)

59

 

0

 

(3

)

Reinvested Dividends & Capital Gains

 

76

 

11

 

58

 

145

 

Net Flows

 

(575

)

181

 

(415

)

(809

)

 

 

 

 

 

 

 

 

 

 

Market Appreciation

 

411

 

109

 

74

 

594

 

Ending Assets

 

$

24,173

 

4,095

 

8,090

 

$

36,358

 

 

The first six months of 2005 yielded overall gross sales of $2.6 billion, comparing favorably to the same period last year.  Overall net flows improved 73% compared to last year.  Subadvised assets under management have grown significantly to $3.3 billion at June 30, 2005.  During the first six months of 2005, gross sales of subadvised funds were $978.3 million, representing 43% of total retail mutual fund gross sales and 37% of overall gross sales.  Gross mutual fund sales through both the Advisors channel and the non-proprietary distribution component of the Wholesale channel were $1.1 billion, improving 2% and 82%, respectively, from last year.  While the dollar value of redemptions in the Advisors channel improved from the same period last year, the net flows in the channel remain negative, although showing improvement of

 

32



 

38% compared to last year.   Net flows of non-proprietary distribution were $568 million positive, resulting in over a 200% increase from last year’s first six months.  As the number of advisors decreased 2% from last year, the advisor productivity level was essentially flat at $376 thousand per advisor.

 

The combined long-term redemption rate, which includes our Funds and institutional and separate accounts (but excludes money market fund redemptions), improved to 14.2% down from 15.6% for the first six months of last year.  The long-term redemption rate improved in both the Advisors channel and the Wholesale channel for the first six months of this year, to 10.1% from 11.3% in the Advisors channel and to 21.6% from 23.7% in the Wholesale channel.

 

Underwriting and Distribution Fee Revenues and Expenses

 

Underwriting and distribution fee revenues were $133.2 million for the first six months of 2005, an increase of $4.7 million compared to last year.  The rise in revenue is due to a $5.0 million increase in Rule 12b-1 fee revenue and higher asset-based distribution fees in the non-proprietary segment of the Wholesale channel, partially offset by a 4% reduction in investment product sales volume in the Advisors channel year to date. Underwriting and distribution fee expenses were $147.8 million, an increase of $12.9 million, or 10%, from last year as expenses climbed in both distribution channels.  Direct underwriting and distribution expenses increased approximately $7.3 million, or 8%, over last year due primarily to a $2.9 million true-up adjustment to both Rule 12b-1 revenues and expenses, higher wholesaler commissions, and an increase in amortization of deferred selling costs from sales of Class B and Class C shares.  Indirect expenses increased $5.6 million, or 13%, over last year.  Included in the increase to indirect expense was approximately $0.4 million for employee severance and restructuring costs in the Advisors channel resulting from changes in leadership made to revitalize sales.  For further discussion on the underwriting and distribution results, refer to the applicable distribution channel discussion below.

 

The following table illustrates our underwriting and distribution fee revenues and expenses segregated by the method of distribution within the respective Advisors or Wholesale channel:

 

 

 

Year to Date 2005

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Legend

 

Total

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

101,031

 

10,426

 

21,762

 

$

133,219

 

Expenses

 

 

 

 

 

 

 

 

 

Direct

 

68,096

 

15,447

 

14,452

 

97,995

 

Indirect

 

37,248

 

6,786

 

5,728

 

49,762

 

 

 

105,344

 

22,233

 

20,180

 

147,757

 

Net Underwriting & Distribution

 

$

(4,313

)

(11,807

)

1,582

 

$

(14,538

)

 

33



 

 

 

Year to Date 2004

 

 

 

Advisors

 

Wholesale Channel

 

 

 

 

 

Channel

 

Non-proprietary

 

Legend

 

Total

 

 

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

101,489

 

6,601

 

20,433

 

$

128,523

 

Expenses

 

 

 

 

 

 

 

 

 

Direct

 

66,057

 

10,808

 

13,825

 

90,690

 

Indirect

 

34,063

 

5,274

 

4,797

 

44,134

 

 

 

100,120

 

16,082

 

18,622

 

134,824

 

Net Underwriting & Distribution

 

$

1,369

 

(9,481

)

1,811

 

$

(6,301

)

 

Distribution Margin

 

Our consolidated distribution margin declined to -10.9% in the first six months of 2005 compared to -4.9% in the comparative period last year; this is due to lower sales in the Advisors channel, an increase in direct selling costs of the Wholesale channel, and an increase in indirect selling costs for both distribution channels.  The Advisors channel distribution margin, which excludes our non-proprietary distribution efforts and better reflects only the activity of our sales force, decreased to -4.3% for the period to date compared to 1.3% for last year’s period to date.  Lower sales volume coupled with higher indirect selling costs from legal and regulatory costs, advertising and marketing costs, and costs of restructuring contributed to the decline in margin in the Advisors channel.

 

Advisors Channel

 

Underwriting and distribution revenues earned in the Advisors channel in this year’s first six months decreased $0.5 million to $101.0 million, essentially flat compared to the prior period . Commissions received from the sale of front-end load products, which include mutual fund Class A shares (those sponsored by the Company and those underwritten by other non-proprietary mutual fund companies), financial plans and various variable annuity products, were $46.3 million, down $1.1 million, or 2%, from last year’s first six months.  The decline in front-load revenues was primarily due to 24% lower variable annuity product sales, resulting in a $2.8 million reduction to front-load revenue.  Higher sales of financial plans combined with a higher average per plan fee contributed a $1.5 million increase to front-load product revenue, somewhat offsetting the decline attributed to variable annuity sales.    For the year to date 2005, our financial advisors sold $639 million of our proprietary Class A share mutual funds, down 2% from the same time period last year.

 

34



 

The following table illustrates commissionable proprietary investment product sales by our financial advisors, including sales of our InvestEd portfolios.  Sales are shown gross of commissions and exclude sales by Legend retirement advisors, money market funds, other non-proprietary mutual funds, insurance products, and mutual funds sold at net asset value for which we receive no commission.

 

 

 

 

 

 

 

Variance

 

 

 

YTD 2005

 

YTD 2004

 

Amount

 

Percentage

 

 

 

(amount in millions, except percentage data)

 

 

 

 

 

 

 

 

 

 

 

Front-end load sales (Class A)

 

$

639

 

628

 

11

 

2

%

Variable annuity products

 

158

 

209

 

(51

)

-24

%

Front-load product total

 

797

 

837

 

(40

)

-5

%

 

 

 

 

 

 

 

 

 

 

Deferred-load sales (Class B&C)

 

114

 

128

 

(14

)

-11

%

Allocation products

 

15

 

 

15

 

nm

 

Total proprietary sales

 

926

 

965

 

(39

)

-4

%

 

Offsetting declines in commission revenues, Rule 12b-1 revenues, which are asset-based, were $3.4 million higher than last year’s first six months, largely due to a $2.9 million true-up adjustment to both revenues and expenses, but also due to growth in related assets.  Additionally, revenues earned on the sale of insurance products were down $1.3 million, or 13%, year to date.  Asset-based distribution fee revenue earned on Class B and Class C shares were flat with last year at $7.0 million. Asset-based fees earned on our allocation products were down $1.6 million, or 22%, from last year corresponding to a 23% decline in average assets in asset allocation products.

 

Underwriting and distribution expenses in the Advisors channel increased $5.2 million, or 5%, to $105.3 million for the first six months of 2005. Direct expenses were up $2.0 million, or 3%, to $68.1 million primarily due to a $2.9 million adjustment to both revenues and expenses in addition to an increase in Rule 12b-1 asset-based service fee commission expenses of approximately $0.7 million, offset by lower selling commission expenses.  Front-load commission expenses, excluding commissions paid on financial plan sales, declined $1.4 million, or 6%, while the corresponding sales decreased 4%.  Commission expenses from the sale of financial plans, which are considered a front-end load product but are not included in the front-end load sales volume, increased $1.5 million, slightly offsetting the overall decline in commission expense.  Commission expenses from insurance sales, which are not considered front-end load investment products, declined $0.9 million, or 15%, corresponding to the 13% decline in insurance commission revenues due to lower sales of these products primarily in this year’s first quarter.

 

Indirect expenses of the Advisors channel increased $3.2 million, or 9%, from last year’s first six months to $37.2 million.  In this year’s second quarter, we incurred approximately $0.4 million in organizational restructuring costs, primarily in the form of employee severance.  Legal and regulatory expenses associated with the Advisors channel increased $0.5 million over last year.  Lower costs for field office rent were offset by increased costs for sales program initiatives, marketing and sales brochures, production costs for an upcoming television campaign, relocation assistance related to leadership changes, and increased compensation and benefits expense associated with the addition of home office financial advisors support personnel.  We are in the process of implementing changes to revitalize this distribution channel with a focus on advisor recruiting and providing internal wholesaling resources for our advisors to improve sales levels and advisor productivity.

 

Wholesale Channel

 

Underwriting and distribution revenues and expenses in the Wholesale channel are generated by non-proprietary distribution of our mutual funds through other broker dealers, other registered investment advisors, 401(k) platforms and through distribution of various investment products by Legend retirement advisors.

 

35



 

Revenues earned in the Wholesale channel increased $5.2 million, or 19%, to $32.2 million. Revenues received from Rule 12b-1 fees collected from certain of our mutual funds increased $1.6 million due to growth in the related average assets.  Revenues at Legend increased $1.3 million from last year’s first six months to $21.8 million due to increases in advisory fees, sales commissions, and asset-based service and distribution fees.  In the current year, commissions received for certain mutual fund sales through non-proprietary distribution increased $1.0 million, to $1.5 million.  Asset-based distribution revenue increased $1.6 million, or 33%, corresponding to the 35% growth in the related Class B and Class C average assets.

 

Underwriting and distribution expenses of the Wholesale channel increased $7.7 million, or 22%, to $42.4 million for the first six months of 2005.  Direct expenses increased $5.3 million, or 21%, to $29.9 million due primarily to increased wholesaler commission expenses, increased amortization of Class B and Class C share deferred selling costs, and higher commission expenses associated with Rule 12b-1 service fees.  Wholesaler commissions on sales of the Ivy Funds through non-proprietary distribution increased $1.4 million as our gross mutual fund sales through this segment of the Wholesale channel increased 82% to $1.1 billion for the first six months of 2005.  Amortization of deferred selling costs resulting from sales of Class B and Class C shares increased $1.5 million from last year to $2.7 million in the current period.  Rule 12b-1 commission expenses increased $0.9 million to $6.7 million in the current period. Commissions paid to Legend retirement advisors increased $0.6 million, or 4%.

 

Indirect expenses increased $2.4 million, or 24%, from last year’s first six months to $12.5 million; $1.5 million due to increased costs of the non-proprietary sales channel and $0.9 million due to increased costs at Legend.   With the addition of several full-time internal and external wholesalers and increased headcount at Legend for the first half of this year, related compensation and benefits expense increased approximately $0.5 million at Legend and $0.8 million in the non-proprietary segment of the Wholesale channel.  A decline in costs for computer software and software maintenance and licensing were offset by increased costs for business meetings and travel and advertising in the first six months of this year.

 

Shareholder Service Fee Revenue

 

Shareholder service fee revenues from transfer agency, custodian, and accounting services were $40.1 million, an increase of $2.1 million, or 5%, from the first six months of 2004.  The average number of shareholder accounts, one of the primary drivers of service fee revenue, increased 5% to 2.48 million at June 30, 2005 compared with 2.36 million at June 30, 2004.

 

Compensation and Related Costs

 

In the first six months of 2005, compensation and related costs (excluding equity compensation discussed below), increased by $3.3 million, or 9%, to $39.6 million.  Salaries, wages, and related payroll taxes were up $2.7 million, or 11%.  A charge of $0.5 million related to the resignation of our former CEO also contributed to the current year increase.  Average employee headcount increased 6% from last year, primarily in our information technology services department, but also at Legend in the area of client service support.  Changes in the discount rate and expected return on plan asset assumptions resulted in an increase in pension expense of  $0.4 million from last year.

 

Equity Compensation

 

Equity compensation expense in the first six months of 2005 was $9.0 million compared to $4.6 million last year, an increase of $4.4 million or 95%.  The increase is due to increased amortization expense of approximately $0.9 million associated with this year’s annual grant of restricted stock on April 2, 2005 discussed below and approximately $1.5 million for amortization expense for the annual grant on April 2, 2004 that was incurred during the first three months of 2005.  Additionally, we incurred $2.2 million in charges related to the resignation of our former CEO - $1.4 million relating to certain stock options for

 

36



 

which vesting had previously been accelerated, and the remaining balance taken to reflect a change in the amortization of restricted stock from the straight-line method to a graded vesting method due to the change in employment status.  We expect to continue experiencing increased stock compensation expense from annual restricted stock grants.

 

On April 2, 2005, we granted 1,107,533 shares of restricted stock with a fair market value of $19.75 per share under the Company’s Stock Incentive Plan, as amended and restated (the “SIP”).  These shares vest over four years in one-third increments annually beginning on the second anniversary of the grant date.  Under the SIP, unvested shares of restricted stock may be forfeited upon the termination of employment with the Company, dependent upon the circumstances of termination.  Except for restrictions placed on the transferability of the restricted stock, holders of restricted stock have full stockholders rights during the term of restriction, including voting rights and the rights to receive cash dividends.  Based on the market value of these restricted shares on the grant date, we recorded deferred compensation totaling $21.9 million during the second quarter of 2005.  Deferred compensation is included as a component of stockholders’ equity and is recognized as expense over the four-year vesting period.

 

Subadvisory Fees

 

Subadvisory fees represent fees paid to other asset managers who provide advisory services for certain Ivy mutual fund portfolios obtained in the acquisition of Mackenzie Investment Management, Inc. and certain assets from the strategic alliance with Securian Financial Group, Inc.  In most cases, these other asset managers were subadvising the assets prior to our acquisition and specialize in investment styles not offered by the Company.  Subadvisory fees for the first six months of 2005 were $7.7 million, an increase of $5.2 million from last year, due to substantial growth in the average assets of certain subadvised funds.  In the first six months of 2005, approximately 43% of total retail mutual fund gross sales were of funds managed by subadvisors.  Gross management fees earned from these assets are included as part of management fee revenues discussed above.

 

General and Administrative Costs

 

General and administrative expenses increased by $41.1 million to $60.1 million for the first six months of 2005.  Of the $41.1 million increase, $38.2 million were charges not typical of ongoing operations of the Company.  As a result of the settlement of outstanding legal matters with Torchmark Corporation for actions in Alabama, California, and Kansas (with the exception of the outstanding tax case between the companies described further in Note 9 “Contingencies” of the Notes to the Unaudited Consolidated Financial Statements) we incurred a charge of $14.5 million.   Additionally, as a result of the settlement of outstanding legal matters with the NASD and a consortium of states relating to variable annuity sales practices, we incurred a charge of $20.5 million.  Also included as a charge in the overall $41.1 million increase to general and administrative expenses was a $3.0 million payment to our former CEO pursuant to his resignation and the entry into an eight year consulting agreement for ongoing managerial and advisory services.  Under this agreement, he will continue to receive $0.4 million per year for rendered services.  We also incurred approximately $0.2 million in legal and consulting fees related to the separation.

 

Excluding the aforementioned charges, general and administrative expenses increased $2.9 million, or 15%, from the first six months of last year.  Lower expenses for contracted business services and employment agencies did not offset increased costs aggregating to $2.7 million for space rent, computer services, dealer services, regulatory shareholder filings, audit, consulting, and legal fees.   We also had non-recurring expenses of $0.4 million related to a change in home office expansion plans.

 

37



 

Investment and Other Income, Interest Expense and Taxes

 

Investment and other income decreased $0.3 million, or 9%, to $2.8 million from last year.  Last year’s comparative six month period included a realized gain on trading securities of  $1.9 million which resulted from the change in classification for certain mutual fund holdings from available-for-sale to trading.  The change in classification was made to hedge our exposure to market volatility created by our deferred compensation liabilities.  In the current period, we had a $1.0 million gain on the sale of available-for-sale securities and increased interest earned on short-term investments of $0.7 million due to higher average balances and rates.   In the current period, we also earned interest of $0.6 million from a cash appeal bond deposit that was returned to us on June 8, 2005 as part of resolution of outstanding legal matters with Torchmark Corporation.

 

Interest expense increased $2.2 million, or 47%, from last year due to a combination of higher average short-term borrowings and rates, and a decrease in the benefit from the interest rate swap on our senior notes compared to the first six months last year.  Higher average short-term borrowings in the current year coupled with higher average interest rates, 2.94% compared to 1.33%, resulted in higher interest of $0.4 million on short-term loans.  The remainder of the increase was attributed to higher interest expense of $1.8 million on our 7.5% senior notes between periods as a result of higher variable rates paid on the interest rate swap.  As of June 30, 2005, the floating rate being paid was 5.79% compared to 3.81% as of June 30, 2004.

 

Our effective income tax rate for the first six months of 2005 was 44.8% compared to 35.9% last year.    The higher effective tax rate in the current year reflects the impact of non-deductible charges recorded in connection with the settlement of litigation with the NASD and consortium of states related to variable annuity sales practices.  We expect our normalized effective income tax rate to be in the range of 36.5% to 36.7%.

 

Liquidity and Capital Resources

 

Our primary source of liquidity is cash provided by operations.  Cash and cash equivalents were $118.5 million at June 30, 2005, an increase of $34.6 million from December 31, 2004.  Cash and cash equivalents include reserves of $17.4 million and $22.6 million for the benefit of customers in compliance with securities regulations at June 30, 2005 and December 31, 2004, respectively.  Cash and cash equivalents, investment securities and current receivables decreased to $236.0 million at June 30, 2005 from $272.6 million at December 31, 2004.

 

A $36.0 million standby letter of credit was issued by a bank on our behalf in connection with a court appeal bond posted with the Supreme Court of the State of New York (the “NY Supreme Court”) in the amount of $28.7 million related to an award against us in the Sawtelle arbitration case. As of June 30, 2005, we had pledged a portion of our investment securities with a combined market value of $15.9 million and a portion of our cash and cash equivalents (in the form of commercial paper) with a combined market value of $26.4 million as collateral for performance of our obligations to the bank under the letter of credit.  On July 21, 2005, as ordered by the NY Supreme Court on January 28, 2004 due to the award being reversed and vacated, the issuer of the appeal bond released the bank of its obligation under the letter of credit agreement.  As such, the pledged securities have been released from their restriction effective July 21, 2005. Refer to Note 9 “Contingencies” for more information regarding the release of the appeal bond.

 

Cash flow provided by operations was $18.9 million, a decline of $21.8 million from June 30, 2004.  This decline was attributable to litigation payments of $21.5 million related to settlements reached with the NASD and Torchmark described in Note 9 “Contingencies” in the Notes to the Unaudited Consolidated Financial Statements.

 

38



 

Cash flow provided by investing activities was $67.7 million during the first six months of 2005, an increase of $64.0 million from last year.  In the second quarter of this year, a cash appeal bond of $56.3 million plus accrued interest of $1.1 million was returned to us as part of the resolution of outstanding legal matters with Torchmark Corporation.  Also, proceeds from sales and maturities of available-for-sale investment securities in the amount of $14.6 million were partially offset by approximately $4.3 million in capital expenditures mainly for data processing equipment and software development.  Cash flow provided by investing activities during the first six months of 2004 was $3.7 million.  Last year, we purchased investment securities in the amount of $1.1 million and made capital expenditures in the amount of $3.9 million.  Offsetting these uses of cash was the maturity of investment securities in the amount of $8.7 million.

 

Cash flow used in financing activities during the first six months of 2005 was $52.1 million, an increase of $11.8 million from the same period last year.  The use of cash consisted of dividends paid in the amount of $25.0 million, repayments of short-term borrowings of $21.0 million, and repurchases of our common stock in the amount of $6.0 million.  Cash flows used in financing activities during the first six months of 2004 were $40.3 million, which consisted primarily of repurchases of our common stock in the amount of $21.8 million and dividends paid in the amount of $24.7 million.  These amounts were partially offset by short-term borrowings of $2.0 million and cash received from the exercise of employee stock options of $4.1 million.

 

We have a 364-day revolving credit facility with various lenders for a total of $200.0 million, whereby the lenders could, at their option upon our request, expand the facility to $300.0 million.  At June 30, 2005, there was no balance outstanding under the facility.

 

Future Capital Requirements

 

We expect significant uses of cash in 2005 to include expected dividend payments, interest payments on outstanding debt, share repurchases and potential acquisitions. Management believes its available cash, marketable securities, and expected cash flow from operations will be sufficient to fund its operating and capital requirements for 2005.  We may continue to repurchase shares of our common stock from time to time, as management deems appropriate. Share repurchases should be financed by our available cash and investments and/or cash from operations.

 

The Company is exploring alternatives for the refinancing of its $200 million in senior notes due January 18, 2006. While the Company believes that it should be able to refinance these notes on acceptable terms prior to their maturity, there can be no assurance that it will be able to do so.

 

Long-term capital requirements include capital expenditures primarily for enhancement of technology infrastructure, strategic acquisitions, payment of dividends, repayment and servicing of the Company’s debt obligations and repurchases of the Company’s stock.

 

39



 

Supplemental Information

 

 

 

2Q 2005

 

2Q 2004

 

Change

 

YTD 2005

 

YTD 2004

 

Change

 

Redemption rates - long term

 

 

 

 

 

 

 

 

 

 

 

 

 

Advisors Channel

 

10.6

%

11.4

%

 

 

10.1

%

11.3

%

 

 

Wholesale Channel

 

18.8

%

26.1

%

 

 

21.6

%

23.7

%

 

 

Non-proprietary

 

21.8

%

25.6

%

 

 

23.2

%

24.4

%

 

 

Institutional

 

17.0

%

26.4

%

 

 

20.6

%

23.4

%

 

 

Total

 

13.5

%

16.4

%

 

 

14.2

%

15.6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales per advisor (000’s) (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

188

 

176

 

6.8

%

376

 

378

 

-0.5

%

2+ Years (2)

 

289

 

259

 

11.6

%

575

 

568

 

1.2

%

0 to 2 Years (3)

 

49

 

50

 

-2.0

%

100

 

111

 

-9.9

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross production per advisor

 

13.4

 

13.0

 

3.1

%

26.3

 

27.3

 

-3.7

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Number of financial advisors (1)

 

2,422

 

2,460

 

-1.5

%

2,422

 

2,460

 

-1.5

%

Average number of financial advisors (1)

 

2,434

 

2,479

 

-1.8

%

2,459

 

2,552

 

-3.6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Number of shareholder accounts (000’s)

 

2,530

 

2,373

 

6.6

%

2,530

 

2,373

 

6.6

%

 


(1) Excludes Legend retirement advisors

(2) Financial advisors licensed with the Company for two or more years

(3) Financial advisors licensed with the Company less than two years

 

Forward Looking Information

 

From time-to-time, information or statements provided by or on behalf of the Company, including those within this Quarterly Report on Form 10-Q may contain certain “forward-looking information,” including information relating to anticipated growth in our revenues or earnings, anticipated changes in the amount and composition of assets under management, our anticipated expense levels, and our expectations regarding financial markets and other conditions.  Readers are cautioned that any forward-looking information provided by or on behalf of the Company is not a guarantee of future performance.  Actual results may differ materially from those contained in these forward-looking statements as a result of various factors, including but not limited to those discussed below.  Further, such forward-looking statements speak only as of the date on which such statements are made, and the Company undertakes no obligation to update or revise any forward-looking statement to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events, whether as a result of new information, future developments or otherwise.

 

Our future revenues will fluctuate due to many factors, such as the total value and composition of assets under our management and related cash inflows or outflows in the Funds and other investment portfolios; fluctuations in national and worldwide financial markets resulting in appreciation or depreciation of assets under our management; the relative investment performance of the Funds and other investment portfolios as compared to competing offerings; the expense ratios of the Funds; investor sentiment and investor confidence; the ability to maintain our investment management and administrative fees at appropriate levels; competitive conditions in the mutual fund, asset management, and broader financial services sectors; our introduction of new mutual funds and investment portfolios; our ability to contract with the Funds for

 

40



 

payment for investment advisory-related administrative services provided to the Funds and their shareholders; the continuation of trends in the retirement plan marketplace favoring defined contribution plans and participant-directed investments; potential misuse of client funds and information in the possession of our financial advisors; and the development of additional distribution channels may not be successful.  Our revenues are substantially dependent on fees earned under contracts with the Funds and could be adversely affected if the independent directors of one or more of the Funds determined to terminate or significantly alter the terms of the investment management or related administrative services agreements.

 

Our future operating results are also dependent upon the level of our operating expenses, which are subject to fluctuation for the following or other reasons: variations in the level of compensation expense due to, among other things, performance-based bonuses, changes in our employee count and mix, and competitive factors; unanticipated costs that may be incurred to protect investor accounts and the goodwill of our clients; legal expenses; and disruptions of services, including those provided by third parties such as communications, power, and the mutual fund transfer agent system.  In addition, our future operating results may also be impacted by our ability to incur additional debt, by adverse litigation and/or arbitration judgments or settlements, failure to retain key personnel and financial advisors, regulatory enforcement actions or settlements and acts of terrorism and/or war.  The Company’s business is also subject to substantial governmental regulation, and changes in legal, regulatory, accounting, tax, and compliance requirements may have a substantial effect on our operations and results, including but not limited to effects on costs we incur and effects on investor interest in mutual funds and investing in general or in particular classes of mutual funds or other investments.

 

Item 3.                                   Quantitative and Qualitative Disclosures About Market Risk

 

The Company has had no significant changes in its Quantitative and Qualitative Disclosures About Market Risk from that previously reported in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

 

Item 4.                                   Controls and Procedures

 

The Company maintains a system of disclosure controls and procedures that are designed to provide reasonable assurance that information, which is required to be timely disclosed, is accumulated and communicated to management in a timely fashion.  A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.  The Company’s Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this quarterly report, have concluded that the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure and are effective to provide reasonable assurance that such information is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

 

The Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) is designed to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.  However, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected.

 

41



 

Separately, during the period covered by this report, the Company transitioned its corporate payroll system to a system administered by a third party provider.  Implementation of the new payroll system required modifications to our internal control procedures that the Company believes are immaterial and did not materially affect, and are not reasonably likely to materially affect, the Company’s internal control over financial reporting.  This system was subjected to internal transitional testing during and subsequent to the period covered by this report to ensure that payroll data and information required to be disclosed by the Company in its reports filed under the Exchange Act are recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations.

 

Part II.  Other Information

 

Item 1.                                   Legal Proceedings

 

See the Notes to the Unaudited Consolidated Financial Statements, Note 9 “Contingencies” beginning on page 17 of this Quarterly Report on Form 10-Q regarding the status of the UILIC/Torchmark Corporation litigation, Sawtelle Arbitration, NASD Enforcement Action, State Variable Annuity settlements, Williams excessive fee litigation, and SEC/New York Attorney General investigation. Information required by this Item 1 is incorporated herein by reference to the disclosure contained in Note 9 of the Notes to the Unaudited Consolidated Financial Statements.

 

Item 2.                                   Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

The following table sets forth certain information about the shares of Class A common stock we repurchased during the second quarter of 2005.

 

Period

 

Total Number of
Shares
Purchased (1) (2)

 

Average
Price Paid
Per Share

 

Total Number of
Shares Purchased as
Part of Publicly
Announced Program

 

Maximum Number (or
Approximate Dollar
Value) of Shares that
May Yet Be Purchased
Under the Program

 

 

 

 

 

 

 

 

 

 

 

April 1 - April 30

 

 

 

 

n/a

(1)

May 1 - May 31

 

 

 

 

n/a

(1)

June 1 - June 30

 

8,956

 

21.62

 

8,956

 

n/a

(1)

 

 

 

 

 

 

 

 

 

 

Total

 

8,956

 

21.62

 

8,956

 

 

 

 


(1)          On August 31, 1998, we announced that our Board of Directors had approved a program to repurchase shares of our Class A common stock.  Under the repurchase program, we are authorized to repurchase, in any seven-day period, the greater of (i) 3% of our outstanding Class A common stock, or (ii) $50 million of our Class A common stock.  Our stock repurchase program does not have an expiration date or an aggregate maximum number or dollar value of shares that may be repurchased.  During this first quarter of 2005, all stock repurchases were made pursuant to this repurchase program.

(2)          All share repurchases in the second quarter of 2005 were made in connection with funding employee income tax withholding obligations arising from the vesting of restricted shares.

 

42



 

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

 

(a)

 

Annual Meeting of Stockholders held on April 27, 2005.

 

 

 

(b)

 

Directors re-elected to additional three year terms at the Annual Meeting:

 

 

 

 

 

Alan W. Kosloff, Keith A. Tucker (who subsequently resigned effective May 25, 2005), and Jerry W. Walton

 

 

 

 

 

Other Directors whose terms of office continued after the Annual Meeting:

 

 

 

 

 

Henry J. Herrmann, Dennis E. Logue, James M. Raines, Ronald C. Reimer, and William J. Rogers

 

 

 

(c) (1)

 

Election of Directors

 

For

 

Withheld

 

 

 

 

 

 

 

 

 

 

 

Alan W. Kosloff

 

70,468,035

 

2,907,283

 

 

 

 

 

 

 

 

 

 

 

Keith A. Tucker

 

71,483,160

 

1,892,158

 

 

 

 

 

 

 

 

 

 

 

Jerry W. Walton

 

72,639,377

 

735,941

 

 

 

 

 

 

 

 

 

 

 

No broker non-votes on this proposal.

 

 

 

 

 

 

Item 6.                                   Exhibits and Reports on Form 8-K

 

(a)                                                          Exhibits:

 

3.1                                 Waddell & Reed Financial, Inc. Bylaws, as Amended and Restated.  Filed as Exhibit 3.1 to the Company’s Current Report on Form 8-K dated May 26, 2005 and incorporated herein by reference.

 

10.1                           Consulting Agreement dated May 25, 2005 by and between Waddell & Reed Financial, Inc. and Keith A. Tucker. Filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K dated May 26, 2005 and incorporated herein by reference.

 

10.2                           Mutual Release dated May 25, 2005 by and between Waddell & Reed Financial, Inc. and Keith A. Tucker. Filed as Exhibit 10.2 to the Company’s Current Report on Form 8-K dated May 26, 2005 and incorporated herein by reference.

 

31.1                           Section 302 Certification of Chief Executive Officer

 

31.2                           Section 302 Certification of Chief Financial Officer

 

32.1                           Section 906 Certification of Chief Executive Officer

 

32.2                           Section 906 Certification of Chief Financial Officer

 

43



 

(b)                                                         Reports on Form 8-K:

 

Current Report on Form 8-K Items 2.02 and 9.01 dated April 26, 2005. Furnished not filed.  No financial statements were required to be filed.

 

Current Report on Form 8-K Items 8.01and 9.01 dated April 29, 2005. Furnished not filed.  No financial statements were required to be filed.

 

Current Report on Form 8-K Items 1.01, 1.02, 5.02, 5.03, 8.01, and 9.01 dated May 26, 2005.  No financial statements were  required to be filed.

 

Current Report on Form 8-K Items 5.02, 8.01 and 9.01 dated June 23, 2005. No financial statements were required to be filed.

 

44



 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, this 27th day of July 2005.

 

 

 

 

WADDELL & REED FINANCIAL, INC.

 

 

 

 

 

 

By:

/s/ Henry J. Herrmann

 

 

 

 

Chief Executive Officer

 

 

 

(Principal Executive Officer)

 

 

 

 

 

 

 

 

 

 

By:

/s/ Daniel P. Connealy

 

 

 

 

Senior Vice President and

 

 

 

Chief Financial Officer

 

 

 

(Principal Financial Officer)

 

 

 

 

 

 

 

 

 

 

By:

/s/ Mark A. Schieber

 

 

 

 

Vice President and

 

 

 

Controller

 

 

 

(Principal Accounting Officer)

 

45