**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

----

 

**FORM 10-Q**

 

**(mark one)**

 

**ý****                                ****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30,2004**

 

**or**

 

**o****                                ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**Commission file No. 0-30066**

 

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**SANDERSMORRIS HARRIS GROUP INC.**

(Exact name of registrant as specified in itscharter)

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

 

**600 Travis, Suite 3100**

**Houston, Texas 77002**

(Address of principal executive office)

 

**(713) 993-4610**

(Registrant’s telephone number, includingarea code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.             YES  ý      NO  o

 

Indicate by check mark whether registrant is an accelerated filer (asdefined in Rule 12b-2 of the Exchange Act).  YES  ý      NO  o

 

The number ofshares of the registrant’s Common Stock, par value $0.01 per share, outstandingas of October  26, 2004, was 17,641,259.

 

 

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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 September 30,  2004 (unaudited) and December 31, 2003 |   |
|                                          |    |   |   |
|                                          |    | Condensed Consolidated Statement of Income  for the Three and Nine Months Ended September 30, 2004 and 2003  (unaudited) |   |
|                                          |    |   |   |
|                                          |    | Condensed Consolidated Statement of  Shareholders’ Equity for the Nine Months Ended September 30, 2004  (unaudited) |   |
|                                          |    |   |   |
|                                          |    | Condensed Consolidated Statement of Cash Flows for the Nine Months  Ended September 30, 2004 and 2003 (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****.  *FinancialStatements***

 

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

**CONDENSEDCONSOLIDATED BALANCE SHEET**

(in thousands, except share and per share amounts)

 
| ** **                                                                                                           | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                           | ** ** | **(unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                           |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                            |       | $                            | 17,422     |                        | $          | 32,590 |   |
| Receivables, net of allowance of $414 and  $400, respectively                                                        |       |                         |       |                        |       |
| Broker-dealers                                                                                                       |       | 681                          |       | 522                         |       |
| Customers                                                                                                            |       | 4,490                        |       | 3,758                       |       |
| Related parties                                                                                                      |       | 8,935                        |       | 6,100                       |       |
| Other                                                                                                                |       | 2,368                        |       | 822                         |       |
| Deposits with clearing brokers                                                                                       |       | 1,055                        |       | 1,054                       |       |
| Securities owned                                                                                                     |       | 44,653                       |       | 32,322                      |       |
| Securities available for sale                                                                                        |       | 3,867                        |       | 3,156                       |       |
| Furniture and equipment, net                                                                                         |       | 7,591                        |       | 4,227                       |       |
| Other assets                                                                                                         |       | 2,355                        |       | 3,004                       |       |
| Goodwill, net                                                                                                        |       | 54,303                       |       | 49,447                      |       |
| Total assets                                                                                                         |       | $                            | 147,720    |                        | $          | 137,002 |   |
|                                                                                                                 |       |                         |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                        |       |                         |       |                        |       |
|                                                                                                                 |       |                         |       |                        |       |
| Liabilities:                                                                                                         |       |                         |       |                        |       |
| Accounts payable and accrued liabilities                                                                             |       | $                            | 12,945     |                        | $          | 16,597 |   |
| Deferred tax liability                                                                                               |       | 116                          |       | 647                         |       |
| Securities sold, not yet purchased                                                                                   |       | 3,189                        |       | 255                         |       |
| Other liabilities                                                                                                    |       | 89                           |       | 144                         |       |
| Total liabilities                                                                                                    |       | 16,339                       |       | 17,643                      |       |
|                                                                                                                 |       |                         |       |                        |       |
| Commitments and contingencies                                                                                        |       |                         |       |                        |       |
|                                                                                                                 |       |                         |       |                        |       |
| Minority interests                                                                                                   |       | 6,033                        |       | 4,506                       |       |
|                                                                                                                 |       |                         |       |                        |       |
| 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; 18,380,661 and 17,991,653 shares issued, respectively |       | 184                          |       | 180                         |       |
| Additional paid-in capital                                                                                           |       | 118,510                      |       | 113,781                     |       |
| Receivables for shares issued                                                                                        |       | (1,746                       | )          | (1,117                      | )          |
| Retained earnings                                                                                                    |       | 13,592                       |       | 6,015                       |       |
| Accumulated other comprehensive loss                                                                                 |       | (109                         | )          | (70                         | )          |
| Unearned compensation                                                                                                |       | (1,602                       | )          | (638                        | )          |
| Treasury stock at cost, 739,402 and 724,003  shares, respectively                                                    |       | (3,481                       | )          | (3,298                      | )          |
| Total shareholders’ equity                                                                                      |       | 125,348                      |       | 114,853                     |       |
| Total liabilities and shareholders’ equity                                                                      |       | $                            | 147,720    |                        | $          | 137,002 |   |

 

The accompanying notes are an integral part of the condensedconsolidated financial statements.

 

2

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

**CONDENSED CONSOLIDATED STATEMENTOF INCOME**

(in thousands, except share and per share amounts)

(unaudited)

 
| ** **                                                                                         | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                         | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                         | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Commissions                                                                                        |       | $                                          | 13,685     |                                      | $          | 12,807 |   | $ | 40,208 |   | $ | 38,441 |   |
| Principal transactions                                                                             |       | 2,016                                      |       | 4,444                                     |       | 5,459 |   | 10,393 |   |
| Investment banking                                                                                 |       | 5,772                                      |       | 2,966                                     |       | 23,133 |   | 13,167 |   |
| Fiduciary, custodial and advisory fees                                                             |       | 5,306                                      |       | 2,768                                     |       | 13,557 |   | 7,049 |   |
| Interest and dividends                                                                             |       | 1,067                                      |       | 621                                       |       | 2,912 |   | 1,830 |   |
| Other income                                                                                       |       | 715                                        |       | 569                                       |       | 1,754 |   | 1,846 |   |
| Total revenues                                                                                     |       | 28,561                                     |       | 24,175                                    |       | 87,023 |   | 72,726 |   |
|                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Expenses:                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Employee compensation and benefits                                                                 |       | 15,990                                     |       | 14,340                                    |       | 50,965 |   | 43,806 |   |
| Floor brokerage, exchange and clearance  fees                                                      |       | 1,546                                      |       | 1,268                                     |       | 4,071 |   | 4,169 |   |
| Communications and data processing                                                                 |       | 1,839                                      |       | 1,398                                     |       | 5,301 |   | 4,135 |   |
| Occupancy                                                                                          |       | 1,838                                      |       | 1,347                                     |       | 5,241 |   | 4,228 |   |
| Goodwill impairment charge                                                                         |       | 400                                        |       | —                                    |       | 400 |   | — |   |
| Other general and administrative                                                                   |       | 2,554                                      |       | 2,501                                     |       | 7,809 |   | 7,154 |   |
| Total expenses                                                                                     |       | 24,167                                     |       | 20,854                                    |       | 73,787 |   | 63,492 |   |
|                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Income before equity in income of  limited partnerships, minority interests and  income taxes |       | 4,394                                      |       | 3,321                                     |       | 13,236 |   | 9,234 |   |
| Equity in income of limited partnerships                                                           |       | 776                                        |       | 338                                       |       | 3,606 |   | 3,191 |   |
|                                                                                               |       | 5,170                                      |       | 3,659                                     |       | 16,842 |   | 12,425 |   |
| Minority interests in net income of  consolidated companies                                        |       | (741                                       | )          | (73                                       | )          | (2,126 | ) | (1,060 | ) |
| Income before income taxes                                                                         |       | 4,429                                      |       | 3,586                                     |       | 14,716 |   | 11,365 |   |
|                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Provision for income taxes                                                                         |       | (1,754                                     | )          | (1,283                                    | )          | (5,824 | ) | (4,478 | ) |
|                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Net income                                                                                         |       | $                                          | 2,675      |                                      | $          | 2,303 |   | $ | 8,892 |   | $ | 6,887 |   |
|                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Earnings per share:                                                                                |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                              |       | $                                          | 0.15       |                                      | $          | 0.13 |   | $ | 0.51 |   | $ | 0.40 |   |
| Diluted                                                                                            |       | $                                          | 0.15       |                                      | $          | 0.13 |   | $ | 0.49 |   | $ | 0.39 |   |
|                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average common shares outstanding:                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                                                                              |       | 17,640,293                                 |       | 17,179,476                                |       | 17,542,678 |   | 17,047,891 |   |
| Diluted                                                                                            |       | 18,212,456                                 |       | 17,669,969                                |       | 18,131,012 |   | 17,575,860 |   |

 

Theaccompanying notes are an integral part of the condensed consolidated financialstatements.

 

3

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**SANDERSMORRIS HARRIS GROUP INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY**

**For thenine months ended September 30, 2004**

(in thousands, exceptshares)

(unaudited)

 
| ** **                                                         | ** ** | **Amounts** | ** **  | ** ** | ** ** | **Shares** | ** **     |
|--------------------------------------------------------------------|------------|-------------|-------------|------------|------------|------------|----------------|
|                                                               |       |        |        |       |       |       |           |
| **Common  stock**                                                  |       |        |        |       |       |       |           |
| Balance, beginning of period                                       |       | $           | 180         |       |       |       | 17,991,653     |   |
| Stock issued pursuant to employee benefit  plan                    |       | 4           |        |       |       | 389,008    |           |
| Balance, end of period                                             |       | 184         |        |       |       | 18,380,661 |           |
| **Additional  paid-in capital**                                    |       |        |        |       |       |       |           |
| Balance, beginning of period                                       |       | $           | 113,781     |       |       |       |           |   |
| Stock issued pursuant to employee benefit  plan                    |       | 4,729       |        |       |       |       |           |
| Balance, end of period                                             |       | 118,510     |        |       |       |       |           |
| **Receivables  for shares issued**                                 |       |        |        |       |       |       |           |
| Balance, beginning of period                                       |       | ($1,117     | )           |       |       |       |           |
| Issuance of restricted stock                                       |       | (1,566      | )           |       |       |       |           |
| Amortization of notes receivable                                   |       | 937         |        |       |       |       |           |
| Balance, end of period                                             |       | (1,746      | )           |       |       |       |           |
| **Retained  earnings**                                             |       |        |        |       |       |       |           |
| Balance, beginning of period                                       |       | $           | 6,015       |       |       |       |           |   |
| Dividends                                                          |       | (1,315      | )           |       |       |       |           |
| Net income                                                         |       | 8,892       |        | 8,892      |       |       |           |
| Balance, end of period                                             |       | 13,592      |        | 8,892      |       |       |           |
| **Accumulated  other comprehensive loss**                          |       |        |        |       |       |       |           |
| Balance, beginning of period                                       |       | $           | (70         | )          |       |       |           |   |
| Net change in unrealized depreciation                              |       |        |        |       |       |       |           |
| on securities available for sale                                   |       | (68         | )           | (68        | )          |       |           |
| Income tax benefit on change                                       |       | 29          |        | 29         |       |       |           |
| Balance, end of period                                             |       | (109        | )           | (39        | )          |       |           |
| **Comprehensive  income**                                          |       |        |        | 8,853      |       |       |           |
| **Unearned  compensation**                                         |       |        |        |       |       |       |           |
| Balance, beginning of period                                       |       | $           | (638        | )          |       |       |           |   |
| Net issuance of restricted stock                                   |       | (1,690      | )           |       |       |       |           |
| Amortization of unearned compensation                              |       | 726         |        |       |       |       |           |
| Balance, end of period                                             |       | (1,602      | )           |       |       |       |           |
| **Treasury  stock**                                                |       |        |        |       |       |       |           |
| Balance, beginning of period                                       |       | $           | (3,298      | )          |       |       | (724,003       | ) |
| Acquisition of treasury stock                                      |       | (183        | )           |       |       | (15,399    | )              |
| Balance, end of period                                             |       | (3,481      | )           |       |       | (739,402   | )              |
| **Total  shareholders’ equity and common shares outstanding** | ** ** | **$**       | **125,348** | ** ** | ** ** | ** ** | **17,641,259** | ** ** |
|                                                                    |            |             |             |            |            |            |                |  |  |  |

 

4

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

**CONDENSED CONSOLIDATED STATEMENT OF CASHFLOWS**

**For the ninemonths ended September 30, 2004 and 2003**

(inthousands)

(unaudited)

 

 
| ** **                                                                                  | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                       |       |       |       |       |       |
| Net income                                                                                  |       | $          | 8,892      |       | $          | 6,887 |   |
| Adjustments to reconcile net income to net  cash used in operating activities:              |       |       |       |       |       |
| Realized gain on securities available for  sale                                             |       | (14        | )          | (8         | )          |
| Depreciation                                                                                |       | 1,416      |       | 869        |       |
| Goodwill impairment change                                                                  |       | 400        |       | —     |       |
| Provision for bad debts                                                                     |       | 35         |       | 190        |       |
| Compensation expense related to  amortization of notes receivable and unearned compensation |       | 1,663      |       | 1,240      |       |
| Deferred income taxes                                                                       |       | (503       | )          | 202        |       |
| Equity in income of limited partnerships                                                    |       | (3,606     | )          | (3,191     | )          |
| Minority interests in income of  consolidated companies                                     |       | 2,126      |       | 1,060      |       |
| Changes in operating assets and liabilities  excluding effects of acquisition:              |       |       |       |       |       |
| Increase in receivables                                                                     |       | (4,509     | )          | (3,086     | )          |
| Increase in securities owned                                                                |       | (9,525     | )          | (3,510     | )          |
| Decrease (increase) in other assets                                                         |       | 668        |       | (940       | )          |
| Increase in securities sold, not yet  purchased                                             |       | 2,935      |       | 365        |       |
| Decrease in other liabilities                                                               |       | (55        | )          | (29        | )          |
| Decrease in accounts payable and accrued  liabilities                                       |       | (4,700     | )          | (2,877     | )          |
| Net cash used in operating activities                                                       |       | (4,777     | )          | (2,828     | )          |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                       |       |       |       |       |       |
| Capital expenditures                                                                        |       | (4,745     | )          | (955       | )          |
| Acquisitions, net of cash acquired of $478  and $142, respectively                          |       | (3,312     | )          | (1,608     | )          |
| Cash of business consolidated                                                               |       | 49         |       | —     |       |
| Purchase of securities available for sale                                                   |       | (1,164     | )          | (1,173     | )          |
| Proceeds from sales and maturities of  securities available for sale                        |       | 400        |       | 1,352      |       |
| Net cash used in investing activities                                                       |       | (8,772     | )          | (2,384     | )          |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                       |       |       |       |       |       |
| Purchase of treasury stock                                                                  |       | (183       | )          | (168       | )          |
| Proceeds from shares issued                                                                 |       | 1,477      |       | 3,273      |       |
| Investment by minority interest                                                             |       | 67         |       | 38         |       |
| Distributions to minority interests                                                         |       | (1,665     | )          | (432       | )          |
| Payment of cash dividends                                                                   |       | (1,315     | )          | (1,036     | )          |
| Net cash (used in) provided by financing  activities                                        |       | (1,619     | )          | 1,675      |       |
| Net decrease in cash and cash equivalents                                                   |       | (15,168    | )          | (3,537     | )          |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                           |       | 32,590     |       | 34,890     |       |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                  |       | $          | 17,422     |       | $          | 31,353 |   |
| Supplemental cash flow information                                                          |       |       |       |       |       |
| Cash paid for income taxes                                                                  |       | $          | 6,011      |       | $          | 3,736 |   |
| Noncash investing and financing activities:                                                 |       |       |       |       |       |
| Acquisition and consolidation:                                                              |       |       |       |       |       |
| Receivables                                                                                 |       | 799        |       | 167        |       |
| Fixed assets                                                                                |       | 34         |       | 30         |       |
| Other assets                                                                                |       | 19         |       | —     |       |
| Securities owned                                                                            |       | (800       | )          | —     |       |
| Goodwill                                                                                    |       | 800        |       | —     |       |
| Accounts payable and accrued liabilities                                                    |       | (1,049     | )          | (206       | )          |
| Minority interests                                                                          |       | (997       | )          | —     |       |

 

The accompanying notes are an integral part of the condensedconsolidated financial statements.

 

5

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**Sanders Morris Harris Group Inc. andSubsidiaries**

**Notes****to Consolidated Financial Statements**

 

### **1.**              BASIS OFPRESENTATION

 

###### *Natureof Operations*

 

Through its operating subsidiaries SandersMorris Harris Inc. (“SMH”), Salient Capital Management (“Salient/PMT”), SMHCapital Advisors (“SMCA”) and Charlotte Capital, the Company provides a broadrange of financial services, including institutional, prime and retailbrokerage, principal trading, investment banking, merchant banking, financialadvisory, trust related services, investment management and financial planning.The Company serves a diverse group of institutional, corporate and individualclients.

 

The Company merged with and acquired itsoperating subsidiaries in 1999 through 2004. The acquisitions were accounted for using the purchase method.

 

###### *Consolidation*

 

The unaudited condensed consolidatedfinancial statements of the Company include the accounts of its wholly ownedsubsidiaries. All material intercompany transactions and balances have beeneliminated in consolidation.

 

In management’s opinion, the unauditedcondensed consolidated financial statements include all adjustments necessaryfor a fair presentation of our consolidated financial position at September 30,2004, our results of operations for the three and nine months ended September 30,2004 and 2003, and our cash flows for the nine months ended September 30,2004 and 2003.  All adjustments are of anormal recurring nature. Interim results are not necessarily indicative ofresults for a full year.

 

These financial statements and notes shouldbe read in conjunction with the Company’s annual report on Form 10-K for theyear ended December 31, 2003.

 

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

 

In December 2003, the FASB issued FASBInterpretation No. 46R (revised December 2003), *Consolidation of Variable Interest Entities,*which addresseshow a business enterprise should evaluate whether it has a controllingfinancial interest in an entity through means other than voting rights andaccordingly should consolidate the entity. FIN 46R replaces FASB Interpretation No. 46, *Consolidation of Variable Interest Entities,*which wasissued in January 2003.  The Companywas required to apply FIN 46R to variable interests in VIEs in its consolidatedfinancial statements beginning with the quarter ended March 31, 2004.  For any VIEs that must be consolidated underFIN 46R that were created before January 1, 2004, the assets, liabilitiesand noncontrolling interests of the VIE initially would be measured at theircarrying amounts with any difference between the net amount added to thebalance sheet and any previously recognized interest being recognized as thecumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value atthe date FIN 46R first applies may be used to measure the assets, liabilitiesand noncontrolling interest of the VIE. The Company has identified one entity that requires consolidation underthis Interpretation.  Consolidation ofthis entity increased the Company’s assets by approximately $14,000,liabilities by approximately $18,000 and had an insignificant effect on theother basic consolidated financial statements.

 

*Stock-Based Compensation*

 

The Company applies the intrinsic value-basedmethod of accounting prescribed by Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees,*andrelated interpretations including FASB Interpretation No. 44, *Accounting for Certain Transactions involving StockCompensation an Interpretation of APB Opinion No. 25,*issued in March 2000,to account for its fixed plan stock options. Under this method, compensation expense is recorded on the date of grantonly if the current market price of the underlying stock exceeded the exerciseprice.

 

6

----

 

The following table illustrates the effect onnet income as if the Company had applied the fair value recognition provisionsof SFAS No. 123 as amended by SFAS No. 148:

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                    | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                    | ** ** | **(in thousands, except per share)**       | ** ** | **(in thousands, except per share)**      | ** ** |
| ** **                                                                                                                                    | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income as reported                                                                                                                        |       | $                                          | 2,675      |                                      | $          | 2,303 |   | $ | 8,892 |   | $ | 6,887 |   |
| Deduct: Total stock based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (80                                        | )          | (121                                      | )          | (330 | ) | (354 | ) |
| Pro forma net income                                                                                                                          |       | $                                          | 2,595      |                                      | $          | 2,182 |   | $ | 8,562 |   | $ | 6,533 |   |
|                                                                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Earnings per share                                                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Basic-as reported                                                                                                                             |       | $                                          | 0.15       |                                      | $          | 0.13 |   | $ | 0.51 |   | $ | 0.40 |   |
| Basic-pro forma                                                                                                                               |       | $                                          | 0.15       |                                      | $          | 0.13 |   | $ | 0.49 |   | $ | 0.38 |   |
|                                                                                                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Diluted-as reported                                                                                                                           |       | $                                          | 0.15       |                                      | $          | 0.13 |   | $ | 0.49 |   | $ | 0.39 |   |
| Diluted-pro forma                                                                                                                             |       | $                                          | 0.14       |                                      | $          | 0.12 |   | $ | 0.47 |   | $ | 0.37 |   |

 

*Reclassifications*

 

Certain reclassificationshave been made to the 2003 condensed consolidated financial statements to conformthem with the 2004 presentation.  Thereclassifications had no effect on retained earnings, results of operations orcash flows as previously reported.

 

### **2.**              ACQUISITIONS

 

On April 1, 2004, the Company acquired a69% interest in Charlotte Capital. Employees of Charlotte Capital retained a 31% ownership interest in thefirm.  Charlotte Capital, based inCharlotte, North Carolina, manages approximately $400 million in assets forinstitutional investors in small cap value and mid cap value styles.  SMHG paid $3.4 million in cash at closing,and is obligated to pay an additional amount in 18 months.  The base amount of the additional payment is$2.3 million; however, it may be adjusted up or down based on changes in the firm’srevenues and assets under management for the 18 month period beginning April 1,2004.  Employees of Charlotte Capital canearn up to an additional 9% ownership interest by achieving specified revenuerun rates during the 18-month period following closing.  The acquisition was accounted for as apurchase, and accordingly, the financial information of Charlotte Capital hasbeen included in the Company’s consolidated financial statements from April 1,2004.  The initial consideration of $3.4million exceeded the fair market value of identifiable net tangible assets byapproximately $4.5 million, which has been recorded as goodwill.

 

On May 2, 2003, the Company acquired a 50% ownershipinterest in the Salient companies. Additionally, the Company acquired a 23.15% profits interest in theadvisor to The Endowment Fund, a related entity.  The former owners of Salient and TheEndowment Fund received cash payments totaling $1.75 million in May 2003.  In July 2004, the former owners ofSalient and The Endowment Fund received cash payments of $250,000 upon theCompany’s conversion of the 23.15% profits interest into a 23.15% ownershipinterest and may later receive up to 1,200,000 common shares of the Companybased on profitability of Salient/PMT for the year ended December 31,2004.  No additional consideration hasbeen earned through September 30, 2004 as the calculation is based on theentire 2004 year; however, if the 

 

7

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additional consideration was based on the profitability of Salient/PMTfor the nine months ended September 30, 2004, the former owners of Salientand The Endowment Fund would have earned approximately 200,000 common shares ofthe Company.  The Salient companies andPinnacle Management & Trust Company subsequently renamed Pinnacle TrustCo., LTA (“PMT”) were contributed to Salient Capital Management, which entity’sClass A limited partner units are jointly owned by the Company and the formerowners of Salient.  Additionally, theCompany received Class B limited partner units of Salient/PMT which, in theevent of a liquidation or sale of Salient/PMT, entitles the Company to firstreceive proceeds, if any, equal to the net asset value of PMT as of May 2,2003, (approximately $4.4 million) with the remaining proceeds to be dividedequally among the owners of the Class A units. The Salient companies provide investment advisory services toindividuals and institutions.  TheEndowment Fund is a diversified fund of funds using hedge fund managers thatspecialize in a variety of investment approaches.  The acquisitions were accounted for as apurchase, and accordingly, the financial information of the Salient companiesand the advisor to The Endowment Fund has been included in the Company’sconsolidated financial statements from May 2, 2003.  The purchase price of approximately $1.8million exceeded the fair market value of identifiable net assets byapproximately $1.7 million, which has been recorded as goodwill.  The Company uses the consolidation method toaccount for its investment in Salient/PMT.

 

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

 

Securities owned and securities sold, not yetpurchased as of September 30, 2004 were as follows:

 
| ** **                           | ** ** | **Owned**          | ** ** | **Sold, Not Yet  Purchased** | ** ** |
|--------------------------------------|------------|--------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **(in thousands)** | ** ** |
| Marketable:                          |       |               |       |                         |       |
| U.S. Government and agency           |       | $                  | 7,588      |                         | $          | 2,742 |   |
| Corporate stocks                     |       | 2,209              |       | 402                          |       |
| Corporate bonds and commercial paper |       | 5,643              |       | 45                           |       |
|                                 |       | 15,440             |       | 3,189                        |       |
| Not readily marketable:              |       |               |       |                         |       |
| Partnerships                         |       | 21,022             |       | —                       |       |
| Corporate stocks and warrants        |       | 8,191              |       | —                       |       |
|                                 |       | $                  | 44,653     |                         | $          | 3,189 |   |

 

Securities not readily marketable includeinvestment securities (a) for which there is no market on a securities exchangeor no independent publicly quoted market, (b) that cannot be publicly offeredor sold 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. and 2003 HoustonEnergy Partners, L.P.

 

The Company has issued a letter of credit inthe amount of $1.5 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 $1.5 million.

 

8

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

 

Securities available for sale at September 30, 2004 were asfollows:

 
| ** **                             | ** ** | **Amortized**      | ** ** | **Gross Unrealized** | ** ** | **Estimated** | ** ** |
|----------------------------------------|------------|--------------------|------------|----------------------|------------|---------------|------------|
| ** **                             | ** ** | **Cost**           | ** ** | **Gains**            | ** ** | **Losses**    | ** ** | **Fair Value** | ** ** |
| ** **                             | ** ** | **(in thousands)** | ** ** |
|                                   |       |               |       |                 |       |          |       |   |   |
| U.S. Government and agency obligations |       | $                  | 1,041      |                 | $          | 6             |       | $ | (4 | ) | $ | 1,043 |   |
| Marketable equity securities           |       | 1,952              |       | 92                   |       | (274          | )          | 1,770 |   |
| Corporate bonds                        |       | 251                |       | —               |       | —        |       | 251 |   |
| Partnerships                           |       | 802                |       | 7                    |       | (6            | )          | 803 |   |
| Total                                  |       | $                  | 4,046      |                 | $          | 105           |       | $ | (284 | ) | $ | 3,867 |   |

 

The contractual maturities of debt securities available for sale at September 30,2004, were as follows:

 
| Due before 5 years                  |   | $ | 998 |   |
|-------------------------------------|--------|---|-----|--------|
| Due after 25 years through 30 years |   | $ | 296 |   |

 

Gross realized gains on sales of securitiesavailable for sale were $15,000 for the nine months ended September 30,2004 and $36,000 for the nine months ended September 30, 2003.  Gross realized losses on securities availablefor sale were $1,000 for the nine months ended September 30, 2004 and$28,000 for the nine months ended September 30, 2003.

 

The Company has pledged securities valued at$250,000 to the bank commissioner of the state of Oklahoma to secure itsperformance of fiduciary duties for trust activities in that state.

 

### **5.**              INCOME TAXES

 

                        The differences between theeffective tax rate reflected in the income tax provision from operations andthe statutory federal rate were as follows:

 
| ** **                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **(in thousands)**                         | ** ** | **(in thousands)**                        | ** ** |
|                                  |       |                                       |       |                                      |       |   |   |   |   |
| Tax computed using the statutory rate |       | $                                          | 1,506      |                                      | $          | 1,219 |   | $ | 5,003 |   | $ | 3,864 |   |
| State income taxes and other          |       | 248                                        |       | 64                                        |       | 821 |   | 614 |   |
| Total                                 |       | $                                          | 1,754      |                                      | $          | 1,283 |   | $ | 5,824 |   | $ | 4,478 |   |

 

### **6.**              COMMITMENTS ANDCONTINGENCIES

 

There were no firm underwriting commitmentsopen at September 30, 2004.

 

The Company and its subsidiaries haveobligations under operating leases that expire by 2014 with initialnoncancelable terms in excess of one year.

 

The Company is a party to various legalproceedings that are of an ordinary or routine nature incidental to itsoperations.  The Company believes it hasadequately reserved for such litigation matters and that they will not have amaterial adverse effect on the Company’s consolidated financial position,results of operations, or cash flows.

 

9

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The Company has uncommitted financingarrangements with clearing brokers who finance customer accounts, certainbroker-dealer balances and firm trading positions.  Although these customer accounts andbroker-dealer balances are not reflected on the consolidated balance sheet forfinancial accounting and reporting purposes, the Company has generally agreedto indemnify these clearing brokers for losses they may sustain in connectionwith the accounts, and therefore, retains risk on these accounts.  The Company is required to maintain certaincash or securities on deposit with its clearing brokers.

 

The Company has issued a letter of credit inthe amount of $1.5 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 $1.5 million.

 

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

 

Basic and diluted earnings per-sharecomputations for the periods indicated were as follows:

 
| ** **                                                                                              | ** ** | **Three Months Ended September 30,**              | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **2004**                                               | ** ** | **2003** | ** ** |
| ** **                                                                                              | ** ** | **(in thousands, except share and per share amounts)** | ** ** |
| Computation of basic and diluted income per  common share for the three months ended September 30: | ** ** | ** **                                             | ** ** | ** ** | ** ** |
| Net income                                                                                              |       | $                                                      | 2,675      |   | $ | 2,303 |   |
| Weighted average number of common shares  outstanding                                                   |       | 17,640,293                                             |       | 17,179,476 |   |
| Common shares issuable under stock option  plan                                                         |       | 1,059,027                                              |       | 1,056,694 |   |
| Less shares assumed repurchased with  proceeds                                                          |       | (486,864                                               | )          | (566,201 | ) |
| Weighted average common shares outstanding                                                              |       | 18,212,456                                             |       | 17,669,969 |   |
| Basic income per common share                                                                           |       | $                                                      | 0.15       |   | $ | 0.13 |   |
| Diluted income per common share                                                                         |       | $                                                      | 0.15       |   | $ | 0.13 |   |
|                                                                                                    |       |                                                   |       |   |   |
| ** **                                                                                              | ** ** | **Nine Months Ended September 30,**               | ** ** |
| ** **                                                                                              | ** ** | **2004**                                               | ** ** | **2003** | ** ** |
| ** **                                                                                              | ** ** | **(in thousands, except share and per share amounts)** | ** ** |
| Computation of basic and diluted income per  common share for the nine months ended September 30:  |       |                                                   |       |   |   |
| Net income                                                                                              |       | $                                                      | 8,892      |   | $ | 6,887 |   |
| Weighted average number of common shares  outstanding                                                   |       | 17,542,678                                             |       | 17,047,891 |   |
| Common shares issuable under stock option  plan                                                         |       | 1,059,027                                              |       | 1,051,693 |   |
| Less shares assumed repurchased with  proceeds                                                          |       | (470,693                                               | )          | (523,724 | ) |
| Weighted average common shares outstanding                                                              |       | 18,131,012                                             |       | 17,575,860 |   |
| Basic income per common share                                                                           |       | $                                                      | 0.51       |   | $ | 0.40 |   |
| Diluted income per common share                                                                         |       | $                                                      | 0.49       |   | $ | 0.39 |   |

 

Outstanding stock options (45,000 for thethree and nine months ended September 30, 2004; 50,000 for the threemonths ended September 30, 2003; and 55,000 for the nine months ended September 30,2003) have not been included in diluted earnings per common share because to doso would have been antidilutive for the periods presented.

 

**8.****              IMPAIRMENT OFGOODWILL**

 

During the three months ended September 30, 2004, the Companyrecognized a goodwill impairment charge of $400,000 related to its investmentin Brava Therapeutics.  The principalfactors contributing to our decision to record the impairment charge relate tothe uncertainty and timing of a proposed joint venture between Brava andanother entity that would create a more viable platform for further developmentof Brava’s products and expertise.  SMHGhas remaining goodwill of $400,000 related to its investment in Brava.

 

10

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### **9.**              BUSINESS SEGMENTINFORMATION

 

SMHG operates through six business segments: Retail Brokerage,Institutional Brokerage, Asset Management, Prime Brokerage, Investment Banking,and Corporate and Other. The business segments are based upon factors such asthe services provided and distribution channels served. Certain services areprovided to customers through more than one of our business segments.  Prior to April 2004, the Companyaggregated the brokerage and investment banking businesses into one segment.

 

The Retail Brokerage segment distributes a range of financial productsthrough its branch distribution network, including equity and fixed incomesecurities, mutual funds and annuities. Retail revenues consist of commissionsand principal credits earned on equity and fixed income transactions incustomer brokerage accounts, distribution fees earned from mutual funds, feesearned from managed accounts, and net interest on customers’ margin loan andcredit account balances. Additionally, retail revenues include sales creditsfrom investment banking transactions such as the distribution of underwritingsthat we co-manage or in which we participate and private placements ofsecurities in which we serve as placement agent.  The firm employs registered representativesand also licenses independent financial advisors.

 

The Institutional Brokerage segment distributes equity and fixed incomeproducts through its distribution network to its institutional clients.Institutional revenues consist of commissions and principal credits earned ontransactions in customer brokerage accounts, a small amount of net interest oncustomers’ margin loan and credit account balances, and sales credits from thedistribution of investment banking products.

 

The Asset Management segment provides investment advisory, wealth andinvestment management, financial planning, and trust services to institutionaland individual clients. It earns an advisory fee based on such factors as theamount of assets under management and the type of services provided. The assetmanagement segment may also earn commission revenues from the sale of equity,fixed income, mutual fund, and annuity products; and sales credits from thedistribution of investment banking issues. In addition, performance fees may beearned for exceeding performance benchmarks for the investment portfolios inthe limited partnerships that we manage.

 

The Prime Brokerage segment provides trade execution, clearing, custodyand other back-office services to hedge funds and other professional traders.Prime broker revenues consist of commissions and principal credits earned onequity, and fixed income transactions; interest income from securities lendingservices to customers; and net interest on customers’ margin loan and creditaccount balances.

 

The Investment Banking segment provides corporate securitiesunderwriting, private financings and financial advisory services. The Companyparticipates in corporate securities distributions as a manager, co-manager ormember of an underwriting syndicate or of a selling group in public offeringsmanaged by other underwriters. Fees earned for our role as an advisor, manager,or underwriter are included in the investment banking segment. Sales creditsassociated with the distribution of investment banking products are reported inRetail Brokerage, Institutional Brokerage or Asset Management depending on therelevant distribution channel.

 

The Corporate and Other segment includes realized and unrealized gainsand losses on the Company’s investment portfolios and interest and dividendsearned on our cash and securities positions. Unallocated corporate revenues andexpenses are included in Corporate and Other.

 

11

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The following summarizes certain financialinformation of each reportable business segment for the three and nine monthsended September 30, 2004 and 2003, respectively.  SMHG does not analyze asset information inall business segments.

 
| ** **                                                                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                           | ** ** | **(in thousands)**                         | ** ** | **(in thousands)**                        | ** ** |
| Revenues:                                                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Retail brokerage                                                                                     |       | 4,377                                      |       | $                                         | 2,974      |   | $ | 12,843 |   | $ | 9,438 |   |
| Institutional brokerage                                                                              |       | 6,756                                      |       | 8,262                                     |       | 23,062 |   | 23,692 |   |
| Asset management                                                                                     |       | 8,122                                      |       | 4,110                                     |       | 21,754 |   | 12,209 |   |
| Prime brokerage                                                                                      |       | 5,153                                      |       | 5,711                                     |       | 14,984 |   | 17,959 |   |
| Investment banking                                                                                   |       | 2,692                                      |       | 1,294                                     |       | 11,664 |   | 6,591 |   |
| Corporate and other                                                                                  |       | 1,461                                      |       | 1,824                                     |       | 2,716 |   | 2,837 |   |
| Total                                                                                                |       | $                                          | 28,561     |                                      | $          | 24,175 |   | $ | 87,023 |   | $ | 72,726 |   |
|                                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) before equity  in income of limited partnerships, income taxes and minority interests: |       |                                       |       |                                      |       |   |   |   |   |
| Retail brokerage                                                                                     |       | $                                          | 473        |                                      | $          | 199 |   | $ | 1,091 |   | $ | 402 |   |
| Institutional brokerage                                                                              |       | 1,210                                      |       | 1,541                                     |       | 3,996 |   | 4,224 |   |
| Asset management                                                                                     |       | 3,232                                      |       | 1,074                                     |       | 7,580 |   | 3,749 |   |
| Prime brokerage                                                                                      |       | 856                                        |       | 955                                       |       | 2,485 |   | 3,240 |   |
| Investment banking                                                                                   |       | 884                                        |       | 476                                       |       | 5,477 |   | 3,261 |   |
| Corporate and other                                                                                  |       | (2,261                                     | )          | (924                                      | )          | (7,393 | ) | (5,642 | ) |
| Total                                                                                                |       | $                                          | 4,394      |                                      | $          | 3,321 |   | $ | 13,236 |   | $ | 9,234 |   |
|                                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Equity in income of limited partnerships:                                                            |       |                                       |       |                                      |       |   |   |   |   |
| Retail brokerage                                                                                     |       | $                                          | —     |                                      | $          | — |   | $ | — |   | $ | — |   |
| Institutional brokerage                                                                              |       | —                                     |       | —                                    |       | — |   | — |   |
| Asset management                                                                                     |       | 624                                        |       | 221                                       |       | 3,386 |   | 2,778 |   |
| Prime brokerage                                                                                      |       | —                                     |       | —                                    |       | — |   | — |   |
| Investment banking                                                                                   |       | —                                     |       | —                                    |       | — |   | — |   |
| Corporate and other                                                                                  |       | 152                                        |       | 117                                       |       | 220 |   | 413 |   |
| Total                                                                                                |       | $                                          | 776        |                                      | $          | 338 |   | $ | 3,606 |   | $ | 3,191 |   |
|                                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Minority interests in net  (income) loss of  consolidated  companies:                           |       |                                       |       |                                      |       |   |   |   |   |
| Retail brokerage                                                                                     |       | $                                          | —     |                                      | $          | — |   | $ | — |   | $ | — |   |
| Institutional brokerage                                                                              |       | —                                     |       | —                                    |       | — |   | — |   |
| Asset management                                                                                     |       | (747                                       | )          | (73                                       | )          | (2,146 | ) | (1,060 | ) |
| Prime brokerage                                                                                      |       | —                                     |       | —                                    |       | — |   | — |   |
| Investment banking                                                                                   |       | —                                     |       | —                                    |       | — |   | — |   |
| Corporate and other                                                                                  |       | 6                                          |       | —                                    |       | 20 |   | — |   |
| Total                                                                                                |       | $                                          | (741       | )                                         | $          | (73 | ) | $ | (2,126 | ) | $ | (1,060 | ) |
|                                                                                                 |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) before income taxes:                                                                   |       |                                       |       |                                      |       |   |   |   |   |
| Retail brokerage                                                                                     |       | $                                          | 473        |                                      | $          | 199 |   | $ | 1,091 |   | $ | 402 |   |
| Institutional brokerage                                                                              |       | 1,210                                      |       | 1,541                                     |       | 3,996 |   | 4,224 |   |
| Asset management                                                                                     |       | 3,109                                      |       | 1,222                                     |       | 8,820 |   | 5,467 |   |
| Prime brokerage                                                                                      |       | 856                                        |       | 955                                       |       | 2,485 |   | 3,240 |   |
| Investment banking                                                                                   |       | 884                                        |       | 476                                       |       | 5,477 |   | 3,261 |   |
| Corporate and other                                                                                  |       | (2,103                                     | )          | (807                                      | )          | (7,153 | ) | (5,229 | ) |
| Total                                                                                                |       | $                                          | 4,429      |                                      | $          | 3,586 |   | $ | 14,716 |   | $ | 11,365 |   |

 

12

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### **10.**       EMPLOYEE BENEFIT PLANS

 

Under its 1998 Incentive Plan, as amended, the Company has reserved 25%of the issued and outstanding Common Stock of the Company, or 4,000,000 sharesof Common Stock, whichever is greater, for the purpose of issuing incentiveawards under the Incentive Plan.  TheCompany had 1,243,684 shares of Common Stock available for grant under theIncentive Plan at September 30, 2004.

 

**Stock Options**

 

The Incentive Plan provides for the issuance to eligible employees of,among other things, incentive and non-qualified stock options, that may expireup to 10 years from the date of grant.  Theoutstanding options vest over varying periods and have an exercise price equalto the closing price of the Company’s stock on the date of the grant.

 

**Capital Incentive Plan (“CIP”)**

 

Effective January 2, 2001, the Company adopted the CIP under itsIncentive Plan in which eligible employees may purchase shares of the Company’srestricted common stock at a discount of up to 33 1/3 % of the 20-day averageof the closing sales prices for a share of the Company’s common stock, endingon the day prior to the date the shares are issued.  The CIP was amended effective November 1,2001 to include eligible consultants as potential participants under theprogram.

 

All shares issued are valued at the closing price on the date theshares are issued.  Consideration paidthrough the deferral of salaries, commissions, or discretionary bonuses isrecorded as compensation expense on the date the shares are issued.  The difference between the value of theshares issued and the consideration paid is recorded as unearned compensation andis shown as a separate component of shareholders’ equity.  Additionally, shares are issued under theIncentive Plan in conjunction with notes receivable, which are also shown as aseparate component of shareholders’ equity. Unearned compensation and the notesreceivable are amortized to compensation expense over the three-year vestingperiods.

 

**Restricted Stock**

 

The Incentive Plan provides for the issuance of restricted stock toeligible employees.  The restrictedshares vest over varying periods.  All sharesissued are valued at the closing price on the date the shares are issued.  The value of the shares is recorded asunearned compensation and is shown as a separate component of shareholders’equity.  Unearned compensation isamortized to compensation expense over the vesting period.

 

Certain summary information related to the CIP and restricted stockplans for the periods indicated were as follows:

 
| ** **                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                            | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **(in thousands, except shares)**          | ** ** | **(in thousands, except shares)**         | ** ** |
| ** **                            | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Number of shares issued               |       | 1,119                                      |       | 10,077                                    |       | 266,570 |   | 102,855 |   |
| Value of shares issued                |       | $                                          | 13         |                                      | $          | 89 |   | $ | 3,265 |   | $ | 874 |   |
| Additions to unearned compensation    |       | 4                                          |       | 1                                         |       | 1,690 |   | 58 |   |
| Additions to notes receivable         |       | —                                     |       | 85                                        |       | 1,566 |   | 813 |   |
| Amortization of unearned compensation |       | 266                                        |       | 191                                       |       | 726 |   | 671 |   |
| Amortization of notes receivable      |       | 311                                        |       | 185                                       |       | 937 |   | 569 |   |
|                                       |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |

 

13

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### **11.**       RELATED PARTIES

 

The Company had receivables from related parties totaling $8.9 millionat September 30, 2004, primarily consisting of $1.2 million of unpaidmanagement fees earned by the Company for managing the limited partnerships and$7.6 million of notes receivable from employees, consultants and other relatedparties.

 

14

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**Item 2****.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The following discussion should be read inconjunction with the Condensed Consolidated Financial Statements and theirrelated notes.

 

**General**

 

We provide diversified financial servicesthrough our subsidiaries, including institutional, prime and retail brokerage,principal trading, investment banking, merchant banking, financial advisory,trust related services, investment management and financial planning. All ofthese activities are highly competitive and are sensitive to many factorsoutside our control, including those factors listed under “Factors AffectingForward-Looking Statements.”

 

We closely monitor our operating environmentto enable us to respond promptly to market cycles. In addition, we seek tolessen earnings volatility by controlling expenses, increasing fee-basedbusiness and developing new revenue sources. Nonetheless, operating results forany specific period should not be considered representative of futureperformance.

 

**Components of Revenues and Expenses**

 

*Revenues*.  Ourrevenues are comprised primarily of (1) commission revenue from retail, prime andinstitutional brokerage transactions, (2) fees from asset-based advisory andfiduciary 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 asset management,financial planning and fiduciary services. We also earn interest on the cash held and dividends received from theequity securities held by us for our corporate capital accounts and haverealized and unrealized gains (or losses) on securities in our inventoryaccount.

 

*Expenses.  *Ourexpenses consist of (1) employee compensation and benefits, (2) brokerage andclearing costs, and (3) other expenses. Compensation and benefits have both a variable component based onrevenue production and a fixed component. The variable component includes institutional and retail salescommissions, bonuses, overrides, and other incentives.  Retail and institutional commissions arebased on a competitive commission schedule. The investment banking group and the research group receive a salary anddiscretionary bonus as compensation.  Thefixed component includes administrative and executive salaries, payroll taxes,employee benefits and temporary employee costs. Compensation and benefits is our largest expense item and includeswages, salaries and benefits. During the third quarter of 2004, compensationand benefits represented 66% of total expenses, and 56% of total revenues,compared to 69% of total expenses, and 59% of total revenues during thecomparable period in 2003.  During thefirst nine months of 2004, compensation and benefits represented 69% of totalexpenses, and 59% of total revenues compared to 69% of total expenses and 60%of total revenues during the comparable period in 2003.

 

Brokerage and clearance expenses includeclearing and trade execution costs associated with the retail, prime andinstitutional brokerage business at SMH. SMH clears its transactions primarily through Pershing LLC, a member ofBNY Securities Group and a subsidiary of The Bank of New York and otherclearing brokers.

 

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

 

# **Business Environment**

 

Our financial services business is affectedby general economic conditions. The improvement in the economy, as well as inthe overall stock market has had a positive impact on underwriting fees derivedfrom public offerings and advisory fees from private placements. During 2004,the increase in interest rates during 

 

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the first nine months led to a decrease inresidential loan refinancing, which had a negative impact on that portion ofour business that derives its income from mortgage-backed fixed-incomesecurities.  In the third quarter of2004, stock trading volume declined significantly from the same period in 2003.

 

Our revenues relating to asset-based advisoryservices and managed accounts are typically from fees based on the market valueof assets under management. The overall increase in equity prices resulted ingrowth in the values of our customers’ investment portfolios, which in turn ledto higher management fees for the Company. The improved stock market has caused many of our customers to rebalancetheir investment portfolios, thereby reducing concentrations in money marketinstruments and increasing exposure to equity and other securities with agreater potential for growth.

 

We have organized 13 private equity funds forthe purpose of investing in public and private companies that we believe areeither significantly 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 inpublic equity and debt securities that we feel are undervalued. Additionally,we may receive warrants as a part of our compensation for investment bankingservices.

 

We have expanded both the range and depth ofservices offered to our clients through a combination of acquisitions andinternal expansion. This growth has necessitated that we add personnel, as wellas production-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 September 30,2004 Compared to Three Months Ended September 30, 2003*

 

FINANCIAL OVERVIEW

 

Total revenues were $28.6 millionin the third quarter of 2004 compared to $24.2 million for the same quarter in2003.  An increase in investment bankingrevenue and fiduciary, custodial and advisory fees was partially offset by adecline in revenues from fixed income institutional sales.  Total expenses for the 2004 period increasedto $24.2 million from $20.9 million in the same quarter of the previousyear.  Minority interests in net incomeof consolidated companies increased to $741,000 during the third quarter of2004 from $73,000 during the third quarter of 2003.  Net income for the three month period ended September 30,2004 increased to $2.7 million from $2.3 million in the same period in2003.  Basic and diluted income per sharewas $0.15 for the three months ended September 30, 2004 compared to $0.13for the same period in 2003.

 

Commissions revenue increased to$13.7 million in the third quarter of 2004 from $12.8 million in 2003,primarily due to higher trading volume in our retail brokerage division.  Principal transactions revenue totaled $2.0million for the 2004 period versus $4.4 million in the third quarter of 2003.  Revenues from fixed income brokerage declinedto $1.0 million during the third quarter of 2004 from $2.6 million during thecomparable prior year quarter mainly due to a decline in residential loanrefinancing.  Investment banking revenueincreased to $5.8 million during the third quarter of 2004 from $3.0 million inthe same period of 2003, principally due to an increase in fees earned fromprivate placement transactions.  Revenuesfrom fiduciary, custodial and advisory fees increased to $5.3 million in thethird quarter of 2004 from $2.8 million in same quarter of 2003.  The acquisition of Charlotte Capital duringthe second quarter of 2004, the December 2003 start up of a new privateequity fund managed by the Company with a focus on life sciences 

 

16

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investments and growth in assetsunder management have contributed to the increase in revenues from advisoryfees.  Interest and dividend incomeincreased to $1.1 million in 2004 from $621,000 in the same period last year.  Interest income has increased due to highermargin interest reflecting an increase in margin balances.  Other income increased from $569,000 during2003 to $715,000 during 2004, due to an increase in fees earned on the Company’scash balances and customer credit balances at its clearing brokers resultingfrom higher deposit balances.

 

During the three months ended September 30,2004, employee compensation and benefits increased to $16.0 million from $14.3million in the same period last year due to the higher revenue during2004.  Floor brokerage, exchange andclearance fees increased to $1.5 million in the third quarter of 2004 from $1.3million in the same quarter of 2003 reflecting higher clearing and executioncosts resulting from the larger trading volume attributable to retail brokerageservices.  Communication and dataprocessing costs increased to $1.8 million in 2004 from $1.4 million in thesame period last year resulting from increased personnel and additionaloffices.  Occupancy costs totaled $1.8million during the third quarter of 2004, compared to $1.3 million in the prioryear quarter due to expansion of our New York City offices, the addition ofCharlotte Capital in April 2004 and the Tulsa office of U.S. BankcorpPiper Jaffray Inc., which was acquired in December 2003.  Other general and administrative expensesincreased to $2.6 million during the third quarter of 2004 from $2.5 million inthe third quarter of last year mainly due to our growth.

 

Minority interests in net incomeof consolidated companies reflect the portion of net income attributable tominority interest ownership of entities included in the Company’s consolidatedfinancial statements.  Incomeattributable to minority interests increased to $741,000 during the thirdquarter of 2004 from $73,000 during the third quarter of 2003, principally dueto increased income from our share of the income of the limited partnershipsmanaged by the Company and the second quarter 2004 acquisition of CharlotteCapital.

 

The effective tax rate fromoperations was 40% for the three months ended September 30, 2004 comparedto 36% for the three months ended September 30, 2003.  The tax rate in the 2003 quarter is lowerthan that of the 2004 quarter due to adjustments recorded in the third quarterof 2003 to arrive at the appropriate effective tax rate for the nine monthsended September 30, 2003.

 

RESULTS BY SEGMENT

 

*Retail Brokerage*

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                         | ** ** |
|                       |       |                                       |       |   |   |
| Revenues                   |       | $                                          | 4,377      |   | $ | 2,974 |   |
|                       |       |                                       |       |   |   |
| Income before income taxes |       | $                                          | 473        |   | $ | 199 |   |

 

Revenues from retail brokerage increased to$4.4 million from $3.0 million, and income before income taxes increased to$473,000 from $199,000. Commission revenue increased to $2.3 million from $1.7million reflecting increased trading volume due to the additions of several newretail brokers and the Tulsa office in December 2003. Sales credits frominvestment banking transactions increased to $1.1 million from $425,000, due toan increase in fees earned from the Company’s participation in privateplacement transactions. Compensation expense increased to $3.1 million from$2.1 million due to the revenue increase.

 

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*Institutional Brokerage*

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                         | ** ** |
|                       |       |                                       |       |   |   |
| Revenues                   |       | $                                          | 6,756      |   | $ | 8,262 |   |
|                       |       |                                       |       |   |   |
| Income before income taxes |       | $                                          | 1,210      |   | $ | 1,541 |   |

 

Revenues from institutional brokeragedeclined to $6.8 million from $8.3 million, and income before taxes declined to$1.2 million from $1.5 million. Commission revenue declined to $5.2 million from $5.4 million due to aslowdown in institutional commission transactions. Sales credits frominvestment banking transactions declined to $916,000 from $1.1 million, due toa decline in fees earned from the Company’s participation in underwritingsyndicates.  Principal transactionrevenue declined to $587,000 from $1.7 million due to reduced trading volumefrom fixed income products relating to fewer residential home refinancingscaused by higher interest rates.

 

*Asset Management*

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                         | ** ** |
|                       |       |                                       |       |   |   |
| Revenues                   |       | $                                          | 8,122      |   | $ | 4,110 |   |
|                       |       |                                       |       |   |   |
| Income before income taxes |       | $                                          | 3,109      |   | $ | 1,222 |   |

 

Revenues from asset management increased to$8.1 million from $4.1 million, and income before taxes increased to $3.1million from $1.2 million. Fiduciary, custodial and advisory fees increased to$5.1 million from $2.5 million. The acquisition of Charlotte Capital in April 2004,growth in assets under management at Salient/PMT and Cummer/Moyers and the December 2003startup of a new private equity fund managed by the Company with a focus onlife sciences investments have contributed to the increase in revenues fromadvisory fees.  Sales credits frominvestment banking transactions increased to $1.0 million from $170,000 due toincreases in fees earned from the Company’s participation in underwritingsyndicates.  Compensation expense rose to$3.1 million from $1.8 million related to the higher revenues. Minorityinterests in net income of consolidated companies reflect the portion of netincome attributable to minority interest ownership of entities included in theCompany’s consolidated financial statements. Income attributable to minority interests, which reduce SMHG’s pretaxincome, increased to $747,000 from $73,000, principally due to income from oneof the limited partnerships, of which minority interests own 40%, and theaddition of Charlotte Capital in April 2004, of which minority interestsown 31%.

 

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*Prime Brokerage*

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                         | ** ** |
|                       |       |                                       |       |   |   |
| Revenues                   |       | $                                          | 5,153      |   | $ | 5,711 |   |
|                       |       |                                       |       |   |   |
| Income before income taxes |       | $                                          | 856        |   | $ | 955 |   |

 

 

                        Revenuesfrom prime brokerage declined to $5.2 million from $5.7 million, and incomebefore taxes declined to $856,000 from $1.0 million. Commission revenuedeclined to $4.4 million from $4.6 million. Principal transactions revenuesdeclined to $381,000 from $875,000 due to reduced trading volume from fixedincome products. Compensation expense declined to $2.4 million from $2.9million due to lower revenues.

 

*Investment Banking*

 
| ** **                 | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------|------------|--------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                         | ** ** |
|                       |       |                                       |       |   |   |
| Revenues                   |       | $                                          | 2,692      |   | $ | 1,294 |   |
|                       |       |                                       |       |   |   |
| Income before income taxes |       | $                                          | 884        |   | $ | 476 |   |

 

Revenues from investment banking increased to$2.7 million from $1.3 million, and income before taxes increased to $884,000from $476,000. The revenue increase is primarily due to increased revenues fromprivate placement transactions during the third quarter of 2004.

 

*Corporate and Other*

 
| ** **               | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------|------------|--------------------------------------------|------------|
| ** **               | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **               | ** ** | **(in thousands)**                         | ** ** |
|                     |       |                                       |       |   |   |
| Revenues                 |       | $                                          | 1,461      |   | $ | 1,824 |   |
|                     |       |                                       |       |   |   |
| Loss before income taxes |       | $                                          | (2,103     | ) | $ | (807 | ) |

 

Revenues from corporate and other declined to$1.5 million from $1.8 million, and the loss before taxes increased to $2.1million from $807,000.  Compensationexpense increased to $2.0 million from $1.7 million.  The change in value of our investments inlimited partnerships resulted in a gain of $152,000 in 2004, compared to$117,000 during 2003.

 

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*Nine Months Ended September 30,2004 Compared to Nine Months Ended September 30, 2003*

 

FINANCIALOVERVIEW

 

Total revenues increased to $87.0million in the first nine months of 2004 from $72.7 million for the same periodin 2003, principally due to increases in fiduciary, custodial and advisory feesand investment banking.  Total expensesfor the same 2004 period increased to $73.8 million from $63.5 million in thesame period of the previous year.  Equityin income of limited partnerships totaled $3.6 million during the first ninemonths of 2004 compared to $3.2 million during the first nine months of2003.  Minority interests in net incomeof consolidated companies increased to $2.1 million during the first ninemonths of 2004 from $1.1 million during the first nine months of 2003.  Net income for the nine month period ended September 30,2004 increased to $8.9 million from $6.9 million in the same period in2003.  Basic income per share was $0.51for the nine months ended September 30, 2004 compared to $0.40 for thesame period in 2003.  Diluted income pershare was $0.49 for the nine months ended September 30, 2004, compared to$0.39 for the same period in 2003.

 

Commissions revenue increased to $40.2million in the first nine months of 2004 from $38.4 million in 2003, primarilyas a result of increased trading volume in our retail brokerage division.  Principal transactions revenue totaled $5.5million for the 2004 period versus $10.4 million in 2003.  Revenues from fixed income brokerage declinedfrom $6.7 million during the first nine months of 2003 to $3.6 million duringthe first nine months of 2004 primarily from a decline in residential loanrefinancings.  Investment banking revenueincreased to $23.1 million during the first nine months of 2004 from $13.2million in the same period of 2003, principally due to an increase in feesearned from private placement transactions. Revenues from fiduciary, custodial and advisory fees increased to $13.6million in 2004 from $7.0 million in 2003. The acquisition of Charlotte Capital in April 2004, growth inassets under management at Salient/PMT and Cummer/Moyers, and the December 2003startup of a new private equity fund managed by the Company with a focus onlife sciences investments have contributed to the increase in revenues fromfiduciary, custodial and advisory fees. Interest and dividend income increased to $2.9 million in 2004 from $1.8million in the same period last year.

 

During the nine months ended September 30,2004, employee compensation and benefits increased to $51.0 million from $43.8million in the same period last year, reflecting commissions and bonuses paidon increased revenues.  Floor brokerage,exchange and clearance fees declined to $4.1 million in the first threequarters of 2004 from $4.2 million in the same period of 2003 reflectingdecreased clearing and execution costs resulting from the reduced tradingvolume attributable to prime brokerage services.  Communication and data processing costsincreased to $5.3 million in 2004 from $4.1 million in the same period lastyear resulting primarily from increased personnel and additional offices.  Occupancy costs totaled $5.2 million duringthe first nine months of 2004, compared to $4.2 million in the prior yearperiod.  Other general and administrativeexpenses increased to $7.8 million during the first nine months of 2004 from$7.2 million in the first nine months of last year mainly due to our growth.

 

The effective tax rate fromoperations was 40% for the nine months ended September 30, 2004 comparedto 39% for the nine months ended September 30, 2003.

 

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RESULTSBY SEGMENT

 

*Retail Brokerage*

 
| ** **                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                        | ** ** |
|                       |       |                                      |       |   |   |
| Revenues                   |       | $                                         | 12,843     |   | $ | 9,438 |   |
|                       |       |                                      |       |   |   |
| Income before income taxes |       | $                                         | 1,091      |   | $ | 402 |   |

 

Revenues from retail brokerage increased to$12.8 million from $9.4 million, and income before income taxes increased to$1.1 million from $402,000. Commission revenue increased to $7.1 million from$4.3 million reflecting increased trading volume due to the additions ofseveral new retail brokers and the Tulsa office in December 2003.Compensation expense increased to $9.2 million from $7.2 million due to therevenue increase.

 

*Institutional Brokerage*

 
| ** **                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                        | ** ** |
|                       |       |                                      |       |   |   |
| Revenues                   |       | $                                         | 23,062     |   | $ | 23,692 |   |
|                       |       |                                      |       |   |   |
| Income before income taxes |       | $                                         | 3,996      |   | $ | 4,224 |   |

 

Revenues from institutional brokeragedeclined to $23.1 million from $23.7 million, and income before taxes decreasedto $4.0 million from $4.2 million. Sales credits from investment bankingtransactions increased to $5.5 million from $3.2 million due to increases infees earned from (i) the Company’s participation in underwriting syndicates and(ii) private placement transactions. Principal transaction revenue declined to$2.0 million from $4.1 million due to reduced trading volume from fixed incomeproducts relating to fewer residential home refinancings caused by higherinterest rates. Compensation expense declined to $14.8 million from $15.1million due to the lower revenues.

 

*Asset Management*

 
| ** **                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                        | ** ** |
|                       |       |                                      |       |   |   |
| Revenues                   |       | $                                         | 21,754     |   | $ | 12,209 |   |
|                       |       |                                      |       |   |   |
| Income before income taxes |       | $                                         | 8,820      |   | $ | 5,467 |   |

 

Revenues from asset management increased to$21.8 million from $12.2 million, and income before taxes increased to $8.8million from $5.5 million. Fiduciary, custodial and advisory fees increased to$12.6 million from $6.5 million. The acquisition of Charlotte Capital in April 2004,growth in assets under 

 

21

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management at Salient/PMT and Cummer/Moyers, and the December 2003startup of a new private equity fund managed by the Company with a focus onlife sciences investments have contributed to the increase in revenues fromadvisory fees. Compensation expense rose to $9.1 million from $6.2 millionrelated to the higher revenues.  Incomeattributable to minority interests, which reduce SMHG’s pretax income,increased to $2.1 million from $1.1 million, principally due to income from oneof the limited partnerships, of which minority interests own 40%, and theaddition of Charlotte Capital in April 2004, of which minority interestsown 31%.

 

*Prime Brokerage*

 
| ** **                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                        | ** ** |
|                       |       |                                      |       |   |   |
| Revenues                   |       | $                                         | 14,984     |   | $ | 17,959 |   |
|                       |       |                                      |       |   |   |
| Income before income taxes |       | $                                         | 2,485      |   | $ | 3,240 |   |

 

Revenues from prime brokerage declined to$15.0 million from $18.0 million, and income before taxes declined to $2.5million from $3.2 million. Commission revenue declined to $12.6 million from$14.4 million reflecting the loss of assets managed by one of our primebrokerage clients during the first half of 2004.  That loss has been replaced with new customerswho are expected to begin trading through the Company during the second half of2004. Principal transactions revenues declined to $1.4 million from $2.7million due to reduced trading volume from fixed income products. Compensationexpense declined to $7.3 million from $8.6 million due to lower revenues.

 

*Investment Banking*

 
| ** **                 | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(in thousands)**                        | ** ** |
|                       |       |                                      |       |   |   |
| Revenues                   |       | $                                         | 11,664     |   | $ | 6,591 |   |
|                       |       |                                      |       |   |   |
| Income before income taxes |       | $                                         | 5,477      |   | $ | 3,261 |   |

 

Revenues from investment banking increased to$11.7 million from $6.6 million, and income before taxes rose to $5.5 millionfrom $3.3 million. The revenue increase is primarily due to an increase inrevenues from private placement transactions, as well as an increase inadvisory, underwriting and management fees due to the Company’s participationin these private placements. Compensation expense increased to $4.8 millionfrom $3.0 million due to the revenue increase.

 

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*Corporate and Other*

 
| ** **               | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------|------------|-------------------------------------------|------------|
| ** **               | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **               | ** ** | **(in thousands)**                        | ** ** |
|                     |       |                                      |       |   |   |
| Revenues                 |       | $                                         | 2,716      |   | $ | 2,837 |   |
|                     |       |                                      |       |   |   |
| Loss before income taxes |       | $                                         | (7,153     | ) | $ | (5,229 | ) |

 

Revenues from corporate and other decreasedto $2.7 million from $2.8 million, and the loss before taxes increased to $7.2million from $5.2 million. Compensation expense increased to $5.8 million from$4.7 million, primarily due to bonus expense related to the increasedconsolidated income. The change in value of our investments in limitedpartnerships resulted in income of $220,000 in 2004, compared to $413,000during 2003.

 

**Liquidity and Capital Resources**

 

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

 

At September 30, 2004, we hadapproximately $17.4 million in cash and cash equivalents, which together withreceivables from broker-dealers, deposits with clearing brokers, marketablesecurities owned, and securities available for sale represented about 26% ofour total assets at the end of the third quarter.

 

For the nine months ended September 30,2004, net cash used in operations totaled $4.8 million versus $2.8 millionduring the first nine months of 2003. Receivables increased by $4.5 million, primarily due to the addition ofa secured receivable that the Company expects to convert into an investmentduring the second half of 2004, as well as an increase in receivables fromcustomers due to the increase in revenues. Securities owned increased by $12.3 million, of which $3.6 millionrepresents equity in income of limited partnerships.  The remainder of the increase in securitiesowned is primarily due to an increase in the value of investments in publicequity and fixed income securities and in limited partnerships.  The increase of $2.9 million in securitiessold, not yet purchased consist primarily of securities sold short to hedgeagainst similar positions recorded as securities owned.  Accounts payable and accrued liabilitiesdeclined by $4.7 million during the nine months ended September 30, 2004,primarily due to the payment of accrued compensation during the first quarterof 2004.

 

Capital expenditures for the first nine months of 2004were $4.7 million, mainly for the purchase of furniture and computer equipmentand software, as well as for leasehold improvements, necessary for ourgrowth.  During the first nine months of2004, we reacquired 15,399 of our common shares at a total cost ofapproximately $183,000.  Dividends paidto shareholders totaled $1.3 million during the first nine months of 2004.

 

At September 30, 2004, SMH, our registeredbroker-dealer subsidiary, was in compliance with the net capital requirementsof the Securities and Exchange Commission’s Uniform Net Capital Rules and hadcapital in excess of the required minimum. PMT was in compliance with the Texas Department of Banking net capitalrequirement 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.

 

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**Factors Affecting Forward-Looking Statements**

 

This quarterly report on Form 10-Q includes “forward-looking statements”within the meaning of Section 27A of the Securities Act of 1933, as amended,and Section 21E of the Securities and Exchange Act of 1934, as amended(the “Acts”). These forward-looking statements may relate to such matters asanticipated financial performance, future revenues or earnings, businessprospects, projected ventures, new products, anticipated market performance andsimilar matters. The Private Securities Litigation Reform Act of 1995 providesa safe harbor for forward-looking statements. To comply with the safe harbor,the Company cautions readers that a variety of factors could cause the Company’sactual results to differ materially from the anticipated results or otherexpectations expressed in the Company’s forward-looking statements. These risksand uncertainties, many of which are beyond the Company’s control, include, butare not limited to (1) trading volume in the securities markets; (2) volatilityof the securities markets and interest rates; (3) changes in regulatoryrequirements, which could affect the demand for the Company’s services or thecost of doing business; (4) general economic conditions, both domestic andforeign, especially in the regions where the Company does business; (5) changesin the rate of inflation and related impact on securities markets; (6)competition from existing financial institutions and other new participants inthe securities markets; (7) legal developments affecting the litigationexperience of the securities industry; (8) successful implementation oftechnology solutions; (9) changes in valuations of the Company’s trading andwarrant portfolios resulting from mark-to-market adjustments; (10) dependenceon key personnel and (11) demand for the Company’s services. The Company doesnot undertake to publicly update or revise any forward-looking statements.

 

**Item 3*****. Quantitative and Qualitative Disclosures About Market Risk***

 

**MarketRisks**

 

Management evaluates the realizability ofsecurities available for sale to determine if a decline in value is other thantemporary.  Such evaluation considers thelength of time and the extent to which market value has been less than cost,the financial condition and near-term prospects of the issuer, and the intentand ability of the Company to retain its investment in the issuer for a periodof time sufficient to allow for any anticipated recovery in market value.  Management believes the unrealized losses aretemporary at September 30, 2004. However, a write-down accounted for as a realized loss may be necessaryin the future.

 

The Company’s trading equity and debtsecurities are marked to market on a daily basis.  At September 30, 2004, the Company’strading equity and debt securities were recorded at a fair value ofapproximately $15.4 million.  Thesetrading equity and debt securities are subject to equity price risk.  This risk would amount to approximately $1.5million based on a potential loss in fair value from a hypothetical 10%decrease in the market value of such equity and debt securities.  The actual equity price risk related to thetrading equity and debt securities may differ substantially.

 

**Item4****.** ***Controls and Procedures***

 

Our management, including ourChief Executive Officer and Chief Financial Officer, have conducted anevaluation of the effectiveness of our disclosure controls and procedures (asdefined in Rule 13a-15(e) promulgated under the Exchange Act, as of the end ofthe fiscal period covered by this report. Based upon that evaluation, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and proceduresare effective in ensuring that the information required to be disclosed in thereports we file or submit under the Exchange Act is recorded, processed,summarized and reported, within the time periods specified in the rules andforms of the Securities and Exchange Commission.  There have been no changes made in ourinternal controls over financial 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 Proceedings***

 

We are a party to various legal proceedingsthat are of an ordinary or routine nature incidental to our operations.  Certain of our litigation and claims are coveredby 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.

 

**Item 6**.  ***Exhibits***

 
| **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  as amended through August 3, 2004 (filed as Exhibit 3.2 to the Company’s  Form 10-Q for the fiscal quarter ended June 30, 2004 (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 the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly 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:****                   November 8,2004**

 

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