Item 1. BUSINESS
General
Morgan Keegan, Inc. (Registrant) is a holding company whose principal subsidiary, Morgan Keegan & Company, Inc. (M.K. & Co.) is a regional securities broker/dealer serving retail customers in the southeastern United States and institutional clients throughout the United States and abroad. The Registrant has very few operations and substantially all of the Registrant's consolidated revenues are generated through the broker/dealer subsidiary. The subsidiary is a trader, broker and underwriter of fixed income and equity securities and provides related financial services in support of its broker/dealer activities. Products offered by M.K. & Co. include stocks; corporate and tax-exempt bonds; U.S. Government, agency and guaranteed securities; tax advantaged investments; options; investment and advisory services; a money market fund; and a regional mutual fund managed by Morgan Asset Management, Inc., a subsidiary of the Registrant. M.K. & Co. also produces capital raising services for corporate and government clients, margin credit for individual customers, research, and economic and business analysis of financial and stock market data for its customers. The percentage (%) of total revenues derived from the various business areas is as follows:
M.K. & Co. is a three seat member of the New York Stock Exchange, Inc. ("NYSE"), owns seats on the American Stock Exchange, Inc. ("AMEX"); the New York Financial Futures Exchange, Inc. ("NYFE"); the Philadelphia Stock Exchange, Inc. ("PHLX"); the Chicago Board of Options Exchange, Inc. ("CBOE") and the Chicago Stock Exchange ("CSE"). Certain seats are leased to third parties under agreements which may be canceled by either party on 30 days' notice. M.K. & Co. is a member of the National Association of Securities Dealers ("NASD"), the Securities Industry Association, and the Securities Investor Protection Corporation ("SIPC"). SIPC provides protection for customers up to $500,000 each, with a limitation of $100,000 for claims for cash balances.
M.K. & Co. has thirty-nine offices in twelve states. The following Table reflects the number of account executives in each office as of July 31, 1998:
TOTAL 662
Revenues by Source
The following table sets forth the Registrant's consolidated revenues indicated in dollars and as a percentage of total revenues for the periods:
Because of the interdependence of various activities and departments of the Registrant's business, and the arbitrary assumptions involved in allocating overhead, including administrative, communications and securities processing expenses, it is not possible to state the percentage contribution to net income of each aspect of the Registrant's operations.
Institutional Business
During the three years ended July 31, 1998, approximately 24% of the Registrant's total consolidated revenues were derived from institutional clients. M.K. & Co.'s institutional clients include mutual funds, commercial banks, thrift institutions, insurance companies, pension funds and private money managers. Most of these clients are located in the United States; however, some are located abroad, principally in the United Kingdom and Canada. In the fiscal year ended July 31, 1998, no single institutional client accounted for more than 2% of the Registrant's total revenues. M.K. & Co.'s institutional clients purchase or sell fixed income and equity securities primarily in large dollar amounts; transactions in these securities are usually executed for these clients on a principal basis. See PRINCIPAL TRANSACTIONS. M.K. & Co. also provides other services, including research, to its institutional clients.
For the fiscal years ended July 31, 1998, 1997, and 1996, institutional revenues and percentages of total consolidated revenues were $100,284,000 (25%), $76,135,000 (23%), and $73,468,000 (24%), respectively.
Retail Business
During each of the three years ended July 31, approximately 43% of the Registrant's total revenues were derived from transactions with retail (individual) customers. For the fiscal years ended July 31, 1998, 1997, and 1996, revenues and percentages of total consolidated revenues were $166,313,000(41%), $137,112,000 (42%), $134,807,000 (45%), respectively.
Retail commissions are charged on both exchange and over-the-counter transactions in accordance with a schedule which M.K. & Co. has formulated. In certain cases, discounts from the schedule are granted to retail customers, generally on large trades or to active customers. In addition to acting as a broker/dealer for its retail customers, M.K. & Co. supplies them with equity and fixed income research, conducts seminars and makes available personal financial planning services.
Transactions in securities may be executed on either a cash or margin basis. As a service to its retail customers, M.K. & Co. provides margin accounts which allow the customer to pay less than the full cost of a security purchased, the balance of the purchase price being provided by M.K. & Co. as a loan secured by the securities purchased. The amount of the loan is subject to the margin requirements (Regulation T) of the Board of Governors of the Federal Reserve System, NYSE margin requirements, and M.K. & Co. internal policies, which in some instances are more stringent than Regulation T or exchange requirements. In permitting customers to purchase securities on margin, M.K. & Co. bears the risk of a market decline which could reduce the value of its collateral below the customers' indebtedness. Interest charged on customer margin accounts represented approximately 7% of total revenues in fiscal 1998.
Principal Transactions
M.K. & Co. trades for its own account in corporate and tax-exempt Securities and U.S. government, agency and guaranteed securities. Most of these transactions are entered into in order to facilitate the execution of customers' orders to buy or sell these securities. In addition, it trades certain equity securities in order to "make a market" in these securities. As of July 31, 1998, the Registrant made a market in common stock or other equity securities of approximately 191 corporations, many of which are stocks followed by its research department.
M.K. & Co.'s trading activities require the commitment of capital. All principal transactions place the Registrant's capital at risk. Profits and losses are dependent upon the skills of employees and market fluctuations. In some cases, in order to hedge the risks of carrying inventory, M.K. & Co. enters into transactions for U.S. Treasury note futures. The following table sets forth for the year ended July 31, 1998, the highest, lowest and average month-end inventories (including the aggregate of both long and short positions) for the types of securities in which M.K. & Co. acts as principal:
The following table sets forth the composition of revenues from principal transactions:
M.K. & Co. participates in selling groups organized to distribute new issues of securities of the Federal Home Loan Bank, the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, the Federal Farm Credit Bank and the Student Loan Mortgage Association. The following table sets forth selling group participation of M.K. & Co. in distributions of agency securities:
Repurchase Transactions
M.K. & Co. engages in repurchase transactions primarily to facilitate the sale of U.S. government, agency and guaranteed securities. A repurchase transaction is the sale of a security coupled with an agreement by the seller to repurchase the security at the sale price. A reverse repurchase transaction is the purchase of the security with an agreement to resell it. M.K. & Co.'s repurchase transactions are generally matched in order to minimize the risk of loss due to fluctuation in the underlying securities prices. In a matched repurchase transaction, M.K. & Co. will simultaneously engage in a repurchase transaction and a reverse repurchase transaction covering the same security. The other party to a matched repurchase agreement looks to M.K. & Co. for delivery of the securities or repurchase of the securities, as the case may be. M.K. & Co. takes a risk that it will be obligated to perform whether or not the other party performs. M.K. & Co. attempts to minimize this risk by dealing with those deemed credit worthy.
Although repurchase transactions are structured as sales, courts recently have treated them as financing transactions, that is, loans collateralized by securities. Because of this uncertain nature of the transaction, it is M.K. & Co.'s practice to take steps to perfect a security interest in the securities to protect itself if a transaction were deemed a loan. In repurchase transactions M.K. & Co. bears the risk that the other party to the transaction will fail to perform its obligation to repurchase the securities (repay the loan) or to deliver the securities purchased (return the collateral). In such event, M.K. & Co. could incur a loss equal to the difference between the price to be paid for the securities and their market value at the repurchase date. If the transaction is deemed to be a loan and should M.K. & Co. fail to take possession of the securities acquired by it in such a transaction, or otherwise fail to perfect a security interest in them, the loss could be equal to the full repurchase price.
Concentrations of Credit Risk
As a securities broker/dealer, M.K. & Co. is engaged in various Securities trading and brokerage activities servicing a diverse group of domestic and foreign corporations, governments, institutional and retail (individual) investors. A substantial portion of M.K. & Co.'s transactions are collateralized and are executed with and on behalf of institutional investors including other broker/dealers, commercial banks, insurance companies, pension plans, mutual funds and other financial institutions. M.K. & Co.'s exposure to credit risk associated with the non-performance of these customers in fulfilling their contractual obligations pursuant to securities and commodities transactions, can be directly impacted by volatile trading markets which may impair the customers' ability to perform. M.K. & Co.'s principal activities are also subject to the risk of the counterpart's non-performance.
In connection with these activities, particularly in U.S. government and agency securities, M.K. & Co. enters into collateralized reverse repurchase and repurchase agreements, securities lending arrangements and certain other secured transactions which may result in significant credit exposure in the event the counterparty to the transaction was unable to fulfill their contractual obligations. In accordance with industry practice, repurchase agreements and securities borrowing arrangements are generally collateralized by cash or securities with a market value in excess of the obligation under the contract. M.K. & Co. attempts to minimize credit risk associated with these activities by monitoring customer credit exposure and collateral values on a daily basis and requiring additional collateral to be deposited when necessary. M.K. & Co. participates in the trading of some derivative securities for its customers which is not a major portion of its business.
Investment Banking
M.K. & Co. participates in corporate and tax-exempt securities distributions as a member of an underwriting syndicate or a member of a selling group. Tax-exempt securities are obligations issued by state and municipal governments, hospitals, public utility systems and industrial development authorities. M.K.& Co.'s underwriting activities, together with its selling group participation, are important as a source of securities for sale to its customers. The following table sets forth corporate and tax-exempt underwriting syndicate participation of the subsidiary:
Participation in an underwriting syndicate or a selling group involves both economic and regulatory risks. A participant may incur losses if it is unable to resell the securities it has committed to purchase, or if it is forced to liquidate its commitment at less than the agreed purchase price. In addition, under federal securities laws, other statutes and court decisions, a participant may be subject to substantial liability for material misstatements or omissions in prospectuses and other communications with respect to such offerings. Further, underwriting commitments involve a charge against net capital and the ability to make underwriting commitments may be limited by the requirement that it must at all times be in compliance with the net capital rule. See Note 10 - Regulatory Requirements - on page 36 of the 1998 Annual Report to Shareholders.
In addition to its underwriting and selling group activities, M.K. & Co. engages in structuring, managing and marketing private offerings of corporate and tax-exempt securities, and assists in arranging mergers, acquisitions, divestitures and venture capital financing. M.K. & Co. provides valuation and financial consulting services for gift and estate tax purposes, employee stock ownership trusts, mergers, acquisitions, stock purchase agreements and other corporate purposes, as well as valuations for private companies in the process of going public. Other services include long-range financial planning, financial public relations and cash management services.
Other Products
M.K. & Co. offers special products, including insurance products and interests in various tax advantaged investments. Such tax advantaged investments are generally in the form of limited partnership interests in real estate, oil drilling, or similar ventures. Neither the Registrant nor the broker/dealer acts as the general partner for such partnerships. Morgan Keegan Fund Management, a wholly-owned subsidiary of the Registrant, acts as general partner to the Southern Capital Enhanced Equity Fund Limited Partnership, (the "FUND"), an investment limited partnership. The Fund seeks substantial capital appreciation through investing approximately 80% of its assets in growth stocks and the remaining assets in a stock index futures trading program.
M.K. & Co. is a distributor of shares of Bedford Money Market Fund, a money market mutual fund whose shares are sold without a sales charge. The fund is managed by Provident Institutional Management Corporation. M.K. & Co. also sells shares in unit investment trusts which hold portfolios of tax-exempt bonds, and as a service to its customers, offers shares of various mutual funds including those of Southern Capital Fund. This fund, which invests primarily in equity securities of companies located in the southern United States, is a mutual fund managed by Morgan Asset Management, Inc., a subsidiary of the Registrant, and is solely distributed by M.K. & Co. Also, M.K. & Co. acts as a broker in the purchase and sale of put and call options on the CBOE, AMEX and other exchanges.
Research Services
M.K. & Co.'s research services include the review and analysis of the economy, general market conditions, industries and specific companies; recommendation of specific action with regard to industries and specific companies; review of customer portfolios; furnishing of information to retail and institutional customers; and responses to inquiries from customers and account executives. These services are made available generally without charge to customers.
Administration and Operations
Administrative and operations personnel are responsible for the execution of orders; processing of securities transactions; receipt, identification and delivery of funds and securities; internal financial control; accounting functions; office services; custody of customers' securities; and compliance with regulatory requirements.
There is considerable fluctuation in the volume of transactions which a securities firm must handle. In the past, when the volume of trading in securities reached record levels, the securities industry experienced serious operating problems. M.K. & Co. has never experienced any significant operating difficulties, even during periods of exceptionally heavy trading. There is, however, no assurance that heavy trading volume in the future will not result in clearing and processing difficulties.
The following table sets forth high, low and average monthly purchase and sale transactions processed by M.K. & Co:
M.K. & Co. uses its own electronic data processing equipment to process orders and floor reports, transmit execution reports to its branches, and record all data pertinent to trades. It also clears its own securities transactions.
M.K. & Co. believes that its internal controls and safeguards against securities theft, including use of depositories and periodic securities counts, are adequate. As required by the NYSE and certain other authorities, M.K. & Co. carries fidelity bonds covering any loss or theft of securities, as well as embezzlement and forgery. The amount of such bonds, which provide total coverage of $25,000,000 (with $500,000 deductible provision per incident) is considered adequate.
M.K. & Co. posts its books and records daily and believes they are accurate. Periodic reviews of certain controls are conducted, and administrative and operations personnel meet frequently with management to review operational conditions in the firm. Operations personnel monitor day to day operations to assure compliance with applicable laws, rules and regulations. There is an internal audit department and an audit committee, both of which help management place an emphasis on strong internal controls.
Employees
As of July 31, 1998, M.K. & Co. had 1,683 employees, 662 of whom were account executives, 693 of whom were engaged in other service areas, including trading, research and investment banking, and 328 of whom were employed in accounting, clearing, data processing, management and other activities.
In large part, the Registrant's future success is dependent upon its subsidiary's continuing ability to hire, train and retain qualified account executives. During the fiscal year ended July 31, 1998, M.K. & Co. hired 114 account executives for a net increase of 38 over the beginning of the fiscal year. M.K. & Co. trains new account executives who are required to take examinations given by the NYSE, the NASD and certain state securities regulators in order to be registered and qualified. M.K. & Co. also provides continuing training programs for account executives. Competition is intense among securities firms for account executives with good sales production records.
M.K. & Co. considers its employee relations to be good and considers compensation and employee benefits offered which includes medical, life and disability insurance, 401(k) retirement plan and a discounted stock purchase plan, to be competitive with those offered by other securities firms.
Regulation
The securities industry in the United States is subject to extensive regulation under federal and state laws. The SEC is the federal agency charged with administration of the federal securities laws. Much of the regulation of broker/dealers, however, has been delegated to self-regulatory organizations, principally the NASD and the national securities exchanges. These self-regulatory organizations adopt rules (which are subject to approval by the SEC) which govern the industry and conduct periodic examinations of member broker/dealers. Securities firms are also subject to regulation by state securities commissions in the states in which they are registered. M.K. & Co. is registered in 50 states.
The regulations to which broker/dealers are subject cover all aspects of the securities business, including sales methods, trade practices among broker/dealers, capital structure of securities firms, uses and safekeeping of customers' funds and securities, recordkeeping, and the conduct of directors, officers and employees. Additional legislation, changes in rules promulgated by the SEC and by self-regulatory organizations, or changes in interpretation or enforcement of existing laws and rules, often affect directly the method of operation and profitability of broker/dealers. The SEC and the self-regulatory organizations may conduct administrative proceedings which can result in censure, fines, suspension or expulsion of a broker/dealer, its officers or employees. The principal purpose of regulation and discipline of broker/dealers is the protection of customer and the securities market rather than the protection of creditors and stockholders of broker/dealers.
One of the most important regulations with which the Registrant's broker/dealer subsidiary must continually comply is the "net capital rule" of the Securities and Exchange Commission and a similar rule of the New York Stock Exchange. These rules, under the alternative method, prohibit a broker/dealer from engaging in any securities transactions at a time when its net capital is less than 2% of aggregate debit balances arising from customer transactions; in addition, restrictions may be imposed on the operations of a broker/dealer if its net capital is less than 5% of aggregate debit items. At July 31, 1998, the Registrant's subsidiary's net capital was 35% of aggregate debit items. See Note 10 - Regulatory Requirements - page 36 of the 1998 Annual Report to Shareholders.
The laws, rules and regulations of the various federal, state and other regulatory bodies to which the business of the Registrant is subject are constantly changing. While management believes that it is currently in compliance in all material respects with all laws, rules and regulations applicable to its business, it cannot predict what effect any such changes might have.
Item 2.
Item 2. PROPERTIES
The Registrant's headquarters occupy approximately 160,000 square feet in Morgan Keegan Tower in Memphis, Tennessee. On May 31, 1996, Morgan Keegan Tower was purchased by Morgan Properties, LLC, a wholly-owned subsidiary of the Registrant. The acquisition was financed with a twenty-five year term mortgage payable at 8.25% fixed rate with the building as collateral. All of the Registrant's offices are leased. See Note 4 - Leases - on page 33 of the 1998 Annual Report to Shareholders.
In September, 1997, Morgan Properties, LLC entered into an agreement to sell the Registrant's corporate headquarters building for $36 million and lease-back a portion of it under a ten year lease agreement. The $13.8 million gain was deferred and will be taken into income over the 10-year life of the lease. A portion of the sale proceeds was used to pay off the mortgage note payable.
Item 3.
Item 3. LEGAL PROCEEDINGS
The Registrant is named in and subject to various proceedings and claims incidental to its securities business. While the ultimate resolution of pending litigation and claims cannot be predicted with certainty, based upon the information currently known, management is of the opinion that the resolution of such litigation and claims will have no material adverse effect on the Registrant's results of operations or financial condition.
Item 4.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to security holders during the fourth quarter of the fiscal year covered by this report.
PART II
Item 5.
Item 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
The information required by this item is incorporated herein by reference to Note 12 - Quarterly Results of Operations (Unaudited) - - - on page 37 of the 1998 Annual Report to Shareholders, a copy of which is enclosed.
Item 6.
Item 6. SELECTED FINANCIAL DATA
The information required by this item is incorporated herein by reference to the Ten Year Financial Summary on pages 24 and 25 and Additional Financial Information (Unaudited) on page 28 of the 1998 Annual Report to Shareholders, a copy of which is enclosed.
Item 7.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information required by this item is incorporated herein by reference to pages 26 and 27 of the 1998 Annual Report to Shareholders, a copy of which is enclosed.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information required by this item is incorporated herein by reference to page 27 of the 1998 Annual Report to Shareholders, a copy of which is enclosed.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this item is incorporated herein by reference to pages 29 through 37 of the 1998 Annual Report to Shareholders, a copy of which is enclosed.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
There were no changes in or disagreements with accountants on accounting and financial disclosure.
PART III
Item 10.
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this item is incorporated herein by reference to the Registrant's definitive Proxy Statement which was filed with the Commission pursuant to Regulation 240.14a(6)(c) on October 20, 1998 and will be used in connection with the solicitation of proxies to be voted at the Registrant's annual meeting of shareholders to be held November 24, 1998.
Item 11.
Item 11. EXECUTIVE COMPENSATION
The information required by this item is incorporated herein by reference to the Registrant's definitive Proxy Statement which was filed with the Commission pursuant to Regulation 240.14a(6)(c) on October 20, 1998 and will be used in connection with the solicitation of proxies to be voted at the Registrant's annual meeting of shareholders to be held November 24, 1998.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated herein by reference to the Registrant's definitive Proxy Statement which was filed with the Commission pursuant to Regulation 240.14a(6)(c) on October 20, 1998 and will be used in connection with the solicitation of proxies to be voted at the Registrant's annual meeting of shareholders to be held November 24, 1998.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated herein by reference to the Registrant's definitive Proxy Statement which was filed with the Commission pursuant to Regulation 240.14a(6)(c) on October 20, 1998 and will be used in connection with the solicitation of proxies to be voted at the Registrant's annual meeting of shareholders to be held November 24, 1998.
PART IV
Item 14.
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) List of Financial Statements, Financial Statement Schedules and Exhibits
(1) The following consolidated financial statements of the Registrant and its subsidiaries, included in the 1998 Annual Report to Shareholders are incorporated by reference in Item 8:
Consolidated Statements of Financial Condition July 31, 1998 and 1997 Consolidated Statements of Income Years ended July 31, 1998 1997, and 1996
Consolidated Statements of Stockholders' Years ended July 31, 1998 Equity 1997, and 1996
Consolidated Statements of Cash Flows Years ended July 31, 1998 1997, and 1996
Notes to Consolidated Financial Statements July 31, 1998
(2) All other schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.
(3) The following exhibits are filed herewith or incorporated by reference as indicated. Exhibit numbers refer to Item 601 of Regulation S-K:
Exhibit 3 - Articles of Incorporation filed as Exhibits B & C and Bylaws to Proxy Statement.
Exhibit 13 - Annual Report to Shareholders*
Exhibit 22 - List of Subsidiaries of Registrant*
Exhibit 23 - Consent of Independent Auditors Page 18
Exhibit 27 - Financial Data Schedule Page 19
*Certain portions of the Annual Report to Shareholders are incorporated herein by reference: the Annual Report to Shareholders is not to be deemed filed as a part of this Annual Report on Form 10-K.
(b) No reports on Form 8-K were filed during the fourth quarter of the year ended July 31, 1998.
(c) Exhibits - The response to this portion of Item 14 is submitted as a separate section of this report.
(d) Financial Statement Schedules - The response to this portion of Item 14 is submitted as a separate section of this report.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Morgan Keegan, Inc. (Registrant)
BY /s/ Allen B. Morgan, Jr. Allen B. Morgan, Jr. Chairman
Date: October 27, 1998
Pursuant to the requirements of Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the date indicated.
SIGNATURE TITLE DATE
/s/ Kenneth F. Clark, Jr. Kenneth F. Clark, Jr. Director October 27, 1998
/s/ William W. Deupree, Jr. William W. Deupree, Jr. Director October 27, 1998
/s/ James E. Harwood, III James E. Harwood, III Director October 27, 1998
/s/ Allen B. Morgan, Jr. Allen B. Morgan, Jr. Chairman and Director October 27, 1998
/s/ Harry J. Phillips Harry J. Phillips Director October 27, 1998
/s/ Donald Ratajczak Donald Ratajczak Director October 27, 1998
/s/ John W. Stokes, Jr. John W. Stokes, Jr. Vice President and Director October 27, 1998
/s/ Joseph C. Weller Joseph C. Weller Secretary/Treasurer and October 27, 1998 Director
EXHIBIT 23 - CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in this Annual Report (Form 10-K) of Morgan Keegan, Inc. of our report dated September 18, 1998, included in the 1998 Annual Report to Shareholders of Morgan Keegan, Inc.
We consent to the incorporation by reference in the Registration Statement (Form S-8 No. 33-16982) pertaining to the 1985 Restricted Stock and Stock Option Plan and in the Registration Statement (Form S-8 No. 33-32974) pertaining to the Employee Stock Purchase Plan of Morgan Keegan, Inc. of our report dated September 18, 1998, with respect to the consolidated financial statements of Morgan Keegan, Inc. incorporated by reference in the Annual Report (Form 10-K) for the year ended July 31, 1998.
/s/ Ernst & Young LLP ERNST & YOUNG LLP
Memphis, Tennessee October 21, 1998
EXHIBIT 27 - FINANCIAL DATA SCHEDULE
Report of Independent Auditors
Board of Directors Morgan Keegan, Inc.
We have audited the accompanying consolidated statements of financial condition of Morgan Keegan, Inc. and subsidiaries as of July 31, 1998 and 1997, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended July 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. These standards require that we plan and perform an audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly in all material respects, the consolidated financial position of Morgan Keegan, Inc. and subsidiaries at July 31, 1998 and 1997 and the consolidated results of their operations and their cash flows for each of the three years in the period ended July 31, 1998 in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP ERNST & YOUNG LLP
Memphis, Tennessee September 18, 1998
General Business Environment
Morgan Keegan, Inc. and its subsidiaries (the "Company") are principally engaged in the origination, underwriting, distribution, trading and brokerage of fixed income and equity securities and also providing investment advisory services. While the Company regularly participates in the trading of some derivative securities for its customers, this trading is not a major portion of the Company's business. The Company is not involved with high yield securities, bridge loan financing, or any other ventures that management feels may not be appropriate for the Company's strategy. Many factors affect the Company's revenues including changes in economic conditions, investor sentiment, the level and volatility of interest rates, inflation, political events and competition. As these factors are beyond the Company's control, and certain expenses are relatively fixed, earnings can significantly vary from year to year regardless of management's efforts to enhance revenue and control costs.
The Company faces increasing competition from commercial banks and thrift institutions as these institutions expand their investment banking and financial services which were previously offered only by securities firms. The Federal Reserve Board has eased numerous restrictions on commercial banks and thrift institutions which has allowed them to greatly increase their abilities to compete in the securities industry. The Company anticipates increasing regulation in the securities industry, meaning that continued compliance may be more difficult and costly. At present, the Company is unable to predict the extent of changes that may be enacted or the effect on the Company's business. Favorable conditions in the U.S. securities markets continued for most of the Company's fiscal year. U.S. equity markets achieved record trading volume and price levels, largely due to continued economic growth, gain in corporate earnings and modest inflation. This was a contributing factor to the Company's third consecutive record year. It is uncertain if the favorable conditions experienced in the past three years will continue. The Company anticipates continuing to grow its regional brokerage and other services in the southeastern United States.
Results of Operations The Company concluded its third consecutive year of record revenues, surpassing $400,000,000 for the first time and exceeding the 1997 revenues by $78,560,000 or 24%. The 1997 revenues of $328,534,000 were $27,128,000 or 9% ahead of the previous year. Outstanding markets for most of the year helped each aspect of the Company's business to contribute to record net income level of $48,186,000 which was $13,808,000 or 40% in excess of the previous years record level. An outstanding fourth quarter in fiscal 1997 pushed the Company to a record net income of $34,378,000, which was $511,000 in excess of the previous year.
More than half of the increase in fiscal 1998 revenues came from the combination of commissions which increased 38% or $30,223,000 and principal transactions which increased $11,826,000. The increases can be attributed to another strong year from trading volume equity securities as well as a substantial increase from government and municipal securities.
The largest percentage increase in fiscal 1998 revenues was in investment management fees which increased 62% or $7,688,000 following a 34% increase over the 1996 fiscal year. The increase reflects the commitment of the Company to grow this aspect of the business with the acquisition of two small money management firms. Investment banking revenues in fiscal 1998 increased $16,584,000 or 32% as the IPO market remained strong for most of the year.
Results of Operations (continued)
Operating expenses rose from $273,256,000 in fiscal 1997 to $329,908,000 in fiscal 1998 representing a $56,652,000 or 21% increase. This follows an 11% increase for fiscal 1997 above 1996. More than 70% of the total fiscal 1998 increase was reflected in compensation which increased 25% or $40,464,000. The 25% increase in compensation closely corresponds to the 24% increase in revenues as much of the Company's compensation costs are directly affected by the increase in production. The increase in compensation expense did not directly correspond to the revenue increase for fiscal 1997 over fiscal 1996 as a significant portion of that revenue increase came from interest income which does not have a direct effect on compensation expense. Other operating expense increased in proportion as the Company continued efforts to expand its retail network and control expenses.
For most of the securities industry, fiscal 1998 was a highly profitable year, as the Dow rose from 8000 to 9300 and fell back to 8800 at the year's close. During the past three years, the Company has benefited from its on-going expansion efforts and the favorable market conditions. During the past year, the securities industry has gone through much consolidation. It is difficult to predict what impact this may have on the Company.
Impact of Year 2000 Many of the world's computer systems currently record years in a two-digit format. Such computer systems will be unable to properly interpret dates beyond the year 1999, which could lead to business disruptions. The potential costs and uncertainties associated with this issue will depend on a number of factors including software, hardware, and the nature of the industry in which a company operates. Additionally, companies must coordinate with other entities with which they electronically interact, such as customers, vendors, and borrowers. This is a significant undertaking for securities firms, as virtually every aspect of the sale of securities and related processing of transactions will be affected and the consequences for noncompliance will be significant.
A significant portion of the Company's operations and information systems are provided by third-party service providers. The Company's interface systems are vulnerable to those third parties' failure to remediate their own year 2000 issues. The Company has developed a plan to analyze how the Year 2000 will impact its operations, including monitoring the status of its service providers and evaluating alternatives. Given the Company's exposure to third-party service providers, management does not believe the internal costs to address the Year 2000 issue will have a material impact on future operations other than the impact such event will have on the cost of services provided by its vendors which is unknown at this time. There is no guarantee that the systems of other companies on which the Company's systems rely will be timely converted and will not have an adverse effect on the Company's information systems. The Company is well into the testing phase of its Year 2000 plan and will participate in the industry wide testing in March, 1999. The interdependent nature of securities transactions and the success of the Company's external counterparties and vendors in dealing with this issue could significantly influence the Company's estimate of the impact the Year 2000 will have on its business.
The Company is reviewing the most reasonably likely worst-case effects of Year 2000 and has a preliminary contingency plan in place for any such unanticipated negative effects. It is expected this plan will be updated and finalized by December 31, 1998.
More than 95% of the Company's revenue is generated by its registered broker dealer. Virtually all the securities owned are held for the short term based on customer demand and are financed by short term borrowings. The Company marks all the securities to market. The short position typically reflects any hedges and all positions are marked to market. While the Company strictly adheres to this philosophy, circumstances may change and the Company may reevaluate its financing arrangements. (See interest rate sensitivity)
Liquidity and Capital Resources The Company's assets are primarily liquid, consisting mainly of cash and assets readily convertible into cash. These assets are financed primarily by free credit balances, commercial paper, equity capital, bank lines of credit, repurchase agreements and other payables.
During the current fiscal year, cash used in operating activities was $43,373,000 which was financed by $18,455,000 of cash provided by financing activities and $24,667,000 provided by investing activities which included the sale of the Company's headquarters building for $34,582,000.
The Company's broker-dealer subsidiary is subject to requirements of the Securities and Exchange Commission and the New York Stock Exchange relating to liquidity and capital standards. It has historically operated well in excess of the standards. At July 31, 1998, the net capital of the Company's broker-dealer subsidiary exceeded the SEC's minimum requirements by approximately $143,000,000 which is $36,000,000 more than the previous years excess. Continued expansion is not expected to have a significant adverse impact on liquidity or capital funds available from operations and lines of credit should provide sufficient sources to meet capital needs for the foreseeable future.
During the year, the Company continued its stock repurchase program, purchasing 180,000 shares at a cost of $4,453,000. This followed fiscal 1997 repurchases of 17,400 shares and 572,000 shares in fiscal 1996. The board previously authorized the purchase of a total of 7,125,000 shares under the repurchase program.
In fiscal 1998, the board further authorized the company to repurchase a total of 1,200,000 shares through 3/31/2000 to fund the Company's restricted stock and employee stock purchase programs.
In fiscal 1999, the board further authorized the Company to repurchase a total of 1,200,000 shares through 3/31/2000 to fund the Company's restricted stock and employee stock purchase programs.
Forward Looking Statements. This Annual Report may be deemed to contain certain forward-looking Statements regarding the anticipated financial and operating results of the Company. The Company undertakes no obligation to publicly release any revisions to any forward-looking statements contained herein to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events. Information contained in these forward-looking statements in inherently uncertain; and actual performance and results may differ materially due to many important factors, many of which are beyond the Company's control including the Company's ability to sustain and manage growth; dealing with increasing competition; additional government regulations; changes in general economic conditions; and the like.
Additional Financial Information (Unaudited)
Morgan Keegan, Inc. and Subsidiaries
Notes to Consolidated Financial Statements Morgan Keegan, Inc., and Subsidiaries July 31, 1998
NOTE 1-SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation: The consolidated financial statements include the accounts of Morgan Keegan, Inc. and its subsidiaries (collectively referred to as the Company). All significant intercompany balances and transactions have been eliminated in consolidation. The Company is in one principal line of business, that of providing investment services primarily in the southern United States.
Financial Assets and Liabilities: Substantially all of the Company's financial assets and liabilities are carried at market value or at amounts which because of the short-term nature of the financial instruments, approximate current fair value.
Securities Transactions: Securities transactions and related commission revenue and expense are recorded on a settlement date basis, generally the third business day following the transaction date, which is not materially different from a trade date basis.
Securities: Securities owned and securities sold, not yet purchased are carried at market value and unrealized gains and losses are reflected in revenues.
Investment Banking: Management fees on investment banking transactions and selling concessions are recorded on the settlement date. Underwriting fees are generally recorded on the date the underwriting syndicate is closed.
Fixed Assets: Furniture, equipment and leasehold improvements are carried at cost. Depreciation and amortization are provided on a straight-line basis over the estimated useful lives of the assets. Prior to sale, building and improvements are carried at cost and are being depreciated over a thirty-one year period.
Securities-Lending Activities: Securities borrowed and securities loaned transactions are generally reported as collateralized financings except where letters of credit or other securities are used as collateral. Securities borrowed transactions require the Company to deposit cash, letters of credit, or other collateral with the lender. With respect to securities loaned, the Company receives collateral in the form of cash or other collateral in an amount generally in excess of the market value of securities loaned. The Company monitors the market value of securities borrowed and loaned on a daily basis, with additional collateral obtained or refunded as necessary.
Reverse Repurchase and Repurchase Agreements: Securities purchased under agreements to resell (Reverse Repurchase Agreements) and securities sold under agreements to repurchase (Repurchase Agreements) are carried at the amounts at which the securities will be subsequently resold or reacquired as specified in the respective agreements. Government securities segregated in a special reserve bank account for the benefit of customers under rule 15c3-3 of the Securities and Exchange Commission represent securities purchased under an agreement to resell of $346,900,000 and $280,100,000 at July 31, 1998 and 1997, respectively.
Income Taxes: The parent and its subsidiaries file a consolidated income tax return. Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.
Net Income Per Share: In fiscal 1998, the Company adopted the provisions of Financial Accounting Standards Board ("FASB") Statement No. 128, "Earnings per Share" ("Statement 128"). Statement 128 replaced the calculation of primary and fully diluted earnings per share with basic and diluted earnings per share. Unlike primary earnings per share, basic earnings per share excludes any dilutive effects of options, warrants and convertible securities. Diluted earnings per share is very similar to the previously reported fully diluted earnings per share. All earnings per share amounts for all periods presented have been restated to conform to the requirements of Statement 128.
The following table sets forth the computation of basic and diluted earnings per share:
All earnings per share data included in the consolidated financial statements and notes thereto have been adjusted to give effect to all stock splits.
Accounts with Customers: Accounts with customers include amounts arising from uncompleted transactions and margin balances. Securities which are owned by customers but held as collateral for receivables from customers are not included in the consolidated financial statements.
Restricted Stock: Amortization of restricted stock is provided on the straight-line basis over the life of the restriction, which is five years.
Stock-based Compensation: The Company grants stock options for a fixed number of shares to employees with an exercise price equal to the fair value of the shares at the date of grant. The Company accounts for stock option grants in accordance with Accounting Principles Board (APB) Opinion No. 25, "Accounting for Stock Issued to Employees," and, accordingly, recognized no compensation expense for the stock option grants.
Other Accounting Pronouncements: In December 1996, the Financial Accounting Standards Board (FASB) issued Statement No. 127, "Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." Statement 127 deferred the effective date of provisions of Statement 125 relating to the recognition of collateral, securities lending transactions, repurchase agreements, dollar-rolls, and similar transactions until January 1, 1998. The adoption of Statement 125 had no material effect on the Company's consolidated financial position or results of operations.
In June 1997, the FASB issued Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information," which is effective for annual and interim periods ending after December 15, 1997. The Company will adopt the new requirements retroactively in fiscal 1999. This statement established standards for the method that public entities use to report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to stockholders. It also establishes standards for related disclosures about products and services, geographical areas and major customers. Management has not completed its review of the statement, but does not anticipate its adoption will have a significant effect on the company's annual or interim reporting.
The Financial Accounting Standards Board issued in June 1998 its new standard on derivatives - Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The new Statement resolves the inconsistencies that existed with respect to derivatives accounting, and dramatically changes the way many derivatives transactions and hedged items are reported. The Statement is effective for years beginning after June 15, 1999. The Company has not yet determined the effect, if any, Statement 133 will have on he earnings and financial condition of the Company.
Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
NOTE 2-BORROWINGS
The short-term borrowings of $68,400,000 and $570,000 at July 31, 1998 and 1997 respectively, consist of loans payable on demand primarily used to finance clearance of securities and to carry customers' margin accounts and firm positions. The notes bear interest at the broker loan rate, which was 6.2% and 6.4% at July 31, 1998 and 1997, respectively.
The Company had total lines of credit of $345,000,000 at July 31, 1998, with expirations prior to July 31, 1999, under which a maximum of $250,000,000 could be borrowed on an unsecured basis. There were no compensating balances associated with these lines of credit. There were no borrowings outstanding on these lines of credit at July 31, 1997.
The Company also issues its own commercial paper to investors at fluctuating interest rates (5.45% and 5.75% at July 31, 1998 and 1997, respectively). The paper matures over various terms not to exceed nine months.
The weighted average interest rate on all forms of short-term borrowings for the years ended July 31, 1998 and 1997 was 6.46% and 6.85%, respectively.
NOTE 3-SECURITIES
Securities owned for trading purposes consist of the following at July 31, in thousands:
State and municipal obligations include an issue with a par value of $12,700,000 which has been written down to an approximate fair market value of $5,715,000 at July 31, 1998 and July 31, 1997, as determined by management of the Company.
Securities sold, not yet purchased at market consist of the following at July 31, in thousands:
NOTE 4-LEASES
The Company leases office space, furniture and equipment under noncancellable leases expiring through 2009, with options to renew the leases for up to five years. Total rental expense for each of the years ended July 31 was as follows, in thousands:
Aggregate future annual minimum rental commitments, excluding escalations, for the years ending July 31 are as follows, in thousands:
NOTE 5-COMMITMENTS AND CONTINGENCIES
At July 31, 1998, the Company was obligated under commercial letters of credit of approximately $20,500,000 drawn in favor of certain clearing organizations which were collateralized by customer-owned securities of $25,353,000 and firm-owned securities of $5,500,000. These obligations normally settle through the clearance of the related securities transactions with the respective organizations.
The Company is named in and subject to various proceedings and claims incidental to its securities business. While the ultimate resolution of pending litigation and claims cannot be predicted with certainty, based upon the information currently known, management is of the opinion that the resolution of such litigation and claims will have no material adverse effect on the Company's consolidated results of operations or financial condition.
NOTE 6-INCOME TAXES
Significant components of the provision (credit) for income taxes are as follows for the years ended July 31, in thousands:
The principal reasons for the difference between the effective rate and the federal statutory income tax rate for the years ended July 31 are as follows, in thousands:
Significant components of the Company's deferred tax assets and liabilities as of July 31 are as follows, in thousands:
NOTE 7-COMMON STOCK
The Board of Directors has reserved 9,168,750 shares for issuance under the Company's Restricted Stock and Incentive Stock Option plans of 1983 and 1985. Under provisions of the Restricted Stock and the Incentive Stock Options Plans, benefits may be granted to key officers and employees in either, or a combination of, incentive stock options or restricted stock awards. Incentive stock options are granted at the fair market value of the stock at the time of grant. There were approximately 1,561,077 remaining shares available to be granted at July 31, 1998.
The Board of Directors has authorized 675,000 shares to be granted to non-employee directors in the form of incentive stock options. As of July 31, 1998, 162,000 options were outstanding and exercisable at an average price of $11.40. During fiscal year 1998, 54,000 options were exercised at an average price of $5.18 and 54,000 options were granted at an average price of $18.875.
Employee stock option activity which includes 6,750 shares that are exercisable, is summarized as follows:
The Company has approximately 2,129,806 shares of restricted stock included in common stock outstanding which was issued at the fair market value at the date of grant.
Under an Employee Stock Purchase Plan, 4,275,000 shares have been reserved to allow employees to purchase company shares at a 15% discount, not to exceed 506,250 shares to all employees in any year.
Activity by year under the plan is summarized as follows:
NOTE 8-REPURCHASE AND REVERSE REPURCHASE AGREEMENTS
The Company enters into sales of securities under agreements to repurchase, which substantially mature in less than 30 days, with the obligation to repurchase the securities sold reflected as a liability in the consolidated statement of financial condition. The majority of the repurchase agreements are matched with a reverse repurchase agreement.
Repurchase agreement information as of July 31, 1998 is summarized as follows, in thousands:
Repurchase agreement information as of July 31, 1997 is summarized as follows, in thousands:
The Company also enters into purchases of securities under agreements to resell (reverse repurchase agreements). The amounts advanced under these agreements represent short-term loans and are reflected as a receivable in the consolidated statement of financial condition. Securities purchased under agreements to resell are held in safekeeping in the Company's name. Should the market value of the underlying securities decrease below the amount recorded, the counterparty is required to place an equivalent amount of additional securities in safekeeping in the name of the Company.
NOTE 9-EMPLOYEE BENEFIT PLANS
The Company makes discretionary contributions to its 401(k) defined contribution plan and its profit sharing plan covering substantially all employees. The Company also has a defined benefit retirement plan covering certain executives. Total provisions for expenses under all plans for each of the years ended July 31, 1998, 1997, and 1996 totaled $2,637,000, $1,994,000, and $1,475,000, respectively.
NOTE 10-REGULATORY REQUIREMENTS
The Company's broker/dealer subsidiary, Morgan Keegan & Company, Inc., is a member of the New York Stock Exchange and is subject to the Securities and Exchange Commission's (SEC) uniform net capital rule. The subsidiary broker/dealer company has elected to operate under the alternate method of the rule, which prohibits a dealer from engaging in any securities transactions when its net capital is less than 2% of its aggregate debit balances, as defined, arising from customer transactions. The SEC may also require a member to reduce its business and restrict withdrawal of subordinated capital if its net capital is less than 4% of aggregate debit balances, and may prohibit a member firm from expanding its business and declaring cash dividends if its net capital is less than 5% of aggregate debit balances.
At July 31, 1998, the subsidiary had net capital of $151,648,000 which was 35% of its aggregate debit balances and $142,996,520 in excess of the 2% net capital requirement. At July 31, 1997, the subsidiary had net capital of $114,572,020, which was 31% of its aggregate debit balances and $107,182,218 in excess of the 2% net capital requirement.
NOTE 11-FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK
In the normal course of business, the Company's activities involve the execution, settlement and financing of various securities transactions. These activities may expose the Company to risk in the event the customer is unable to fulfill its contractual obligations. The Company maintains cash and margin accounts for its customers located throughout the United States but primarily in the Southeast.
The Company, as part of its normal brokerage activities, assumes short positions on securities. The establishment of short positions exposes the Company to off-balance sheet risk in the event prices increase, as the Company may be obligated to cover such positions at a loss. The Company manages its exposure to these instruments by entering into offsetting or other positions in a variety of financial instruments.
As a securities broker/dealer, a substantial portion of the Company's transactions are collateralized. The Company's exposure to credit risk associated with nonperformance in fulfilling contractual obligations pursuant to securities transactions can be directly impacted by volatile trading markets which may impair the customer's or contra party's ability to satisfy their obligations to the Company. Where considered necessary, the Company requires a deposit of additional collateral, or a reduction of securities positions.
In the normal course of business, the Company enters into underwriting and forward and future commitments. At July 31, 1998, the contract amount of future contracts to purchase and sell U.S. Government and municipal securities was approximately $85 and $22 million, respectively. At July 31, 1997, the contract amount of future contracts to purchase and sell U.S. Government and municipal securities was approximately $104 million and $9 million, respectively. The Company typically settles its position by entering into equal but opposite contracts and, as such, the contract amounts do not necessarily represent future cash requirements. Substantially all transactions relating to such commitments were subsequently settled and had no material effect on the Company's consolidated financial position.
The Company will occasionally hedge a portion of its long proprietary inventory position through the use of short positions in financial future contracts. At July 31, 1998, the Company did not have any open futures contracts. At July 31, 1997, the Company had $11 million of these contracts. The contract amounts do not necessarily represent future cash requirements.
While the Company regularly participates in the trading of some derivative securities for its customers, this trading is not a significant portion of the Company's business.