Stifel Financial Corp. (SF) Q3 2016 Earnings Report, Transcript and Summary

Good morning. My name is Heidi and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter Earnings Call 2016. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] Thank you. James Zemlyak, you may begin your conference.

Thank you, operator. Good morning, I'm Jim Zemlyak, CFO of Stifel. I would like to welcome everyone to our conference call today to discuss our third quarter 2016 financial results. Please note that this conference call is being recorded. If you would like a copy of today's presentation, you may download slides from our website at www.stifel.com. Before we begin today's call, we'd like to remind listeners that this presentation may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not statements of fact or guarantees of performance. They may include statements regarding, among other things, our ability to successfully integrate acquired companies, our branch offices and financial advisors, general economic, political, regulatory and market conditions, the investment banking and brokerage industries, our objectives and results, and may include our belief regarding the effect of various regulatory matters, legal proceedings, management expectations, our liquidity and funding sources, counterparty credit risk or other similar matters. As such they are subject to risks, uncertainties and other factors that may cause actual future results to differ materially from those discussed in the statements. To supplement our financial statements presented in accordance with GAAP, we may use certain non-GAAP measures of financial performance and liquidity. These non-GAAP measures should only be considered together with the Company's GAAP results. To the extent we discuss non-GAAP measures, the reconciliation to GAAP is available on our website at www.stifel.com. And finally, for a discussion of risk and uncertainties in our business, please see the business factors affecting the Company and the financial services industry in the Company's Annual Report on Form 10-K and MD&A results in the Company's quarterly reports on Form 10-Q. I will now turn the call over to our Chairman and CEO of Stifel, Ron Kruszewski.

Thanks Jim, and good morning, everyone. And thank you for taking the time to listen to our third quarter 2016 results. Yesterday afternoon we released a press release with our third quarter results and this morning we posted a slide deck on our website. So with that, let's start with my opening comments and some of the highlights of the quarter. I'm pleased with our third quarter results as we generated 642 million in GAAP net revenue and 645 million of adjusted non-GAAP net revenue. I'd like to note that we've sold the Sterne Agee independent advisory business at the beginning of the quarter, which generated approximately 25 million of net revenue in the second quarter of this year. Adjusting for this sale, adjusted revenue increased 3% sequentially and 9% from the third quarter of 2015, the increase in sequential revenue was driven by our Global Wealth Management advisory businesses. We continue to benefit from the growth in our balance sheet, which increased to more than 17 billion during the quarter. In addition, our bottom line was positively impacted by our recently implemented cost reduction initiative as adjusted non-compensation expense came in below our guidance for the quarter. Despite the progress we continue to make in our growth initiative, our industry continues to face headwinds from lower trading volumes and subdued issuance of market, the origination markets, if you will, as well as from heightened regulatory oversight. While these conditions can weigh on results from time to time, we remain focused on maximizing shareholder returns over the longer term. Given our market position and our strong and growing balance sheet, I believe that Stifel remains well positioned to capitalize on near term opportunities, as well as long term profitable growth. In terms of our third quarter results, total GAAP net revenue, as I said, was $642 million while GAAP earnings per share available to common was $0.21. Stifel utilizes certain adjusted non-GAAP measures to aid in understanding and analyzing the Company's financial results. I would refer you to our press release under the caption non-GAAP financial measures for a more robust discussion of non-GAAP measures. As such, we believe that our adjusted non-GAAP results in the far right column of this slide is more representative of our ongoing operating business as it excludes the impact this quarter of debt issuance costs, merger-related expenses and litigation. On a non-GAAP basis, we generated $645 million of net revenue and $0.69 of adjusted non-GAAP EPS to common shareholders. I'd also mention that in September, we announced the acquisition of City Securities, which is expected to close in the first quarter of 2017. This modest acquisition is another step in further enhancing our private client and municipal finance business. Before I get into our revenue and segment results, I want to review the reconciliation of our GAAP and non-GAAP results. On Slide 4, we review our expenses for the quarter and the impact of our non-GAAP adjustments. I want to spend some time on the issue as we've conformed how we are reporting our adjustments to conform with the SEC's recently updated guidance on GAAP versus non-GAAP measures. Stifel, as I said in the past, structures its acquisition to maximize retention and path structure. As such, significant amounts of what we consider purchase price is expense to Company's income statement. We project both merger-related expenses, including stock-based retention, contract and lease terminations, severance and legal, professional expenses, as well as additional operating expenses, which we have eliminate over time and are duplicative to Stifel's infrastructure. Historically, we have utilized adjusted non-GAAP measures, which excludes the impact of both merger-related and duplicative operating expenses. The updated SEC guidance discourages the elimination of duplicative operating expenses in our adjusted non-GAAP measure. Consequently, we will no longer include these costs in merger-related expenses. Said another way, while we will still report these duplicative expenses, we will calculate adjusted non-GAAP net income or and EPS excluding these expenses. I would note that the majority of these duplicative expenses were in conjunction with our acquisition of Sterne Agee, primarily the expense of operating Sterne's back-office and infrastructure for what we estimate it would be a year from the date of acquisition. As noted, we've sold the Sterne independent business and the back-office and associated infrastructure expenses at the beginning of this quarter. Therefore, no duplicative merger-related expenses were incurred this quarter. In order to make future comparisons to prior periods for adjusted non-GAAP measures, we revised adjusted non-GAAP EPS for prior periods in our press release. Please note that this does not change any of our analysis regarding our acquisition nor do they change the amount of merger-related expenses. It does change the way we will present our non-GAAP measures in the future. To illustrate, in the second quarter of 2016, we would have reported $0.57 of adjusted non-GAAP EPS and then state that that included approximately $14.7 million of duplicative costs. Last quarter, you recall, that we broke out these duplicative expenses from other merger-related expenses. Again, all these charges were really related to the Sterne Agee business. In the third quarter, we incurred anticipated merger-related charges, as well as litigation charges and debt issuance costs that impacted our GAAP results. GAAP compensation expense of $434 million included nearly $31 million of merger-related expenses, primarily stock-based comp for our Barclays acquisition. Excluding this charge, our adjusted comp ratio was 62.5%, down 30 basis points sequentially and at the lower end of our target range. With only a quarter remaining in 2016, we still believe that our range of 62% to 64% of adjusted comp is appropriate. GAAP non-comp expenses came in at $179.8 million, which included $16 million of acquisition-related charges tied to the final disposition of Sterne Agee as well as a $9 million lease revaluation. In addition, we had $11.7 million of litigation-related charges. Excluding these charges, our non-comp expenses came in at a $152 million, which was below our range of $155 million to $165 million and down 5% sequentially. The lower number was due to the realization of some of the benefits of our recent cost cutting initiatives and obviously the removal of costs tied to the Stern Agee business we've sold. In terms of our expectations for the fourth quarter, we believe non-comp expenses will be between $150 million and $160 million. I would note that these expenses do vary on things like loan loss provisions and legal expenses. But within this range, I'm comfortable with $150 million to $160 million. In the table on the right side of the slide, you can see the reconciliation between our GAAP results and our non-GAAP results. Net revenue was impacted by nearly $4 million on debt issuance costs and acquisition-related charges. As you can see here, our acquisition-related charges accounted for nearly $47 million, primarily relating to the Barclays and Sterne Agee transaction. Lastly, litigation-related matters totaled $11.7 million. I want to say something about the litigation charges as there have been some press reports regarding a potential settlement in one of our legal matters. We do not comment on ongoing litigation, but what we will say is, we did take additional reserves in the quarter related to our previously disclosed legal matters. Turning the page to slide five, we highlight the merger-related charges from our recent large acquisition to the most recent quarter, as well as our estimates through the end of 2017. As I said last quarter, the third quarter is really the last final quarter that our bottom line will be significantly impacted relating to these acquisitions. For the quarter, total deal-related charges were again 47 million. This was above our guidance from last quarter's call, and that was due to a nearly $9 million charge we took related to the termination of a lease that we inherited in the Sterne Agee acquisition. Now looking ahead to the fourth quarter and beyond, we expect that the charges relating to Barclays to decline by almost 25 million in the fourth quarter and we have no further charges tied to Sterne Agee. This will positively benefit our GAAP results and quote the difference with our adjusted non-GAAP results. Also to illustrate the point that our forecast for merger related expenses have been relatively accurate, we've included a comparison of our initial estimate when we did these transactions versus our expense expectation for ballpark Barclays and Sterne. As you can see, we're pretty much right on target with our Barclays estimate. We are about 20 million above our initial estimate for Sterne Agee. The vast majority of this difference is attributable to the lead termination charge that I just discussed and an accounting treatment for a portion of goodwill. So it's pretty clear that we've done what we've said at the time these deals were announced. Moving to our primary revenue lines, I'll start with brokerage revenue. Brokerage revenues totaled 288 million, or 0.5% decrease compared to the third quarter of '15 and a 6.6% decrease compared to the second quarter of '16. Excluding the brokerage revenues generated by the Sterne business, brokerage revenue increased 6.4% year-over-year but declined 1.5% sequentially. Global Wealth Management brokerage revenues were 165.5 million, a 2.3% decrease compared to the third quarter of 2015 and a 3.9% decrease sequentially. But again, excluding the Stern business, Global Wealth Management revenues on the brokerage side for the third quarter increased 8.7% compared to '15 and nearly 4% compared to the second quarter of 2016. Institutional equity brokerage revenues were 51 million, a 14.7% decrease compared to the third quarter of 2015 and a 7.3% decrease compared to the second quarter of 2016. Industry-wide average daily volumes were down 9.2% sequentially and 10% year-over-year. Institutional fixed income brokerage revenues were 71.8 million, an 18.5% increase compared to the third quarter of 2015, but a 11.7% decrease sequentially. I would note that the second quarter of 2016 was a strong quarter for our fixed income. We are very pleased with our year-to-date fixed income results, which are up 33% in 2015, and but I would say that our third quarter results were impacted by slower market volumes as investment grade and high yield average daily volumes declined, 3% year-over-year and 9% sequentially. I would note that we are not a balance sheet driven firm as illustrated by our value at risk measure which, during the quarter, was 4.3 million. Given that much, given our much lower levels of capital that we used to generate revenue versus larger more balance sheet driven firms, we correlate more to trading activity, but I must stand very comfortable with the amount of revenue that we generate in fixed income relative to our risk that we take. Investment banking revenues were $144.8 million, a 21.9% increase compared to the third quarter of 2015 and 8.8% increase sequentially. The growth in the quarter was the result of strong advisory revenues of $86.3 million. That is up 73% from the third quarter of 2015 and 29.4% sequentially. Our improved results were driven, were positively impacted by a large fee from advising Talmer Bancorp and strong results from Eaton Partners. Although the third quarter benefited from large deal closings, we do continue to feel good about our pipeline as it grows at a steady state. Also I would note that the investments that we have made have begun to pay off on this line item. In terms of equity capital raising, revenues were $32.5 million, which was an 11% decrease compared to 15%, 13.6% sequential decrease. While revenues were down during the quarter as the issuance markets continue to recover from depressed levels, we have started to see an uptick in business across the platform and our pipeline continues to build despite a still challenging environment. The revenue from fixed income capital raising was $26 million, which was a 19.8% decrease compared to the third quarter of 15% and 9.7% decrease compared to the second quarter of 2016. That said, we are preparing very strong results in our public finance business as our public finance business has grown to be the Number 1 ranked public finance business in the country in terms of number of transactions. Given that both presidential candidates have pushed for increased infrastructure spending, we believe that issuance in this market could see some tailwind in the future. Moving on, as you all know, our balance sheet has been a significant focus of our growth initiatives, and we continue to see the benefits through increased net interest income. As you can see our Slide 9, we continued to significantly grow our balance sheet during the quarter and we are now relatively close to the $18 billion we targeted roughly a year ago. In fact, we have actually increased our total assets by $7.9 billion in the past four quarters, and we are now just $800 million below the $18 billion threshold we have targeted. You can see that the sizable growth in our balance sheet was accomplished while maintaining strong capital ratio. Our Tier 1 leverage ratio increased sequentially to 11.8% and our risk-based capital rate was 22%. Improvement in the ratios during the quarter was due to earnings growth, as well as the preferred capital we raised during the quarter. You can also see the additional capital has benefited our illustrated capital ratio at $18 billion in assets from what our prior estimates were. The higher ratios give us added flexibility to deploy capital through continued balance sheet growth beyond $18 billion, as well as other means such as share repurchases and other capital deployment options. That being said, we’ll continue to focus on the rate of return we generate when using our excess capital as our primary measure for allocated capital. On the next slide, we illustrate not only the progress we made growing our balance sheet, but the impact it has had on net interest income and net interest margin. Total assets continue to increase, reaching $17.2 billion and our interest earning assets averaged $12.2 billion during the quarter. In fact, interest earning assets are up more than 92% from the third quarter of 2015 due to growth at Stifel Bank. Firm-wide net interest margin was 178 basis points, up 7 basis points sequentially. The improvement in firm-wide NIM was driven by the improvement in Stifel Bank's net interest margin. As you can see in the slide, our Bank NIM is up 5 basis points sequentially to 240 basis points as our funding costs decreased due to the planned reduction of Federal Home Loan Bank loan that were replaced with the positive funding. We highlighted the increased use of FHLB funding as being responsible for a 6 basis point contraction in our Bank's NIM last quarter. While we did recapture the costs associated with the FHLB funding, we did see some modest decline in the yields and assets acquired during the quarter. The results of the increase in our balance sheet size and recovery in NIM is a 14.4% sequential increase and 65% year-over-year increase in net interest income. I would also note that our NIM and our NII were negatively impacted by the impact of our debt issuance costs in the quarter that added $3.4 million to our interest expense. Excluding this charge, our NIM in the third quarter would have been 189 basis points and NII would have been $58.9 million. In terms of share repurchases, we bought back 600,000 shares in the quarter and we have 7.4 million shares remaining on our existing authorization. I also want to mention that our average diluted share count came in about 2 million higher than the consensus number for the quarter as it increased 1.6 million from the second quarter. This was due primarily to the impact from the shares issued in the Barclays transaction and is the result of the charge that we took to our earnings with respect to Barclays. Moving on, I will briefly touch on the results from our two primary segments as I’ve already addressed most of the factors impacting them in earlier slides. So starting with Global Wealth Management, it was a strong quarter in Global Wealth Management. I already talked about revenue increasing despite the loss on the Sterne Agee revenues. On an apples-to-apples basis, Global Wealth Management net revenue increased 6% sequentially. This segment continues to benefit from the growth of our Bank balance sheet and increased productivity from our financial advisers. Brokerage revenue in the private client business was again impacted by the sale of Sterne. Total advisors in this segment were 2,280 at the end of the quarter. Our headcount was down 1% sequentially. Now, I want to spend a little more time on our adviser count given the sequential decline. In the quarter, we recruited 33 advisors with average production above our firm-wide level. We did have, during the quarter, 48 departures for the quarter. 17 of those departures transitioned to retirement. So, the clients remain with our Company. 13 departed due to a lack of production, and the remaining 18 advisors that left, a significant number of them have productivity levels blow the firm's average. So while we are focused on growing our ranks through recruiting and acquisition, we are also focused on improving productivity. Total client assets reached 234.5 billion, up 4% sequentially. This excludes 11.5 billion of assets from Sterne Agee. Fee-based assets totaled 67.9 billion, up 4% sequentially and 22% year-over-year. The higher revenue in the quarter and the sales of the Sterne independent contractor business had a positive impact on our comp ratio for this segment, which declined to 55.2% in the quarter. Our non-comp ratio was 16.8%, altogether, resulting in pre-tax margin of 28%. On the next slide, we look at the results for Stifel Bank & Trust, which benefited from growth in asset as we continue to conservatively lever our balance sheet. Total bank assets were 11.2 billion. Bank loan of 5.1 billion increased 19% sequentially and nearly doubled up 104% year-over-year primarily to 600 million growth in our residential mortgage portfolio. Investment securities totaled 5.4 billion, investment portfolio growth in the quarter was consistent with our long term strategy of emphasizing high credit quality short duration issues that provide attractive risk-adjusted returns. As such, the portfolio's average yield was 2.23%; the duration was 2.13 years. The provision expense in the quarter increased to 3.6 million, up from 1.8 million in the prior quarter, but down from 3.7 million in 2015. The ratio of loan loss allowance to total loans declined sequentially due to the growth in our residential mortgage portfolio, which carries lower reserves as a percentage of loan. Overall, our credit metrics remain strong as NPL and non-performing loans and non-performing asset ratios in the quarter were 0.54% and 0.28%, respectively. Moving to the next slide. Our Institutional Group generated 259 million of net revenue. Advisory revenues were 86 million, which were up 29% sequentially and 74% year-over-year. This also followed strong second quarter results. Our second quarter advisory revenues, as I said, were helped by our Talmer Bancorp as well. Although advisory revenues can be lumpy from quarter-to-quarter, we continue to see opportunities to grow our existing verticals and add new verticals by recruiting senior-level talent. During the quarter, we added an energy team, a diversified financials team, as well as three tech bankers; and we also had a significant restructuring banker hire. Despite the strength of our advisory quarter, market conditions remain challenging for others, for other areas in this business. Although the S&P 500 was up 3% in the quarter, equities and fixed income to average daily volume declined. Given our Institutional business is primarily flow driven, these market conditions were headwind for us in the quarter. Our Institutional equities brokerage revenues declined 7%. And I've already discussed our fixed income brokerage revenue. Looking at equity underwriting revenue, it was $21 million and this declined 23% sequentially. IPO activity was relatively flat both sequentially and year-over-year in terms of the number of US new issues, but dollar amount rates increased slightly. Despite the sequential decline in equity underwriting revenues, we have started to see an uptick in business across the platform showing the benefits of broad industry coverage as we have equity new issue activity in consumer, energy, [fed] and across really all of our verticals. While it remains difficult to predict the near-term new issue windows, our pipeline continues to build with quality issues preparing to access the market. The next slide shows a summary financials for our Institutional Group. Before I open it to Q&A, I want to talk a little bit about where we are with the fiduciary role and give an update on our interest rate sensitivity. With respect to the Department of Labor's new fiduciary rule, we continue to implement and refine our business model related to retirement accounts. On one end of the spectrum, several firms have decided to eliminate commission based accounts entirely, while others have indicated a business model which will more significantly use the best interest contract exemption or as it's referred to the BIC. At Stifel, we are taking a balanced approach which preserves choice while recognizing the new fiduciary requirements. Over the last several months, we have communicated plans for our platform and timetable to all of our advisors. With respect to Choice, we have supplemented our advisory platforms with new capabilities programmed, and importantly have reduced minimums. Where it makes sense, we will utilize the best when we believe this option is more weighted to larger accounts. We are mindful of the costs relating to adopting accounts to the new standard of care, as well as the ongoing costs related to new systems policies, procedures and controls. We're now prepared to have an estimate of these costs at this point, but we will report as we get further into the process. This rule continues to evolve and we continue to evolve with it. I will say we share the industry's concern for the need to standardize costs and expenses across the providers of investment products. And finally, while much of the industry is raising costs and pushing out smaller accounts, we have lowered many of our minimums and welcome the opportunity to provide early savers with professional advice. With investor attention once again focused on a potential fed reserve or a hike in short term rates, we wanted to give some updated thoughts on our rate sensitivity. We have previously guided to $66 million of incremental pre-tax income from the first 100 basis point increase in the fed fund rate. We now believe that the next 100 basis point increase should generate pre-tax income of $70 million to $80 million annually. In terms of the impact of a 25 basis point increase, at this point, we think that we would capture roughly a quarter of our annual sensitivity, but this is dependent on a number of market factors including but not limited to the shape of the yield curve and obviously the composition of our balance sheet. A little bit on the next slide gives additional color on rate sensitivity. I actually don’t think that it does. So, to sum up, we believe we had another solid quarter in a relatively challenging environment. We believe our business has a scale to show meaningful improvement as markets improve. We have successfully grown our balance sheet to just below our targeted level and continue to generate significant excess capital. Our costs cutting initiative and the investments we’ve made in our institutional business are starting to show results. And lastly, we feel that our wealth management business is well positioned to navigate through the new Department of Labor rule. So with that, let’s open the lines to questions.

[Operator Instructions] Your first question comes from the line of Devin Ryan from JMP Securities. Please go ahead.

Hi, guys. Good morning, Ron. How are you?

Hi, Devin.

A couple here. I guess first, NII has been growing at a pretty nice clip here and as you continue grow the balance sheet, it just doesn’t seem that you’re getting much leverage yet on the comp ratio despite these higher margin revenues. And I’m just curious if that's because it’s being offset just with investment back into the business or is it timing. Just trying to think about the comp ratio because I would suspect that should be moving structurally lower, just given the accelerated growth in the balance sheet?

It's a fair question, Devin, I will say that, as you did see some improvement in the comp ratio. But we’re still dealing with, what I would say is, a difficult market environment. So while we - I believe that we’re not operating near the level that we can and better market them. And so, I would say that what you’re observing is probably correct, in that if we saw more robust market, you would see a - maybe a more significant improvement in that comp ratio. As such, we are investing in our business; and therefore, you are not seeing the leverage that you might otherwise see. So I think that’s a good question.

Got it. Okay. Helpful. And with respect to just another one, the balance sheet, you are getting pretty close to that $18 billion balance sheet illustration. I do know that’s not an end-point. So assuming that target could maybe move higher, but you’ll be creating capital through earnings, and so I suspect that could help the growth. How do you think about the opportunity or maybe capacity to accelerate further growth just with more preferred equity issuance?

Well, I think capital structures is good. You’ll see - we have - we’re generating and we can generate a lot of earnings plus we generate a fair amount of equity because of our stock-based compensation plan. So, the $18 billion was to get us to ratios that I thought were more indicative of what our capital structure was. But we can continue to grow the balance sheet and we have ample deposits to fund balance sheet as long as -- again it provides risk-adjusted returns. So I think that looking forward, we can manage our capital structure whether it's through share repurchases, balance sheet growth or whatever it is, we can do it on internally generated equity for capital, if you will.

Okay. I mean, I guess on capital, just a follow-up here. In recent quarters, you have spoken about taking a little bit of a pause in acquisitions. This has been a slower year for Stifel, especially as you build out the balance sheet. But you did note in the prepared remarks that you look to grow wealth management organically and through acquisitions. So I'm just curious as you sit today, how you're thinking about opportunities maybe inorganic opportunities in wealth management right now and what's your appetite to do deals ahead of DOL implementations?

I think, across the industry, there is a lot of question about implementing of DOL and I think that is a general governor, if you will, or dampener on activity you saw recent commentary on frequently asked questions from the DOL that puts some questions on recruiting and how recruiting is done. So in general, I would say that the big item in front of most firms and the big question mark is the implementation of this rule and its impact on systems and, frankly, how we're going to interact with clients. So I think that, as I think about it, the opportunity for us is to grow our balance sheet. We've done a number of deals. Our merger related charges over the last two years have been significant. And as I said, we're focusing on growing the balance sheet, increasing or looking at our cost base hard. And in the end, you'll see a narrowing of the difference between our non-GAAP and our GAAP measures, and that's what we're looking at as we go forward. But the great opportunity comes along; sure, we would look at it.

Your next question comes from the line Conor Fitzgerald from Goldman Sachs. Please go ahead.

First, I just want to kind of quickly follow up on a question, I think, Devin asked. The 9% kind of Tier 1 leverage target, I think you originally outlined, is that how you're still thinking about your binding capital constraints, how we should think about kind of your ability to deploy capital going forward?

Yes, look, I think, it's 9%. You've seen other firms that have been a little bit lower than 9%. The way we look at is, 9% in that range and 18% to 20% on Tier 1 risk-based capital. And obviously those numbers are related as it relates to your risk density. In other words, how much of your balance sheet is loans versus investments. But I think that those are fair guard rails in terms of how we think about risk density and leverage and risk-based capital.

Thanks. And I just want to make sure I fully understood your commentary around using the BICE. It sound like you're saying you're going to use the BICE for some of your larger clients perhaps migrating over kind of some of your smaller customers to advice-based accounts. I don't want to put words in your mouth, but I think that's what you are indicating. So, I guess, two questions on that. One, is that because you think the compliance costs are the same basically regardless of the account size. So it just makes more sense to shift over smaller customers and not face kind of the legal or compliance risk of using the BICE? And then two, as you migrate over smaller customers, the DOL has put up in their recent FAQ about keeping fees the same for customers that are switching levers, does mean you'll be cutting advice base rates for smaller customers as you switch them over?

That was a multi-pronged question.

It was, sorry.

Yes. And that's all right. I don't I hate to generalize. That said, I guess I'll generalize a little bit here. You have to look at a fiduciary standard of care and what the BICE allows you to do in many ways is have commission-based products and our systems, and for a lot of smaller accounts, net-net, an advisory solution makes more sense. And from the firm's perspective, there is a lot of there is a difference in the way you have to look and monitor fee-based versus commission-based accounts. And it doesn't as I've said numerous times, what the BICE requires makes it extremely difficult to provide that service to small accounts on that basis. That's been my belief since this rule was in its draft stages. So, that's on one hand. With respect to revenue, you read a lot about this, but to me, before this rule came into effect, we did not have an ongoing fiduciary standard of care and to say that you're going to provide the same service as you would in episodic commission-based transaction, it's just not accurate. It's not how business works and its if you're going to provide a fiduciary ongoing best interest type product, that's going to be as I believe, that's going to be more expensive for smaller investors. And I think they'll prove out across the industry. So, I don't think that for small accounts that the BIC necessarily makes a lot of sense on either sides of the ledger from the client choice or for the firm's perspective. But, we're not going to be absolute in anything. We were going to have our programs that allow clients to have choice and will utilize both the BICE and advisory solution.

Thanks for taking the questions.

Your next question comes from the line of Steven Chubak from Nomura. Please go ahead.

Hi, good morning. This is actually Sharon Leung stepping in for Steven this morning. So, I guess my first question is regarding the litigation costs this quarter, is there any further risk of this increasing? In other words, should we think of this as like a recurring item? And can you give any updates on what other matters that might be still outstanding?

I pointed it out as and we are always reluctant to say that anything is non-recurring and I'm not saying that it's non-recurring. I would also say that I don't believe that's a recurring charge going forward. We pointed it out and all I really am going to say is that there have been some press release points in this that charge relates to matters that are disclosed on our Q. And I just have to leave it at that right now, if I can, but that I wouldn’t have put it as an adjustment to GAAP if, I believe, it was a recurring normal charge.

Okay. Great. And then also in terms of your capital management priorities, this quarter your share count crept up a little bit and we were just wondering if you could give us an update on your priorities and how to manage that as balancing that with dividend buybacks, et cetera?

Yes. Well, it hasn’t changed. We look at deployment of capital either by returning it to shareholders or through balance sheet growth and we look at measures like book value or tangible book value dilution, EPS accretion or what I - in many times, the ongoing revenue that you can get by monetizing what I believe are our low - our core deposits, all right. And that’s the way we've been looking at it. As I said, our share count went up because the way we account for acquisitions is that we view what we give new associates as purchase price and when we expense that, we put the shares immediately in share count, and that’s why the increase of that went up. But, as always, we’ll be opportunistic and we will deploy capital either through share repurchases or balance sheet growth, dependent on market conditions at the time. And I think that’s been our history and it hasn’t changed during this quarter at all.

Okay, great. That’s it from me. Thanks, guys.

Thank you.

[Operator Instructions] Your next question comes from the line of Hugh Miller from Macquarie. Please go ahead.

Good morning. So, I guess, first question maybe on the cost side of the business. I understand you guys are taking a keener focused on expense discipline and I think historically, you’ve always talked about 20% non-comp ratio as being kind of the longer-term target for the business, particularly if you get into an environment, we’re not making as many acquisitions. But as we think about now, a world post-DOL and some of those regulatory costs, is 20% still kind of a viable long term goal. How should we think about that and the opportunity to have some additional expense savings going forward?

I think it’s - certainly in the increased - the new environment that we’re in and a lot of the things we have to do, I think 20% is becoming more difficult to get there. It depends on mix of business and it depends on environment. So you can - I believe that we’re not operating near our capacity and so, if we could get back to a more robust environment, obviously the non-comp ratio has leverage to it, as you just increased revenues, because those costs are primarily fixed relative for the most part, I mean we have execution costs, but a big chunk of that is communication, it's your quote machines, your rent, and cost of conferences, et cetera. So, we always want to be diligent about costs, but what we saw is that, as we've looked at all of our acquisitions, we've really looked at to make sure that we're streamlining everything. That's one that you saw some of the benefits of that this quarter and I think you'll continue to see that as there are costs that can still come out of what we've put together. But in the end, 20% was always my thought, but certainly the regulatory environment has changed and the need for systems and things outside the comp level has made that, I would say, more of a stretched bow, if you will.

Okay. That's definitely helpful. Another question, you have kind of alluded to in some of your remarks about the recruiting side of the business and it seems like there's been some guidance from the DOL which will weigh on the ability to kind of use quotas, and it seems like one of the larger peers has considered making an adjustment to using some of those deferred bonus awards. How do you see that really influencing kind of the landscape for recruiting in 2017? Would it likely provide maybe a tailwind to some of the regional players who aren't as, I don't know if aggressive is the right word, but active in terms of using upfront incentives? Your thoughts there will be helpful.

Yes, I'll be interested in seeing how it plays out. I think that there's a lot of ways to do things and I'll be interested in watching the new creative ways to do new things as it relates to recruiting side. I don't want to speculate day-to-day that changes the spectrum, I really don't think that it does that much. I think it changes certain very specific things that you can do. But overall, I don't think it will really have that much of an impact in terms of a fee change or a change in the flow of recruiting from, say, mid-sized firms from the bigger firms or vice versa. I don't really believe that will have that much of an impact. I think the industry will adjust and water will be pretty much at the same level.

Definitely helpful. And then I guess last from me, it seems like in times of challenges, we're going to do some reputational challenges at firms and things like that, there has been opportunity to kind of see some improvement in recruiting. This year has provided some of those things that have happened, are you seeing any differences in maybe home office visits and the pipeline on the recruiting side?

Yes, turmoil or things like that always will have an impact on that. I would just leave it at that. I would really not want to comment. I think these things also have certain shelf lives and then things move. So, there's not, I wouldn't say it's some tsunami of anything, all right. There have been some difficult situations, but the industry has done a pretty good job of as everyone in the industry having something going on one way or another. So, I don't want to point one way or another to anything.

[Operator Instructions]. Your next question comes from the line of Chris Harris of Wells Fargo. Please go ahead.

Thanks. So when you step back and just look at the capital markets industry more broadly, as you guys know, there's all kinds of money flowing out of active products (inaudible). So this isn't really a new trend at all, but it just continues unabated. And so when you look at that, does that change how you think about your existing business or your existing infrastructure at all? And does it change how you think about deals, because it just seems like it's something that's not really at all cyclical and more of a structural problem?

Well, certainly you think about it. I often say, as an investor, that I would like to be the last active stock selector in a 100% indexed world, and I think that I don't view I view that the move toward has an endpoint. And not structuring deals that way or doing things that way, I just believe that. I believe that there is a number of things that have favored passive management, including the low return environment that we've been in. And so, if policy change in GDP gets out of 1% to 2% rates and rates go up and you're able to differentiate and not every asset or not every stock within an asset seems to be as correlated as it is, I think that active management will come back and evolve as it has in past. That will be good for our business, will be good for a lot of people, and I believe that we will reach an inflection point where you'll see inflows to active again. That's just my belief. Now, my are we betting the on that belief? No. But in general, any firm that's providing equity research and trying to add alpha is being disadvantaged in a passive environment. So, I'm just in a state that I believe in my career and it's going to be still a long curve, I'm not going anywhere, we will see inflows into active management again.

Well, I hope you're right. I think we all [indiscernible].

That doesn't mean a lot of people [indiscernible]. Again, I don't think that as the world becomes more indexed, the ability to outperform that is going to, I believe, will happen, but we'll see.

Okay. And I guess just my follow up, I wanted to come back to some of the questions on DOL and some of the comments that you made. I'm just maybe curious to get your opinion whether you think advisors that service smaller accounts whether or not they can make their business models work without commissions. It would seem to me like that might be something that's hard to do, but you might have a different perspective on it. And if it is hard to do, might we see some attrition? And maybe that’s already happening and you had mentioned that some lower producing advisors have been leaving. So updated thoughts on that would be…

Well, I think that you have to - actually the harder transition is the larger account, okay. I will tell you it’s not with smaller accounts. We provided a very cost effective for smaller investors. We had a very cost effective platform and our advisors managed their business accordingly. And in larger accounts that we have a lot of - we have a lot of larger accounts where they really want to buy and hold just one commission based episodic type advice, they want to handle their they want to talk to people that this rule impacts that. I wrote about this rule prohibit sophisticated investors from calling their advisors and buying an IPO. I mean, it prohibits it. You can’t even do it subject to the BICE. So, I think that there’s going to be a - there’s going to be a real recognition by investors and it’s going to be larger investors that are going to be - feel more of the impact. Smaller investors will - in many ways will be grandfathered; and if not grandfathered, we have solutions and the industry has solutions that are both cost effective and products that don’t - that provide diversification to everything else. But in many ways, I think, revenues can actually go up. That’s maybe a good thing for industry. I’ve always said it's not necessarily a good thing for smaller investors.

Okay. Thank you.

Your next question comes from the line of Christian Bolu from Credit Suisse. Please go ahead. Christian Bolu, please go ahead. Your line is open.

Hi, Christian Bolu me. Just one for me, Ron. Wanted to circle back on the longer-term target of 15% ROE. You’ve made very significant progress in terms of integrating Sterne and the Barclays acquisition. The fixed income business has rebounded and you are getting closer to your balance sheet target. By my math, ROE is still around 9%, so just curious where else in the business you see further opportunities to optimize and get closer to that 15% target.

Well, we got couple of things, Christian. As we look forward and we optimize the balance sheet and NII, the improvement is going to come from a couple of places. First of all, most financial institutions - if you think about a financial institution that is, call it, levered 10:1, okay, for that 10% capital ratio, the low rate environment is on a pre-tax basis is 300 basis points to 400 basis points in ROE, when you think about the fact that your equity is not earning the short term rate. And that’s why so many financial institutions are positively levered to increasing rates, because simply if you look at our interest rate sensitivity and add that to our earnings, all things being equal as there are a lot of assumptions that go in that. But the fact is, there is a tremendous amount of leveraged ROE in increased rates. That's one. Two for us is making sure expense base is rationalizing. And then three is in a better environment, our revenues can be higher than they are today versus what we have and so the combination of those three things can get there. But I would say, as I've talked to a lot of banking not only peers but clients in an rate environment where the short term rates of 50 basis points, financial institutions getting to a 15% ROE, that's a big deal when the target was 15% when fed funds was 3 or 4, simply because that 300 basis points or 400 basis points right there on the equity base, and that's how it has you think about it. So, a lot of it is increasing rates while not flattening the yield curve and making sure we're obviously building on expenses. And then obviously increased revenue across our expense base would be the way we would like to get to that level.

Your next question comes from the line of Devin Ryan from JMP Securities. Please go ahead.

Hey, Ron. Just a quick follow-up here. I'm getting some questions here, as the call is being going on. I think there's a little bit of confusion just around how the duplicative costs are going to be treated on a go-forward basis in terms of when you report kind of that non-GAAP number. And then just what that impact is going to be, I guess moving forward? I guess it sounds like it didn't impact the third quarter, but how should we think about that on a forward basis?

I think it's not really an impact. The way to think about it is, look at the second quarter and what I would say is that what we did was we would project the synergies that we would take, we would take the fact that we would carry duplicate expenses and we would view that as a cost of an acquisition. And then we would have moved to eliminate those expensive. And those duplicative expenses that we would project, in Sterne Agee we projected them, we would then tell you what they were and then say how much they were in the quarter, and then adjust our EPS. We thought that was the earnings power as we would get those synergies. What we did now, what the guidance says that if they would prefer that we do is that we tell you we don't adjust earnings for duplicate expenses, but we can still tell you what they are and you can do the math. And it's nothing really changes other than that. And I would say that, for us, the vast majority of duplicate expenses in almost all of our deals were really focused on Sterne Agee, because we projected that we were going to run duplicate back offices primarily in infrastructure for nearly a year. That was part of what we baked in the purchase price. And we would additional, we would say that these synergies are coming, we would say how much they were in the quarter, and then we would adjust our earnings as if we had achieved those synergies. And now this quarter we don't have them, because they've gone away. And I think as we go forward, I'll think about how to communicate that, but really it's a matter of saying that our adjusted earnings are at or our adjusted earnings are lower but it were caring duplicative expenses, and then you will do the math. And that's really what the guidance is. We have encouraging firms to do and we understand that, and obviously we're going to comply.

Got it. So it's more a thought process for potentially future deals, and looks like Sterne Agee you've already kind of run through the merger-related duplicative expenses, so nothing probably for us to model at this time unless there's more acquisitions.

Correct.

Got it. Okay, very helpful. Thanks Ron.

Alright.

There are no further questions in the queue.

Okay. Well, that was good way. We normally do this call in the afternoon. So, this is a good pickup to your morning to start this call early. And I want to thank everyone for attending and look forward to continuing the progress as we have laid out, and wish everyone a good day. Thank you.

This concludes today's conference call. You may now disconnect.