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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 SEPTEMBER 30, 1999
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)
52-2096335
(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 November 11, 1999 the number of shares outstanding of the registrant's
Class A common stock was 111,434,649 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 September 30, 1999
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........... 9
Item 3. Quantitative and Qualitative Disclosures About Market Risk...................................... 17
PART II OTHER INFORMATION:
Item 1. Legal Proceedings............................................................................... 18
Item 2. Changes in Securities and Use of Proceeds....................................................... 18
Item 3. Defaults Upon Senior Securities................................................................. 18
Item 4. Submission of Matters to a Vote of Security Holders............................................. 18
Item 5. Other Information............................................................................... 18
Item 6. Exhibits and Reports on Form 8-K................................................................ 18
Signatures
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
KNIGHT/TRIMARK GROUP, INC.
Consolidated Statements of Income
(unaudited)
For the three months For the nine months
ended September 30, ended September 30,
=============================== ==============================
1999 1998 1999 1998
============= ============= ============= =============
Revenues
Net trading revenue $129,434,821 $ 89,941,017 $524,423,136 $233,134,057
Commissions and fees 4,721,877 1,372,247 11,687,933 1,486,701
Interest, net 3,423,430 1,062,482 8,180,381 1,873,185
------------- ------------- ------------- -------------
Total revenues 137,580,128 92,375,746 544,291,450 236,493,943
------------- ------------- ------------- -------------
Expenses
Employee compensation and benefits 36,969,707 28,335,434 164,428,927 68,132,238
Payments for order flow 31,068,700 20,351,538 98,850,716 56,097,708
Execution and clearance fees 19,708,859 11,984,448 57,472,143 32,358,112
Communications and data processing 4,829,222 2,764,860 12,777,707 7,449,224
Business development 3,341,296 608,679 5,355,986 1,620,996
Occupancy and equipment rentals 2,669,230 1,647,143 6,959,035 4,044,607
Depreciation and amortization 2,416,149 1,520,842 6,549,768 4,160,269
Professional fees 978,324 1,256,418 4,198,553 2,207,458
Interest on Preferred Units - 36,845 - 714,904
Other 875,278 786,744 2,536,371 1,385,062
------------- ------------- ------------- -------------
Total expenses 102,856,765 69,292,951 359,129,206 178,170,578
------------- ------------- ------------- -------------
Income before income taxes 34,723,363 23,082,795 185,162,244 58,323,365
Income tax expense 12,880,970 9,259,200 75,718,212 9,259,200
------------- ------------- ------------- -------------
Net income $ 21,842,393 $ 13,823,595 $109,444,032 $ 49,064,165
============= ============= ============= =============
Basic earnings per share $ 0.20 $ 0.13 $ 1.00 $ 0.54
============= ============= ============= =============
Diluted earnings per share $ 0.19 $ 0.13 $ 0.95 $ 0.54
============= ============= ============= =============
Pro forma adjustment (Notes 5 and 6):
Income before income taxes $ 23,082,795 $ 58,323,365
Pro forma income tax expense 9,925,602 25,079,047
------------- -------------
Pro forma net income $ 13,157,193 $ 33,244,318
============= =============
Pro forma basic earnings per share $ 0.13 $ 0.36
============= =============
Pro forma diluted earnings per share $ 0.13 $ 0.36
============= =============
Shares used in basic earnings per share calculation 111,203,800 102,565,439 109,921,171 91,319,460
============= ============= ============= =============
Shares used in diluted earnings per share calculation 116,350,861 102,565,439 114,843,985 91,319,460
============= ============= ============= =============
The accompanying notes are an integral part of these consolidated financial
statements.
3
KNIGHT/TRIMARK GROUP, INC.
Consolidated Statements of Financial Condition
September 30, December 31,
1999 1998
(unaudited)
Assets
Cash and cash equivalents $ 265,298,079 $ 117,381,556
Securities owned, at market value 100,822,606 100,476,151
Receivable from clearing brokers 107,738,486 107,503,274
Fixed assets and leasehold improvements at cost,
less accumulated depreciation 15,272,283 12,014,991
Goodwill, less accumulated amortization 17,695,978 16,036,859
Income taxes receivable 4,902,306 -
Investments 11,672,934 1,913,000
Other assets 10,752,127 3,534,544
------------------------ -----------------------
Total assets $ 534,154,799 $ 358,860,375
======================== =======================
Liabilities and Stockholders' Equity
Liabilities
Securities sold, not yet purchased, at market value $ 86,789,389 $ 108,909,217
Short-term borrowings - 10,000,000
Accrued compensation expense 21,442,851 16,529,004
Accrued execution and clearance fees 7,947,576 6,898,095
Accrued payments for order flow 8,862,301 8,672,668
Accounts payable, accrued expenses and other liabilities 9,110,418 5,445,112
Income taxes payable - 2,285,620
------------------------ -----------------------
Total liabilities 134,152,535 158,739,716
------------------------ -----------------------
Stockholders' equity
Class A Common Stock, $0.01 par value, 200,000,000 shares authorized;
111,334,154 and 98,124,368 shares issued and outstanding at
September 30, 1999 and December 31, 1998, respectively 1,113,342 981,244
Class B Common Stock, $0.01 par value, 20,000,000 shares authorized;
7,885,396 shares issued and outstanding at
December 31, 1998 - 78,854
Additional paid-in capital 259,634,209 169,249,880
Retained earnings 139,254,713 29,810,681
------------------------ -----------------------
Total stockholders' equity 400,002,264 200,120,659
------------------------ -----------------------
Total liabilities and stockholders' equity $ 534,154,799 $ 358,860,375
======================== =======================
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 nine months ended September 30,
-----------------------------------------------------
1999 1998
------------------------- -------------------------
Cash flows from operating activities
Net income $ 109,444,032 $ 49,064,165
Adjustments to reconcile net income to net cash
provided by operating activities
Noncash item included in net income
Depreciation and amortization 6,549,768 4,160,269
(Increase) decrease in operating assets
Securities owned (346,455) 6,720,722
Receivable from clearing brokers (235,212) (35,487,435)
Income taxes receivable (4,902,306) -
Other assets (7,217,582) (1,340,827)
Increase (decrease) in operating liabilities
Securities sold, not yet purchased (22,119,828) 23,719,612
Accrued compensation expense 4,913,847 8,794,336
Accrued execution and clearance fees 1,049,481 428,977
Accrued payments for order flow 189,633 1,217,625
Accounts payable, accrued expenses and other liabilities 3,665,306 2,601,141
Income taxes payable (2,285,620) 9,238,200
------------------------- -------------------------
Net cash provided by operating activities 88,705,064 69,116,785
------------------------- -------------------------
Cash flows from investing activities
Investments (9,759,934) (410,000)
Payment of contingent consideration (4,140,977) (2,886,048)
Purchases of fixed assets and leasehold improvements (7,325,202) (7,270,528)
------------------------- -------------------------
Net cash used in investing activities (21,226,113) (10,566,576)
------------------------- -------------------------
Cash flows from financing activities
Repayment of short-term loan (10,000,000) (500,000)
Increase in short-term loan - 25,000,000
Net proceeds from issuance of common stock 80,219,537 136,811,757
Stock options exercised 3,443,388 -
Income tax credit - stock options 6,774,647 -
Redemptions of Manditorily Redeemable Preferred A Units - (12,483,610)
Redemptions of Manditorily Redeemable Preferred B Units - (15,000,000)
Distributions on Common Units - (65,670,909)
------------------------- -------------------------
Net cash provided by financing activities 80,437,572 68,157,238
------------------------- -------------------------
Increase in cash and cash equivalents 147,916,523 126,707,447
Cash and cash equivalents at beginning of period 117,381,556 13,797,198
------------------------- -------------------------
Cash and cash equivalents at end of period $ 265,298,079 $ 140,504,645
========================= =========================
Supplemental disclosure of cash flow information:
Cash paid for interest $ 945,300 $ 1,712,796
========================= =========================
Cash paid for income taxes $ 84,014,615 $ -
========================= =========================
The accompanying notes are an integral part of these consolidated financial
statements.
5
KNIGHT/TRIMARK GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 1999
(Unaudited)
1. Organization and Description of the Business
Knight/Trimark Group, Inc. (''Knight/Trimark'') was organized in April 1998 as
the successor to the business of Roundtable Partners, L.L.C. (''Roundtable'')
(hereafter, references to the ''Company'' refer to Knight/Trimark or Roundtable,
as appropriate) and to own and operate the securities market-making businesses
of its wholly-owned subsidiaries, Knight Securities, Inc. (''Knight'') and
Trimark Securities, Inc. (''Trimark''). As part of an internal restructuring in
July 1999 Knight Securities, Inc. became Knight Securities, L.P.
The Company operates in one segment and line of business--equity securities
market-making. 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. Trimark operates as a market maker in the
over-the-counter market for equity securities that are listed on the New York
and American Stock Exchanges (''listed securities''). Knight and Trimark are
registered as broker-dealers with the Securities and Exchange Commission
(''SEC'') and are members of the National Association of Securities Dealers,
Inc. (''NASD'').
The accompanying unaudited consolidated financial statements include the
accounts of the Company, Knight and Trimark 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 periods. 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, 1998 included in the Company's Report on
Form 10-K as filed with the SEC.
Certain prior period amounts have been reclassified to conform to the current
period presentation. All share and per share amounts have been adjusted to
reflect the two-for-one stock split described in Note 2.
2. Reorganization, Public Stock Offerings and Stock Split
Concurrent with the closing of the initial public offering of the Company's
Common Stock on July 13, 1998, based on the initial public offering price of
$7.25 per share, all of the member interests of Roundtable were exchanged for
73,324,830 shares of Class A Common Stock of the Company and 7,885,396 shares of
nonvoting Class B Common Stock of the Company (the ''Reorganization'').
The initial public offering of 23,000,000 shares of Class A Stock included
20,376,492 newly-issued shares and 2,623,508 shares from a selling shareholder.
Proceeds received by the Company from the initial public offering, net of the
applicable underwriting discounts and commissions and offering expenses, were
approximately $136.5 million.
On February 25, 1999 a Registration Statement on Form S-1 (No. 333-71559) was
declared effective by the SEC, pursuant to which 18,000,000 shares of Class A
common stock were offered and sold at a price to the public of $17.50 per share.
Of those shares, 4,849,440 were sold by Knight/Trimark, generating net offering
proceeds, after deducting underwriting discounts and commissions and offering
expenses, of approximately $80.2 million. An additional 13,150,560 were sold by
selling shareholders, generating gross offering proceeds to the selling
shareholders of approximately $230.1 million. Certain selling shareholders
granted the underwriters a 30-day option to purchase up to an additional
2,700,000 shares of Class A common stock to cover over-allotments. That option
was exercised in full on March 18, 1999.
6
In April 1999, the Company's Board of Directors approved a two-for-one stock
split of the Company's Class A and Class B Common Stock. Shareholders of record
as of the close of business on April 30, 1999 received, in the form of a stock
dividend, one additional share for each share held by them. On May 14, 1999, the
transfer agent distributed the additional shares.
On October 8, 1998, the Company's Board of Directors approved a program to
repurchase, over a period of up to eighteen months, up to 3 million shares of
outstanding Class A common stock up to a total aggregate amount not to exceed
$20 million. On July 21, 1999, the Board of Directors cancelled the repurchase
program. The Company did not repurchase any shares under this program.
3. Investments
Investments consist of strategic ownership interests in privately held
corporations and limited partnerships. Investments in common stock which
represent a 20% or more ownership interest in the corporation, as well as
interests in limited partnerships, are accounted for under the equity method.
All other investments are carried at cost, adjusted only for permanent declines
in value. The largest component of Investments is an 18.92% interest in EASDAQ
(the European Association of Securities Dealers Automated Quotations) which the
Company purchased on July 28, 1999 for approximately $8.2 million. EASDAQ is a
pan-European stock market for international growth and technology companies. The
Company subsequently made an additional investment of approximately $940,000 in
EASDAQ on October 21, 1999, bringing its total ownership interest to
approximately 19.49%.
4. Related Party Transactions and Significant Customers
Before the Reorganization and initial public offering, Roundtable was owned by
a consortium of 31 independent securities firms and investors (the ''Broker
Dealer Owners''). Under Roundtable's limited liability company agreement, the
Broker Dealer Owners, who were considered affiliated companies, shared in
Roundtable's profits in proportion to their equity interests and the quantity of
order flow they directed to the Company. After the initial public offering, this
profit sharing practice was discontinued and, while some of the Broker Dealer
Owners still own common stock in the Company, these Broker Dealer Owners do not
receive any special inducement to provide the Company with order flow.
Subsequent to the initial public offering, the Company considers affiliates to
be holders of 5% or more of the Company's outstanding common stock
(''Affiliates''). For the three months ended September 30, 1999 there were 2
Broker Dealer Owners who were considered Affiliates of the Company. As measured
in share volume, each Affiliate represented 10.3% and 11.8%, respectively, of
the Company's order flow for the three months ended September 30, 1999, and
11.1% and 12.1%, respectively, of the Company's order flow for the nine months
ended September 30, 1999. On September 29, 1999, one of these Affiliates sold a
significant portion of its remaining outstanding shares of the Company's common
stock and will no longer be considered an Affiliate of the Company for
financial reporting purposes.
Included within payments for order flow on the Consolidated Statements of
Income for the three and nine month periods ended September 30, 1999 is
$10,429,032 and $34,390,251, respectively, related to Affiliates. Additionally,
included within payments for order flow on the Consolidated Statements of Income
for the three and nine month periods ended September 30, 1998 is $5,233,909 and
$15,701,583, respectively, related to Affiliates. Included within accrued
payments for order flow on the Consolidated Statement of Financial Condition as
of September 30, 1999 is $3,091,305 related to Affiliates.
Trimark clears its securities transactions through an Affiliate. Knight clears
its securities transactions through an unaffiliated clearing broker. Included
within execution and clearance fees on the Consolidated Statement of Income for
the three and nine month periods ended September 30, 1999 is $7,198,421 and
$24,083,851, respectively, related to this Affiliate. Additionally, included
within execution and clearance fees on the Consolidated Statement of Income for
the three and nine month periods ended September 30, 1998 is $5,233,909 and
$15,701,583 related to this Affiliate. Included within accrued execution and
clearance fees on the Consolidated Statement of Financial Condition as of
September 30, 1999 is $2,468,927 related to this Affiliate.
One customer not considered an Affiliate provided 9.8% and 10.7% of the
Company's order flow for the three and nine month periods ended September 30,
1999, respectively.
7
5. Income Taxes
The Company and its subsidiaries file a consolidated federal income tax
return. Before the Reorganization, Roundtable was a limited liability company
and was not subject to federal or state income taxes. Subsequent to the
Reorganization, the Company is subject to federal income taxes and state income
taxes in New York, New Jersey and other states.
Pro forma income represents net income adjusted to reflect pro forma income
taxes as if the Company was a C Corporation for the three and nine month periods
ended September 30, 1998.
6. Earnings per Share
Basic earnings per share has 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. The diluted earnings per share
calculation includes the effect of dilutive stock options, as calculated under
the treasury stock method. All shares of Class B Common Stock, which are non-
voting, were held by a single shareholder. Except for voting rights, the Class B
Common Stock has identical rights and rewards as the Class A Common Stock and
must be automatically converted to Class A Common Stock in the event of a sale
or a transfer by the current owner. All outstanding shares of Class B Common
Stock were sold by their holder on September 29, 1999 and were automatically
converted into shares of Class A Common Stock.
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations:
Three months ended September 30, 1999 Three months ended September 30, 1998
------------------------------------- -------------------------------------
Numerator / Numerator / Denominator /
net Denominator / pro forma pro forma
income shares income shares
------------------------------------- -------------------------------------
Shares and income used in basic calculations $ 21,842,393 111,203,800 $ 13,157,193 102,565,439
Effect of dilutive stock options - 5,147,061 - -
--------------------------------------- -------------------------------------
Shares and income used in diluted calculations $ 21,842,393 116,350,861 $ 13,157,193 102,565,439
======================================== ====================================
Basic earnings per share $ 0.20 $ 0.13
====================== ===================
Diluted earnings per share $ 0.19 $ 0.13
====================== ===================
Nine months ended September 30, 1999 Nine months ended September 30, 1998
--------------------------------------- -------------------------------------
Numerator / Numerator / Denominator /
net Denominator / pro forma pro forma
income shares income shares
--------------------------------------- ------------------------------------
Shares and income used in basic calculations $ 109,444,032 109,921,171 $ 33,244,318 91,319,460
Effect of dilutive stock options - 4,922,814 - -
--------------------------------------- -----------------------------------
Shares and income used in diluted calculations $ 109,444,032 114,843,985 $ 33,244,318 91,319,460
======================================== ====================================
Basic earnings per share $ 1.00 $ 0.36
====================== ===================
Diluted earnings per share $ 0.95 $ 0.36
====================== ===================
8
Pro forma shares outstanding for the three and nine months periods ended
September 30, 1998 have been determined as if the Reorganization described in
Note 2 occurred as of January 1, 1998.
7. Net Capital Requirements
As registered broker-dealers and NASD member firms, Knight and Trimark are
subject to the SEC's Uniform Net Capital Rule (the ''Rule'') which requires the
maintenance of minimum net capital. Knight and Trimark 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.
At September 30, 1999, Knight had net capital of $190,171,967, which was
$188,046,353 in excess of its required net capital of $2,125,614 and Trimark had
net capital of $36,407,054 which was $35,407,054 in excess of its required net
capital of $1 million.
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, 1998 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.
9
We are the leading market maker in Nasdaq securities, other OTC equity
securities, and NYSE- and AMEX-listed equity securities in the Third Market.
Through our wholly-owned subsidiary, Knight, we make markets in over 7,300
equity securities in Nasdaq and on the NASD's OTC Bulletin Board. Through our
wholly-owned subsidiary, Trimark, we make markets in all NYSE- and AMEX-listed
equity securities in the Third Market.
Knight commenced Nasdaq and OTC securities market-making operations on July
24, 1995. Based on rankings published by The AutEx Group, a widely recognized
industry reporting service that publishes daily trading volume and market share
statistics reported by broker-dealer market makers, Knight was ranked first in
AutEx's Nasdaq/OTC Securities rankings, with a 14.55% market share during
September 1999. Knight's share volume totaled 14.0 billion and 6.7 billion, or
78% and 71% of our total share volume, for the three months ended September 30,
1999, and 1998, respectively. Trimark has held the #1 market share ranking in
trading of NYSE- and AMEX-listed securities in the Third Market for over three
years. Trimark's share volume totaled 3.8 billion and 2.8 billion, or 22% and
29% of our total share volume for the three months ended September 30, 1999 and
1998, 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.
Revenues
Our revenues consist principally of net trading revenue from equity securities
market-making activities. Net trading revenue, which represents trading gains
net of trading losses, is primarily affected by changes in trade and share
volumes from customers, our ability to derive trading gains by taking
proprietary positions primarily to facilitate customer transactions, changes in
our execution standards and by regulatory changes and evolving industry customs
and practices. Our net trading revenue per trade for OTC securities has
historically exceeded the net trading revenue per trade for listed securities.
We continue to focus on increasing our 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.
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, net of transaction-related
interest charged by clearing brokers for facilitating the settlement and
financing of securities sold, not yet purchased, and interest on subordinated
notes and short-term debt. Interest, net is primarily affected by the changes in
cash balances held at banks and clearing brokers, and the level of securities
sold, not yet purchased.
Expenses
Our operating expenses largely consist of employee compensation and benefits,
payments for order flow and execution and clearance fees. Substantial portions
of each expense are variable in nature. Employee compensation and
10
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 compared to
other institutional customers. Execution and clearance fees fluctuate primarily
based on changes in trade and share volume, the mix of trades of OTC securities
compared to listed securities 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 77% 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 related 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 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 for OTC and listed securities, transaction fees paid to Nasdaq,
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. Execution and
clearance fees are higher for listed securities than for OTC securities. Due to
our significant growth in 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.
Depreciation and amortization expense results from the depreciation of fixed
assets purchased by us or financed under a capital lease, and the amortization
of goodwill, which includes contingent consideration resulting from the
acquisition of the listed securities market-making businesses of Trimark and
Tradetech Securities, L.P., which we acquired in November 1997.
Occupancy and equipment rentals expense primarily consists of rental payments
on office and equipment leases.
Professional fees primarily consist of fees paid to computer programming and
systems consultants, as well as legal fees and other professional fees.
Business development expense primarily consists of marketing expenses,
including promotion and advertising costs and travel and entertainment.
Interest on Preferred Units represents required interest payments on our
Mandatorily Redeemable Preferred A and B Units at a rate approximating the
Federal Funds rate. All Preferred Units were redeemed during 1998.
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
Prior to our initial public offering, we were a limited liability company and
were not subject to federal or state income taxes. Subsequent to our
reorganization from a limited liability company to a corporation, which occurred
11
immediately before the closing of our initial public offering, we became subject
to federal income taxes and state income taxes in New York, New Jersey and other
states.
Results of Operations
Three Months Ended September 30, 1999 and 1998
Revenues
Net trading revenue increased 43.9% to $129.4 million for the three months
ended September 30, 1999, from $89.9 million for the comparable period in 1998.
This increase was primarily due to higher trading volume, partially offset by
decreased average revenue per trade and per share. Total trade volume increased
94.5% to 20.4 million trades for the three months ended September 30, 1999, from
10.5 million trades for the comparable period in 1998. Total share volume
increased 87.9% to 17.8 billion shares traded for the three months ended
September 30, 1999, from 9.5 billion shares traded for the comparable period in
1998.
Commissions and fees increased to $4.7 million for the three months ended
September 30, 1999, from $1.4 million for the comparable period in 1998. This
increase is primarily due to higher trade and share volumes from institutional
customers in listed securities and the receipt of fees in 1999 for providing
certain information to market data providers.
Interest, net increased to $3.4 million for the three months ended September
30, 1999, from $1.1 million for the comparable period in 1998. This increase was
primarily due to larger cash balances held at banks and our clearing brokers as
a result of our initial and follow-on stock offerings, which was offset in part
by increased transaction-related interest expense resulting from a higher level
of securities sold, not yet purchased.
Expenses
Employee compensation and benefits expense increased 30.5% to $37.0 million
for the three months ended September 30, 1999, from $28.3 million for the
comparable period in 1998. As a percentage of net trading revenue, employee
compensation and benefits expense decreased to 28.6% for the three months ended
September 30, 1999, from 31.5% for the comparable period in 1998. The increase
on a dollar basis was primarily due to increased gross trading profits and
growth in the number of employees. The decrease as a percentage of net trading
revenue was primarily due to reductions in our market maker compensation
formula. Due to increased net trading revenue, profitability based compensation
increased 31.2% to $27.8 million for the three months ended September 30, 1999,
from $21.2 million for the comparable period in 1998, and represented 75.3% and
74.9% of total employee compensation and benefits expense for the three months
ended September 30, 1999 and 1998, respectively. The number of employees
increased to 587 employees as of September 30, 1999, from 428 employees as of
September 30, 1998.
Payments for order flow increased 52.7% to $31.1 million for the three months
ended September 30, 1999, from $20.4 million for the comparable period in 1998.
As a percentage of net trading revenue, payments for order flow increased to
24.0% for the three months ended September 30, 1999 from 22.6% for the
comparable period in 1998. The increase in payments for order flow on a dollar
basis was primarily due to an 87.9% increase in shares traded for the three
months ended September 30, 1999 to 17.8 billion shares, up from 9.5 billion for
the comparable period in 1998, partially offset by a decrease in our average
revenue per share. The increase in payments for order flow as a percentage of
net trading revenue was primarily due to a decrease in our average revenue per
share.
Execution and clearance fees increased 64.5% to $19.7 million for the three
months ended September 30, 1999, from $12.0 million for the comparable period in
1998. As a percentage of net trading revenue, execution and clearance fees
increased to 15.2% for the three months ended September 30, 1999 from 13.3% for
the comparable period in 1998. The increase on a dollar basis was primarily due
to a 94.5% increase in trades for the three months ended September 30, 1999,
which was offset, in part, by a decrease in clearance rates charged by clearing
brokers, volume discounts and a decrease in our average revenue per trade. 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 and growth in the volume of OTC securities
transactions.
12
Communications and data processing expense increased 74.7% to $4.8 million for
the three months ended September 30, 1999, from $2.8 million for the comparable
period in 1998. This increase was generally attributable to higher trading
volumes and an increase in the number of employees.
Business development expense increased to $3.3 million for the three months
ended September 30, 1999, from $609,000 for the comparable period in 1998. This
increase was primarily the result of the launch of our advertising campaign and
higher travel and entertainment costs consistent with the growth in our business
and our increased focus on the institutional sales business.
Occupancy and equipment rentals expense increased 62.1% to $2.7 million for
the three months ended September 30, 1999, from $1.6 million for the comparable
period in 1998. This increase was primarily attributable to additional office
space and increased computer equipment lease expense. We occupied 93,687 square
feet of office space at September 30, 1999, up from 75,768 square feet of office
space at September 30, 1998.
Depreciation and amortization expense increased 58.9% to $2.4 million for the
three months ended September 30, 1999, from $1.5 million for the comparable
period in 1998. This increase was primarily due to the purchase of approximately
$3.0 million of additional fixed assets and leasehold improvements during the
three months ended September 30, 1999 and the amortization of goodwill related
to the acquisition of the listed securities market-making businesses of Trimark
and Tradetech.
Professional fees decreased 22.1% to $978,000 for the three months ended
September 30, 1999, down from $1.3 million for the comparable period in 1998.
This decrease was primarily due to increased consulting expenses in 1998 related
to our establishment of an institutional sales office in London.
Interest on Preferred Units was zero for the three months ended September 30,
1999, and $37,000 for the comparable period in 1998. This decrease is due to our
redemption of all of the remaining Preferred A and B Units during the third
quarter of 1998.
Other expenses increased 11.3% to $875,000 for the three months ended
September 30, 1999, from $787,000 for the comparable 1998 period. This was
primarily the result of increased operating costs in connection with our overall
business growth.
Income Tax
Our effective tax rate for the three months ended September 30, 1999 and pro
forma effective tax rate for the three months ended September 30, 1998 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 September 30, 1999
due to lower state and local income taxes.
Nine Months Ended September 30, 1999 and 1998
Revenues
Net trading revenue increased 124.9% to $524.4 million for the nine months
ended September 30, 1999, from $233.1 million for the comparable period in 1998.
This increase was primarily due to higher trading volume and increased average
revenue per trade and per share. Total trade volume increased 123.6% to 60.6
million trades for the nine months ended September 30, 1999, from 27.1 million
trades for the comparable period in 1998. Total share volume increased 108.9% to
55.1 billion shares traded for the nine months ended September 30, 1999, from
26.4 billion shares traded for the comparable period in 1998.
13
Commissions and fees increased to $11.7 million for the nine months ended
September 30, 1999, from $1.5 million for the comparable period in 1998. This
increase is primarily due to higher trade and share volumes from institutional
customers in listed securities and the receipt of fees in 1999 for providing
certain information to market data providers.
Interest, net increased to $8.2 million for the nine months ended September
30, 1999, from $1.9 million for the comparable period in 1998. This increase was
primarily due to larger cash balances held at banks and our clearing brokers as
a result of our initial and follow-on stock offerings, which was offset in part
by increased transaction-related interest expense resulting from a higher level
of securities sold, not yet purchased.
Expenses
Employee compensation and benefits expense increased 141.3% to $164.4 million
for the nine months ended September 30, 1999, from $68.1 million for the
comparable period in 1998. As a percentage of net trading revenue, employee
compensation and benefits expense increased to 31.4% for the nine months ended
September 30, 1999, from 29.2% for the comparable period in 1998. The increase
on a dollar basis was primarily due to increases in gross trading profits and
growth in the number of employees. The increase as a percentage of net trading
revenue was primarily due to increased profitability, and decreases in payments
for order flow as a percentage of net trading revenue which increased market
maker compensation. Due to increased net trading revenue and profitability,
profitability based compensation increased 173.1% to $139.1 million for the nine
months ended September 30, 1999, from $50.9 million for the comparable period in
1998, and represented 84.6% and 75.1% of total employee compensation and
benefits expense for the nine months ended September 30, 1999 and 1998,
respectively. The number of employees increased to 587 employees as of
September 30, 1999, from 428 employees as of September 30, 1998.
Payments for order flow increased 76.2% to $98.9 million for the nine months
ended September 30, 1999, from $56.1 million for the comparable period in 1998.
As a percentage of net trading revenue, payments for order flow decreased to
18.8% for the nine months ended September 30, 1999 from 24.1% for the comparable
period in 1998. The increase in payments for order flow on a dollar basis was
primarily due to a 108.9% increase in shares traded for the nine months ended
September 30, 1999 to 55.1 billion shares, up from 26.4 billion for the
comparable period in 1998. The decrease in payments for order flow as a
percentage of net trading revenue resulted from increased average revenue per
share and growth in our institutional business.
Execution and clearance fees increased 77.6% to $57.5 million for the nine
months ended September 30, 1999, from $32.4 million for the comparable period in
1998. As a percentage of net trading revenue, execution and clearance fees
decreased to 11.0% for the nine months ended September 30, 1999 from 13.9% for
the comparable period in 1998. The increase on a dollar basis was primarily due
to a 123.6% increase in trades for the nine months ended September 30, 1999,
which was offset, in part, by a decrease in clearance rates charged by clearing
brokers and volume discounts. The decrease in execution and clearance fees as a
percentage of net trading revenue was due to the decrease in clearance rates
charged by clearing brokers, volume discounts, increased average revenue per
trade and growth in the volume of OTC securities transactions.
Communications and data processing expense increased 71.5% to $12.8 million
for the nine months ended September 30, 1999, from $7.4 million for the
comparable period in 1998. This increase was generally attributable to higher
trading volumes and an increase in the number of employees.
Business development expense increased to $5.4 million for the nine months
ended September 30, 1999, from $1.6 million for the comparable period in 1998.
This increase was primarily the result of the launch of our advertising campaign
and higher travel and entertainment costs consistent with the growth in our
business and our increased focus on the institutional sales business.
Occupancy and equipment rentals expense increased 72.1% to $7.0 million for
the nine months ended September 30, 1999, from $4.0 million for the comparable
period in 1998. This increase was primarily attributable to additional office
space and increased computer equipment lease expense. We occupied 93,687 square
feet of office space at September 30, 1999, up from 75,768 square feet of office
space at September 30, 1998.
14
Depreciation and amortization expense increased 57.4% to $6.5 million for the
nine months ended September 30, 1999, from $4.2 million for the comparable
period in 1998. This increase was primarily due to the purchase of approximately
$7.3 million of additional fixed assets and leasehold improvements during the
nine months ended September 30, 1999 and the amortization of goodwill related to
the acquisition of the listed securities market-making businesses of Trimark and
Tradetech.
Professional fees increased 90.2% to $4.2 million for the nine months ended
September 30, 1999, up from $2.2 million for the comparable period in 1998. This
increase was primarily due to increased consulting expenses related to our
investments in technology, as well as legal fees and other professional fees.
Interest on Preferred Units was zero for the nine months ended September 30,
1999, and $715,000 for the comparable period in 1998. This decrease is due to
our redemption of all of the remaining Preferred A and B Units during 1998.
Other expenses increased 83.1% to $2.5 million for the nine months ended
September 30, 1999, from $1.4 million for the comparable 1998 period. This was
primarily the result of increased operating costs in connection with our overall
business growth.
Income Tax
Our effective tax rate for the nine months ended September 30, 1999 and pro
forma effective tax rate for the nine months ended September 30, 1998 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 41% for the nine months ended September 30, 1999
due to lower state and local income taxes.
Liquidity and Capital Resources
Historically, we have financed our business primarily through cash generated
by operations, as well as the proceeds from our stock offerings, the private
placement of preferred and common units and borrowings under subordinated notes.
As of September 30, 1999, we had $534.2 million in assets, 89% 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, 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.
Net income plus depreciation and amortization was $24.3 million and $14.7
million during the three months ended September 30, 1999 and 1998, respectively.
Depreciation and amortization expense, which related to fixed assets and
goodwill, was $2.4 million and $1.5 million during the three months ended
September 30, 1999 and 1998, respectively. Capital expenditures were $3.0
million and $2.1 million for the three months ended September 30, 1999 and 1998,
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
$198,000 for the three months ended September 30, 1999 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 1999 capital
expenditure needs out of operating cash flows.
As registered broker-dealers and market makers, Knight and Trimark 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 ($2.1 million and $1.0 million,
respectively as of September 30, 1999). 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 and Trimark, 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
15
prohibit or restrict such transactions if the result is detrimental to the
financial integrity of the broker-dealer. At September 30, 1999, Knight had net
capital of $190.2 million, which was $188.1 million in excess of its required
net capital of $2.1 million and Trimark had net capital of $36.4 million, which
was $35.4 million in excess of its required net capital of $1.0 million.
PaineWebber Capital Inc., an affiliate of PaineWebber Incorporated, loaned
$30.0 million to Roundtable under a loan agreement dated as of June 19, 1998.
Roundtable used the proceeds from this loan to make distributions of
undistributed profits to the members of Roundtable before our reorganization
from a limited liability company to a Delaware corporation immediately before
our initial public offering. In connection with the dissolution of Roundtable,
we assumed all of Roundtable's obligations under the loan. We subsequently
repaid the entire loan from our operating cash flows, making principal pre-
payments of $5.0 million, $9.0 million, $6.0 million and $10.0 million on
September 15, 1998, October 20, 1998, December 15, 1998 and January 19, 1999,
respectively.
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.
In April 1999, our Board of Directors approved a two-for-one stock split of
our Class A and Class B Common Stock. Shareholders of record as of the close of
business on April 30, 1999 received, in the form of a stock dividend, one
additional share for each share held by them. On May 14, 1999, the transfer
agent distributed the additional shares.
Recent Developments
In October 1999, Knight began clearing and settling all of its securities
transactions through Broadcort Capital Corp., Merrill Lynch's clearing and
settlement subsidiary.
Year 2000 Compliance
Many currently installed computer systems and software products are coded to
accept or recognize only two digit entries in the date code field. These date
code fields will need 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 may need to be upgraded to
comply with such Year 2000 requirements or risk system failure or
miscalculations causing disruptions of normal business activities.
State of Readiness. We have made an assessment of the Year 2000 readiness of
our trading-related, communications and data processing systems. Our readiness
plan consists of: (1) quality assurance testing of our main trading-related
systems including all customer interfaces and links to exchanges and utilities;
(2) contacting third-party vendors and licensors of material hardware, software
and services that relate directly and indirectly to the main trading systems;
(3) contacting vendors of critical non-trading related communications and data
processing systems; (4) contacting our clearing brokers; (5) assessment of
repair or replacement requirements; (6) repair or replacement; (7)
implementation; and (8) creation of contingency plans for possible Year 2000
failures. Additionally, we participated in the Securities Industry Association
''streetwide'' testing in March 1999. We believe that our main trading-related
systems are currently Year 2000 compliant. We have required vendors of material
hardware and software components of our information technology systems to
provide assurances of their Year 2000 compliance. We have recently received
certification from all mission-critical vendors of information equipment. We
have also completed testing of all internal trading systems and the majority of
our trading interfaces.
Costs. To date, we have incurred approximately $500,000 in costs in connection
with identifying and evaluating Year 2000 compliance issues. Most of our
expenses have related to, and are expected to continue to relate to, the
operating costs associated with time spent by employees in the evaluation
process and Year 2000 compliance matters generally. At this time, we estimate
that the total cost of the Year 2000 project to be approximately $550,000.
Risks. We are not currently aware of any Year 2000 compliance problems
relating to our main trading-related, communications or data processing systems
that would have a material adverse effect on our business, financial condition
and operating results, without taking into account our efforts to avoid or fix
such problems. We cannot assure that we will not discover Year 2000 compliance
problems that will require substantial revisions. In addition, we cannot assure
you that third-party software, hardware or services incorporated into our
systems will not need to be revised or replaced, all of which could be time
consuming and expensive. If we fail to fix our trading-related, communications
or data processing systems or to fix or replace third-party software, hardware
or services on a timely basis our business, financial condition and operating
results could be materially adversely affected. Moreover, the failure to
adequately address Year 2000 compliance issues in our main trading-related,
communications or data processing systems could result in litigation, which
could be costly and time-consuming to defend.
16
In addition, we cannot assure you that customers, governmental agencies,
utility companies, securities exchanges, Internet access companies, third-party
service providers, including our clearing brokers, and others outside our
control will be Year 2000 compliant. The failure by these entities to be Year
2000 compliant could result in a systemic failure beyond our control, such as a
prolonged Internet, telecommunications or electrical failure, which could also
prevent us from delivering our services to our customers and could have a
material adverse effect on our business, results of operations and financial
condition.
Business Continuity Plan. We have finalized our business continuity plan and
have formulated action steps to be taken in the event of a Year 2000 related
failure.
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 or changes in liquidity, over which we have
virtually no control.
We employ an automated proprietary trading and risk management system which
provides 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 share 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 market-making business, we maintain inventories of
exchange-listed and OTC securities. The fair value of these securities at
September 30, 1999 was $100.8 million in long positions and $86.8 million in
short positions. The potential change in fair value, using a hypothetical 10.0%
decline in prices, is estimated to be a $1.4 million loss as of September 30,
1999 due to the offset of losses in long positions with gains in short
positions.
For working capital purposes, we invest in money market funds or maintain
interest bearing balances in our trading accounts with clearing brokers, which
are classified as cash equivalents and receivable from clearing brokers,
respectively, in the Consolidated Statements of Financial Condition. These
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. Since its
inception, neither Knight/Trimark nor any of its subsidiaries has traded or
otherwise transacted in derivatives.
17
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We are not currently a party to any legal proceedings the adverse outcome of
which, individually or in the aggregate, could have a material adverse effect on
our business, financial condition or operating results. 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.
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 10.1 Clearing Agreement between Knight Securities, L.P.
and Broadcort Capital Corp. (the "Knight Clearing Agreement")
dated September 28, 1999.
Exhibit 10.2 Amendment to the Knight Clearing Agreement, dated October 18,
1999.
Exhibit 27. Financial Data Schedule.
18
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, Treasurer, Executive Vice President,
and Chief Financial Officer (principal
financial and accounting officer)
Date: November 11, 1999
19