================================================================================
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, 2002
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, 2002 the number of shares outstanding of the registrant's Class
A common stock was 123,153,624 and there were no shares outstanding of the
registrant's Class B common stock.
================================================================================
KNIGHT TRADING GROUP, INC.
FORM 10-Q QUARTERLY REPORT
For the Quarter Ended MARCH 31, 2002
TABLE OF CONTENTS
Page
----
PART I FINANCIAL INFORMATION:
Item 1. Financial Statements ........................................................................ 3
Consolidated Statements of Operations ....................................................... 3
Consolidated Statements of Financial Condition .............................................. 4
Consolidated Statements of Cash Flows ....................................................... 5
Notes to Consolidated Financial Statements .................................................. 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ....... 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk .................................. 20
PART II OTHER INFORMATION:
Item 1. Legal Proceedings ........................................................................... 21
Item 2. Changes in Securities and Use of Proceeds ................................................... 22
Item 3. Defaults Upon Senior Securities ............................................................. 22
Item 4. Submission of Matters to a Vote of Security Holders ......................................... 22
Item 5. Other Information ........................................................................... 22
Item 6. Exhibits and Reports on Form 8-K ............................................................ 22
Signatures ............................................................................................ 22
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Operations
(Unaudited)
For the three months ended March 31,
------------------------------------
2002 2001
----------------- ----------------
Revenues
Net trading revenue $ 112,680,478 $ 187,454,445
Commissions and fees 10,750,107 14,512,201
Asset management fees 7,129,981 12,720,036
Interest and dividends, net 1,606,557 5,309,313
Investment income and other 1,332,940 5,651,129
---------------- ---------------
Total revenues 133,500,063 225,647,124
---------------- ---------------
Expenses
Employee compensation and benefits 58,642,942 79,695,673
Execution and clearance fees 29,463,775 30,049,055
Payments for order flow 19,005,324 29,718,426
Communications and data processing 10,926,560 12,831,389
Depreciation and amortization 9,704,292 10,222,579
Occupancy and equipment rentals 7,237,946 5,010,858
Professional fees 6,683,451 5,654,011
Business development 1,190,682 3,369,758
Writedown of assets 6,485,848 -
Other 5,457,529 5,942,719
---------------- ---------------
Total expenses 154,798,349 182,494,468
---------------- ---------------
(Loss)/income before income taxes and minority interest (21,298,286) 43,152,656
Income tax (benefit)/expense (5,414,442) 17,982,130
---------------- ---------------
(Loss)/income before minority interest (15,883,844) 25,170,526
Minority interest in losses of consolidated subsidiaries 3,188,358 1,746,937
---------------- ---------------
Net (loss)/income $ (12,695,486) $ 26,917,463
================ ===============
Basic earnings per share $ (0.10) $ 0.22
================ ===============
Diluted earnings per share $ (0.10) $ 0.21
================ ===============
Shares used in basic earnings per share
calculations (see Note 10) 124,131,683 123,517,121
================ ===============
Shares used in diluted earnings per share
calculations (see Note 10) 124,131,683 126,179,906
================ ===============
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,
2002 2001
Assets
Cash and cash equivalents $ 431,855,708 $ 361,294,311
Securities owned, held at clearing broker, at market value 1,697,830,700 1,754,482,505
Receivable from brokers and dealers 607,902,104 820,103,479
Fixed assets and leasehold improvements at cost, less
accumulated depreciation and amortization 84,333,397 90,125,704
Goodwill, less accumulated amortization 17,536,945 17,536,945
Intangible assets, less accumulated amortization 33,743,747 34,363,040
Investments 96,609,735 92,665,597
Income taxes receivable 2,988,632 -
Other assets 45,724,754 56,115,374
--------------- ---------------
Total assets $ 3,018,525,722 $ 3,226,686,955
=============== ===============
Liabilities and Stockholders' Equity
Liabilities
Securities sold, not yet purchased, at market value $ 1,930,281,518 $ 2,039,355,967
Payable to brokers and dealers 183,771,819 227,526,691
Accrued compensation expense 30,091,878 65,121,718
Accrued execution and clearance fees 7,334,904 10,271,164
Accrued payments for order flow 6,276,733 5,594,935
Accounts payable, accrued expenses and other liabilities 20,972,384 22,286,928
Income taxes payable - 1,624,319
--------------- ---------------
Total liabilities 2,178,729,236 2,371,781,722
--------------- ---------------
Minority interest in consolidated subsidiaries 17,647,980 20,648,809
--------------- ---------------
Stockholders' equity
Class A Common Stock 1,243,404 1,241,586
Additional paid-in capital 337,201,387 335,796,119
Retained earnings 491,777,375 504,472,861
Unamortized stock-based compensation (1,583,596) (672,763)
Accumulated other comprehensive income (loss) - foreign currency
translation adjustments, net of tax (6,490,064) (6,581,379)
--------------- ---------------
Total stockholders' equity 822,148,506 834,256,424
--------------- ---------------
Total liabilities and stockholders' equity $ 3,018,525,722 $ 3,226,686,955
=============== ===============
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,
------------------------------------
2002 2001
-------------- -------------
Cash flows from operating activities
Net (loss)/income $ (12,695,486) $ 26,917,463
Adjustments to reconcile net (loss)/income to net cash provided by operating activities
Income tax credit from stock options exercised - 1,976,947
Issuance of restricted stock to employees 1,302 -
Cancellation of restricted stock to employees (11,591) -
Depreciation and amortization 9,704,292 10,222,579
Amortization of stock based compensation 95,355 -
Minority interest in losses of consolidated subsidiaries (3,188,358) (1,746,937)
Writedown of capitalized software 1,273,667 -
Writedown of assets 6,485,848 -
(Increase) decrease in operating assets
Securities owned 56,651,805 282,012,403
Receivable from brokers and dealers 212,201,375 (544,313,935)
Income taxes receivable (2,988,632) -
Other assets 9,965,620 (658,172)
Increase (decrease) in operating liabilities
Securities sold, not yet purchased (109,074,449) 318,221,930
Payable to brokers and dealers (43,754,872) (49,936,348)
Accrued compensation expense (35,029,840) (20,751,446)
Accounts payable, accrued expenses and other liabilities 205,912 (11,122,932)
Accrued execution and clearance fees (2,936,260) (1,052,128)
Accrued payments for order flow 681,798 (5,653,968)
Income taxes payable (1,624,319) 12,749,634
-------------- -------------
Net cash provided by operating activities 85,963,167 16,865,090
-------------- -------------
Cash flows from investing activities
Purchases of fixed assets and leasehold improvements (5,995,500) (15,987,043)
Investment in Deephaven sponsored fund (11,770,083) (19,169,659)
Strategic investments 1,765,097 834,210
-------------- -------------
Net cash used in investing activities (16,000,486) (34,322,492)
-------------- -------------
Cash flows from financing activities
Stock options exercised 411,187 2,495,450
Minority interest in consolidated subsidiaries 187,529 25,753,384
-------------- -------------
Net cash provided by financing activities 598,716 28,248,834
-------------- -------------
Increase in cash and cash equivalents 70,561,397 10,791,432
Cash and cash equivalents at beginning of period 361,294,311 364,057,534
-------------- -------------
Cash and cash equivalents at end of period $ 431,855,708 $ 374,848,966
-------------- -------------
Supplemental disclosure of cash flow information:
Cash paid for interest $ 3,944,992 $ 8,057,835
============== =============
Cash paid for income taxes $ - $ 5,232,496
============== =============
The accompanying notes are an integral part of these consolidated financial
statements.
5
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2002
(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 ("OTCBB"). Knight Capital Markets ("KCM," formerly known as
Trimark Securities) operates as a market maker in the Nasdaq Intermarket, the
over-the-counter market for New York Stock Exchange (NYSE)-and American Stock
Exchange (AMEX)-listed securities. Knight Roundtable Europe owns an approximate
85% interest in Knight Securities International, Ltd. ("KSIL"), which provides
execution services for European investors in European and U.S. equities.
Additionally, the Company owns 60% of a joint venture, with Nikko Cordial Group,
called Knight Securities Japan ("KSJ"), which provides wholesale market-making
services in Japanese equity securities. Knight Financial Products ("KFP") makes
markets in options on individual equities, equity indices and fixed income
futures instruments in the U.S. The Company also operates a professional option
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"). KFP is a member
of the Chicago Board Options Exchange as well as the American Stock Exchange,
the Pacific Exchange, the Philadelphia Stock Exchange and the International
Stock Exchange. The Company also maintains an asset management business for
institutional investors and high net worth individuals through its Deephaven
Capital Management ("Deephaven") subsidiary.
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, 2001 as
filed with the SEC.
Certain prior year amounts have been reclassified to conform to the current year
presentation.
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
6
Investments on the Consolidated Statements of Financial Condition includes
strategic ownership interests of less than 20% in publicly and non-publicly
traded companies which are accounted for under the equity method or the cost
basis of accounting. The equity method of accounting is used for investments in
limited partnerships. Investments also include the Company's investments in the
Deephaven Market Neutral Master Fund (the "Fund"), a private investment fund for
which the Company is the investment manager and sponsor. Investments are
reviewed on an ongoing basis to ensure that the valuations have not been
impaired.
Market-making activities
Securities owned and securities sold, not yet purchased, which primarily
consist of listed and OTC stocks and listed options 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, 2002 and 2001 was $3,863,979 and $7,777,226, respectively.
Asset management fees
The Company earns asset management fees for sponsoring and managing the
investments of the Fund. Such fees are recorded monthly as earned and are
calculated as a percentage of the Fund's monthly 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 his purchase.
Securities borrowed/loaned
Securities borrowed and securities loaned, which are included in receivable
from and payable to brokers and dealers, are recorded at the amount of cash or
other 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. 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 currencies 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 translation of
financial statements of a subsidiary whose functional currency is not the U.S.
dollar are included as a separate component of stockholders' equity in the
Consolidated Statements of Financial Condition. Gains or losses resulting from
foreign currency transactions are included in Investment income and other in the
Consolidated Statements of Operations.
Depreciation, amortization and occupancy
7
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 and amortizes the software over its
estimated useful life of three years.
Goodwill and Intangible Assets
The Company adopted the provisions of Statement of Financial Accounting
Standards (SFAS) No. 142 Goodwill and Other Intangible Assets as of January 1,
2002. This statement established new standards for accounting for goodwill and
intangible assets acquired outside of, and subsequent to a business combination.
Under the new standards, goodwill and certain intangible assets with an
indefinite useful life are no longer being amortized, but are tested for
impairment at least annually or when an event occurs or circumstances change
that signify the existence of impairment. Other intangible assets continue to be
amortized over their useful lives.
Writedown of fixed assets
Writedowns for fixed assets are recognized when it is determined that the
carrying amount of fixed assets is not recoverable. The amount of the impairment
writedown is determined by the difference between the carrying amount and the
fair value of the fixed asset. In determining the impairment, an estimated fair
value is obtained through research and inquiry of the market.
Lease loss accrual
It is the Company's policy to identify excess real estate capacity and where
applicable, accrue against such future costs. In determining the accrual, a
nominal cash flow analysis is performed, and costs related to the excess
capacity are accrued for.
Income taxes
Income tax (benefit)/expense in the Consolidated Statements of Operations
represents income taxes for the three months ended March 31, 2002 and 2001,
respectively.
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. Fair value for securities owned and securities sold,
not yet purchased, is estimated using market quotations available from major
securities exchanges and dealers. 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
8
Minority interest represents minority owners' share of net income or losses
and equity in two of the Company's consolidated subsidiaries, KSIL and KSJ.
Accounting for derivatives
The Company's derivative financial instruments are all held for trading
purposes and are carried at fair value.
Restricted stock
The Company records as unamortized stock-based compensation in
stockholders' equity the fair market value of shares associated with restricted
stock awards and amortizes the balance to compensation expense over the vesting
period.
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.
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,
2002 2001
------------------------------------
Securities owned:
Equities $ 821,209,333 $ 734,638,954
Options 861,762,772 907,988,169
Convertible bonds 1,446,538 93,474,975
U.S. government obligations 13,412,057 18,380,407
------------------------------------
$ 1,697,830,700 $ 1,754,482,505
====================================
Securities sold, not yet purchased:
Equities $ 985,808,630 $ 998,438,044
Options 943,026,350 1,019,052,935
Convertible bonds 1,446,538 21,864,988
------------------------------------
$ 1,930,281,518 $ 2,039,355,967
------------------------------------
4. Receivable from/Payable to Brokers and Dealers
Amounts receivable from and payable to brokers and dealers consist of the
following:
9
March 31, December 31,
2002 2001
-------------------------------------
Receivable:
Clearing brokers $ 568,301,729 $ 701,748,826
Securities failed to deliver 7,231,587 6,007,502
Securities borrowed 30,215,696 110,268,570
Other 2,153,092 2,078,581
-------------------------------------
$ 607,902,104 $ 820,103,479
=====================================
Payable:
Clearing brokers $ 170,428,769 $ 133,253,448
Securities failed to receive 6,257,271 12,947,759
Securities loaned 7,085,779 81,325,484
-------------------------------------
$ 183,771,819 $ 227,526,691
=====================================
5. Goodwill and Intangible Assets
The Company has adopted the provisions of Statement of Financial Accounting
Standards (SFAS) No. 142 Goodwill and Other Intangible Assets as of January 1,
2002. This statement established new standards for accounting for goodwill and
intangible assets acquired outside of, and subsequent to a business combination.
Under the new standards, goodwill and certain intangible assets with indefinite
useful lives are no longer being amortized, but are tested for impairment at
least annually or when an event occurs or circumstances change that signify the
existence of impairment. The Company continues to evaluate the effects, if any,
of impairment of its goodwill, all of which is attributable to its wholesale
market-making business segment. Intangible assets deemed to have definite lives
are being amortized over their useful lives, which have been determined to be 15
years.
The following table sets forth reported net earnings and EPS, as adjusted to
exclude goodwill amortization expense:
Three months ended March 31,
2002 2001
Net (loss) / income, as reported $ (12,695,486) $ 26,917,463
Net (loss) / income, as adjusted (12,695,486) 27,875,052
EPS, as reported:
Basic $ (0.10) $ 0.22
Diluted $ (0.10) $ 0.21
EPS, as adjusted
Basic $ (0.10) $ 0.23
Diluted $ (0.10) $ 0.22
At March 31, 2002, the Company has intangible assets with a gross carrying
amount of $37,240,877 and accumulated amortization of $3,497,130, which resulted
from the purchase of various options related businesses. During the quarter
ended March 31, 2002, the Company recorded amortization expense relating to
these intangible assets of $620,682. The estimated amortization expense relating
to the intangible assets for each of the five succeeding years approximates $2.5
million.
6. Investments
The Company's wholly-owned subsidiary, Deephaven, is the investment manager
and sponsor of a private investment fund, the Deephaven Market Neutral Master
Fund, LP (the "Fund") that engages in various trading strategies involving
equities, debt instruments and derivatives. The Company owns a $56.5 million
interest in the Fund at March 31, 2002. Certain officers and
10
directors of the Company also own interests the Fund. Additionally, the Company
owns a $6.2 million option to purchase an additional interest in the Fund. The
option is carried at fair value, which reflects the underlying value of an
interest in the Fund. The option was received by the Company in lieu of payment
for the performance fees earned from the Fund. Additionally, the Company has
made strategic investments in Nasdaq, Nasdaq Europe (formerly known as
Easdaq), Nasdaq Japan and other public and non-public companies.
7. Significant Customers
The Company considers significant customers to be customers who provide the
Company with 10% or more of its U.S. equity order flow, as measured in U.S.
equity share volume, during the period. One customer provided 11.4% of the
Company's U.S. equity order flow during the first quarter of 2002. Rebates paid
to this firm for U.S. equity and U.S. options contract order flow amounted to
$4.6 million during the same period.
8. Writedown of Assets
The writedown of assets on the Consolidated Statements of Operations
includes $6.5 million in pre-tax non-operating charges, or $4.0 million after
taxes and minority interest. The pre-tax writedown consists of $3.6 million
related to an impaired investment held by KSJ, $2.5 million related to an
impaired investment in a non-public e-commerce company and $425,000 related to a
writedown of options exchange seats.
9. 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,
2002 2001
------------------- -------------------
Net (loss)/income $ (12,695,486) $ 26,917,463
Foreign currency translation adjustment, net of tax 91,315 (3,373,129)
------------------ -------------------
Total comprehensive (loss)/income, net of tax $ (12,604,171) $ 23,544,334
================== ===================
10. Earnings per Share
Basic earnings per common share ("EPS") has been calculated by dividing net
income by the weighted average shares of Class A Common Stock outstanding during
each respective period. Diluted EPS reflects the potential reduction in EPS
using the treasury stock method to reflect the impact of common share
equivalents if stock awards such as stock options and restricted stock were
exercised or converted into common stock.
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, 2002 and 2001:
11
For the three months ended March 31,
2002 2001
---------------------------------- ----------------------------------
Numerator / Denominator / Numerator / Denominator /
net income shares net income shares
---------------------------------- ----------------------------------
(Loss)/income and shares used in basic calculations $ (12,695,486) 124,131,683 $ 26,917,463 123,517,121
Effect of dilutive stock based awards - - - 2,662,785
--------------------------------- ----------------------------------
(Loss)/income and shares used in diluted calculation $ (12,695,486) 124,131,683 $ 26,917,463 126,179,906
================================= ==================================
Basic earnings per share $ (0.10) $ 0.22
=============== ================
Diluted earnings per share $ (0.10) $ 0.21
=============== =================
For the three months ended March 31, 2002, 857,056 shares of common stock
equivalents were not included in the calculation of weighted average shares for
diluted EPS because the effect of their inclusion would be anti-dilutive.
11. 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 and KCM 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 or 6 2/3% of aggregate indebtness, as defined. KEP has also elected
to use the basic method, permitted by the Rule, which requires that it maintain
net capital equal to the greater of $100,000 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, 2002, KS had net capital of $218,286,633 which was
$216,801,486 in excess of its required net capital of $1,485,147, KCM had net
capital of $13,022,560 which was $12,022,560 in excess of its required net
capital of $1,000,000, KFP had net capital of $36,578,146 which was $36,328,146
in excess of its required net capital of $250,000 and KEP had net capital of
$2,653,828 which was $2,553,828 in excess of its required net capital of
$100,000.
Additionally, KSIL, KSJ and KFP are subject to regulatory requirements in
the countries in which they operate, including the requirements of the Financial
Services Authority in the United Kingdom and the Financial Supervisory Agency in
Japan. As of March 31, 2002, the Company was in compliance with these capital
adequacy requirements.
12. Business Segments
The Company has two reportable business segments: wholesale securities
market-making and asset management. Domestic securities market-making primarily
represents market-making in U.S. 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 U.S. options on individual equities, equity indices and fixed
income futures instruments. International securities market-making includes
market-making in equities in Europe and Japan and in options in Europe. The
asset management segment consists of investment management and sponsorship for
the Fund.
The Company's net revenues, income before income taxes and minority
interest and assets by segment are summarized below:
12
International
Domestic Market Market Total Market Asset
Marking* Making** Making Management***
--------------- ------------- --------------- ----------------
For the three months ended March 31, 2002:
Revenues $ 123,009,601 $ 4,380,174 $ 127,389,775 $ 8,769,231
Intra-segment revenues (84,298) (1,432,282) (1,516,580) -
--------------- ------------- --------------- ----------------
Total Revenues 122,925,303 2,947,892 125,873,195 8,769,231
(Loss) before income taxes and minority interest (4,883,555) (15,648,616) (20,532,171) (766,115)
Total Assets 2,533,743,637 418,417,374 2,952,161,011 66,364,711
For the three months ended March 31, 2001:
Revenues $ 209,397,750 $ 2,611,557 $ 212,009,307 $ 14,632,332
Intra-segment revenues (84,679) (909,836) (994,515) -
--------------- ------------- --------------- ----------------
Total Revenues 209,313,071 1,701,721 211,014,792 14,632,332
Income/(loss) before income taxes and minority interest 52,857,274 (18,590,149) 34,267,125 8,885,531
Total Assets 2,146,217,793 623,993,265 2,770,211,058 49,044,483
Elimination of
Intersegment Consolidated
Balances**** Total
-------------- -----------------
For the three months ended March 31, 2002:
Revenues $ (1,142,363) $ 135,016,643
Intra-segment revenues - (1,516,580)
------------- ---------------
Total Revenues (1,142,363) 133,500,063
(Loss) before income taxes and minority interest - (21,298,286)
Total Assets - 3,018,525,722
For the three months ended March 31, 2001:
Revenues $ - $ 226,641,639
Intra-segment revenues - (994,515)
------------- ---------------
Total Revenues - 225,647,124
Income/(loss) before income taxes and minority interest - 43,152,656
Total Assets - 2,819,255,541
---------
* - The three months ended March 31, 2002 includes $2.5 million in pre-tax
non-operating charges related to an impaired investment in a non-public
e-commerce company and $425,000 related to a writedown of options exchange
seats.
** - The three months ended March 31, 2002 includes a $3.6 million pre-tax,
pre-minority interest non-operating charge related to the impairment of a
strategic investment held by KSJ. Additionally, international market-making
includes costs incurred in the U.S. that are related to international
market-making businesses.
*** - The three months ended March 31, 2002 and 2001 includes $957,000 and $1.9
million, respectively, which consists of revenues generated from the Company's
investment in the Fund.
**** - Intersegment balances primarily represents asset management fees paid to
Deephaven by certain of the Company's domestic market-making subsidiaries for
management services.
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, 2001.
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.
Our results of operations may be materially affected by market
fluctuations, regulatory changes and by economic factors. We have experienced,
and expect to continue to experience, significant fluctuations in quarterly
operating results due to a variety of factors, including, but not limited to,
the value of our securities positions and our ability to manage the risks
attendant thereto, the volume of our market-making activities, the dollar value
of securities traded, volatility in the securities markets, our ability to
manage personnel and expenses, our ability to manage our client base, the amount
of revenue derived from limit orders as a percentage of net trading revenues,
changes in payments for order flow and clearing costs, the addition or loss of
sales and trading professionals, legislative, legal and regulatory changes, the
amount and timing of capital expenditures and divestitures, the incurrence of
costs associated with acquisitions and dispositions, investor sentiment,
technological changes and events, competition and market conditions. Such
factors may also have an impact on our ability to achieve our strategic
objectives, including (without limitation to) increased market share in our
market-making activities and growth in assets under management. If demand for
our market-making services declines and we are unable to adjust our cost
structure on a timely basis, our operating results and strategic objectives
could be materially and adversely affected.
As a result 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 return to 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 regain our profitability levels on
a quarterly basis.
13
Overview
We are a leading market maker in equity securities and in options on
individual equities, equity indices and fixed income futures instruments.
Additionally, we maintain an asset management business for institutions and high
net worth individuals. Our principal operating subsidiaries are:
.. Knight Securities ("KS"): KS is the largest wholesale market maker
operating in Nasdaq. KS's U.S. equity share volume totaled 32.6 billion and
21.4 billion, or 79% and 81% of our total U.S. equity share volume, for the
three months ended March 31, 2002 and 2001, respectively.
.. Knight Capital Markets ("KCM"): Through KCM we are the largest market maker
in the Nasdaq Intermarket, the over-the-counter market for all NYSE and
AMEX listed equity securities. KCM's U.S. equity share volume totaled 8.5
billion and 5.1 billion, or 21% and 19% of our total U.S. equity share
volume for the three months ended March 31, 2002 and 2001, respectively.
.. Knight Roundtable Europe, Ltd. ("KREL"): Through KREL, and its U.K.
broker-dealer, Knight Securities International Ltd. ("KSIL"), we provide
wholesale market-making services primarily in U.K. equity securities. KSIL
also routes U.S. equity orders to KS for execution. Our majority interest
in KREL is approximately 85%. The remaining 15% is owned by 21 pan-European
and U.S. broker-dealers and banks.
.. Knight Securities Japan ("KSJ"): Through KSJ we make markets in equity
securities in Japan. We own a majority interest of 60% of the business of
KSJ. The remaining 40% is owned by Nikko Cordial Group.
.. Knight Financial Products ("KFP"): Through KFP we make markets in listed
options on individual equities, equity indices and fixed income futures
instruments in the U.S. KFP's U.S. option contract volume amounted to 11.3
million and 8.5 million for the three months ended March 31, 2002 and 2001,
respectively.
.. Knight Execution Partners ("KEP"): KEP operates a professional options
execution services business.
.. Deephaven Capital Management ("Deephaven"): Through Deephaven, we perform
investment management services and sponsor a private investment fund for
institutions and high net worth individuals. Deephaven's assets under
management totaled approximately $1.3 billion and $899 million at March 31,
2002 and 2001, respectively.
We have two reportable business segments: wholesale securities
market-making and asset management. Wholesale securities market-making primarily
includes the operations of KS, KCM, KFP, KSIL and KSJ and primarily includes
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 and fixed income futures
instruments in the U.S. The asset management segment includes the operations of
Deephaven and consists of investment management and sponsorship of a private
investment fund.
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 U.S.
equity trade and share volumes and U.S. option contract volumes, our revenue
capture per U.S. equity share and per U.S. option contract, dollar value of U.S.
equities and U.S. options traded, 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 clients and by
regulatory changes and evolving industry customs and practices.
OTC securities transactions with institutional clients are executed as
principal, and all related profits and losses are included within net trading
revenue. Listed securities transactions with institutional clients are executed
on an agency basis through KS, 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 as well as by changes in fees earned for directing
trades to certain destinations for execution.
Asset management fees represent fees earned for sponsoring and managing the
investments of a private investment fund. Asset management fees are primarily
affected by the rates of return earned on the fund we manage and changes in the
amount of assets under management.
14
We earn interest income from our cash held at financial institutions 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 financial institutions and clearing brokers and
our level of securities positions in which we are long compared to our
securities positions in which we are short.
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
and volume. Employee compensation and benefits expense 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 U.S. equity share and
option volume, the mix of market orders and limit orders, the mix of orders
received from broker-dealers who accept payments for order flow and changes in
our payment for order flow policy. Execution and clearance fees primarily
fluctuate 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 fees to access electronic
communications networks, commonly referred to as ECNs.
Employee compensation and benefits expense primarily consists of salaries
and wages paid to all employees 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. At March 31, 2002,
approximately 67% 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 overhead costs we allocate to employees
engaged in market-making and sales activities.
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, execution fees paid to third parties, primarily for executing
trades in listed securities on the NYSE and AMEX and for executing orders
through ECNs and clearance fees for our international businesses. Due to our
equity share and trade volume, we have been able to negotiate favorable rates
and volume discounts from clearing brokers and providers of execution services.
Payments for order flow represent payments to certain broker-dealers, in
the normal course of business, for directing their order flow in U.S. equity
securities and U.S. option contracts to us. We only pay broker-dealers for
orders that provide us with a profit opportunity. For example, in our U.S.
equities market-making activities, we make payments on market orders and
marketable limit orders, but do not pay on non-marketable limit orders. Payments
for order flow change as we modify our payment formulas and as our percentage of
customers whose policy is not to accept payments for order flow varies.
Communications and data processing expense primarily consists of costs for
obtaining market data, telecommunications services and systems maintenance.
Depreciation and amortization expense results from the depreciation of
fixed assets and leasehold improvements and the amortization of intangible
assets with definite lives related to our purchases of various options-related
businesses. In accordance with Statement of Financial Accounting Standards No.
142 Goodwill and Other Intangible Assets, as of January 1, 2002, goodwill, which
includes contingent consideration resulting from the acquisitions of the listed
securities market-making businesses of KCM and Tradetech Securities, L.P.,
("Tradetech") is no longer being amortized.
Occupancy and equipment rentals expense primarily consists of rental
payments on office and equipment leases.
15
Professional fees consist of fees paid to computer programming, systems and
management consultants, as well as legal and other professional fees.
Business development expense primarily consists of travel, promotional and
advertising costs.
The writedown of assets consists of losses related to permanent impairments
to outside investments and options exchange seats.
Other expenses primarily consist of administrative expenses and other
operating costs such as recruitment fees, regulatory fees and general office
expenses.
Income Tax
Income tax (benefit)/expense in the Consolidated Statements of Operations
represents actual income taxes for the three months ended March 31, 2002 and
2001, respectively.
Results of Operations
Three Months Ended March 31, 2002 and 2001
Revenues
----------------------------------------------------------------------------------------------------------------------
For the three months ended
March 31,
----------------------------------------------------------------------------------------------------------------------
2002 2001 Change % of Change
---- ---- ------ -----------
----------------------------------------------------------------------------------------------------------------------
Equity market making trading revenues (millions) $ 85.5 $ 145.9 $ (60.4) -41.4%
----------------------------------------------------------------------------------------------------------------------
Options market making trading revenues (millions) $ 27.2 $ 41.6 $ (14.4) -34.6%
------- ------- --------
----------------------------------------------------------------------------------------------------------------------
Total trading revenues (millions) $ 112.7 $ 187.5 $ (74.8) -39.9%
----------------------------------------------------------------------------------------------------------------------
U.S. equity shares traded (billions) 41.1 26.5 14.7 55.4%
----------------------------------------------------------------------------------------------------------------------
U.S. equity trades executed (millions) 28.8 30.2 (1.4) -4.6%
----------------------------------------------------------------------------------------------------------------------
U.S. option contracts (millions) 11.3 8.5 2.8 33.6%
----------------------------------------------------------------------------------------------------------------------
Revenue capture per U.S. equity share ($) 0.0020 0.0055 (0.0035) -63.6%
----------------------------------------------------------------------------------------------------------------------
Revenue capture per U.S. option contract ($) 2.32 4.89 (2.57) -52.6%
----------------------------------------------------------------------------------------------------------------------
% of Bulletin Board equity shares of total U.S. 50.4% 36.7% 13.7% 37.3%
equity shares
----------------------------------------------------------------------------------------------------------------------
Our net trading revenue from equity security market-making decreased 41.4%
to $85.5 million for the three months ended March 31, 2002, from $145.9 million
for the comparable period in 2001. U.S. equity trading revenue represents the
majority of our equity market-making. This decrease in equity trading revenue
was primarily due to decreased average revenue capture per U.S. equity share and
unfavorable market conditions. Average revenue capture per U.S. equity share was
impacted by a reduction in spreads due to decimalization and the introduction of
a one-penny Minimum Price Variation ("MPV"), which allows for trading increments
as small as one cent, and was fully implemented in the second quarter of 2001.
Average revenue capture per U.S. equity share decreased to $.0020 for the three
months ended March 31, 2002, from $.0055 for the comparable period in 2001. The
decrease was offset, in part, by an increase in U.S. equity share volume. Total
U.S. equity share volume increased 55.4% to 41.1 billion U.S. equity shares for
the three months ended March 31, 2002, from 26.5 billion U.S. equity shares
traded for the comparable period in 2001. The increase in U.S. equity share
volume only partially offset the effect that decreased average revenue capture
had on equity market-making net trading revenue, due to higher share volume in
low-priced Bulletin Board and Pink Sheet stocks, which have a lower revenue
capture per share
16
opportunity. Net trading revenue from options market-making decreased 34.6% to
$27.2 million for the three months ended March 31, 2002 from $41.6 million for
the comparable period in 2001. The decrease was primarily due to lower average
revenue capture per U.S. option contract due to low volatility and increased
competition. Average revenue per U.S. option contract decreased to $2.32 for the
three months ended March 31, 2002, from $4.89 for the comparable period in 2001.
The decrease was partially offset by the increase in U.S. option contracts
executed. Total U.S. option contracts executed increased 33.6% to 11.3 million
contracts for the three months ended March 31, 2002, from 8.5 million for the
comparable period in 2001. Our U.S. option contract volume was positively
impacted by KFP's purchases of additional exchange posts during 2001, which
increased our overall options market-making coverage.
Commissions and fees decreased 25.9% to $10.8 million for the three months
ended March 31, 2002, from $14.5 million for the comparable period in 2001. This
decrease is primarily due to lower commission based volumes and lowered
commission rates in our options order routing activities. Additionally, there
was a decrease in fees we receive for providing certain information to market
data providers.
Asset management fees decreased 43.9% to $7.1 million for the three months
ended March 31, 2002, from $12.7 million for the comparable period in 2001. The
decrease in fees was primarily due to a decrease in fund returns from 5.1% for
the first quarter of 2001 to 1.3% for the first quarter of 2002. The decrease
was offset, in part, by the increase in the amount of funds under management in
the Deephaven Market Neutral Master Fund from $899 million at March 31, 2001 to
$1.3 billion at March 31, 2002.
Interest income, net decreased 69.7% to $1.6 million for the three months
ended March 31, 2002, from $5.3 million for the comparable period in 2001. This
decrease was primarily due to lower cash balances held at our clearing brokers
as well as lower interest rates.
Investment income and other income decreased 76.4% to $1.3 million for the
three months ended March 31, 2002, from $5.7 million for the comparable period
in 2001. This decrease was primarily due to a decrease in income from our
investments, which includes our investment in the Deephaven Market Neutral
Master Fund that we sponsor and manage. Additionally, there was a decrease in
benefits received from a state employment incentive grant.
Expenses
Employee compensation and benefits expense decreased 26.4% to $58.6 million
for the three months ended March 31, 2002, from $79.7 million for the comparable
period in 2001. As a percentage of total revenue, employee compensation and
benefits expense increased to 43.9% for the three months ended March 31, 2002,
from 35.3% for the comparable period in 2001. The decrease on a dollar basis was
primarily due to decreased gross trading profits, lower margins and a decrease
in our headcount offset, in part, by increased severance costs. The increase on
a percentage basis is primarily due to lower revenues and the decrease in
average revenue capture per U.S. equity share and per U.S. option contract as
well as increased severance costs. Due to unfavorable market and economic
conditions, employee headcount was reduced during 2001. Our number of full time
employees decreased to 1,283 at March 31, 2002, from 1,389 full time employees
at March 31, 2001. Due to decreased net trading revenue and profitability,
profitability based compensation decreased 46.3% to $26.5 million for the three
months ended March 31, 2002, from $49.3 million for the comparable period in
2001, and represented 45.2% and 61.9% of total employee compensation and
benefits expense for the three months ended March 31, 2002 and 2001,
respectively.
Execution and clearance fees decreased 1.9% to $29.5 million for the three
months ended March 31, 2002, from $30.0 million for the comparable period in
2001. As a percentage of total revenue, execution and clearance fees increased
to 22.1% for the three months ended March 31, 2002, from 13.3% for the
comparable period in 2001. Execution and clearance fees decreased on a dollar
basis due to the 4.6% decrease in U.S. equity trades executed to 28.8 million
U.S. equity trades for the three months ended March 31, 2002 from 30.2 million
U.S. equity trades for the comparable period in 2001. The decrease was partially
offset by the 33.6% increase in U.S. options contracts executed as well as
additional fixed costs related to our puchases of options trading posts during
2001. Execution and clearance fees also increased as a result of our
international operations in Europe and Japan. The increase in execution and
clearance charges as a percentage of total revenue was primarily due to the
decrease in average revenue capture per U.S. equity trade and per U.S. option
contract.
17
Payments for order flow decreased 36.0% to $19.0 million for the three
months ended March 31, 2002, from $29.7 million for the comparable period in
2001. As a percentage of total revenue, payments for order flow increased to
14.2% for the three months ended March 31, 2002 from 13.2% for the comparable
period in 2001. The decrease in payments for order flow on a dollar basis was
primarily due to changes in our payment for order flow policy as a result of
decimalization and the introduction of a one-penny MPV, initiated in the second
quarter of 2001. The decrease was partially offset by the 55.4% increase in U.S.
equity shares traded and the 33.6% increase in U.S. options contracts executed.
The increase in payments for order flow as a percentage of total revenue was due
to the decrease in average revenue capture per U.S. equity share and per U.S.
option contract.
Communications and data processing expense decreased 14.8% to $10.9 million
for the three months ended March 31, 2002, from $12.8 million for the comparable
period in 2001. This decrease was generally attributable to a decrease in our
number of employees and decreased technology costs and costs associated with our
international operations in Europe and Japan.
Depreciation and amortization expense decreased 5.1% to $9.7 million for
the three months ended March 31, 2002, from $10.2 million for the comparable
period in 2001. This decrease was primarily due to adoption of Statement of
Financial Accounting Standards No. 142 Goodwill and Other Intangible Assets. The
adoption of this statement decreased amortization expense by approximately $1.7
million in the first quarter 2002, compared to the first quarter 2001. The
decrease was offset, in part, by the effect of the purchase of approximately
$40.6 million of additional fixed assets and leasehold improvements between
March 31, 2001 and March 31, 2002 and the amortization of intangible assets with
definite lives related to our acquisitions of various options related
businesses.
Occupancy and equipment rentals expense increased 44.4% to $7.2 million for
the three months ended March 31, 2002, from $5.0 million for the comparable
period in 2001. This increase was primarily attributable to additional leased
office space.
Professional fees increased 18.2% to $6.7 million for the three months
ended March 31, 2002, from $5.7 million for the comparable period in 2001. This
increase was primarily due to an increase in one-time management consulting
expenses related to our asset management business, offset, in part, by decreased
consulting and legal fees related to our European and Asian expansion efforts in
the first quarter of 2001.
Business development expense decreased 64.7% to $1.2 million for the three
months ended March 31, 2002, from $3.4 million for the comparable period in
2001. The primary reason for the decrease was the result of lower travel and
entertainment costs.
During the three months ended March 31, 2002, pre-tax non-operating charges
of $6.5 million were incurred. The charges consist of $3.6 million related to an
impaired investment held by KSJ, $2.5 million related to an impaired investment
in a non-public e-commerce company and $425,000 related to a writedown of
options exchange seats.
Other expenses decreased 8.2% to $5.5 million for the three months ended
March 31, 2002, from $5.9 million for the comparable period in 2001. This was
primarily the result of decreased administrative expenses.
Our effective tax rates of 25.4% and 41.2% for the three months ended March
31, 2002 and 2001, respectively, differ from the federal statutory rate of 35%
due to state income taxes, non-deductible foreign losses as well as non
deductible expenses, including the amortization of goodwill resulting from the
acquisition of KCM and a portion of business development expenses.
Recently Issued Accounting Standards
In June 2001, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 141, Business
Combinations. This statement requires that companies account for all business
combinations initiated after June 30, 2001 using the purchase method of
accounting. Business combinations
18
completed before June 30, 2001 originally accounted for under the pooling of
interest method will continue to be accounted for under that method. This
statement also addresses the initial recognition and measurement of goodwill and
other intangible assets acquired in a business combination. We adopted the
provisions of SFAS No. 141 as of July 1, 2001. The adoption of this statement
did not have an impact on our financial statements.
In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets. This statement establishes new standards for accounting for goodwill and
intangible assets acquired outside of, and subsequent to a business combination.
Under the new standards, goodwill and certain intangible assets with an
indefinite useful life will no longer be amortized, but will be tested for
impairment at least annually. Other intangible assets will continue to be
amortized over their useful lives. The useful lives and any impairment of other
intangible assets will also be tested at least annually or when an event occurs
or circumstances change that signify the existence of impairment. We adopted the
provisions of SFAS No. 142 as of January 1, 2002. We continue to evaluate the
effects, if any, of impairment of goodwill. We expect that the elimination of
the amortization of goodwill will decrease operating expenses by approximately
$6.4 million in 2002.
In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations. This statement establishes standards for financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. We adopted the provisions of
SFAS No. 143 as of January 1, 2002. The adoption of this statement did not have
an impact on our financial statements.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. This statement supersedes SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of. SFAS No. 144 establishes a single model for accounting for the
impairment or disposal of long-lived assets. We adopted the provisions of SFAS
No. 144 as of January 1, 2002. The adoption of this statement did not have an
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. As of
March 31, 2002, we had $3.0 billion in assets, 91% 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. In addition to our cash and assets readily convertible
into cash, at March 31, 2002, we had a $51.8 million general partner interest in
the Deephaven Market Neutral Master Fund (the "Fund"), the private investment
fund that we sponsor and manage. This general partner investment can be
liquidated upon request with no advance notice. In March 2002, we liquidated
approximately $123.5 million in long security positions and $59.0 million in
short security positions owned by the Company, from separate accounts managed by
Deephaven. In April 2002, we invested, as a limited partner, an additional $87.7
million in the Fund. Additionally, in May 2002, we converted $51.0 million of
our general partner interest in the Fund into a limited partner investment. As a
limited partner in such fund, we are subject to a ninety-day written
notification period before funds can be redeemed, subject to monthly redemption
limits. Currently, our overall investment in the Fund is approximately $144.2
million. In addition, the Company owns a $6.2 million option to purchase an
additional interest in the Fund. This option may be exercised at any time. At
March 31, 2002, the Company had net liquid assets, which consists of net assets
readily convertible into cash, of approximately $603.4 million.
Net (loss)/income plus depreciation and amortization was $(3.0) million and
$37.1 million during the three months ended March 31, 2002 and 2001,
respectively. Depreciation and amortization expense, which related to fixed
assets and intangible assets, was $9.7 million and $10.2 million during the
three months ended March 31, 2002 and 2001, respectively. Capital expenditures
were $6.0 million and $16.0 million for the three months ended March 31, 2002
and 2001, respectively. Capital expenditures in 2002 primarily related to the
purchase of data processing and communications equipment, as well as leasehold
improvements. In acquiring fixed assets, particularly technology equipment, we
make a decision about whether to lease such equipment or purchase it outright
based on a
19
number of factors including its estimated useful life, obsolescence and cost. We
also made investments in the Fund of $11.8 million and $19.2 million during the
three months ended March 31, 2002 and 2001, respectively. Our general partner
investment in the Fund can be liquidated upon request with no advance notice.
We have no debt at March 31, 2002 nor do we currently have any debt
commitments for 2002. We do not anticipate that we will need to incur debt to
meet our 2002 capital expenditure and operating needs.
In April 2002, our Board of Directors approved a program to repurchase,
from time to time, shares of the Company's outstanding Class A Common Stock up
to a total amount of $35 million. Under this program, we may repurchase shares
in the open market or through privately negotiated transactions, depending on
prevailing market conditions, alternative use of capital and other factors. As
of May 14, 2002, the Company has repurchased approximately 1.2 million shares of
Class A Common Stock under this program.
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
its parent, affiliates or employees, or otherwise entering into transactions,
which, if executed, would result in a reduction of 30.0% or more of its 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, 2002, KS had net capital
of $218.3 million, which was $216.8 million in excess of its required net
capital of $1.5 million, KCM had net capital of $13.0 million which was $12.0
million in excess of its required net capital of $1.0 million, KFP had net
capital of $36.6 million which was $36.3 million in excess of its required net
capital of $250,000 and KEP had net capital of $2.7 million which was $2.6
million in excess of its required net captial of $100,000. Additionally, KSIL,
KSJ and KFP are subject to capital adequacy requirements of the Financial
Services Authority in the United Kingdom and the Financial Supervisory Agency in
Japan. As of March 31, 2002, 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 2002, the Company discontinued its options market-making
activities in London and Australia. The decision was based on global economic
and market conditions and is in line with the Company's desire to operate within
a more efficient infrastructure. The options market-making activities in London
and Australia were unprofitable, non-strategic and required a high level of
management focus that could not be justified given the limited profit
opportunities. Pre-tax charges related to the decision to discontinue our
options market-making activities in London and Australia were approximately
$938,000, or approximately $600,000 after taxes.
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
20
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 equity securities. The fair value of
these securities at March 31, 2002 was $149.3 million in long positions and
$141.3 million in short positions. The potential change in fair value, using a
hypothetical 10.0% decline in prices, is estimated to be a $803,000 loss as of
March 31, 2002 due to the offset of gains in short positions with losses in long
positions.
In the normal course of our options market-making business, we maintain
inventories of options, futures and equities. Our main exposure is 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, 2002, 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% ............. $ 8.8 million $ 1.1 million $ 14.2 million
None ............ 8.3 million -- 13.0 million
-10% ............. 8.0 million (1.2 million) 11.2 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 brokers and dealers, 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. Our cash and cash equivalents held in
foreign currencies are subject to the exposure of foreign currency fluctuations.
These balances are monitored daily, and are not material to the Company's
overall cash position.
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. As noted in previous filings, on March 5, 2002,
Judge Katherine Hayden of the United States District Court for the District of
New Jersey dismissed with prejudice the putative class action entitled Patricia
Murray et al v. Knight Trading Group, Inc. et al (now known as
21
In Re: Knight Trading Group, Inc. Securities Litigation). The Murray plaintiffs'
time to file a Notice of Appeal and their time to file a Request to File a Late
Appeal have expired without any notice having been received.
From time to time, we have been threatened with, or named as a defendant
in, lawsuits, securities arbitrations before the NASDR, and administrative
claims. Compliance and trading problems that are reported to the NASDR or the
NASD by dissatisfied customers of our broker-dealer clients are investigated by
the NASDR or the SEC and, if pursued by such customers, may rise to the level of
arbitration or disciplinary action.
The securities industry is subject to extensive regulation under federal,
state and applicable international laws. As a result, we are required to comply
with many complex laws and rules and our ability to so comply is dependent in
large part upon the establishment and maintenance of a qualified compliance
system. From time to time, NASDR and the SEC make allegations of our
noncompliance which we defend vigorously.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
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
On April 4, 2002, the Company filed a current report on Form 8-K to
report that its Board of Directors approved a program to repurchase, from
time to time, shares of the Company's outstanding Class A Common Stock up
to a total of $35 million.
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, 2002
22