**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM 10-Q**

 

**(mark one)**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**   |
|------------|------------|----------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                     |
|       |       | **FOR THE QUARTERLY PERIOD ENDED  MARCH 31, 2005, OR**                                              |
|       |       |                                                                                                     |
| o          |       | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |

 

**Commissionfile No. 0-30066**

 

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**SANDERSMORRIS HARRIS GROUP INC.**

(Exact name ofregistrant as specified in its charter)

 
| **Texas**                                                        | ** ** | **76-0583569**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |

 

**600Travis, Suite 3100**

**Houston,Texas 77002**

(Address ofprincipal executive office)

 

**(713) 993-4610**

(Registrant’stelephone number, including area code)

 

Indicate by check markwhether the registrant:  (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.    YES  ý      NO o

 

Indicate by check markwhether registrant is an accelerated filer (as defined in Rule 12b-2 ofthe Exchange Act).YES   ý      NO o

 

The number ofshares of the registrant’s Common Stock, par value $0.01 per share, outstandingas of May 1, 2005, was 18,446,084.

 

 

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**SANDERSMORRIS HARRIS GROUP INC. AND SUBSIDIARIES**

 

# **INDEX**

# ** **

| **PART I.  FINANCIAL INFORMATION** |    |
|----------------------------------------------|---------|
|                                         |    |   |   |
|                                         | Item 1. | Financial Statements |   |
|                                         |    |   |   |
|                                         |    | Condensed  Consolidated Balance Sheet as of March 31, 2005 (unaudited) and  December 31, 2004 |   |
|                                         |    |   |   |
|                                         |    | Condensed  Consolidated Statement of Income for the Three Months Ended March 31,  2005 and 2004 (unaudited) |   |
|                                         |    |   |   |
|                                         |    | Condensed  Consolidated Statement of Shareholders’ Equity for the Three Months Ended  March 31, 2005 (unaudited) |   |
|                                         |    |   |   |
|                                         |    | Condensed  Consolidated Statement of Cash Flows for the Three Months Ended  March 31, 2005 and 2004 (unaudited) |   |
|                                         |    |   |   |
|                                         |    | Notes  to Condensed Consolidated Financial Statements (unaudited) |   |
|                                         |    |   |   |
|                                         | 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 6. | Exhibits |   |

 

1

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**PART I.  FINANCIAL INFORMATION**

**Item 1****.  *Financial Statements***

 

**SANDERSMORRIS HARRIS GROUP INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEET**

(in thousands,except share and per share amounts)

 
| ** **                                                                                                            | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                            | ** ** | **(unaudited)**          | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                            |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                            |       | $                        | 19,948     |                        | $          | 21,678 |   |
| Receivables, net  of allowance of $476                                                                                |       |                     |       |                        |       |
| Broker-dealers                                                                                                        |       | 553                      |       | 412                         |       |
| Customers                                                                                                             |       | 5,793                    |       | 6,662                       |       |
| Related parties                                                                                                       |       | 3,955                    |       | 5,986                       |       |
| Other                                                                                                                 |       | 3,669                    |       | 4,834                       |       |
| Deposits with  clearing brokers                                                                                       |       | 1,069                    |       | 1,068                       |       |
| Securities owned                                                                                                      |       | 59,927                   |       | 56,851                      |       |
| Securities  available for sale                                                                                        |       | 3,366                    |       | 3,078                       |       |
| Furniture and  equipment, net                                                                                         |       | 7,989                    |       | 7,643                       |       |
| Other assets                                                                                                          |       | 2,181                    |       | 1,915                       |       |
| Goodwill, net                                                                                                         |       | 61,722                   |       | 61,722                      |       |
| Total assets                                                                                                          |       | $                        | 170,172    |                        | $          | 171,849 |   |
|                                                                                                                  |       |                     |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                         |       |                     |       |                        |       |
|                                                                                                                  |       |                     |       |                        |       |
| Liabilities:                                                                                                          |       |                     |       |                        |       |
| Accounts payable  and accrued liabilities                                                                             |       | $                        | 11,695     |                        | $          | 19,882 |   |
| Deferred tax  liability, net                                                                                          |       | 668                      |       | 1,526                       |       |
| Securities sold,  not yet purchased                                                                                   |       | 10,216                   |       | 6,349                       |       |
| Other  liabilities                                                                                                    |       | 52                       |       | 78                          |       |
| Total  liabilities                                                                                                    |       | 22,631                   |       | 27,835                      |       |
|                                                                                                                  |       |                     |       |                        |       |
| Commitments and  contingencies                                                                                        |       |                     |       |                        |       |
|                                                                                                                  |       |                     |       |                        |       |
| Minority  interests                                                                                                   |       | 5,910                    |       | 5,230                       |       |
|                                                                                                                  |       |                     |       |                        |       |
| Shareholders’  equity:                                                                                           |       |                     |       |                        |       |
| Preferred stock,  $0.10 par value; 10,000,000 shares authorized; no shares issued and  outstanding                    |       | —                   |       | —                      |       |
| Common stock,  $0.01 par value; 100,000,000 shares authorized; 19,113,536 and 18,547,978  shares issued, respectively |       | 191                      |       | 185                         |       |
| Common stock  committed, 440,000 shares                                                                               |       | —                   |       | 7,819                       |       |
| Additional  paid-in capital                                                                                           |       | 130,958                  |       | 120,988                     |       |
| Receivables for  shares issued                                                                                        |       | (1,335                   | )          | (1,494                      | )          |
| Retained  earnings                                                                                                    |       | 17,618                   |       | 16,452                      |       |
| Accumulated  other comprehensive loss                                                                                 |       | (56                      | )          | (50                         | )          |
| Unearned compensation                                                                                                 |       | (2,264                   | )          | (1,635                      | )          |
| Treasury stock  at cost, 739,402 shares                                                                               |       | (3,481                   | )          | (3,481                      | )          |
| Total  shareholders’ equity                                                                                      |       | 141,631                  |       | 138,784                     |       |
| Total  liabilities and shareholders’ equity                                                                      |       | $                        | 170,172    |                        | $          | 171,849 |   |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

2

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**SANDERSMORRIS HARRIS GROUP INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENT OF INCOME**

(in thousands, exceptshare and per share amounts)

(unaudited)

 
| ** **                                                                                     | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                     | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Revenues:                                                                                      |       |                                   |       |   |   |
| Commissions                                                                                    |       | $                                      | 11,352     |   | $ | 13,910 |   |
| Principal  transactions                                                                        |       | 1,850                                  |       | 1,454 |   |
| Investment  banking                                                                            |       | 6,092                                  |       | 9,536 |   |
| Fiduciary,  custodial and advisory fees                                                        |       | 5,012                                  |       | 3,520 |   |
| Interest and  dividends                                                                        |       | 1,183                                  |       | 865 |   |
| Other income                                                                                   |       | 851                                    |       | 522 |   |
| Total revenues                                                                                 |       | 26,340                                 |       | 29,807 |   |
| Expenses:                                                                                      |       |                                   |       |   |   |
| Employee  compensation and benefits                                                            |       | 16,491                                 |       | 17,857 |   |
| Floor brokerage,  exchange and clearance fees                                                  |       | 1,068                                  |       | 1,215 |   |
| Communications  and data processing                                                            |       | 1,766                                  |       | 1,537 |   |
| Occupancy                                                                                      |       | 2,072                                  |       | 1,708 |   |
| Other general  and administrative                                                              |       | 2,754                                  |       | 2,445 |   |
| Total expenses                                                                                 |       | 24,151                                 |       | 24,762 |   |
| Income before  equity in income of limited partnerships, minority interests, and income  taxes |       | 2,189                                  |       | 5,045 |   |
| Equity in income  of limited partnerships                                                      |       | 1,696                                  |       | 805 |   |
| Income before  minority interests and income taxes                                             |       | 3,885                                  |       | 5,850 |   |
| Minority  interests in net income of consolidated companies                                    |       | (797                                   | )          | (452 | ) |
| Income before  income taxes                                                                    |       | 3,088                                  |       | 5,398 |   |
|                                                                                           |       |                                   |       |   |   |
| Provision for  income taxes                                                                    |       | (1,255                                 | )          | (2,128 | ) |
| Net income                                                                                     |       | $                                      | 1,833      |   | $ | 3,270 |   |
| Earnings per  share:                                                                           |       |                                   |       |   |   |
| Basic                                                                                          |       | $                                      | 0.10       |   | $ | 0.19 |   |
| Diluted                                                                                        |       | $                                      | 0.10       |   | $ | 0.18 |   |
|                                                                                           |       |                                   |       |   |   |
| Weighted average  common shares outstanding:                                                   |       |                                   |       |   |   |
| Basic                                                                                          |       | 18,304,652                             |       | 17,394,045 |   |
| Diluted                                                                                        |       | 18,962,386                             |       | 17,987,680 |   |

 

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

 

3

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**SANDERS MORRIS HARRIS GROUP INC. ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY**

**For the three months ended March 31,2005**

(in thousands, except shares)

(unaudited)

 
| ** **                                                              | ** ** | **Amounts** | ** **  | ** ** | ** ** | **Shares** | ** **     |
|-------------------------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|----------------|
| **Common  stock**                                                       |       |        |        |       |       |       |           |
| Balance,  beginning of period                                           |       | $           | 185         |       |       |       | 18,547,978     |   |
| Stock issued  pursuant to commitment                                    |       | 5           |        |       |       | 440,000    |           |
| Stock issued  pursuant to employee benefit plan                         |       | 1           |        |       |       | 125,558    |           |
| Balance, end of  period                                                 |       | 191         |        |       |       | 19,113,536 |           |
| **Common  stock committed**                                             |       |        |        |       |       |       |           |
| Balance,  beginning of period                                           |       | 7,819       |        |       |       | 440,000    |           |
| Stock issued                                                            |       | (7,819      | )           |       |       | (440,000   | )              |
| Balance, end of  period                                                 |       | —      |        |       |       | —     |           |
| **Additional  paid-in capital**                                         |       |        |        |       |       |       |           |
| Balance,  beginning of period                                           |       | 120,988     |        |       |       |       |           |
| Stock issued  pursuant to commitment                                    |       | 7,814       |        |       |       |       |           |
| Stock issued  pursuant to employee benefit plan                         |       | 2,156       |        |       |       |       |           |
| Balance, end of  period                                                 |       | 130,958     |        |       |       |       |           |
| **Receivables  for shares issued**                                      |       |        |        |       |       |       |           |
| Balance,  beginning of period                                           |       | (1,494      | )           |       |       |       |           |
| Issuance of  restricted stock                                           |       | (42         | )           |       |       |       |           |
| Amortization of  notes receivable                                       |       | 201         |        |       |       |       |           |
| Balance, end of  period                                                 |       | (1,335      | )           |       |       |       |           |
| **Retained  earnings**                                                  |       |        |        |       |       |       |           |
| Balance,  beginning of period                                           |       | 16,452      |        |       |       |       |           |
| Dividends  ($0.045 per share)                                           |       | (667        | )           |       |       |       |           |
| Net income                                                              |       | 1,833       |        | 1,833      |       |       |           |
| Balance, end of  period                                                 |       | 17,618      |        | 1,833      |       |       |           |
| **Accumulated  other comprehensive loss**                               |       |        |        |       |       |       |           |
| Balance,  beginning of period                                           |       | (50         | )           |       |       |       |           |
| Net change in  unrealized depreciation on securities available for sale |       | (9          | )           | (9         | )          |       |           |
| Income tax  benefit on change                                           |       | 3           |        | 3          |       |       |           |
| Balance, end of  period                                                 |       | (56         | )           | (6         | )          |       |           |
| **Comprehensive  income**                                               |       |        |        | 1,827      |       |       |           |
| **Unearned  compensation**                                              |       |        |        |       |       |       |           |
| Balance,  beginning of period                                           |       | (1,635      | )           |       |       |       |           |
| Net issuance of  restricted stock                                       |       | (907        | )           |       |       |       |           |
| Amortization of  unearned compensation                                  |       | 278         |        |       |       |       |           |
| Balance, end of  period                                                 |       | (2,264      | )           |       |       |       |           |
| **Treasury  stock**                                                     |       |        |        |       |       |       |           |
| Balance,  beginning of period                                           |       | (3,481      | )           |       |       | (739,402   | )              |
| Balance, end of  period                                                 |       | (3,481      | )           |       |       | (739,402   | )              |
| **Total  shareholders’ equity and common shares outstanding**      | ** ** | **$**       | **141,631** | ** ** | ** ** | ** ** | **18,374,134** | ** ** |

 

The accompanyingnotes are an integral part of these condensed consolidated financialstatements.

 

4

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**SANDERSMORRIS HARRIS GROUP INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENT OF CASH FLOWS**

**For thethree months ended March 31, 2005 and 2004**

(in thousands)

(unaudited)

 
| ** **                                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                      |       |     |       |     |       |
| Net income                                                                                  |       | $        | 1,833      |     | $          | 3,270 |   |
| Adjustments to  reconcile net income to net cash used in operating activities:              |       |     |       |     |       |
| Realized gain on  securities available for sale                                             |       | —   |       | (11      | )          |
| Depreciation                                                                                |       | 448      |       | 475      |       |
| Provision for  bad debts                                                                    |       | 52       |       | 46       |       |
| Compensation  expense related to amortization of notes receivable and unearned compensation |       | 479      |       | 486      |       |
| Deferred income  taxes                                                                      |       | (855     | )          | (699     | )          |
| Equity in income  of limited partnerships                                                   |       | (1,696   | )          | (805     | )          |
| Minority  interests in income of consolidated companies                                     |       | 797      |       | 452      |       |
| Changes in  assets and liabilities:                                                         |       |     |       |     |       |
| Decrease  (increase) in receivables                                                         |       | 3,872    |       | (223     | )          |
| Increase in  deposits with clearing brokers                                                 |       | (1       | )          | —   |       |
| Increase in  securities owned                                                               |       | (1,380   | )          | (7,001   | )          |
| Increase in  other assets                                                                   |       | (266     | )          | (455     | )          |
| Increase in  securities sold, not yet purchased                                             |       | 3,867    |       | 504      |       |
| Decrease in  other liabilities                                                              |       | (26      | )          | (22      | )          |
| Decrease in  accounts payable and accrued liabilities                                       |       | (8,187   | )          | (2,429   | )          |
| Net cash used in  operating activities                                                      |       | (1,063   | )          | (6,412   | )          |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                      |       |     |       |     |       |
| Capital  expenditures                                                                       |       | (794     | )          | (1,495   | )          |
| Cash of business  consolidated                                                              |       | —   |       | 49       |       |
| Purchase of  securities available for sale                                                  |       | (298     | )          | (41      | )          |
| Proceeds from  sales and maturities of securities available for sale                        |       | 1        |       | 318      |       |
| Net cash used in  investing activities                                                      |       | (1,091   | )          | (1,169   | )          |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                      |       |     |       |     |       |
| Purchase of  treasury stock                                                                 |       | —   |       | (183     | )          |
| Proceeds from  shares issued                                                                |       | 1,208    |       | 828      |       |
| Distributions to  minority interests                                                        |       | (117     | )          | (88      | )          |
| Payments of cash  dividends                                                                 |       | (667     | )          | (518     | )          |
| Net cash  provided by financing activities                                                  |       | 424      |       | 39       |       |
| Net decrease in  cash and cash equivalents                                                  |       | (1,730   | )          | (7,542   | )          |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF PERIOD                                           |       | 21,678   |       | 32,590   |       |
| CASH AND CASH  EQUIVALENTS AT END OF PERIOD                                                 |       | $        | 19,948     |     | $          | 25,048 |   |
| Noncash  investing and financing activities:                                                |       |     |       |     |       |
| Cash paid  (refund) for income taxes, net                                                   |       | $        | 292        |     | $          | (15 | ) |
| Consolidation:                                                                              |       |     |       |     |       |
| Fixed assets                                                                                |       | —   |       | 6        |       |
| Other assets                                                                                |       | —   |       | (5       | )          |
| Securities owned                                                                            |       | —   |       | (800     | )          |
| Goodwill                                                                                    |       | —   |       | 800      |       |
| Accounts payable  and accrued liabilities                                                   |       | —   |       | (18      | )          |
| Minority interests                                                                          |       | —   |       | (32      | )          |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

 

5

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**SANDERS MORRIS HARRIS GROUP INC.AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

 

### **1.**              BASIS OFPRESENTATION

### ** **

###### *Natureof Operations*

###### * *

Through its operatingsubsidiaries Sanders Morris Harris Inc. (“Sanders Morris Harris” or “SMH”),Salient Capital Management (“Salient/PMT”), SMH Capital Advisors (“SMCA”),Charlotte Capital, and Select Sports Group (“SSG”), Sanders Morris Harris GroupInc. (“SMHG” or “the Company”) provides a broad range of financial and otherprofessional services, including institutional, retail and prime brokerage,principal trading, investment banking, merchant banking, financial advisory,trust related services, investment management, financial planning and sportsrepresentation and management.  TheCompany serves a diverse group of institutional, corporate and individualclients.

 

The Company merged withand acquired its operating subsidiaries in 1999 through 2004.  The acquisitions were accounted for using thepurchase method and as a result current period results are not comparable tothe prior periods.

 

###### *Consolidation*

###### * *

The unaudited condensedconsolidated financial statements of the Company include the accounts of itswholly owned subsidiaries. All material intercompany transactions and balanceshave been eliminated in consolidation.

 

In management’s opinion,the unaudited condensed consolidated financial statements include alladjustments necessary for a fair presentation of our consolidated financialposition at March 31, 2005, our results of operations for the three monthsended March 31, 2005 and 2004, and our cash flows for the three monthsended March 31, 2005 and 2004.  Alladjustments are of a normal recurring nature. Interim results are notnecessarily indicative of results for a full year.

 

These financialstatements and notes should be read in conjunction with the Company’s annualreport on Form 10-K for the year ended December 31, 2004.

 

###### *Effectsof Recently Issued Accounting Standards*

###### * *

###### *In December 2004,the FASB issued SFAS No. 123R,*“Share-Based Payment(Revised 2004).”  SFAS 123R establishes standards for theaccounting for transactions in which an entity (i) exchanges its equityinstruments for goods or services, or (ii) incurs liabilities in exchangefor goods or services that are based on the fair value of the entity’s equityinstruments or that may be settled by the issuance of the equity instruments.  SFAS 123R eliminates the ability to accountfor stock-based compensation using APB 25 and requires that such transactionsbe recognized as compensation cost in the income statement based on their fairvalues on the date of the grant.  SFAS123R is effective for the Company on January 1, 2006.  The Company will transition to fair valuebased accounting for stock-based compensation using a modified version ofprospective application (“modified prospective application”).  Under modified prospective application, as itis applicable to the Company, SFAS 123R applies to new awards and to awardsmodified, repurchased, or cancelled after January 1, 2006.  Additionally, compensation cost for theportion of awards for which the requisite service has not been rendered(generally referring to non-vested awards) that are outstanding as of January 1,2006 must be recognized as the remaining requisite service is rendered duringthe period of and/or the periods after the adoption of SFAS 123R.  The attribution of compensation cost forthose earlier awards will be based on the same method and on the samegrant-date fair values previously determined for the pro forma disclosuresrequired for companies that did not adopt the fair value accounting method forstock-based employee compensation.  Basedon the stock-based compensation awards outstanding as of March 31, 2005for which the requisite service is not expected to be fully rendered prior to January 1,2006, the Company expects to recognize additional pre-tax, quarterlycompensation cost of approximately $45,000 beginning in the first quarter of2006 as a result of the adoption of SFAS 123R. Future levels of compensation cost recognized related to stock-basedcompensation awards (including the aforementioned expected costs during theperiod of adoption) may be impacted by new awards and/or modifications,repurchase and cancellations of existing awards before and after the adoptionof this standard.

 

6

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*Stock-Based Compensation*

 

SFAS No. 148, *Accountingfor Stock-Based Compensation – Transition and Disclosure,*was issuedin December 2002.  SFAS No. 148amends SFAS No. 123, *Accounting forStock-Based Compensation,*to provide alternative methods fortransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, SFAS No 148 amends the disclosure requirements of SFAS No. 123to require prominent disclosures in both annual and interim financialstatements about the method of accounting for stock-based employee compensationand the effect of the method used on reported results.  The Company has adopted the disclosureprovisions included in SFAS No. 148 in the notes to the consolidatedfinancial statements contained herein.

 

The following table illustrates the effect on netincome as if the Company had applied the fair value recognition provisions ofSFAS No. 123 as amended by SFAS No. 148:

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Net income as  reported                                                                                                                       |       | $                                      | 1,833      |   | $ | 3,270 |   |
| Deduct: Total  stock based employee compensation expense determined under fair value based method  for all awards, net of related tax effects |       | (58                                    | )          | (60 | ) |
| Adjusted income                                                                                                                               |       | $                                      | 1,775      |   | $ | 3,210 |   |
|                                                                                                                                          |       |                                   |       |   |   |
| Earnings per  share                                                                                                                           |       |                                   |       |   |   |
| Basic-as reported                                                                                                                             |       | $                                      | 0.10       |   | $ | 0.19 |   |
| Basic-pro forma                                                                                                                               |       | $                                      | 0.10       |   | $ | 0.18 |   |
|                                                                                                                                          |       |                                   |       |   |   |
| Diluted-as  reported                                                                                                                          |       | $                                      | 0.10       |   | $ | 0.18 |   |
| Diluted-pro  forma                                                                                                                            |       | $                                      | 0.09       |   | $ | 0.18 |   |

 

*Reclassifications*

 

Certain reclassificationshave been made to the 2004 condensed consolidated financial statements toconform them with the 2005 presentation.  The reclassifications had no effect on retained earnings, results ofoperations or cash flows as previously reported.

 

### **2.**              ACQUISITIONS

 

On April 1, 2004, the Company acquired a 69%interest in Charlotte Capital from a previous investor.  Employees of Charlotte Capital retained a 31%ownership interest in the firm. Charlotte Capital, based in Charlotte, North Carolina, managesapproximately $400 million in assets for institutional investors in small capvalue and small/mid cap value styles. SMHG paid $3.4 million in cash at closing, and is obligated to pay anadditional amount in 18 months.  The baseamount of the additional payment is $2.3 million; however, it may be adjustedup or down based on changes in the firm’s revenues and assets under managementfor the 18 month period beginning April 1, 2004.  No additional consideration has been earnedthrough March 31, 2005 as the calculation is based on the 18-month periodending September 30, 2005.  Employeesof Charlotte Capital can earn up to an additional 9% ownership interest byachieving specified revenue run rates during the 18-month period followingclosing.  The acquisition was accountedfor as a purchase, and accordingly, the financial information of CharlotteCapital has been included in the Company’s consolidated financial statementsfrom April 1, 2004.  The initialconsideration of $3.4 million exceeded the fair market value of identifiablenet tangible assets by approximately $4.5 million, which has been recorded asgoodwill.

 

7

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On November 23, 2004, the Company acquired a 50%interest in Select Sports Group(“SSG”), a sports representation and managementservices firm based in Houston, Texas. The former owners of SSG received cash of approximately $2.8 million and66,538 common shares of the Company with a market value of $965,000.  Additionally, the Company paid SSG debttotaling approximately $596,000.  TheCompany’s investment in SSG is accounted for using the equity method.

 

### **3.**              SECURITIES OWNED ANDSECURITIES SOLD, NOT YET PURCHASED

 

Securities owned andsecurities sold, not yet purchased as of March 31, 2005  were as follows:

 
| ** **                     | ** ** | **2005**           | ** ** |
|--------------------------------|------------|--------------------|------------|
| ** **                     | ** ** | **Owned**          | ** ** | **Sold, Not Yet  Purchased** | ** ** |
| ** **                     | ** ** | **(in thousands)** | ** ** |
| Marketable:                    |       |               |       |   |   |
| U.S. Government  and agency    |       | $                  | 11,962     |   | $ | 8,058 |   |
| Corporate stocks               |       | 5,861              |       | 2,158 |   |
| Corporate bonds                |       | 7,190              |       | — |   |
|                           |       | 25,013             |       | 10,216 |   |
| Not readily marketable:        |       |               |       |   |   |
| Partnerships                   |       | 28,088             |       | — |   |
| Corporate stocks  and warrants |       | 6,826              |       | — |   |
|                           |       | $                  | 59,927     |   | $ | 10,216 |   |

 

Securities not readily marketable include investmentsecurities (a) for which there is no market on a securities exchange or noindependent publicly quoted market, (b) that cannot be publicly offered orsold unless registration has been effected under the Securities Act of 1933, or(c) that cannot be offered or sold because of other arrangements,restrictions, or conditions applicable to the securities or to theCompany.  Not readily marketablesecurities consist of investments in limited partnerships, equities, optionsand warrants.  The investments in limitedpartnerships are accounted for using the equity method, which approximates fairvalue, and principally consist of Environmental Opportunities Fund, L.P.,Environmental Opportunities Fund II, L.P., Environmental Opportunities Fund II(Institutional), L.P., Corporate Opportunities Fund, L.P., CorporateOpportunities Fund (Institutional), L.P., Sanders Opportunity Fund, L.P.,Sanders Opportunity Fund (Institutional), L.P., Tactical Opportunities HighYield Fund, L.P., Life Sciences Opportunity Fund, L.P., Life SciencesOpportunity Fund (Institutional), L.P., Life Sciences Opportunity Fund II,L.P., Life Sciences Opportunity Fund (Institutional) II, L.P., 2003 HoustonEnergy Partners, L.P., Concept Capital, LLC, Select Sports Group, The EndowmentFund G.P., L.P., Endowment Advisors, L.P., SMH Private Equity Group, L.P.,PTC-Houston Investors, LLC and High Conviction Portfolio.

 

The Company has issued a letter of credit in the amountof $1.2 million to the owner of one of the offices that we lease to securepayment of our lease obligation for that facility.  The letter of credit is secured by securitiesowned in the amount of $1.2 million.

 

8

----

 

### **4.**              SECURITIES AVAILABLEFOR SALE

 

Securities available forsale at March 31, 2005  were asfollows:

 
| ** **                              | ** ** | **Amortized**      | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|-----------------------------------------|------------|--------------------|------------|----------------------|------------|---------------|------------|
| ** **                              | ** ** | **Cost**           | ** ** | **Gains**            | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| ** **                              | ** ** | **(in thousands)** | ** ** |
| **2005:**                               |       |               |       |                 |       |          |       |   |   |
| U.S. Government  and agency obligations |       | $                  | 1,036      |                 | $          | 9             |       | $ | (11 | ) | $ | 1,034 |   |
| Corporate Bonds                         |       | 251                |       | —               |       | (2            | )          | 249 |   |
| Marketable  equity securities           |       | 1,160              |       | 13                   |       | (185          | )          | 988 |   |
| Partnerships                            |       | 1,011              |       | 84                   |       | —        |       | 1,095 |   |
| Total                                   |       | $                  | 3,458      |                 | $          | 106           |       | $ | (198 | ) | $ | 3,366 |   |

 

The contractual maturities of debt securitiesavailable for sale at March 31, 2005, were as follows (in thousands):

 
| Due before 5  years                  |   | $ | 986 |   |   |   |   |   |   |   |   |   |
|--------------------------------------|--------|---|-----|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Due after 25  years through 30 years |   | $ | 297 |   |   |   |   |   |   |   |   |   |

 

Gross realizedgains on sales of securities available for sale were $0 for the three monthsended March 31, 2005 and $11,000 for the three months ended March 31,2004.  No realized losses on securitiesavailable for sale were recorded for the three months ended March 31, 2005and 2004.

 

The Company has pledgedsecurities valued at $250,000 to the bank commissioner of the state of Oklahomato secure its performance of fiduciary duties for trust activities in thatstate.

 

### **5.**              INCOME TAXES

 

The differences between the effective tax ratereflected in the income tax provision from operations and the statutory federalrate were as follows:

 
| ** **                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **(in thousands)**                     | ** ** |
|                                   |       |                                   |       |   |   |
| Tax computed  using the statutory rate |       | $                                      | 1,081      |   | $ | 1,835 |   |
| State income  taxes and other          |       | 174                                    |       | 293 |   |
| Total                                  |       | $                                      | 1,255      |   | $ | 2,128 |   |

 

### **6.**              COMMITMENTS ANDCONTINGENCIES

### ** **

In the normal course of business, the Company entersinto underwriting commitments.  Therewere no firm underwriting commitments open at March 31, 2005.

 

The Company and its subsidiaries have obligationsunder operating leases that expire by 2014 with initial noncancelable terms inexcess of one year.

 

9

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The Company is a party to various legal proceedingsthat are of an ordinary or routine nature incidental to its operations.  The Company believes it has adequatelyreserved for such litigation matters and that they will not have a materialadverse effect on the Company’s consolidated financial position, results ofoperations, or cash flows.

 

The Company has uncommitted financing arrangementswith clearing brokers who finance customer accounts, certain broker-dealerbalances and firm trading positions. Although these customer accounts and broker-dealer balances are notreflected on the consolidated balance sheet for financial accounting andreporting purposes, the Company has generally agreed to indemnify theseclearing brokers for losses they may sustain in connection with the accounts,and therefore, retains risk on these accounts. The Company is required to maintain certain cash or securities ondeposit with its clearing brokers.

 

The Company has issued a letter of credit in theamount of $1.2 million to the owner of one of the offices that we lease tosecure payment of our lease obligation for that facility.  The letter of credit is secured by securitiesowned in the amount of $1.2 million.

 

### **7.**              EARNINGS PER COMMONSHARE

 

Basic and dilutedearnings per-share computations for the periods indicated were as follows:

 
| ** **                                      | ** ** | **Three Months Ended March 31,**                  | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                      | ** ** | **2005**                                               | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | **(in thousands, except share and per share amounts)** | ** ** |
|                                            |       |                                                   |       |   |   |
| Computation of  basic earnings per common share | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Net income                                      |       | $                                                      | 1,833      |   | $ | 3,270 |   |
| Weighted average  common shares outstanding     |       | 18,304,652                                             |       | 17,394,045 |   |
| Basic income per  common share                  |       | $                                                      | 0.10       |   | $ | 0.19 |   |

 
| ** **                                        | ** ** | **Three Months Ended March 31,**                  | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                        | ** ** | **2005**                                               | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(in thousands, except share and per share amounts)** | ** ** |
|                                              |       |                                                   |       |   |   |
| Computation of  diluted earnings per common share | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Net income                                        |       | $                                                      | 1,833      |   | $ | 3,270 |   |
| Weighted average  common shares outstanding       |       | 18,304,652                                             |       | 17,394,045 |   |
| Common shares  issuable under stock option plan   |       | 981,896                                                |       | 1,033,627 |   |
| Less shares  assumed repurchased with proceeds    |       | (324,162                                               | )          | (439,992 | ) |
| Weighted average  common shares outstanding       |       | 18,962,386                                             |       | 17,987,680 |   |
| Diluted income per  common share                  |       | $                                                      | 0.10       |   | $ | 0.18 |   |

 

### **8.**              BUSINESS SEGMENTINFORMATION

 

SMHG operates through sixbusiness segments: Retail Brokerage, Institutional Brokerage, Asset Management,Prime Brokerage, Investment Banking, and Corporate and Other. The business segmentsare based upon factors such as the services provided and distribution channelsserved. Certain services are provided to customers through more than one of ourbusiness segments.  Prior to April 2004,the Company aggregated the brokerage and investment banking businesses into onesegment.

 

The Retail Brokeragesegment distributes a range of financial products through its branchdistribution network, including equity and fixed income securities, mutualfunds and annuities. Retail revenues consist of

 

10

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commissions and principal credits earned on equity and fixed incometransactions in customer brokerage accounts, distribution fees earned frommutual funds, fees earned from managed accounts, and net interest on customers’margin loan and credit account balances. Additionally, retail revenues includesales credits from investment banking transactions such as the distribution ofunderwritings that we co-manage or in which we participate and privateplacements of securities in which we serve as placement agent.  The firm employs registered representativesand also licenses independent financial advisors.

 

The InstitutionalBrokerage segment distributes equity and fixed income products through itsdistribution network to its institutional clients. Institutional revenuesconsist of commissions and principal credits earned on transactions in customerbrokerage accounts, net interest on customers’ margin loan and credit accountbalances, and sales credits from the distribution of investment bankingproducts.

 

The Asset Managementsegment provides investment advisory, wealth and investment management,financial planning, and trust services to institutional and individual clients.It earns an advisory fee based on such factors as the amount of assets undermanagement and the type of services provided. The asset management segment mayalso earn commission revenues from the sale of equity, fixed income, mutualfund, and annuity products; and sales credits from the distribution ofinvestment banking issues. In addition, performance fees may be earned forexceeding performance benchmarks for the investment portfolios in the limitedpartnerships that we manage.

 

The Prime Brokeragesegment provides trade execution, clearing, custody and other back-officeservices to hedge funds and other professional traders. Prime broker revenuesconsist of commissions and principal credits earned on equity, and fixed incometransactions; interest income from securities lending services to customers;and net interest on customers’ margin loan and credit account balances.

 

The Investment Bankingsegment provides corporate securities underwriting, private financings andfinancial advisory services. The Company participates in corporate securitiesdistributions as a manager, co-manager or member of an underwriting syndicateor of a selling group in public offerings managed by other underwriters. Feesearned for our role as an advisor, manager, or underwriter are included in theinvestment banking segment. Sales credits associated with the distribution ofinvestment banking products are reported in Retail Brokerage, InstitutionalBrokerage or Asset Management depending on the relevant distribution channel.

 

The Corporate and Othersegment includes realized and unrealized gains and losses on the Company’sinvestment portfolios and interest and dividends earned on our cash andsecurities positions. Unallocated corporate revenues and expenses are includedin Corporate and Other.  Gains and lossesfrom sports representation and management services performed by SSG areincluded in Corporate and Other.

 

The following summarizescertain financial information of each reportable business segment for the threemonths in the period ended March 31, 2005 and 2004, respectively.  SMHG does not analyze asset information inall business segments.

 

11

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| ** **                                                                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                           | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                                                                                           | ** ** | **(in thousands)**                     | ** ** |
| Revenues:                                                                                            | ** ** | ** **                             |       |   |   |
| Retail brokerage                                                                                     |       | $                                      | 4,651      |   | $ | 4,106 |   |
| Institutional  brokerage                                                                             |       | 5,832                                  |       | 8,221 |   |
| Asset management                                                                                     |       | 7,042                                  |       | 6,232 |   |
| Prime brokerage                                                                                      |       | 4,111                                  |       | 5,003 |   |
| Investment  banking                                                                                  |       | 3,673                                  |       | 5,850 |   |
| Corporate and  other                                                                                 |       | 1,031                                  |       | 395 |   |
| Total                                                                                                |       | $                                      | 26,340     |   | $ | 29,807 |   |
|                                                                                                 |       |                                   |       |   |   |
| Income (loss)  before equity in income of limited partnerships, minority interest and income  taxes: |       |                                   |       |   |   |
| Retail brokerage                                                                                     |       | $                                      | 617        |   | $ | 198 |   |
| Institutional  brokerage                                                                             |       | 425                                    |       | 1,436 |   |
| Asset management                                                                                     |       | 1,414                                  |       | 1,786 |   |
| Prime brokerage                                                                                      |       | 389                                    |       | 906 |   |
| Investment  banking                                                                                  |       | 1,033                                  |       | 3,438 |   |
| Corporate and  other                                                                                 |       | (1,689                                 | )          | (2,719 | ) |
| Total                                                                                                |       | $                                      | 2,189      |   | $ | 5,045 |   |
|                                                                                                 |       |                                   |       |   |   |
| Equity in income  of limited partnerships:                                                           |       |                                   |       |   |   |
| Retail brokerage                                                                                     |       | $                                      | —     |   | $ | — |   |
| Institutional  brokerage                                                                             |       | —                                 |       | — |   |
| Asset management                                                                                     |       | 1,666                                  |       | 732 |   |
| Prime brokerage                                                                                      |       | —                                 |       | — |   |
| Investment  banking                                                                                  |       | —                                 |       | — |   |
| Corporate and  other                                                                                 |       | 30                                     |       | 73 |   |
| Total                                                                                                |       | $                                      | 1,696      |   | $ | 805 |   |
|                                                                                                 |       |                                   |       |   |   |
| Minority  interests in net (income) loss of consolidated companies:                                  |       |                                   |       |   |   |
| Retail brokerage                                                                                     |       | $                                      | —     |   | $ | — |   |
| Institutional  brokerage                                                                             |       | —                                 |       | — |   |
| Asset management                                                                                     |       | (799                                   | )          | (465 | ) |
| Prime brokerage                                                                                      |       | —                                 |       | — |   |
| Investment  banking                                                                                  |       | —                                 |       | — |   |
| Corporate and  other                                                                                 |       | 2                                      |       | 13 |   |
| Total                                                                                                |       | $                                      | (797       | ) | $ | (452 | ) |
|                                                                                                 |       |                                   |       |   |   |
| Income (loss)  before income taxes:                                                                  |       |                                   |       |   |   |
| Retail brokerage                                                                                     |       | $                                      | 617        |   | $ | 198 |   |
| Institutional  brokerage                                                                             |       | 425                                    |       | 1,436 |   |
| Asset management                                                                                     |       | 2,281                                  |       | 2,053 |   |
| Prime brokerage                                                                                      |       | 389                                    |       | 906 |   |
| Investment  banking                                                                                  |       | 1,033                                  |       | 3,438 |   |
| Corporate and  other                                                                                 |       | (1,657                                 | )          | (2,633 | ) |
| Total                                                                                                |       | $                                      | 3,088      |   | $ | 5,398 |   |

 

12

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### **9.**              EMPLOYEE BENEFITPLANS

### ** **

Under its 1998 IncentivePlan, as amended, the Company has reserved 25% of the outstanding Common Stockof the Company, or 4,000,000 shares of Common Stock, whichever is greater, forthe purpose of issuing incentive awards under the Incentive Plan.  The Company had 1,322,702 shares of CommonStock available for grant under the Incentive Plan at March 31, 2005.

 

**StockOptions**

 

The Incentive Planprovides for the issuance to eligible employees of, among other things,incentive and non-qualified stock options, that may expire up to 10 years fromthe date of grant.   The outstandingoptions vest over varying periods and have an exercise price equal to theclosing price of the Company’s stock on the date of the grant.

 

**Restrictedand Capital Incentive Plan (“CIP”)**

 

Effective January 2,2001, the Company adopted the CIP under its Incentive Plan in which eligibleemployees and consultants may purchase in lieu of salary, commission or bonus,shares of the Company’s restricted common stock at a price equal to 66.6% ofthe 20-day average of the closing sales prices for a share of the Company’scommon stock, ending on the day prior to the date the shares are issued.

 

All shares issued arevalued at the closing price on the date the shares are issued.  Consideration paid through the deferral ofsalaries, commissions, or discretionary bonuses is recorded as compensationexpense on the date the shares are issued. The difference between the value of the shares issued and theconsideration paid is recorded as unearned compensation and is shown as aseparate component of shareholders’ equity. Additionally, shares are issued under the CIP in conjunction with notesreceivable, which are amortized to compensation expense over the three to fiveyear vesting periods.

 

The following summarizes certain information relatedto the CIP for the three months ended March 31, 2005

 
| ** **                             | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                             | ** ** | **(in thousands, except shares)**      | ** ** |
| ** **                             | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Number of shares  issued               |       | 58,426                                 |       | 118,137 |   |
| Value of shares  issued                |       | $                                      | 995        |   | $ | 1,435 |   |
| Additions to  unearned compensation    |       | 907                                    |       | 527 |   |
| Additions to  notes receivable         |       | 42                                     |       | 908 |   |
| Amortization of  unearned compensation |       | 278                                    |       | 186 |   |
| Amortization of  notes receivable      |       | 201                                    |       | 300 |   |
|                                        |            |                                        |            |  |  |  |  |

 

### **10.**       RELATED PARTIES

### ** **

The Company hadreceivables from related parties totaling $4.0 million at March 31, 2005,primarily consisting of  $3.4 million ofnotes receivable from employees and consultants.

 

13

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### **11.  SUBSEQUENT EVENT**

### ** **

In May 2005, the Company paid approximately $12.5million in cash and SMHG stock for a 51% interest in the Edelman FinancialCenter, LLC, (“Edelman”).  SMHG may haveto pay more for the interest if Edelman’s earnings for the one-year ended September 30,2006 exceed various threshold levels. SMHG has agreed to acquire the remaining 49% of Edelman over a period offour years at a purchase price determined by a multiple of pretax income thatvaries with the compound annual growth rate of Edelman’s earnings.  SMHG has advanced Edelman cash and SMHGcommon stock totaling $7.5 million in value that will be applied against anyfuture consideration payments for both the 51% interest and the remaininginterest to be acquired later.  Edelman,based in Fairfax, Virginia, manages assets in excess of $2.6 billion forindividuals and families.

 

In May 2005, SMHG entered into a one-year $15.0million revolving credit facility with a bank.

 

14

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**Item 2****.    *Management’s Discussion and Analysis of FinancialCondition and Results of Operations***

 

The following discussionshould be read in conjunction with the Condensed Consolidated FinancialStatements and their related notes.

 

**General**

 

We provide a broad range of financial and otherprofessional services, including institutional, retail and prime brokerage,principal trading, investment banking, merchant banking, financial advisory,trust related services, investment management, financial planning and sportsrepresentation and management. All of these activities are highly competitiveand are sensitive to many factors outside our control, including those factorslisted under “Factors Affecting Forward-Looking Statements.”

 

We closely monitor our operating environment to enableus to respond promptly to market cycles. In addition, we seek to lessenearnings volatility by controlling expenses, increasing fee-based business anddeveloping new revenue sources. Nonetheless, operating results for any specificperiod should not be considered representative of future performance.

 

**Componentsof Revenues and Expenses**

 

*Revenues*.  Our revenues are comprised primarily of (1) commissionrevenue from retail, prime and institutional brokerage transactions, (2) feesfrom asset-based advisory services, (3) principal and agent transactions, (4) investmentbanking revenue from corporate finance fees, public and private offerings,mergers and acquisitions, merchant banking and (5) fees from assetmanagement, financial planning and fiduciary services.  We also earn interest on the cash held anddividends received from the equity securities held by us for our corporatecapital accounts and have realized and unrealized gains (or losses) onsecurities in our inventory account.

 

*Expenses. *Our expenses consist of (1) employeecompensation and benefits, (2) brokerage and clearing costs, and (3) otherexpenses.  Compensation and benefits haveboth a variable component based on revenue production and a fixedcomponent.  The variable componentincludes institutional and retail sales commissions, bonuses, overrides, andother incentives.  Retail andinstitutional commissions are based on a competitive commission schedule.  The investment banking group and the researchgroup receive a salary and discretionary bonus as compensation.  The fixed component includes administrativeand executive salaries, payroll taxes, employee benefits and temporary employeecosts.  Compensation and benefits is ourlargest expense item and includes wages, salaries and benefits. During thefirst three months of 2005, compensation and benefits represented 68% of totalexpenses and 63% of total revenues compared to 72% of total expenses, and 60%of total revenues during the same period in 2004.

 

Brokerage and clearance expenses include clearing andtrade execution costs associated with the retail, prime and institutionalbrokerage business at SMH.  SMH clearsits transactions primarily through Pershing LLC, a member of BNY SecuritiesGroup and a subsidiary of The Bank of New York and other clearing brokers.

 

Other expenses include (1) occupancy andequipment expenses, such as rent and utility charges for facilities and (2) communicationsand data processing expenses, such as third-party systems, market data andsoftware program providers.

 

# **Overview**

# ** **

Our financial servicesbusiness is affected by general economic conditions. The instability in theoverall stock market has had a negative impact on our commission revenues,underwriting fees derived from public offerings, and advisory fees from privateplacements.

 

15

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Our revenues relating to asset-based advisory servicesand managed accounts are typically from fees based on the market value ofassets under management. The growth in assets under management resulted inhigher management fees for the Company.

 

We have organized 14 private equity funds for thepurpose of investing in public and private companies that we believe are eithersignificantly undervalued relative to their growth potential or havesubstantial prospects for capital growth. We invest in these funds along withour clients and earn management fees based on capital commitments, net assetsor capital contributions. We also receive incentive compensation of a portionof the profit if the profit exceeds specified hurdle rates. The improvement inthe overall stock market, as well as in individual investment positions ownedby the private equity funds provided the Company with realized and unrealizedgains from its ownership interests and incentive compensation due to fundperformance.

 

We invest a portion of our excess cash in publicequity and debt securities that we feel are undervalued. Additionally, we mayreceive warrants as a part of our compensation for investment banking services.

 

We have expanded both the range and depth of servicesoffered to our clients through a combination of acquisitions and internalexpansion. This growth has necessitated that we add personnel, as well asproduction-related incentive compensation plans. We have also improved andexpanded our infrastructure including facilities, technology, and informationservices, to enable us to better compete with other firms that offer servicessimilar to ours.

 

**Results of Operations**

 

*Three Months Ended March 31, 2005 Compared to ThreeMonths Ended March 31, 2004*

 

Totalrevenues were $26.3 million in the first quarter of 2005 compared to $29.8million for the same quarter in 2004.  Adecline in revenues from commissions and investment banking was partiallyoffset by an increase in fiduciary, custodial and advisory fees.  Total expenses for the first quarter of 2005decreased to $24.2 million from $24.8 million in the same quarter of theprevious year.  Equity in income oflimited partnerships increased from $805,000 during the first quarter of 2004to $1.7 million during the first quarter of 2005 reflecting the receipt of a$1.1 million carried interest payment from one of the limited partnershipsmanaged by the Company.  The paymentrepresents a tax distribution that the partnership was obligated to pay during1998, but was unable to do so until the first quarter of 2005, due to a lack ofliquidity at the partnership during the 1999 through 2004 period.  Net income for the three month period ended March 31,2005 declined to $1.8 million from $3.3 million in the same period in 2004.  Basic income per share was $0.10 for thethree months ended March 31, 2005 compared to $0.19 for the same period in2004.   Diluted income per share was$0.10 for the three months ended March 31, 2005 compared to $0.18 for thesame period in 2004.

 

Commissionsrevenue declined to $11.4 million in the first quarter of 2005 from $13.9million for the same period in 2004, primarily as a result of reduced tradingvolume in our institutional divisions as well as an overall reduction incommission rates in our prime brokerage division.  Principal transactions revenue totaled $1.9million for the first quarter of 2005 versus $1.5 million in the first quarterof 2004.  Investment banking revenuedeclined to $6.1 million during the first quarter of 2005 from $9.5 million inthe same period of 2004, principally due to a reduction in private placementand advisory fees.  Revenues fromfiduciary, custodial and advisory fees increased to $5.0 million in the firstquarter of 2005 from $3.5 million in the same quarter of 2004 primarily due tothe acquisition of Charlotte Capital during the second quarter of 2004.  Interest and dividend income increased to$1.2 million in the first quarter of 2005 from $865,000 in the same period lastyear, due to higher margin interest reflecting an increase in marginbalances.  Other income increased from$522,000 during the first quarter of 2004 to $851,000 during  the same period in 2005.

 

Duringthe three months ended March 31, 2005, employee compensation and benefitsdeclined to $16.5 million from $17.9 million in the same

 

16

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period last year due to lower revenues during2005.  Floor brokerage, exchange andclearance fees declined to $1.1 million in the first quarter of 2005 from $1.2 millionin the same quarter of 2004 reflecting lower clearing and execution costsresulting from the reduced trading volume. Communication and data processing costs increased to $1.8 million in2005 from $1.5 million in the same period last year resulting primarily fromincreased personnel and additional offices. Occupancy costs totaled $2.1 million during the first quarter of 2005,compared to $1.7 million in the prior year quarter due to expansion of our NewYork City offices, and the addition of Charlotte Capital.  Other general and administrative expensesincreased to $2.8 million during the first three months of 2005 from $2.4million in the first quarter of last year mainly due to our growth.

 

Our effective tax rate was40.6% for the three months ended March 31, 2005 compared to 39.4% for thethree months ended March 31, 2004.

 

RESULTS BY SEGMENT

 

*Retail Brokerage*

 
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
| ** **                  | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                  | ** ** | **(in thousands)**                    | ** ** |
|                        |       |                                  |       |   |   |
| Revenues                    |       | $                                     | 4,651      |   | $ | 4,106 |   |
|                        |       |                                  |       |   |   |
| Income before  income taxes |       | $                                     | 617        |   | $ | 198 |   |

 

Revenues from retailbrokerage increased to $4.7 million from $4.1 million, and income before incometaxes increased to $617,000 from $198,000. Sales credits from investment banking transactions increased to $1.0 millionfrom $724,000 due to an increase in fees earned from the Company’sparticipation in private placement transactions and public offerings.

 
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
| ** **                  | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                  | ** ** | **(in thousands)**                    | ** ** |
|                        |       |                                  |       |   |   |
| Revenues                    |       | $                                     | 5,832      |   | $ | 8,221 |   |
|                        |       |                                  |       |   |   |
| Income before  income taxes |       | $                                     | 425        |   | $ | 1,436 |   |

 

*Institutional Brokerage*

 

Revenues frominstitutional brokerage declined to $5.8 million from $8.2 million, and incomebefore taxes declined to $425,000 from $1.4 million.  Commission revenue declined to $4.2 millionfrom $5.5 million due to a slowdown in institutional commission transactionsand a decline in commission rates. Sales credits from investment bankingtransactions declined to $1.1 million from $2.1 million, due to a decrease infees earned from the Company’s participation in underwriting syndicates.  Compensation expense declined from $5.4million during 2004 to $4.0 million during 2005 primarily due to the revenuedecline.

 

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*Asset Management*

 
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
| ** **                  | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                  | ** ** | **(in thousands)**                    | ** ** |
|                        |       |                                  |       |   |   |
| Revenues                    |       | $                                     | 7,042      |   | $ | 6,232 |   |
|                        |       |                                  |       |   |   |
| Income before  income taxes |       | $                                     | 2,281      |   | $ | 2,053 |   |

 

Revenues from asset management increased to $7.0million from $6.2 million, and income before taxes increased to $2.3 millionfrom $2.1 million. Fiduciary, custodial and advisory fees increased to $4.8million from $3.2 million. The acquisition of Charlotte Capital in April 2004,and growth in assets under management at Salient/PMT and Cummer/Moyers havecontributed to the increase in revenues from advisory fees.  Total expenses rose to $5.6 million from $4.4million due to the higher revenues and the acquisition a 69% interest inCharlotte Capital.  The change in valueof our investments in limited partnerships as well as the receipt of a $1.1million carried interest payment from one of the limited partnerships managedby the Company resulted in a gain of $1.7 million in 2005, compared to $732,000in 2004.  The payment represents a taxdistribution that the partnership was obligated to pay during 1998, but wasunable to do so until the first quarter of 2005, due to a lack of liquidity atthe partnership during the 1999 through 2004 period.  Minority interests in net income ofconsolidated companies reflect the portion of net income attributable tominority interest ownership of entities included in the Company’s consolidatedfinancial statements.  Incomeattributable to minority interests, which reduces SMHG’s pretax income,increased to $799,000 in 2005 from $465,000 in 2004, principally due toincreased income from the Company’s ownership of 69% of Charlotte Capital.

 

*Prime Brokerage*

 
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
| ** **                  | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                  | ** ** | **(in thousands)**                    | ** ** |
|                        |       |                                  |       |   |   |
| Revenues                    |       | $                                     | 4,111      |   | $ | 5,003 |   |
|                        |       |                                  |       |   |   |
| Income before  income taxes |       | $                                     | 389        |   | $ | 906 |   |

 

Revenues from primebrokerage declined to $4.1 million from $5.0 million, and income before taxesdecreased to $389,000 from $906,000. Commission revenue decreased to $3.2million from $4.3 million reflecting an overall reduction in commissionrates.  Compensation expense decreased to$1.9 million from $2.6 million due to lower revenues.

 

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*Investment Banking*

 
| ** **                  | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------|------------|---------------------------------------|------------|
| ** **                  | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                  | ** ** | **(in thousands)**                    | ** ** |
|                        |       |                                  |       |   |   |
| Revenues                    |       | $                                     | 3,673      |   | $ | 5,850 |   |
|                        |       |                                  |       |   |   |
| Income before  income taxes |       | $                                     | 1,033      |   | $ | 3,438 |   |

 

Revenues from investment banking declined to $3.7million from $5.9 million, and income before taxes decreased to $1.0 millionfrom $3.4 million.  The revenue declineis primarily due to decreased revenues from private placement transactions andadvisory fees during 2005.

 

*Corporate and Other*

 
| ** **                | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| ** **                | ** ** | **(in  thousands)**                   | ** ** |
|                      |       |                                  |       |   |   |
| Revenues                  |       | $                                     | 1,031      |   | $ | 395 |   |
|                      |       |                                  |       |   |   |
| Loss before  income taxes |       | $                                     | (1,657     | ) | $ | (2,633 | ) |

 

Revenues from corporateand other increased to $1.0 million from $395,000, and the loss before taxesdeclined to $1.7 million from $2.6 million. Revenues from principal transactions, which consist principally ofchanges in the values of our investment portfolios, increased to $201,000 in2005, from a loss of $118,000 in 2004. Interest and dividend income increased to $756,000 from $405,000.

 

**Liquidity and Capital Resources**

 

We intend to satisfy a large portion of our fundingneeds with our own capital resources, consisting largely of internallygenerated earnings and liquid assets we currently hold.

 

At March 31, 2005, we had approximately $19.9million in cash and cash equivalents, which together with receivables frombroker-dealers, deposits with clearing brokers, marketable securities owned,and securities available for sale represented about 29% of our total assets atthe end of the first quarter.

 

For the three months ended March 31, 2005, net cashused in operations totaled $1.1 million versus $6.4 million during the firstthree months of 2004.  Accounts payableand accrued liabilities declined by $8.2 million during the three months ended March 31,2005, principally due to the payment of accrued compensation during the firstquarter of 2005.  Securities ownedincreased by $1.4 million during the first three months of 2005, primarily dueto new investments and net realized and unrealized gains on the investmentportfolio.  The realized gains are generallyreinvested in the portfolio.  Theincrease of $3.9 million in securities sold, not yet purchased in 2005 consistprimarily of securities sold short to hedge against similar positions recordedas securities owned.

 

Capital expenditures for the first quarter of 2005were $794,000, mainly for the purchase of furniture,  computer equipment and software, as well asfor leasehold improvements, necessary for our growth.

 

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At March 31, 2005, SMH, our registeredbroker-dealer subsidiary, was in compliance with the net capital requirementsof the Securities and Exchange Commission’s Uniform Net Capital Rules andhad capital in excess of the required minimum. Salient/PMT was in compliance with the Texas Department of Banking netcapital requirement and had capital in excess of the required minimum.

 

We are a party to various legal proceedings that areof an ordinary or routine nature incidental to our operations.  We believe we have adequately reserved forsuch litigation matters and that they will not have a material adverse effecton our consolidated financial position, results of operations, or cash flows.

 

**Factors Affecting Forward-LookingStatements**

 

This quarterly report on Form 10-Qincludes “forward-looking statements” within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the Securitiesand Exchange Act of 1934, as amended (the “Acts”). These forward-lookingstatements may relate to such matters as anticipated financial performance,future revenues or earnings, business prospects, projected ventures, newproducts, anticipated market performance and similar matters. The PrivateSecurities Litigation Reform Act of 1995 provides a safe harbor for forward-lookingstatements. To comply with the safe harbor, the Company cautions readers that avariety of factors could cause the Company’s actual results to differmaterially from the anticipated results or other expectations expressed in theCompany’s forward-looking statements. These risks and uncertainties, many ofwhich are beyond the Company’s control, include, but are not limited to (1) tradingvolume in the securities markets; (2) volatility of the securities marketsand interest rates; (3) changes in regulatory requirements, which couldaffect the demand for the Company’s services or the cost of doing business; (4) generaleconomic conditions, both domestic and foreign, especially in the regions wherethe Company does business; (5) changes in the rate of inflation andrelated impact on securities markets; (6) competition from existingfinancial institutions and other new participants in the securities markets; (7) legaldevelopments affecting the litigation experience of the securities industry; (8) successfulimplementation of technology solutions; (9) changes in valuations of theCompany’s trading and warrant portfolios resulting from mark-to-marketadjustments; (10) dependence on key personnel and (11) demand for theCompany’s services. The Company does not undertake to publicly update or reviseany forward-looking statements.

 

**Item 3*****.  Quantitative and Qualitative DisclosuresAbout Market Risk***

 

**Market Risks**

** **

At March 31, 2005,Salient/PMT had securities available for sale with a fair value of $3.4million.   These securities have anoriginal cost of $3.5 million, and are subject to equity price risk.  At March 31, 2005, the unrealizeddecline in market value totaling $92,000 less tax of $36,000 has been includedas a separate component of shareholders’ equity.

 

Management evaluates therealizability of securities available for sale to determine if a decline invalue is other than temporary.  Suchevaluation considers the length of time and the extent to which market valuehas been less than cost, the financial condition and near-term prospects of theissuer, and the intent and ability of the Company to retain its investment inthe issuer for a period of time sufficient to allow for any anticipatedrecovery in market value.  Managementbelieves the unrealized losses are temporary at March 31, 2005.  However, a write-down accounted for as arealized loss may be necessary in the future.

 

At March 31, 2005, securities owned by theCompany were recorded at a fair value of $59.9 million, including $25.0 millionin marketable securities, $28.1 million representing the Company’s investmentsin limited partnerships and $6.8 million representing other not readilymarketable securities.

 

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**Item 4****.** ***Controls and Procedures***

 

Ourmanagement, including our Chief Executive Officer and Chief Financial Officer,have conducted an evaluation of the effectiveness of our disclosure controlsand procedures (as defined in Rule 13a-15(e) promulgated underExchange Act), as of the end of the fiscal period covered by this report.  Based upon that evaluation, our ChiefExecutive Officer and Chief Financial Officer have concluded that ourdisclosure controls and procedures are effective in ensuring that the informationrequired to be disclosed in the reports we file or submit under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the rules and forms of the Securities and Exchange Commissionand that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate to allow timely decisions regarding required disclosure.  There have been no changes made in ourinternal controls over financials reporting during the period covered by thisreport that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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**PART II****.   OTHER INFORMATION**

 

**Item1.  *Legal Proceeding**s***

 

We are a party to various legal proceedings that areof an ordinary or routine nature incidental to our operations.  Certain of our litigation and claims arecovered by insurance with a maximum deductible of $50,000.  We believe we have adequately reserved forsuch litigation matters and that they will not have a material adverse effecton our consolidated financial position, results of operations, or cash flows.

 

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**Item 6**.  ***Exhibit******s***

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                    |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                               |
| 3.1                 |       | Articles  of Incorporation of the Company, as amended (filed as Exhibit 3.1 to the  Company’s Form 10-K for the year ended December 31, 2001 (File  No. 000-30066) and incorporated herein by reference). |
| 3.2                 |       | Amended and Restated Bylaws of the Company (filed as  Exhibit 3.2 to the Company’s Form 10-K for the year ending  December 31, 1998 (File No. 000-30066) and incorporated herein by  reference).          |
| *31.1               |       | Rule 13a-14(a)/15d  – 14(a) Certification of Chief Executive Officer.                                                                                                                                               |
| *31.2               |       | Rule 13a-14(a)/15d  – 14(a) Certification of Chief Financial Officer.                                                                                                                                               |
| *32.1               |       | Certification Pursuant  to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                             |
| *32.2               |       | Certification Pursuant  to 18 U.S.C. 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                             |

 

----

| ** ** | ** ** | * Filed herewith. |
|------------|------------|-------------------|

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|                               | **SANDERS  MORRIS HARRIS GROUP INC.** |
|------------------------------------|---------------------------------------|
|                               |                                  |   |   |
|                               | By                                    | /s/   BEN T. MORRIS |
|                               |                                  | **Ben  T. Morris** |
|                               |                                  | **Chief  Executive Officer** |
|                               |                                  |   |   |
|                               |                                  |   |   |
|                               | By                                    | /s/  RICK BERRY |
|                               |                                  | **Rick  Berry** |
|                               |                                  | **Chief  Financial Officer** |
|                               |                                  |   |   |
|                               |                                  |   |   |
| Date:   May 9, 2005 |                                  |   |   |

 

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