TRADESTATION GROUP INC - Quarter Report: 2003 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 30, 2003

OR

For the transition period from                       to                      

Commission file number 0-31049

TradeStation Group, Inc.

8050 S.W. 10^th Street, Suite 4000, Plantation, Florida 33324
(Address of principal executive offices)
(Zip Code)

954-652-7000
(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 [   ]

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

     As of October 27, 2003, there were 41,241,774 shares of the Registrant’s Common Stock outstanding.

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TRADESTATION GROUP, INC. AND SUBSIDIARIES

INDEX

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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

TRADESTATION GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

The accompanying notes are an integral part of these consolidated financial statements.

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TRADESTATION GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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TRADESTATION GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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TRADESTATION GROUP, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(All notes and related disclosures applicable to
the three and nine months ended September 30, 2003 and 2002 are unaudited)

     TradeStation Group, Inc. (the “Company”), a Florida corporation formed in 2000, is the successor company to Omega Research, Inc., a Florida corporation that was formed in 1982. TradeStation Group is listed on The Nasdaq National Market under the symbol “TRAD.” TradeStation Securities, Inc. and TradeStation Technologies, Inc. are TradeStation Group’s two operating subsidiaries. The accompanying consolidated financial statements should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements included in the Annual Report on Form 10-K of TradeStation Group for the year ended December 31, 2002. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) necessary to present fairly the consolidated financial position as of September 30, 2003, the consolidated results of operations for the three and nine months ended September 30, 2003 and 2002 and the consolidated cash flows for the nine months ended September 30, 2003 and 2002 have been recorded. The results of operations and cash flows for an interim period are not necessarily indicative of the results of operations or cash flows that may be reported for the year or for any subsequent period. Certain prior period amounts have been reclassified to conform to the current period presentation.

(1) EARNINGS (LOSS) PER SHARE

     Weighted average shares outstanding for the three and nine months ended September 30, 2003 and 2002 are calculated as follows:

     Stock options and warrants outstanding for the three and nine months ended September 30, 2003 and 2002, which are not included in the calculation of diluted earnings (loss) per share because their impact is antidilutive, are as follows:

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(2) STOCK-BASED COMPENSATION – PRO FORMA NET INCOME (LOSS)

     In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, in accounting for stock-based transactions with non-employees, the Company records compensation expense in the statement of operations when such equity instruments are issued. No such compensation expense was recorded for the three and nine months ended September 30, 2003. Such compensation expense for the three and nine months ended September 30, 2002 was $0 and $38,000, respectively.

     As permitted by SFAS No. 123, the Company accounts for its stock-based compensation paid to employees using the intrinsic value method in accordance with the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Generally, no stock-based employee compensation cost is reflected in net income (loss), as all options granted under the Company’s plans have an exercise price equal to the fair value of the underlying common stock on the date of grant.

     The following table illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

     The fair value of each option grant is estimated on the date of grant using the Black-Scholes model with the following assumptions:

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(3) COMPREHENSIVE INCOME (LOSS)

     Comprehensive income (loss) is defined as the change in a business enterprise’s equity during a period arising from transactions, events or circumstances relating to non-owner sources, such as unrealized gains or losses on available-for-sale securities and foreign currency translation adjustments. It includes all changes in equity during a period except those resulting from investments by, or distributions to, owners. In June 2003, the Company recorded a loss of approximately $55,000 when it sold an investment in corporate stock, classified as an available-for-sale security, at market value. Prior to the sale of such investment, temporary unrealized holding gains and losses were excluded from earnings and reported in comprehensive income (loss).

     A reconciliation of net income (loss) to comprehensive income (loss) is as follows:

(4) ACCRUED EXPENSES

     Accrued expenses consist of the following as of September 30, 2003 and December 31, 2002:

     “Other” includes customer credits, commissions to third parties, technical support costs, returns, advertising (at December 31, 2002), event termination fees (at December 31, 2002), and other accrued expenses and reserves, none of which individually exceeds 5% of total liabilities.

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(5) NET CAPITAL REQUIREMENTS

     TradeStation Securities is subject to the net capital requirements of the Securities and Exchange Commission’s Uniform Net Capital Rule (Rule 15c3-1) and the Commodity Futures Trading Commission’s financial requirement (Regulation 1.17). To satisfy each requirement, TradeStation Securities is required to maintain net capital equal to the greater of $250,000 or 1/15^th of aggregate indebtedness. Also, the ratio of aggregate indebtedness to net capital cannot exceed 15 to 1. As of September 30, 2003, TradeStation Securities had net capital of $10.6 million, which was $10.0 million in excess of its required net capital of $599,000, and a ratio of aggregate indebtedness to net capital of 0.85 to 1. As of December 31, 2002, TradeStation Securities had net capital of $8.3 million, which was $8.0 million in excess of its required net capital of $273,000, and a ratio of aggregate indebtedness to net capital of 0.49 to 1.

(6) SEGMENT AND RELATED INFORMATION

     For the three and nine months ended September 30, 2003 and 2002, TradeStation Group operated in two principal business segments: (i) brokerage services; and (ii) software products and services. The Company evaluates the performance of its segments based on revenue and operating income. The brokerage services segment represents the operations of TradeStation Securities and the software products and services segment represents the operations of TradeStation Technologies. All intercompany transactions are eliminated in consolidation.

(7) INCOME TAX PROVISION (BENEFIT)

     During the nine months ended September 30, 2003, the Company recorded a net income tax benefit of $730,000 comprised of refunds related to prior year federal income tax returns (see below), and a state income tax refund received during the 2003 first quarter for the overpayment of a prior year’s income tax, partially offset by an increase to the valuation allowance established for the amount due under the current year’s alternative minimum tax calculation. Other than the increase to the valuation allowance for the amount due under the current year’s alternative minimum tax calculation, the income tax expense associated with net operating income generated during the nine months ended September 30, 2003 was totally offset by a reduction to the previously established valuation allowance associated with deferred tax assets, primarily net operating loss carryforwards.

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     In February 2003, in connection with an Internal Revenue Service (“IRS”) audit of a prior year’s federal income tax return, the Company learned that it was entitled to a $72,000 refund related to research and development tax credits. The Company recorded that benefit in the 2003 first quarter. Also in conjunction with the IRS audit, in late April 2003 the Company was advised that it was due a refund relating to its 1997 income taxes paid. Accordingly, during the 2003 second quarter, the Company recorded a benefit of approximately $802,000. The full amount of this federal income tax refund and related interest thereon was received during October 2003.

(8) RECENTLY ISSUED ACCOUNTING STANDARDS

     In November 2002, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others (“FIN No. 45”). FIN No. 45 elaborates on the disclosures to be made by a guarantor in its financial statements about its obligations under certain guarantees that it has issued. It also clarifies that a guarantor is required to recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN No. 45 should be applied only on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year end. The disclosure requirements were effective for financial statements ending after December 15, 2002. The adoption of FIN No. 45 did not have any impact on the Company’s consolidated financial position, results of operations or cash flows.

     In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities (“FIN No. 46”). FIN No. 46 clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. FIN No. 46 requires a variable interest entity to be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both. FIN No. 46 also requires disclosures about variable interest entities that the company is not required to consolidate but in which it has a significant variable interest. The consolidation requirements of FIN No. 46 apply immediately to variable interest entities created after January 31, 2003 and to variable interest entities that existed prior to February 1, 2003 in the first interim or annual period beginning after December 15, 2003. The adoption of FIN No. 46 is not expected to have any impact on the Company’s consolidated financial position, results of operations or cash flows as the Company does not have any variable interest entities.

     In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. Most of the guidance in SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003, applied prospectively. The adoption of SFAS No. 149 did not have any impact on the Company’s consolidated financial position, results of operations or cash flows.

     In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 improves the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. SFAS No. 150 requires that those instruments be classified as liabilities in statements of financial position. Most of the guidance in SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have any impact on the Company’s consolidated financial position, results of operations or cash flows.

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(9) COMMITMENTS AND CONTINGENCIES

     Restricted Cash

     As of September 30, 2003, the Company had $2.7 million of restricted cash, broken down as follows: (i) $2.15 million of cash supporting a ten-year lease agreement; (ii) $511,000 of cash reserved for the benefit of certain customers; and (iii) $77,000 of cash securing a letter of credit, which secures an equipment lease.

     Contractual Obligations

     A summary of contractual obligations, including capital lease obligations, operating lease obligations (net of subleases), and minimum purchase obligations, as of September 30, 2003 is as follows:

     Litigation and Claims

     On September 5, 2003, Datamize, Inc., a Wyoming corporation, filed an Original Complaint for Patent Infringement against nine defendants, including TradeStation Securities, all of whom offer online securities trading services. The other defendants are Fidelity Brokerage Services, Scottrade, Interactive Brokers Group, Instinet, Charles Schwab, CyberTrader, E*Trade Securities and Terra Nova Trading. The complaint was filed in the United States District Court, Eastern District of Texas. The complaint alleges that the online trading platforms and services the defendants offer to their customers infringes United States Patent No. 6,460,040 issued to Datamize on October 1, 2002. The lawsuit seeks injunctive relief, actual damages and attorneys’ fees. The Company believes Datamize’s claim is baseless and intends to defend itself vigorously.

     Three lawsuits have recently been filed by former principal owners of onlinetradinginc.com corp. (the predecessor of TradeStation Securities) against the Company, certain of its directors and executive officers and certain family partnerships owned by two of the executive officers. On July 25, 2003, Benedict S. Gambino, from whom the Company, as of October 18, 2002, purchased 2,417,000 shares of its common stock in a private transaction, filed a lawsuit against the Company and three of its executive officers, William R. Cruz, Ralph L. Cruz and Marc J. Stone, in the Circuit Court of Broward County, State of Florida. This lawsuit’s allegations include violation of the Florida Securities and Investor Protection Act, common law fraud, negligent misrepresentation, breach of fiduciary duty and breach of contract. On August 18, 2003, Andrew A. Allen Family Limited Partnership (owned and controlled by Andrew A. Allen), from whom the Company, as of November 26, 2002, purchased 1,000,000 shares of its common stock in a private transaction, filed a lawsuit against the same defendants in the same court. This lawsuit’s allegations include violation of the Florida Securities and Investor Protection Act, common law fraud, breach of fiduciary duty, negligent misrepresentation and fraudulent inducement. On August 28, 2003, Farshid Tafazzoli and E. Steven zum Tobel filed a lawsuit against the Company, the Cruzes, family

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partnerships owned and controlled by the Cruzes, Mr. Stone, Charles Wright and David Fleischman in the Circuit Court of Miami-Dade County, State of Florida. Mr. Tafazzoli’s claims relate to his family partnership’s sale, as of May 1, 2002, of 3,000,000 shares of Company common stock to family partnerships owned by William and Ralph Cruz, and Mr. zum Tobel’s claims relate to his family partnership’s sale, as of May 3, 2002, of 133,942 shares of Company common stock to Charles Wright. This lawsuit’s allegations include violation of the Florida Securities and Investor Protection Act, common law fraud and breach of fiduciary duty. Each of the three lawsuits seeks rescission of the share purchases and/or compensatory damages, plus interest, costs and attorneys’ fees. The Company believes all of the allegations are baseless, intends to defend itself and the other named parties vigorously in court, and expects to prevail in each of the lawsuits.

     On February 11, 2003, the plan administrator appointed under the reorganization plan in the Chapter 11 bankruptcy of Bridge Information Systems, Inc. and its affiliates filed an adversary complaint against TradeStation Technologies and the Company in the United States Bankruptcy Court for the Eastern District of Missouri demanding that the Company and TradeStation Technologies return payments made to TradeStation Technologies by a Bridge subsidiary in December 2000 and January 2001 totaling approximately $1.0 million, claiming such payments were preferences under the federal bankruptcy code as a result of being made to TradeStation Technologies during the ninety-day period immediately preceding the Chapter 11 bankruptcy filing. The Company believes this claim to be without merit on various grounds and intends to vigorously defend this claim.

     In October 2002, the Company received information about alleged fraudulent conduct by an executive of an unrelated company in no way affiliated with TradeStation Securities (the “Referral Company”) that referred individual accounts to TradeStation Securities. The executive of the Referral Company was authorized to trade on behalf of such individuals (the “Referred Account Holders”) and allegedly issued fraudulent account statements to them. The Referred Account Holders incurred several million dollars of trading losses, in the aggregate, during the time the executive of the Referral Company traded on their behalves. On February 2, 2003, the Referral Company communicated to TradeStation Securities in writing that it believes TradeStation Securities shares responsibility for some or all of the alleged losses incurred by the Referred Account Holders and/or the Referral Company and wishes to make an amicable settlement. The Referral Company further stated that if an amicable settlement is not reached it intends to initiate legal action of some kind against TradeStation Securities in the United States. The Company believes the Referral Company’s claims are without merit and, to date, no legal action has been commenced against the Company by any of the Referred Account Holders or the Referral Company.

     TradeStation Securities is also engaged in routine litigation or other dispute resolution proceedings, such as arbitration, incidental to, and part of the ordinary course of, its business (claims in pending arbitrations seek, in the aggregate, damages in excess of $2 million, plus, in certain cases, punitive or treble damages).

     While no assurances can be given, the Company does not believe that the ultimate outcome of any of the above legal matters or claims will result in a material adverse effect on its consolidated financial position, results of operations or cash flows.

     The Company decided, as of June 1, 2002, to no longer carry errors or omissions insurance that covers third-party claims made by brokerage clients or software subscribers as a result of alleged human or system errors, failures, acts or omissions. This decision was made based upon the Company’s assessment of the potential risks and benefits, including significant increases in premium rates, deductibles and coinsurance amounts, reductions in available per occurrence and aggregate coverage amounts, and the unavailability of policies that sufficiently cover the types of risks that relate to the Company’s business.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     This discussion should be read in conjunction with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements of TradeStation Group and its subsidiaries contained herein. The results of operations for an interim period are not necessarily indicative of results for the year, or for any subsequent period.

Recent Developments

     The company continues to work towards commencing self-clearing operations for its active trader equities brokerage services, which are expected to begin in January 2004. The company is already deeply immersed in the process of obtaining the required self-regulatory organization and exchange approvals and memberships, and has already been working for more than three months with SunGard Financial to integrate SunGard’s Phase3 and other back-office trade processing, clearing and settlement systems with the company’s trade server and back-office systems.

     We also recently announced plans to launch forex execution services in November 2003 and options execution services in the first half of 2004. TradeStation trading analysis software is well-known in the forex trading community, as it has been offered over the past seven years worldwide by Dow Jones Telerate, Bridge Telerate and MoneyLine Network as a premium service to institutional traders who use it to design, test and optimize their forex trading strategies. Now, through an arrangement with a forex dealer firm, we will be able to offer this state-of-the-art forex trading technology together with the electronic placement of forex orders. Our planned options execution services will offer all of the features of our premium, award-winning OptionStation trading analysis software package plus seamless execution of options trades.

Results of Operations

     For the three and nine months ended September 30, 2003 and 2002, we operated in two principal business segments: (i) brokerage services and (ii) software products and services. All intercompany transactions are eliminated in consolidation. The following table presents, for the periods indicated, certain items in our consolidated statements of operations broken down by segment: