Back to GetFilings.com
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998 COMMISSION FILE NUMBER 0--23644
------------------------
INVESTMENT TECHNOLOGY GROUP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 13-3757717
(State of incorporation) (IRS Employer Identification No.)
380 MADISON AVENUE, NEW YORK, NEW YORK (212) 588-4000
(Address of principal executive offices) (Registrant's telephone number, including
area code)
10017
(Zip Code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
------------------------
COMMON STOCK, $0.01 PAR VALUE NASDAQ NATIONAL MARKET
(Title of class) (Name of exchange on which registered)
Aggregate market value of the voting stock held Number of shares outstanding of the
Registrant's
by non-affiliates of the Registrant at March Class of common stock at March 15, 1999:
15, 1999:
$168,832,991 18,630,817
------------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes /X/ No / /
Indicate by check mark if disclosure of delinquent filers pursuant to item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this form 10-K or any amendment to this
form 10-K [ ]
DOCUMENTS INCORPORATED BY REFERENCE:
Proxy Statement relating to the 1999 Annual Meeting of Stockholders
(incorporated, in part, in Form 10-K Part III).
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
1998 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PAGE
-----
PART I
Item 1. Business............................................................................ 4
Item 2. Properties.......................................................................... 14
Item 3. Legal Proceedings................................................................... 14
Item 4. Submission of Matters to a Vote of Security Holders................................. 15
PART II
Item 5. Market for Registrant's Common Stock and Related Stockholder Matters................ 16
Item 6. Selected Financial Data............................................................. 17
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations.......................................................................... 19
Item 7A. Quantitative and Qualitative Disclosure about Market Risk........................... 27
Item 8. Financial Statements and Supplementary Data......................................... 28
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure.......................................................................... 51
PART III
Item 10. Directors and Executive Officers of the Registrant.................................. 51
Item 11. Executive Compensation.............................................................. 51
Item 12. Security Ownership of Certain Beneficial Owners and Management...................... 51
Item 13. Certain Relationships and Related Transactions...................................... 51
PART IV
Item 14. Exhibits, Financial Statements, Schedules and Reports on Form 8-K................... 52
QUANTEX -REGISTERED TRADEMARK- ("QUANTEX") IS A REGISTERED TRADEMARK OF
INVESTMENT TECHNOLOGY GROUP, INC.
POSIT -REGISTERED TRADEMARK- ("POSIT") IS A REGISTERED SERVICE MARK OF THE POSIT
JOINT VENTURE.
SMARTSERVER IS A SERVICE MARK OF INVESTMENT TECHNOLOGY GROUP, INC.
2
FORWARD-LOOKING STATEMENTS
In addition to the historical information contained throughout this Annual
Report on Form 10-K, there are forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended (the "Securities Act"),
and Section 21E of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"). All statements regarding our expected future financial
position, results of operations, cash flows, dividends, financing plans,
business strategies, competitive positions, plans and objectives of management
for future operations, and concerning securities markets and economic trends are
forward-looking statements. Although we believe our expectations reflected in
such forward-looking statements are based on reasonable assumptions, there can
be no assurance that such expectations will prove to have been correct.
Important factors that could cause actual results to differ materially from the
expectations reflected in the forward-looking statements herein include, among
others, the actions of both current and potential new competitors, rapid changes
in technology, fluctuations in market trading volumes, market volatility,
changes in the regulatory environment, risk of errors or malfunctions in our
systems or technology, cash flows into or redemptions from equity funds, effects
of inflation, customer trading patterns, securities industry participants'
responses to Year 2000 issues, as well as general economic and business
conditions; securities, credit and financial and market conditions; adverse
changes or volatility in interest rates.
3
PART I
ITEM 1. BUSINESS.
Investment Technology Group, Inc. ("ITGI" or the "Company") was formed as a
Delaware corporation on March 10, 1994 and its principal subsidiaries include:
(1) ITG Inc., a broker-dealer in securities registered under the Exchange Act,
(2) Investment Technology Group International Limited, which is a 50% partner in
the ITG Europe joint venture, and (3) ITG Australia Holdings Pty Limited, which
is a 50% partner in ITG Pacific Holdings Pty Limited. We provide equity trading
services and transaction research to institutional investors and brokers.
We are a full service trade execution firm that uses technology to increase
the effectiveness and lower the cost of trading. With an emphasis on ongoing
research, we offer the following services:
- POSIT: an electronic stock crossing system.
- QuantEX: a decision-support, trade management and routing system.
- SmartServers: offers server based implementation of trading strategies.
- Electronic Trading Desk: an agency-only trading desk offering clients
efficient trading services accessing multiple sources of liquidity.
- ITG Platform: a PC-based routing and trade management system.
- ISIS: a set of pre- and post-trade tools for systematically analyzing and
lowering transaction costs.
- ITG/Opt: a computer-based equity portfolio selection system.
- Research: research, development, sales and consulting services to our
clients.
We generate revenues on a "per transaction" basis for all orders executed.
Orders are delivered to us from our "front-end" software products, QuantEX and
ITG Platform, as well as vendors' front-ends and directcomputer-to-computer
links to customers. Orders may be executed on (1) POSIT, (2) the New York Stock
Exchange, (3) certain regional exchanges, (4) market makers, (5) electronic
communications networks and (6) alternative trading systems.
POSIT
POSIT was introduced in 1987 as a technology-based solution to the trade
execution needs of quantitative and passive investment managers. It has since
grown to serve the active trading and broker-dealer community. There are
approximately 490 clients currently using POSIT, including corporate and
government pension plans, insurance companies, bank trust departments,
investment advisors and mutual funds.
POSIT is an electronic stock crossing system through which clients enter buy
and sell orders to trade single stocks and portfolios of equity securities among
themselves in a confidential environment. Orders may be placed in the system
directly via QuantEX and ITG Platform and computer-to-computer links or
indirectly via the Electronic Trading Desk, which then enters the orders in the
central computer. We also work in partnership with vendors of other popular
trading systems, allowing users the flexibility to route orders directly to
POSIT from trading products distributed by Bridge Information Systems, BRASS,
Bloomberg and others.
POSIT currently accepts orders for approximately 18,000 different equity
securities, but may be modified, as the need arises, to include additional
equity securities registered pursuant to Section 12 of the Exchange Act. An
algorithm is run at scheduled times to find the maximum possible number of buy
and sell orders that match or "cross." Typically, there is an imbalance between
the number of shares
4
available to be bought or sold in the system. When this occurs, shares are
allocated pro rata across participants, resulting in partial execution. POSIT
has been designed to allow clients trade execution flexibility. Clients may
specify constraints on the portion of a portfolio that trades, such as the
requirement that net cash resulting from buys and sells remain within specified
constraints. A client may also specify a minimum number of shares to be executed
for a given order. POSIT prices trades at the midpoint of the best bid and offer
on the primary market for each security at the time of the cross, based on
information provided directly to the system by a third-party data vendor. There
are seven scheduled crosses every business day: six regular crosses scheduled
hourly, on the hour, between 10:00 a.m. and 3:00 p.m. (Eastern time) and an
American Depositary Receipts cross at 8:45 a.m. (Eastern time). Each scheduled
cross is normally executed within a five minute window selected randomly by the
system.
POSIT provides the following significant benefits to clients:
- Confidential matching of buy and sell orders eliminates market impact. In
contrast, participants in traditional or other open markets constantly
face the risk that disclosure of an order will unfavorably affect price
conditions.
- Access to the substantial pool of liquidity represented by POSIT orders.
- Clients pay a low transaction fee on completed transactions relative to
the industry average of 5 to 6 cents per share. POSIT generates revenue
from transaction fees charged on each share crossed through the system.
- Immediately after each cross, the system electronically provides clients
with reports of matched and unmatched (residual) orders. Clients can then
execute residual orders by traditional means or take advantage of the
Electronic Trading Desk services (described below).
Since December 1997, we have offered POSIT 4. POSIT 4 gives POSIT users the
option of customizing their trading objective and specifying additional
constraints, while preserving the functionality of the existing POSIT system.
This capability is referred to collectively as a POSIT 4 "strategy." This
capability allows orders that might otherwise be ineligible for POSIT to
participate in the match. POSIT 4 strategies include ResRisk, which allows users
to control the risk of the unexecuted "residual" portfolio, and Pairs, which
makes execution of one trade contingent on the execution of another, at or
better than a given relative valuation. Portfolio funding, liquidation,
restructuring and rebalancing are some of the types of transactions that are
appropriate for execution using ResRisk. Risk arbitrage, statistical arbitrage
and portfolio substitution trades are examples of transactions that can be
implemented using the Pairs strategy. We also implement custom applications upon
request. Total volume attributable to POSIT 4 in 1998 is 66 million shares. We
have obtained a patent on the technology underlying POSIT 4.
5
The following graph illustrates the average daily volume of shares crossed
on POSIT:
AVERAGE DAILY POSIT SHARE VOLUME
EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC
SHARES PER DAY
1989 642,857
1990 1,703,557
1991 2,320,158
1992 4,330,709
1993 6,142,405
1994 7,737,742
1995 9,040,978
1996 13,067,553
1997 14,527,878
1998 23,151,105
QUANTEX
QuantEX is our trade management system, an advanced tool for technologically
sophisticated clients transacting large volumes of orders. QuantEX helps clients
manage efficiently every step in the trading process: from decision-making to
execution to tracking of trade list status. From a dedicated workstation at
their desks, users can access fully-integrated real-time and historical data and
analytics, execute electronic order routing and perform trade management
functions. To date, trading systems have generally addressed just one or two of
these functions--a situation that has left many users with the inefficiency of
multiple unrelated systems.
QuantEX is a rule-based decision support system that allows traders to
quantify their trading processes. It is designed to implement each client's
trading styles and strategies and to apply them to hundreds of stocks,
portfolios or industry groups at once. With QuantEX, clients can flag precisely
the same kinds of moment-to-moment opportunities they would ordinarily want to
pursue, but do so much more efficiently and rapidly.
QuantEX analyzes lists of securities based on the individual user's trading
strategy. QuantEX enables clients to have access to our proprietary research,
including pre-trade, post-trade and intra-day analytical tools. QuantEX has
access to the ITG Data Center, which is a comprehensive historical database that
provides a variety of derived analytics based upon raw historical data. Our
support specialists translate the trading criteria developed by the client into
a set of trading rules for trading securities, which are then loaded into
QuantEX. QuantEX applies the client's proprietary trading rules to a continuous
flow of current market information on the list of securities selected by the
user to generate real-time decision support. A user's rules can be based on a
wide range of quantitative models or strategies, such as liquidity measures,
technical indicators, price benchmarks, tracking to specific industries and
sectors, pairs or other long or short strategies, index arbitrage, risk
measurements and liquidity parameters for trade urgency, size or timing. These
rules typically serve as a guide in support of a client's trading decisions.
Additionally, QuantEX supports the ability to implement these trading decisions
automatically via an auto-trading strategy.
6
As such, QuantEX can automate the complex trade management requirements
typical of investment strategies that trade large volumes of securities through
multiple sources of liquidity. Orders can be electronically routed to multiple
markets, including the New York, American and certain regional stock exchanges,
the Nasdaq National Market, POSIT, the Electronic Trading Desk, over-the-counter
market-makers, Bloomberg's Tradebook and selected broker-dealers. We intend to
create links to additional electronic communications networks and other
liquidity sources where appropriate. Trades routed through QuantEX are
automatically tracked and summarized. Each order can be monitored by source of
execution, by trade list, by portfolio or globally with all other orders placed.
QuantEX's built-in trade allocation features provides a facility for automated
back-office clearance and settlement.
Our support specialists install the system, train users and provide ongoing
support for the use of QuantEX's order routing and analysis capabilities.
Specialists are knowledgeable about portfolio management and trading as well as
the system's hardware and software. Our support team works closely with each
client to develop trading strategies and rules, explore new trading approaches,
provide system integration services and implement system upgrades and
enhancements.
Revenues are generated through commissions and transaction fees attached to
each trade electronically routed through QuantEX to the many destinations
available from the application. We do not derive royalties from the sale or
licensing of the QuantEX software.
SMARTSERVERS
SmartServers allow clients to send orders to a computer for execution using
a designated trading strategy. Clients may send orders via the Platform and
QuantEX, via direct connections and via our Electronic Trading Desk.
SmartServers implement a trading strategy in an automated fashion and thereby
serve as an additional trading resource, allowing clients to focus their time
and attention on other trading issues.
We have introduced our first server-based trading strategy with the VWAP
SmartServer. The VWAP SmartServer is designed to allow clients to direct their
orders to us to be executed in a manner designed to closely track a security's
volume-weighted average price, or VWAP, throughout the trading day. The VWAP
SmartServer analyzes trade size and liquidity and determines the appropriate
order size and order price to approximate the VWAP. Clients may choose to
execute relative to the VWAP price for the entire trading day, or for some
subset of that trading day.
ELECTRONIC TRADING DESK
The Electronic Trading Desk is a full-service agency execution group that
specializes in the use of our proprietary products, including extensive use of
POSIT for trade execution. For clients that do not send orders electronically to
POSIT, our account executives receive orders for POSIT matches by telephone, fax
or e-mail. The desk accepts orders until a POSIT match begins and after
completion of the match execution reports are given verbally to clients who have
placed verbal or fax orders with the desk.
In addition to order management services for POSIT, the Electronic Trading
Desk provides agency execution services. QuantEX and Platform clients deliver
lists of orders electronically to our desk and, as orders are executed by the
desk, reports are automatically delivered electronically to the client's
terminal. Trading desk personnel are thereby able to assist customers with
decision support analyses generated by ITG Platform or QuantEX and with the
execution of trades. Clients give traders single stock orders or lists of orders
to work throughout the day as well as unfilled orders that remain due to order
imbalances in POSIT matches.
7
For order completion outside of POSIT match windows, the Electronic Trading
Desk utilizes numerous sources of liquidity to complete the trade. The trading
desk will actively seek the contra side of client orders by soliciting interest
among other clients, use QuantEX to route the orders to multiple markets,
including primary exchanges, regional exchanges, over-the-counter market makers
and electronic communications networks, or use our active order traders to
execute the trade with floor brokers or over-the-counter brokers.
The Portfolio Trading Group of our desk focuses on agency-only list and
program trading. By employing a step-by-step process that leverages technology
and access to multiple sources of liquidity, the Portfolio Trading Group seeks
to systematically achieve high quality execution for the client. A client
program is evaluated with a pre-trade analysis to determine aggregate portfolio
characteristics, liquidity ranking and market impact, and to quantify risk. The
group implements a number of sophisticated trading strategies using QuantEX to
meet execution objectives on an agency or agency incentive basis. After the
execution is completed, we provide the client with comprehensive reports
analyzing execution results utilizing ITG Research products.
ITG PLATFORM
ITG Platform, introduced in the first quarter of 1996, provides clients with
seamless connectivity from their desktop to a variety of execution destinations,
such as POSIT, the Electronic Trading Desk, our SmartServers, New York Stock
Exchange and American Stock Exchange via SuperDOT, and the Nasdaq National
Market and other over-the-counter market makers. We intend to create links to
additional electronic communications networks and other liquidity sources where
appropriate. Orders may be corrected or canceled electronically, and all reports
are delivered electronically back to the ITG Platform. The ITG Platform also
supports special trading interfaces as needed by POSIT 4 applications.
Allocation information can be associated with executions in the ITG Platform and
delivered to us electronically. ITG Platform has access to historical data
through the ITG Data Center, including a wide array of analytics, such as
average historical share volumes, dollar volumes, volatility and historical
spread statistics.
The ITG Platform was intended for broad distribution to institutional
clients, so it was designed to run in conventional PC environments alongside
other applications, and be inexpensive to install, maintain and support.
Many technical features support these goals:
- Other PC applications can interact with the ITG Platform using the
Financial Information eXchange, or FIX, data messaging protocol or using
"drag and drop."
- ITG Platform incorporates a spreadsheet package, so users can extend their
trade blotter with custom calculations.
- Custom execution reports can be created to fit each user's requirements.
- ITG Platform can access Bridge and ILX quote data if those systems are
used by the client.
- New versions of ITG Platform are distributed automatically to client sites
and installed without user or our intervention.
As of December 31, 1998, there were 507 installations of ITG Platform at 266
client sites.
"ISIS" PRE- AND POST-TRADE ANALYSIS
Accessed through QuantEX, ISIS is an equity pre- and post-trade analysis
system. Via the ISIS facility, QuantEX users can request both aggregate and
stock-by-stock liquidity reports for a trade portfolio prior to and during
execution. Clients can generate standard reports or use a report writer to
8
design custom reports. Reports can be viewed, printed or saved to a file.
Certain elements of these reports can also be displayed directly on the QuantEX
execution page and referenced in QuantEX strategies. These pre-trade analyses
help QuantEX users make decisions about how best to trade a portfolio, for
example by helping identify the most difficult trades for special handling and
by providing a reference point for evaluating principal trade pricing.
The ISIS post-trade reporting facility allows QuantEX users to compare
actual executed prices to user-selected benchmark prices in order to help assess
trade execution quality. Available benchmarks include the volume-weighted
average price, closing price and opening price. Post-trade reports generated by
ISIS have the same output options as the pre-trade facility, namely on screen,
to a printer or to a file.
ITG/OPT
ITG/Opt is a computer-based equity portfolio selection system that employs
advanced optimization techniques to help investors construct portfolios that
meet their investment objectives. Special features of the system make it
particularly useful to "long/short" and taxable investors, as well as any
investor seeking to control transaction costs. ITG/Opt is usually delivered as a
"turnkey" system that includes software and, in some cases, hardware and data.
Included in the service is telephone and on-site support to assist in training
and integration of the system with the user's other investment systems and
databases. In addition to its core portfolio construction capabilities, ITG/Opt
has powerful backtesting and batch scheduling features that permit efficient
researching of new or refined investment strategies. The system, which is
targeted at highly sophisticated investment applications, is offered primarily
on a value-added basis to our largest clients. Typically, portfolios that are
constructed using ITG/Opt are executed via ITG, using one or more execution
services, such as QuantEX, the Electronic Trading Desk and POSIT 4.
ITG RESEARCH
In addition to its role in the firm's overall research and development
effort, Research provides both sales and consulting services to our clients and
prospects. Taken together, these activities are a key component of our overall
relationship development and maintenance activities.
In its sales capacity, Research introduces our clients and prospects to the
full range of products and services offered by the firm and provides information
about features, pricing and technical/ functional specifications. The sales
process includes development of an in-depth understanding of client practices
and requirements and the design and presentation of integrated solutions based
on our products.
Consulting encompasses a set of value-added services for the benefit of our
clients. These services break down into two main categories: support for our
products and provision of quantitative analysis. The products supported by
Research are QuantEX, ISIS, Platform, POSIT 4 and ITG/Opt. Support activities
include trading strategy design and implementation, system integration, training
and coordination of technical support. Quantitative analysis covers a broad
range of activities such as transaction cost analysis, investment strategy
simulations and provision of historical time series of proprietary analytics. As
part of its analysis activities, Research publishes and distributes studies on
topics of interest to its clients. In the same way users of fundamental research
compensate the traditional brokerages that provide such research (i.e.,
directing commissions to such brokerage house), our clients reward the firm for
these value-added research services.
ITG EUROPE
We are pursuing the international market in a variety of ways, through
joint-ventures with strategic partners and the development of specially-tailored
versions of our services. In the fourth quarter of
9
1998, we and Societe Generale finalized a 50/50 joint venture through the
creation of Investment Technology Group (Europe) Limited. On November 18, 1998,
ITG Europe launched a new agency brokerage operation that includes the operation
of a European version of the POSIT system, which currently matches buyers and
sellers of U.K.-listed equities twice daily, at 11:00 a.m. and 3:00 p.m., London
time.
AUSTRALIAN POSIT
In 1997, we and Burdett, Buckeridge & Young finalized a 50/50 joint venture
through the creation of ITG Australia Limited, a new international brokerage
firm that applies our cost-saving execution and transaction research
technologies to Australian equity trading. ITG Australia is the culmination of
efforts commenced in 1995 when a license to POSIT was granted to Burdett, one of
Australia's leading brokerage firms. Through this joint venture we are pursuing
U.S. business from Australian investors and providing U.S. clients with access
to the Australian marketplace.
CANADIAN QUANTEX
We have developed a version of QuantEX for the Canadian markets. This
software is licensed on a perpetual, exclusive, royalty-free basis to VERSUS
Technologies, Inc., a Canadian technology-focused trade automation firm based in
Toronto. The period of exclusivity for the Canadian QuantEX license expires on
December 31, 1999. Pursuant to this license and a series of transactions with
RBC Dominion Securities, the predecessor owner of the VERSUS assets, we received
a minority interest in VERSUS. We and VERSUS have also entered into three
agreements for trade execution by us in POSIT and other United States markets:
(a) a routing agreement pursuant to which VERSUS routes orders of Canadian
registered brokers to us, (b) an introducing broker agreement pursuant to which
VERSUS's registered broker affiliate sends institutional orders to us and (c) an
introducing broker agreement pursuant to which VERSUS's registered broker
affiliate sends retail orders to us.
ARIZONA STOCK EXCHANGE
We are the executing broker for all transactions executed on the Arizona
Stock Exchange. We perform this function as a courtesy to our clients. We share
revenues generated from these transactions with the Arizona Stock Exchange.
REGULATION
The securities industry in the United States is subject to extensive
regulation under both federal and state laws. The SEC is the federal agency
responsible for the administration of the federal securities laws. Regulation of
broker-dealers has been primarily delegated to self-regulatory organizations,
principally the National Association of Securities Dealers, Inc. and national
securities exchanges. The National Association of Securities Dealers has been
designated by the SEC as our self-regulatory organization. The self-regulatory
organizations conduct periodic examinations of member broker-dealers in
accordance with rules they have adopted and amended from time to time, subject
to approval by the SEC. Securities firms are also subject to regulation by state
securities administrators in those states in which they conduct business. ITG
Inc. is a registered broker-dealer in 49 states and the District of Columbia.
Broker-dealers are subject to regulations covering all aspects of the
securities business, including sales methods, trade practices among
broker-dealers, use and safekeeping of clients' funds and securities, capital
structure of securities firms, record-keeping and conduct of directors, officers
and employees. Additional legislation, changes in the interpretation or
enforcement of existing laws and rules may directly affect the mode of operation
and profitability of broker-dealers. The SEC, self-regulatory organizations and
state securities commissions may conduct administrative proceedings,
10
which can result in censure, fine, the issuance of cease-and-desist orders or
the suspension or expulsion of a broker-dealer, its officers or employees. The
principal purpose of regulation and discipline of broker-dealers is the
protection of clients and the securities markets, rather than the protection of
creditors and stockholders of broker-dealers.
ITG Inc. is required by law to belong to the Securities Investor Protection
Corporation. In the event of a broker-dealer's insolvency, the Securities
Investor Protection Corporation fund provides protection for client accounts up
to $500,000 per customer, with a limitation of $100,000 on claims for cash
balances.
REGULATION ATS
Since the formation of the POSIT joint venture, POSIT has operated under a
no-action letter from the SEC staff that it would take no enforcement action if
POSIT were operated without registering as an exchange. As a result, POSIT has
not been registered with the SEC as an exchange, although ITG Inc. is registered
as a broker-dealer and is subject to regulation as such. Material changes to
POSIT currently require prior notice to the SEC pursuant to the conditions of
the no-action letter and under Rule 17a-23 under the Exchange Act. On December
2, 1998, the SEC adopted Regulation ATS, which repeals Rule 17a-23 and
establishes a new regulatory framework for alternative trading systems such as
POSIT. Regulation ATS will allow alternative trading systems to choose to
register as exchanges or as broker-dealers and will require compliance with
informational requirements that are similar to Rule 17a-23. However, POSIT will
no longer be subject to the restrictions of the no-action letter. Upon
effectiveness of Regulation ATS on April 21, 1999, we anticipate that we will
continue to operate POSIT as part of our broker-dealer operations and will not
register POSIT as an exchange. There can be no assurance that the SEC will not
in the future seek to impose more stringent regulatory requirements on the
operation of alternative trading systems such as POSIT. In addition, certain of
the securities exchanges have actively sought to have more stringent regulatory
requirements imposed upon automated trade execution systems. There can be no
assurance that Congress will not enact legislation applicable to alternative
trading systems.
NET CAPITAL REQUIREMENT
As a registered broker-dealer, ITG Inc. is subject to the SEC's uniform net
capital rule. The net capital rule is designed to measure the general integrity
and liquidity of a broker-dealer and requires that at least a minimum part of
its assets be kept in a relatively liquid form.
The net capital rule prohibits a broker-dealer doing business with the
public from allowing the aggregate amount of its indebtedness to exceed 15 times
its adjusted net capital or, alternatively, its adjusted net capital to be less
than 2% of its aggregate debit balances (primarily receivables from clients and
broker-dealers) computed in accordance with the net capital rule. We use the
latter method of calculation.
A change in the net capital rule, imposition of new rules or any unusually
large charge against capital could limit certain operations of ITG Inc., such as
trading activities that require the use of significant amounts of capital.
As of December 31, 1998, ITG Inc. had net capital of $72.0 million, which
exceeded minimum net capital requirements by $71.7 million. Jefferies Group,
Inc. ("Jefferies Group") and we have previously announced plans to separate
Jefferies & Company, Inc. ("Jefferies & Company") and other Jefferies Group
subsidiaries from our company through a spin-off and upstream merger and the
related transactions. If the spin-off and upstream merger and the related
transactions had been completed on December 31, 1998, on a pro forma basis ITG
Inc. would have had regulatory net capital of $10 million, which includes pro
forma borrowing of approximately $1.4 million. Based on a closing of the
upstream merger of March 31, 1999, we estimate that ITG Inc. will have excess
net regulatory
11
capital of approximately $20 million. In addition, we have arranged a $20
million revolving credit facility that we will be entitled to draw on to
increase net regulatory capital. For a discussion of these transactions and the
anticipated effects on operating and regulatory capital, see "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources and--Jefferies Group and ITGI Plan
to Separate into Two Independent Companies". Although we believe that the
combination of our existing net regulatory capital, operating cash flows and the
revolving credit facility will be sufficient to meet regulatory capital
requirements, a shortfall in net regulatory capital would have a material
adverse effect on our business and our results of operations.
CREDIT RISK
Although ITG Inc. is registered as a broker-dealer, we generally do not
perform traditional broker-dealer services. We do not act as a market-maker with
respect to any securities or otherwise as a principal in any securities
transactions; we act only on an agency basis. Therefore, we do not have exposure
to credit risks in the way that traditional broker-dealers have such exposure.
The relatively low credit risk of our businesses is reflected in the minimal net
capital requirements imposed on ITG Inc. as a broker-dealer.
LICENSE AND RELATIONSHIP WITH BARRA
In 1987, Jefferies & Company and BARRA Inc. formed a joint venture for the
purpose of developing and marketing POSIT. In 1993, Jefferies & Company assigned
all of its rights relating to the joint venture and the license agreement,
discussed below, to us.
The technology used to operate POSIT is licensed to us pursuant to a
perpetual license agreement between us and the joint venture. The license
agreement grants us the exclusive right to use certain proprietary software
necessary to the continued operation of POSIT and a non-exclusive license to use
proprietary software that operates in conjunction with POSIT. We pay quarterly
royalties to the joint venture to use other proprietary software that operates
in conjunction with POSIT equal to specified percentages of the transaction fees
charged by us on each share crossed through POSIT. For the years ended December
31, 1998, 1997 and 1996, BARRA received aggregate royalty payments from the
joint venture of $15.2 million, $9.8 million, and $8.8 million, respectively,
under the license agreement. Under the terms of the joint venture, we and BARRA
are prohibited from competing directly or indirectly with POSIT.
The license agreement permits BARRA on behalf of the joint venture to
terminate the agreement upon certain events of bankruptcy or insolvency or upon
an uncured breach by us of certain covenants, the performance of which are all
within our control. Although we do not believe that we will experience
difficulty in complying with our obligations under the license agreement, any
termination of the license agreement resulting from an uncured default would
have a material adverse effect on us.
Under the license agreement and the terms of the joint venture, BARRA
continues to provide certain support services to us in connection with the
operation of POSIT, including computer time, software updates and the
availability of experienced personnel. BARRA also provides support for the
development and maintenance of POSIT.
Under the terms of the joint venture, BARRA generally has the right to
approve any sale, transfer, assignment or encumbrance of our interest in the
joint venture. The POSIT joint venture may earn a royalty from licensing the
POSIT technology to other businesses. The joint venture licensed to us and
Burdett the right to use the POSIT technology for crossing equity securities in
Australia.
In the third quarter of 1997, BARRA finalized a joint venture with Prebon
Yamane to market POSIT-FRA, the first computer-based system for crossing forward
rate agreements. The POSIT joint
12
venture licensed the POSIT software to Prebon. POSIT-FRA provides a confidential
electronic environment where major financial institutions can match specific
sets of forward rate agreements contracts to offset interest rate risk, a
condition that is pervasive in interest rate swap portfolios.
In the fourth quarter of 1998, we finalized the formation of ITG Europe with
Societe Generale. The POSIT joint venture has licensed to ITG Europe the POSIT
software.
COMPETITION
The automated trade execution and analysis services offered by us compete
with services offered by leading brokerage firms and transaction processing
firms, and with providers of electronic trading and trade order management
systems and financial information services. POSIT also competes with various
national and regional securities exchanges and execution facilities, Nasdaq and
electronic communications networks such as Instinet, for trade execution
services. Many of our competitors have substantially greater financial, research
and development and other resources. We believe that our services compete on the
basis of access to liquidity, transaction costs, market impact cost, timeliness
of execution and probability of trade completion. Although we believe that
POSIT, QuantEX, ITG Platform and the Electronic Trading Desk and Research
services have established certain competitive advantages, our ability to
maintain these advantages will require continued investment in the development
of our services, additional marketing activities and customer support services.
There can be no assurance that we will have sufficient resources to continue to
make this investment, that our competitors will not devote significantly more
resources to competing services or that we will otherwise be successful in
maintaining our current competitive advantages. In addition, we cannot predict
the effect that changes in regulation may have on the competitive environment.
In particular, the adoption of Regulation ATS may make it easier for securities
exchanges, Nasdaq or others to establish competing trading systems.
RESEARCH AND PRODUCT DEVELOPMENT
We believe that fundamental changes in the securities industry have
increased the demand for technology-based services. We devote a significant
portion of our resources to the development and improvement of these services.
Important aspects of our research and development effort include enhancements of
existing software, the ongoing development of new software and services and
investment in technology to enhance our efficiency. The software programs, which
are incorporated into our services, are subject, in most cases, to copyright
protection. Research and development costs were $11.0 million, $8.4 million and
$6.8 million for 1998, 1997 and 1996, respectively.
In connection with such research and product development and capital
expenditures to improve other aspects of our business, we incur substantial
expenses that do not vary directly, at least in the short term, with
fluctuations in securities transaction volumes and revenues. In the event of a
material reduction in revenues, we may not reduce such expenses quickly and, as
a result, we could experience reduced profitability or losses. Conversely,
sudden surges in transaction volumes can result in increased profit and profit
margin. To ensure that we have the capacity to process projected increases in
transaction volumes, we have historically made substantial capital and operating
expenditures in advance of such projected increases, including during periods of
low transaction volumes. In the event that such growth in transaction volumes
does not occur, the expenses related to such investments could, as they have in
the past, cause reduced profitability or losses. Additionally, during recent
periods of high transaction volumes and increased revenues, we have also made
substantial capital and operating expenditures to enhance future growth
prospects.
We work closely with BARRA on the development of POSIT enhancements. We
expect to continue this level of investment to improve existing services and
continue the development of new services.
13
DEPENDENCE ON PROPRIETARY INTELLECTUAL PROPERTY; RISKS OF INFRINGEMENT
Our success is dependent, in part, upon our proprietary intellectual
property. We generally rely upon patents, copyrights and trademarks to establish
and protect our rights in our proprietary technology, methods and products. A
third party may still try to challenge, invalidate or circumvent the protective
mechanisms that we select. We cannot assure that any of the rights granted under
any patent, copyright or trademark we may obtain will protect our competitive
advantages. In addition, the laws of some foreign countries may not protect our
proprietary rights to the same extent as the laws of the United States.
There are numerous patents in the computer and financial industries and new
patents are being issued at a rapid rate. Therefore, it is not economically
practicable to determine in advance whether any of our products or any of its
components or a service or method infringes the patent rights of others. It is
likely that from time to time, we will receive notices from others of claims or
potential claims of intellectual property infringement or we may be called upon
to defend a joint venture partner, customer, vendee or licensee against such
third party claims. Responding to these kinds of claims, regardless of merit,
could consume valuable time, result in costly litigation or cause delays, all of
which could have a material adverse effect on us. Responding to these claims
could also require us to enter into royalty or licensing agreements with the
third parties claiming infringement. Such royalty or licensing agreements, if
available, may not be available on terms acceptable to us.
EMPLOYEES
As of December 31, 1998, we employed 261 personnel.
ITEM 2. PROPERTIES
Our principal offices are located at 380 Madison Avenue in New York City
where we occupy the entire 4(th) floor or approximately 44,704 square feet of
office space. In anticipation of future expansion we have leased a portion of
the 5(th) floor (approximately 12,726 square feet of office space). This space
is currently being sub-let. The lease payment as compared to the rental income
will have an immaterial effect upon our operating results. The fifteen-year
lease term for both the fourth and fifth floors expire in 2012.
We also maintain a research, development and technical support services
facility in Culver City, California where we occupy approximately 44,316 square
feet of office space. We lease the California facility pursuant to a ten-year
lease agreement that expires in December 2005.
Additionally, we also maintain a "hot" backup and regional office for
Financial Engineering Research and QuantEX support in Boston, Massachusetts
where we occupy approximately 10,588 square feet of office space. The ten-year
lease term for this space expires in 2005.
ITEM 3. LEGAL PROCEEDINGS
In 1998, we received a "30-day letter" proposing certain adjustments which,
if sustained, would result in a tax deficiency of approximately $9.6 million
plus interest. The adjustments proposed relate to (i) the disallowance of
deductions taken in connection with the termination of certain compensation
plans at the time of our initial public offering in 1994 and (ii) the
disallowance of tax credits taken in connection with certain research and
development expenditures. We believe that the tax benefits in question were
taken properly and intend to vigorously contest the proposed adjustments. Based
on the facts and circumstances known at this time, we are unable to predict when
this matter will be resolved or the costs associated with its resolution.
In February 1999, we became aware of patents purportedly owned by Belzberg
Financial Markets & News International Inc. and Sydney Belzberg, an officer of
that company (the "Belzberg
14
Patents"). One or more of the Belzberg Patents may relate to the devices, means
an or methods that we and/or customers, licensees or joint venture partners use
in the conduct of business. On March 5, 1999, a Canadian licensee of some of our
technology, received a letter asserting that the licensee was infringing one of
the Belzberg Patents. The licensee has denied the claims of infringement and has
asserted that the Belzberg Patent at issue is invalid or unenforceable. Under
certain conditions, we may have a duty to defend or indemnify the licensee for
any costs or damages arising out of an infringing use of the technology we have
licensed to them. We are monitoring the matter and may participate in any
challenge to the Belzberg Patent the licensee may make.
We are unaware of any actual claims of patent infringement leveled against
us or any of our customers or joint venture partners by any of the title owners
of the Belzberg Patents. Based upon our review to date we believe that any such
claims arising out of the Belzberg Patents would be without merit and we would
vigorously defend any such claim, including, if warranted, initiating legal
proceedings. However, intellectual property disputes are subject to inherent
uncertainties and there can be no assurance that any potential claim would be
resolved favorable to us or that it would not have a material adverse affect on
us. We will monitor the Belzberg Patent situation and take action accordingly.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
fourth quarter ended December 31, 1998.
15
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
COMMON STOCK DATA
Our common stock is quoted on the Nasdaq National Market under the symbol
"ITGI". In connection with the spin-off and upstream merger and the related
transactions, we have applied for listing of New ITGI common stock on the New
York Stock Exchange under the symbol "ITG."
The following table sets forth, for the periods indicated, the range of the
high and low closing sales prices per share of our common stock as reported on
the Nasdaq National Market.
HIGH LOW
--------- ---------
1998
First Quarter............................................................ $ 37.50 $ 24.38
Second Quarter........................................................... 35.50 25.50
Third Quarter............................................................ 34.00 27.25
Fourth Quarter........................................................... 62.06 18.50
1997
First Quarter............................................................ 23.75 18.38
Second Quarter........................................................... 26.88 17.88
Third Quarter............................................................ 32.00 26.31
Fourth Quarter........................................................... 31.25 26.25
On March 15, 1999, the closing sales price per share for our common stock as
reported on the Nasdaq National Market was $46.50. On March 15, 1999, we believe
that our common stock was held by approximately 1,500 stockholders of record or
through nominee in street name accounts with brokers.
We have not paid a dividend since May 4, 1994. Prior to and subject to the
satisfaction of the conditions to the upstream merger, we will pay a special
cash dividend of $4.00 per share to each stockholder of record as of April 20,
1999. Our revolving credit facillity restricts our ability to pay dividends. See
"Management's Discussion of Financial Condition and Results of
Operations--Liquidity and Capital Resources." Our dividend policy following
consummation of the upstream merger will be to retain earnings to finance the
operations and expansion of our businesses. Other than the special cash
dividend, we do not anticipate paying any cash dividends on our common stock in
the foreseeable future.
16
ITEM 6. SELECTED FINANCIAL DATA
The selected Consolidated Statement of Operations data and the Consolidated
Statement of Financial Condition data presented below as of and for each of the
years in the five-year period ended December 31, 1998, are derived from our
consolidated financial statements, which financial statements have been audited
by KPMG LLP, independent auditors. Earnings per share information prior to 1997
has been retroactively restated to conform with the FASB SFAS No. 128, EARNINGS
PER SHARE. Such data should be read in connection with the consolidated
financial statements contained on pages 28 through 51.
YEAR ENDED DECEMBER 31,
---------------------------------------------------------
1998 1997 1996 1995 1994(1)
---------- ---------- ---------- --------- ----------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Total revenues................................................ $ 212,205 $ 137,042 $ 111,556 $ 72,381 $ 56,716
Total expenses................................................ 131,270 89,782 70,555 47,493 69,106
---------- ---------- ---------- --------- ----------
Income (loss) before income taxes............................. 80,935 47,260 41,001 24,888 (12,390)
Income tax expense (benefit).................................. 37,541 20,343 17,666 9,983 (4,529)
---------- ---------- ---------- --------- ----------
Net income (loss)............................................. $ 43,394 $ 26,917 $ 23,335 $ 14,905 $ (7,861)
---------- ---------- ---------- --------- ----------
---------- ---------- ---------- --------- ----------
Basic net earnings (loss) per share of common stock........... $ 2.36 $ 1.48 $ 1.28 $ 0.81 $ (0.45)
---------- ---------- ---------- --------- ----------
---------- ---------- ---------- --------- ----------
Diluted net earnings (loss) per share of common stock......... $ 2.25 $ 1.42 $ 1.26 $ 0.81 $ (0.45)
---------- ---------- ---------- --------- ----------
---------- ---------- ---------- --------- ----------
Basic weighted average shares outstanding (in millions)....... 18.4 18.2 18.3 18.5 17.5
Diluted weighted average shares and common stock equivalents
outstanding (in millions)................................... 19.3 18.9 18.6 18.5 17.5
CONSOLIDATED STATEMENT OF FINANCIAL CONDITION DATA:
Total assets.................................................. $ 180,512 $ 113,641 $ 82,798 $ 55,318 $ 38,354
Total stockholders' equity.................................... $ 143,709 $ 93,763 $ 67,093 $ 45,479 $ 31,893
OTHER SELECTED FINANCIAL DATA:
Revenues per trading day (in thousands)....................... $ 842 $ 542 $ 439 $ 287 $ 225
Shares executed per day (in millions)......................... 43 27 22 15 10
Revenues per average number of employees (in thousands)....... $ 888 $ 733 $ 814 $ 689 $ 675
Average number of employees................................... 239 187 137 105 84
Total number of customers(2).................................. 535 452 417 354 274
POSIT....................................................... 490 414 396 330 253
QuantEX..................................................... 54 50 55 81 58
Platform.................................................... 266 138 36 N/A N/A
Total number of customer installations:
QuantEX..................................................... 144 138 109 97 78
Platform.................................................... 507 204 67 N/A N/A
Return on average stockholders' equity........................ 37.4% 33.9% 45.5% 39.3% (35.0)%
Book value per share.......................................... $ 7.73 $ 5.15 $ 3.68 $ 2.47 $ 1.72
Tangible book value per share................................. $ 7.66 $ 5.04 $ 3.54 $ 2.27 $ 1.52
Price to earnings ratio using diluted net earnings per share
of common stock............................................. 27.6 19.7 15.3 11.4 N/A
17
The following graph represents the number of shares ITG Inc. executed as a
percentage of the market volume in the U.S. market.( 3)
EDGAR REPRESENTATION OF DATA POINTS USED IN PRINTED GRAPHIC
ITG VOLUME AS A PERCENTAGE OF MARKET VOLUME
1993 0.0153
1994 0.017
1995 0.019
1996 0.0226
1997 0.0224
1998 0.0294
- ------------------------------
(1) In connection with our initial public offering (the "Offering") in May
1994, certain management employment agreements, the performance share plans
(consisting of a 12.7% phantom equity interest in ITG Inc. and an annual
profits bonus component) and non-compensatory ITG stock options (on 10% of
the outstanding shares of ITG Inc. common stock) were terminated as of May
1, 1994 in exchange for $31.1 million in cash, a portion of which was used
to purchase Jefferies Group common stock. Prior to December 31, 1993, we
had expensed and paid to Jefferies Group an additional $9.4 million related
to the above-mentioned Performance Share Plans. Immediately prior to the
consummation of the Offering, Jefferies Group transferred its $9.4 million
liability and an equivalent amount of cash to us and it was to be applied
by the us as part of the termination of the Performance Share Plans. The
total liability in connection with the above-mentioned plans was $40.5
million. Of the non-recurring expense of $31.1 million, approximately
$900,000 was recorded in Performance Share Plans expense in the first two
quarters of 1994 under the terms of the prior agreement. The total
Performance Share Plans expense recorded for the first two quarters of 1994
was $1.5 million. The remaining $600,000 of such expense was for the annual
profits bonus component of the Performance Share Plans for January 1, 1994
through May 1, 1994 (the termination date of the above-mentioned plans).
Only the future annual profits bonus component (post Offering) of the
above-mentioned plans was determined to be a component of the $40.5 million
liability. The annual profits bonus component was earned during the period
January 1, 1994 through May 1, 1994 by the payees regardless of the
Offering. The remaining liability of $30.2 million was recorded as
termination of plans expense in the second quarter of 1994.
(2) Customers include those clients who have generated revenues in each year
in excess of $1,000.00.
(3) The percentages on the graph are total ITG shares executed divided by the
"market" volume. Total ITG shares executed includes total POSIT shares,
QuantEX shares and shares executed by the Electronic Trading Desk. Market
volume includes shares executed by and as provided by the New York Stock
Exchange and Nasdaq. Market volume excludes ITG shares executed.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
You should read the following discussion and analysis along with our
financial statements, including the notes.
GENERAL
We are a leading provider of automated securities trade execution and
analysis services to institutional equity investors. We are a full-service
execution firm that utilizes transaction processing technology to increase the
effectiveness and lower the cost of institutional and other trading. We generate
substantially all of our revenues from a single line of business consisting of
the following four services:
- POSIT, an electronic stock crossing system;
- QuantEX, a decision-support, trade management and routing system;
- ITG Platform, a PC-based routing and trade management system; and
- Electronic Trading Desk, an agency-only trading desk offering clients
efficient trading services with multiple sources of liquidity.
REVENUES primarily consist of commissions and fees from customers' use of
our transaction processing and analysis services. Because these commissions and
fees are paid on a per-transaction basis, revenues fluctuate from period to
period depending on the volume of securities traded through our services.
EXPENSES consist of compensation and employee benefits, transaction
processing, software royalties, occupancy and equipment, consulting,
telecommunications and data processing services, net loss on long-term
investments, spin-off costs and other general and administrative expenses.
Compensation and employee benefits expenses include base salaries, bonuses,
employment agency fees, part-time employee compensation, commissions paid to
employees of Jefferies Group, fringe benefits, including employer contributions
for medical insurance, life insurance, retirement plans and payroll taxes,
reduced by the employee portion of capitalized software. Transaction processing
expenses consist of floor brokerage and clearing fees. Software royalties
expenses are payments to our POSIT joint venture partner, BARRA. Occupancy and
equipment expenses include rent, depreciation, amortization of leasehold
improvements, maintenance, utilities, occupancy taxes and property insurance.
Consulting expenses are fees and commissions paid to non-employee consultants
for equity research, product development and other activities.
Telecommunications and data processing services include costs for computer
hardware, office automation and workstations, data center equipment, market data
services and voice, data, telex and network communications. Net loss on
long-term investments includes gains on the sale of equity investments, as
offset by amortization of goodwill, equity loss pickup and initial start-up
costs. Spin-off costs include legal, accounting, consulting and various other
expenses related to the Company's proposed spin-off and upstream merger and the
related transactions. Other general and administrative expenses include
amortization of goodwill, legal, audit, tax and promotional expenses.
19
RESULTS OF OPERATIONS
The table below sets forth certain items in the statement of income
expressed as a percentage of revenues for the periods indicated:
YEAR ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
Revenues................................................................................. 100.0% 100.0% 100.0%
Expenses.................................................................................
Compensation and employee benefits..................................................... 24.3 22.2 22.5
Transaction processing................................................................. 12.7 15.6 14.1
Software royalties..................................................................... 7.2 7.2 7.9
Occupancy and equipment................................................................ 5.6 6.7 5.5
Consulting............................................................................. 1.1 1.5 2.2
Telecommunications and data processing services........................................ 3.8 4.8 4.3
Net loss on long-term investments...................................................... 0.1 0.2 0.0
Spin-off costs......................................................................... 0.9 0.0 0.0
Other general and administrative....................................................... 6.2 7.3 6.8
Total expenses................................................................... 61.9 65.5 63.2
Operating income......................................................................... 38.1 34.5 36.8
Income tax expense....................................................................... 17.7 14.8 15.8
Net income............................................................................... 20.4 19.6 20.9
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
REVENUES
Total revenues increased $75.2 million, or 54.9%, from $137.0 million to
$212.2 million. The number of trading days were 252 in 1998 compared to 253 in
1997. Revenues per trading day increased by $300,000, or 55.5%, from $542,000 to
$842,000. Revenues per employee increased $182,000, or 28.8%, from $631,000 to
$813,000. The increases were attributable to increases in the number of our
customers and increases in trading volume by our existing customers. Revenues
from the Electronic Trading Desk increased $19.5 million, or 64.9%, from $30.1
million to $49.6 million. Number of shares crossed on the POSIT system increased
2.1 billion, or 56.8%, from 3.7 billion to 5.8 billion. POSIT revenues in turn
increased $41.6 million, or 55.2%, from $75.4 million to $117.0 million. QuantEX
revenues increased $12.0 million, or 39.9%, from $30.1 million to $42.1 million.
EXPENSES
Total expenses increased $41.5 million, or 46.2%, from $89.8 million to
$131.3 million.
20
The following table itemizes expenses by category (in thousands):
YEAR ENDED DECEMBER
31,
--------------------
1998 1997 CHANGE % CHANGE
--------- --------- --------- -----------
Compensation and employee benefits................................... $ 51,462 $ 30,479 $ 20,983 68.8%
Transaction processing............................................... 26,920 21,413 5,507 25.7
Software royalties................................................... 15,247 9,848 5,399 54.8
Occupancy and equipment.............................................. 11,886 9,204 2,682 29.1
Consulting........................................................... 2,338 2,017 321 15.9
Telecommunications and data processing services...................... 8,138 6,605 1,533 23.2
Net loss on long-term investments.................................... 204 297 (93) (31.3)
Spin-off costs....................................................... 1,936 -- 1,936 N/A
Other general and administrative..................................... 13,139 9,919 3,220 32.5
Income taxes......................................................... 37,541 20,343 17,198 84.5
COMPENSATION AND EMPLOYEE BENEFITS. Salaries, bonuses and related employee
benefits increased approximately $21.0 million over the prior year. Such
increases were primarily due to our profitability-based compensation plan,
growth in our employee base of 44 or 20.3%, from 217 to 261 and additional
compensation necessary to attract and retain quality personnel. Over 50% of the
increase in new employees were staffed in technology, product development and
production infrastructure. In addition, our board of directors voted to
accelerate the vesting of the options of our recently deceased President and
Chief Executive Officer, Scott P. Mason, resulting in a $2.8 million charge to
compensation expense, representing 13% of the increase.
TRANSACTION PROCESSING. The increase in transaction processing is primarily
due to an increase in ticket charges associated with a higher volume of
transactions in 1998. The increase in ticket charges of 28% was not
proportionate with the increase in revenues of 55% due to volume discounts
associated with clearing and execution services. A decrease in specialist fees
of 26% and floor broker fees of 3%, was offset by the volume increases in shares
executed by specialists of 49% and floor brokers of 51%, resulting in a net
increase in transaction processing expenses. Transaction processing as a
percentage of revenues decreased from 15.6% in 1997 to 12.7% in 1998.
SOFTWARE ROYALTIES. As software royalties are contractually fixed at 13% of
POSIT revenues, the increase is wholly attributable to an increase in POSIT
revenues.
OCCUPANCY AND EQUIPMENT. The increase in occupancy and equipment is
primarily attributable to additional depreciation and amortization of leasehold
improvements (representing 65% of the increase) and rent expense (representing
33% of the increase) related to the relocation and expansion of our corporate
headquarters (occupied in June 1997), combined with increases in headcount and
purchases of additional technologically advanced software.
CONSULTING. The increase in consulting expense is primarily due to costs
incurred for accounting and financial research of international joint venture
opportunities and a major telecommunication system conversion.
TELECOMMUNICATIONS AND DATA PROCESSING SERVICES. The increase in
technological and data communications processing expenses stems primarily from
the data feed upgrades for clients, primarily market data line connections, and
expenses relating to a telecommunication network conversion and contingency
planning.
NET LOSS ON LONG-TERM INVESTMENTS. The decrease in net loss on long-term
investments is due to income of $3.8 million recognized from the sale of our
37.4% equity ownership interest in the
Long-
21
View Group, Inc., offset by initial start-up costs for ITG Europe of $1.3
million and the combined costs of equity loss pick-up and amortization of
goodwill on ITG Australia of $0.2 million and the LongView Group, Inc, of $0.8
million.
SPIN-OFF COSTS. The spin-off expenses are attributable to our legal,
accounting, consulting and other expenses incurred for the spin-off
transactions.
OTHER GENERAL AND ADMINISTRATIVE. The increase in other general and
administrative expenses was the result of a write-off of a net receivable from
the former Global POSIT joint venture of approximately $1.0 million, accelerated
software amortization for specific products, increases in business development
costs, such as advertising and active sales efforts, and additional
administrative costs, associated with ITG Europe.
INCOME TAX EXPENSE
The increase in income tax expense is the result of an increase in pretax
income and an increase in the effective tax rate from 43.0% in 1997 to 46.4% in
1998. The increase in the effective rate was due to certain non-deductible
expenses, such as goodwill amortization and spin-off costs and the inability to
offset international losses with United States profits in calculating income tax
expense, that were not present in 1997.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
REVENUES
Total revenues increased $25.4, or 22.9%, from $111.6 million to $137.0
million. Increased revenues were attributed to a growing use of POSIT, QuantEX
and Electronic Trading Desk services. POSIT revenues increased $8.2 million, or
12.2%, from $67.2 million to $75.4 million while QuantEX revenues increased $5.2
million, or 21.2%, from $24.9 million to $30.1 million. Electronic Trading Desk
services increased $12.3 million, or 69.2%, from $17.8 million to $30.1 million.
Revenues per trading day increased by $103,000, or 23.5%, from $439,000 to
$542,000. Revenues per employee decreased $80,000, or 11.3%, from $711,000 to
$631,000.
EXPENSES
Total expenses increased $19.2 million, or 27.3%, from $70.6 million to
$89.8 million.
The following table itemizes expenses by category (in thousands):
YEAR ENDED DECEMBER
31,
--------------------
1997 1996 CHANGE % CHANGE
--------- --------- --------- -----------
Compensation and employee benefits..................................... $ 30,479 $ 25,047 $ 5,432 21.7%
Transaction processing................................................. 21,413 15,737 5,676 36.1
Software royalties..................................................... 9,848 8,798 1,050 11.9
Occupancy and equipment................................................ 9,204 6,111 3,093 50.6
Consulting............................................................. 2,017 2,492 (475) (19.1)
Telecommunications and data processing services........................ 6,605 4,789 1,816 37.9
Net loss on long-term investments...................................... 297 -- 297 N/A
Spin-off costs......................................................... -- -- -- N/A
Other general and administrative....................................... 9,919 7,581 2,338 30.8
Income taxes........................................................... 20,343 17,666 2,677 15.2
COMPENSATION AND EMPLOYEE BENEFITS. The increase in compensation and
employee benefits expenses is due to an increase in the number of employees
offset by an increase in capitalized software.
22
Capitalized software development costs increased approximately $4.4 million,
primarily due to additional projects and an increase in staff engaged in
software development. Compensation and employee benefits expenses per person
decreased $18,000, or 11.3%, from $159,000 to $141,000.
TRANSACTION PROCESSING. The increase in transactions processing expenses is
primarily due to the expense associated with a higher volume of transactions and
shares. Transaction processing expenses as a percentage of revenues increased
from 14.1% to 15.6%, primarily from a shift in the business mix towards QuantEX
and Electronic Trading Desk services. Those products have slightly lower margins
than POSIT due to charges for floor brokerage fees which are not incurred with
the POSIT business.
SOFTWARE ROYALTIES. As software royalties are contractually fixed at 13% of
POSIT revenues, the increase is wholly attributable to an increase in POSIT
revenues.
OCCUPANCY AND EQUIPMENT. The increase in occupancy and equipment expense is
due primarily to relocation of our corporate headquarters from 900 Third Avenue
to 380 Madison Avenue in mid-June 1997. Rent expense increased accordingly as
the rental square footage increased by more than 100%. We also had to accelerate
the write-off of the unamortized leasehold improvements from the 900 Third
Avenue location. In addition, depreciation expense increased approximately $1.7
million as a result of purchases of additional equipment associated with both
the move and increased headcount.
CONSULTING. Consulting is primarily for functions, which we currently
believe, are advantageous to out-source. The decrease is due primarily to our
undertaking in 1996 nonrecurring special projects related to contingency
planning and systems' security.
TELECOMMUNICATIONS AND DATA PROCESSING SERVICE. The increase is due
primarily to communications costs incurred in 1995 and 1996 relating to the
POSIT Joint Venture, which were presented for payment in the second quarter of
1997. In addition, duplicate services were required for the 900 Third Avenue and
380 Madison Avenue locations in connection with the move of our headquarters.
NET LOSS ON LONG-TERM INVESTMENTS. The increase in the net loss on
long-term investments is due to the combined costs of equity loss pick-up and
amortization of goodwill on ITG Australia and the LongView Group, Inc, of
$79,000 and $218,000, respectfully.
OTHER GENERAL AND ADMINISTRATIVE EXPENSE. The increase is largely
attributable to the increase in headcount of 60 employees. Related costs,
primarily services provided by Jefferies & Company, increased by approximately
$374,000. Travel and entertainment costs increased by approximately $1.1 million
primarily from an increased effort to promote our products. Legal fees increased
by approximately $510,000 as a result of exploring several strategic initiatives
and the costs associated with outsourcing legal services pending the hiring of a
new in-house general counsel.
INCOME TAX EXPENSE
Income tax expense increased by $2.6 million, or 14.7% from $17,700 to
$20,300. The increase is primarily due to an increase in pretax income. The
effective tax rate in 1997 and 1996 was 43.0% and 43.1%, respectively.
DEPENDENCE ON MAJOR CUSTOMERS
During 1998, revenue from our 10 largest customers accounted for
approximately 30.7% of our total revenue while revenue from each of our three
largest customers accounted for 7.9%, 4.5% and 3.2%, respectively, of total
revenue. During 1997, revenue from our 10 largest customers accounted for
approximately 34.5% of our total revenue while revenue from each of our three
largest customers accounted for 8.8%, 5.9%, and 3.4%, respectively, of total
revenue. Customers may discontinue use of our services at any time. The loss of
any significant customers could have a material adverse effect on
23
our results of operations. In addition, the loss of significant POSIT customers
could result in lower share volumes of securities offered through POSIT, which
may adversely affect the liquidity of the system.
LIQUIDITY AND CAPITAL RESOURCES
Our liquidity and capital resource requirements are the result of the
funding of working capital needs, primarily consisting of compensation, benefits
and transaction processing fees and software royalty fees. Historically, all
working capital requirements have been met by cash from operations. A
substantial portion of our assets is liquid, consisting of cash and cash
equivalents or assets readily convertible into cash.
We believe that our cash flow from operations and existing cash balances
will be sufficient to meet our cash requirements. We generally invest our excess
cash in money market funds and other short-term investments that generally
mature within 90 days or less. Additionally, securities owned, at fair value,
include highly liquid, variable rate municipal securities, auction rate
preferred stock and common stock. At December 31, 1998, cash equivalents
amounted to $77.3 million and receivables from brokers, dealers and other of
$24.1 million were due within 30 days.
We also invest a portion of our excess cash balances in cash enhanced
strategies, which we believe should yield higher returns without any significant
effect on risk. As of December 31, 1998, we had an investment in an arbitrage
fund. The fund's strategy is to invest in a hedged portfolio of convertible
securities. This strategy seeks an enhanced level of capital appreciation by
focusing on current income and capital appreciation. At December 31, 1998, the
amount of these investments was $1.0 million.
Historically, all regulatory capital needs of ITG Inc. have been provided by
cash from operations. See "Business--Regulation." We believe that cash flows
from operations and the payment of the exercise price upon the exercise of
expiring options will provide ITG Inc. with sufficient regulatory capital. On
March 16, 1999, we entered into an agreement with a bank to borrow, effective
upon the closing of the merger, up to $20 million on a revolving basis to enable
ITG Inc. to satisfy its regulatory net capital requirements. The commitment will
expire on March 14, 2000. Any amounts drawn may be prepaid at any time, but no
later than March 15, 2001. We have agreed to pay an up-front fee totaling 1.5%
of the commitment and will incur a fee at a rate per annum equal to 0.35% on the
daily amount of the unused commitment to March 13, 2000. The interest rate on
any amounts drawn will be prime; if such amounts are not repaid within two
weeks, the interest rate will increase to prime plus 2%. The credit facility is
secured by a pledge of the stock of ITG Inc., ITG Ventures, Inc. and ITG Global
Trading Incorporated. This agreement limits our ability to pay cash dividends or
incur indebtedness and requires us to comply with certain financial covenants.
Assuming that the merger and related transactions will close on March 31, 1999,
following payment of the special cash dividend we estimate that ITG Inc. will
have excess net regulatory capital of approximately $20 million (not including
the $20 million available under the new revolving credit facility). Although we
believe that the combination of our existing net regulatory capital, operating
cash flows and the revolving credit facility will be sufficient to meet
regulatory capital requirements, a shortfall in net regulatory capital would
have a material adverse effect on us.
In 1998, we established a $2 million credit line with a bank to fund
temporary regulatory capital shortfalls encountered periodically by ITG
Australia. The lender charges us interest at the federal funds rate plus 1%. We
lend amounts borrowed to the ITG Australia and charge interest at the federal
funds rate plus 2%. At December 31, 1998, no amounts were outstanding under this
bank credit line and no amounts were owed to us by the ITG Australia. Borrowings
from the bank and loans to the ITG Australia will not be permitted during the
period that the revolving credit agreement discussed above is effective.
24
EFFECTS OF INFLATION
We do not believe that the relatively moderate levels of inflation which
have been experienced in North America in recent years have had a significant
effect on our revenue or profitability. However, high inflation may lead to
higher interest rates which might cause investment funds to move from equity
securities to debt securities or cash equivalents.
THE YEAR 2000 ISSUE
Some computer systems and software products were originally designed to
accept only two digit entries in the data code field. As a result, certain
computer systems and software packages will not be able to interpret dates
beyond December 31, 1999 and thus will interpret dates beginning January 1, 2000
incorrectly. This could potentially result in computer failure or
miscalculations, causing operating disruptions, including an inability to
process transactions, send invoices or engage in normal business operations.
Therefore, companies may have to upgrade or replace computer and software
systems in order to comply with the "Year 2000" requirements.
STRATEGY
We are well aware of and are actively addressing the Year 2000 issue and the
potential problems that can arise in any computer and software system. Planning
and evaluation work began in 1997 including the identification of those systems
affected. We established a "Year 2000 working group" to address the Year 2000
issue. We have targeted our efforts into three major areas: (1) vendors; (2)
company proprietary products; and (3) clients.
VENDORS. Our ability to successfully meet the Year 2000 challenge is in
part dependent on our vendors. We have contacted our vendors to determine the
status of their Year 2000 programs and have created a database recording each
vendor's readiness status. Over 95% of our vendors have responded that their
systems are currently Year 2000 compliant, and substantially all of our vendors
have indicated that they expect their systems to be Year 2000 compliant by
September 30, 1999. Based upon the results of our testing to date, we are
satisfied with the representations we have received from our vendors. We are in
the process of integrating Year 2000 compliant versions of our vendors' software
and hardware with our proprietary products.
COMPANY PROPRIETARY PRODUCTS. We have evaluated our trading systems and
have endeavored to examine all code contained in our internally produced
software. We have completed regression testing of all mission critical systems
and released Year 2000 compliant versions of all such systems other than
QuantEX. We plan to complete date-forward testing of all mission critical
systems and release a Year 2000 compliant version of QuantEX by the end of June
1999. We also intend to participate in the Securities Industry Association's
industry-wide testing program in 1999.
CLIENTS. We sent a letter explaining our Year 2000 strategy to all clients
in July 1998. In addition, we contacted clients on a project-by-project basis to
ascertain compatibility between our systems and changes made to the clients'
systems. We plan to provide point-to-point testing opportunities for our clients
starting in April 1999.
YEAR 2000 CONTINGENCY PLANNING
We are in the early stages of establishing a Year 2000 contingency plan to
deal with both internal and external failures of critical systems. The Year 2000
issue can affect all businesses that rely heavily on automated systems. Our Year
2000 contingency plan is therefore intended to address failures of internal
systems, client connections and connections to trading destinations, as well as
failures of major infrastructure components. We intend to have our contingency
plan in place by July 1999 and to update and refine such plan as needed on a
continuing basis. We believe, however, that such contingency plan
25
will not provide satisfactory solutions for our worst-case scenario--the general
failure of computer and communication systems relied upon by the securities
industry, such as the systems provided by long distance telephone companies, the
stock exchanges, Nasdaq, The Depository Trust Company and ADP Brokerage
Services, and the failure of Jefferies & Company and W&D to provide services
under their clearing and execution agreement with us. Such failure would prevent
us from operating in whole or in part until such systems or services have been
restored and could have a material adverse effect on us.
In the event any of our internally developed systems fails, we will
undertake to remediate such system on an emergency basis at the time of such
failure. To ensure that adequate staff will be available to handle any such
emergencies in January of 2000, we have imposed a moratorium on employee
vacations during the first two weeks of January 2000, and have made arrangements
to have a number of software development personnel (normally based in our Culver
City office) at our New York headquarters during the final week of December 1999
and the first week of January 2000. Our inability to remediate a failure of any
of our internally developed mission critical systems would prevent us from
operating in whole or in part until such systems have been restored and could
have a material adverse effect on us.
COSTS
We do not believe that the costs incurred to ready our systems for the Year
2000 will have a material effect on our financial condition. Total costs for the
whole project are estimated to be between $2.5 and $3.0 million, which includes
the cost of personnel, consultants and software and hardware costs. Through
December 31, 1998, we had spent approximately $1.5 million on the Year 2000
project.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131, "DISCLOSURES ABOUT SEGMENTS OF AN
ENTERPRISE AND RELATED INFORMATION". SFAS 131 requires that public business
enterprises report certain information about operating segments in complete sets
of financial statements of the enterprise and in condensed financial statements
of interim periods issued to shareholders. It also requires that these
enterprises report certain information about their products and services, the
geographical areas in which they operate, and their major customers. SFAS 131 is
effective for fiscal years beginning after December 15, 1997, although earlier
application was permitted. The disclosure requirements of this standard were not
applicable since the Company manages its operations through a single line of
business (institutional agency trade executions).
In March 1998, the Accounting Standards Executive Committee issued Statement
of Position 98-1 "ACCOUNTING FOR THE COSTS OF COMPUTER SOFTWARE DEVELOPED OR
OBTAINED FOR INTERNAL USE". SOP 98-1 provides guidance on accounting for the
costs of computer software developed or obtained for internal use. It identifies
the characteristics of internal-use software and provides examples to assist in
determining when the computer software is for internal use. SOP 98-1 is
effective for financial statements for fiscal years beginning after December 15,
1998, although earlier application is encouraged, and should be applied to
internal-use computer software costs incurred in those fiscal years for all
projects, including those in progress upon initial application of this SOP. We
do not anticipate that the implementation of this statement will have a material
impact on our consolidated financial statements.
JEFFERIES GROUP AND ITGI PLAN TO SEPARATE INTO TWO INDEPENDENT COMPANIES
On March 17, 1998, we announced that we were planning the separation of
Jefferies & Company and other Jefferies Group subsidiaries from our company
through a series of transactions, including a special cash dividend, the
transfer of Jefferies Group's assets and liabilities (other than those related
to our company), a spin-off and a merger. Upon the consummation of the spin-off
and upstream merger
26
and the related transactions, the stockholders of Jefferies Group will be
stockholders of our company and Jefferies Group will cease to be our parent
company.
First, the Company will pay a special cash dividend of $4.00 per share,
payable pro rata to all of our stockholders of record on April 20, 1999,
including Jefferies Group. The aggregate amount of the special cash dividend
will be up to $75 million, of which we will pay $60.0 million to Jefferies
Group.
Following the payment of the special cash dividend, Jefferies Group will
transfer all of its assets (other than its approximately 80.5% equity interest
in our company) and all of its liabilities (other than liabilities related to
our company) to a new company ("New Jefferies"). After such transfers have been
completed and certain other conditions have been satisfied, Jefferies Group will
distribute all of the outstanding common stock of New Jefferies pro rata to
Jefferies Group stockholders.
The spin-off will be followed immediately by a tax-free merger of our
company into Jefferies Group, with our public shareholders receiving shares of
Jefferies Group. Jefferies Group will then be renamed Investment Technology
Group, Inc. ("New ITGI"). Based on the number of shares of Jefferies Group
common stock expected to be outstanding on the date of the spin-off and upstream
merger (approximately 23,900,000) and the number of shares of our common stock
held by Jefferies Group (15,000,000), our public stockholders other than
Jefferies Group will receive approximately 1.59 shares of common stock of New
ITGI for each share of our common stock held by them.
The spin-off and upstream merger and the related transactions are contingent
on a number of factors, including receipt of all board of directors and
shareholder approvals of Jefferies Group and our company and other required
regulatory and contractual approvals. The spin-off and upstream merger and the
related transactions are expected to close in April 1999.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
None.
27
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
FINANCIAL REPORTS SECTION
PAGES
-----
Management's Responsibility for Compliance and Financial Reporting............................... 29
Independent Auditors' Report..................................................................... 30
Consolidated Statements of Income................................................................ 31
Consolidated Statements of Financial Condition................................................... 32
Consolidated Statements of Changes in Stockholders' Equity....................................... 33
Consolidated Statements of Cash Flows............................................................ 34
Notes to Consolidated Financial Statements....................................................... 35
28
MANAGEMENT'S RESPONSIBILITY FOR COMPLIANCE AND FINANCIAL REPORTING
TO THE SHAREHOLDERS:
The management of Investment Technology Group, Inc. is responsible for the
integrity and objectivity of the financial information presented in this Annual
Report. Financial information appearing throughout the Annual Report is
consistent with that in the accompanying financial statements. The financial
statements have been prepared by management of our company in conformity with
generally accepted accounting principles in the United States. The financial
statements reflect, where applicable, management's best judgments and estimates.
The management of our company has established and maintains an internal
control structure and monitors that structure for compliance with established
policies and procedures. The objectives of an internal control structure are to
provide reasonable, but not absolute, assurance as to the integrity and
reliability of the financial statements, the protection of assets from
unauthorized use or disposition, and that transactions are executed in
accordance with management's authorization.
Management also recognizes its responsibility to foster and maintain a
strong ethical environment within our company to ensure that its business
affairs are conducted with integrity and in accordance with high standards of
personal and corporate conduct. This responsibility is characterized and
reflected in our company's Statement of Policy on Standards of Employee Conduct,
which is distributed to all of our employees. As part of the monitoring system,
we maintain Corporate Compliance Personnel, who have oversight responsibilities
for administering and coordinating the application of these standards of
conduct. Senior legal and compliance personnel have been directed to report
compliance concerns directly to the President of our company. Ongoing oversight
of compliance activities is the responsibility of our President.
Our board of directors appoints an audit committee composed solely of
outside directors. The function of the audit committee is to oversee the
accounting, reporting, audit and internal control policies and procedures
established by our management. The committee meets regularly with management and
the internal and independent auditors. The auditors have free access to the
audit committee without the presence of management. The audit committee reports
regularly to our board of directors on its activities, and such other matters as
it deems necessary.
Our company's annual consolidated financial statements have been audited by
KPMG LLP, independent auditors, who were appointed by the board of directors.
Management has made available to KPMG LLP all of our company's financial records
and related data, as well as the minutes of directors' meetings.
Furthermore, management believes that all its representations to KPMG LLP
are valid and appropriate. In addition, KPMG LLP, in determining the nature and
extent of their auditing procedures, considered our company's accounting
procedures and policies and the effectiveness of the related internal control
structure.
Management believes that, as of December 31, 1998, our company's internal
control structure was adequate to accomplish the objectives discussed herein.
Raymond L. Killian, Jr. John R. MacDonald Angelo Bulone
Chairman, Chief Executive Officer Senior Vice President Vice President
and President and Chief Financial Officer and Controller
29
INDEPENDENT AUDITORS' REPORT
The Board of Directors
Investment Technology Group, Inc.:
We have audited the accompanying consolidated statements of financial
condition of Investment Technology Group, Inc. and subsidiaries as of December
31, 1998 and 1997, and the related consolidated statements of income, changes in
stockholders' equity and cash flows for each of the years in the three-year
period ended December 31, 1998. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Investment
Technology Group, Inc. and subsidiaries as of December 31, 1998 and 1997, and
the results of their operations and their cash flows for each of the years in
the three-year period ended December 31, 1998, in conformity with generally
accepted accounting principles.
KPMG LLP
New York, New York
January 20, 1999
30
INVESTMENT TECHNOLOGY GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
YEAR ENDED DECEMBER 31,
----------------------------------
1998 1997 1996
---------- ---------- ----------
REVENUES:
Commissions................................................................ $ 205,163 $ 133,700 $ 108,821
Interest and dividends..................................................... 3,635 2,650 1,751
Other...................................................................... 3,407 692 984
---------- ---------- ----------
Total revenues........................................................... 212,205 137,042 111,556
EXPENSES:
Compensation and employee benefits......................................... 51,462 30,479 25,047
Transaction processing..................................................... 26,920 21,413 15,737
Software royalties......................................................... 15,247 9,848 8,798
Occupancy and equipment.................................................... 11,886 9,204 6,111
Consulting................................................................. 2,338 2,017 2,492
Telecommunications and data processing services............................ 8,138 6,605 4,789
Net loss on long-term investments.......................................... 204 297 --
Spin-off costs............................................................. 1,936 -- --
Other general and administrative........................................... 13,139 9,919 7,581
---------- ---------- ----------
Total expenses........................................................... 131,270 89,782 70,555
Income before income tax expense............................................. 80,935 47,260 41,001
Income tax expense........................................................... 37,541 20,343 17,666
---------- ---------- ----------
NET INCOME................................................................... $ 43,394 $ 26,917 $ 23,335
---------- ---------- ----------
---------- ---------- ----------
Basic net earnings per share of common stock................................. $ 2.36 $ 1.48 $ 1.28
---------- ---------- ----------
---------- ---------- ----------
Diluted net earnings per share of common stock............................... $ 2.25 $ 1.42 $ 1.26
---------- ---------- ----------
---------- ---------- ----------
Basic weighted average shares outstanding.................................... 18,365 18,178 18,284
---------- ---------- ----------
---------- ---------- ----------
Diluted weighted average shares and common stock
equivalents outstanding.................................................... 19,289 18,940 18,586
---------- ---------- ----------
---------- ---------- ----------
The accompanying Notes to Consolidated Financial Statements are integral parts
of this statement.
31
INVESTMENT TECHNOLOGY GROUP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
DECEMBER 31,
----------------------
1998 1997
---------- ----------
ASSETS
Cash and cash equivalents................................................................. $ 77,324 $ 14,263
Securities owned, at fair value........................................................... 39,615 37,358
Receivables from brokers, dealers and other, net.......................................... 24,127 10,131
Due from affiliates....................................................................... 722 1,365
Investments............................................................................... 1,000 10,935
Premises and equipment.................................................................... 19,662 19,506
Capitalized software...................................................................... 6,450 5,973
Goodwill.................................................................................. 1,373 1,922
Deferred taxes............................................................................ 2,784 2,460
Other assets.............................................................................. 7,455 9,728
---------- ----------
Total assets.............................................................................. $ 180,512 $ 113,641
---------- ----------
---------- ----------
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable and accrued expenses..................................................... $ 24,154 $ 12,664
Payable to brokers, dealers and other..................................................... 1,881 61
Software royalties payable................................................................ 4,070 2,663
Securities sold, not yet purchased, at fair value......................................... 288 3
Due to affiliates......................................................................... 2,557 2,999
Income taxes payable to affiliate......................................................... 3,853 1,488
---------- ----------
Total liabilities..................................................................... 36,803 19,878
---------- ----------
Lease commitments (note 14)
Contingencies (note 17)
STOCKHOLDERS' EQUITY:
Preferred stock, par value $0.01; shares authorized:
5,000,000; shares issued: none.......................................................... -- --
Common stock, par value $0.01; shares authorized:
30,000,000; shares issued: 19,405,361 in 1998 and 18,818,468 in 1997.................... 194 188
Additional paid-in capital................................................................ 51,511 38,554
Retained earnings......................................................................... 104,925 61,531
Common stock held in treasury, at cost; shares:
815,000 in 1998 and 597,500 in 1997..................................................... (12,760) (6,510)
Accumulated other comprehensive loss:
Currency translation adjustment......................................................... (161) --
---------- ----------
Total stockholders' equity............................................................ 143,709 93,763
---------- ----------
Total liabilities and stockholders' equity................................................ $ 180,512 $ 113,641
---------- ----------
---------- ----------
The accompanying Notes to Consolidated Financial Statements are integral parts
of this statement.
32
INVESTMENT TECHNOLOGY GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
COMMON
ADDITIONAL STOCK ACCUMULATED
PREFERRED COMMON PAID-IN RETAINED HELD IN COMPREHENSIVE
STOCK STOCK CAPITAL EARNINGS TREASURY LOSS
----------- ----------- ----------- ----------- ----------- -----------------
Balance at December 31, 1995.......... $ -- $ 187 $ 36,055 $ 11,279 $ (2,042) $ --
Net income............................ -- -- -- 23,335 -- --
Purchase of common stock for treasury
(135,000 shares).................... -- -- -- -- (1,721) --
----------- ----- ----------- ----------- ----------- -----
Balance at December 31, 1996.......... -- 187 36,055 34,614 (3,763) --
Net income............................ -- -- -- 26,917 -- --
Issuance of restricted stock (24,219
shares)............................. -- -- 630 -- -- --
Issuance of common stock in connection
with the employee stock option plan
(92,249 shares)..................... -- 1 1,869 -- -- --
Purchase of common stock for treasury
(152,300 shares).................... -- -- -- -- (2,747) --
----------- ----- ----------- ----------- ----------- -----
Balance at December 31, 1997.......... -- 188 38,554 61,531 (6,510) --
Issuance of common stock in connection
with the employee stock option plan
(574,978 shares).................... -- 6 12,652 -- -- --
Issuance of common stock in connection
with the employee stock purchase
plan (11,915 shares)................ -- -- 305 -- -- --
Purchase of common stock for treasury
(217,500 shares).................... -- -- -- -- (6,250) --
Comprehensive income/(loss):
Net income.......................... -- -- -- 43,394 -- --
Other comprehensive loss, net of tax
($0.00):
Currency translation adjustment... -- -- -- -- -- (161)
Comprehensive income..................
----------- ----- ----------- ----------- ----------- -----
Balance at December 31, 1998.......... $ -- $ 194 $ 51,511 $ 104,925 $ (12,760) $ (161)
----------- ----- ----------- ----------- ----------- -----
----------- ----- ----------- ----------- ----------- -----
TOTAL
STOCKHOLDERS'
EQUITY
-------------
Balance at December 31, 1995.......... $ 45,479
Net income............................ 23,335
Purchase of common stock for treasury
(135,000 shares).................... (1,721)
-------------
Balance at December 31, 1996.......... 67,093
Net income............................ 26,917
Issuance of restricted stock (24,219
shares)............................. 630
Issuance of common stock in connection
with the employee stock option plan
(92,249 shares)..................... 1,870
Purchase of common stock for treasury
(152,300 shares).................... (2,747)
-------------
Balance at December 31, 1997.......... 93,763
Issuance of common stock in connection
with the employee stock option plan
(574,978 shares).................... 12,658
Issuance of common stock in connection
with the employee stock purchase
plan (11,915 shares)................ 305
Purchase of common stock for treasury
(217,500 shares).................... (6,250)
Comprehensive income/(loss):
Net income.......................... 43,394
Other comprehensive loss, net of tax
($0.00):
Currency translation adjustment... (161)
-------------
Comprehensive income.................. 43,233
-------------
Balance at December 31, 1998.......... $ 143,709
-------------
-------------
The accompanying Notes to Consolidated Financial Statements are integral parts
of this statement.
33
INVESTMENT TECHNOLOGY GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEAR ENDED DECEMBER 31,
---------------------------------
1998 1997 1996
---------- ---------- ---------
Cash flows from operating activities:
Net income..........................................................