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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2001
001-14223
COMMISSION FILE NUMBER
Knight Trading Group, Inc.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction
of incorporation or organization)
22-3689303
(I.R.S. Employer
Identification Number)
525 Washington Boulevard
Jersey City, NJ 07310
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (201) 222-9400
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days, Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
At May 14, 2001 the number of shares outstanding of the registrant's Class A
common stock was 123,718,730 and there were no shares outstanding of the
registrant's Class B common stock.
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KNIGHT TRADING GROUP, INC.
FORM 10-Q QUARTERLY REPORT
For the Quarter Ended March 31, 2001
TABLE OF CONTENTS
Page
----
PART I FINANCIAL INFORMATION:
Item 1. Financial Statements........................................... 3
Consolidated Statements of Income.............................. 3
Consolidated Statements of Financial Condition................. 4
Consolidated Statements of Cash Flows.......................... 5
Notes to Consolidated Financial Statements..................... 6
Management's Discussion and Analysis of Financial Condition and
Item 2. Results of Operations.......................................... 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 17
PART II OTHER INFORMATION:
Item 1. Legal Proceedings.............................................. 18
Item 2. Changes in Securities and Use of Proceeds...................... 18
Item 3. Defaults Upon Senior Securities................................ 18
Item 4. Submission of Matters to a Vote of Security Holders............ 19
Item 5. Other Information.............................................. 19
Item 6. Exhibits and Reports on Form 8-K............................... 19
Signatures.............................................................. 19
2
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Income
(Unaudited)
For the three months
ended March 31,
-------------------------
2001 2000
------------ ------------
Revenues
Net trading revenue.............................. $187,454,445 $486,778,104
Commissions and fees............................. 14,512,201 7,027,629
Asset management fees............................ 12,720,036 9,773,589
Interest and dividends, net of interest expense.. 5,309,313 3,507,417
Investment income and other...................... 5,651,129 3,512,299
------------ ------------
Total revenues................................. 225,647,124 510,599,038
------------ ------------
Expenses
Employee compensation and benefits............... 79,695,673 175,198,790
Payments for order flow.......................... 29,718,426 59,317,560
Execution and clearance fees..................... 30,049,055 30,222,288
Communications and data processing............... 12,831,389 7,125,993
Depreciation and amortization.................... 10,222,579 4,214,963
Professional fees................................ 5,654,011 4,532,062
Occupancy and equipment rentals.................. 5,010,858 3,093,186
Business development............................. 3,369,758 5,238,693
Other............................................ 5,942,719 4,605,761
------------ ------------
Total expenses................................. 182,494,468 293,549,296
------------ ------------
Income before income taxes and minority interest... 43,152,656 217,049,742
Income tax expense................................. 17,982,130 80,454,361
------------ ------------
Income before minority interest.................... 25,170,526 136,595,381
Minority interest in consolidated subsidiaries..... 1,746,937 --
------------ ------------
Net income......................................... $ 26,917,463 $136,595,381
============ ============
Basic earnings per share........................... $ 0.22 $ 1.12
============ ============
Diluted earnings per share......................... $ 0.21 $ 1.08
============ ============
Pro forma adjustments
Income before income taxes....................... $217,049,742
Adjustment for pro forma employee compensation
and benefits.................................... (267,109)
------------
Pro forma income before income taxes............. 216,782,633
Pro forma income tax expense..................... 81,050,811
------------
Pro forma net income............................. 135,731,822
============
Pro forma basic earnings per share............... $ 1.11
============
Pro forma diluted earnings per share............. $ 1.07
============
Shares used in basic earnings per share
calculations (see Note 8)......................... 123,517,121 122,146,982
============ ============
Shares used in diluted earnings per share
calculations (see Note 8)......................... 126,179,906 126,981,962
============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
3
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Financial Condition
(Unaudited)
March 31, December 31,
2001 2000
-------------- --------------
Assets
Cash and cash equivalents.................... $ 374,848,966 $ 364,057,534
Securities owned, held at clearing broker, at
market value................................ 1,517,954,276 1,799,966,679
Receivable from brokers and dealers.......... 658,361,210 114,047,275
Fixed assets and leasehold improvements at
cost, less accumulated depreciation and
amortization................................ 86,819,156 79,014,393
Goodwill, less accumulated amortization...... 43,194,198 45,239,177
Investments.................................. 83,253,424 64,917,975
Other assets................................. 54,824,311 54,166,139
-------------- --------------
Total assets............................... $2,819,255,541 $2,521,409,172
============== ==============
Liabilities and Stockholders' Equity
Liabilities
Securities sold, not yet purchased, at market
value....................................... $1,745,436,253 $1,427,214,323
Payable to brokers and dealers............... 134,333,130 184,269,478
Accrued compensation expense................. 41,693,199 62,444,645
Accrued execution and clearance fees......... 5,040,626 6,092,754
Accrued payments for order flow.............. 5,981,101 11,635,069
Accounts payable, accrued expenses and other
liabilities................................. 22,827,010 30,576,814
Income taxes payable......................... 17,563,405 4,813,771
-------------- --------------
Total liabilities.......................... 1,972,874,724 1,727,046,854
-------------- --------------
Minority interest in consolidated
subsidiaries.................................. 27,094,662 20,175,872
-------------- --------------
Stockholders' equity
Class A Common Stock......................... 1,236,505 1,232,908
Additional paid-in capital................... 331,163,026 309,611,248
Retained earnings............................ 492,864,757 465,947,294
Accumulated other comprehensive income
(loss)--foreign currency translation
adjustments, net of tax..................... (5,978,133) (2,605,004)
-------------- --------------
Total stockholders' equity................. 819,286,155 774,186,446
-------------- --------------
Total liabilities and stockholders'
equity.................................... $2,819,255,541 $2,521,409,172
============== ==============
The accompanying notes are an integral part of these consolidated financial
statements.
4
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Cash Flows
(Unaudited)
For the three months ended
March 31,
----------------------------
2001 2000
------------- -------------
Cash flows from operating activities
Net income...................................... $ 26,917,463 $ 136,595,381
Adjustments to reconcile net income to net cash
provided by operating activities
Income tax credit from stock options
exercised.................................... 1,976,947 --
Depreciation and amortization................. 10,222,579 4,214,963
Minority interest in earnings of consolidated
subsidiaries................................. (1,746,937) --
(Increase) decrease in operating assets
Securities owned.............................. 282,012,403 (169,320,546)
Receivable from clearing brokers.............. (544,313,935) (20,372,710)
Other assets.................................. (658,172) (5,163,400)
Increase (decrease) in operating liabilities
Securities sold, not yet purchased............ 318,221,930 171,345,782
Securities sold under agreements to
repurchase................................... -- (131,639)
Payable to clearing broker.................... (49,936,348) (33,819,013)
Accrued compensation expense.................. (20,751,446) 42,455,742
Accounts payable, accrued expenses and other
liabilities.................................. (11,122,932) (32,406,614)
Accrued execution and clearance fees.......... (1,052,128) (1,157,790)
Accrued payments for order flow............... (5,653,968) 4,295,298
Income taxes payable.......................... 12,749,634 63,551,880
------------- -------------
Net cash provided by operating activities... 16,865,090 160,087,334
------------- -------------
Cash flows from investing activities
Purchases of fixed assets and leasehold
improvements................................... (15,987,043) (14,086,080)
Investments and acquisitions.................... (18,335,449) 2,832,705
Payment of contingent consideration............. -- (3,764,257)
------------- -------------
Net cash used in investing activities....... (34,322,492) (15,017,632)
------------- -------------
Cash flows from financing activities
Stock options exercised......................... 2,495,450 255,997
Minority interest in consolidated subsidiaries.. 25,753,384 --
------------- -------------
Net cash provided by financing activities... 28,248,834 255,997
------------- -------------
Increase in cash and cash equivalents........... 10,791,432 145,325,699
Cash and cash equivalents at beginning of
period......................................... 364,057,534 304,053,554
------------- -------------
Cash and cash equivalents at end of period...... $ 374,848,966 $ 449,379,253
============= =============
Supplemental disclosure of cash flow
information:
Cash paid for interest........................ $ 8,057,835 $ 5,122,211
============= =============
Cash paid for income taxes.................... $ 5,232,496 $ 18,101,279
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
5
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2001
(Unaudited)
1. Organization and Description of the Business
Knight Trading Group, Inc. (the "Company") and its subsidiaries operate in
securities market-making and asset management business lines. Knight Securities
("KS") operates as a market maker in over-the-counter equity securities ("OTC
securities"), primarily those traded in the Nasdaq stock market and on the OTC
Bulletin Board. Knight Capital Markets ("KCM," formerly known as Trimark
Securities) operates as a market maker in the over-the-counter market for New
York Stock Exchange (NYSE)-and American Stock Exchange (AMEX)-listed
securities. Knight Financial Products ("KFP") makes markets in options on
individual equities, equity indices and fixed income instruments in the U.S.
and in Europe. The Company also maintains an asset management business for
institutional investors and high net worth individuals through its Deephaven
Capital Management ("Deephaven") subsidiary. The Company also operates a
professional execution services business through Knight Execution Partners
("KEP"). KS, KCM, KFP and KEP are registered as broker-dealers with the
Securities and Exchange Commission ("SEC" or the "Commission"). Additionally,
KS and KCM are members of the National Association of Securities Dealers, Inc.
("NASD").
In the first quarter of 2001, the Company began its Knight Roundtable Europe
venture with 19 broker-dealers and banks from Europe and the United States that
own an approximate 15% minority interest in the venture. The venture owns and
operates Knight Securities International, Ltd. ("KSIL"), which provides best
execution solutions for European investors in European and U.S. equities. In
the third quarter of 2000 the Company established a joint venture operation,
called Knight Securities Japan ("KSJ"), with Nikko Securities Co., Ltd. to
provide wholesale market-making services in Japanese equity securities.
2. Significant Accounting Policies
Basis of consolidation and form of presentation
The accompanying consolidated financial statements include the accounts of
the Company and its majority and wholly-owned subsidiaries and, in the opinion
of management, reflect all adjustments, consisting only of normal recurring
adjustments, necessary for a fair statement of the results for the interim
period. All significant intercompany transactions and balances have been
eliminated. Certain footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted pursuant to SEC rules and regulations, although
the Company believes that the disclosures are adequate to make the information
presented not misleading. The nature of the Company's business is such that the
results of an interim period are not necessarily indicative of the results for
the full year. These consolidated financial statements should be read in
conjunction with the financial statements and notes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2000 as
filed with the SEC.
Cash equivalents
Cash equivalents represent money market accounts, which are payable on
demand, or short-term investments with an original maturity of less than 30
days. The carrying amount of such cash equivalents approximates their fair
value due to the short-term nature of these instruments.
Investments
Investments on the Consolidated Statements of Financial Condition comprise
ownership interests of less than 20% in publicly and non-publicly traded
companies which are accounted for under the equity method or
6
the cost basis of accounting. Investments also include the Company's
investments in private investment funds for which the Company is the investment
manager and sponsor.
Market-making activities
Securities owned and securities sold, not yet purchased, which primarily
consist of listed and OTC stocks, listed options contacts and futures
contracts, are carried at market value and are recorded on a trade date basis.
Net trading revenue (trading gains, net of trading losses) and commissions and
related expenses, including compensation and benefits, execution and clearance
fees and payments for order flow, are also recorded on a trade date basis.
Payments for order flow represent payments to other broker-dealers for
directing their order executions to the Company. The Company records interest
income net of transaction-related interest charged by clearing brokers for
facilitating the settlement and financing of securities transactions. Interest
expense for the three months ended March 31, 2001 and 2000 was $7,777,226 and
$5,162,123, respectively.
Asset management fees
The Company earns asset management fees for sponsoring and managing the
investments of certain private investment funds. Such fees are recorded when
earned and are calculated as a percentage of the fund's quarterly net assets,
plus a percentage of a new high net asset value, as defined, for any six-month
period ended June 30th or December 31st. A new high net asset value is
generally defined as the amount by which the net asset value of the fund
exceeds the greater of either the highest previous net asset value in the fund,
or the net asset value at the time each investor made their purchase.
Securities borrowed/loaned
Securities borrowed and securities loaned, which are included in receivable
from and payable to clearing brokers, are recorded at the amount of cash
collateral advanced or received. Securities borrowed transactions require the
Company to deposit cash or similar collateral with the lender. With respect to
securities loaned, the Company receives collateral in the form of cash in an
amount generally in excess of the market value of securities loaned. Interest
income and interest expense are recorded on an accrual basis. The Company
monitors the market value of securities borrowed and loaned on a daily basis.
Substantially all of the Company's securities borrowed and securities loaned
transactions are conducted with banks and other securities firms.
Foreign currencies
The functional currency of the Company's consolidated foreign subsidiaries
are the U.S. dollar, the British Pound and the Japanese Yen. Assets and
liabilities in foreign currencies are translated into U.S. dollars using
current exchange rates at the date of the Consolidated Statements of Financial
Condition. Revenues and expenses are translated at average rates during the
periods. The foreign exchange gains and losses resulting from these
translations are included as a separate component of stockholders' equity in
the Consolidated Statements of Financial Condition.
Depreciation, amortization and occupancy
Fixed assets are being depreciated on a straight-line basis over their
estimated useful lives of three to seven years. Leasehold improvements are
being amortized on a straight-line basis over the life of the related office
lease. The Company records rent expense on a straight-line basis over the life
of the lease. The Company capitalizes certain costs associated with the
acquisition or development of internal-use software in accordance with
Statement of Position No. 98-1 and amortizes the software over its estimated
useful life of three years.
7
Income taxes
Income tax expense in the Consolidated Statements of Income represents
actual income taxes incurred through March 31, 2001. Before the Company's
merger with KFP ("the Merger"), which was completed on January 12, 2000, KFP
was a limited liability company which was treated as a partnership for tax
purposes and its federal and state income taxes were borne by KFP's individual
partners. As such, KFP's historical financial statements only include a
provision for non U.S. income taxes. Subsequent to the Merger, KFP's income is
subject to federal and state income taxes. Pro forma income tax expense
reflects income taxes as if the Company was subject to federal and state income
taxes on KFP's income prior to the Merger.
The Company records deferred tax assets and liabilities for the expected
future tax consequences of temporary differences between the financial
reporting and tax bases of assets and liabilities and are measured using the
enacted tax rates and laws that will be in effect when such differences are
expected to reverse.
Estimated fair value of financial instruments
The Company's securities owned and securities sold, not yet purchased are
carried at market value. Management estimates that the fair values of other
financial instruments recognized on the Consolidated Statements of Financial
Condition (including receivables, payables and accrued expenses) approximate
their carrying values, as such financial instruments are short-term in nature,
bear interest at current market rates or are subject to frequent repricing.
Minority interest
Minority interest represents minority owners' share of net income and equity
in two of the Company's consolidated subsidiaries, KSIL and KSJ.
Accounting for derivatives
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments, including
certain derivative instruments imbedded in other contracts, and for hedging
activities. In June 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133-an amendment of FASB Statement No. 133. In June 2000,
the FASB issued SFAS No. 138 Accounting for Certain Derivative Instruments and
Certain Hedging Activities, which is an amendment to SFAS No. 133 and is
effective concurrently with SFAS No. 137. The Company adopted the provisions of
SFAS No. 133, 137 and 138 as of January 1, 2001. The Company's derivative
financial instruments are all held for trading purposes and historically have
been carried at fair value. As such the adoption of these statements did not
have a material impact on the Company's financial statements.
Other
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
Certain prior year amounts have been reclassified to conform to the current
year presentation.
8
3. Securities Owned and Securities Sold, Not Yet Purchased
Securities owned and securities sold, not yet purchased consist of the
following:
March 31, December 31,
2001 2000
-------------- --------------
Securities owned:
Equities....................................... $ 426,864,278 $ 661,327,729
Options........................................ 1,078,764,887 1,126,483,498
U.S. government obligations.................... 12,325,111 12,155,452
-------------- --------------
$1,517,954,276 $1,799,966,679
============== ==============
Securities sold, not yet purchased:
Equities....................................... $ 507,660,726 $ 170,167,713
Options........................................ 1,237,775,527 1,257,046,610
-------------- --------------
$1,745,436,253 $1,427,214,323
============== ==============
4. Receivable from/Payable to Brokers and Dealers
Amounts receivable from and payable to brokers and dealers consist of the
following:
March 31, December 31,
2001 2000
-------------- --------------
Receivable:
Clearing brokers............................... $ 622,198,654 $ 86,156,298
Securities failed to deliver................... 21,369,812 19,815,796
Securities borrowed............................ 14,792,744 8,075,181
-------------- --------------
$ 658,361,210 $ 114,047,275
============== ==============
Payable:
Clearing brokers............................... $ 123,973,583 $ 175,552,245
Securities failed to receive................... 9,770,033 8,574,981
Securities loaned.............................. 589,514 142,252
-------------- --------------
$ 134,333,130 $ 184,269,478
============== ==============
The Company has received and pledged collateral approximately equal to the
amounts borrowed and loaned, respectively.
5. Investments
The Company's wholly-owned subsidiary, Deephaven, is the investment manager
and sponsor of private investment funds that engage in various trading
strategies involving equities, debt instruments and derivatives. The Company
owns interests in these private investment funds. Such investments amounted to
approximately $33.1 million at March 31, 2001. Certain officers of the Company
also own interests in these private investment funds. Additionally, the Company
has made strategic investments in the National Association of Securities
Dealers, Inc., Nasdaq Europe (formerly known as Easdaq), Netfolio, Inc. and
other public and private companies.
9
6. Significant Customers
The Company considers significant customers to be customers who provide the
Company with 10% or more of its order flow, as measured in share volume, during
the period. For the three months ended March 31, 2001, the Company had no
significant customers.
7. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is as follows:
Three months ended
March 31,
-----------------------
2001 2000
---------- -----------
Net income/pro forma net income.......................$ 26,917,463 $ 135,731,822
Foreign currency translation adjustment, net of tax... (3,373,129) (63,374)
---------- -----------
Total comprehensive income, net of tax................$ 23,544,334 $ 135,668,448
========== ===========
8. Earnings per Share
Basic and diluted earnings per common share have been calculated by dividing
net income by the sum of the weighted average shares of Class A Common Stock
outstanding during each respective period.
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations for the three months ended
March 31, 2001 and 2000:
For the three months ended March 31,
--------------------------------------------------
2001 2000
------------------------ -------------------------
Numerator/ Denominator/
Numerator/ Denominator/ pro forma pro forma
net income shares net income shares
----------- ------------ ------------ ------------
Income and shares used in
basic calculations........ $26,917,463 123,517,121 $135,731,822 122,146,982
Effect of dilutive stock
options................... -- 2,662,785 -- 4,834,980
----------- ----------- ------------ -----------
Income and shares used in
diluted calculations...... $26,917,463 126,179,906 $135,731,822 126,981,962
=========== =========== ============ ===========
Basic earnings per
share................... $ 0.22 $ 1.11
=========== ===========
Diluted earnings per
share................... $ 0.21 $ 1.07
=========== ===========
9. Net Capital Requirements
As registered broker-dealers, KS, KCM, KFP and KEP are subject to the SEC's
Uniform Net Capital Rule (the "Rule") which requires the maintenance of minimum
net capital. KS, KCM and KEP have elected to use the basic method, permitted by
the Rule, which requires that they each maintain net capital equal to the
greater of $1.0 million ($100,000 for KEP) or 6 2/3% of aggregate indebtedness,
as defined. KFP has elected to use the alternative method, permitted by the
Rule, which requires that it maintains net capital equal to the greater of
$250,000 or 2% of aggregate debit items, as defined.
At March 31, 2001, KS had net capital of $277,218,655 which was $274,732,205
in excess of its required net capital of $2,486,450, KCM had net capital of
$45,892,193 which was $44,861,771 in excess of its required net capital of
$1,030,422, KFP had net capital of $35,097,162 which was $34,847,162 in excess
of its required net capital of $250,000, and KEP had net capital of $7,566,636
which was $7,422,745 in excess of its required net capital of $143,891.
10
Additionally, KSIL and KSJ are subject to regulatory requirements in the
countries in which they operate, including the requirements of the Securities
and Futures Authority Limited in the United Kingdom and the Financial
Supervisory Agency in Japan. As of March 31, 2001, the Company was in
compliance with these capital adequacy requirements.
10. Business Segments
The Company has two reportable business segments: securities market-making
and asset management. Securities market-making primarily represents market-
making in equity securities listed on Nasdaq, on the OTCBB of the NASD, in the
over-the-counter market for NYSE- and AMEX-listed securities and in options on
individual equities, equity indices, fixed income instruments and certain
commodities. The asset management segment consists of investment management and
sponsorship for a series of private investment funds.
The Company's net revenues, income before income taxes and minority interest
and assets by segment are summarized below:
Securities Asset
Market Making Management Total
-------------- ----------- --------------
For the three months ended March 31,
2001:
Revenues........................... $ 211,014,792 $14,632,332 $ 225,647,124
Income before income taxes and
minority interest................. 34,267,125 8,885,531 43,152,656
Total Assets....................... 2,770,211,058 49,044,483 2,819,255,541
For the three months ended March 31,
2000:
Revenues........................... 499,279,490 11,319,548 510,599,038
Pro forma income before income
taxes............................. 207,875,207 8,907,426 216,782,633
Total Assets....................... 1,862,915,235 28,355,590 1,891,270,825
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion of our results of operations should be read in
conjunction with our consolidated financial statements and notes thereto
included in our Annual Report on Form 10-K for the year ended December 31,
2000. This discussion contains forward-looking statements that involve risks
and uncertainties. Our actual results may differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including, but not limited to, those set forth elsewhere in this document.
We have experienced and expect to continue to experience, significant
fluctuations in quarterly operating results due to a variety of factors,
including the value of our securities positions and our ability to manage the
risks attendant thereto, the volume of our market-making activities, volatility
in the securities markets, our ability to manage personnel and expenses, the
amount of revenue derived from limit orders as a percentage of net trading
revenues, changes in payments for order flow or clearing costs, the addition or
loss of sales and trading professionals, regulatory changes, the amount and
timing of capital expenditures, the incurrence of costs associated with
acquisitions and general market conditions. If demand for our market-making
services and asset management declines and we are unable to adjust our cost
structure on a timely basis, our operating results could be materially and
adversely affected. We have experienced, and may experience in the future,
significant seasonality in our business.
Due to all of the foregoing factors, period-to-period comparisons of our
revenues and operating results are not necessarily meaningful and such
comparisons cannot be relied upon as indicators of future performance. There
also can be no assurance that we will be able to sustain the rates of revenue
growth that we have experienced in the past, that we will be able to improve
our operating results or that we will be able to sustain our profitability on a
quarterly basis.
11
Overview
We are the leading market maker in equity securities listed on Nasdaq, the
OTCBB of the NASD, and the over-the-counter market for New York Stock Exchange
(NYSE) and American Stock Exchange (AMEX)--listed securities. Additionally, we
make markets in equity securities in Europe and Japan. We are also a leading
market maker in options on individual equities, equity indices and fixed income
instruments in the U.S. and Europe. The firm also maintains an asset management
business for institutional investors and high net worth individuals through our
Deephaven subsidiary.
KS's share volume totaled 21.4 billion and 37.9 billion, or 81% and 86% of
our total equity market-making share volume, for the three months ended March
31, 2001 and 2000, respectively. KCM's share volume totaled 6.0 billion and 5.1
billion, or 19% and 14% of our total equity market-making share volume for the
three months ended March 31, 2001 and 2000, respectively. KFP's U.S. option
contract volume amounted to 8.5 million and 3.5 million contracts for the three
months ended March 31, 2001 and 2000, respectively.
Revenues
Our revenues consist principally of net trading revenue from U.S. securities
market-making activities. Net trading revenue, which represents trading gains
net of trading losses, is primarily affected by changes in equity trade and
share volumes and option contract volumes, our revenue capture per share and
option contract, our ability to derive trading gains by taking proprietary
positions, changes in our execution standards, volatility in the marketplace,
our mix of broker-dealer and institutional customers and by regulatory changes
and evolving industry customs and practices. Our net trading revenue per trade
for OTC securities has historically exceeded the net trading revenue per trade
for listed securities.
We continue to focus on increasing our institutional business. OTC
securities transactions with institutional customers are executed as principal,
and all related profits and losses are included within net trading revenue.
Listed securities transactions with institutional customers are executed on an
agency basis, for which we earn commissions on a per share basis. We also
receive fees for providing certain information to market data providers and for
directing trades to certain destinations for execution. Commissions and fees
are primarily affected by changes in our trade and share volumes in listed
securities.
Asset management fees represent fees earned for sponsoring and managing the
investments of private investment funds. Asset management fees are primarily
affected by the rates of return earned on the funds we manage and changes in
the amounts of assets under management.
We earn interest income from our cash held at banks and cash held in trading
accounts at clearing brokers, net of transaction-related interest charged by
clearing brokers for facilitating the settlement and financing of securities
transactions. Net interest is primarily affected by the changes in cash
balances held at banks and clearing brokers and our level of securities
positions.
Expenses
Our operating expenses largely consist of employee compensation and
benefits, payments for order flow and execution and clearance fees. A
substantial portion of these expenses vary in proportion to our trading
revenue. Employee compensation and benefits expense, which is largely
profitability based, fluctuates, for the most part, based on changes in net
trading revenue, our profitability and our number of employees. Payments for
order flow fluctuate based on equity share and options volume, the mix of
market orders and limit orders and the mix of orders received from broker-
dealers who accept payments for order flow. Execution and clearance fees
fluctuate primarily based on changes in equity trade and share volume, option
contract volume, the mix of trades of OTC securities compared to listed
securities, clearance fees charged by clearing brokers and electronic
communications networks, commonly referred to as ECNs. Our international
expansion efforts have increased our operating expenses.
12
Employee compensation and benefits expense primarily consists of salaries
and wages paid to administrative and customer service personnel and
profitability based compensation, which includes compensation and benefits paid
to market-making and sales personnel based on their individual performance, and
incentive compensation paid to all other employees based on our overall
profitability. Approximately 60% of our employees are directly involved in
market-making, sales or customer service activities. Compensation for employees
engaged in market-making and sales activities, the largest component of
employee compensation and benefits, is determined primarily based on a
percentage of gross trading profits net of expenses including payments for
order flow, execution and clearance costs and overhead allocations. Employee
compensation and benefits will, therefore, be affected by changes in payments
for order flow, execution and clearance costs and the costs we allocate to
employees engaged in market-making and sales activities.
Payments for order flow represent customary payments to broker-dealers, in
the normal course of business, for directing their order flow in equity
securities and options to us. We only pay broker-dealers for orders that
provide us with a profit opportunity. For example, we make payments on market
orders, but do not pay on limit orders. Payments for order flow also change as
we modify our payment formulas and as our percentage of customers whose policy
is not to accept payments for order flow varies.
Execution and clearance fees primarily represent clearance fees paid to
clearing brokers for OTC and listed securities and options contracts,
transaction fees paid to Nasdaq, payments made to third parties for exchange
seat leases and execution fees paid to third parties, primarily for executing
trades in listed securities on the NYSE and AMEX and for executing orders
through ECNs. Due to our significant equity share and trade volume, we have
been able to negotiate favorable rates and volume discounts from clearing
brokers and providers of execution services. As a result of these lower rates
and discounts and the increase in equity trade volume of OTC securities as a
percentage of total trade volume, execution and clearance fees per trade have
decreased.
Communications and data processing expense primarily consists of costs for
obtaining stock market data and telecommunications services.
Depreciation and amortization expense results from the depreciation of fixed
assets purchased by us and the amortization of goodwill, which includes
contingent consideration resulting from the acquisitions of the listed
securities market-making businesses of KCM and Tradetech Securities, L.P.,
("Tradetech"). Depreciation and amortization expense also includes the
amortization of goodwill related to our purchases of various options-related
businesses.
Professional fees primarily consist of fees paid to computer programming and
systems consultants, as well as legal fees and other professional fees.
Occupancy and equipment rentals expense primarily consists of rental
payments on office and equipment leases.
Business development expense primarily consists of advertising costs and
marketing expenses, including travel and entertainment expenses and promotion
costs.
Other expenses primarily consist of administrative expenses and other
operating costs.
Income Tax
Income tax expense in the Consolidated Statements of Income represents
actual income taxes incurred through March 31, 2001 and 2000, respectively.
Before the Merger, KFP was a limited liability company which was treated as a
partnership for tax purposes and its U.S. federal and state income taxes were
borne by KFP's individual partners. As such, KFP's historical financial
statements only include a provision for non-U.S. income taxes. Subsequent to
the Merger on January 12, 2000, KFP's income is subject to federal income taxes
and
13
state income taxes. Pro forma income tax expense reflects income taxes as if
the Company was subject to federal and state income taxes on KFP's income prior
to the Merger.
Results of Operations
Three Months Ended March 31, 2001 and 2000
Revenues
Net trading revenue from equity security market-making decreased 67.8% to
$145.9 million for the three months ended March 31, 2001, from $453.7 million
for the comparable period in 2000. This decrease was primarily due to lower
equity share volume and decreased average revenue per equity share. Total
equity share volume decreased 39.6% to 26.5 billion equity shares for the three
months ended March 31, 2001, from 43.8 billion equity shares for the comparable
period in 2000, while average revenue per equity share decreased to $.0055 per
share from $.0104 during the same period in 2000. Net trading revenue from
options market-making increased 25.8% to $41.6 million for the three months
ended March 31, 2001, from $33.0 million for the comparable period in 2000.
This increase is primarily due to higher U.S. option contract volume, offset by
lower average revenue per option contract. Total U.S. option contract volume
increased 139.6% to 8.5 million contracts for the three months ended March 31,
2001, from 3.5 million contracts for the comparable period in 2000, while
average revenue per U.S. option contract decreased to $4.92 per contract for
the three months ended March 31, 2001, from $9.37 per contract during the same
period in 2000.
Commissions and fees increased 106.5% to $14.5 million for the three months
ended March 31, 2001, from $7.0 million for the comparable period in 2000. This
increase is primarily due to payments received by our professional execution
services business, KEP, for directing order executions, as well as higher
equity share volumes from institutional customers in listed securities and
higher fees for providing certain information to market data providers.
Asset management fees increased 30.1% to $12.7 million for the three months
ended March 31, 2001, from $9.8 million for the comparable period in 2000. The
increase in fees was primarily due to an increase in the amount of funds under
management in the Deephaven Market Neutral Master Fund, which contained the
majority of our funds under management, from $374 million at March 31, 2000 to
$899 million at March 31, 2001. The increase was partially offset by the
decrease in fund return from 9.05% for the first quarter of 2000 to 5.11% for
the first quarter of 2001.
Interest income, net of interest expense, increased 51.4% to $5.3 million
for the three months ended March 31, 2001, from $3.5 million for the comparable
period in 2000. This increase was primarily due to larger cash balances held at
our clearing brokers.
Investment income and other income increased 60.9% to $5.7 million for the
three months ended March 31, 2001, from $3.5 million for the comparable period
in 2000. This increase was primarily due to an increase in income from our
investments, primarily our investments in the private hedge funds that we
sponsor and manage.
Expenses
Employee compensation and benefits expense decreased 54.6% to $79.7 million
for the three months ended March 31, 2001, from $175.5 million for the
comparable pro forma period in 2000. As a percentage of total revenue, employee
compensation and benefits expense increased to 35.3% for the three months ended
March 31, 2001, from 34.4% for the comparable pro forma period in 2000. The
decrease on a dollar basis was primarily due to decreased gross trading profits
and lower margins, offset, in part, by a growth in the number of employees. The
increase on a percentage basis was primarily due to a growth in our number of
employees and the decrease in average net revenue per equity share. Due to
decreased net trading revenue and profitability,
14
profitability based compensation decreased 68.9% to $48.3 million for the three
months ended March 31, 2001, from $155.6 million for the comparable pro forma
period in 2000, and represented 60.6% and 88.7% of total employee compensation
and benefits expense for the three months ended March 31, 2001 and 2000,
respectively. Our number of employees increased to 1,389 employees as of March
31, 2001, from 925 employees as of March 31, 2000.
Payments for order flow decreased 49.9% to $29.7 million for the three
months ended March 31, 2001, from $59.3 million for the comparable period in
2000. As a percentage of total revenue, payments for order flow increased to
13.2% for the three months ended March 31, 2001 from 11.6% for the comparable
period in 2000. The decrease in payments for order flow on a dollar basis was
primarily due to a 39.6% decrease in equity shares traded for the three months
ended March 31, 2001 to 26.5 billion shares, down from 43.8 billion for the
comparable period in 2000. The increase in payments for order flow as a
percentage of total revenue was primarily due to a decrease in our average
revenue per equity share and the introduction of payment for order flow in the
options marketplace in the third quarter of 2000.
Execution and clearance fees decreased 0.6% to $30.0 million for the three
months ended March 31, 2001, from $30.2 million for the comparable period in
2000. As a percentage of revenue, execution and clearance fees increased to
13.3% for the three months ended March 31, 2001 from 5.9% for the comparable
period in 2000. Despite the 31.5% decrease in equity trades executed to 30.2
million equity trades for the three months ended March 31, 2001 from 44.1
million equity trades for the comparable period in 2000, execution and
clearance fees remained relatively constant due to an offsetting 139.6%
increase in U.S. options contracts executed from 3.5 million U.S. options
contracts executed for the three months ended March 31, 2000 to 8.5 million for
the three months ended March 31, 2001. The increase in our execution and
clearance fees as a percentage of net trading revenue was primarily due to a
decrease in average revenue per equity trade and an increase in options volume.
Communications and data processing expense increased 80.1% to $12.8 million
for the three months ended March 31, 2001, from $7.1 million for the comparable
period in 2000. This increase was generally attributable to an increase in our
number of employees and our international expansion in Europe and Japan.
Depreciation and amortization expense increased 142.5% to $10.2 million for
the three months ended March 31, 2001, from $4.2 million for the comparable
period in 2000. This increase was primarily due to the purchase of
approximately $72.9 million of additional fixed assets and leasehold
improvements between March 31, 2000 and March 31, 2001 and the amortization of
goodwill related to our acquisitions of the listed securities market-making
businesses of KCM and Tradetech and various options specialist businesses.
Professional fees increased 24.8% to $5.7 million for the three months ended
March 31, 2001, up from $4.5 million for the comparable period in 2000. This
increase was primarily due to increased consulting expenses related to our
investments in technology, our European and Japanese expansion efforts as well
as legal and other professional fees.
Occupancy and equipment rentals expense increased 62.0% to $5.0 million for
the three months ended March 31, 2001, from $3.1 million for the comparable
period in 2000. This increase was primarily attributable to additional office
space and increased computer equipment lease expense. We occupied 277,812
square feet of office space at March 31, 2001, up from 161,909 square feet of
office space at March 31, 2000.
Business development expense decreased to $3.4 million for the three months
ended March 31, 2001, from $5.2 million for the comparable period in 2000. This
decrease was primarily the result of decreased advertising costs in the first
quarter of 2001 from the first quarter of 2000.
Other expenses increased 29.0% to $5.9 million for the three months ended
March 31, 2001, from $4.6 million for the comparable period in 2000. This was
primarily the result of increased administrative expenses and other operating
costs in connection with our overall business growth.
15
Our effective and pro forma effective tax rates for the three months ended
March 31, 2001 and 2000 differ from the federal statutory rate of 35% due to
state income taxes, as well as nondeductible expenses, including the
amortization of goodwill resulting from the acquisition of KCM and a portion of
business development expenses. Our effective tax rate increased to 42% for the
three months ended March 31, 2001 from 37% for the three months ended March 31,
2000 primarily due to non-deductible foreign losses and state and local income
taxes.
Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments, including
certain derivative instruments imbedded in other contracts, and for hedging
activities. In June 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133-an amendment of FASB Statement No. 133. In June 2000,
the FASB issued SFAS No. 138 Accounting for Certain Derivative Instruments and
Certain Hedging Activities, which is an amendment to SFAS No. 133 and is
effective concurrently with SFAS No. 137. We adopted the provisions of SFAS No.
133, 137 and 138 as of January 1, 2001. The adoption of these statements did
not have a material impact on our financial statements.
In September 2000, the FASB issued SFAS No. 140 Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities--a replacement
of FASB Statement No. 125. This statement resets accounting standards for
differentiating between securitizations and other transfers of financial assets
that are sales from transfers that are secured borrowings. We adopted certain
provisions of SFAS No. 140 as of December 31, 2000 which did not have a
material impact on our financial statements. We anticipate adopting the
remaining provisions of SFAS No. 140 effective Aptil 1, 2001 and do not believe
that the adoption of these remaining provisions will have a material impact on
our financial statements.
Liquidity and Capital Resources
Historically, we have financed our business primarily through cash generated
by operations, as well as the proceeds from our stock offerings, the private
placement of preferred and common units and borrowings under subordinated
notes. As of March 31, 2001, we had $2.8 billion in assets, 90.5% of which
consisted of cash or assets readily convertible into cash, principally
receivables from clearing brokers and securities owned. Receivables from
clearing brokers include interest bearing cash balances held with clearing
brokers, including, or net of, amounts related to securities transactions that
have not yet reached their contracted settlement date, which is generally
within three business days of the trade date. Securities owned principally
consist of equity securities that trade in Nasdaq and on the NYSE and AMEX
markets and listed options contracts that trade on national exchanges.
Net income and pro forma net income plus depreciation and amortization was
$37.1 million and $139.9 million during the three months ended March 31, 2001
and 2000, respectively. Depreciation and amortization expense, which related to
fixed assets and goodwill, was $10.2 million and $4.2 million during the three
months ended March 31, 2001 and 2000, respectively. Capital expenditures were
$16.0 million and $14.1 million for the three months ended March 31, 2001 and
2000, respectively, primarily related to the purchase of data processing and
communications equipment, as well as leasehold improvements and additional
office facilities to support our growth. In acquiring fixed assets,
particularly technology equipment, we make a decision about whether to lease
such equipment or purchase it outright based on a number of factors including
its estimated useful life, obsolescence and cost. Additionally, we made cash
payments of $3.8 million for the three months ended March 31, 2000 in
connection with our acquisitions of the listed securities market-making
businesses of KCM in 1995 and Tradetech in 1997. These arrangements ended
during 2000. We anticipate that we will meet our 2001 capital expenditure needs
out of operating cash flows.
16
As registered broker-dealers and market makers, KS, KCM, KFP and KEP are
subject to regulatory requirements intended to ensure the general financial
soundness and liquidity of broker-dealers and requiring the maintenance of
minimum levels of net capital, as defined in SEC Rule 15c3-1. These regulations
also prohibit a broker-dealer from repaying subordinated borrowings, paying
cash dividends, making loans to its parent, affiliates or employees, or
otherwise entering into transactions which would result in a reduction of its
total net capital to less than 120.0% of its required minimum capital.
Moreover, broker-dealers, including KS, KCM, KFP and KEP, are required to
notify the SEC prior to repaying subordinated borrowings, paying dividends and
making loans to their parents, affiliates or employees, or otherwise entering
into transactions, which, if executed, would result in a reduction of 30.0% or
more of their excess net capital (net capital less minimum requirement). The
SEC has the ability to prohibit or restrict such transactions if the result is
detrimental to the financial integrity of the broker-dealer. At March 31, 2001,
KS had net capital of $277.2 million, which was $274.7 million in excess of its
required net capital of $2.5 million, KCM had net capital of $45.9 million
which was $44.9 million in excess of its required net capital of $1.0 million,
KFP had net capital of $35.1 million, which was $34.8 million in excess of its
required net capital of $250,000 and KEP had net capital of $7.6 million, which
was $7.4 million in excess of its required net capital of $143,891.
Additionally, KSIL and KSJ are subject to capital adequacy requirements of the
Securities and Futures Authority Limited in the United Kingdom and the
Financial Supervisory Agency in Japan, respectively. As of March 31, 2001, we
were in compliance with the capital adequacy requirements of all of our foreign
subsidiaries.
We currently anticipate that available cash resources and credit facilities
will be sufficient to meet our anticipated working capital and capital
expenditure requirements for at least the next 12 months.
Other
In March 2001, we finalized our first closing for a pan-European market-
making venture with 19 broker-dealers and banks from Europe and the United
States. Our partners in the initial closing of Knight Roundtable Europe
Limited, which consist of a diverse group of leading pan-European and U.S.
securities firms, banks and broker-dealers, have contributed a total of $27.6
million. This amount has been matched by us and we have also contributed to the
venture our UK broker-dealer, KSIL. Following this closing, our ownership in
Knight Roundtable Europe Limited stands at approximately 85%. Additional
closings may occur, and, upon completion, our partners could collectively own
up to 30% of the venture. We believe Knight Roundtable Europe Limited will
further establish our international presence by leveraging technology and the
Company's trading methodologies to provide best execution solutions for
European investors in pan-European and U.S. equities.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our market-making and trading activities expose our capital to significant
risks. These risks include, but are not limited to, absolute and relative price
movements, price volatility and changes in liquidity, over which we have
virtually no control.
We employ automated proprietary trading and risk management systems which
provide real time, on-line risk management and inventory control. We monitor
our risks by a constant review of trading positions and their appropriate risk
measures. We have established a system whereby transactions are monitored by
senior management on a real-time basis as are individual and aggregate dollar
and inventory position totals, appropriate risk measures and real-time profits
and losses. The management of trading positions is enhanced by review of mark-
to-market valuations and position summaries on a daily basis.
In the normal course of our equities market-making business, we maintain
inventories of exchange-listed and OTC securities. The fair value of these
securities at March 31, 2001 was $115.2 million in long positions and $85.6
million in short positions. The potential change in fair value, using a
hypothetical 10.0% decline in prices, is estimated to be a $2.9 million loss as
of March 31, 2001 due to the offset of losses in long positions with gains in
short positions.
17
In the normal course of options market making, we maintain inventories of
options, futures and equities. Our main exposures are from equity price and
volatility risk. We manage these exposures by constantly monitoring and
diversifying our exposures and position sizes and establishing offsetting
hedges. Our market-making staff and trading room managers continuously manage
our positions and our risk exposures. Our systems incorporate trades and update
our risk profile using options pricing models on a real time basis.
Our proprietary options risk management system allows us to stress test our
portfolio on a real-time basis. On a daily basis, risk reports are distributed
to senior management and the firm's risk managers who incorporate this
information in our daily market-making decisions. These reports identify
potential exposures in terms of options and futures on individual securities
and index contracts, organized in different ways such as industry sectors,
under extreme price and volatility movements. At March 31, 2001, 10% movements
in volatility and stock prices on our entire equity options and equity index
options portfolios, which contain the majority of our market risk, would have
resulted in approximately the following gains (losses) in our options market-
making portfolio:
Change in Stock Prices
----------------------------------------
-10% None +10%
------------ ------------ ------------
Change in Volatility
+10%................................. ($6,000) ($789,000) $3.7 million
None................................. (645,000) -- 4.4 million
-10%................................. (1.5 million) (1.1 million) 5.5 million
This stress analysis covers positions in options and futures, underlying
securities and related hedges. The 10% changes in stock prices and volatility
in the charts above make the assumption of a universal 10% movement in all of
our underlying positions. The analysis also includes a number of estimates that
we believe to be reasonable, but cannot assure that they produce an accurate
measure of future risk.
For working capital purposes, we invest in money market funds, commercial
paper, government securities or maintain interest bearing balances in our
trading accounts with clearing brokers, which are classified as cash
equivalents and receivable from clearing brokers, respectively, in the
Consolidated Statements of Financial Condition. These other amounts do not have
maturity dates or present a material market risk, as the balances are short-
term in nature and subject to daily repricing.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We and certain of our officers and employees have been subject to legal
proceedings in the past and may be subject to legal proceedings in the future.
We are not currently a party to any legal proceedings, the adverse outcome of
which, individually or in the aggregate, we can predict with any reasonable
certainty, could have a material adverse effect on our business, financial
condition or operating results. We and certain of our past and present officers
and employees are currently the subject of legal proceedings, such as those
stated in our 8-K filing of November 30, 2000, that are in their preliminary
stages. As such, we are unable to predict the outcome of any such proceeding
and assess or quantify the potential damages, if any.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
18
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
None.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereto until duly authorized.
Knight Trading Group, Inc.
/s/ Robert I. Turner
-------------------------------------
By: Robert I. Turner
Title: Director, Executive Vice
President, Chief Financial
Officer and Treasurer (principal
financial and accounting
officer)
Date: May 14, 2001
19