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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, 2000
001-14223
COMMISSION FILE NUMBER
Knight / Trimark 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 12, 2000 the number of shares outstanding of the registrant's Class A
common stock was 122,246,870 and there were no shares outstanding of the
registrant's Class B common stock.
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KNIGHT/TRIMARK GROUP, INC.
FORM 10-Q QUARTERLY REPORT
For the Quarter Ended March 31, 2000
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
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................. 10
Item 3. Quantitative and Qualitative Disclosures About Market
Risk....................................................... 16
PART II OTHER INFORMATION:
Item 1. Legal Proceedings.......................................... 17
Item 2. Changes in Securities and Use of Proceeds.................. 17
Item 3. Defaults Upon Senior Securities............................ 17
Item 4. Submission of Matters to a Vote of Security Holders........ 17
Item 5. Other Information.......................................... 17
Item 6. Exhibits and Reports on Form 8-K........................... 17
Signatures.......................................................... 17
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
KNIGHT/TRIMARK GROUP, INC.
Consolidated Statements of Income
(Unaudited)
For the three months
ended March 31,
--------------------------
2000 1999
------------ ------------
Revenues
Net trading revenue............................. $487,044,508 $193,262,964
Asset management fees........................... 9,428,494 3,422,785
Interest and dividends.......................... 8,641,705 3,634,987
Commissions and fees............................ 4,694,706 2,527,182
Investment income and other..................... 3,244,822 592,247
------------ ------------
Total revenues................................ 513,054,235 203,440,165
------------ ------------
Expenses
Employee compensation and benefits.............. 175,140,659 62,214,498
Payments for order flow......................... 59,317,560 32,427,828
Execution and clearance fees.................... 29,757,518 19,715,171
Communications and data processing.............. 7,132,471 4,130,699
Business development............................ 5,234,228 767,541
Interest........................................ 5,162,123 2,704,590
Professional fees............................... 4,531,673 1,299,266
Depreciation and amortization................... 4,201,149 2,140,097
Occupancy and equipment rentals................. 3,074,132 1,923,381
Other........................................... 2,563,197 1,794,113
------------ ------------
Total expenses................................ 296,114,710 129,117,184
------------ ------------
Income before income taxes........................ 216,939,525 74,322,981
Income tax expense................................ 80,407,523 27,317,554
------------ ------------
Net income........................................ $136,532,002 $ 47,005,427
============ ============
Basic earnings per share.......................... $ 1.12 $ 0.40
============ ============
Diluted earnings per share........................ $ 1.08 $ 0.39
============ ============
Pro forma adjustments (see Note 1):
Income before income taxes...................... $216,939,525 $ 74,322,981
Adjustment for pro forma employee compensation
and benefits................................... (267,109) (1,706,065)
------------ ------------
Pro forma income before income taxes............ 216,672,416 72,616,916
Pro forma income tax expense.................... 81,050,811 30,673,724
------------ ------------
Pro forma net income............................ $135,621,605 $ 41,943,192
============ ============
Pro forma basic earnings per share.............. $ 1.11 $ 0.36
============ ============
Pro forma diluted earnings per share............ $ 1.07 $ 0.34
============ ============
Shares used in the computation of basic earnings
per share (see Note 6)........................... 122,146,982 118,108,473
Shares used in the computation of diluted earnings
per share (see Note 6)........................... 126,981,962 122,077,051
The accompanying notes are an integral part of these consolidated financial
statements.
3
KNIGHT/TRIMARK GROUP, INC.
Consolidated Statements of Financial Condition
(Unaudited)
March 31, December 31,
2000 1999
-------------- --------------
Assets
Cash and cash equivalents....................... $ 449,379,253 $ 304,053,554
Securities owned, at market value............... 1,079,553,462 910,232,916
Receivable from clearing brokers................ 235,795,918 215,423,208
Fixed assets and leasehold improvements at cost,
less accumulated depreciation.................. 37,915,025 26,820,045
Goodwill, less accumulated amortization......... 28,990,372 24,899,982
Investments..................................... 36,025,848 40,408,554
Other assets.................................... 23,610,947 18,447,547
-------------- --------------
Total assets................................ $1,891,270,825 $1,540,285,806
============== ==============
Liabilities & Stockholders' Equity
Liabilities
Securities sold, not yet purchased, at market
value........................................ $ 892,264,795 $ 720,919,013
Securities sold under agreements to
repurchase................................... 10,278,097 10,409,736
Payable to clearing brokers................... 126,124,005 159,943,018
Accrued compensation expense.................. 99,690,350 57,234,608
Accrued execution and clearance fees.......... 7,213,266 8,371,056
Accrued payments for order flow............... 18,274,152 13,978,854
Accounts payable, accrued expenses and other
liabilities.................................. 21,862,242 54,205,482
Income taxes payable.......................... 79,544,817 15,992,937
-------------- --------------
Total liabilities........................... 1,255,251,724 1,041,054,704
-------------- --------------
Stockholders' equity
Class A Common Shares......................... 1,221,556 1,221,215
Additional paid-in capital.................... 300,610,750 300,355,094
Retained earnings............................. 334,186,795 197,654,793
-------------- --------------
Total stockholders' equity.................. 636,019,101 499,231,102
-------------- --------------
Total liabilities and stockholders' equity.. $1,891,270,825 $1,540,285,806
============== ==============
The accompanying notes are an integral part of these consolidated financial
statements.
4
KNIGHT/TRIMARK GROUP, INC.
Consolidated Statements of Cash Flows
(Unaudited)
For the three months ended
March 31,
----------------------------
2000 1999
------------- -------------
Cash flows from operating activities
Net income....................................... $ 136,532,002 $ 47,005,427
Adjustments to reconcile net income to net cash
provided by operating activities
Depreciation and amortization.................. 4,201,149 2,140,097
Undistributed earnings from investments
accounted for under the equity method......... (2,376,291) (88,854)
(Increase) decrease in operating assets
Securities owned............................... (169,320,546) (496,482,833)
Receivable from clearing brokers............... (20,372,710) 35,891,169
Other assets................................... (5,163,400) (6,498,974)
Increase (decrease) in operating liabilities
Securities sold, not yet purchased............. 171,345,782 350,697,268
Securities sold under agreements to
repurchase.................................... (131,639) 154,824,816
Payable to clearing brokers.................... (33,819,013) (51,406,175)
Accrued compensation expense................... 42,455,742 8,126,714
Accrued execution and clearance fees........... (1,157,790) 533,525
Accrued payments for order flow................ 4,295,298 1,853,948
Accounts payable, accrued expenses and other
liabilities................................... (32,343,240) (7,600,852)
Income taxes payable........................... 63,551,880 26,694,614
------------- -------------
Net cash provided by operating activities.... 157,697,224 65,689,890
------------- -------------
Cash flows from investing activities
Payment of contingent consideration............ (3,764,257) (1,618,686)
Investments.................................... 6,758,997 (4,638,692)
Purchase of Philadelphia specialist posts...... (1,550,000) --
Purchases of fixed assets and leasehold
improvements.................................. (14,072,262) (1,517,012)
------------- -------------
Net cash used in investing activities........ (12,627,522) (7,774,390)
------------- -------------
Cash flows from financing activities
Repayment of short-term loan................... -- (11,016,766)
Proceeds from issuance of common stock......... -- 80,606,183
Stock options exercised, including income tax
credit........................................ 255,997 516,050
Capital contributions from members of KFP...... -- 5,502,669
------------- -------------
Net cash provided by financing activities.... 255,997 75,608,136
------------- -------------
Increase in cash and cash equivalents............ 145,325,699 133,523,636
Cash and cash equivalents at beginning of
period.......................................... 304,053,554 117,704,635
------------- -------------
Cash and cash equivalents at end of period....... $ 449,379,253 $ 251,228,271
============= =============
Supplemental disclosure of cash flow information:
Cash paid for interest......................... $ 5,122,211 $ 2,614,921
============= =============
Cash paid for income taxes..................... $ 18,101,279 $ 5,284,276
============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
5
KNIGHT/TRIMARK GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2000
(Unaudited)
1. Organization and Description of the Business
Knight/Trimark Group, Inc. (the "Company") and its subsidiaries operate in
market-making and asset management business lines. Knight Securities ("Knight")
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 New York Stock Exchange (NYSE)-and
American Stock Exchange (AMEX)-listed equity securities over the counter-the
Third Market. Knight Financial Products ("KFP") makes markets in options on
individual equities, equity indices, fixed income instruments and certain
commodities 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 subsidiaries. Knight, KCM and KFP are registered as
broker-dealers with the Securities and Exchange Commission ("SEC" or the
"Commission"). Additionally, Knight and KCM are members of the National
Association of Securities Dealers, Inc. ("NASD").
The Company was organized in January 2000 as the successor to the business
of its predecessor (the "Predecessor") which operated under the same name. The
Predecessor was organized in April 1998 as the successor to the business of
Roundtable Partners, L.L.C. ("Roundtable"). On January 12, 2000, the Company
completed a merger (the "Merger") with Arbitrade Holdings LLC ("Arbitrade").
The transaction resulted in the newly formed parent holding company issuing
shares on a tax-free basis to holders of the Predecessor's common stock and to
the owners of Arbitrade. Following the transaction, the Predecessor and
Arbitrade became subsidiaries of the Company, which became the publicly traded
Nasdaq company under the same ticker symbol as the Predecessor (NITE).
Arbitrade's options market making unit subsequently changed its name to "Knight
Financial Products LLC." The transaction was accounted for as a pooling of
interests, and, as such, the historical financial statements have been restated
to account for the merger on a retroactive basis. Pro forma adjustments for
compensation and income taxes have been made to the historical financial
statements of Arbitrade to adjust for partners' compensation, which was
previously paid as distributions of capital, and income taxes, which were
previously borne by the individual partners of Arbitrade. The foregoing
description of the Arbitrade transaction is a brief summary and is qualified in
its entirety by reference to the Merger Agreement, a copy of which was filed as
an exhibit to the Company's current report on Form 8-K filed with the SEC on
January 12, 2000. Unless otherwise indicated, all references to the "Company"
refer to the Company or the Predecessor, as appropriate.
2. Significant Accounting Policies
Basis of consolidation and form of presentation
The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiaries (see Note 1) 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 audited financial statements as of December 31, 1999 included in the
Company's Report on Form 10-K as filed with the SEC. All share and per share
amounts presented in this document have been adjusted to reflect the Company's
two-for-one stock split on May 14, 1999.
6
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 Statement of Financial Condition comprise of
ownership interests of less than 20% in non-publicly traded companies which are
accounted for under the equity method or 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
equity order executions to the Company.
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.
Resale and repurchase agreements
Securities purchased under agreements to resell ("resale agreements") and
securities sold under agreements to repurchase ("repurchase agreements") are
accounted for as collateralized financing transactions and are recorded at
their contracted resale or repurchase amounts plus accrued interest.
Counterparties are major financial institutions. The Company's policy is to
take possession or control of securities with a market value in excess of the
principal amount loaned, plus accrued interest, in order to collateralize
securities purchased under agreements to resell. The Company monitors the
market value of the underlying securities which collateralize the related
receivable on resale agreements, including accrued interest, and requests
additional collateral when deemed appropriate. Similarly, the Company is
required to provide securities to counterparties in order to collateralize
securities sold under agreements to repurchase.
Foreign currencies
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 functional currency of the Company's wholly owned
foreign subsidiaries is the U.S. dollar. The foreign exchange gains and losses
resulting from these translations are included in other expenses in the
Consolidated Statements of Income.
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.
7
Income taxes
Income tax expense in the Consolidated Statements of Income represents
actual income taxes incurred through March 31, 2000. Before the Merger, 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 do not include a provision for
income taxes. Subsequent to the Merger, the Company is subject to federal
income taxes and state income taxes based on KFP's income. 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 based upon enacted
tax rates for the expected future tax consequences of temporary differences
between the financial reporting and tax bases of assets and liabilities.
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.
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.
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,
2000 1999
-------------- ------------
Securities owned:
Equities......................................... $ 496,266,650 $381,240,123
Options.......................................... 573,039,096 518,408,094
U.S. government obligations...................... 10,247,716 10,584,699
-------------- ------------
$1,079,553,462 $910,232,916
============== ============
Securities sold, not yet purchased:
Equities......................................... $ 344,401,967 $263,614,076
Options.......................................... 547,862,828 457,304,937
-------------- ------------
$ 892,264,795 $720,919,013
============== ============
4. Investments
The Company's wholly-owned subsidiaries, Deephaven Capital Management LLC,
Deephaven Capital LLC and Deephaven Investment Advisers LLC, are the investment
managers and sponsors 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 $23.0 million at March 31, 2000. Certain officers of
the Company also own interests in these private investment funds.
8
5. Significant Customers
The Company considers affiliates to be holders of 10% or more of the
Company's outstanding common stock ("Affiliates"). During the first quarter of
2000 there were no Affiliates of the Company.
Two customers provided 17% and 11%, respectively, of the Company's order
flow for the quarter ended March 31, 2000 as measured in share volume. Order
flow payments to these firms amounted to $8,998,336 and $10,511,694,
respectively, during the same period. One of these customers acts as a clearing
broker for KCM.
6. 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
and Class B Common Stock outstanding during each respective period.
Weighted-average shares outstanding for the three months ended March 31,
2000 and 1999 have been determined as if the Merger described in Note 1
occurred as of the earliest date presented. 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, 2000 and 1999:
Three months ended Three months ended
March 31, 2000 March 31, 1999
------------------------ -----------------------
Numerator / Denominator Numerator / Denominator
pro forma / pro forma /
income shares income shares
------------ ----------- ----------- -----------
Shares and income used in
basic calculations.......... $135,621,605 122,146,982 $41,943,192 118,108,473
Effect of dilutive stock
options..................... -- 4,834,980 -- 3,968,578
------------ ----------- ----------- -----------
Shares and income used in
diluted calculations........ $135,621,605 126,981,962 $41,943,192 122,077,051
============ =========== =========== ===========
Pro forma basic earnings
per share................. $ 1.11 $ 0.36
=========== ===========
Pro forma diluted earnings
per share................. $ 1.07 $ 0.34
=========== ===========
7. Net Capital Requirements
As registered broker-dealers, Knight, KCM and KFP are subject to the SEC's
Uniform Net Capital Rule (the "Rule") which requires the maintenance of minimum
net capital. Knight 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 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, 2000, Knight had net capital of $389,230,839 which was
$382,295,070 in excess of its required net capital of $6,935,769, KCM had net
capital of $50,814,947 which was $49,171,686 in excess of its required net
capital of $1,643,261 and KFP had net capital of $27,007,640 which was
$26,757,640 in excess of its required net capital of $250,000.
8. Business Segments
The Company has two reportable business segments: securities market-making
and asset management. Securities market making includes the operations of
Knight, KCM and KFP and 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,
fixed income instruments and certain commodities. The asset management segment
includes the operations of Deephaven Management LLC, Deephaven Capital LLC and
Deephaven Investment Advisers LLC and consists of investment management and
sponsorship for a series of private investment funds.
9
The Company's net revenues, income before income taxes and assets by
segment are summarized below:
Securities Asset
Market Making Management Total
-------------- ----------- --------------
For the three months ended March 31,
2000:
Revenues.......................... $ 502,079,782 $10,974,453 $ 513,054,235
Pro forma income before income
taxes............................ 207,764,990 8,907,426 216,672,416
Total assets...................... 1,862,915,235 28,355,590 1,891,270,825
For the three months ended March 31,
1999:
Revenues.......................... 199,804,410 3,635,755 203,440,165
Pro forma income before income
taxes............................ 69,771,218 2,845,698 72,616,916
Total assets...................... 1,278,515,309 12,465,926 1,290,981,235
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 audited financial statements as of December 31, 1999 included
within our report on Form 10-K. 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 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. We are also a
leading market maker in options on individual equities, equity indices, fixed
income instruments and certain commodities 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 subsidiaries.
Knight commenced Nasdaq and OTC securities market-making operations on July
24, 1995. Knight's share volume totaled 34.9 billion and 13.2 billion, or 79%
and 70% of our total share volume, for the three months ended March 31, 2000,
and 1999, respectively. KCM's share volume totaled 9.2 billion and 5.5
billion, or 21% and 30% of our total share volume for the three months ended
March 31, 2000 and 1999, respectively.
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,
overhead and other expenses, the amount of revenue derived from limit orders
as a percentage of net trading revenues, changes in payments for order flow,
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 economic
conditions. If demand for our market-making services 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.
10
Revenues
Our revenues consist principally of net trading revenue from 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 ability to derive trading gains
by taking proprietary positions, changes in our execution standards and by
regulatory changes and evolving industry customs and practices.
We continue to focus on increasing our sales to institutional customers. OTC
securities transactions with institutional customers are executed as principal,
and all related profits and losses are included within net trading revenue.
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.
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.
Commissions and fees are primarily affected by changes in our trade and share
volumes in listed securities.
We also earn interest income from our cash and securities positions held at
banks and in trading accounts at clearing brokers. Interest income is primarily
affected by the changes in cash balances held at banks and clearing brokers.
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 are variable in nature. Employee
compensation and benefits expense, which is largely profitability based,
fluctuates, for the most part, based on changes in net trading revenue and our
profitability. Payments for order flow fluctuate based on share 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 trade, share and contract volume, and
the clearance fees charged by clearing brokers.
Employee compensation and benefits expense primarily consists of salaries
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 75% 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 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.
Execution and clearance fees primarily represent clearance fees paid to
clearing brokers, 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 electronic communications networks, commonly
referred to as ECNs. Due to our significant growth in
11
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 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.
Business development expense primarily consists of advertising costs and
marketing expenses, including travel and entertainment and promotion costs.
Interest expense primarily consists of transaction-related interest charged
by clearing brokers for facilitating the settlement and financing of securities
sold, not yet purchased. Interest expense is primarily affected by the changes
in cash balances held at clearing brokers and the level of securities sold, not
yet purchased.
Professional fees primarily consist of fees paid to computer programming and
systems consultants, as well as legal fees and other professional fees.
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 Trimark and Tradetech Securities, L.P.,
("Tradetech") which we acquired in November 1997, and of the AMEX specialist
operations of Gargoyle Specialists, L.P. ("Gargoyle") which KFP acquired in
July 1999.
Occupancy and equipment rentals expense primarily consists of rental
payments on office and equipment leases.
Other expenses primarily consist of administrative expenses and other
operating costs incurred in connection with our business growth, as well as
director fees.
Income Tax
Income tax expense in the Consolidated Statements of Income represents
actual income taxes incurred through March 31, 2000. Before the Merger, 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 do not include a provision for
income taxes. Subsequent to the Merger, the Company is subject to federal
income taxes and state income taxes based on KFP's income. 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, 2000 and 1999
Revenues
Net trading revenue increased 152.0% to $487.0 million for the three months
ended March 31, 2000, from $193.3 million for the comparable period in 1999.
This increase was primarily due to higher equity trading volume and increased
average revenue per equity trade and per equity share. Total equity trade
volume increased 135.8% to 44.1 million trades for the three months ended March
31, 2000, from 18.7 million equity trades for the comparable period in 1999.
Total equity share volume increased 174.8% to 43.8 billion equity shares traded
for the three months ended March 31, 2000, from 15.9 billion equity shares
traded for the comparable period in 1999.
12
Asset management fees increased 175.5% to $9.4 million for the three months
ended March 31, 2000, from $3.4 million for the comparable period in 1999. The
increase in fees was primarily due to an increase in fund return from 3.42% for
the first quarter of 1999 to 9.05% for the first quarter of 2000 and 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 $260 million at March 31, 1999 to $374 million at March 31,
2000.
Interest income increased 137.7% to $8.6 million for the three months ended
March 31, 2000, from $3.6 million for the comparable period in 1999. This
increase was primarily due to larger cash balances held at banks and our
clearing brokers.
Commissions and fees increased 85.8% to $4.7 million for the three months
ended March 31, 2000, from $2.5 million for the comparable period in 1999. This
increase is primarily due to higher trade and share volumes from institutional
customers in listed securities.
Investment income and other income increased 447.9% to $3.2 million for the
three months ended March 31, 2000, from $592,000 for the comparable period in
1999. 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 increased 181.5% to $175.1
million for the three months ended March 31, 2000, from $62.2 million for the
comparable period in 1999. As a percentage of revenue, employee compensation
and benefits expense increased to 34.1% for the three months ended March 31,
2000, from 30.6% for the comparable period in 1999. The increase on a dollar
and on a percentage basis was primarily due to increased gross trading profits,
growth in the number of employees and higher margins. Due to increased net
trading revenue, profitability based compensation increased 192% to $155.6
million for the three months ended March 31, 2000, from $53.3 million for the
comparable period in 1999, and represented 88.8% and 85.6% of total employee
compensation and benefits expense for the three months ended March 31, 2000 and
1999, respectively. Our number of employees increased to 925 employees as of
March 31, 2000, from 641 employees as of March 31, 1999.
Payments for order flow increased 82.9% to $59.3 million for the three
months ended March 31, 2000, from $32.4 million for the comparable period in
1999. As a percentage of total revenue, payments for order flow decreased to
11.6% for the three months ended March 31, 2000 from 15.9% for the comparable
period in 1999. The increase in payments for order flow on a dollar basis was
primarily due to an 174.8% increase in equity shares traded for the three
months ended March 31, 2000 to 43.8 billion shares, up from 15.9 billion for
the comparable period in 1999. The decrease in payments for order flow as a
percentage of total revenue was primarily due to an increase in our average
revenue per equity share.
Execution and clearance fees increased 50.9% to $29.8 million for the three
months ended March 31, 2000, from $19.7 million for the comparable period in
1999. As a percentage of revenue, execution and clearance fees decreased to
5.8% for the three months ended March 31, 2000 from 9.7% for the comparable
period in 1999. The increase on a dollar basis was primarily due to a 135.8%
increase in equity trades executed for the three months ended March 31, 2000,
which was offset, in part, by a decrease in clearance rates charged by clearing
brokers and volume discounts. The decrease in our execution and clearance fees
as a percentage of net trading revenue was primarily due to a decrease in
clearance rates charged by clearing brokers, volume discounts, growth in the
volume of OTC securities transactions and an increase in our average revenue
per equity trade.
13
Communications and data processing expense increased 72.7% to $7.1 million
for the three months ended March 31, 2000, from $4.1 million for the comparable
period in 1999. This increase was generally attributable to higher trading
volumes and an increase in our number of employees.
Business development expense increased to $5.2 million for the three months
ended March 31, 2000, from $768,000 for the comparable period in 1999. This
increase was primarily the result of increased advertising and higher travel
and entertainment costs consistent with the growth in our business and our
increased focus on the institutional sales business.
Interest expense increased 90.9% to $5.2 million for the three months ended
March 31, 2000, up from $2.7 million for the comparable period in 1999. This
increase was primarily due to transaction-related interest expense resulting
from a higher level of securities sold, not yet purchased.
Professional fees increased 248.8% to $4.5 million for the three months
ended March 31, 2000, up from $1.3 million for the comparable period in 1999.
This increase was primarily due to increased consulting expenses related to our
investments in technology, our European expansion efforts and legal and other
professional fees.
Depreciation and amortization expense increased 96.3% to $4.2 million for
the three months ended March 31, 2000, from $2.1 million for the comparable
period in 1999. This increase was primarily due to the purchase of
approximately $31.9 million of additional fixed assets and leasehold
improvements between March 31, 1999 and March 31, 2000 and the amortization of
goodwill related to our acquisitions of the listed securities market-making
businesses of Trimark and Tradetech and the options specialist business of
Gargoyle.
Occupancy and equipment rentals expense increased 59.8% to $3.1 million for
the three months ended March 31, 2000, from $1.9 million for the comparable
period in 1999. This increase was primarily attributable to additional office
space and increased computer equipment lease expense. We occupied 161,909
square feet of office space at March 31, 2000, up from 100,454 square feet of
office space at March 31, 1999.
Other expenses increased 42.9% to $2.6 million for the three months ended
March 31, 2000, from $1.8 million for the comparable 1999 period. This was
primarily the result of increased operating costs in connection with our
overall business growth.
Our pro forma effective tax rates for the three months ended March 31, 2000
and 1999 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 Trimark and a portion of business
development expenses. Our effective tax rate declined to 37% for the three
months ended March 31, 2000 from 42% for the three months ended March 31, 1999
primarily due to lower 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. We anticipate
adopting the provisions of SFAS No. 133 and 137 effective January 1, 2001 and
do not believe that the adoption of this statement 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
14
subordinated notes. As of March 31, 2000, we had $1.9 billion in assets, 93.3%
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 plus depreciation and amortization was $139.8 million and $44.1
million during the three months ended March 31, 2000 and 1999, respectively.
Depreciation and amortization expense, which related to fixed assets and
goodwill, was $4.2 million and $2.1 million during the three months ended March
31, 2000 and 1999, respectively. Capital expenditures were $14.1 million and
$1.5 million for the three months ended March 31, 2000 and 1999, 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. 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 Trimark in 1995 and Tradetech
in 1997. We anticipate that we will meet our 2000 capital expenditure needs out
of operating cash flows.
As registered broker-dealers and market makers, Knight, KCM and KFP 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 ($6.9 million,
$1.6 million and $250,000, respectively as of March 31, 2000). 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 Knight, KCM and KFP, 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, 2000, Knight had net capital of $389.2 million, which was $382.3
million in excess of its required net capital of $6.9 million, KCM had net
capital of $50.8 million which was $49.2 million in excess of its required net
capital of $1.6 million and KFP had net capital of $27.0 million which was
$26.8 million in excess of its required net capital of $250,000.
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.
Year 2000 Compliance
Many currently installed computer systems and software products were coded
to accept or recognize only two digit entries in the date code field. These
date code fields needed to accept four digit entries to distinguish 21st
century dates from 20th century dates. As a result, computer systems and/or
software used by many companies and governmental agencies had to be upgraded to
comply with such Year 2000 requirements or risk system failure or
miscalculations causing disruptions of normal business activities. We estimate
that the total cost of our Year 2000 project was approximately $550,000.
To date, we have not experienced any material outages or failures as a
result of Year 2000 related issues. We cannot make any assurances that we may
not experience any such failures in the future. We have finalized a business
continuity plan and have formulated action steps to be taken in the event that
a material Year 2000 related failure should arise.
15
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our market-making 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. For each market maker, we
have established a system whereby transactions are monitored by senior
management as are individual and aggregate dollar and inventory position totals
and real-time profits and losses. The management of trading positions is
enhanced by review of mark-to-market valuations and/or position summaries on a
daily basis.
In the normal course of our OTC and exchange-listed market-making business,
we maintain inventories of exchange-listed and OTC securities. The fair value
of these securities at March 31, 2000 was $184.4 million in long positions and
$163.1 million in short positions. The potential change in fair value, using a
hypothetical 10.0% decline in prices, is estimated to be a $2.1 million loss as
of March 31, 2000 due to the offset of losses in long positions with gains in
short positions.
In the normal course of options market making, we maintain inventories of
options, futures and equities. Our main exposure is from equity price risk. We
manage this exposure by constantly monitoring and diversifying our exposures
and position sizes and establishing offsetting hedges whenever possible. 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 daily basis. On a daily basis, these 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, 2000, 10% movements in volatility
and stock prices on our 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%............................... $ 396,000 $1.1 million $2.5 million
None............................... (1.4 million) -- 1.3 million
-10%............................... (3.0 million) (755,000) 253,000
This stress analysis covers positions in options and futures, underlying
securities and related hedges. This makes the assumption that historical,
nonlinear correlations among products and hedges will remain constant. 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. The 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.
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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 currently a party to certain legal proceedings; however, we do not
believe the outcomes of these proceedings, individually or in the aggregate,
could have a material adverse effect on our business, financial condition or
operating results.
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
Exhibit 27. Financial Data Schedule.
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/Trimark 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 12, 2000
17