UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
x		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
		For the quarterly period ended September 30, 2006
		OR
o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

Commission file number 001-13913

WADDELL & REED FINANCIAL, INC.
(Exact name of registrant as specified in its charter)

 

6300 Lamar Avenue
Overland Park, Kansas  66202
(Address, including zip code, of Registrant’s principal executive offices)

(913) 236-2000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Large accelerated filer   x

Accelerated Filer   o

Non-accelerated Filer   o

 

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).
Yes o No x.

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

 

Waddell & Reed Financial, Inc.

Form 10-Q

Quarter Ended September 30, 2006

Index
Part I.		Financial Information
Item 1.			Financial Statements (unaudited)
			Consolidated Balance Sheets at September 30, 2006 and December 31, 2005
			Consolidated Statements of Operations for the three months and nine months ended September 30, 2006 and September 30, 2005
			Consolidated Statements of Comprehensive Income for the three months and nine months ended September 30, 2006 and September 30, 2005
			Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2006
			Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and September 30, 2005
			Notes to the Unaudited Consolidated Financial Statements
Item 2.			Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.			Quantitative and Qualitative Disclosures About Market Risk
Item 4.			Controls and Procedures
Part II.		Other Information
Item 1.			Legal Proceedings
Item 1A.			Risk Factors
Item 2.			Unregistered Sales of Equity Securities and Use of Proceeds
Item 6.			Exhibits and Reports on Form 8-K
			Signatures

 

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PART I.  FINANCIAL INFORMATION

ITEM 1.   FINANCIAL STATEMENTS

WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(in thousands)

		September 30,			December 31,
		2006			2005
		(unaudited)
Assets
Assets:
Cash and cash equivalents		$	158,464		162,775
Investment securities		45,184			51,701
Receivables:
Funds and separate accounts		35,977			33,405
Customers and other		42,616			43,261
Deferred income taxes		—			1,978
Prepaid expenses and other current assets		7,205			6,602
Total current assets		289,446			299,722
Property and equipment, net		50,989			52,963
Deferred sales commissions, net		20,251			15,899
Goodwill		175,309			195,309
Intangible assets		54,999			54,999
Other assets		13,979			13,379
Total assets		$	604,973		632,271
Liabilities and Stockholders’ Equity
Liabilities:
Accounts payable		$	72,024		60,930
Accrued sales force compensation		17,275			18,412
Accrued other compensation		18,987			14,536
Short-term notes payable		—			1,746
Income taxes payable		1,252			11,975
Deferred income taxes		1,404			—
Other current liabilities		38,905			49,185
Total current liabilities		149,847			156,784
Long-term debt		199,939			198,230
Accrued pensions and post-retirement costs		13,391			8,303
Deferred income taxes		13,754			15,707
Other		6,113			5,873
Total liabilities		383,044			384,897
Commitments and contingencies (Note 9)
Stockholders’ equity :
Common stock - $0.01 par value: 250,000 shares authorized; 99,701 shares issued; 84,078 shares outstanding (83,804 at December 31, 2005)		997			997
Additional paid-in capital		189,118			195,315
Retained earnings		371,171			393,043
Cost of 15,623 common shares in treasury (15,897 at December 31, 2005)		(339,820		)	(343,100	)
Accumulated other comprehensive income		463			1,119
Total stockholders’ equity		221,929			247,374
Total liabilities and stockholders’ equity		$	604,973		632,271

 

See accompanying notes to unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Operations

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

		For the three months ended September 30,					For the nine months ended September 30,
		2006			2005		2006		2005
Revenues:
Investment management fees		$	77,955		68,857		230,194		196,972
Underwriting and distribution fees		77,908			68,069		235,414		201,248
Shareholder service fees		22,719			20,587		67,355		60,717
Total revenues		178,582			157,513		532,963		458,937
Operating expenses:
Underwriting and distribution		87,927			75,957		264,225		223,673
Compensation and related costs (including share-based compensation of $4.9 million, $4.3 million, $16.7 million and $13.3 million, respectively)		25,767			25,692		82,290		74,344
General and administrative		15,539			10,106		90,765		70,210
Subadvisory fees		7,960			4,953		22,108		12,619
Depreciation		2,970			2,651		8,780		7,435
Goodwill impairment		—			—		20,000		—
Total operating expenses		140,163			119,359		488,168		388,281
Operating income		38,419			38,154		44,795		70,656
Investment and other income		2,960			1,449		7,367		4,268
Interest expense		(3,048		)	(3,659	)	(9,286	)	(10,598	)
Income before provision for income taxes		38,331			35,944		42,876		64,326
Provision for income taxes		13,740			11,412		27,036		24,131
Net income before cumulative effect of change in accounting principle		24,591			24,532		15,840		40,195
Cumulative effect of change in accounting principle, net of tax		—			—		(321	)	—
Net income		$	24,591		24,532		16,161		40,195
Earnings per share before cumulative effect of change in accounting principle:
- Basic		$	0.30		0.30		0.19		0.50
- Diluted		$	0.30		0.30		0.19		0.49
Earnings per share:
- Basic		$	0.30		0.30		0.20		0.50
- Diluted		$	0.30		0.30		0.19		0.49
Weighted average shares outstanding:
- Basic		81,595			80,914		81,458		80,881
- Diluted		83,171			81,891		83,162		81,916
Dividends declared per common share		$	0.1500		0.1500		0.4500		0.4500

 

See accompanying notes to unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income

(Unaudited, in thousands)

		For the three months					For the nine months
		ended September 30,					ended September 30,
		2006			2005		2006		2005
Net income		$	24,591		24,532		16,161		40,195
Other comprehensive income:
Available-for sale investments:
Net unrealized appreciation of investments during the period, net of income taxes of $251, $465, $552 and $676, respectively		429			791		940		1,150
Derivatives:
Net unrealized loss on derivatives, net of income taxes of $0, $(21), $(174) and $(21), respectively		—			(36	)	(297	)	(36	)
Reclassification adjustment for amounts included in net income, net of income taxes of $(636), $0, $(763) and $(381), respectively		(1,083		)	—		(1,299	)	(648	)
Comprehensive income		$	23,937		25,287		15,505		40,661

 

See accompanying notes to unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statement of  Stockholders’ Equity

For the Nine Months Ended September 30, 2006
(Unaudited, in thousands)

																Accumulated
							Additional									other			Total
		Common stock					paid-in			Retained			Treasury			comprehensive			stockholders’
		Shares		Amount			capital			earnings			stock			income			equity
Balance at December 31, 2005		99,701		$	997		$	195,315		$	393,043		$	(343,100	)	$	1,119		$	247,374
Net income		—		—			—			16,161			—			—			16,161
Share-based compensationm		—		—			16,174			9			—			—			16,183
Issuance of restricted shares		—		—			(21,963		)	—			21,963			—			—
Dividends accrued		—		—			—			(38,042		)	—			—			(38,042		)
Exercise of stock options		—		—			(2,367		)	—			8,531			—			6,164
Tax benefit from equity awards		—		—			1,959			—			—			—			1,959
Other stock transactions		—		—			—			—			(4,684		)	—			(4,684		)
Treasury stock repurchases		—		—			—			—			(22,530		)	—			(22,530		)
Change in fair value of derivatives		—		—			—			—			—			(297		)	(297		)
Reclassification for amounts included in net income		—		—			—			—			—			(1,299		)	(1,299		)
Unrealized gain on investment securities		—		—			—			—			—			940			940
Balance at September 30, 2006		99,701		$	997		$	189,118		$	371,171		$	(339,820	)	$	463		$	221,929

 

See accompanying notes to unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

(Unaudited, in thousands)

		For the nine months
		ended September 30,
		2006			2005
Cash flows from operating activities:
Net income		$	16,161		40,195
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		8,972			8,386
Share-based compensation		16,183			13,316
Gain on sale of available-for-sale investments		(2,702		)	(1,029	)
Net purchases and sales of trading securities		(852		)	1,675
Gain on trading securities		(156		)	(448	)
Goodwill impairment		20,000			—
Write down of investment securities		750			—
Loss on sale and retirement of property and equipment		163			136
Capital gains and dividends reinvested		(157		)	(105	)
Deferred income taxes		1,812			1,604
Changes in assets and liabilities:
Receivables from funds and separate accounts		(2,572		)	(4,819	)
Other receivables		693			3,514
Other assets		(4,355		)	1,161
Accounts payable		11,094			(8,900	)
Other liabilities		(14,005		)	16,091
Net cash provided by operating activities		$	51,029		70,777
Cash flows from investing activities:
Purchases of available-for-sale investment securities		(3,350		)	—
Proceeds from sales of available-for-sale investment securities		11,774			66,464
Proceeds from maturity of available-for-sale investment securities		435			8,272
Additions to property and equipment		(6,969		)	(7,786	)
Cash paid for acquisitions		—			(15	)
Net cash provided by investing activities		$	1,890		66,935
Cash flows from financing activities:
Proceeds from long term debt and interest rate swap termination		199,862			—
Repayment of long term debt		(200,000		)	—
Net short-term borrowings (repayments)		—			(35,000	)
Cash dividends		(38,001		)	(37,521	)
Purchase of treasury stock		(22,530		)	(5,997	)
Exercise of stock options		6,164			1,232
Excess tax benefits from share-based payment arrangements		1,959			—
Other stock transactions		(4,684		)	(1,823	)
Net cash used in financing activities		$	(57,230	)	(79,109	)
Net increase (decrease) in cash and cash equivalents		(4,311		)	58,603
Cash and cash equivalents at beginning of period		162,775			83,900
Cash and cash equivalents at end of period		$	158,464		142,503

 

See accompanying notes to unaudited consolidated financial statements.

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WADDELL & REED FINANCIAL, INC.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1.              The Company and Significant Accounting Policies

Waddell & Reed Financial, Inc. and Subsidiaries

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

Basis of Presentation

We have prepared the accompanying unaudited consolidated financial statements included herein pursuant to the rules and regulations of the SEC.  Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations, although we believe that the disclosures are adequate to enable a reasonable understanding of the information presented.  The information in this Quarterly Report on Form 10-Q should be read in conjunction with Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005 (the “2005 Form 10-K”). Certain amounts in the prior years’ financial statements have been reclassified for consistent presentation.

The accompanying unaudited consolidated financial statements have been prepared consistently with the accounting policies described in Note 2 to the consolidated financial statements included in our 2005 Form 10-K, which include the following: use of estimates, cash and cash equivalents, disclosures about fair value of financial instruments, investment securities and investments in affiliated mutual funds, property and equipment, software developed for internal use, goodwill and intangible assets, deferred sales commissions, revenue recognition, advertising and promotion, stock-based compensation, income taxes, and derivatives and hedging activities.

In our opinion, the accompanying unaudited consolidated financial statements reflect all adjustments (consisting of only a normal and recurring nature) necessary to present fairly our financial position at September 30, 2006 and December 31, 2005, the results of operations for the three and nine months ended September 30, 2006 and 2005 and cash flows for the nine months ended September 30, 2006 and 2005 in conformity with accounting principles generally accepted in the United States.

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2.              Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and short-term investments.  We consider all highly liquid investments with original or remaining maturities of 90 days or less at the date of purchase to be cash equivalents.  Cash and cash equivalents at September 30, 2006 and December 31, 2005 include amounts of $34.3 million and $26.1 million, respectively, for the benefit of customers segregated in compliance with federal and other regulations.  Substantially all cash balances are in excess of federal deposit insurance limits.

3.              Indebtedness

On January 13, 2006, the Company issued $200 million in principal amount 5.6% senior notes due in 2011 (the “New Notes”) resulting in proceeds of approximately $198.2 million (net of discounts, commissions and estimated expenses). The Company used the net proceeds, together with cash on hand, to repay the entire $200 million aggregate principal amount outstanding of its 7.5% senior notes due January 18, 2006 (the “7.5% Notes”).  In 2002, the 7.5% Notes were effectively converted to variable rate debt by entering into an interest rate swap agreement.  We accounted for the interest rate swap as a fair value hedge of the 7.5% Notes.  The swap was considered 100% effective in hedging the changes in the fair value of the 7.5% Notes arising from changes in interest rates, and accordingly, there was no impact on earnings resulting from any ineffectiveness associated with the transaction throughout its term.

The New Notes represent senior unsecured obligations and are rated “Baa2” by Moody’s and “BBB” by Standard & Poor’s. Interest is payable semi-annually on January 15 and July 15 at a rate of 5.6% per annum. The Company may, at its option, call the New Notes at any time pursuant to a make whole redemption provision, which would compensate holders for any changes in interest rate levels of the notes upon early extinguishment. The Company currently has no intention to call the New Notes.

During 2005, the Company entered into two forward starting interest rate swap agreements with five-year fixed swap rates of 4.57% and 4.84%, respectively, on notional amounts of $100 million for each swap. The swaps were put in place to hedge against changes in forecasted interest payments on the 7.5% Notes attributable to changes in the LIBOR swap rate prior to the time we anticipated refinancing the 7.5% Notes in January 2006. We assessed the effectiveness of the swaps as hedges at their inception and in subsequent periods, and considered these swaps to be completely effective cash flow hedges under Statement of Financial Accounting Standards (“SFAS’) No. 133, “Accounting for Derivative Instruments and Hedging Activities.”  As of December 31, 2005, net unrealized gains attributed to the forward swap cash flow hedges were approximately $1.6 million and were included as a component of other comprehensive income.

On January 10, 2006, the Company terminated the two 2005 forward interest rate swap agreements upon the closing of the New Notes. In connection with those terminations, the Company received a net cash settlement of $1.1 million. Such amount has been recorded in accumulated other comprehensive income and is being amortized into earnings as a reduction of interest expense over the five-year term of the New Notes.

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4.     Investment Securities

Investment Securities are as follows:

		Fair Value
		September 30,			December 31,
		2006			2005
		(in thousands)
Available-for-sale securities:
United States government-backed mortgage securities		$	13		214
Municipal bonds		7,180			12,134
Corporate bonds		—			719
Affiliated mutual funds		26,951			29,927
		$	34,144		42,994
Trading securities:
United States government-backed mortgage securities		129			—
Municipal bonds		511			—
Corporate bonds		416			—
Affiliated mutual funds		9,984			8,707
		$	11,040		8,707
Total Investment Securities		$	45,184		51,701

 

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

		September 30,			December 31,
		2006			2005
		(in thousands)
Cost—available-for-sale securities		$	26,202		34,654
Gross unrealized gains		8,099			8,937
Gross unrealized losses		(157		)	(597	)
Market value—available-for-sale securities		$	34,144		42,994

 

Purchases and sales of trading securities for the nine months ended September 30, 2006 were $1,118 thousand and $201 thousand, respectively.

In the first quarter of 2006, the Company recorded a $750 thousand write-down for other-than-temporary impairment of a municipal bond classified as available-for-sale.  In the third quarter of 2006, the Company sold the same bond and recognized a gain on the sale of $183 thousand.

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5.     Stockholders’ Equity

Earnings per Share

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

 

		Three months ended September 30,					Nine months ended September 30,
		2006			2005		2006		2005
		(in thousands, except per share data)
Net income, as reported		$	24,591		24,532		16,161		40,195
Weighted average shares outstanding—basic		81,595			80,914		81,458		80,881
Dilutive potential shares from stock options and restricted stock awards, computed under the treasury stock method		1,576			977		1,704		1,035
Weighted average shares outstanding—diluted		83,171			81,891		83,162		81,916
Earnings per share before cumulative effect of change in accounting principle
Basic		$	0.30		0.30		0.19		0.50
Diluted		$	0.30		0.30		0.19		0.49
Earnings per share
Basic		$	0.30		0.30		0.20		0.50
Diluted		$	0.30		0.30		0.19		0.49

 

Anti-dilutive Securities

Options to purchase 2.8 million shares of common stock were excluded from the dilutive earnings per share calculation for the three and nine months ended September 30, 2006 and options to purchase 3.2 million shares and 2.8 million shares of common stock were excluded from the dilutive earnings per share calculation for the three and nine months ended September 30, 2005, respectively because they were anti-dilutive.  Excluded from the diluted earnings per share calculation were 1,944 shares of anti-dilutive unvested restricted stock for the nine months ended September 30, 2006 and 33,466 shares and 33,641 shares for the three and nine months ended September 30, 2005, respectively.

Dividends

On July 13, 2006, the Board of Directors (the “Board”) approved a dividend in the amount of $0.15 per share to stockholders of record as of October 6, 2006 to be paid on November 1, 2006.  The total dividend to be paid is approximately $12.6 million.

Common Stock Repurchases

The Board has authorized the repurchase of our common stock in the open market and/or private purchases. The acquired shares may be used for corporate purposes, including shares issued to employees in our stock-based compensation programs.  There were 933,229 common shares repurchased in the open market and in private purchases for the three and nine months ended September 30, 2006.  No common shares were repurchased for the three months ended September 30, 2005.  A total of 292,600 common shares were repurchased in the open market for the nine months ended September 30, 2005.

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6.     Share-Based Compensation

The Company has three stock-based compensation plans:  the Company 1998 Stock Incentive Plan, as amended and restated (the “SI Plan”), the Company 1998 Executive Stock Award Plan, as amended and restated (the “ESA Plan”) and the Company 1998 Non-Employee Director Stock Award Plan, as amended and restated (the “NED Plan”) (collectively, the “Stock Plans”).

The SI Plan allows us to grant equity compensation awards, including, among other awards, non-qualified stock options and restricted stock as part of our overall compensation program to attract and retain key personnel and encourage a greater personal financial investment in the Company. A maximum of 30,000,000 shares of common stock are authorized for issuance under the SI Plan. The Stock Plans also allow us to grant non-qualified stock options and/or restricted stock to promote the long-term growth of the Company. A maximum of 3,750,000 and 1,200,000 shares of common stock are authorized for issuance under the ESA Plan and NED Plan, respectively. In addition, we make incentive payments under the Company 2003 Executive Incentive Plan, as amended and restated (the “EIP”) in the form of cash, stock options, restricted stock or a combination thereof. Incentive awards paid under the EIP in the form of stock options or restricted stock are issued out of shares reserved for issuance under the SI and ESA Plans. Generally, shares of common stock covered by terminated, surrendered or cancelled options, by forfeited restricted stock, or by the forfeiture of other awards that do not result in issuance of shares of common stock are again available for awards under the plan from which they were terminated, surrendered, cancelled or forfeited.

Under our Stock Plans, the exercise price of a stock option is equal to the closing market price of the stock on the date of grant. The maximum term of non-qualified options granted under the SI Plan is ten years and two days and the options generally vest in 331¤3% increments on the second, third and fourth anniversaries of the grant date. The maximum term of non-qualified options granted under the ESA Plan and NED Plan is 11 years and the options generally vest 10% each year, beginning on the first anniversary of the grant date. Our Stock Plans include a Stock Option Restoration Program feature (the “SORP”) that allows, on the first trading day of August, an employee to pay the exercise price on vested in-the-money options by surrendering common stock of the Company that has been owned for at least six months. This feature also permits an employee exercising an option to be granted new options in an amount equal to the number of common shares used to satisfy both the exercise price and withholding taxes due upon exercise. New options are granted with an expiration date equal to that of the original option and vest six months after the grant date. The SORP, which facilitates ownership of our common stock by management and key employees, results in a net issuance of shares of common stock and fewer stock options outstanding. We receive a current income tax benefit for stock option exercises.

Prior to January 1, 2006, the Company used the intrinsic value method as described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) to measure employee stock-based compensation as permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”).  Under this method, compensation expense related to stock options was measured as the difference between the exercise price and the fair value of the shares on the grant date, if any, and was recognized over the vesting period, which approximated the anticipated service period.

Restricted stock awards are valued on the date of grant, have no purchase price and, with the exception of those issued in the stock option tender in 2003, vest over four years in 331/3% increments on the second, third and fourth anniversaries of the grant date. Under the Stock Plans, unvested shares of restricted stock may be forfeited upon the termination of employment with the Company or service on the Board, dependent upon the circumstances of termination. Except for restrictions placed on the transferability of restricted stock, holders of restricted stock have full stockholders’ rights during the term of restriction, including voting rights and the rights to receive cash dividends. Restricted shares issued in the stock option tender offer were fully vested

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upon issuance, but remain subject to transfer restrictions that lapse in 331¤3% increments annually beginning March 14, 2005.

Had compensation cost for the Company’s stock-based compensation plans been determined using the fair value method as described in SFAS No. 123, the Company’s net income and earnings per share for the three and nine months ended September 30, 2005 would have approximated the pro forma amounts indicated below:

		Three months ended			Nine months ended
		September 30, 2005			September 30, 2005
		(in thousands, except per share data)
Net income, as reported		$	24,532		40,195
Add:
Total stock-based employee compensation expense included in reported net income, net of related tax effects		—			910
Deduct:
Total stock-based employee compensation expense determined under fair-value based method for all awards, net of related tax effects		(174		)	(1,332	)
Pro forma net income		$	24,358		39,773
Basic earnings per share
As reported		$	0.30		0.50
Pro forma		$	0.30		0.49
Diluted earnings per share
As reported		$	0.30		0.49
Pro forma		$	0.30		0.49

 

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

A summary of stock option activity and related information for the nine months ended September 30, 2006 follows:

		Options		Weighted average exercise price
Outstanding, December 31, 2005		7,115,837		$	22.27
Granted		7,410		21.20
Exercised		(402,610	)	15.68
Terminated/Cancelled		(6,200	)	31.30
Outstanding, September 30, 2006		6,714,437		$	22.65
Exercisable, September 30, 2006		6,707,027		$	22.66

SORP options with vesting periods of six months were the only options granted for the nine months ended September 30, 2006.  Share-based compensation expense related to the options issued under the SORP totaling $7 thousand was recorded for the three months ended September 30, 2006.  The expense was calculated using a Black-Scholes option-pricing model assuming 22.5% expected volatility, a risk-free interest rate of 4.92%, a 2.8% expected dividend yield and an expected life of 2.09 years.  Share-based compensation expense recorded in the first quarter 2006 related to 2005 SORP grants was $138 thousand and those grants are now fully amortized.

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Following is a summary of options outstanding and exercisable at September 30, 2006:

		Outstanding Options							Exercisable Options
Exercise Price Range		Number		Weighted Average Remaining Contractual Life (in years)		Weighted Average Exercise Price			Number		Weighted Average Exercise Price
$  5.95 to $9.99		59,299		0.30		$	7.77		59,299		$	7.77
$10.00 to $14.99		639,274		2.27		14.31			639,274		14.31
$15.00 to $19.99		3,204,993		2.48		17.26			3,204,993		17.26
$20.00 to $29.99		913,743		2.79		25.88			906,333		25.92
$30.00 to $34.19		1,897,128		2.59		33.50			1,897,128		33.50
		6,714,437		2.51		$	22.65		6,707,027		$	22.66

The aggregate intrinsic value of outstanding options and exercisable options as of September 30, 2006 was $31,825,988 and $31,799,683, respectively.  The total intrinsic value of options exercised during the nine months ended September 30, 2006 and 2005 was $3.1 million and $1.6 million, respectively.

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

The Board approved the accelerated vesting of these options based on the belief that it was in the best interest of the stockholders to reduce future compensation expense that the Company would otherwise be required to report in its statement of operations upon adoption of SFAS No. 123R, “Share-Based Payment, (revised 2004)” (“SFAS No. 123R”) in the first quarter of 2006.  We anticipate that holders of “in-the-money” accelerated options will remain employed with the Company throughout the original vesting term of such options, and therefore, no expense will be recorded for these options unless option holders are able to exercise an option that would have expired unexercisable pursuant to its original terms.

Effective January 1, 2006, the Company adopted SFAS No. 123R.  The revised standard eliminated the intrinsic value method of accounting required under APB 25. The Company adopted SFAS No. 123R using the modified prospective transition method of adoption, which does not require restatement of prior periods.  Under that transition method, compensation expense recognized in 2006 for all share-based awards granted after December 31, 2005 is based on the grant date fair value of the awards, net of estimated forfeitures.

In its computation of stock-based compensation expense under APB 25, the Company recognized actual forfeitures when they occurred.  Under SFAS No. 123R, the Company is required to estimate forfeitures at the grant date.  The Company recognized a cumulative effect of change in accounting principle of $503 thousand ($321 thousand increase to net income after-tax) on January 1, 2006, the SFAS No. 123R adoption date, in order to adjust for expected forfeitures on all restricted awards made before December 31, 2005.

Prior to adopting SFAS No. 123R, the Company presented all tax benefits of deductions resulting from the exercise of share-based awards as operating cash flows in the consolidated statement of cash flows.  SFAS No. 123R requires that the cash flows resulting from the tax benefits generated from tax deductions in excess of the compensation costs recognized for the share-based awards (excess tax benefits) be classified as financing cash flows.  The excess tax benefit of $2.0 million recorded for the nine months ended September

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30, 2006, classified as a financing tax inflow, would have been classified as an operating cash flow prior to the Company’s adoption of SFAS No. 123R.

The Board approved grants of restricted shares of the Company’s Class A common stock in lieu of stock options beginning in 2002.  As of September 30, 2006, a total of 3,085,772 shares of unvested restricted stock were outstanding.  A summary of restricted share activity and related fair value for the nine months ended September 30, 2006 follows:

		Shares		Grant Date Fair Value
Unvested at January 1, 2006		2,686,569		$	21.71
Granted		1,093,517		23.04
Vested		(616,958	)	22.61
Forfeited		(77,356	)	21.83
Unvested at September 30, 2006		3,085,772		$	21.99

 

The total fair value of shares vested during the nine months ended September 30, 2006 and 2005 was $14.1 million and $4.3 million, respectively.

Consistent with the provisions of APB 25, the Company recorded the fair value of restricted stock grants and an offsetting deferred compensation amount within stockholders’ equity for unearned stock compensation cost.  Under SFAS No. 123R guidance, the Company has reclassified its deferred compensation balance to additional paid-in capital on the consolidated balance sheet.  As of September 30, 2006, there was $45.2 million of unamortized restricted stock compensation related to unvested restricted stock grants awarded under the Company’s Stock Plans.  As of September 30, 2006, the remaining unamortized expense is expected to be recognized over a weighted average period of 2.45 years.  For the three and nine months ended September 30, 2006, share-based compensation totaled $4.9 million and $16.7 million, respectively (excluding the cumulative effect of change in accounting principle). Share-based compensation totaled $4.3 million and $13.3 million, respectively, for the three and nine months ended September 30, 2005.

For restricted stock awards granted prior to the adoption of SFAS No. 123R, the Company will continue to recognize compensation expense over the full vesting period.  Had compensation expense for restricted stock awards issued prior to January 1, 2006 been determined based on the date a participant first becomes eligible for retirement, the Company’s net income in the three month periods ended September 30, 2006 and 2005 would have decreased by $26 thousand and increased by $72 thousand, respectively, and net income in the nine month periods ended September 30, 2006 and 2005 would have increased by $301 thousand and decreased by $217 thousand, respectively.

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7.     Goodwill and Identifiable Intangible Assets

Goodwill

Goodwill represents the excess of the purchase price over the tangible assets and identifiable intangible assets of an acquired business.  Goodwill is not amortized, but instead is reviewed annually and when events or circumstances occur which indicate that goodwill might be impaired. Impairment of goodwill is tested at the Company’s reporting unit level.  To determine fair value, our review process uses the income and market approaches. In performing the analysis, we use the best information available under the circumstances, including reasonable and supportable assumptions and projections. If the carrying amount of the reporting unit exceeds its implied fair value, goodwill is considered impaired and a second step is performed to measure the amount of impairment loss, if any.

Based on our annual review of goodwill in the second quarter of 2006, in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we recorded an impairment charge of $20.0 million related to our subsidiary, Austin Calvert & Flavin, Inc. (“ACF”). Factors that led to this conclusion included, but were not limited to, the negative impact of the continued decline in ACF’s asset under management and diminished involvement of ACF’s investment staff in mutual fund advisory responsibilities during the second quarter of 2006.  Continued asset redemptions place significant risk on ACF’s ability to achieve and maintain profitability, and therefore have adversely impacted its earnings potential.

The goodwill impairment is not deductible for income tax purposes and represents a permanent book-tax difference. As a result, no tax benefit has been recognized for the goodwill impairment charge.

At September 30, 2006 and December 31, 2005, consolidated gross goodwill was $213.9 million and $233.9 million, respectively, and consolidated accumulated amortization was $38.6 million and $38.6 million, respectively.  ACF’s remaining unamortized goodwill balance at September 30, 2006 was $7.2 million.

Identifiable Intangible Assets

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

		September 30,			December 31,
		2006			2005
		(in thousands)
Unamortized intangible assets:
Mutual fund management advisory contracts		$	38,699		$	38,699
Mutual fund subadvisory management contracts		16,300			16,300
Total		$	54,999		$	54,999

 

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8.     Pension Plan and Postretirement Benefits Other Than Pension

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

							Other Postretirement								Other Postretirement
		Pension Benefits					Benefits				Pension Benefits				Benefits
		Three months ended  September 30,					Three months ended  September 30,				Nine months ended  September 30,				Nine months ended  September 30,
		2006			2005		2006		2005		2006		2005		2006		2005
		(in thousands)									(in thousands)
Components of net periodic benefit cost:
Service cost		$	1,362		1,400		75		106		4,085		4,199		224		317
Interest cost		1,187			1,206		52		77		3,561		3,618		156		230
Expected return on plan assets		(1,405		)	(1,302	)	—		—		(4,216	)	(3,906	)	—		—
Actuarial loss (gain) amortization		208			358		(10	)	22		625		1,075		(27	)	66
Prior service costs amortization		109			109		6		6		327		327		17		17
Transition obligation amortization		1			1		—		—		4		4		—		—
Total		$	1,462		1,772		123		211		4,386		5,317		370		630

 

We anticipate that our contribution to the Pension Plan for 2006 will range from $5 to $7 million.  During the nine month period ended September 30, 2006, we did not make any contribution to the Pension Plan.

9.     Contingencies

The Company is involved from time to time in various legal proceedings, regulatory investigations and claims incident to the normal conduct of business. Our pending legal and regulatory actions include proceedings that are specific to us and others generally applicable to business practices within the industries in which we operate. A substantial legal liability or a significant regulatory action against us could have an adverse effect on our business, financial condition and on the results of operations in a particular quarter or year.

SEC/New York Attorney General/Kansas Securities Commission

See Note 17 of the Notes to the Consolidated Financial Statements of the Company’s 2005 Form 10-K and Note 9 of the Notes to the Unaudited Consolidated Financial Statements of the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006 for the background, description and discussion of this matter.   In addition, please see the Company’s Current Report on Form 8-K dated July 24, 2006.  During the quarter, the Company paid $50 million to the SEC and $2 million to the State of Kansas pursuant to the terms of the settlement documents.  The Company recorded both of these charges in the second quarter of 2006.  In addition, effective October 1, 2006, the Company instituted its annual $5 million investment management fee waiver pursuant to the New York Attorney General settlement.

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Williams Excessive Fee Litigation

See Note 17 of the Notes to the Consolidated Financial Statements of the Company’s 2005 Form 10-K and Note 9 of the Notes to the Unaudited Consolidated Financial Statements of the Company’s Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2006 and June 30, 2006 for the background, description and discussion of this matter.  On May 30, 2006, the investment advisor and underwriter subsidiaries of the Company for the Ivy Funds were dismissed from the case with prejudice.  On September 25, 2006 the remainder of this case was dismissed with prejudice.  The negotiations and discussions leading up to, and the terms of, the dismissal are confidential.

Waddell & Reed Financial, Inc. vs. Torchmark Corporation

See Note 17 of the Notes to the Consolidated Financial Statements of the 2005 Form 10-K and Note 9 of the Notes to the Unaudited Consolidated Financial Statements of the Company’s Quarterly Reports on Form 10-Q for the quarterly periods ended March 31, 2006 and June 30, 2006 for the background, description and discussion of this matter.

As previously disclosed in the third quarter, the Arbitration Panel adjudicating this matter ruled against the Company and determined that the Company owed Torchmark $7.4 million.  The Company paid the award in the third quarter.  A reserve previously established for this matter largely covered this exposure.  The remaining amount was immaterial to the Company’s earnings.

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

Certain statements contained in this Quarterly Report on Form 10-Q constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding our expectations, hopes, beliefs, intentions or strategies regarding the future.  All statements, other than statements of historical fact included in this Form 10-Q regarding our financial position, business strategy and other plans and objectives for future operations are forward-looking statements.  All forward-looking statements included in this Form 10-Q are based on information available to us on the date hereof, and we assume no obligation to update such forward-looking statements, whether as a result of new information, future events or otherwise.  Although we believe that the assumptions and expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to have been correct or that we will take any actions that may presently be planned and neither us nor any other person will be responsible for the accuracy or completeness of any such forward-looking statements.  Certain important factors that could cause actual results to differ materially from our expectations are disclosed in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2005, which include, without limitation, the adverse effect from a decline in securities markets or a decline in our products’ performance, regulatory settlements, reduction of investment management fees, failure to renew investment management agreements, adverse results of litigation and/or arbitration, acts of terrorism and/or war, competition, changes in government regulation, and availability and terms of capital. Should one or more of these risks materialize or should the underlying assumptions prove incorrect, actual results could differ materially from those forecasted or expected.  All subsequent written or oral forward-looking statements attributable to us, or persons acting on our behalf, are expressly qualified in their entirety by such factors.

The information contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in this Form 10-Q and the audited financial statements and notes thereto in our 2005 Annual Report on Form 10-K, as well as a more detailed explanation of risk factors at the end of this Item 2 under the heading entitled “Forward Looking Information.”

Overview

Our earnings and cash flows are heavily dependent on financial market conditions.  Significant increases or decreases in the various securities markets, particularly United States equity markets, can have a material impact on our results of operations, financial condition and cash flows.  We derive our revenues primarily from providing investment management, distribution and administrative services to the Funds and institutional and separately managed accounts.  Investment management fees, a substantial source of revenues, are based on the amount of average assets under management and are affected by sales levels, financial market conditions, redemptions and the composition of assets.  Underwriting and distribution revenues, another substantial source of revenues, consist of commissions derived from sales of investment and insurance products, distribution fees on certain variable products, and fees earned on fee-based asset allocation products, as well as advisory services.  The products sold have various commission structures and the revenues received from product sales vary based on the type and amount sold.  Our products are distributed through either our sales force of registered financial advisors (the “Advisors channel”) or third-party distribution methods such as other broker-dealers and other registered investment advisors (including the retirement advisors of the Legend group of subsidiaries (“Legend”)) (the “Wholesale channel”).  Our institutional efforts include defined benefit plans, pension plans, endowments, subadvisory relationships and high net worth clients (the “Institutional channel”).  Rule 12b-1 service and distribution fees earned for servicing and/or distributing certain mutual fund shares are based upon a percentage of assets and fluctuate based on sales, redemptions and financial market conditions.  Other service fees include transfer agency fees, custodian fees for retirement plan accounts and portfolio accounting.

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Recent Accounting Developments

In December 2004, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123R, “Share-Based Payment, (revised 2004)” (“SFAS No. 123R”) which the Company adopted effective January 1, 2006.  The revised standard eliminated the intrinsic value method of accounting required under APB 25 and requires entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The Company adopted SFAS No. 123R using the modified prospective transition method of adoption, which does not require restatement of prior periods.  Under that transition method, compensation expense recognized in 2006, for all share-based payments granted after December 31, 2005, is based on the grant date fair value of the stock grants less estimated forfeitures.

In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48”), to clarify certain aspects of accounting for uncertain tax positions, including issues related to the recognition and measurement of those tax positions. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are in the process of evaluating the impact of the adoption of this interpretation on our results of operations and financial condition.

In September 2006, the SEC released Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”).  SAB 108 provides guidance on how the effects of prior-year uncorrected financial statement misstatements should be considered in quantifying a current year misstatement.  SAB 108 requires registrants to quantify misstatements using both an income statement (“rollover”) and balance sheet (“iron curtain”) approach and evaluate whether either approach results in a misstatement that, when all relevant quantitative and qualitative factors are considered, is material.  If prior year errors that had been previously considered immaterial now are considered material based on either approach, no restatement is required so long as management properly applied its previous approach and all relevant facts and circumstances were considered.  If prior years are not restated, the cumulative effect adjustment is recorded in opening accumulated earnings as of the beginning of the fiscal year of adoption.  SAB 108 is effective for fiscal years ending on or after November 15, 2006.  We are in the process of evaluating the impact the adoption of SAB 108 might have on our results of operations and financial condition.

In June 2006 the Emerging Issues Task Force (the “EITF”) reached a consensus on EITF Issue No. 06-4, “Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements” (“EITF 06-4”) which requires the application of the provisions of Statement of Financial Accounting Standards No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” (“SFAS No. 106”) to split-dollar life insurance arrangements.  SFAS No. 106 would require the Company to recognize a liability for the discounted future benefit obligation that the Company will have to pay upon the death of the underlying insured employee.  EITF 06-4 is effective for fiscal years beginning after December 15, 2007.  We currently have certain policies subject to the provisions of this new pronouncement and are evaluating the impact of the adoption of EITF 06-4 might have on our results of operations and financial condition.

In September 2006, the FASB issued SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Retirement Plans – an amendment of FASB Statements No. 87, 88, 106 and 132(R)” (“SFAS No. 158”).   SFAS No. 158 requires employers to recognize the overfunded or underfunded status of a defined benefit post-retirement plan as an asset or liability in its statement of financial position, measured as the difference between the fair value of plan assets and the benefit obligation.  Further, this statement requires employers to recognize changes in that funded status in the year in which the changes occur through comprehensive income.  SFAS No. 158 is effective for the fiscal year ending after December 15, 2006.  We currently estimate that this pronouncement will result in an increase to accrued pensions and post-retirement costs and a reduction to equity of approximately $8 million.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”).  This Statement defines fair value, establishes a framework for measuring fair value and expands disclosure

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of fair value measurements.  SFAS No. 157 applies under other accounting pronouncements that require or permit fair value measurements and accordingly, does not require any new fair value measurements.  SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007.  We are in the process of evaluating the impact of the adoption of SFAS No. 157 will have on our results of operations and financial condition.

Third Quarter Highlights

Highlights for the current quarter compared to the third quarter of 2005:

·                  Gross sales increased 66% to $2.2 billion.

·                  Total assets under management increased $4.9 billion.

·                  Total revenues increased 13% or $21.1 million.

·                  Underwriting and distribution revenues in the Wholesale channel grew by $6.7 million.

·                  Operating expenses increased $20.8 million.

·                  The redemption rate dropped from 16.0% to 13.7%.

Additionally, we repurchased over 930,000 shares of our common stock during the quarter.

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