i P p e r J a f f r a y C o m p a n i e s A n n u a l R e p o r t 2 0 0 4 Piper Jaffray Companies Annual Report 200 4 Dear Shareholders, After completing a successful spin-off in 2003, we began 2004 as an independent public company and set ourselves to the work of rebuilding. Re-engaging our employee partners with the prospect of new opportunities. Re-introducing Piper Jaffray to our shareholders. And offering to our clients what we always have — our best advice and service. And now, we are executing a strategy that we believe will propel our fi rm to new levels of growth over time. Our 3,000 employees work toward this strategy every day. Guiding our clients along their fi nancial journeys. Serving our clients’ best interests. And refl ecting the personalized, partnership culture that distinguishes our fi rm. Together, we are building a foundation for growth. In 2004 we made solid progress toward achieving our goals and delivering results. But we can do better. Piper Jaffray Annual Report 2004 1 Our revenues are building slowly as we regain our footing as an independent public company and adapt to market changes. Growing revenues remains our biggest challenge. However, we are pleased with the margin improvement that we achieved in 2004, largely through cost discipline. More importantly, we are encouraged with the traction we have gained around our strategy— to earn the privilege to serve as our clients’ primary advisor. Most clients select a trusted advisor with whom they set their strategy and do the majority of their business. We believe we can be that trusted primary advisor for more of our clients, and achieving that role will signifi cantly improve our long-term fi nancial performance. We stabilized our Private Client Services business in 2004. Margins improved during the year, evidence of diligent cost discipline and focused execution. We began rebuilding our advisor ranks, largely by developing our own. We also expanded the number and types of high-quality planning tools and specialist advice to help clients achieve their goals. 2 Piper Jaffray Annual Report 2004 Net Income in millions $50.3 $26.0 ’04 ’03 Pre-Tax Operating Margin 10.0% 5.2% ’04 ’03 award-winning research • Ranked top 10 in the Wall Street Journal Best on the Street 2004 Analyst Survey. • Ranked second by Greenwich Associates among small- and mid-cap funds, and fi rst for “Most Creative Ideas and Themes.” • Tied for seventh place overall in Forbes/ StarMine survey on earnings estimates, stock picking and overall analysis. Our Capital Markets businesses continue to sharpen their focus as primary advisor to middle-market clients. Equities and Investment Banking continues to deepen its expertise in four sectors: consumer, fi nancial, health care and technology. We helped numerous companies grow their businesses through public offerings, mergers and acquisitions. Within our Fixed Income business, our public fi nance area continues to build on its legacy of leadership. Success stems from our talented people with deep expertise in four key areas: government, health care, higher education and housing. With our accomplishments have come new challenges. For example, the industry’s business model for trading is changing rapidly. Piper Jaffray has responded. This year we acquired a key partner, Vie Securities, llc, which will enable us to fulfi ll the increasing client demand for automated, cost-effective equity trading services. This new service naturally expands and complements our current capabilities. Piper Jaffray Annual Report 2004 3 At the heart of these accomplishments are the employees who deliver on our commitments every day. They are smart. Professional. Dedicated. Capable of accom- plishing so much more collectively than any of us could individually. This year we began building employee ownership with equity-based compensation. We believe we are creating a distinctive employee value proposition that helps us attract and retain the best people serving our clients. The foundation of our fi rm is a set of core values we call our Guiding Principles. More than words on a wall, our employees make these phrases come to life every day: Clients come fi rst. Integrity. Respect. Partnership. Contribute to our communities. contributing to our communities in 2004 • Awarded $1.2 million in grants to more than 150 organizations across our geographic footprint, supporting strong communities, vibrant culture and strong youth. • Launched A Place to Call Home, a partnership with Minnesota-based Neighborhood Development Center, Inc. to support low-income communities. Employee volunteer time and expertise and a commitment of $500,000 over three years will help realize meaningful, long-term economic and social success. • Pledged more than $845,000 in employee contributions to their local United Way offi ces. With a rich history that spans 110 years, Piper Jaffray is proud to be building again. 4 Piper Jaffray Annual Report 2004 Building trusted relationships as our clients’ primary advisor. Building portfolios that create a brighter future for our clients. Building a track record of success serving the middle market. Building employee engagement in the long-term success of Piper Jaffray. To be a trusted guide, you need a strong foundation. That’s what we’re building. Return on Tangible Common Equity 1 12.9% 8.0% ’04 ’03 1 See footnote on page 12. Sincerely, Andrew S. Duff Chairman and Chief Executive Offi cer board of directors Andrew S. Duff Chairman and Chief Executive Officer, Piper Jaffray Companies Samuel L. Kaplan Partner and Founding Member, Kaplan, Strangis and Kaplan, P.A. Addison L. (Tad) Piper Vice Chairman, Piper Jaffray Companies Michael R. Francis Executive Vice President of Marketing, Target Corporation B. Kristine Johnson President, Affinity Capital Management Frank L. Sims Corporate Vice President, Transportation and Product Assurance, Cargill, Inc. Richard A. Zona Chairman and Chief Executive Officer, Zona Financial LLC Piper Jaffray Annual Report 2004 5 Piper Jaffray Companies company-wide summary Overview Piper Jaffray Companies (nyse: pjc) is a focused securities fi rm that comprises two principal revenue-generating segments: Capital Markets and Private Client Services. Clients of both segments are supported by Investment Research. Through its chief operating subsidiary, Piper Jaffray & Co., the fi rm has served corporations, government and nonprofi t entities, institutional investors and the fi nancial advisory needs of private individuals since 1895. With headquarters in Minneapolis, Piper Jaffray has approximately 3,000 employees in 105 offi ces in 23 states across the country and in London. 2004 in review Net revenues (in millions) $797.5 $786.7 2004 2003 Pre-tax operating income (in millions) $79.6 Net income (in millions) Pre-tax operating margin Earnings per diluted share $50.3 10.0 % $2.60 $40.9 $26.0 5.2 % $1.35 92.6% Percent Increase 1.4% 94.6% 93.5% – Return on tangible common equity 1 12.9 % 8.0 % – 1 See footnote on page 12. • Committed to fi rm-wide strategy to become clients’ primary advisor. • Engaged employees as owners through equity-based compensation. • Improved pre-tax operating margin throughout 2004 on slow revenue growth. .. Looking ahead to 2005 • Focus on fi nancial performance by growing revenues and maintaining cost discipline. • Advance our primary advisor strategy within each business segment. • Build on our partnership culture through expanded employee ownership. 6 Piper Jaffray Annual Report 2004 private client services capital markets Individual investor guidance in wealth management, retirement planning, estate planning, education funding and insurance through comprehensive fi nancial planning. Equity and fi xed-income institutional sales and trading and investment banking activities, including corporate and public fi nance underwritings, private placements, mergers and acquisitions. • $51.2 billion in client assets in 2004, up from $49.6 billion in 2003. • Placed a signifi cant number of new hires into our developing fi nancial advisor (DFA) program, which further expands our strong talent pool. • Began increasing the number of fi nancial advisors in the second half of 2004, ending the year at 860 advisors. • Provided advisors and managers with crucial data to help them focus on the quality of their client rela- tionships and determine where our advice, service, and top-of-the-line planning tools are most needed and valued. • Maintained our ‘open architecture’ model, which provides clients with best-in-class products. • Strengthened wealth advisory teams of specialized experts to support planning efforts for clients. • Raised $12.6 billion in capital through 93 equity offerings, placing the fi rm 13th nationally, up from 14th in 2003, based on number of transactions. (Source: Dealogic) • Advised clients on 49 mergers and acquisitions with an enterprise value of $6.8 billion. • Underwrote 502 tax-exempt issues with a total par value of $5.9 billion, ranking the fi rm fourth nationally, up from fi fth in 2003 based on number of transactions. In the Upper Midwest, the fi rm completed 286 public fi nance issues for a total par value of $2.4 billion, again placing the fi rm as the lead underwriter of Upper Midwest tax-exempt issues based on number of transactions. (Source: Thomson Financial) • Created a fi rst-of-its-kind loan-to-bond offering that raised $82 million for business development in low- income areas, the fi rst community development issue to be rated by a major debt-rating agency. • Develop relationships with targeted high net-worth • Become the primary advisor for targeted middle- clients as their primary advisor. market clients. • Enhance professional development with focused, disci- plined training that adds value to client relationships. • Develop and sustain differentiation from our competitors by concentrating resources in our franchise specialties. • Streamline transaction processes from the client to the back offi ce, making service more consistent and more effi cient. • Deliver electronic trading capabilities based on client demand. Piper Jaffray Annual Report 2004 7 our guiding principles We create and implement superior fi nancial solutions for our clients. Serving clients is our fundamental purpose. We earn our clients’ trust by delivering the best guidance and service. Great people are our competitive advantage. As we serve, we are committed to these core values: • Always place our clients’ interests fi rst. • Conduct ourselves with integrity and treat others with respect. • Work in partnership with our clients and each other. • Maintain a high-quality environment that attracts, retains and develops the best people. • Contribute our talents and resources to serve the communities in which we live and work. 8 Piper Jaffray Annual Report 2004 executive leadership Andrew S. Duff Chairman and Chief Executive Officer Addison L. (Tad) Piper Vice Chairman James L. Chosy General Counsel and Secretary Barry J. Nordstrand Head of Fixed Income Robert W. Peterson Head of Investment Research Thomas P. Schnettler Head of Equities and Investment Banking R. Todd Firebaugh Chief Administrative Offi cer Sandra G. Sponem Chief Financial Officer Paul D. Grangaard Head of Private Client Services Financials Piper Jaffray Companies Management’s Discussion and Analysis and Financial Statements Period ended December 31,200 4 Piper Jaffray Annual Report 2004 9 Piper Jaffray Companies SELECTED FINANCIAL DATA The following table presents our selected consolidated financial data for the periods and dates indicated. The information set forth below should be read in con- junction with ‘‘Management’s Discussion and Analy- sis of Financial Condition and Results of Operations’’ and our consolidated financial statements and notes thereto. YEARS ENDED DECEMBER 31, (Dollars and Shares in Thousands, Except Per Share Data) 2004 2003 2002 2001 2000 Revenues: Commissions and fees Principal transactions Investment banking Interest Other income Total revenues Interest expense Net revenues Non-interest expenses: Compensation and benefits Cash award program Regulatory settlement Amortization of acquisition-related compensation and goodwill Merger and restructuring Royalty fee $ 263,730 $ 256,747 $ 275,682 $ 302,289 $ 374,611 188,526 257,932 47,469 57,967 815,624 18,126 215,191 229,945 45,276 59,082 806,241 19,511 171,957 208,740 59,685 47,303 763,367 34,315 181,469 247,929 95,436 52,865 879,988 79,216 232,426 342,104 144,308 53,006 1,146,455 128,177 797,498 786,730 729,052 800,772 1,018,278 488,394 4,717 482,397 24,000 – – – – – – – 3,911 235,539 449,329 513,623 662,592 – 32,500 – 7,976 7,482 – – 17,641 65,697 55,753 – – 30,108 8,889 47,750 226,966 221,940 229,750 Other non-compensation and benefits 224,766 Total non-interest expense 717,877 745,847 724,253 874,654 979,089 Income (loss) before income tax expense (benefit) Income tax expense (benefit) 79,621 29,273 40,883 14,884 4,799 4,693 (73,882) (23,831) 39,189 18,481 Net income (loss) $ 50,348 $ 25,999 $ 106 $ (50,051) $ 20,708 Earnings per common share Basic Diluted Weighted average number of common shares Basic Diluted Other data Total assets Long-term debt Shareholders’ equity Total employees Total Private Client Services offices $ $ 2.60 2.60 $ $ 1.35 1.35 $ $ 0.01 0.01 $ $ (2.60) (2.60) $ $ 1.09 1.09 19,333 19,399 19,237 19,237 19,160 19,160 19,279 19,279 19,060 19,060 $ 2,828,257 $ 2,380,647 $ 2,032,452 $ 2,734,370 $ 2,735,918 $ 180,000 $ 180,000 $ 215,000 $ 475,000 $ 475,000 $ 725,428 $ 669,795 $ 609,857 $ 378,724 $ 362,331 3,027 91 2,991 96 3,227 103 3,255 107 3,845 112 10 Piper Jaffray Annual Report 2004 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Piper Jaffray Companies branches. It generates revenues primarily through commissions earned on equity and fixed income trans- actions, commissions earned for distribution of mu- tual funds and annuities, fees earned on fee-based investment management accounts and net interest from customers’ margin loan balances. The following information should be read in conjunc- tion with the accompanying audited consolidated fi- nancial statements and related notes and exhibits included elsewhere in this report. Certain statements in this report may be considered forward-looking. Statements that are not historical or current facts, including statements about beliefs and expectations, ) Corporate Support and Other – This segment includes are forward-looking statements. These forward-look- business activities managed on a corporate basis (in- ing statements cover, among other things, the future cluding services such as finance, legal and human re- prospects of Piper Jaffray Companies. Forward-look- sources), interest expense on our subordinated debt ing statements involve inherent risks and uncertain- and the results of our private equity and venture capi- ties, and important factors could cause actual results to differ materially from those anticipated, including tal businesses, which generate revenues through the those factors identified in the document entitled ‘‘Risk management of private equity and venture capital funds. This segment also includes results related to Factors’’ filed as Exhibit 99.1 to our Annual Report our investments in these funds. Effective Decem- on Form 10-K for the year ended December 31, 2004, ber 31, 2004, the management of our venture capital and in our subsequent reports filed with the SEC. funds was transitioned to an independent company. These reports are available at our Web site at www.piperjaffray.com and at the SEC’s Web site at www.sec.gov. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update them in light of new information or future events. The securities business is a human capital business; accordingly, compensation and benefits comprise the largest component of our expenses, and our perform- ance is dependent upon our ability to attract, develop and retain highly skilled employees who are motivated to serve the best interests of our clients, thereby serv- ing the best interests of our company. EXECUTIVE OVERVIEW We are principally engaged in providing securities brokerage, investment banking and related financial services to individuals, corporations and public sector and non-profit entities in the United States, with lim- ited activity in Europe. We operate through three re- portable segments: For 2004, our net income increased to $50.3 million from $26.0 million for 2003, resulting in diluted earn- ings per share of $2.60, a 92.6 percent increase over the prior year. Net revenues for 2004 were essentially flat over 2003, increasing $10.8 million, or 1.4 per- cent, to $797.5 million compared to $786.7 million in 2003. Our 2004 results reflected the stabilization of a three-year negative trend in private client revenues and substantially stronger equity underwriting and mergers and acquisitions revenues compared to 2003, offsetting weaker fixed income sales and trading revenues. ) Capital Markets – This segment consists of our equity and fixed income institutional sales and trading and investment banking businesses. It generates revenues primarily through commissions and sales credits earned on equity and fixed income transactions, fees earned on investment banking and public finance ac- tivities, and net interest earned on securities invento- ries. While we maintain securities inventories primarily to facilitate customer transactions, our Cap- ital Markets business also realizes profits and losses from trading activities related to these securities inventories. These results led to an increased return on tangible shareholders’ equity1 in 2004, which improved to 12.9 percent compared to 8.0 percent for 2003. Given the significant goodwill on our balance sheet, we be- lieve that return on tangible shareholders’ equity is a more meaningful measure of our performance than return on total shareholders’ equity. The majority of ) Private Client Services – This segment comprises our the goodwill recorded on our balance sheet relates to retail brokerage business, which provides financial ad- U.S. Bancorp’s acquisition of our predecessor com- pany, Piper Jaffray Companies Inc., and its subsidiar- vice and a wide range of financial products and ser- ies in 1998. This goodwill reflects the premium paid vices to individual investors through our network of Piper Jaffray Annual Report 2004 11 Management’s Discussion and Analysis of Financial Condition and Results of Operations by U.S. Bancorp for our business, and is reflected on our books in accordance with U.S. generally accepted accounting principles (‘‘GAAP’’). The following table sets forth a reconciliation of shareholders’ equity to tangible shareholders’ equity. Shareholders’ equity is the most directly comparable GAAP financial measure to tangible shareholders’ equity. (Dollars in Thousands) Shareholders’ equity Deduct: Goodwill and identifiable intangible assets AVERAGE FOR THE Year Ended December 31, 2004 Year Ended December 31, 2003 As of December 31, 2004 $ 699,163 $ 629,466 $ 725,428 (308,875) (305,635) (321,834) Tangible shareholders’ equity $ 390,288 $ 323,831 $ 403,594 (1) Tangible shareholders’ equity equals total shareholders’ equity less goodwill and identifiable intangible assets. Return on average tangible shareholders’ equity is calculated by dividing trailing 12-month net income, for each period presented, by the average quarterly tangible common equity for the trailing 12-month period. Economic Conditions and Financial Market Activities Performance in the financial services industry in which we operate is highly correlated to the overall strength of economic conditions and financial market activity. Overall market conditions are a product of many fac- tors, which are mostly unpredictable and beyond our control. These factors may affect the financial deci- sions made by investors, including their level of par- ticipation in the financial markets. In turn, these decisions may affect our business results. With respect to financial market activity, our profitability is sensi- tive to a variety of factors, including the volume and value of trading in securities, the volatility of the eq- uity and fixed income markets, the level and shape of various yield curves and the demand for investment banking services as reflected by the number and size of public offerings and merger and acquisition transactions. Factors that differentiate our business within the fi- nancial services industry also may affect our financial results. For example, our Capital Markets business focuses primarily on the consumer, financial institu- tions, health care and technology industries within the corporate sector and on health care, higher education, housing, and state and local government entities within the government/non-profit sector. These indus- tries may experience growth or downturns indepen- dently of general economic and market conditions, or may face market conditions that are disproportion- ately better or worse than those impacting the econ- omy and markets generally. In either case, our business could be affected differently than overall market trends. Our Private Client Services business primarily operates in the midwest, mountain and west coast states, and an economic growth spurt or down- turn that disproportionately impacts one or all of these regions may disproportionately affect our busi- ness compared with companies operating in other re- gions or more nationally or globally. Given the variability of the capital markets and securities busi- nesses, our earnings may fluctuate significantly from period to period, and results of any individual period should not be considered indicative of future results. RECENT ECONOMIC TRENDS Challenging investment and economic conditions pre- vailed during 2002 and the first part of 2003 as the economy continued to show signs of weakness and recession driven by softness in corporate earnings, geopolitical concerns and reduced confidence in the integrity of reported financial information of several high-profile corporations. The impact of these eco- nomic conditions in 2002 through the first part of 2003 caused declines in equity returns for investors and a substantially lower number of investment bank- ing transactions, as well as a decline in the volume and value of trading transactions. Economic condi- tions began to improve in the second quarter of 2003 as the economic stimulus provided by low interest rates and tax cuts eased some of the uncertainties in the U.S. and global economies. Capital expenditures began to increase and the major indices, fueled partly by a sharp rise in corporate profits, increased signifi- in 2003. Economic expansion continued cantly through 2004 at a measured pace. The Federal Re- serve maintained an accommodating monetary envi- ronment through the second quarter, holding its target interest rate at one percent before starting a series of five 25-basis-point increases in the federal funds rate in 2004. In 2004, the broad indices failed to build on the 2003 market gains and maintained fairly narrow trading ranges until turning higher after the U.S. presidential election. 12 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations MARKET DATA The following table provides a summary of relevant market data over the past three years. YEAR ENDED DECEMBER 31, Dow Jones Industrials a NASDAQ a NYSE Average Daily Value Traded ($ BILLIONS) NASDAQ Average Daily Value Traded ($ BILLIONS) Mergers and Acquisitions (NUMBER OF TRANSACTIONS) b Public Equity Offerings (NUMBER OF TRANSACTIONS) c e Initial Public Offerings (NUMBER OF TRANSACTIONS) c Managed Municipal Underwritings (NUMBER OF TRANSACTIONS) d Managed Municipal Underwritings (VALUE OF TRANSACTIONS IN BILLIONS) d 10-Year Treasuries Average Rate a (a) Data provided is at period end. (b) Source: Securities Data Corporation. (c) Source: Dealogic (offerings with reported market value greater than $10 million). (d) Source: Thomson Financial. (e) Number of transactions includes convertible offerings. Information Regarding Our Spin-Off from U.S. Bancorp 2004 2003 $ $ 10,783 2,175 46.1 34.6 7,808 1,005 214 10,454 2,003 $ $38.5 $ $28.0 7,130 861 79 2002 8,342 1,336 $ $40.9 $ $28.8 6,451 608 75 13,556 15,033 14,404 $ 360.2 $ 383.7 $ 358.8 4.27% 4.02% 4.61% 2004 v 2003 2003 v 2002 3.1% 25.3% 8.6 19.7 23.6 9.5 16.7 170.9 (9.8) (6.1) 6.2 49.9 (5.9) (2.8) 10.5 41.6 5.3 4.4 6.9 (12.8) proximately $4.8 million, $4.8 million and $4.6 mil- lion in 2005, 2006 and 2007, respectively. On February 19, 2003, U.S. Bancorp announced its intention to organize its capital markets business unit into a new company and to effect a tax-free distribu- tion of its shares in that company to U.S. Bancorp’s Results of Operations shareholders. This type of distribution is commonly referred to as a ‘‘spin-off.’’ On April 28, 2003, Piper Our consolidated financial statements are prepared in conformity with GAAP. The consolidated financial Jaffray Companies was incorporated in Delaware as a statements, for periods prior to the spin-off, included subsidiary of U.S. Bancorp for the purpose of effecting the adjustments necessary to reflect our operations as the proposed spin-off. On December 31, 2003, after receiving regulatory approval, U.S. Bancorp distrib- if the organizational changes resulting from our spin- uted to its shareholders all of its interest in our new off had been consummated prior to the distribution. company. On that date, 19,334,261 shares of Piper However, the consolidated financial statements, for periods prior to the spin-off, may not necessarily be Jaffray Companies common stock were issued to indicative of our results of operations, financial posi- U.S. Bancorp shareholders based on a distribution ra- tion and cash flows in the future or what our results of tio of one share of Piper Jaffray Companies common operations, financial position and cash flows would stock for every 100 shares of U.S. Bancorp common have been had we operated as a stand-alone company stock owned. during those periods. In connection with the spin-off, we implemented a cash award program consisting of cash payments to a Generally, our consolidated results, for periods prior to the spin-off, include revenues generated and ex- broad-based group of our employees. The award pro- penses incurred based on customer relationships and gram was designed to aid in retention of employees related business activities. In certain situations, affili- and to compensate for the value of U.S. Bancorp stock ated entities of U.S. Bancorp may have provided ser- options and restricted stock lost by our employees as a vices to us. These services primarily related to result of the spin-off. We incurred a $24.0 million employee services and benefits, technology and data charge at the time of the spin-off from U.S. Bancorp processing services, and corporate functions including and $4.7 million of cash awards expense in 2004. The audit, tax and real estate management. Costs included balance of each cash award will be expensed over the in the consolidated financial statements for these types next three years, which will result in charges of ap- of shared services were determined based on actual Piper Jaffray Annual Report 2004 13 Management’s Discussion and Analysis of Financial Condition and Results of Operations aging its tax position for the benefit of its entire port- costs to U.S. Bancorp and allocated to us based on our folio of businesses, and its tax strategies are not proportionate usage of those services. Proportionate usage was determined based on the number of our necessarily reflective of the tax strategies that we employees, actual hours used, square footage of office would have followed had we been a stand-alone space or other similar methodologies. Our manage- ment believes the assumptions underlying the consoli- dated financial statements are reasonable. FINANCIAL SUMMARY entity. Prior to the spin-off, income taxes were determined on a separate return basis as if we had not been eligible to be included in the consolidated income tax return of U.S. Bancorp and its affiliates. U.S. Bancorp was man- The following table provides a summary of the results of our operations and the results of our operations as a percentage of net revenues for the periods indicated. RESULTS OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, (Amounts in Thousands) Revenues: 2004 2003 2002 2004 v 2003 2003 v 2002 2004 2003 2002 AS A PERCENTAGE OF NET REVENUES FOR THE YEAR ENDED DECEMBER 31, Commissions and fees $ 263,730 $ 256,747 $ 275,682 2.7% (6.9)% Principal transactions Investment banking Interest Other income Total revenues Interest expense 188,526 257,932 47,469 57,967 215,191 229,945 45,276 59,082 171,957 208,740 59,685 47,303 815,624 (18,126) 806,241 (19,511) 763,367 (34,315) (12.4) 12.2 4.8 (1.9) 1.2 (7.1) 25.1 10.2 (24.1) 24.9 5.6 (43.1) 33.1% 32.6% 37.8% 23.6 27.4 23.6 32.3 6.0 7.3 29.2 5.8 7.5 28.6 8.2 6.5 102.3 102.5 104.7 (2.3) (2.5) (4.7) Net revenues 797,498 786,730 729,052 1.4 7.9 100.0 100.0 100.0 Non-interest expenses: Compensation and benefits 488,394 482,397 449,329 Occupancy and equipment Communications Floor brokerage and clearance Marketing and business development Outside services Cash award program Regulatory settlement Merger and restructuring Royalty fee 57,066 42,198 17,309 42,468 41,477 4,717 – – – Other operating expenses 24,248 58,025 37,599 22,755 39,030 38,511 24,000 – – 3,911 39,619 55,549 36,316 26,040 44,115 42,535 – 32,500 7,976 7,482 22,411 1.2 (1.7) 12.2 7.4 4.5 3.5 (23.9) (12.6) 8.8 7.7 (80.3) N/M N/M N/M (38.8) (11.5) (9.5) N/M N/M N/M (47.7) 76.8 Total non-interest expenses 717,877 745,847 724,253 (3.8) 3.0 Income before taxes Income tax expense 79,621 29,273 40,883 14,884 4,799 4,693 94.8 96.7 751.9 217.2 61.2 61.3 61.6 7.2 5.3 2.2 5.3 5.2 0.6 – – – 3.0 90.0 10.0 3.7 7.4 4.8 2.9 5.0 4.9 3.1 – – 0.5 4.9 7.6 5.0 3.6 6.1 5.8 – 4.5 1.1 1.0 3.0 94.8 99.3 5.2 1.9 0.7 0.7 Net income $ 50,348 $ 25,999 $ 106 93.7% N/M% 6.3% 3.3% 0.0% NM – Not Meaningful nearly offset by a decline in principal transactions. Net income increased to $50.3 million for the year Principal transactions decreased 12.4 percent from ended December 31, 2004, up from $26.0 million for the year ended December 31, 2003. Net revenues in- 2003, largely due to a decline in our fixed income creased 1.4 percent to $797.5 million in 2004, from institutional sales and trading business. Our fixed income institutional sales and trading revenues hit re- $786.7 million in the prior year, as increased revenues cord levels for Piper Jaffray in the second and third in investment banking and commissions and fees were 14 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations tion-related expenses, as well as additions to employee loan loss reserves in anticipation of financial advisor attrition resulting from our new Private Client Ser- vices compensation plan. In addition, 2003 non-inter- est expenses include the $24.0 million charge related to the cash award program. Non-interest expenses in 2002 included a $32.5 million charge resulting from the settlement we entered into in connection with the regulatory investigation of equity research and its re- lationship to investment banking. For more details regarding this settlement, see ‘‘Consolidated Non-In- terest Expenses – Regulatory Settlement’’ below. quarters of 2003, but rising interest rates created a more challenging fixed income environment in 2004. Investment banking revenues increased 12.2 percent to $257.9 million in 2004, compared with $229.9 million in 2003, as a result of increased merger and acquisition and equity underwriting activ- ity. Commissions and fees revenue totaled $263.7 mil- lion in 2004, an increase of 2.7 percent from 2003. The increase in commissions and fees was driven by increased managed account balances that resulted in increased managed account fees, which are charged as a percentage of the account balance rather than on a transaction basis. Non-interest expenses decreased 3.8 percent to $717.9 million for 2004, from CONSOLIDATED NON-INTEREST EXPENSES $745.8 million for 2003. This decrease was primarily attributable to the cash award charge of $24.0 million taken in the fourth quarter of 2003. Additionally in 2004, we recorded lower loan losses on employee loans and lower litigation-related charges, which were partially offset by new costs related to our status as a public company. Compensation and Benefits – A substantial portion of compensation expense is comprised of variable incen- tive arrangements and commissions, the amounts of which fluctuate in proportion to the level of business activity, increasing with higher revenues and operat- ing profits. Other compensation costs, primarily base salaries and benefits, are more fixed in nature. Com- pensation and benefits expenses increased 1.2 percent Net income increased to $26.0 million in 2003, up to $488.4 million in 2004, from $482.4 million in from $0.1 million in 2002, reflecting the improved 2003. Compensation and benefits expenses as a per- economy and market performance during the last six centage of net revenues were essentially flat at months of 2003. Net revenues to 61.2 percent for 2004, versus 61.3 percent for 2003. $786.7 million in 2003, up 7.9 percent over 2002 net revenues of $729.1 million. The largest component of We recorded $7.3 million in expense for the discre- tionary profit-sharing component of our Retirement our 2003 revenue stream was commissions and fees at $256.7 million, down 6.9 percent from the prior year. Plan in 2004. Commissions and fees declined due to lower transac- tion volumes in equities and equity-related products, such as mutual funds, in the first half of 2003. In addition, commission revenues decreased due to con- tinued attrition of financial advisors in our Private Client Services business. Principal transactions grew 25.1 percent from 2002 to 2003, largely due to strong fixed income sales and trading activity, which led this business to achieve record levels of revenue in the second and third quarters of 2003. Fixed income products, and particularly corporate bonds and mort- gages, were a key driver of our revenue growth throughout 2003. Investment banking revenue in- Occupancy and Equipment – Occupancy and equipment expenses were $57.1 million in 2004, compared with creased 10.2 percent in 2003 over 2002, primarily due $58.0 million in 2003. Occupancy and equipment ex- to improved equity underwriting activity. This in- penses in 2004 included $1.5 million of accelerated crease was aided by the first full-year results of the depreciation expense relating to an information sys- convertible bond product offering we added at the tem conversion and higher software amortization end of 2002. Other income grew 24.9 percent, prima- costs reflecting the fact that we recorded a full year of rily due to a new agreement related to providing cash amortization associated with the implementation of a sweep products to our clients. Non-interest expenses new fixed income trading system in late 2003. Ex- increased to $745.8 million in 2003 from $724.3 mil- penses for 2003 included a $4.1 million write-off of lion in 2002, due largely to higher incentive compen- internally developed software associated with the new sation resulting improved financial fixed income trading system implementation. performance compared to 2002 and increased litiga- to Compensation and benefits expenses rose $482.4 million in 2003 from $449.3 million in 2002, an increase of 7.4 percent. The increase was due pri- marily to an increase in the variable portion of our compensation as a result of increased revenue and operating profits. In addition, in 2003 we recorded $9.5 million in expense for the discretionary profit- sharing component of our Retirement Plan based on our 2003 profitability. In 2002, we did not record expense for the discretionary profit-sharing compo- nent of our Retirement Plan. from our increased Piper Jaffray Annual Report 2004 15 Management’s Discussion and Analysis of Financial Condition and Results of Operations Occupancy and equipment expenses were $58.0 mil- Marketing and business development expenses de- clined 11.5 percent in 2003 over 2002, to $39.0 mil- lion in 2003 compared with $55.5 million in 2002. lion for 2003 from $44.1 million for 2002. The This increase was due primarily to the 2003 $4.1 mil- decrease was primarily attributable to our efforts to lion write-off of internally developed software de- reduce discretionary spending on travel and advertis- scribed above. This write-off was offset partially by ing in the first half of 2003 while market activity reduced depreciation on furniture and equipment. remained soft, a continuation from 2002. Communications – Communications expenses include costs for telecommunication and data communication services, primarily consisting of expense for obtaining third-party market data information. Communica- tions expenses were $42.2 million in 2004, compared with $37.6 million in 2003. This increase was due primarily to higher communication infrastructure costs resulting from our separation from U.S. Bancorp and increased costs to support our fixed income sales and trading capabilities. Communications expenses increased 3.5 percent to $37.6 million in 2003, compared with $36.3 million in 2002. This increase was driven by higher market data services expenses that reflected our increased business activity. Outside Services – Outside services expenses include securities processing expenses, outsourced technology functions, outside legal fees and other professional fees. Outside services expenses increased to $41.5 mil- lion in 2004, compared with $38.5 million for the prior year. This 7.7 percent increase primarily reflects the costs for outsourcing the operation of our net- work and mainframe to a third-party vendor, a change we made in 2004, and additional costs result- ing from our new status as a public company. Outside services expenses decreased 9.5 percent to $38.5 million in 2003 compared with $42.5 million for 2002. This decrease primarily reflects a decline in computer consulting expenses in 2003 over 2002 due to the completion in 2002 of a project to outsource certain securities processing activities. Floor Brokerage and Clearance – Floor brokerage and clearance expenses were $17.3 million in 2004, com- Cash Award Program – As discussed above under the caption, ‘‘Information Regarding Our Spin-off from pared with $22.8 million for 2003, a decrease of 23.9 percent. This decrease is a result of our contin- U.S. Bancorp,’’ a broad-based group of our employees ued efforts to reduce expenses associated with acces- was granted cash awards in connection with our spin- off from U.S. Bancorp. We incurred a $24.0 million sing electronic communication networks and our efforts to execute a greater number of trades through charge at the time of the spin-off from U.S. Bancorp, our own trading desks. Floor brokerage and clearance which was included in our 2003 results of operations, expenses as a percentage of net revenues were 2.2 per- cent in 2004, reduced from 2.9 percent in 2003. and $4.7 million of cash awards expense in 2004. Regulatory Settlement – In connection with a broad in- dustry investigation of equity research and its rela- Floor brokerage and clearance expenses decreased 12.6 percent in 2003 compared to 2002, from tionship to investment banking, we recognized a $26.0 million in 2002 to $22.8 million in 2003, again $32.5 million settlement charge in 2002. The charge due to our efforts to reduce fees for accessing elec- was predicated on a settlement with certain federal, state and industry regulatory agencies consisting of tronic communication networks. Floor brokerage and $12.5 million in fines and penalties, $12.5 million for clearance expenses as a percentage of net revenues a distribution fund primarily representing the dis- were 2.9 percent in 2003, compared to 3.6 percent in gorgement of profits and $7.5 million to fund inde- 2002. pendent equity research to be provided to investors. The terms of this settlement were finalized effective Marketing and Business Development – Marketing and business development expenses include travel and en- April 28, 2003. tertainment, postage, supplies and promotional and advertising costs. Marketing and business develop- ment expenses were $42.5 million in 2004, compared with $39.0 million in 2003, an increase of 8.8 percent. This increase was attributable to a significant increase in equity deal activity as we completed 32 more deals in 2004, an increase of 52.5 percent over 2003, and higher travel costs related to our fixed income corpo- rate sales and trading efforts. Merger and Restructuring – Merger and restructuring- related charges were $8.0 million in 2002. Restructur- ing measures were taken in response to continued weakness in the equity market and resulted in ex- penses of $5.3 million for severance, other benefits and outplacement costs associated with the termina- tion of employees and $0.5 million for asset write- downs and lease terminations for branch closings. In addition, we incurred expenses of $2.2 million related 16 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations the fixed integrating to income division of U.S. Bancorp Investments, Inc. into our fixed income business in connection with an integration plan asso- ciated with the 2001 merger of U.S. Bancorp and Firstar Corporation. visors related to the new compensation plan, as well as the fact that attrition related to the plan was lower than originally expected. the time of our spin-off Further contributing to the decrease in other operat- ing expenses were reduced litigation-related costs, Royalty Fee – As a subsidiary of U.S. Bancorp, we were which totaled $4.4 million in 2004 in comparison to $16.1 million in 2003, a decrease of 72.7 percent. The charged royalty fees for the use of U.S. Bancorp decrease in other operating expenses was offset in part tradenames and trademarks. These charges were dis- from by a $3.1 million increase in costs for corporate insur- continued at ance as a result of being a stand-alone public company U.S. Bancorp. and new expenses associated with our charitable giv- ing program. In 2002, other operating expenses included, in addi- tion to the items mentioned above, service charges from U.S. Bancorp and its affiliates for corporate sup- port. Other operating expenses increased from $22.4 million in 2002 to $39.6 million in 2003. This increase related primarily to the 76.8 percent $8.8 million increase in our loan loss allowance. Also contributing to the increase in other operating ex- penses was an increase in litigation-related expenses incurred in 2003 as these expenses were $16.1 million for 2003 as compared with $10.9 million in 2002. Other Operating Expenses – Other operating expenses include insurance costs, license and registration fees, financial advisor loan loss contingencies, expenses re- lated to our charitable giving program, and litigation- related expenses, which consist of the amounts we reserve and/or pay out related to legal and regulatory settlements, awards or judgments, and fines. Other operating expenses decreased to $24.2 million in 2004, compared with $39.6 million in 2003, a de- crease of $15.4 million or 38.8 percent. In the second quarter of 2003, we increased our allowance for fi- nancial advisor loan losses by $8.8 million in conjunc- tion with implementing a new compensation plan that we expected would result in attrition of certain finan- cial advisors. The underlying loans are typically made to financial advisors in connection with their recruit- ment and are forgivable based on continued employ- ment. We amortize the loans using the straight-line method over the terms of the loans, which generally range from three to five years. Loan recipients who leave us prior to full forgiveness of their loan balance are obligated to repay remaining balances. However, historical collection efforts have been difficult. Given these facts, an employee loan loss reserve is estab- lished when employees with remaining balances termi- nate and it is probable that the loans are not collectible. During the first and second quarters of We measure financial performance by business seg- 2003, we communicated to financial advisors certain ment. Our three segments are Capital Markets, Pri- changes to our production-based compensation plans vate Client Services, and Corporate Support and that were effective in the third quarter of 2003. These Other. We determined these segments based on fac- tors such as the type of customers served, the nature compensation changes reflected a shift from a prod- of products and services provided and the distribution uct-based payout to a production-based payout. This channels used to provide those products and services. change more closely aligned our new compensation plan with the compensation plans of our competitors. Segment pre-tax operating income or loss and seg- Subsequent to these communications, we experienced ment pre-tax operating margin are used by our man- agement team to evaluate and measure segment attrition of certain financial advisors, primarily those performance for purposes of allocating resources and with low levels of production. We expected this trend to assess our performance relative to that of our com- to continue and, based on historical collection efforts, petitors. Segment pre-tax operating income or loss is to result in employee loan losses. Accordingly, we derived from our business unit profitability reporting increased our allowance for our exposure to employee systems by specifically attributing customer relation- loan losses in 2003. In 2004, we reduced the loan loss ships and their related revenues and expenses to the reserve by $2.1 million, reflecting our belief that we appropriate segment. Expenses directly managed by would not experience further attrition of financial ad- Income Taxes – Our provision for income taxes for 2004 was $29.3 million, an effective tax rate of 36.8 percent, compared with $14.9 million, an effec- tive tax rate of 36.4 percent, for 2003, and compared with $4.7 million, an effective tax rate of 97.8 per- cent, for 2002. The non-deductibility in 2002 of the regulatory fine associated with the equity research reg- ulatory settlement was the primary factor in the higher effective tax rate in 2002 compared to that in subsequent years. SEGMENT PERFORMANCE Piper Jaffray Annual Report 2004 17 Management’s Discussion and Analysis of Financial Condition and Results of Operations the business unit are accounted for within each seg- ments are realigned to better serve our customer base. The presentation reflects our current management ment’s pre-tax operating income or loss. Investment structure and, accordingly, all periods are presented research, operations, technology and compliance costs are allocated based on each segment’s use of these on a comparable basis. functions to support its business. General and admin- istrative expenses incurred by centrally managed cor- porate support included within functions are Corporate Support and Other. To enhance the compa- rability of business segment results over time, the roy- alty fees previously assessed by U.S. Bancorp, cash awards granted to employees in connection with our spin-off from U.S. Bancorp, merger and restructuring- related charges and certain infrequent regulatory set- tlement costs are not included in segment pre-tax op- erating income or loss. We may change designations, assignments and allocations from time to time as our financial reporting systems are enhanced and methods of evaluating performance change or business seg- Our primary revenue-producing segments, Capital Markets and Private Client Services, have different compensation plans and non-compensation cost struc- tures that impact the operating margins of the two segments differently during periods of increasing or decreasing business activity and revenues. Compensa- tion expense for Capital Markets is driven primarily by pre-tax operating income of the segment, whereas compensation expense for Private Client Services is driven primarily by net revenues. The following table provides our segment perform- ance for the periods presented: FOR THE YEAR ENDED DECEMBER 31, (Dollars in Thousands) Net revenues Capital Markets Private Client Services Corporate Support and Other 2004 2003 2002 PERCENT INC/(DEC) 2004 v 2003 2003 v 2002 $ 431,135 $ 430,355 $ 376,074 355,176 11,187 352,113 4,262 357,155 (4,177) 0.2% 0.9 14.4% (1.4) 162.5 202.0 Total $ 797,498 $ 786,730 $ 729,052 1.4% 7.9% Pre-tax operating income (loss) before unallocated charges a Capital Markets Private Client Services Corporate Support and Other $ 74,392 $ 76,749 $ 60,655 (3.1)% 26.5% 48,034 (38,088) 28,180 (36,135) 29,902 (37,800) 70.5 5.4 (5.8) (4.4) Total $ 84,338 $ 68,794 $ 52,757 22.6% 30.4% Pre-tax operating margin before unallocated charges Capital Markets Private Client Services Total 17.3% 13.5% 10.6% 17.8% 8.0% 8.7% 16.1% 8.4% 7.2% (a) See Reconciliation to pre-tax operating income (loss) including unallocated charges for detail on expenses excluded from segment performance. Reconciliation to pre-tax operating income including unallocated charges: Pre-tax operating income before unallocated charges $ 84,338 $ 68,794 $ 52,757 Cash award program Regulatory settlement Merger and restructuring Royalty fee 4,717 24,000 – – – – – 3,911 – 32,500 7,976 7,482 Consolidated income before income tax expense $ 79,621 $ 40,883 $ 4,799 18 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations CAPITAL MARKETS FOR THE YEAR ENDED DECEMBER 31, (Dollars in Thousands) Net revenues: Institutional sales and trading Fixed income Equities 2004 2003 2002 PERCENT INC/(DEC) 2004 v 2003 2003 v 2002 $ 79,752 $ 101,865 $ 70,318 (21.7)% 44.9% 117,302 122,303 112,871 (4.1) 8.4 Total institutional sales and trading 197,054 224,168 183,189 (12.1) 22.4 Investment banking Underwriting Fixed income Equities Mergers and acquisitions Total investment banking Other net interest income Other income Total net revenues 62,097 87,505 78,066 64,762 70,202 63,258 73,346 46,027 62,156 (4.1) 24.6 23.4 227,668 198,222 181,529 14.9 4,912 1,501 4,242 3,723 8,000 3,356 15.8 (59.7) (11.7) 52.5 1.8 9.2 (47.0) 10.9 $ 431,135 $ 430,355 $ 376,074 0.2% 14.4% Pre-tax operating income before unallocated charges $ 74,392 $ 76,749 $ 60,655 (3.1)% 26.5% Pre-tax operating margin 17.3% 17.8% 16.1% Institutional sales and trading revenues are comprised of all the revenues generated through trading activi- ties. These revenues, which are generated primarily through the facilitation of customer trades, include principal transactions revenues, commissions and the interest income or expense associated with financing or hedging our inventory positions. To assess the prof- itability of institutional sales and trading activities, we aggregate principal transactions, commissions and net interest revenues. Institutional sales and trading reve- nues decreased 12.1 percent in 2004 to $197.1 mil- lion, compared to $224.2 million in 2003. Equity institutional sales and trading decreased 4.1 percent in 2004, to $117.3 million, compared to $122.3 million in the prior year. This decline is primarily attributable to a reduction in revenue related to convertible sales and trading activity as a result of difficult market conditions. Fixed income institutional sales and trad- ing revenues decreased 21.7 percent to $79.8 million in 2004, compared to $101.9 million in 2003. The significant decline in fixed income revenues from the prior year was primarily attributable to substantially reduced institutional client order flow and reduced trading profits. The decrease in 2004 also reflected the fact that our fixed income business achieved record revenues in the second and third quarters of 2003 driven by high-yield corporate bonds where we have mained flat. proprietary research capabilities. The rising interest rate environment in 2004 created a more challenging fixed income environment. As a result of the more challenging fixed income environment in 2004, we took steps during the second quarter of 2004 to re- duce our fixed income inventory Value-at-Risk. This reduction limited both the risk and the potential re- turn associated with principal transactions. Investment banking revenue increased to $227.7 mil- lion in 2004, compared with $198.2 million in the prior year, up 14.9 percent. This increase reflects higher equity underwriting activity during the first half of 2004 compared with the corresponding period of 2003. During 2004, we completed 93 equity offer- ings, raising $12.6 billion in capital for our clients, compared to 61 equity offerings, raising $8.2 billion in capital, during 2003. Additionally, merger and ac- quisition activity rose. We completed 49 deals valued at $6.8 billion in 2004, compared to 38 deals valued at $5.1 billion in 2003. Fixed income investment banking revenues decreased 4.1 percent from the prior year to $62.1 million in 2004, as a result of a shift from advisory fee revenue to principal transactions revenue in our fixed income derivatives business. Segment pre-tax operating margin for 2004 decreased to 17.3 percent from 17.8 percent for 2003 as fixed compensation costs increased while net revenues re- Capital Markets net revenues increased 14.4 percent to $430.4 million in 2003 from $376.1 million in Piper Jaffray Annual Report 2004 19 Management’s Discussion and Analysis of Financial Condition and Results of Operations 2002. Institutional sales and trading revenue in- creased 22.4 percent to $224.2 million in 2003 com- pared with $183.2 million for 2002, primarily due to higher institutional trading volumes, particularly in fixed income products. In addition, equity institu- tional revenue grew in 2003 despite lower trading volumes as we reduced trading losses incurred from facilitating customer transactions. Investment banking revenue increased to $198.2 mil- lion in 2003 compared with $181.5 million in 2002, an increase of 9.2 percent, due primarily to increased equity underwriting activity, aided by the first full year of results for the convertible bond product offer- ings we added at the end of 2002. Segment pre-tax operating margin for Capital Mar- kets increased to 17.8 percent for 2003, compared with 16.1 percent for 2002. The increase in pre-tax operating margin for 2003, was due primarily to the increase in net revenues over 2002 and improved leveraging of fixed expenses such as marketing and business development, occupancy and salary costs. PRIVATE CLIENT SERVICES FOR THE YEAR ENDED DECEMBER 31, (Dollars in Thousands) Net revenues Pre-tax operating income before unallocated charges Pre-tax operating margin Number of financial advisors (period end) 2004 2003 2002 PERCENT INC/(DEC) 2004 v 2003 2003 v 2002 $ 355,176 $ 48,034 $ 352,113 $ 357,155 $ 28,180 $ 29,902 0.9% 70.5% (1.4)% (5.8)% 13.5% 860 8.0% 874 8.4% 991 Private Client Services 2004 net revenues were rela- halted in the third quarter of 2004. We continue to tively flat compared to 2003. Managed account fees, work to grow our financial advisor ranks, which we expect to accomplish over the long term primarily by which are charged as a percentage of an account’s training professionals to become financial advisors asset balance rather than on a transaction basis, in- and by selectively recruiting experienced financial creased as a result of higher asset balances in managed accounts in 2004, reflecting improved conditions in advisors. the equity markets. This increase was partially offset by decreased transactional business due to a decline in individual investor sentiment that began during the second half of 2004 and continued until the conclu- sion of the presidential election, after which we exper- ienced an increase in activity. Total Private Client Services assets under management increased from $49.6 billion at December 31, 2003, to $51.2 billion at December 31, 2004, largely due to 2004 equity market gains. Despite net revenues being flat year over year, segment pre-tax operating margin for Private Client Services increased to 13.5 percent for 2004 compared to 8.0 percent in 2003, due to lower financial advisor loan loss reserves, a reduction in litigation-related ex- penses and diligent cost control efforts. Private Client Services net revenues decreased to $352.1 million in 2003, compared with $357.2 mil- lion in 2002, due primarily to reduced mutual fund commissions, lower account fees and reduced invest- ment management account fees. These reductions were offset partially by increased revenue resulting from a new agreement related to providing cash sweep products to our clients. The reductions in revenue also reflected significant attrition among lower-producing financial advisors due to the new compensation plan for financial advisors implemented in mid-2003, as described above. Another factor that limited 2004 net revenues was the decline in the number of our financial advisors when compared to 2003. The number of financial advisors includes both developing and experienced financial advisors. The decreased number of financial advisors reflected both the attrition of certain financial advisors following the change in our compensation program described above under the caption ‘‘Consolidated Non-Interest Expenses – Operating Expenses’’ and the Segment pre-tax operating margin for Private Client difficulty of recruiting experienced financial advisors following the announcement in early 2003 of our im- Services decreased to 8.0 percent in 2003, compared pending spin-off from U.S. Bancorp and the resulting with 8.4 percent for 2002. This decline was primarily attributable to an increase in employee loan losses uncertainty surrounding the future of our business. related to forgivable loans made to our financial advi- Recruiting efforts improved somewhat over the course sors. Also contributing to the decreased operating of 2004, and the net attrition of financial advisors 20 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations margin were increased litigation-related expenses in 2003 as compared with 2002 reflecting an increase in the number of complaints, legal actions, investigations and regulatory proceedings in which we were in- volved, which was a trend throughout the securities industry. Mostly offsetting these additional expenses were reductions in fixed and variable compensation expense for 2003 that resulted from our previous re- structuring efforts. Corporate Support and Other Corporate Support and Other includes revenues pri- marily attributable to our private equity and venture capital businesses and our investments in private eq- uity and venture capital funds. On December 31, 2004, we transitioned our venture capital business to an independent firm. Going forward, we will maintain our existing investments in the venture capital funds, but management of these funds will be performed by this independent firm, rather than by Piper Jaffray. This change is not expected to have a significant im- pact on our future operating results. The Corporate Support and Other segment also includes interest ex- pense on our subordinated debt, which is recorded as a reduction of net revenues. Net revenues for this segment increased to $11.2 million in 2004, compared with $4.3 million for the prior year. This change was due primarily to revenue recorded in 2004 pertaining to our investments in two limited partnerships that are consolidated for financial statement purposes. In addi- tion, interest expense on our subordinated debt de- creased as we reduced our subordinated debt balance by $35.0 million in the fourth quarter of 2003. Corporate Support and Other net revenues increased to $4.3 million in 2003 compared with a loss of $4.2 million in 2002. This change was due primarily to a reduction in interest expense on our subordinated debt and increased management fees generated by our venture capital business. Initiatives Related to Our Business Described below are certain significant initiatives cur- rently underway at our company that we believe may affect our future business and operations. COMPANY-WIDE ) We will focus on growing revenues by advancing our strategy to serve as our clients’ primary finan- cial advisor and by focusing on the niches where we are experts and can differentiate ourselves with clients. ) We will continue building on our partnership cul- ture through expanded employee ownership. We believe that in a human capital business like ours, each employee’s personal contributions can impact our company’s performance, and that giving our employees a greater equity stake in our company will directly contribute to improved financial re- sults. During 2004, we granted our employees 550,659 shares of restricted stock and options to purchase 322,005 shares of our common stock. In 2005, through February 22, 2005, we have granted our employees approximately 781,553 shares of re- stricted stock and options to purchase approxi- mately 393,786 shares of our common stock. In addition, we expect to issue approximately 340,000 shares of our common stock, in the aggre- gate, to employees’ accounts in the Piper Jaffray Companies Retirement Plan during the first quarter of 2005, reflecting the company’s 401(k) matching contribution for 2004 and a discretionary profit- sharing respect of 2004 performance. contribution in ) To maximize our use of capital, our board of direc- tors has authorized the repurchase of up to 1.3 mil- lion shares of our common stock for a maximum aggregate purchase price of $65 million. As previ- ously announced, the repurchase program com- menced in early 2005 and is authorized through December 31, 2005. The principal purpose of the share repurchase program is to manage our equity capital relative to the growth of our business and to offset the dilutive effect of employee equity-based compensation. CAPITAL MARKETS ) The acquisition of Vie Securities allows us to offer our equity institutional clients a full suite of trading products, meeting increased client demand for auto- mated, cost-effective execution services. This new service expands and complements our current capa- bilities and helps meet the customer demand of lower-cost trading execution. The acquisition is ex- pected to have an immaterial effect on our 2005 earnings, but be accretive to earnings in 2006. PRIVATE CLIENT SERVICES ) We are focusing on developing our own financial advisors and selectively recruiting seasoned advi- sors. This approach takes longer to produce results, but we believe it is the best long-term strategy for our business. In 2004, we exceeded our hiring plans for developing financial advisors, and these profes- sionals are an important source of future revenues. Piper Jaffray Annual Report 2004 21 Management’s Discussion and Analysis of Financial Condition and Results of Operations ) We are providing additional resources to our finan- mate fair value. Financial instruments carried at contract amounts that approximate fair value either cial advisors to give them enhanced tools to serve have short-term maturities (one year or less), are our clients. In the second quarter of 2004, we rolled repriced frequently or bear market interest rates and, out information to each financial advisor on client accordingly, are carried at amounts approximating relationship metrics. This information provides fi- fair value. Financial instruments carried at contract nancial advisors detailed information on client rela- tionships and helps them identify ways to redirect amount on our Consolidated Statements of Financial their efforts to improve the quality of their existing Condition include receivables from and payables to brokers, dealers and clearing organizations, securities client relationships. In addition, we have added spe- purchased under agreements to resell, securities sold cialty resources in targeted areas, namely, fixed in- under agreements to repurchase, receivables from and come products, wealth advisory services and high payables to customers, short-term financing and sub- net-worth services. We believe these resources and ordinated debt. Financial instruments recorded at fair efforts are key to improving the financial perform- value are generally priced based upon independent ance of our private client services business. sources such as listed market prices or dealer price quotations. Unrealized gains and losses related to these financial instruments are reflected on our Con- solidated Statements of Operations. Recent Accounting Pronouncements Recent accounting pronouncements are set forth in Note 3 to our consolidated financial statements and are incorporated herein by reference. For investments in illiquid or privately held securities that do not have readily determinable fair values, the determination of fair value requires us to estimate the value of the securities using the best information avail- able. Among the factors considered by us in determin- ing the fair value of financial instruments are the cost, terms and liquidity of the investment, the financial condition and operating results of the issuer, the quoted market price of publicly traded securities with similar quality and yield, and other factors generally pertinent to the valuation of investments. In instances where a security is subject to transfer restrictions, the value of the security is based primarily on the quoted price of a similar security without restriction but may be reduced by an amount estimated to reflect such restrictions. In addition, even where the value of a security is derived from an independent source, cer- tain assumptions may be required to determine the security’s fair value. For instance, we generally assume that the size of positions in securities that we hold would not be large enough to affect the quoted price of the securities if we sell them, and that any such sale would happen in an orderly manner. The actual value realized upon disposition could be different from the currently estimated fair value. Fair values for derivative contracts represent amounts estimated to be received from or paid to a third party in settlement of these instruments. These derivatives are valued using quoted market prices when available or pricing models based on the net present value of estimated future cash flows. Management deemed the net present value of estimated future cash flows model to be the best estimate of fair value as most of our derivative products are interest rate swaps. The valua- tion models used require inputs including contractual Critical Accounting Policies Our accounting and reporting policies comply with GAAP and conform to practices within the securities industry. The preparation of financial statements in compliance with GAAP and industry practices re- quires us to make estimates and assumptions that could materially affect amounts reported in our con- solidated financial statements. Critical accounting pol- icies are those policies that we believe to be the most important to the portrayal of our financial condition and results of operations and that require us to make estimates that are difficult, subjective or complex. Most accounting policies are not considered by us to be critical accounting policies. Several factors are con- sidered in determining whether or not a policy is criti- cal, including, among others, whether the estimates are significant to the consolidated financial statements taken as a whole, the nature of the estimates, the ability to readily validate the estimates with other in- formation, independent including third-party or sources, the sensitivity of the estimates to changes in economic conditions and whether alternative account- ing methods may be used under GAAP. For a full description of our significant accounting policies, see Note 2 to our consolidated financial statements. We believe that of our significant policies, the following are our critical accounting policies: VALUATION OF FINANCIAL INSTRUMENTS Substantially all of our financial instruments are re- corded at fair value or contract amounts that approxi- 22 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations terms, market prices, yield curves, credit curves and measures of volatility. The valuation models are monitored over the life of the derivative product. If there are any changes in the underlying inputs, the model is updated for those new inputs. GOODWILL AND INTANGIBLE ASSETS and tangible capital ratios of comparable public com- panies in relevant industry sectors. In certain circum- stances, we may engage a third party to validate independently our assessment of the fair value of our operating segments. If during any future period it is determined that an impairment exists, the results of operations in that period could be materially ad- versely affected. STOCK-BASED COMPENSATION We record all assets and liabilities acquired in purchase acquisitions, including goodwill, at fair value as required by Statement of Financial Account- ing Standards No. 141, ‘‘Business Combinations.’’ At As part of our compensation of employees, we use stock-based compensation, including stock options December 31, 2004, we had goodwill of $317.2 mil- and restricted stock. Compensation paid in the form lion, principally as a result of the 1998 acquisition of of restricted stock is amortized on a straight-line basis our predecessor, Piper Jaffray Companies Inc., and its over the vesting period of the award, which is gener- subsidiaries by U.S. Bancorp. ally three years, and is included in our results of oper- ations as compensation. GAAP permits the use of alternative methods of accounting for stock options, including an ‘‘intrinsic value’’ method and a ‘‘fair value’’ method. The intrinsic value method is intended to reflect the effect of stock options on shareholder returns based on any appreciation in the value of the stock option over time, which generally would be driven by improved financial performance. In con- trast, the fair value method requires an estimate of the value of stock options to be recognized as compensa- tion over the vesting period of the awards. Prior to our spin-off from U.S. Bancorp, we utilized the intrin- sic value method and did not recognize the value of stock option awards as compensation expense. Ac- cordingly, we provided disclosure of the impact of the estimated fair value of stock options on our compen- sation and reported income in the notes to our consol- idated financial statements. In determining the estimated fair value of stock options, we used the Black-Scholes option-pricing model, which requires judgment regarding certain assumptions, including the expected life of the options granted, dividend yields and stock volatility. The initial recognition of goodwill and other intangi- ble assets and the subsequent impairment analysis re- quires management to make subjective judgments concerning estimates of how the acquired assets or businesses will perform in the future using valuation methods including discounted cash flow analysis. Ad- ditionally, estimated cash flows may extend beyond ten years and, by their nature, are difficult to deter- mine over an extended time period. Events and factors that may significantly affect the estimates include, among others, competitive forces and changes in reve- nue growth trends, cost structures, technology, dis- count rates and market conditions. To assess the reasonableness of cash flow estimates and validate as- sumptions used in our estimates, we review historical performance of the underlying assets or similar assets. In assessing the fair value of our operating segments, the volatile nature of the securities markets and our industry requires us to consider the business and mar- ket cycle and assess the stage of the cycle in estimating the timing and extent of future cash flows. In addition to estimating the fair value of an operating segment based on discounted cash flows, we consider other information to validate the reasonableness of our val- uations, including public market comparables, multi- ples of recent mergers and acquisitions of similar businesses and third-party assessments. Valuation multiples may be based on revenues, price-to-earnings and tangible capital ratios of comparable public com- panies and business segments. These multiples may be adjusted to consider competitive differences including size, operating leverage and other factors. We deter- mine the carrying amount of an operating segment based on the capital required to support the segment’s activities, including its tangible and intangible assets. The determination of a segment’s capital allocation requires management judgment and considers many factors, including the regulatory capital requirements Effective January 1, 2004, we elected to account for stock-based employee compensation on a prospective basis under the fair value method, as prescribed by Statement of Financial Accounting Standards No. 123, ‘‘Accounting and Disclosure of Stock-Based Compensation,’’ and as amended by Statement of Fi- nancial Accounting Standards No. 148, ‘‘Accounting for Stock-Based Compensation – Transition and Dis- closure.’’ The amended standard provides alterna- tive methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, we are required to present prominent disclosures in both annual and interim financial statements about the method of Piper Jaffray Annual Report 2004 23 Management’s Discussion and Analysis of Financial Condition and Results of Operations CONTINGENCIES accounting for stock-based employee compensation with outside legal counsel and after taking into ac- count our established reserves and the U.S. Bancorp utilized and its effect on the reported results. indemnity agreement, that pending litigation, arbitra- tion and regulatory proceedings will be resolved with no material adverse effect on our financial condition. However, if, during any period, a potential adverse contingency should become probable or resolved for an amount in excess of the established reserves and indemnification, the results of operations in that pe- riod could be materially adversely affected. We are involved in various pending and potential legal proceedings related to our business, including litiga- tion, arbitration and regulatory proceedings. Some of these matters involve claims for substantial amounts, including claims for punitive and other special dam- ages. The number of these legal proceedings has in- creased in recent years. We have, after consultation with outside legal counsel and consideration of facts currently known by management, recorded estimated losses in accordance with Statement of Financial Ac- counting Standards No. 5, ‘‘Accounting for Contin- gencies,’’ to the extent that claims are probable of loss and the amount of the loss can be reasonably esti- mated. The determination of these reserve amounts requires significant judgment on the part of manage- ment. In making these determinations, we consider many factors, including, but not limited to, the loss and damages sought by the plaintiff or claimant, the basis and validity of the claim, the likelihood of a successful defense against the claim, and the potential for, and magnitude of, damages or settlements from such pending and potential litigation and arbitration proceedings, and fines and penalties or orders from regulatory agencies. Liquidity and Capital Resources We have a liquid balance sheet. Most of our assets consist of cash and assets readily convertible into cash. Securities inventories are stated at fair value and are generally readily marketable. Customers’ margin loans are collateralized by securities and have floating interest rates. Other receivables and payables with customers and other brokers and dealers usually settle within a few days. As part of our liquidity strategy, we emphasize diversification of funding sources. We utilize a mix of funding sources and, to the extent possible, maximize our lower-cost financing associ- ated with securities lending and repurchasing agree- ments. Our assets are financed by our cash flows from operations, equity capital, subordinated debt, bank lines of credit and proceeds from securities lending and securities sold under agreements to repurchase. The fluctuations in cash flows from financing activities are directly related to daily operating activities from our various businesses. liabilities CASH FLOWS We do not intend to pay cash dividends on our com- mon stock for the foreseeable future. Under the terms of our separation and distribution agreement with U.S. Bancorp and ancillary agree- ments entered into in connection with the spin-off, we generally will be responsible for all liabilities relating to our business, including those liabilities relating to our business while it was operated as a segment of U.S. Bancorp under the supervision of its management and board of directors and while our employees were employees of U.S. Bancorp servicing our business. Cash and cash equivalents decreased $17.0 million in 2004 to $67.4 million at December 31, 2004. Operat- Similarly, U.S. Bancorp generally will be responsible ing activities used cash of $2.3 million, as cash re- for all the businesses relating ceived from earnings and operating assets and U.S. Bancorp retained. However, in addition to our liabilities was exceeded by cash utilized toward fails established reserves, U.S. Bancorp has agreed to in- to deliver, stock borrowed and for processing ac- demnify us in an amount up to $17.5 million for counts. Cash of $31.1 million was used for investing losses that result from third-party claims relating to activities toward the purchase of fixed assets and the research analyst independence, regulatory investiga- acquisition of Vie Securities, LLC. Cash of $16.4 mil- tions regarding the allocation of initial public offering lion was generated by financing activities, including shares to directors and officers of public companies, $133.6 million received from secured financing activi- and regulatory investigations of mutual fund prac- ties and $41.7 million from securities loaned. The tices. U.S. Bancorp has the right to terminate this cash generated through financing was offset by a net indemnification obligation in the event of a change in control of our company. As of December 31, 2004, reduction of short-term borrowings of $159.0 million. $14.2 million of the indemnification remained. to Cash and cash equivalents increased $51.8 million in 2003 to $84.4 million at December 31, 2003. Operat- ing activities used cash of $5.7 million as cash Subject to the foregoing, we believe, based on our current knowledge, after appropriate consultation 24 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations erage securities lending arrangements of $213 million received from earnings and operating assets and liabil- and $212 million in 2004 and 2003, respectively, ities was exceeded by cash utilized toward the purchase of repurchase agreements and reverse repur- were primarily used to finance customer receivables. chase agreements. Cash of $10.7 million was used for Average repurchase agreements of $170 million and $165 million in 2004 and 2003, respectively, were investing activities toward the purchase of fixed as- primarily used to finance inventory. Growth in margin sets. Cash of $68.3 million was generated by financing loans to customers is generally financed through in- activities, including $153.9 million received from se- creases in securities lending to third parties while cured financing activities and $33.9 million in capital growth in our securities inventory is generally fi- contributions from U.S. Bancorp. The cash generated nanced through repurchase agreements. Bank financ- through financing was offset by a net reduction of short-term borrowings of $91.0 million and a ing supplements these sources as necessary. $35.0 million reduction in our subordinated debt. Cash and cash equivalents increased $4.9 million in 2002 to $32.6 million at December 31, 2002. Operat- ing activities provided cash of $220.9 million as cash received from earnings and operating assets exceeded cash used by operating liabilities. Cash of $5.7 million was used for investing activities toward the purchase of fixed assets. Cash of $210.3 million was used for financing activities, including the reduction of short- term borrowings, which decreased by $257.7 million, subordinated debt, which decreased by and $260.0 million. The cash generated through financing was offset in part by $231.0 million of cash generated from capital contributions from U.S. Bancorp and $76.4 million received from securities loaned. FUNDING SOURCES We have available discretionary short-term financing on both a secured and unsecured basis. Secured fi- nancing is obtained through the use of securities lend- ing agreements, repurchase agreements and secured bank loans. Securities lending agreements are secured by client collateral pledged for margin loans while bank loans and repurchase agreements are typically collateralized by the firm’s securities inventory. Short- term funding is generally obtained at rates based upon the federal funds rate. Average short-term bank loans of $46 million and $144 million in 2004 and 2003, respectively, and av- (Dollars in Millions) Long-term borrowings Operating leases Technology contracts Cash award program Venture fund commitments a As of December 31, 2004, we had uncommitted credit agreements with banks totaling $650 million, com- prising $530 million in discretionary secured lines and $120 million in discretionary unsecured lines. We have been able to obtain necessary short-term bor- rowings in the past and believe that we will continue to be able to do so in the future. We have also estab- lished arrangements to obtain financing using as col- lateral our securities held by our clearing bank or by another broker dealer at the end of each business day. In addition to the $650 million of credit agreements described above, our broker dealer subsidiary is party to a $180 million subordinated debt facility with an affiliate of U.S. Bancorp, which has been approved by the NYSE for regulatory net capital purposes as al- lowable in our broker dealer subsidiary’s net capital computation. The interest on the $180 million subor- dinated debt facility is based on the three-month London Interbank Offer Rate. The entire amount out- standing matures in 2008. We have an additional committed, but undrawn, temporary subordinated debt facility of $40 million. The interest on the $40 million subordinated debt facility is based on the prime rate, and the facility expires in December 2005. CASH REQUIREMENTS The following table provides a summary of our con- tractual obligations as of December 31, 2004: 2006 Through 2007 2008 Through 2009 2010 and Thereafter 2005 Total $ – $ – $ 180.0 $ – $ 180.0 27.1 13.4 4.8 – 44.9 22.7 9.4 – 41.9 9.3 – – 74.2 – – – 188.1 45.4 14.2 4.8 (a) The venture fund commitments have no specified call dates. The timing of capital calls is based on market conditions and investment opportunities. equipment leases were $188.1 million. Certain leases As of December 31, 2004, our long-term borrowings were $180.0 million, all due in 2008. Our minimum have renewal options and clauses for escalation and operation cost adjustments. We have commitments lease commitments for non-cancelable office space and Piper Jaffray Annual Report 2004 25 Management’s Discussion and Analysis of Financial Condition and Results of Operations to invest an additional $4.8 million in venture capital funds and commitments for technology contracts of $45.4 million. hold retained interests in nonconsolidated entities, in- cur obligations to commit capital to nonconsolidated entities, enter into derivative transactions, enter into nonderivative guarantees and enter into other off-bal- ance sheet arrangements. CAPITAL REQUIREMENTS In 2005, our board of directors authorized us to re- purchase up to 1.3 million shares of our outstanding common stock for a maximum aggregate purchase We enter into arrangements with special-purpose enti- ties (‘‘SPE’s’’), also known as variable interest entities price of $65.0 million. The principal purpose of the (‘‘VIE’s’’). SPE’s are corporations, trusts or partner- share repurchase program is to manage our equity ships that are established for a limited purpose. SPE’s, capital relative to the growth of our business and to by their nature, generally are not controlled by their offset the dilutive effect of employee equity-based equity owners, as the establishing documents govern compensation. Purchases will be made on the open all material decisions. Our primary involvement with market pursuant to a 10b5-1 plan established with an SPE’s relates to securitization transactions in which independent agent. The program commenced in early highly rated fixed rate municipal bonds are sold to an 2005 and is authorized through December 31, 2005. SPE. We follow Statement of Financial Accounting Standards No. 140 (‘‘SFAS 140’’), ‘‘Accounting for Transfers and Servicing of Financial Assets and Extin- guishments of Liabilities – a Replacement of FASB Statement No. 125,’’ to account for securitizations and other transfers of financial assets. Therefore, we derecognize financial assets transferred in securitiza- tions provided that such transfer meets all of the SFAS 140 criteria. See Note 19, ‘‘Securitizations,’’ in the Notes to Consolidated Financial Statements for a complete discussion of our securitization activities. As a registered broker dealer and member firm of the NYSE, our broker dealer subsidiary is subject to the uniform net capital rule of the SEC and the net capital rule of the NYSE. We have elected to use the alterna- tive method permitted by the uniform net capital rule, which requires that we maintain minimum net capital of the greater of $1.0 million or 2 percent of aggregate debit balances arising from customer transactions, as this is defined in the rule. The NYSE may prohibit a member firm from expanding its business or paying We have investments in various entities, typically part- nerships or limited liability companies, established for dividends if resulting net capital would be less than the purpose of investing in emerging growth compa- 5 percent of aggregate debit balances. Advances to nies. We commit capital or act as the managing part- affiliates, repayment of subordinated liabilities, divi- ner or member of these entities. These entities are dend payments and other equity withdrawals are sub- reviewed under variable interest entity and voting in- ject to certain notification and other provisions of the terest entity standards. If it is deemed an entity should uniform net capital rule and the net capital rule of the not be consolidated, we record these investments on NYSE. We expect these provisions will not impact our the equity method of accounting. The cost method is ability to meet current and future obligations. In addi- applied when the ability to exercise significant influ- tion, we are subject to certain notification require- ence is not present. See Note 20, ‘‘Variable Interest ments related to withdrawals of excess net capital Entities,’’ in our Notes to Consolidated Financial from our broker dealer subsidiary. Our broker dealer Statements for a complete discussion of our activities subsidiary is also registered with the Commodity Fu- tures Trading Commission (‘‘CFTC’’) and therefore is related to these types of partnerships. subject to CFTC regulations. Piper Jaffray Ltd., our registered United Kingdom broker dealer subsidiary, is subject to the capital requirements of the U.K. Fi- nancial Services Authority. We use derivative products in a principal capacity as a dealer to satisfy the financial needs of clients. We also use derivative products to manage the interest rate and market value risks associated with our security positions. For a complete discussion of our activities related to these derivative products, see Note 4, ‘‘De- rivatives,’’ in our Notes to Consolidated Financial Statements. Our other types of off-balance-sheet arrangements in- clude leases, letters of credit and other commitments or guarantees. For a complete discussion of our activities related to other types of off-balance sheet arrangements, ‘‘Commitments, Contingencies, and see Note 12, At December 31, 2004, net capital under the SEC’s Uniform Net Capital Rule was $280.3 million or 49.2 percent of aggregate debit balances, and $268.9 million in excess of the minimum required net capital. Off-Balance Sheet Arrangements We enter into various types of off-balance sheet ar- rangements in the ordinary course of business. We 26 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations Guarantees,’’ in our Notes to Consolidated Financial Statements. related securities and using derivatives such as interest rate swaps and exchange-traded interest rate futures and options. Enterprise Risk Management LIQUIDITY RISK Market risk can be exacerbated in times of trading illiquidity when market participants refrain from transacting in normal quantities and/or at normal bid- offer spreads. Depending on the specific security, the structure of the financial product, and/or overall mar- ket conditions, we may be forced to hold onto a secur- ity for days or weeks longer than we had planned. Risk is an inherent part of our business. In the course of conducting business operations, we are exposed to a variety of risks. Market risk, credit risk, liquidity risk, operational risk, and legal, regulatory and com- pliance risk are the principal risks we face in operating our business. We seek to identify, assess and monitor each risk in accordance with defined policies and pro- cedures. The extent to which we properly identify and effectively manage each of these risks is critical to our We carefully watch our aged inventory to minimize the amount of illiquid securities we own at any one financial condition and profitability. time. Also, given that we attempt to hedge away most of our market risk, it is likely that change in value of our long positions in an illiquid market would be largely offset by changes in value of our short positions. With respect to market risk and credit risk, the cor- nerstone of our risk management process is daily com- munication between traders, trading department management and senior management concerning our inventory positions and overall risk profile. Our enter- prise risk management department supplements this We are also exposed to liquidity risk in our day-to-day funding activities. In addition to the benefit of having communication process by providing its independent a strong capital structure, we manage this risk by perspective on our market and credit risk profile on a diversifying our funding sources across products and daily basis through a series of reports. The broader among individual counterparties within those prod- goals of our enterprise risk management department ucts. For example, our treasury department, working are to understand the risk profile of each trading area, under the guidance of our asset/liability committee, to consolidate risk monitoring company-wide, to ar- can switch between securities lending, repurchase ticulate large trading or position risks to senior man- agreements, box loans and bank borrowings on any agement, to provide traders with perspectives on their given day depending on the pricing and availability of positions and to ensure accurate mark-to-market funding from any one of those sources. pricing. In addition to supporting daily risk management processes on the trading desks, our enterprise risk management department supports our market risk, institutional credit risk and asset/liability committees. These committees oversee risk management practices, including defining acceptable risk tolerances and ap- proving risk management policies. In addition to managing our capital and funding, the asset/liability committee oversees the management of net interest income risk, portfolio collateral, and the overall use of our capital, funding, and balance sheet. INTEREST RATE RISK MARKET RISK Interest rate risk represents the potential loss from adverse changes in market interest rates. We are ex- posed to interest rate risk arising from changes in the level and volatility of interest rates, changes in the Market risk represents the risk of financial loss that shape of the yield curve, changes in credit spreads, may result from the change in value of a financial and the rate of mortgage prepayments. Interest rate instrument due to fluctuations in its market price. Our exposure to market risk is directly related to our role risk is managed through the use of short positions in as a financial intermediary for our clients and to our U.S. government securities, agency securities, mort- gage-backed securities, corporate debt securities, in- market-making activities. Market risk is inherent in terest rate swaps, options, futures and forward both cash and derivative financial instruments. The contracts. We utilize interest rate swap contracts to scope of our market risk management policies and hedge a portion of our fixed income inventory, to procedures includes all market-sensitive financial hedge residual cash flows from our tender option instruments. bond program, and to hedge rate lock agreements and forward bond purchase agreements we may enter into with our public finance customers. These interest rate We use a variety of hedging strategies to manage our risk, including maintaining long and short positions in Piper Jaffray Annual Report 2004 27 Management’s Discussion and Analysis of Financial Condition and Results of Operations EQUITY PRICE RISK swap contracts are recorded at fair value with the Consistent with industry practice, we use a 95 percent confidence level and a one-day time horizon. A changes in fair value recognized in earnings. 95 percent confidence level and one-day time horizon means that there is a 5 percent chance that daily net trading revenues will experience a loss equal to or greater than the reported VaR. In other words, on average, we expect daily trading revenue shortfalls to exceed our VaR estimate about once a month. Equity price risk represents the potential loss in value due to adverse changes in the level or volatility of equity prices. We are exposed to equity price risk through our trading activities in both listed and over-the-counter equity markets. We attempt to re- VaR has inherent limitations, including reliance on historical data to predict future market risk, and the duce the risk of loss inherent in our market-making quantitative risk information is limited by the parame- and in our inventory of equity securities by establish- ters established in creating the models. There can be ing limits on the level of our position in any individual no assurance that actual losses occurring on any given security and by managing net position levels with day arising from changes in market conditions will those limits. not exceed the VaR amounts shown below or that such losses will not occur more than once in a 20 day period. However, we believe that VaR models are an appropriate methodology for comparing market risk profiles across different types of securities, business lines and different companies in the financial services industry. VALUE-AT-RISK Value-at-Risk (‘‘VaR’’) is the potential loss in market value, for a given confidence level and time horizon, which could occur for a portfolio of securities. We perform a daily VaR analysis on substantially all of our trading positions, including fixed income, equi- ties, convertible bonds and all associated hedges. We use a VaR model because it provides a common metric for assessing market risk across business lines and products. The modeling of the market risk character- istics of our trading positions involves a number of assumptions and approximations. While we believe that these assumptions and approximations are rea- sonable, different assumptions and approximations could produce different VaR estimates. For example, we include the risk-reducing diversification benefit be- tween various securities because it is highly unlikely that all securities would have an equally adverse move on a typical trading day. In addition to daily VaR estimates, we calculate the potential market risk to our trading positions under selected stress scenarios. We calculate the daily 99.9 percent VaR estimates both with and without diversification benefits for each risk category and firmwide. These stress tests allow us to measure the potential effects on net revenue from adverse changes in market volatilities, correlations and trading liquidity. The following table quantifies the estimated 95 per- cent, one-day VaR for each component of market risk for the periods presented: 2004 2003 2002 $ 316 232 548 (242) $ 828 $ 662 299 404 1,127 (613) 1,066 (563) $ 306 $ 514 $ 503 DECEMBER 31 (Dollars in Thousands) Interest Rate Risk Equity Price Risk Aggregate Undiversified Risk Diversification Benefit Aggregate Diversified Value-at-Risk 28 Piper Jaffray Annual Report 2004 Management’s Discussion and Analysis of Financial Condition and Results of Operations The table below illustrates the daily high, low and average 95 percent, one-day value-at-risk calculated for each component of market risk during the years ended 2004, 2003 and 2002, respectively. FOR THE YEAR ENDED DECEMBER 31, 2004 (Dollars in Thousands) Interest Rate Risk Equity Price Risk Aggregate Undiversified Risk Aggregate Diversified Value-at-Risk FOR THE YEAR ENDED DECEMBER 31, 2003 (Dollars in Thousands) Interest Rate Risk Equity Price Risk Aggregate Undiversified Risk Aggregate Diversified Value-at-Risk FOR THE YEAR ENDED DECEMBER 31, 2002 (Dollars in Thousands) Interest Rate Risk Equity Price Risk Aggregate Undiversified Risk Aggregate Diversified Value-at-Risk High Low Average $ 1,446 $ 154 $ 514 578 1,695 945 209 414 204 312 826 378 High Low Average $ 1,193 $ 544 $ 870 1,051 1,971 944 256 1,028 481 536 1,406 664 High Low Average $ 1,138 $ 413 $ 862 521 1,603 738 348 812 396 425 1,287 599 CREDIT RISK Credit risk in our Capital Markets business arises from potential non-performance by counterparties, customers, borrowers or issuers of securities we hold in our trading inventory. We are exposed to credit risk in our role as a trading counterparty to dealers and customers, as a holder of securities and as a member of exchanges and clearing organizations. Our client activities involve the execution, settlement and financ- ing of various transactions. Client activities are trans- acted on a cash, delivery versus payment or margin basis. Our credit exposure to institutional client busi- ness is mitigated by the use of industry-standard deliv- ery versus payment through depositories and clearing banks. Credit exposure associated with our Private Client Services business consists primarily of customer mar- gin accounts, which are monitored daily and are col- treasury and credit services lateralized. Our departments, in conjunction with our retail credit committee, establishes and reviews appropriate credit limits for our Private Client Services customers. Our institutional credit committee reviews risk associ- ated with institutional counterparties with whom we hold repurchase and resale agreement facilities, stock borrow or loan facilities, derivatives, TBAs and other documented institutional counterparty agreements that may give rise to credit exposure. Counterparty levels are established relative to the level of counterparty ratings and potential levels of activity. We are subject to credit concentration risk if we hold large individual securities positions, execute large transactions with individual counterparties or groups of related counterparties, extend large loans to indi- vidual borrowers or make substantial underwriting commitments. Concentration risk can occur by indus- try, geographic area or type of client. Potential credit concentration risk is carefully monitored and is man- aged through the use of policies and limits. We are also exposed to the risk of loss related to changes in the credit spreads of debt instruments. Credit spread risk arises from potential changes in an issuer’s credit rating or the market’s perception of the issuer’s credit worthiness. Credit spread risk is man- aged through offsetting long or short positions in sim- ilar securities. Piper Jaffray Annual Report 2004 29 Management’s Discussion and Analysis of Financial Condition and Results of Operations OPERATIONAL RISK performance obligations will be unenforceable. We are generally subject to extensive regulation in the various jurisdictions in which we conduct our busi- ness. We have established procedures that are de- signed to ensure compliance with applicable statutory and regulatory requirements, including, but not lim- ited to, those related to regulatory net capital require- ments, sales and trading practices, use and safekeeping of customer funds and securities, credit and extension, money-laundering, recordkeeping. Operational risk refers to the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. We rely on the ability of our employees, our internal systems and processes and systems at computer cen- ters operated by third parties to process a large num- ber of transactions. In the event of a breakdown or improper operation of our systems or processes or improper action by our employees or third-party ven- dors, we could suffer financial loss, regulatory sanc- tions and damage to our reputation. We have business We have established internal policies relating to ethics and business conduct, and compliance with applicable continuity plans in place that we believe will cover legal and regulatory requirements, as well as training critical processes on a company-wide basis, and re- and other procedures designed to ensure that these dundancies are built into our systems as we have policies are followed. deemed appropriate. privacy In order to mitigate and control operational risk, we have developed and continue to enhance a quarterly Effects of Inflation risk profile review that is designed to identify and assess operational risk throughout the organization. These control mechanisms attempt to ensure that op- erations policies and procedures are being followed and that our various businesses are operating within established corporate policies and limits. Because our assets are liquid in nature, they are not significantly affected by inflation. However, the rate of inflation affects our expenses, such as employee compensation, office space leasing costs and commu- nications charges, which may not be readily recover- able in the price of services offered by us. To the extent inflation results in rising interest rates and has other adverse effects upon the securities markets, it Legal, regulatory and compliance risk includes the may adversely affect our financial position and results risk of non-compliance with applicable legal and regu- latory requirements and the risk that a counterparty’s LEGAL, REGULATORY AND COMPLIANCE RISK of operations. CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS This Annual Report contains forward-looking statements. Statements that are not historical or current facts, including statements about beliefs and expectations, are forward-looking statements. These forward-looking statements cover, among other things, the future prospects of Piper Jaffray Companies. Forward-looking statements involve inherent risks and uncertainties, and important factors could cause actual results to differ materially from those anticipated, including the following: (1) we have agreed to certain restrictions to preserve the tax treatment of our spin-off from U.S. Bancorp, which reduce our strategic and operating flexibility, (2) we have agreed to indemnify U.S. Bancorp for taxes and related losses resulting from any actions we take that cause the spin-off to fail to qualify as a tax-free transaction, (3) developments in market and economic conditions have in the past adversely affected, and may in the future adversely affect, our business and profitability, (4) we may not be able to compete successfully with other companies in the financial services industry, (5) our underwriting and market-making activities may place our capital at risk, (6) an inability to readily divest or transfer trading positions may result in financial losses to our business, (7) use of derivative instruments as part of our risk management techniques may place our capital at risk, while our risk management techniques themselves may not fully mitigate our market risk exposure, (8) an inability to access capital readily or on terms favorable to us could impair our ability to fund operations and could jeopardize our financial condition, (9) we may make strategic acquisitions of businesses or may divest or exit existing businesses, which could cause us to incur unforeseen expense and have disruptive effects on our business but may not yield the benefits we expect, (10) our technology systems are critical components of our operations and the failure of those systems may disrupt our business, cause financial loss and constrain our growth, (11) our business is subject to extensive regulation that limits our business activities, and a significant regulatory action against our company may have a material adverse financial effect or cause significant reputational harm, (12) regulatory capital requirements may adversely affect our ability to expand or maintain present levels of our business or impair our ability to meet our financial obligations, (13) our exposure to legal liability is significant, and could lead to substantial damages and restrictions on our business going forward, (14) we may suffer losses if our reputation is harmed, (15) provisions in our certificate of incorporation and bylaws and of Delaware law may prevent or delay an acquisition of our company, which could decrease the market value of our common stock, (16) other factors identified in the document entitled ‘‘Risk Factors’’ filed as Exhibit 99.1 to our Annual Report on Form 10-K for the year ended December 31, 2004, and in our subsequent reports filed with the SEC. These reports are available at our Web site at www.piperjaffray.com and at the SEC’s Web site at www.sec.gov. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update them in light of new information or future events. 30 Piper Jaffray Annual Report 2004 INDEX TO AUDITED CONSOLIDATED FINANCIAL STATEMENTS Management’s Report on Internal Control Over Financial Reporting Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm Report of Independent Registered Public Accounting Firm Consolidated Financial Statements: Consolidated Statements of Financial Condition Consolidated Statements of Operations Consolidated Statements of Changes in Shareholders’ Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements Piper Jaffray Companies Page 32 33 34 35 36 37 38 39 40 Piper Jaffray Annual Report 2004 31 Piper Jaffray Companies MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING Our management is responsible for establishing and maintaining adequate internal control over our financial reporting. Our internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on its assessment and those criteria, management has concluded that we maintained effective internal control over financial reporting as of December 31, 2004. Our independent auditors have issued an attestation report on management’s assessment of our internal control over financial reporting. 32 Piper Jaffray Annual Report 2004 Piper Jaffray Companies REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of Piper Jaffray Companies We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Piper Jaffray Companies maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Piper Jaffray Companies’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating manage- ment’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstate- ments. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management’s assessment that Piper Jaffray Companies maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Piper Jaffray Companies maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the 2004 consolidated financial statements of Piper Jaffray Companies and subsidiaries and our report dated February 25, 2005 expressed an unqualified opinion thereon. Minneapolis, Minnesota February 25, 2005 Piper Jaffray Annual Report 2004 33 Piper Jaffray Companies REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors and Shareholders of Piper Jaffray Companies: In our opinion, the accompanying consolidated statements of operations, changes in shareholders’ equity, and cash flows of Piper Jaffray Companies and its subsidiaries present fairly, in all material respects, the consoli- dated results of their operations and their cash flows for the year ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by manage- ment, and evaluating the overall financial statement presentation. We believe that our audit provides a reasona- ble basis for our opinion. As discussed in Note 2 of the notes to the consolidated financial statements, in 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, ‘‘Goodwill and Other Intangible Assets.’’ Minneapolis, Minnesota April 30, 2003 34 Piper Jaffray Annual Report 2004 Piper Jaffray Companies REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM The Board of Directors and Shareholders of Piper Jaffray Companies We have audited the accompanying consolidated statements of financial condition of Piper Jaffray Companies and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Piper Jaffray Companies and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for the years then ended in conformity with U.S. generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Piper Jaffray Companies’ internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2005 expressed an unqualified opinion thereon. Minneapolis, Minnesota February 25, 2005 Piper Jaffray Annual Report 2004 35 Piper Jaffray Companies CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION DECEMBER 31 (Amounts in Thousands, Except Share Data) Assets Cash and cash equivalents Cash and cash equivalents segregated for regulatory purposes Receivables: Customers (net of allowance of $1,793 and $1,993, respectively) Brokers, dealers and clearing organizations Deposits with clearing organizations Securities purchased under agreements to resell Trading securities owned Trading securities owned and pledged as collateral Total trading securities owned Fixed assets (net of accumulated depreciation and amortization of $110,928 and $103,573, respectively) Goodwill and intangible assets (net of accumulated amortization of $52,664 and $52,531, respectively) Other receivables Other assets Total assets Liabilities and Shareholders’ Equity Short-term bank financing Payables: Customers Checks and drafts Brokers, dealers and clearing organizations Securities sold under agreements to repurchase Trading securities sold, but not yet purchased Accrued compensation Other liabilities and accrued expenses Total liabilities Subordinated debt Shareholders’ equity: Common stock, $0.01 par value; 100,000,000 shares authorized, 19,333,261 issued and outstanding at December 31, 2004 and 19,334,261 issued and outstanding at December 31, 2003 Additional paid-in capital Other comprehensive loss Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity See Notes to Consolidated Financial Statements 36 Piper Jaffray Annual Report 2004 2004 2003 $ 67,387 $ – 433,173 536,705 70,886 251,923 694,222 290,499 84,436 66,000 463,557 238,393 66,570 306,987 325,500 332,112 984,721 657,612 53,968 60,757 321,834 31,832 75,828 305,635 37,082 93,618 $ 2,828,257 $ 2,380,647 $ – $ 159,000 189,153 63,270 287,217 312,273 746,604 184,608 139,704 226,163 64,438 224,208 178,716 392,456 194,583 91,288 1,922,829 180,000 1,530,852 180,000 193 678,755 (3,868) 50,348 193 669,602 – – 725,428 669,795 $ 2,828,257 $ 2,380,647 CONSOLIDATED STATEMENTS OF OPERATIONS YEAR ENDED DECEMBER 31, (Amounts in Thousands, Except Per Share Data) Revenues: Commissions and fees Principal transactions Investment banking Interest Other income Total revenues Interest expense Net revenues Non-interest expenses: Compensation and benefits Occupancy and equipment Communications Floor brokerage and clearance Marketing and business development Outside services Cash award program Regulatory settlement Merger and restructuring Royalty fee Other operating expenses Total non-interest expenses Income before income tax expense Income tax expense Net income Earnings per common share Basic Diluted Weighted average number of common shares Basic Diluted See Notes to Consolidated Financial Statements Piper Jaffray Companies 2004 2003 2002 $ 263,730 $ 256,747 $ 275,682 188,526 257,932 47,469 57,967 815,624 18,126 215,191 229,945 45,276 59,082 806,241 19,511 171,957 208,740 59,685 47,303 763,367 34,315 797,498 786,730 729,052 488,394 482,397 449,329 57,066 42,198 17,309 42,468 41,477 4,717 – – – 24,248 58,025 37,599 22,755 39,030 38,511 24,000 – – 3,911 39,619 55,549 36,316 26,040 44,115 42,535 – 32,500 7,976 7,482 22,411 717,877 745,847 724,253 79,621 29,273 40,883 14,884 $ 50,348 $ 25,999 $ $ 2.60 2.60 $ $ 1.35 1.35 19,333 19,399 19,237 19,237 $ $ $ 4,799 4,693 106 0.01 0.01 19,160 19,160 Piper Jaffray Annual Report 2004 37 Piper Jaffray Companies CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (Amounts in Thousands, Except Share Amounts) Balance at December 31, 2001 Net income Capital contribution from U.S. Bancorp Distribution to U.S. Bancorp Balance at December 31, 2002 Net income Capital contribution from U.S. Bancorp Distribution to U.S. Bancorp Recapitalization upon spin-off from Common Shares Common Stock Outstanding Additional Other Paid-In Comprehensive Loss Capital Retained Earnings Invested Capital Total Shareholders’ Equity $ $ – – – – – – – – $ $ – – – – – – – – – – – – – – – – $ – $ – $ 378,724 $ – – – – – – 106 250,000 (18,973) $ – $ – $ 609,857 $ 25,999 37,500 (3,561) – – – – – – – – – – – – – – – – (669,795) 669,795 – – – – – – – $ 669,795 50,348 7,119 2,034 (3,868) – $ 725,428 U.S. Bancorp 19,334,261 193 669,602 Balance at December 31, 2003 19,334,261 $ 193 $ 669,602 $ – $ – $ Net income Amortization of restricted stock Amortization of stock options Minimum pension liability adjustment, net of tax – – – – Retirement of common stock (1,000) – – – – – – 7,119 2,034 – – – – – (3,868) – 50,348 – – – – Balance at December 31, 2004 19,333,261 $ 193 $ 678,755 $ (3,868) $ 50,348 $ See Notes to Consolidated Financial Statements 38 Piper Jaffray Annual Report 2004 CONSOLIDATED STATEMENTS OF CASH FLOWS YEAR ENDED DECEMBER 31, (Dollars in Thousands) Operating Activities: Piper Jaffray Companies 2004 2003 2002 Net income Adjustments to reconcile net income to net cash provided by (used in) operating $ 50,348 $ 25,999 $ 106 activities: Depreciation and amortization Deferred income taxes Loss on disposal of fixed assets Stock-based compensation Amortization of intangible assets Forgivable loan reserve Decrease (increase) in operating assets: Cash and cash equivalents segregated for regulatory purposes Receivables: Customers Brokers, dealers and clearing organizations Deposits with clearing organizations Securities purchased under agreements to resell Net trading securities owned Other receivables Other assets Increase (decrease) in operating liabilities: Payables: Customers Checks and drafts Brokers, dealers and clearing organizations Securities sold under agreements to repurchase Accrued compensation Other liabilities and accrued expenses 21,391 6,553 233 9,153 133 (2,100) 19,031 (6,491) 4,380 3,859 – 8,800 20,787 (11,386) 83 3,861 – – 66,000 (66,000) – 30,384 (297,405) (4,316) 55,064 27,039 7,782 11,302 (37,010) (1,333) 21,273 (64) (9,975) 43,478 10,445 (20,936) (29,988) (66,973) 32,231 27,067 19,469 82,583 6,519 10,559 (90,988) 53,611 (24,526) 187,350 223,017 (21,924) 132,123 35,341 34,049 100,190 (113,427) (37,004) (177,264) (87,422) (15,066) (52,457) Net cash provided by (used in) operating activities (2,070) (1,349) 220,957 Investing Activities: Purchases of fixed assets, net Acquisition, net of cash acquired Net cash used in investing activities Financing Activities: Increase in securities loaned Increase in securities sold under agreements to repurchase Decrease in short-term bank financing, net Decrease in subordinated debt, net Capital contribution from U.S. Bancorp Capital distribution to U.S. Bancorp Net cash provided by (used in) financing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Supplemental disclosure of cash flow information – Cash paid (received) during the year for: Interest Income taxes See Notes to Consolidated Financial Statements (14,712) (16,624) (15,109) – (5,800) – (31,336) (15,109) (5,800) 41,736 133,621 (159,000) – – – 6,467 153,913 (91,040) (35,000) 37,500 (3,561) 76,374 – (257,652) (260,000) 250,000 (18,973) 16,357 68,279 (210,251) (17,049) 84,436 51,821 32,615 4,906 27,709 $ 67,387 $ 84,436 $ 32,615 $ 16,647 $ 18,949 $ 19,427 $ (1,937) $ 36,001 1,311 $ Piper Jaffray Annual Report 2004 39 Piper Jaffray Companies NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1 Background BACKGROUND Piper Jaffray Companies is the parent company of Piper Jaffray & Co. (‘‘Piper Jaffray’’), a securities bro- ker dealer and investment banking firm; Piper Jaffray Ltd., a firm providing securities brokerage and invest- ment banking services in Europe through an office located in London, England; Piper Jaffray Financial Products Inc. and Piper Jaffray Financial Products II Inc., two entities that facilitate Piper Jaffray Compa- nies customer derivative transactions; and Piper Jaf- fray Ventures Inc. (‘‘Piper Jaffray Ventures’’), which served until December 31, 2004, as a venture capital firm managing funds that invested in emerging growth companies. Effective December 31, 2004, the manage- ment of these funds was transitioned to an indepen- dent company. On April 28, 2003, Piper Jaffray Companies was in- corporated in Delaware as a subsidiary of U.S. Bancorp (‘‘USB’’) to effect the spin-off of USB’s capital markets business to its shareholders. On De- cember 31, 2003, after receiving regulatory approval, USB distributed to its shareholders all of its interest in Piper Jaffray Companies and its subsidiaries (collec- tively, date, ‘‘Company’’). On 19,334,261 shares of Piper Jaffray Companies com- mon stock were issued to USB shareholders (the ‘‘Distribution’’). that the justments necessary to reflect the Company’s opera- tions as if the organizational changes had been consummated prior to the Distribution. However, the consolidated financial statements for periods prior to the Distribution included herein may not necessarily be indicative of the Company’s results of operations, financial position and cash flows in the future or what its results of operations, financial position and cash flows would have been had Piper Jaffray Companies been a stand-alone company prior to the Distribution. Prior to the Distribution, the consolidated results in- cluded revenues generated and expenses incurred based on customer relationships and related business activities. In certain situations, affiliated entities of USB may have provided services to, and thus charged expense to, the Company. These expenses primarily relate to providing employee-related services and ben- efits, technology and data processing services, and corporate functions including audit, tax and real es- tate management services. Costs included on the con- solidated financial statements for shared services were determined based on actual costs to USB and allocated based on the Company’s proportionate usage of those services. Proportionate usage was determined based on the number of employees, actual hours used, square footage of office space or other similar meth- odologies. Management believes the assumptions un- derlying the consolidated financial statements are reasonable. Prior to the Distribution, the consolidated financial statements included the accounts and operations of Piper Jaffray Companies and its subsidiaries as well as certain assets, liabilities and related operations trans- Prior to the Distribution, income taxes were deter- ferred to Piper Jaffray Companies from USB immedi- mined on a separate return basis as if the Company had not been eligible to be included in the consoli- ately prior to the Distribution. Because prior to the Distribution no direct ownership relationship existed dated income tax return of USB and its affiliates. among all the various units comprising the Company, However, USB was managing its tax position for the benefit of its entire portfolio of businesses, and its tax USB and its subsidiaries’ interest in the Company is strategies are not necessarily reflective of the tax strat- shown in the consolidated financial statements as in- egies that the Company would have followed as a vested capital. The consolidated financial statements, stand-alone entity. for periods prior to the Distribution, include the ad- 40 Piper Jaffray Annual Report 2004 Note 2 Summary of Significant Accounting Policies Notes To Consolidated Financial Statements PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the ac- QSPE. A QSPE can generally be described as an entity counts of Piper Jaffray Companies, its subsidiaries, with significantly limited powers that are intended to limit it to passively holding financial assets and dis- and all other entities in which the Company has a tributing cash flows based upon predetermined crite- controlling financial interest. All material intercom- pany accounts and transactions have been eliminated. ria. Based upon the guidance in SFAS No. 140, the The Company determines whether it has a controlling Company does not consolidate such QSPE’s. The financial interest in an entity by first evaluating Company accounts for its involvement with such whether the entity is a voting interest entity, a variable QSPE’s under a financial components approach in interest entity (‘‘VIE’’), a special-purpose entity which the Company recognizes only its retained residual interest in the QSPE. The Company accounts (‘‘SPE’’), or a qualifying special-purpose entity for such retained interests at fair value. (‘‘QSPE’’) under U.S. generally accepted accounting principles. Voting interest entities are entities in which the total equity investment at risk is sufficient to enable each entity to finance itself independently and provides the equity holders with the obligation to absorb losses, the right to receive residual returns and the right to make decisions about the entity’s activities. Voting interest entities are consolidated in accordance with Accounting Research Bulletin No. 51 (‘‘ARB 51’’), ‘‘Consolidated Financial Statements,’’ as amended. ARB 51 states that the usual condition for a control- ling financial interest in an entity is ownership of a majority voting interest. Accordingly, the Company consolidates voting interest entities in which it has all, or a majority of, the voting interest. As defined in Financial Accounting Standards Board Interpretation No. 46(R) (‘‘FIN 46(R)’’), ‘‘Consolida- tion of Variable Interest Entities,’’ VIE’s are entities that lack one or more of the characteristics of a voting interest entity described above. FIN 46(R) states that a controlling financial interest in an entity is present when an enterprise has a variable interest, or combi- nation of variable interests, that will absorb a major- ity of the entity’s expected losses, receive a majority of the entity’s expected residual returns, or both. The enterprise with a controlling financial interest, known as the primary beneficiary, consolidates the VIE. Ac- cordingly, the Company consolidates VIE’s in which the Company is deemed to be the primary beneficiary. SPE’s are trusts, partnerships or corporations estab- lished for a particular limited purpose. The Company follows the accounting guidance in Statement of Fi- nancial Accounting Standards No. 140 (‘‘SFAS 140’’), ‘‘Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities,’’ to deter- mine whether or not such SPE’s are required to be consolidated. The Company establishes SPE’s to securitize fixed rate municipal bonds. The majority of these securitizations meet the SFAS 140 definition of a Certain SPE’s do not meet the QSPE criteria due to their permitted activities not being sufficiently limited or to control remaining with one of the owners. These SPE’s are typically considered VIE’s and are reviewed under FIN 46(R) the primary beneficiary. to determine When the Company does not have a controlling finan- cial interest in an entity but exerts significant influence over the entity’s operating and financial policies (gen- erally defined as owning a voting or economic interest of between 20 percent to 50 percent), the Company accounts for its investment in accordance with the equity method of accounting prescribed by Account- ing Principles Board Opinion No. 18 (‘‘APB 18’’), ‘‘The Equity Method of Accounting for Investments in Common Stock.’’ If the Company does not have a controlling financial interest in, or exert significant influence over, an entity, the Company accounts for its investment at fair value. USE OF ESTIMATES The preparation of financial statements and related disclosures in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of reve- nues and expenses during the reporting period. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of cash and highly liquid investments with maturities of 90 days or less at the date of purchase. In accordance with Rule 15c3-3 of the Securities Ex- change Act of 1934, Piper Jaffray, as a registered bro- ker dealer carrying customer accounts, is subject to requirements related to maintaining cash or qualified Piper Jaffray Annual Report 2004 41 Notes To Consolidated Financial Statements securities in a segregated reserve account for the ex- clusive benefit of its customers. deferred until the related revenue is recognized or the engagement is otherwise concluded. Investment bank- ing revenues are presented net of related expenses. ALLOWANCE FOR DOUBTFUL ACCOUNTS COLLATERALIZED SECURITIES TRANSACTIONS Securities purchased under agreements to resell and securities sold under agreements to repurchase are Management estimates an allowance for doubtful ac- counts to reserve for probable losses from unsecured carried at the contractual amounts at which the secu- rities will be subsequently resold or repurchased, in- and partially secured customer accounts. Manage- cluding accrued interest. It is the Company’s policy to ment is continually evaluating its receivables from customers for collectibility and possible write-off by take possession or control of securities purchased examining the facts and circumstances surrounding under agreements to resell at the time these agree- ments are entered into. The counterparties to these each customer where a loss is deemed possible. agreements typically are primary dealers of U.S. government securities and major financial institu- tions. Collateral is valued daily, and additional collat- eral is obtained from or refunded to counterparties when appropriate. Securities borrowed and loaned result from transac- tions with other broker dealers or financial institu- tions and are recorded at the amount of cash collateral advanced or received. These amounts are included in receivables from and payable to brokers, dealers and clearing organizations on the Consoli- dated Statements of Financial Condition. Securities borrowed transactions require the Company to de- posit cash or other collateral with the lender. Securi- ties loaned transactions require the borrower to deposit cash with the Company. The Company monitors the market value of securities borrowed and loaned on a daily basis, with additional collateral ob- tained or refunded as necessary. Interest is accrued on securities borrowed and loaned transactions and is included in other assets and other liabilities and ac- crued expenses on the Consolidated Statements of Fi- nancial Condition and the respective interest balances on the Consolidated Statements of Operations. FIXED ASSETS Fixed assets include furniture and equipment, software and leasehold improvements. Depreciation of furniture and equipment and software is provided using the straight-line method over estimated useful lives of three to ten years. Leasehold improvements are amortized over their estimated useful life or the life of the lease, whichever is shorter. Additionally, certain costs incurred in connection with internal-use software projects are capitalized and amortized over the expected useful life of the asset, generally three to seven years. GOODWILL AND INTANGIBLE ASSETS Statement of Financial Accounting Standards No. 142 (‘‘SFAS 142’’), ‘‘Goodwill and Other Intangible As- sets,’’ addresses the accounting for goodwill and in- tangible assets subsequent to their acquisition. The recoverability of goodwill is evaluated annually, at a minimum, or on an interim basis if events or circum- stances indicate a possible inability to realize the car- rying amount. The evaluation includes assessing the estimated fair value of the goodwill based on market prices for similar assets, where available, and the pre- sent value of the estimated future cash flows associ- ated with the goodwill. Intangible assets with determinable lives consist of unpatented technologies that are amortized on a straight-line basis over three years. Included in other receivables are loans made to finan- cial advisors and other revenue-producing employees, typically in connection with their recruitment. These loans are forgiven based on continued employment and are amortized to compensation and benefits using the straight-line method over the terms of the loans, CUSTOMER TRANSACTIONS Customer securities transactions are recorded on a settlement date basis, while the related commission revenues and expenses are recorded on a trade date basis. Customer receivables and payables include amounts related to both cash and margin transac- tions. Securities owned by customers, including those OTHER RECEIVABLES that collateralize margin or other similar transactions, are not reflected on the Consolidated Statements of Financial Condition. INVESTMENT BANKING Investment banking revenues, which include under- writing fees, management fees and advisory fees, are which generally range from three to five years. recorded when services for the transactions are sub- stantially completed under the terms of each engage- ment. Expenses associated with such transactions are In conjunction with these loans, management esti- mates an allowance for loan losses. This allowance is 42 Piper Jaffray Annual Report 2004 Notes To Consolidated Financial Statements the including dealer prices from independent sources where they are established for situations where loan recipients leave available and reliable. A substantial percentage of the the Company prior to full forgiveness of their loan fair values recorded for the Company’s trading securi- balance and the Company is subsequently not able to ties owned and trading securities sold, but not yet recover the remaining balances. The Company deter- purchased are based on observable market prices. The mines adequacy of the allowance based upon an eval- fair values of trading securities for which a quoted the loan portfolio, uation of collectibility of unforgiven balances of departed em- market or dealer price is not available are based on ployees, recent experience related to attrition of cer- management’s estimate, using the best information available, of amounts that could be realized under tain revenue-producing employees and other pertinent current market conditions. Among the factors consid- factors. ered by management in determining the fair value of these securities are the cost, terms and liquidity of the investment, the financial condition and operating re- sults of the issuer, the quoted market price of securi- ties with similar quality and yield that are publicly traded, and other factors generally pertinent to the valuation of investments. OTHER ASSETS Included in other assets are investments that the Com- pany has made to fund certain deferred compensation liabilities for employees. The Company has fully funded these deferred compensation liabilities by in- vesting in venture capital stage companies or by in- vesting in partnerships that invest in venture capital stage companies. Future payments, if any, to partici- pants in these deferred compensation plans are di- rectly linked to the performance of these investments. No further deferrals of compensation are expected under these deferred compensation plans. Also in- cluded in other assets are the Company’s other ven- ture capital investments. Investments are carried at estimated fair value based on valuations set forth in Financial instruments carried at contract amounts that statements obtained from the underlying fund man- approximate fair value either have short-term maturi- ager or based on published market quotes, with the resulting gains and losses recognized in other income ties (one year or less), are repriced frequently, or bear on the Consolidated Statements of Operations. In the market interest rates and, accordingly, are carried at amounts approximating fair value. Financial instru- event a security is thinly traded or the market price of an investment is not readily available, management ments carried at contract amounts on the Consoli- dated Statements of Financial Condition include estimates fair value using other valuation methods de- receivables from and payables to brokers, dealers and pending on the type of security and related market. clearing organizations, securities purchased under agreements to resell, securities sold under agreements to repurchase, receivables from and payables to cus- tomers, short-term financing and subordinated debt. The fair value of over-the-counter (‘‘OTC’’) derivative contracts are valued using valuation models. The model primarily used by the Company is the present value of cash flow model, as most of the Company’s derivative products are interest rate swaps. This model requires inputs including contractual terms, market prices, yield curves, credit curves and mea- sures of volatility. Net deferred tax assets also are included in other as- sets. Refer to Note 22 for additional information re- garding income taxes. FAIR VALUE OF FINANCIAL INSTRUMENTS Substantially all of the Company’s financial instru- ments are recorded on the Company’s Consolidated Statements of Financial Condition at fair value or the contract amount. The fair value of a financial instru- ment is the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. Trading securities owned and trading securities sold, but not yet purchased are recorded on a trade date basis and are stated at market or fair value. Unreal- ized gains and losses related to these financial instru- ments are reflected in principal transactions on the Consolidated Statements of Operations. The Com- pany’s valuation policy is to use quoted market or The carrying amount of subordinated debt closely ap- proximates fair value based upon market rates of in- terest available to the Company at December 31, 2004. INCOME TAXES Income tax expense (benefit) is provided for using the asset and liability method. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to temporary differences between amounts reported for income tax purposes and financial statement purposes, using current tax rates. A valuation allowance is recognized if it is antic- ipated that some or all of a deferred tax asset will not be realized. Piper Jaffray Annual Report 2004 43 Notes To Consolidated Financial Statements Standards No. Standards No. Stock Issued to Employees,’’ and accordingly, recog- nized no compensation expense for the stock option grants as all options granted under those plans had an exercise price equal to the market value of the under- lying common stock on the date of grant. STOCK-BASED COMPENSATION Effective January 1, 2004, the Company adopted the fair value method of accounting for grants of stock- based compensation, as prescribed by Statement of Financial Accounting 123 (‘‘SFAS 123’’), ‘‘Accounting and Disclosure of Stock- Based Compensation,’’ as amended by Statement of EARNINGS PER SHARE Basic earnings per common share is computed by di- Financial Accounting 148 viding net income by the weighted average number of (‘‘SFAS 148’’), ‘‘Accounting for Stock-Based Compen- common shares outstanding for the year. Diluted sation – Transition and Disclosure.’’ SFAS 148 pro- earnings per common share is calculated by adjusting vided alternative methods of transition for a voluntary the weighted average outstanding shares to assume change to the fair value method of accounting for conversion of all potentially dilutive restricted stock stock-based employee compensation. In addition, and stock options. Because Piper Jaffray Companies SFAS 148 amended the disclosure requirements of common stock was not publicly issued until Decem- SFAS 123 to require prominent disclosures in both annual and interim financial statements about the ber 31, 2003, the date of the Distribution, the method of accounting for stock-based employee com- weighted average number of common shares out- standing for each year presented prior to the Distribu- pensation and the effect of the method used on re- tion was calculated by applying the distribution ratio ported results. utilized in the spin-off to the historical USB weighted average number of common shares outstanding for the same periods presented. Prior to the Distribution, certain employees of the Company were eligible to participate in USB employee incentive plans pursuant to which they received stock option and restricted stock awards that are described more fully in Note 17. The Company accounted for these stock option grants under the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25 (‘‘APB 25’’), ‘‘Accounting for RECLASSIFICATIONS Certain prior period amounts have been reclassified to conform to the current year presentation. Note 3 Recent Accounting Pronouncements ployee stock options, to be recognized in the income In December 2004, the Financial Accounting Stan- statement based on their fair values. Pro forma disclo- dards Board issued Statement of Financial Accounting sure is no longer an alternative. The new standard will Standards No. 123R (‘‘SFAS 123(R)’’), Share-Based be effective for the Company beginning July 1, 2005. is a revision of SFAS 123. Payment, which The Company has evaluated the impact of the adop- SFAS 123(R), which is effective for public companies for interim or annual periods beginning after June 15, tion of SFAS 123(R) and does not believe the impact 2005, supersedes APB Opinion No. 25 and amends will be significant to the Company’s overall results of operations or financial position as the Company Statement of Financial Accounting Standards No. 95, elected to account for stock-based compensation Statement of Cash Flows. Generally, the approach in under the fair value method as prescribed by SFAS 123(R) is similar to the approach described in SFAS 123. However, SFAS 123(R) requires all share- SFAS 123, effective January 1, 2004. based payments to employees, including grants of em- Note 4 Derivatives Derivative contracts are financial instruments such as forwards, futures, swaps or option contracts that de- rive their value from underlying assets, reference rates, indices or a combination of these factors. A derivative contract generally represents future commitments to purchase or sell financial instruments at specified terms on a specified date or to exchange currency or interest payment streams based on the contract or notional amount. Derivative contracts exclude certain cash instruments, such as mortgage-backed securities, interest-only and principal-only obligations and in- dexed debt instruments that derive their values or con- tractually required cash flows from the price of some other security or index. 44 Piper Jaffray Annual Report 2004 Notes To Consolidated Financial Statements In the normal course of business, the Company enters in principal transactions on the Consolidated State- into derivative contracts to facilitate customer trans- ments of Operations. Derivatives are reported on a net-by-counterparty basis when a legal right of offset actions and as a means to manage risk in certain inventory positions. The Company also enters into exists under an enforceable netting agreement. interest rate swap agreements to manage interest rate exposure associated with holding residual interest se- curities from its tender option bond program. As of December 31, 2004 and 2003, the Company was counterparty to notional/contract amounts of $2.5 billion and $0.8 billion, respectively, of deriva- tive instruments. Fair values for derivative contracts represent amounts estimated to be received from or paid to a counterparty in settlement of these instruments. These derivatives are valued using quoted market prices when available or pricing models based on the net present value of estimated future cash flows. The valu- ation models used require inputs including contrac- tual terms, market prices, yield curves, credit curves and measures of volatility. The net fair value of deriv- ative contracts was an asset of approximately $1.7 million and a liability of approximately $2.2 mil- lion as of December 31, 2004 and 2003, respectively. The market or fair values related to derivative con- tract transactions are reported in trading securities owned and trading securities sold, but not yet pur- chased on the Consolidated Statements of Financial Condition and any unrealized gain or loss resulting from changes in fair values of derivatives is recognized Note 5 Receivables from and Payables to Brokers, Dealers and Clearing Organizations Amounts receivable from brokers, dealers and clear- Amounts payable to brokers, dealers and clearing or- ing organizations at December 31 included: ganizations at December 31 included: (Dollars in Thousands) 2004 2003 (Dollars in Thousands) 2004 2003 Receivable arising from unsettled Deposits received for securities securities transactions, net $ 264,471 $ 106,187 loaned 116,041 72,751 Securities failed to receive Payable to clearing organizations Other $ 222,902 $ 181,166 44,226 19,986 103 8,990 31,926 2,126 Deposits paid for securities borrowed Receivable from clearing organizations Securities failed to deliver Other 52,822 88,286 15,085 10,577 34,277 14,601 Total receivables $ 536,705 $ 238,393 Total payables $ 287,217 $ 224,208 Securities failed to deliver and receive represent the contract value of securities that have not been deliv- ered or received by the Company on settlement date. Deposits paid for securities borrowed and deposits received for securities loaned approximate the market value of the related securities. Note 6 Receivables from and Payables to Customers Amounts receivable from customers at December 31 included: (Dollars in Thousands) Cash accounts Margin accounts 2004 2003 $ 27,211 $ 81,853 405,962 381,704 Total receivables $ 433,173 $ 463,557 Securities owned by customers are held as collateral for margin loan receivables. This collateral is not re- flected on the consolidated financial statements. Mar- gin loan receivables earn interest at floating interest rates based on broker call rates. Piper Jaffray Annual Report 2004 45 Notes To Consolidated Financial Statements Amounts payable to customers at December 31 included: (Dollars in Thousands) Cash accounts Margin accounts 2004 2003 $ 120,572 $ 168,901 68,581 57,262 Total payables $ 189,153 $ 226,163 Payables to customers primarily comprise certain cash balances in customer accounts consisting of customer funds pending settlement of securities transactions and customer funds on deposit. Except for amounts arising from customer short sales, all amounts payable to customers are subject to withdrawal by customers upon their request. Note 7 Trading Securities Owned and Trading Securities Sold, but Not Yet Purchased At December 31, trading securities owned and trading At December 31, 2004 and 2003, trading securities owned in the amount of $290.5 million and securities sold, but not yet purchased were as follows: $332.1 million, respectively, have been pledged as col- lateral for the Company’s secured borrowings, repur- chase agreements and securities loaned activities. (Dollars in Thousands) 2004 2003 Owned: Corporate securities: Equity securities Convertible securities Fixed income securities Mortgage-backed securities U.S. government securities Municipal securities Other Sold, but not yet purchased: Corporate securities: Equity securities Convertible securities Fixed income securities Mortgage-backed securities U.S. government securities Municipal securities Other $ 9,490 93,480 208,494 459,322 37,244 165,435 11,256 $ 984,721 $ 15,903 311,038 78,474 90,459 Trading securities sold, but not yet purchased repre- sent obligations of the Company to deliver the speci- fied security at the contracted price, thereby creating a liability to purchase the security in the market at pre- vailing prices. The Company is obligated to acquire 21,502 the securities sold short at prevailing market prices, 136,288 which may exceed the amount reflected on the Con- solidated Statements of Financial Condition. The Company manages the risk of changes in market value of its trading securities owned utilizing trading securi- ties sold, but not yet purchased, interest rate swaps and listed options. 3,948 $ 657,612 $ 59,106 $ 46,700 12,600 155,534 406,621 103,148 – 9,595 1,137 14,316 118,754 205,110 264 6,175 $ 746,604 $ 392,456 Note 8 Collateralized Securities Transactions The Company’s financing and customer securities ac- tivities involve the Company using securities as collat- eral. In the event that the counterparty does not meet its contractual obligation to return securities used as collateral, or customers do not deposit additional se- curities or cash for margin when required, the Com- pany may be exposed to the risk of reacquiring the securities or selling the securities at unfavorable mar- ket prices in order to satisfy its obligations to its cus- tomers or counterparties. The Company seeks to control this risk by monitoring the market value of securities pledged or used as collateral on a daily basis and requiring adjustments in the event of excess mar- ket exposure. In the normal course of business, the Company ob- tains securities purchased under agreements to resell, securities borrowed and margin agreements on terms that permit it to repledge or resell the securities to others. The Company obtained securities with a fair 46 Piper Jaffray Annual Report 2004 Notes To Consolidated Financial Statements value of approximately $931.6 million and At December 31, 2004, the Company’s securities sold under agreements to repurchase (‘‘Repurchase Liabili- $914.5 million at December 31, 2004 and 2003, re- spectively, of which $489.8 million and $498.8 mil- ties’’) exceeded 10 percent of total assets. lion, respectively, has been either pledged or otherwise transferred to others in connection with the Com- pany’s financing activities or to satisfy its commit- ments under trading securities sold, but not yet purchased. The following is a summary of Repurchase Liabilities as of December 31, 2004: Carrying Amount of Assets Sold Repurchase Liabilities Interest Rates $ 305,262 $ 299,334 1.70%-2.52% 7,445 5,652 7,361 5,578 1.70% 0.70%-1.75% $ 318,359 $ 312,273 For the years ended December 31, 2004, 2003 and 2002, depreciation and amortization of furniture and equipment, software and leasehold improvements to- taled $21.4 million, $19.0 million and $20.8 million, respectively, and is included in occupancy and equip- ment on the Consolidated Statements of Operations. (Dollars in Thousands) Overnight maturity 1-30 days maturity On demand maturity Note 9 Fixed Assets The following is a summary of fixed assets as of De- cember 31, 2004 and 2003: (Dollars in Thousands) 2004 2003 Furniture and equipment Leasehold improvements Software Projects in process Total Less accumulated depreciation and $ 89,217 $ 93,323 30,538 38,803 6,338 27,999 40,823 2,185 164,896 164,330 amortization 110,928 103,573 $ 53,968 $ 60,757 Piper Jaffray Annual Report 2004 47 Notes To Consolidated Financial Statements Note 10 Goodwill and Intangible Assets The following table presents the changes in the carry- ing value of goodwill and intangible assets by reporta- ble segment for the year ended December 31, 2004: (Dollars in Thousands) Goodwill Balance at December 31, 2003 Goodwill acquired Impairment losses Balance at December 31, 2004 Intangible assets Balance at December 31, 2003 Intangible assets acquired Amortization of intangible assets Impairment losses Capital Markets Private Client Services Corporate Support and Other Consolidated Company $ 220,035 $ 85,600 $ – $ 305,635 11,532 – – – – – 11,532 – $ 231,567 $ 85,600 $ – $ 317,167 $ – $ 4,800 (133) – – – – – – $ – $ – – – – $ – $ – 4,800 (133) – $ 4,667 $ 321,834 Balance at December 31, 2004 $ 4,667 $ Total goodwill and intangible assets $ 236,234 $ 85,600 The additions of goodwill and intangible assets during 2004 were based on the purchase price allocation of the Vie Securities, LLC acquisition in November 2004, as discussed in Note 23. The intangible assets consist of unpatented technology that will be amor- tized over three years, based on the provisions of SFAS 142. Note 11 Short-Term Financing 2005. The Company has uncommitted credit agreements will be used as necessary to facilitate convertible un- derwriting transactions. The temporary subordinated with banks totaling $650 million at December 31, 2004, composed of $530 million in discretionary se- debt satisfies provisions of Appendix D of SEC cured lines and $120 million in discretionary un- Rule 15c3-1, and in form has been approved by the lines. In addition, the Company has NYSE and would therefore be allowed in Piper Jaf- secured established arrangements to obtain financing using as fray’s net capital computation. The term of the agree- collateral the Company’s securities held by its clearing ment is from December 20, 2004 to December 20, bank and by another broker dealer at the end of each business day. Repurchase agreements and securities loaned to other broker dealers are also used as sources of funding. The Company’s subordinated debt and short-term bank financing bear interest at rates based on the London Interbank Offered Rate or federal funds rate. Piper Jaffray has executed a $180 million subordi- At December 31, 2004 and 2003, the weighted aver- age interest rate on borrowings was 3.51 percent and nated debt agreement with an affiliate of USB, which 2.07 percent, respectively. At December 31, 2004 and satisfies provisions of Appendix D of SEC Rule 15c3- 2003, no formal compensating balance agreements 1 and has been approved by the New York Stock existed, and the Company was in compliance with all Exchange, Inc. (‘‘NYSE’’) and is therefore allowable debt covenants related to these facilities. The Com- in Piper Jaffray’s net capital computation. The entire pany recognized and paid to USB and affiliates amount of the subordinated debt will mature in 2008. $9.0 million and $15.9 million of interest expense related to borrowings for the years ended Decem- ber 31, 2003 and 2002, respectively. During 2004, Piper Jaffray entered into an agreement whereby an affiliate of USB has agreed to provide up to $40 million in temporary subordinated debt, which 48 Piper Jaffray Annual Report 2004 Notes To Consolidated Financial Statements Note 12 Commitments, Contingencies and Guarantees In the normal course of business, the Company enters into various commitments and guarantees, and main- tains contingency reserves, the most significant of which are as follows: partnerships that make private equity investments. The commitments will be funded, if called, through the end of the respective investment periods ranging from 2005 to 2011. CONTRACTUAL COMMITMENTS The Company leases office space and equipment under various noncancelable leases. Certain leases have renewal options and clauses for escalation and operating cost adjustments. Aggregate minimum lease commitments under operating leases as of Decem- ber 31, 2004 are as follows: (Dollars in Thousands) 2005 2006 $ 27,115 23,193 LEGAL CONTINGENCIES The Company has been the subject of customer com- plaints and also has been named as a defendant in various legal proceedings arising primarily from secu- rities brokerage and investment banking activities, in- cluding certain class actions that primarily allege violations of securities laws and seek unspecified dam- ages, which could be substantial. Also, the Company is involved from time to time in investigations and proceedings by governmental agencies and self-regula- tory organizations. 2007 21,731 2008 2009 $ 188,133 Thereafter available as of December 31, 2004. The Company has established reserves for potential 21,083 losses that are probable and reasonably estimable that 20,843 may result from pending and potential complaints, 74,168 legal actions, investigations and proceedings. In addi- tion to the Company’s established reserves, USB has agreed to indemnify the Company in an amount up to $17.5 million for certain legal and regulatory matters. Rental expense, including operating costs and real es- Approximately $14.2 million of this amount remained tate taxes, charged to operations was $28.1 million, $27.5 million and $30.8 million for the years ended December 31, 2004, 2003 and 2002, respectively. Given uncertainties regarding the timing, scope, vol- ume and outcome of pending and potential litigation, arbitration and regulatory proceedings and other fac- Additionally, the Company has entered into contracts tors, the reserve is difficult to determine and of neces- with outside vendors to support the Company’s tech- sity subject to future revision. Subject to the nology and securities processing. The contracts range foregoing, management of the Company believes, from three to five years with the last contract expiring in 2009. Aggregate minimum contract commitments based on its current knowledge, after consultation as of December 31, 2004, for services pursuant to the with counsel and after taking into account its estab- lished reserves and the USB indemnity agreement en- contracts are as follows: tered into in connection with the spin-off, that pending legal actions, investigations and proceedings will be resolved with no material adverse effect on the financial condition of the Company. However, if dur- ing any period a potential adverse contingency should become probable or resolved for an amount in excess of the established reserves and indemnification, the results of operations in that period could be materially adversely affected. (Dollars in Thousands) $ 45,407 $ 13,394 10,938 11,722 8,696 2006 2009 2008 2007 2005 657 Service expense related to the contracts that was charged to operations in 2004 and 2003 was $12.9 million and $2.7 million, respectively. VENTURE CAPITAL COMMITMENTS As of December 31, 2004, the Company had commit- ments to invest approximately $4.8 million in limited Litigation-related expenses charged to operations in- cluded within other operating expenses were $4.4 mil- lion, $16.1 million, and $10.9 million for the years ended December 31, 2004, 2003 and 2002, respectively. Piper Jaffray Annual Report 2004 49 Notes To Consolidated Financial Statements OTHER COMMITMENTS SECURITIES LENDING The Company is a member of numerous exchanges As a funding source for the Company, the Company participates in securities lending activities by using and clearinghouses. Under the membership agree- customer excess margin securities. The Company in- ments with these entities, members generally are re- demnifies customers for the difference between the quired to guarantee the performance of other market value of the securities loaned and the market members, and if a member becomes unable to satisfy value of the collateral received. Cash collateralizes its obligations to the clearinghouse, other members these transactions. At December 31, 2004, future pay- would be required to meet shortfalls. To mitigate these performance risks, the exchanges and clearing- ments guaranteed by the Company under these ar- houses often require members to post collateral. The rangements were approximately $212.7 million and represent the market value of the customer securities Company’s maximum potential liability under these arrangements cannot be quantified. However, the like- loaned to third parties. At December 31, 2004, the lihood that the Company would be required to make Company held cash of $222.5 million as collateral for payments under these arrangements is remote. Ac- these arrangements. The value of this collateral is in- cordingly, no liability is recorded in the consolidated cluded on the Consolidated Statements of Financial Condition within payables to brokers, dealers and financial statements for these arrangements. clearing organizations. At December 31, 2004, the Company had collateral in excess of the market value of the securities loaned and, therefore, no liability is recorded related to potential future payments made under these guarantees. CONCENTRATION OF CREDIT RISK The Company provides investment, capital-raising and related services to a diverse group of domestic and foreign customers, including governments, corpo- rations, and institutional and individual investors. The Company’s exposure to credit risk associated REIMBURSEMENT GUARANTEE The Company has contracted with a major third- with the non-performance of customers in fulfilling their contractual obligations pursuant to securities party financial institution to act as the liquidity pro- transactions can be directly impacted by volatile secu- vider for the Company’s tender option bond securi- rities markets, credit markets and regulatory changes. tized trusts. The Company has agreed to reimburse This exposure is measured on an individual customer this party for any losses associated with providing basis and on a group basis for customers that share liquidity to the trusts. The maximum exposure to loss similar attributes. To alleviate the potential for risk at December 31, 2004 and 2003 was $246.9 million concentrations, credit limits are established and con- and $166.2 million, respectively, representing the out- standing amount of all trust certificates at those dates. tinually monitored in light of changing customer and This exposure to loss is mitigated by the underlying market conditions. As of December 31, 2004 and bonds in the trusts, which are either AAA or AA 2003, the Company did not have significant concen- trations of credit risk with any one customer or rated. These bonds had a market value of approxi- counterparty, or any group of customers or mately $260.0 million and $176.0 million at Decem- ber 31, 2004 and 2003, respectively. The Company counterparties, except as discussed below. believes the likelihood it will be required to fund the reimbursement agreement obligation under any provi- sion of the arrangement is remote, and accordingly, no liability for such guarantee has been recorded in the accompanying consolidated financial statements. The Company had approximately $220.6 million in collateralized overnight repurchase agreements with one broker dealer at December 31, 2004. Note 13 Merger and Restructuring Items The Company recorded pre-tax merger and restruc- market volatility, declines in equity valuations and an increasingly competitive environment for the securi- turing-related charges of $8.0 million in 2002. Costs ties industry. The restructuring was designed to im- of $2.2 million were incurred in connection with the prove the operating efficiency of the business by merger of USB and Firstar Corporation (‘‘Firstar’’). removing excess capacity from the product distribu- Costs of $5.8 million were incurred to restructure the tion network and by implementing more effective bus- Company’s operations in response to significant iness processes. changes in the securities markets, including increased 50 Piper Jaffray Annual Report 2004 Notes To Consolidated Financial Statements USB/ Firstar Piper Restructuring Total $ – 2,161 – $ 5,314 $ 5,314 – 501 2,161 501 $ 2,161 $ 5,815 $ 7,976 The components of the charges described above are shown below for the year ended December 31, 2002: (Dollars in Thousands) Severance and employee-related Business integration costs Asset write-downs and lease terminations Total The Company determined merger and restructuring charges and related accruals based on specific formu- lated plans or integration strategies. Business integration charges primarily pertained to costs incurred to realign the retail distribution net- works and integrate certain components of a USB af- filiate’s fixed income division with the fixed income business of Piper Jaffray. Severance and employee-related charges included the cost of severance, other benefits and outplacement costs associated with the termination of employees Asset write-downs and lease terminations represented costs associated with redundant office space, branches due to the reconfiguration or closure of certain that were vacated, and equipment disposed of as part branches and the downsizing and consolidation of of the restructuring plans. Generally, payments related certain back office support functions. The severance to terminated lease contracts continue through the amounts were determined based on the Company’s severance pay programs in place at the time of termi- original term of the lease. nation and were paid out over a benefit period of up to two years from the time of termination. Approxi- mately 110 employees received severance or otherwise caused the Company to incur employee-related sever- ance charges for 2002. The following table presents a summary of activity with respect to the merger and restructuring-related accruals: (Dollars in Thousands) Balance at December 31, 2001 Provision charged to operating expense Cash outlays Noncash write-downs and other Balance at December 31, 2002 Cash outlays Noncash write-downs and other Balance at December 31, 2003 Cash outlays Noncash write-downs and other Balance at December 31, 2004 USB/ Firstar Piper Restructuring Total $ – $ 18,102 $ 18,102 2,161 (853) – 5,815 7,976 (13,277) (14,130) (1,617) (1,617) $ 1,308 $ 9,023 $ 10,331 (1,308) – – – – – $ $ (6,547) (144) (7,855) (144) $ 2,332 $ 2,332 (898) (500) (898) (500) $ 934 $ 934 The adequacy of the merger and restructuring-related liability is reviewed regularly, taking into considera- tion actual and projected payment liabilities. Adjust- ments are made to increase or decrease these accruals as needed. Reversals of expenses, if any, can reflect a lower-than-expected use of benefits by affected em- ployees, changes in initial assumptions as a result of subsequent events, and the alteration of business inte- gration plans. Piper Jaffray Annual Report 2004 51 Notes To Consolidated Financial Statements Note 14 Transactions with U.S. Bancorp Prior to the Distribution Prior to the Distribution, the Company regularly en- During 2003, Piper Jaffray repaid its outstanding sub- ordinated debt of $215.0 million and entered into a tered into transactions with USB and its affiliates. These transactions resulted in either charges to or re- new subordinated debt agreement of $180.0 million imbursements from the Company, including fees for with an affiliate of USB. The Company received capi- tal contributions of $37.5 million and $250.0 million referrals, fees for the underwriting and selling of USB in 2003 and 2002, respectively, from USB. Addition- affiliated mutual funds and costs for occupancy, tech- ally, the Company made distributions of $3.6 million nology support and general and administrative ser- and $19.0 million to USB in 2003 and 2002, vices. Royalty fees for the use of the USB brand names and other USB trademarks were charged to the Com- respectively. pany by a USB affiliate in the amount of $3.9 million and $7.5 million for the years ended December 31, 2003 and 2002, respectively. Note 15 Net Capital Requirements and Other Regulatory Matters As a registered broker dealer and member firm of the NYSE, Piper Jaffray is subject to the Uniform Net Capital Rule (the ‘‘Rule’’) of the SEC and the net capital rule of the NYSE. Piper Jaffray has elected to use the alternative method permitted by the Rule, which requires that it maintain minimum net capital of the greater of $1.0 million or 2 percent of aggregate debit balances arising from customer transactions, as such term is defined in the Rule. The NYSE may pro- hibit a member firm from expanding its business or paying dividends if resulting net capital would be less than 5 percent of aggregate debit balances. Advances to affiliates, repayment of subordinated debt, dividend payments and other equity withdrawals by Piper Jaf- fray are subject to certain notification and other pro- visions of the Rule and the net capital rule of the NYSE. In addition, Piper Jaffray is subject to certain notification requirements related to withdrawals of excess net capital. At December 31, 2004, net capital under the Rule was $280.3 million, or 49.2 percent of aggregate debit balances, and $268.9 million in excess of the mini- mum net capital required under the Rule. Piper Jaffray is also registered with the Commodity Futures Trading Commission (‘‘CFTC’’) and therefore is subject to CFTC regulations. Piper Jaffray Ltd., which is a registered United King- dom broker dealer, is subject to the capital require- ments of the Financial Services Authority (‘‘FSA’’). As of December 31, 2004, Piper Jaffray Ltd. was in com- pliance with the capital requirements of the FSA. 52 Piper Jaffray Annual Report 2004 Note 16 Employee Benefit Plans Notes To Consolidated Financial Statements The Company has various employee benefit plans, Retirement Plan at the time of the Distribution, the profit-sharing component of the plan was operated as and substantially all employees are covered by at least a stand-alone plan. The Company expensed $7.3 mil- one plan. The plans include a 401(k) and profit-shar- lion and $9.5 million related to profit-sharing contri- ing plan, a non-qualified pension plan, a post-retire- butions in 2004 and 2003, respectively. There was no ment benefit plan and health and welfare plans. During the years ended December 31, 2004, 2003 and such expense in 2002. 2002, the Company incurred employee benefit ex- penses of $28.2 million, $31.3 million and $23.2 mil- lion, respectively. RETIREMENT PLAN Effective with the Distribution, the Company estab- lished the Piper Jaffray Companies Retirement Plan (‘‘Retirement Plan’’), which has two components: a defined contribution retirement savings plan and a qualified, non-contributory profit-sharing plan. The defined contribution retirement savings plan allows qualified employees, at their option, to make contri- butions through salary deductions under Sec- tion 401(k) of the Internal Revenue Code. Employee contributions are 100 percent matched by the Com- pany to a maximum of 4 percent of recognized com- pensation up to the social security taxable wage base. Although the Company’s matching contribution vests immediately, a participant must be employed on De- cember 31 to receive that year’s matching contribu- tion. The matching contribution can be made in cash or Piper Jaffray Companies common stock. Prior to the Distribution, Company employees partici- pated in a similar USB defined contribution retirement savings plan. Effective upon the Distribution, employ- ees of the Company became inactive participants in the USB plan, similar to terminated employees. PENSION AND POST-RETIREMENT MEDICAL PLANS Certain employees participate in the Piper Jaffray Companies Non-Qualified Retirement Plan, an un- funded, non-qualified cash balance pension plan. This plan is substantially similar to a non-qualified cash balance pension plan maintained by USB, which Com- pany employees participated in prior to the Distribu- tion. Effective upon the Distribution, the existing non- qualified pension liability relating to Company em- ployees was transferred from the USB cash balance pension plan to the Company’s new plan. As most of the Company’s employees participating in the USB plan were fully vested, the Company froze the new plan immediately upon establishment, thereby elimi- nating future benefits related to pay increases and ex- cluding new participants from the plan. The Company recorded a $1.1 million pre-tax curtailment gain as a result of freezing the plan. All employees of the Company who meet defined age and service requirements are eligible to receive post- retirement health care benefits provided under a post- retirement benefit plan established by the Company in 2004. The estimated cost of these retiree health care benefits is accrued during the employees’ active service. Prior to the Distribution, Company employees were eligible for retiree health care benefits as part of a substantially similar USB post-retirement benefit plan. The qualified, non-contributory profit-sharing compo- nent of the Retirement Plan covers substantially all employees. Company profit-sharing contributions are discretionary within limits to qualify as deductions for income tax purposes. Employees are fully vested after five years of service. Prior to the establishment of the December 31, 2004 and 2003, are as follows: The Company uses a September 30 measurement date for the pension and post-retirement benefit plans. Fi- nancial information on changes in benefit obligation and plan assets funded and balance sheet status as of Piper Jaffray Annual Report 2004 53 Notes To Consolidated Financial Statements (Dollars in Thousands) Change in benefit obligation: Benefit obligation at beginning of year Service cost Interest cost Plan participant’s contributions Actuarial loss (gain) Curtailments Benefits paid Pension Benefits Postretirement Medical Benefits 2004 2003 2004 2003 $ 27,254 $ 27,684 $ 1,448 $ 1,036 – 1,363 – 2,753 (819) (1,162) – 1,817 – 1,157 – (3,404) 185 66 – (12) – – 246 88 – 78 – – Benefit obligation at measurement date $ 29,389 $ 27,254 $ 1,687 $ 1,448 Change in plan assets: Fair value of plan assets at beginning of year Actual return on plan assets Employer contribution Plan participant’s contributions Benefits paid $ $ – – $ – – 1,162 – 3,404 – (1,162) (3,404) Fair value of plan assets at measurement date $ – $ – $ – – – – – – $ $ – – – – – – Funded status Adjustment for fourth quarter contributions Unrecognized net actuarial loss (gain) Unrecognized prior service cost Net amount recognized Amounts recognized in the Consolidated Statements of Financial Condition: Accrued benefit liability Accumulated other comprehensive loss Net amount recognized Accumulated benefit obligation $ (29,389) $ (27,254) $ (1,687) $ (1,448) 1,260 6,381 – – 4,592 (1,282) – 328 (424) – 361 (471) $ (21,748) $ (23,944) $ (1,783) $ (1,558) $ (28,129) $ (23,944) $ (1,783) $ (1,558) 6,381 – – – $ (21,748) $ (23,944) $ (1,783) $ (1,558) $ 29,389 $ 25,077 The minimum pension liability adjustment included in ‘‘other comprehensive loss’’ at December 31, 2004, is $3.9 million, which is net of a $2.5 million deferred tax benefit. The components of the net periodic benefits costs for the years ended December 31, 2004, 2003 and 2002, are as follows: (Dollars in Thousands) Service cost Interest cost Expected return on plan assets Amortization of prior service cost Amortization of net (gain) loss Curtailment gain Pension Benefits Post-retirement Medical Benefits 2004 2003 2002 2004 2003 2002 $ – $ 1,363 (158) 145 (1,124) – 1,817 – $ – 1,882 – $ 185 66 – $ 246 88 – (210) (210) (48) (64) 185 – – – 22 – 25 – $ 177 70 – (52) 2 – Net periodic benefit cost $ 226 $ 1,792 $ 1,672 $ 225 $ 295 $ 197 54 Piper Jaffray Annual Report 2004 The assumptions used in the measurement of our ben- efit obligations as of December 31, 2004 and 2003, are as follows: Discount rate used to determine year-end obligation Discount rate used to determine fiscal year expense Expected long-term rate of return on participant balances Rate of compensation increase Health care cost trend rate assumed for next year (pre-medicare/post-medicare) Rate to which the cost trend rate is assumed to decline (the ultimate trend rate) (pre-medicare/post-medicare) Year that the rate reaches the ultimate trend rate (pre-medicare/post-medicare) Notes To Consolidated Financial Statements Pension Benefits Post-retirement Benefits 2004 2003 2004 2003 6.00% 6.20% 6.50% N/A 6.20% 6.80% 5.50% N/A 6.00% 6.20% N/A N/A 2004 6.20% 6.80% N/A N/A 2003 10%/12% 10%/12% 5.0%/5.0% 5.5%/6.0% 2012/2013 2011/2011 The health care cost trend rate assumption does not have a significant impact on the post-retirement medi- cal benefit obligations since the Company’s obliga- tions are largely fixed dollar amounts in future years. To illustrate, a one-percentage-point change in as- sumed health care cost trends would have the follow- ing effects: (Dollars in Thousands) Effect on total of service and interest cost Effect on post-retirement benefit obligation 1-Percentage-Point Increase 1-Percentage-Point Decrease $ 1 3 $ (1) (4) The pension plan and post-retirement medical plan do HEALTH AND WELFARE PLANS not have assets and are not funded. The Company expects to contribute cash of $4.5 million to the pen- sion plan and $0.1 million to the post-retirement ben- efit plan to fund anticipated withdrawals in 2005. Company employees meeting certain work sched- ule and service requirements are eligible to par- ticipate in the Company’s health and welfare plans. The Company subsidizes the cost of cover- age for employees. The medical plan contains cost-sharing features such as deductibles and coinsurance. Pension and post-retirement benefit payments, which reflect expected future service, are expected to be paid as follows: (Dollars in Thousands) 2005 2006 2007 2008 2009 Thereafter Pension Benefits Post- Retirement Benefits $ 4,531 $ 2,426 2,812 2,267 2,125 9,979 87 131 166 214 222 1,599 $ 24,140 $ 2,419 Piper Jaffray Annual Report 2004 55 Notes To Consolidated Financial Statements Note 17 Stock-Based Compensation and Cash Award Program In 2004, the Company granted shares of restricted stock and options to purchase Piper Jaffray Compa- nies common stock to employees and directors. The awards granted to employees have three-year cliff vesting periods. The director awards are fully vested upon grant. The following table summarizes the Com- pany’s stock options and restricted stock outstanding for the year ended December 31, 2004: December 31, 2003 Granted: Stock options Restricted stock Exercised Canceled options Canceled restricted stock December 31, 2004 Additional information regarding Piper Jaffray Com- panies options outstanding as of December 31, 2004, is as follows: Range of Exercise Prices $47.30 – $51.05 Options Outstanding Weighted Average Exercise Price – – 322,005 $ 47.49 – – 26,322 – – – 47.30 – 295,683 $ 47.50 Shares of Restricted Stock Outstanding – – 550,659 – – 18,774 531,885 Options Outstanding Exercisable Options Weighted Average Weighted Average Exercise Price Remaining Contractual Life (Years) Weighted Average Exercise Price Shares Shares 295,683 9.1 $ 47.50 21,249 $ 50.13 Dividend yield Stock volatility factor Risk-free interest rates Expected life of options (in years) the estimated value of stock option grants in Piper Jaffray Companies common stock: Effective January 1, 2004, the Company elected to account for stock-based compensation under the fair value method as prescribed by SFAS 123 and as amended by SFAS 148. Therefore, employee and di- Weighted average assumptions in option valuation rector stock options granted on and after January 1, 2004, are expensed by the Company on a straight-line basis over the option vesting period, based on the estimated fair value of the award on the date of grant using a Black-Scholes option-pricing model. Re- Weighted average fair value of options granted stricted stock expense is based on the market price of Piper Jaffray Companies stock on the date of the grant Certain of the Company’s employees received cash awards under a program established in connection and is amortized on a straight-line basis over the vest- ing period. For the year ended December 31, 2004, with the Distribution. The cash award program was intended to aid in retention of employees and to com- the Company recorded compensation expense, net of pensate employees for the value of USB stock options estimated forfeitures, of $8.9 million related to em- and restricted stock lost by employees as a result of ployee stock option and restricted stock grants and the Distribution. The cash award program has an ag- $0.3 million in outside services expense related to di- gregate maximum value of approximately $47.0 mil- rector stock option and grants. lion. The Company incurred a $24.0 million charge at the time of the Distribution for the portion of the cash awards that were paid within 120 days of the Distri- bution. The remaining cash awards vest and will be The following table provides a summary of the valua- tion assumptions used by the Company to determine $ 21.24 5.79 3.20% 0.00% 40.00% 56 Piper Jaffray Annual Report 2004 Notes To Consolidated Financial Statements expensed over the next three years. Participants must be employed on the date of payment to receive the award. Expense related to the cash award program is included as a separate line item on the Company’s Consolidated Statements of Operations. Prior to the Distribution, certain of the Company’s employees were eligible to participate in the stock incentive plans maintained by USB, which included non-qualified and incentive stock options, restricted stock and other stock-based awards. While part of USB, the Company applied APB 25 in accounting for USB employee stock incentive plans. Because the exer- cise price of the USB employee stock options equaled the market price of the underlying stock on the date of the grant, under APB 25, no compensation expense was recognized at the grant date. Options granted under the USB plans were generally exercisable up to ten years from the date of grant and vested over three to five years. Restricted shares vested over three to five years. Expense for restricted stock was based on the market price of USB stock at the time of the grant and amortized on a straight-line basis over the vesting pe- riod. Expense related to restricted stock grants was $3.9 million in 2003 and 2002, respectively. Based on the USB plans, these options and restricted stock ei- ther terminated within 90 days following the Distribu- tion or remained with USB. The following table summarizes USB stock options and restricted stock outstanding and exercised under various equity plans of USB while the Company’s em- ployees were employed by USB: December 31, 2001 Granted: Stock options Restricted stock Exercised Canceled options Canceled/vested restricted stock December 31, 2002 Exercised Canceled options Canceled/vested restricted stock December 31, 2003 Options Outstanding Weighted Average Exercise Price Shares of Restricted Stock Outstanding 19,136,420 $23.28 593,236 2,820,104 – 1,305,813 98,330 – 20,552,381 4,992,438 3,821,652 11,738,291 – 22.84 – 22.36 27.29 – $23.47 25.87 24.49 24.19 – – – – 193,569 399,667 – 327,754 71,913 – Pro forma information regarding net income is re- quired to be disclosed by SFAS No. 123 and has been determined as if the Company had accounted for em- ployee stock option and stock purchase plans (collec- tively, the ‘‘options’’) under the fair value method of SFAS 123. The fair value of the options was estimated at the grant date using a Black-Scholes option-pricing model. The pro forma disclosures include USB options granted to the Company’s employees while employed by USB and therefore should not be viewed as repre- sentative of future years. Furthermore, the value of certain of USB options that terminated as a result of the Distribution were replaced by cash awards to our employees. The following table shows pro forma compensation expense, net income and earnings per share adjusted for the impact of applying the fair value method of accounting for stock-based compensation. Piper Jaffray Annual Report 2004 57 Notes To Consolidated Financial Statements YEAR ENDED DECEMBER 31 (Dollars in Thousands, Except Per Share Data) Reported compensation expense Stock-based compensation Pro forma compensation expense Reported net income Stock-based compensation, net of tax Pro forma net income (loss) Pro forma earnings per share Weighted average assumptions in USB option valuation Risk-free interest rates Dividend yields Stock volatility factor Expected life of options (in years) Weighted average fair value of options granted Note 18 Shareholders’ Equity Piper Jaffray Companies’ certificate of incorporation provides for the issuance of up to 100,000,000 shares of common stock with a par value of $0.01 per share and up to 5,000,000 shares of undesignated preferred stock with a par value of $0.01 per share. COMMON STOCK The holders of Piper Jaffray Companies common stock are entitled to one vote per share on all matters to be voted upon by the shareholders. Subject to pref- erences that may be applicable to any outstanding preferred stock of Piper Jaffray Companies, the hold- ers of its common stock are entitled to receive ratably such dividends, if any, as may be declared from time to time by the Piper Jaffray Companies board of direc- tors out of funds legally available for that purpose. In the event that Piper Jaffray Companies is liquidated, dissolved or wound up, the holders of its common stock are entitled to share ratably in all assets remain- ing after payment of liabilities, subject to any prior distribution rights of Piper Jaffray Companies pre- ferred stock, if any, then outstanding. The holders of the common stock have no preemptive or conversion rights or other subscription rights. There are no re- demption or sinking fund provisions applicable to Piper Jaffray Companies common stock. Piper Jaffray Companies does not intend to pay cash dividends on its common stock for the foreseeable future. Instead, Piper Jaffray Companies intends to retain all available funds and any future earnings for use in the operation and expansion of its business and to repurchase outstanding common stock to the ex- 58 Piper Jaffray Annual Report 2004 2003 2002 $ 482,397 $ 449,329 21,457 27,973 $ 503,854 $ 477,302 $ 25,999 $ 106 (12,874) (16,784) $ 13,125 $ (16,678) $ .68 $ (.87) 4.90% 3.00% 38.00% 6.00 7.27 $ tent authorized by its board of directors. Additionally, as set forth in Note 15, there are restrictions on its broker dealer subsidiary in paying dividends. PREFERRED STOCK The Piper Jaffray Companies board of directors has the authority, without action by its shareholders, to designate and issue preferred stock in one or more series and to designate the rights, preferences and privileges of each series, which may be greater than the rights associated with the common stock. It is not possible to state the actual effect of the issuance of any shares of preferred stock upon the rights of holders of common stock until the Piper Jaffray Companies board of directors determines the specific rights of the holders of preferred stock. However, the effects might include, among other things, the following: restricting dividends on its common stock, diluting the voting power of its common stock, impairing the liquidation rights of its common stock and delaying or preventing a change in control of Piper Jaffray Companies with- out further action by its shareholders. RIGHTS AGREEMENT Piper Jaffray Companies adopted a rights agreement prior to the Distribution date. The issuance of a share of Piper Jaffray Companies common stock also consti- tutes the issuance of a preferred stock purchase right associated with such share. These rights are intended to have anti-takeover effects in that the existence of the rights may deter a potential acquirer from making Notes To Consolidated Financial Statements a takeover proposal or a tender offer for Piper Jaffray Companies stock. EARNINGS PER SHARE Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per common share is cal- culated by adjusting the weighted average out- standing shares to assume conversion of all potentially dilutive restricted stock and stock op- tions. Because Piper Jaffray Companies common stock was not publicly issued until December 31, 2003, the date of Distribution, the weighted aver- age number of common shares outstanding for 2003 and 2002 was calculated by applying the distribution ratio utilized in the spin-off to USB’s historical weighted average number of common shares outstanding for the applicable period. The computation of earnings per share is as follows: YEAR ENDED DECEMBER 31 (Amounts in Thousands, Except Per Share Data) Net income Shares for basic and diluted calculations: Average shares used in basic computation Stock options Restricted stock Average shares used in diluted computation Earnings per share: Basic Diluted 2004 2003 2002 $ 50,348 $ 25,999 $ 106 19,333 19,237 19,160 – 66 – – – – 19,399 19,237 19,160 $ $ 2.60 2.60 $ $ 1.35 1.35 $ $ 0.01 0.01 The Company has excluded 67,000 average shares from its calculation of diluted earnings per share for the period ended December 31, 2004, as they repre- sented antidilutive stock options. There were no an- tidilutive effects for the periods ended December 31, 2003 and 2002. Note 19 Securitizations In connection with its tender option bond program, at December 31, 2004 and 2003 the Company has securitized $246.9 million and $166.2 million, respec- tively, of highly rated municipal bonds. Each munici- pal bond is sold into a separate trust that is funded by the sale of variable rate certificates to institutional customers seeking variable rate tax-free investment products. These variable rate certificates reprice weekly. Securitization transactions meeting certain SFAS 140 criteria are treated as sales, with the result- ing gain included in principal transactions on the Consolidated Statements of Operations. If a securi- tization does not meet the sale of asset requirements of SFAS 140, the transaction is recorded as a borrow- ing. The Company retains a residual interest in each structure and accounts for the residual interest as a trading security, which is recorded at fair value on the Consolidated Statements of Financial Condition. The fair value of retained interests was $10.1 million and $7.4 million at December 31, 2004 and 2003, respec- tively, with a weighted average life of 9.9 years and 9.6 years, respectively. Fair value of retained interests is estimated based on the present value of future cash flows using management’s best estimates of the key assumptions – expected yield, credit losses of 0 per- cent and a 12 percent discount rate. The Company receives a fee to remarket the variable rate certificates derived from the securitizations. At December 31, 2004, the sensitivity of the current fair value of retained interests to immediate 10 per- cent and 20 percent adverse changes in the key eco- nomic assumptions was not material. The sensitivity analysis does not include the offsetting benefit of fi- nancial instruments the Company utilizes to hedge risks inherent in its retained interests and is hypotheti- cal. Changes in fair value based on a 10 percent or 20 percent variation in an assumption generally can- not be extrapolated because the relationship of the change in the assumption to the change in the fair value may not be linear. Also, the effect of a variation in a particular assumption on the fair value of the retained interests is calculated independent of changes in any other assumption; in practice, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. In addition, the sensitivity analysis does not consider any Piper Jaffray Annual Report 2004 59 Notes To Consolidated Financial Statements Certain cash flow activity for the municipal bond securitizations described above during 2004 and 2003 includes: corrective action that the Company might take to mit- Company consolidated these trusts. As a result, the igate the impact of any adverse changes in key Company has recorded an asset for the underlying bonds of approximately $46.5 million in trading secu- assumptions. rities on the Consolidated Statement of Financial Con- dition and a liability for the certificates sold by the trust for approximately $46.3 million in other liabili- ties on the Consolidated Statement of Financial Con- dition. The Company has hedged the activities of these securitizations with interest rate swaps. The in- terest rate swap has been recorded at fair value and resulted in a liability of approximately $0.2 million at December 31, 2004. Cash flows received on retained Remarketing fees received Proceeds from new sales (Dollars in Thousands) $ 22,595 $ 98,822 2004 2003 89 98 interests 5,874 4,921 During 2004, two securitizations did not meet the asset sale requirements of SFAS 140; therefore, the Note 20 Variable Interest Entities In the normal course of business, the Company regu- included in the consolidated financial statements. The larly creates or transacts with entities that may be Company’s maximum exposure to a loss at Decem- ber 31, 2004, as a result of its relationship with these VIE’s. These entities are either securitization vehicles three VIE’s is approximately $0.6 million, which rep- or investment vehicles. resents the fair value of aggregate net investments in these partnerships and the remaining capital commit- ment to these partnerships. The Company also owns significant variable interest in two VIE’s for which the Company is not the pri- mary beneficiary and therefore does not consolidate these entities. In the aggregate, these two VIE’s have assets approximating $6.7 million at December 31, 2004. The Company has no exposure to loss from these entities at December 31, 2004, as the Company has met all capital commitments and the partnerships are in the process of being dissolved. The Company also consolidates those partnerships and LLC’s in which it has the ability to exercise con- trol over major operating and financial policies. Any partnership or LLC that is not consolidated is ac- counted for on the equity or cost method of account- ing, depending upon the ownership percentage and/or the ability to exercise significant influence over the business activities. The Company acts as transferor, seller, investor, structurer or underwriter in securitizations. These transactions typically involve entities that are qualify- in special purpose entities as defined ing SFAS No. 140. For further discussion on these types of transactions, see Note 19. limited The Company has investments in and/or acts as the managing partner or member to approximately 30 partnerships and liability companies (LLC’s). These entities were established for the pur- pose of investing in emerging growth companies. At December 31, 2004, the Company’s aggregate net in- vestment in these partnerships and LLC’s totaled $4.5 million. The Company’s remaining commitment to these partnerships and LLC’s was $4.8 million at December 31, 2004. The Company has identified five of the partnerships described above as VIE’s. Furthermore, it was deter- mined that the Company is the primary beneficiary of three of these VIE’s with aggregate assets of approxi- mately $0.4 million at December 31, 2004, which are 60 Piper Jaffray Annual Report 2004 Note 21 Business Segments Notes To Consolidated Financial Statements CAPITAL MARKETS (‘‘CM’’) Within the Company, financial performance is mea- Designations, assignments and allocations may change from time to time as financial reporting sys- sured by lines of business. The Company’s reportable tems are enhanced and methods of evaluating per- business segments include Capital Markets, Private formance change or segments are realigned to better Client Services and Corporate Support and Other. serve the clients of the Company. Accordingly, prior The business segments are determined based upon fac- periods are reclassified and presented on a comparable tors such as the type of customers, the nature of products and services provided and the distribution basis. channels used to provide those products and services. Certain services that the Company offers are provided to clients through more than one of our business seg- CM includes institutional sales and trading services and investment banking services. Institutional sales ments. These business segments are components of the Company about which financial information is availa- and trading services focus on the sale of U.S. equities ble and is evaluated on a regular basis in deciding how and fixed income products to institutions and govern- to allocate resources and assess performance relative ment and non-profit entities. Investment banking ser- vices include management of and participation in to competitors. underwritings, merger and acquisition services and public finance activities. Additionally, CM includes earnings on trading activities related to securities in- ventories held to facilitate customer transactions and net interest revenues on trading securities held in inventory. BASIS FOR PRESENTATION Segment results are derived from the Company’s fi- nancial reporting systems by specifically attributing customer relationships and their related revenues and expenses to the appropriate segment. Revenue-sharing of sales credits associated with underwritten offerings is based on the distribution channel generating the sales. Expenses directly managed by the business line, including salaries, commissions, incentives, employee benefits, occupancy, marketing and business develop- ment and other direct expenses, are accounted for within each segment’s financial results in a manner similar to the consolidated financial results. Invest- ment research, operations, technology and compliance costs are allocated based on the segment’s use of these areas to support its businesses. General and adminis- trative expenses incurred by centrally managed corpo- rate support functions are included in Corporate Corporate Support and Other includes the Company’s private equity and venture capital businesses and Support and Other and are not allocated. Cash award other activities managed on a corporate basis, such as plan charges related to the Distribution, merger and enterprise-wide administrative support functions. Re- restructuring-related charges, royalty fees assessed by sults for this segment primarily reflect management USB, income taxes and certain infrequent regulatory fees generated by the Company’s private equity and settlement costs are not assigned to the business seg- venture capital businesses and gains and losses on ments. The financial management of assets, liabilities investments in private equity and venture capital and capital is performed on an enterprise-wide basis. funds managed by these businesses, as well as interest Company’s from Net expense on the Company’s subordinated debt and the non-U.S. operations were $11.3 million, $9.2 million expenses of other business activities managed on a and $8.2 million for the years ended December 31, 2004, 2003 and 2002, respectively, and are included corporate basis. segment. in Non-U.S. long-lived assets were $0.6 million at De- cember 31, 2004 and 2003. PRIVATE CLIENT SERVICES (‘‘PCS’’) PCS principally provides individual investors with fi- nancial advice and investment products and services, including equity and fixed income securities, mutual funds and annuities. This segment also includes net interest income on customer margin loans. As of De- cember 31, 2004, PCS had 860 financial advisors op- erating in 91 branch offices in 17 midwest, mountain and west coast states. the Capital Markets business CORPORATE SUPPORT AND OTHER revenues the Piper Jaffray Annual Report 2004 61 Notes To Consolidated Financial Statements Reportable segment financial results for the respective year ended December 31, were as follows: (Dollars in Thousands) 2004 2003 2004 2003 2004 2003 2004 2003 Capital Markets Private Client Services Corporate Support and Other Consolidated Company Net revenues $ 431,135 $ 430,355 $ 355,176 $ 352,113 $ 11,187 $ 4,262 $ 797,498 $ 786,730 Operating expense 356,743 353,606 307,142 323,933 49,275 40,397 713,160 717,936 Pre-tax operating income before unallocated charges Cash award program Royalty fee Consolidated income before income taxes $ 74,392 $ 76,749 $ 48,034 $ 28,180 $ (38,088) $ (36,135) $ 84,338 $ 68,794 4,717 – 24,000 3,911 $ 79,621 $ 40,883 Capital Markets Private Client Services Corporate Support and Other Consolidated Company (Dollars in Thousands) 2003 2002 2003 2002 2003 2002 2003 2002 Net revenues Operating expense $ 430,355 353,606 $ 376,074 $ 352,113 323,933 315,419 $ 357,155 $ 327,253 4,262 40,397 $ (4,177) $ 786,730 717,936 33,623 $ 729,052 676,295 Pre-tax operating income before unallocated charges $ 76,749 $ 60,655 $ 28,180 $ 29,902 $ (36,135) $ (37,800) $ 68,794 $ 52,757 Cash award program Regulatory settlement Merger and restructuring Royalty fee Consolidated income before income taxes Income Taxes Note 22 Income tax expense (benefit) is provided for using the asset and liability method. Deferred tax assets and liabilities are recognized for the expected future tax consequences attributable to temporary differences between amounts reported for income tax purposes and financial statement purposes, using current tax YEAR ENDED DECEMBER 31 (Dollars in Thousands) Current: Federal State Foreign Deferred: Federal State Total income tax expense 62 Piper Jaffray Annual Report 2004 24,000 – – 3,911 – 32,500 7,976 7,482 $ 40,883 $ 4,799 rates. Prior to the Distribution, income taxes were determined on a separate return basis as if the Com- pany had not been eligible to be included in the con- solidated income tax return of USB and its affiliates. The components of income tax expense are as follows: 2004 2003 2002 $ 15,008 $ 17,528 $ 12,809 3,839 489 3,429 418 2,990 280 19,336 21,375 16,079 8,222 1,715 (5,529) (962) (9,952) (1,434) 9,937 (6,491) (11,386) $ 29,273 $ 14,884 $ 4,693 A reconciliation of the statutory federal income tax rates to the Company’s effective tax rates for the fiscal years ended December 31, is as follows: (Dollars in Thousands) Federal income tax at statutory rates Increase (reduction) in taxes resulting from: State income taxes, net of federal tax benefit Net tax-exempt interest income Fines and penalties Other, net Total income tax expense Notes To Consolidated Financial Statements 2004 2003 2002 $ 27,867 $ 14,642 $ 2,087 3,610 (3,677) – 1,473 1,319 (2,933) 350 1,506 605 (3,692) 4,953 740 $ 29,273 $ 14,884 $ 4,693 Deferred income tax assets and liabilities reflect the tax effect of temporary differences between the carry- ing amount of assets and liabilities for financial re- porting purposes and the amounts used for the same ment’s expectation of future taxable income. items for income tax reporting purposes. The Company has reviewed the components of the deferred tax assets and has determined that no valua- tion allowance is deemed necessary based on manage- As part of the Distribution, the Company entered into a tax-sharing agreement with USB that governs each parties’ responsibilities, as it relates to income taxes, going forward. Pursuant to this agreement, USB is generally responsible for any future liabilities resulting from Internal Revenue Service audits for those years when the Company was part of the USB consolidated income tax return. The net deferred tax asset included in other assets on the Consolidated Statements of Financial Condition consisted of the following items at December 31: (Dollars in Thousands) 2004 2003 Deferred tax assets: Liabilities /accruals not currently deductible $ 20,975 $ 26,254 Pension and retirement costs Deferred compensation Partnership investments Other Deferred tax liabilities: Partnership investments Fixed assets Other 11,811 9,640 233 4,855 10,086 14,854 – 5,382 47,514 56,576 – 1,101 296 1,397 588 3,188 130 3,906 Net deferred tax asset $ 46,117 $ 52,670 Note 23 Acquisition of Vie Securities, LLC services to the Company’s trading capabilities. The In November 2004, the Company acquired Vie Securi- acquisition is not material to the Company’s opera- ties, LLC, the broker dealer subsidiary of parent Vie tions or financial condition. An allocation of the Financial Group, Inc. The Company recorded purchase price to assets acquired and liabilities as- $11.5 million in goodwill, $4.8 million in identifiable intangible assets and $0.3 million in net assets in con- sumed has been recorded as of December 31, 2004. nection with this acquisition. The acquisition of Vie Adjustments, if any, to the purchase price allocation Securities adds algorithm-based, electronic execution are not expected to be material. Piper Jaffray Annual Report 2004 63 SUPPLEMENTAL INFORMATION Quarterly Information (Unaudited) 2004 FISCAL QUARTER (Amounts in Thousands, Except Per Share Data) Total revenues Interest expense Net revenues Non-interest expenses Income before income taxes Net income Earnings per common share Basic Diluted Weighted average number of common shares Basic Diluted 2003 FISCAL QUARTER Total revenues Interest expense Net revenues Non-interest expenses Income (loss) before income taxes Net income (loss) Earnings per common share Basic Diluted Weighted average number of common shares Basic Diluted First Second Third Fourth $ 213,313 $ 211,694 $ 190,442 $ 200,175 3,913 209,400 187,228 22,172 13,790 4,391 207,303 186,613 20,690 12,980 4,217 186,225 167,650 18,575 11,769 5,605 194,570 176,386 18,184 11,809 $ $ 0.71 0.71 $ $ 0.67 0.67 $ $ 0.61 0.61 $ $ 0.61 0.61 19,333 19,366 19,333 19,395 19,333 19,387 19,333 19,445 First Second Third Fourth $ 174,634 $ 210,377 $ 214,900 $ 206,330 5,427 169,207 162,232 6,975 4,693 5,327 205,050 191,622 13,428 8,622 4,225 210,675 184,821 25,854 16,030 4,532 201,798 207,172 (5,374) (3,346) $ $ 0.24 0.24 $ $ 0.45 0.45 $ $ 0.83 0.83 $ $ (0.17) (0.17) 19,190 19,190 19,223 19,223 19,260 19,260 19,273 19,273 Market for Piper Jaffray Common Stock and Related Shareholder Matters SHAREHOLDERS stock as of February 18, 2005. STOCK PRICE INFORMATION Our common stock is listed on the New York Stock We had 26,000 shareholders of record and an esti- Exchange under the symbol ‘‘PJC.’’ Our separation mated 140,000 beneficial owners of our common from U.S. Bancorp was completed on December 31, 2003, and our common stock began ‘‘regular-way trading’’ on the New York Stock Exchange on Janu- ary 2, 2004. Consequently, historical quarterly price information is not available for shares of our common stock for the year ended December 31, 2003. The following table describes the historical quarterly price information for the year ended December 31, 2004. On February 18, 2005, the last reported sale price of our common stock was $40.23. DIVIDENDS We do not intend to pay cash dividends on our com- mon stock for the foreseeable future. Instead, we cur- rently intend to retain all available funds and any future earnings for use in the operation and expansion of our business. Our board of directors is free to change our dividend policy at any time. Restrictions on our broker dealer subsidiary’s ability to pay divi- dends are described in Note 15 to the consolidated financial statements. First Quarter Second Quarter Third Quarter Fourth Quarter High Low $ 57.63 $ 41.35 55.55 44.70 49.37 45.23 39.20 37.65 64 Piper Jaffray Annual Report 2004 company information Corporate Headquarters Piper Jaffray Companies Suite 800 800 Nicollet Mall Minneapolis, MN 55402 612 303-6000 Company Web Site www.piperjaffray.com Stock Transfer Agent and Registrar Mellon Investor Services LLC acts as transfer agent and registrar for Piper Jaffray Companies and maintains all shareholder records for the company. For questions regarding owned Piper Jaffray Companies stock, stock transfers, address corrections or changes, lost stock certifi cates or duplicate mailings, please contact Mellon Investor Services by writing or calling: Mellon Investor Services LLC P.O. Box 3315 South Hackensack, NJ 07606 800 872-4409 Street address for overnight deliveries: 85 Challenger Road Ridgefi eld Park, NJ 07660 Web Site Access to Registrar Shareholders may access their investor statements online 24 hours a day, seven days a week with MLinkSM; for more information, go to www.melloninvestor.com/ISD. E-mail Delivery of Shareholder Materials Piper Jaffray invites its shareholders to join in its commit- ment to being an environmentally responsible corporation by receiving future shareholder materials electronically. Registered shareholders may now access important investor communications online with MLinkSM, a new program from Mellon Investor Services. Enrollment is quick and easy; just log on to www.melloninvestor.com/ ISD and follow the instructions. This program will help Piper Jaffray reduce paper waste and minimize printing and postage costs. In addition, this book was printed on paper that contains recycled fi bers. The cover and pages 1 – 8 contain 15 percent post-consumer waste. The fi nancial section contains 30 percent post-consumer waste. Independent Accountants Ernst & Young LLP Common Stock Listing New York Stock Exchange (symbol: PJC) Investor Inquiries Shareholders, securities analysts and investors seeking more information about the company should contact Jennifer A. Olson-Goude, Director of Investor Relations, jennifer.a.olson-goude@pjc.com, 612 303-6277, at the corporate headquarters address. Web Site Access to SEC Reports and Corporate Governance Information Piper Jaffray Companies makes available free of charge on its Web site, www.piperjaffray.com, its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports fi led or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as well as all other reports fi led by Piper Jaffray Companies with the SEC, as soon as reason- ably practicable after it electronically fi les them with, or furnishes them to, the SEC. Piper Jaffray Companies also makes available free of charge on its Web site the company’s code of ethics and business conduct, its corporate governance principles and the charters of the audit, compensation, and nominating and governance committees of the board of directors. Printed copies of these materials will be mailed upon request. Dividends Piper Jaffray Companies does not currently pay cash dividends on its common stock. Certifi cations The certifi cations by the chief executive offi cer and chief fi nancial offi cer of Piper Jaffray Companies required under Section 302 of the Sarbanes-Oxley Act of 2002 have been fi led as exhibits to its 2004 Annual Report on Form 10-K. The certifi cation by the chief executive offi cer of Piper Jaffray Companies required under Section 303A.12(a) of the corporate governance rules of the New York Stock Exchange has been submitted to the New York Stock Exchange. i P p e r J a f f r a y C o m p a n i e s A n n u a l R e p o r t 2 0 0 4 Piper Jaffray Companies Annual Report 200 4