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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, 2001
001-14223
COMMISSION FILE NUMBER
Knight Trading Group, Inc.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction
of incorporation or organization)
22-3689303
(I.R.S. Employer
Identification Number)
525 Washington Boulevard
Jersey City, NJ 07310
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (201) 222-9400
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
At November 13, 2001 the number of shares outstanding of the registrant's
Class A common stock was 124,122,987 and there were no shares outstanding of
the registrant's Class B common stock.
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KNIGHT TRADING GROUP, INC.
FORM 10-Q QUARTERLY REPORT
For the Quarter Ended September 30, 2001
TABLE OF CONTENTS
Page
----
PART I FINANCIAL INFORMATION:
Item 1. Financial Statements................................................................. 3
Consolidated Statements of Operations.................................................. 3
Consolidated Statements of Financial Condition......................................... 4
Consolidated Statements of Cash Flows.................................................. 5
Notes to Consolidated Financial Statements............................................. 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 13
Item 3. Quantitative and Qualitative Disclosures About Market Risk........................... 21
PART II OTHER INFORMATION:
Item 1. Legal Proceedings.................................................................... 22
Item 2. Changes in Securities and Use of Proceeds............................................ 23
Item 3. Defaults Upon Senior Securities...................................................... 23
Item 4. Submission of Matters to a Vote of Security Holders.................................. 23
Item 5. Other Information.................................................................... 23
Item 6. Exhibits and Reports on Form 8-K..................................................... 23
Signatures................................................................................... 24
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Operations
(Unaudited)
For the three months For the nine months ended
ended September 30, September 30,
-------------------------- ---------------------------
2001 2000 2001 2000
------------ ------------ ------------ --------------
Revenues
Net trading revenue............................................. $103,035,435 $165,106,177 $425,520,038 $ 934,399,747
Asset management fees........................................... 10,509,686 10,012,506 31,824,854 31,027,351
Commissions and fees............................................ 9,648,640 5,876,668 36,580,089 18,902,232
Interest and dividends, net of interest expense................. 6,599,050 5,653,424 20,616,938 13,272,532
Investment income and other..................................... 1,142,097 1,216,212 7,846,672 7,990,114
------------ ------------ ------------ --------------
Total revenues............................................... 130,934,908 187,864,987 522,388,591 1,005,591,976
------------ ------------ ------------ --------------
Expenses
Employee compensation and benefits.............................. 53,636,003 57,307,783 191,969,605 334,792,813
Execution and clearance fees.................................... 26,645,135 24,475,966 86,790,180 83,615,566
Payments for order flow......................................... 14,413,046 37,270,268 64,331,781 134,907,102
Communications and data processing.............................. 13,236,478 8,057,211 39,464,320 22,288,031
Depreciation and amortization................................... 10,620,019 7,375,100 31,210,749 17,091,498
Occupancy and equipment rentals................................. 4,143,809 5,404,623 13,740,835 12,811,955
Professional fees............................................... 3,681,321 5,844,373 12,855,597 16,483,145
Business development............................................ 2,392,246 2,437,801 9,866,475 10,560,904
Other........................................................... 5,658,935 5,175,687 15,862,694 12,076,468
Loss on writedown of assets..................................... 6,624,056 -- 18,195,569 --
------------ ------------ ------------ --------------
Total expenses............................................... 141,051,048 153,348,812 484,287,805 644,627,482
------------ ------------ ------------ --------------
Income (Loss) before income taxes and minority interest............ (10,116,140) 34,516,175 38,100,786 360,964,494
Income tax expense (benefit)....................................... (1,129,322) 14,109,959 20,409,297 136,470,415
------------ ------------ ------------ --------------
Income (Loss) before minority interest............................. (8,986,818) 20,406,216 17,691,489 224,494,079
Minority interest in net loss of consolidated subsidiaries......... 3,310,974 177,763 7,353,134 177,763
------------ ------------ ------------ --------------
Net income (loss).................................................. $ (5,675,844) $ 20,583,979 $ 25,044,623 $ 224,671,842
============ ============ ============ ==============
Basic earnings per share........................................... $ (0.05) $ 0.17 $ 0.20 $ 1.84
============ ============ ============ ==============
Diluted earnings per share......................................... $ (0.05) $ 0.16 $ 0.20 $ 1.77
============ ============ ============ ==============
Pro forma adjustments
Income before income taxes and minority interest................ $ 360,964,494
Adjustment for pro forma employee compensation and benefits..... (267,109)
--------------
Pro forma income before income taxes and minority interest...... 360,697,385
Pro forma income tax expense.................................... 137,121,175
--------------
Pro forma income before minority interest....................... 223,576,210
Minority interest in consolidated subsidiaries.................. 177,763
--------------
Pro forma net income............................................ $ 223,753,973
Pro foma basic earnings per share............................... $ 1.83
==============
Pro forma diluted earnings per share............................ $ 1.76
==============
Shares used in basic earnings per share calculations (see Note 9).. 123,998,269 122,661,830 123,711,607 122,350,107
============ ============ ============ ==============
Shares used in diluted earnings per share calculations (see Note 9) 125,168,828 126,565,409 125,845,652 126,930,997
============ ============ ============ ==============
The accompanying notes are an integral part of these consolidated financial
statements
3
KNIGHT TRADING GROUP, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited)
September 30, December 31,
2001 2000
-------------- --------------
Assets
Cash and cash equivalents......................................... $ 337,320,671 $ 364,057,534
Securities owned, held at clearing broker, at market value........ 1,653,654,486 1,799,966,679
Receivable from brokers and dealers............................... 829,213,887 114,047,275
Fixed assets and leasehold improvements at cost, less accumulated
depreciation and amortization................................... 94,470,960 79,014,393
Goodwill, less accumulated amortization........................... 46,437,217 45,239,177
Investments....................................................... 92,595,336 64,917,975
Income taxes receivable........................................... 8,798,842 --
Other assets...................................................... 48,684,447 54,166,139
-------------- --------------
Total assets.................................................. $3,111,175,846 $2,521,409,172
============== ==============
Liabilities and Stockholders' Equity
Liabilities
Securities sold, not yet purchased, at market value............... $1,909,662,274 $1,427,214,323
Payable to brokers and dealers.................................... 259,858,024 184,269,478
Accrued compensation expense...................................... 54,075,384 62,444,645
Accrued execution and clearance fees.............................. 7,246,975 6,092,754
Accrued payments for order flow................................... 3,830,855 11,635,069
Accounts payable, accrued expenses and other liabilities.......... 29,852,340 30,576,814
Income taxes payable.............................................. -- 4,813,771
-------------- --------------
Total liabilities............................................. 2,264,525,852 1,727,046,854
-------------- --------------
Minority interest in consolidated subsidiaries....................... 24,433,777 20,175,872
-------------- --------------
Stockholders' equity
Class A Common Stock.............................................. 1,240,515 1,232,908
Additional paid-in capital........................................ 334,883,381 309,611,248
Retained earnings................................................. 490,981,414 465,947,294
Unamortized stock-based compensation.............................. (758,514) --
Accumulated other comprehensive income (loss)--foreign currency
translation adjustments, net of tax............................. (4,130,579) (2,605,004)
-------------- --------------
Total stockholders' equity.................................... 822,216,217 774,186,446
-------------- --------------
Total liabilities and stockholders' equity.................... $3,111,175,846 $2,521,409,172
============== ==============
The accompanying notes are an integral part of these consolidated financial
statements.
4
KNGHT TRADING GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
For the nine months ended
September 30,
----------------------------
2001 2000
------------- -------------
Cash flows from operating activities
Net income........................................................... $ 25,044,623 $ 224,671,842
Adjustments to reconcile net income to net cash provided by operating
activities
Income tax credit from stock options exercised.................... 2,468,299 6,832,029
Depreciation and amortization..................................... 31,315,326 17,091,498
Minority interest in earnings of consolidated subsidiaries........ (7,353,134) (177,763)
Writedown of assets............................................... 18,195,569 --
(Increase) decrease in operating assets
Securities owned.................................................. 146,312,193 (754,792,066)
Receivable from brokers and dealers............................... (715,166,612) 18,393,036
Income taxes receivable........................................... (8,798,842) (10,421,043)
Other assets...................................................... 3,910,179 (24,436,963)
Increase (decrease) in operating liabilities
Securities sold, not yet purchased................................ 482,447,951 668,853,928
Securities sold under agreements to repurchase.................... -- (10,409,736)
Payable to brokers and dealers.................................... 75,588,546 37,007,591
Accrued compensation expense...................................... (8,369,261) (13,062,045)
Accounts payable, accrued expenses and other liabilities.......... (6,200,226) (36,704,993)
Accrued execution and clearance fees.............................. 1,154,221 (1,178,027)
Accrued payments for order flow................................... (7,804,214) (3,313,463)
Income taxes payable.............................................. (4,813,771) (15,992,937)
------------- -------------
Net cash provided by operating activities..................... 27,930,847 102,360,888
------------- -------------
Cash flows from investing activities
Purchases of fixed assets and leasehold improvements................. (43,049,780) (42,857,511)
Investments and acquisitions......................................... (45,177,361) (23,132,430)
Payment of contingent consideration.................................. -- (5,093,791)
------------- -------------
Net cash used in investing activities......................... (88,227,141) (71,083,732)
------------- -------------
Cash flows from financing activities
Stock options exercised.............................................. 4,860,735 5,251,837
Minority interest in consolidated subsidiaries....................... 28,698,696 7,407,139
------------- -------------
Net cash provided by financing activities..................... 33,559,431 12,658,976
------------- -------------
(Decrease) increase in cash and cash equivalents..................... (26,736,863) 43,936,132
Cash and cash equivalents at beginning of period..................... 364,057,534 304,053,554
------------- -------------
Cash and cash equivalents at end of period........................... $ 337,320,671 $ 347,989,686
============= =============
Supplemental disclosure of cash flow information:....................
Cash paid for interest............................................ $ 19,078,954 $ 26,697,274
============= =============
Cash paid for income taxes........................................ $ 34,021,910 $ 164,137,503
============= =============
The accompanying notes are an integral part of these consolidated financial
statements
5
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2001
(Unaudited)
1. Organization and Description of the Business
Knight Trading Group, Inc. (the ''Company'') and its subsidiaries operate in
securities market-making and asset management business lines. Knight Securities
(''KS'') operates as a market maker in over-the-counter equity securities
(''OTC securities''), primarily those traded in the Nasdaq Stock Market and on
the OTC Bulletin Board ("OTCBB"). Knight Capital Markets (''KCM,'' formerly
known as Trimark Securities) operates as a market maker in the over-the-counter
market for New York Stock Exchange (NYSE)-and American Stock Exchange
(AMEX)-listed securities. Knight Financial Products (''KFP'') makes markets in
options on individual equities, equity indices and fixed income instruments in
the U.S., Europe and Australia. The Company also operates a professional option
execution services business through Knight Execution Partners ("KEP"). KS, KCM,
KFP and KEP are registered as broker-dealers with the Securities and Exchange
Commission (''SEC'' or the ''Commission''). Additionally, KS and KCM are
members of the National Association of Securities Dealers, Inc. (''NASD''). KFP
is a member of the Chicago Board Options Exchange as well as the American Stock
Exchange, the Pacific Exchange, the Philadelphia Stock Exchange, the
International Stock Exchange and the Australian Stock Exchange. The Company
also maintains an asset management business for institutional investors and
high net worth individuals through its Deephaven Capital Management
("Deephaven") subsidiary.
In the first quarter of 2001, the Company began its Knight Roundtable Europe
venture. Currently, 21 broker-dealers and banks from Europe and the United
States own an approximate 15% minority interest in the venture. The venture
owns and operates Knight Securities International, Ltd. ("KSIL"), which
provides best execution solutions for European investors in European and U.S.
equities. In the third quarter of 2000 the Company established a joint venture
operation of which it owns 60%, called Knight Securities Japan ("KSJ"), with
Nikko Securities Co., Ltd. to provide wholesale market-making services in
Japanese equity securities.
2. Significant Accounting Policies
Basis of consolidation and form of presentation
The accompanying consolidated financial statements include the accounts of
the Company and its majority and wholly-owned subsidiaries and, in the opinion
of management, reflect all adjustments, consisting only of normal recurring
adjustments, necessary for a fair statement of the results for the interim
period. All significant intercompany transactions and balances have been
eliminated. Certain footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been condensed or omitted pursuant to SEC rules and regulations, although
the Company believes that the disclosures are adequate to make the information
presented not misleading. The nature of the Company's business is such that the
results of an interim period are not necessarily indicative of the results for
the full year. These consolidated financial statements should be read in
conjunction with the financial statements and notes thereto included in the
Company's Annual Report on Form 10-K for the year ended December 31, 2000 as
filed with the SEC.
Cash equivalents
Cash equivalents represent money market accounts, which are payable on
demand, or short-term investments with an original maturity of less than 30
days. The carrying amount of such cash equivalents approximates their fair
value due to the short-term nature of these instruments.
Investments
Investments on the Consolidated Statements of Financial Condition comprise
ownership interests of less than 20% in publicly and non-publicly traded
companies which are accounted for under the equity method or the
6
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 contracts 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 and option order executions to the Company. The Company
records interest income net of transaction-related interest charged by clearing
brokers for facilitating the settlement and financing of securities
transactions. Interest expense for the three months ended September 30, 2001
and 2000 was $6,882,170 and $11,607,266, respectively. Interest expense for the
nine months ended September 30, 2001 and 2000 was $18,766,087 and $26,834,684,
respectively.
Asset management fees
The Company earns asset management fees for sponsoring and managing the
investments of certain private investment funds. Such fees are recorded monthly
as earned and are calculated as a percentage of the fund's quarterly net
assets, plus a percentage of a new high net asset value, as defined, for any
six-month period ended June 30th or December 31st. A new high net asset value
is generally defined as the amount by which the net asset value of the fund
exceeds the greater of either the highest previous net asset value in the fund,
or the net asset value at the time each investor made their purchase.
Securities borrowed/loaned
Securities borrowed and securities loaned, which are included in receivable
from and payable to brokers and dealers, are recorded at the amount of cash
collateral advanced or received. Securities borrowed transactions require the
Company to deposit cash or similar collateral with the lender. With respect to
securities loaned, the Company receives collateral in the form of cash in an
amount generally in excess of the market value of securities loaned. Interest
income and interest expense are recorded on an accrual basis. The Company
monitors the market value of securities borrowed and loaned on a daily basis.
Substantially all of the Company's securities borrowed and securities loaned
transactions are conducted with banks and other securities firms.
Foreign currencies
The functional currencies of the Company's consolidated foreign subsidiaries
are the U.S. dollar, the British Pound and the Japanese Yen. Assets and
liabilities in foreign currencies are translated into U.S. dollars using
current exchange rates at the date of the Consolidated Statements of Financial
Condition. Revenues and expenses are translated at average rates during the
periods. The foreign exchange gains and losses resulting from these
translations are included as a separate component of stockholders' equity in
the Consolidated Statements of Financial Condition.
Depreciation, amortization and occupancy
Fixed assets are being depreciated on a straight-line basis over their
estimated useful lives of three to seven years. Leasehold improvements are
being amortized on a straight-line basis over the life of the related office
7
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
lease. The Company records rent expense on a straight-line basis over the life
of the lease. The Company capitalizes certain costs associated with the
acquisition or development of internal-use software and amortizes the software
over its estimated useful life of three years.
Income taxes
Income tax expense (benefit) in the Consolidated Statements of Operations
represents actual income taxes incurred through September 30, 2001. Before the
Company's merger with KFP ("the Merger"), which was completed on January 12,
2000, KFP was a limited liability company which was treated as a partnership
for tax purposes and its federal and state income taxes were borne by KFP's
individual partners. As such, KFP's historical financial statements only
include a provision for non U.S. income taxes. Subsequent to the Merger, KFP's
income is subject to federal and state income taxes. Pro forma income tax
expense reflects income taxes as if the Company was subject to federal and
state income taxes on KFP's income prior to the Merger.
The Company records deferred tax assets and liabilities for the expected
future tax consequences of temporary differences between the financial
reporting and tax bases of assets and liabilities and are measured using the
enacted tax rates and laws that will be in effect when such differences are
expected to reverse.
Estimated fair value of financial instruments
The Company's securities owned and securities sold, not yet purchased are
carried at market value. Management estimates that the fair values of other
financial instruments recognized on the Consolidated Statements of Financial
Condition (including receivables, payables and accrued expenses) approximate
their carrying values, as such financial instruments are short-term in nature,
bear interest at current market rates or are subject to frequent repricing.
Minority interest
Minority interest represents minority owners' share of net income or losses
and equity in two of the Company's consolidated subsidiaries, KSIL and KSJ.
Accounting for derivatives
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments, including
certain derivative instruments imbedded in other contracts, and for hedging
activities. In June 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities-Deferral of the Effective Date of
FASB Statement No. 133 -an amendment of FASB Statement No. 133. In June 2000,
the FASB issued SFAS No. 138 Accounting for Certain Derivative Instruments and
Certain Hedging Activities, which is an amendment to SFAS No. 133 and is
effective concurrently with SFAS No. 137. The Company adopted the provisions of
SFAS No. 133, 137 and 138 as of January 1, 2001. The Company's derivative
financial instruments are all held for trading purposes and historically have
been carried at fair value. As such, the adoption of these statements did not
have a material impact on the Company's financial statements.
Restricted stock
The Company records the fair market value of shares associated with
restricted stock awards as unamortized stock-based compensation in
stockholders' equity and amortizes the balance to compensation expense over the
vesting period.
8
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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:
September 30, December 31,
2001 2000
-------------- --------------
Securities owned:
Equities........................ $ 520,275,479 $ 661,327,729
Options......................... 1,043,373,768 1,126,483,498
Convertible bonds............... 76,695,890 --
U.S. government obligations..... 13,309,349 12,155,452
-------------- --------------
$1,653,654,486 $1,799,966,679
============== ==============
Securities sold, not yet purchased:
Equities........................ $ 699,347,222 $ 170,167,713
Convertible bonds............... 7,668,200 --
Options......................... 1,202,646,852 1,257,046,610
-------------- --------------
$1,909,662,274 $1,427,214,323
============== ==============
4. Receivable from/Payable to Brokers and Dealers
Amounts receivable from and payable to brokers and dealers consist of the
following:
September 30, December 31,
2001 2000
------------- ------------
Receivable:
Clearing brokers............. $783,641,208 $ 86,156,298
Securities failed to deliver. 8,235,106 19,815,796
Securities borrowed.......... 34,855,282 8,075,181
Other........................ 2,482,291 --
------------ ------------
$829,213,887 $114,047,275
============ ============
Payable:
Clearing brokers............. $242,140,068 $175,552,245
Securities failed to receive. 13,804,519 8,574,981
Securities loaned............ 3,913,437 142,252
------------ ------------
$259,858,024 $184,269,478
============ ============
9
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
5. Investments
The Company's wholly-owned subsidiary, Deephaven, is the investment manager
and sponsor of private investment funds that engage in various trading
strategies involving equities, debt instruments and derivatives. The Company
owns interests in these private investment funds. Such investments amounted to
approximately $51.8 million at September 30, 2001. Certain officers of the
Company also own interests in these private investment funds. Additionally, the
Company has made strategic investments in the National Association of
Securities Dealers, Inc., Nasdaq Europe (formerly known as Easdaq), Nasdaq
Japan and other public and non-public companies.
6. Significant Customers
The Company considers significant customers to be customers who provide the
Company with 10% or more of its U.S. equity order flow, as measured in equity
share volume, during the period. One customer provided 12.6% of the Company's
U.S. equity order flow during the third quarter of 2001. Order flow payments to
this firm amounted to $1.2 million during the same period.
7. Writedown of Assets
The loss on the writedown of assets on the Consolidated Statements of
Operations includes $6.6 million in pre-tax non-operating charges, which
consists of the write-down of assets related to excess real-estate capacity,
for the three months ended September 30, 2001. For the nine months ended
September 30, 2001, the loss on the writedown of assets includes the $6.6
million write-down of assets related to excess real-estate capacity, a $10
million non-recurring charge relating to an impaired investment in a non-public
e-commerce company and $1.6 million related to a write-down of certain exchange
seats.
8. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is as follows:
Three months ended Nine months ended
September 30, September 30,
------------------------ -------------------------
2001 2000 2001 2000
----------- ----------- ----------- ------------
Net income/ pro forma net income........ $(5,675,844) $20,583,979 $25,044,623 $223,753,973
Foreign currency translation adjustment,
net of tax............................ 1,477,378 (567,480) (1,525,575) (914,527)
----------- ----------- ----------- ------------
Total comprehensive income, net of tax.. $(4,198,466) $20,016,499 $23,519,048 $222,839,446
=========== =========== =========== ============
9. Earnings per Share
Basic earnings per common share ("EPS") has been calculated by dividing net
income by the weighted average shares of Class A Common Stock outstanding
during each respective period. Diluted EPS reflects the potential reduction in
EPS using the treasury stock method to reflect the impact of common share
equivalents if stock awards such as stock options and restricted stock were
exercised or converted into common stock.
10
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations for the three and nine month
periods ended September 30, 2001 and 2000:
For the three months ended September 30,
------------------------------------------------------
2001 2000
------------------------- ---------------------------
Numerator / Denominator / Numerator / Denominator /
net income shares net income shares
----------- ------------- ------------- -------------
Income and shares used in basic
calculations...................... $(5,675,844) 123,998,269 $ 20,583,979 122,661,830
Effect of dilutive stock awards..... -- 1,170,559 -- 3,903,579
----------- ------------ ------------ ------------
Income and shares used in diluted
calculations...................... $(5,675,844) 125,168,828 $ 20,583,979 126,565,409
----------- ------------ ------------ ------------
Basic earnings per share............ $ (0.05) $ 0.17
------------ ------------
Diluted earnings per share.......... $ (0.05) $ 0.16
------------ ------------
For the nine months ended September 30,
------------------------------------------------------
2001 2000
------------------------- ---------------------------
Numerator / Denominator /
Numerator / Denominator / pro forma net pro forma
net income shares income shares
----------- ------------- ------------- -------------
Income and shares used in basic
calculations...................... $25,044,623 123,711,607 $223,753,973 122,350,107
Effect of dilutive stock awards..... -- 2,134,045 -- 4,580,890
----------- ------------ ------------ ------------
Income and shares used in diluted
calculations...................... $25,044,623 125,845,652 $223,753,973 126,930,997
----------- ------------ ------------ ------------
Pro forma basic earnings per share.. $ 0.20 $ 1.83
------------ ------------
Pro forma diluted earnings per share $ 0.20 $ 1.76
------------ ------------
10. Net Capital Requirements
As registered broker-dealers, KS, KCM, KFP and KEP are subject to the SEC's
Uniform Net Capital Rule (the ''Rule'') which requires the maintenance of
minimum net capital. KS, KCM and KEP have elected to use the basic method,
permitted by the Rule, which requires that they each maintain net capital equal
to the greater of $1.0 million ($100,000 for KEP) or 6 2/3% of aggregate
indebtedness, as defined. KFP has elected to use the alternative method,
permitted by the Rule, which requires that it maintains net capital equal to
the greater of $250,000 or 2% of aggregate debit items, as defined.
At September 30, 2001, KS had net capital of $254,963,517 which was
$252,139,192 in excess of its required net capital of $2,824,325, KCM had net
capital of $50,679,528 which was $49,679,528 in excess of its required net
capital of $1,000,000, KFP had net capital of $50,330,320 which was $50,080,320
in excess of its required net capital of $250,000 and KEP had net capital of
$2,419,166 which was $2,319,166 in excess of its required net capital of
$100,000.
Additionally, KSIL, KSJ and KFP are subject to regulatory requirements in
the countries in which they operate, including the requirements of the
Securities and Futures Authority Limited in the United Kingdom, the Financial
Supervisory Agency in Japan and the Australian Stock Exchange in Australia. As
of September 30, 2001, the Company was in compliance with these capital
adequacy requirements.
11
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
11. Business Segments
The Company has two reportable business segments: securities market-making
and asset management. Securities market-making primarily represents
market-making in U.S. equity securities listed on Nasdaq, on the OTCBB of the
NASD, in the over-the-counter market for NYSE- and AMEX-listed securities and
in U.S. options on individual equities, equity indices, fixed income
instruments and certain commodities. The Company also makes markets in equities
in Europe and Japan and in options in Europe and Australia. The asset
management segment consists of investment management and sponsorship for a
series of private investment funds.
The Company's net revenues, income before income taxes and minority interest
and assets by segment are summarized below:
Securities Market Asset
Making* Management Total
----------------- ----------- --------------
For the three months ended September 30, 2001:
Revenues................................................ $ 118,153,709 $12,781,199 $ 130,934,908
Income (loss) before income taxes and minority interest. (18,500,280) 8,384,140 (10,116,140)
Total Assets............................................ 3,044,063,987 67,111,859 3,111,175,846
For the three months ended September 30, 2000:
Revenues................................................ 177,246,902 10,618,085 187,864,987
Income before income taxes and minority interest........ 26,858,159 7,658,016 34,516,175
Total Assets............................................ 2,380,357,812 29,113,396 2,409,471,208
For the nine months ended September 30, 2001:
Revenues................................................ 485,390,853 36,997,738 522,388,591
Income before income taxes and minority interest........ 14,908,085 23,192,701 38,100,786
Total Assets............................................ 3,044,063,987 67,111,859 3,111,175,846
For the nine months ended September 30, 2000:
Revenues................................................ 970,795,648 34,796,328 1,005,591,976
Income before income taxes and minority interest........ 334,228,668 26,468,717 360,697,385
Total Assets............................................ 2,380,357,812 29,113,396 2,409,471,208
--------
* The three months ended September 30, 2001 includes $6.6 million in pre-tax
non-operating charges, which consists of the write-down of assets related to
excess real-estate capacity. The nine months ended September 30, 2001
includes $18.2 million in pre-tax non-operating charges, which consists of a
$6.6 million write-down of assets related to excess real-estate capacity, a
$10 million non-recurring charge relating to an impaired investment in a
non-public e-commerce company and $1.6 million related to a write-down of
certain exchange seats.
12
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion of our results of operations should be read in
conjunction with our consolidated financial statements and notes thereto
included in our Annual Report on Form 10-K for the year ended December 31,
2000. This discussion contains forward-looking statements that involve risks
and uncertainties. Our actual results may differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including, but not limited to, those set forth elsewhere in this document. We
have experienced, and expect to continue to experience, significant
fluctuations in quarterly results due to a variety of factors, including the
value of our securities positions and our ability to manage the risks attendant
thereto, the volume of our market-making activities, volatility in the
securities markets, our ability to manage personnel and expenses, the amount of
revenue derived from limit orders as a percentage of net trading revenues,
changes in payments for order flow or clearing costs, the addition or loss of
sales and trading professionals, regulatory changes, the amount and timing of
capital expenditures, the incurrence of costs associated with acquisitions, the
gain or loss on investments and real-estate and general economic conditions. If
demand for our market-making services and asset management services declines
and we are unable to adjust our cost structure on a timely basis, our 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 results are not necessarily meaningful and such comparisons cannot
be relied upon as indicators of future performance. There also can be no
assurance that we will be able to return to the rates of revenue growth that we
have experienced in the past, that we will be able to improve our results or
that we will be able to regain and sustain our profitability levels on a
quarterly basis.
Overview
We are the leading market maker in equity securities listed on Nasdaq, the
OTCBB of the NASD, and the over-the-counter market for New York Stock Exchange
(NYSE) and American Stock Exchange (AMEX)-listed securities. Additionally, we
make markets in equity securities in Europe and Japan. We are also a leading
market maker in options on individual equities, equity indices and fixed income
instruments in the U.S., Europe and Australia. The firm also maintains an asset
management business for institutional investors and high net worth individuals
through our Deephaven subsidiary.
KS's equity share volume totaled 26.4 billion and 17.0 billion, or 84% and
77% of our total U.S. equity share volume, for the three months ended September
30, 2001, and 2000, respectively. KCM's share volume totaled 5.0 billion in
each of the three months ended September 30, 2001 and 2000, respectively or 16%
and 23% of our total U.S. equity share volume. KFP's U.S. option contract
volume totaled 8.7 million and 5.1 million for the three months ended September
30, 2001 and 2000, respectively. Deephaven's total assets under management
totaled $1.2 billion and $630.0 million at September 30, 2001 and 2000,
respectively.
Revenues
Our revenues consist principally of net trading revenue from U.S. securities
market-making activities. Net trading revenue, which represents trading gains
net of trading losses, is primarily affected by changes in U.S. equity trade
and share volumes and U.S. option contract volumes, our revenue capture per
U.S. equity share and per U.S. option contract, our ability to derive trading
gains by taking proprietary positions, changes in our execution standards,
volatility in the marketplace, our mix of broker-dealer and institutional
customers and by regulatory changes and evolving industry customs and practices.
OTC securities transactions with institutional customers are executed as
principal, and all related profits and losses are included within net trading
revenue. Listed securities transactions with institutional customers are
executed on an agency basis, for which we earn commissions on a per share
basis. We also receive fees for providing certain information to market data
providers and for directing trades to certain destinations for execution.
Commissions and fees are primarily affected by changes in our trade and share
volumes in listed securities as well as by changes in fees earned for directing
trades to certain destinations for execution.
13
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 amount of assets under management.
We earn interest income from our cash held at banks and cash held in trading
accounts at clearing brokers, net of transaction-related interest charged by
clearing brokers for facilitating the settlement and financing of securities
transactions. Net interest is primarily affected by the changes in cash
balances held at banks and clearing brokers and our level of securities
positions.
Expenses
Our operating expenses largely consist of employee compensation and
benefits, payments for order flow and execution and clearance fees. A
substantial portion of these expenses vary in proportion to our trading revenue
and volume. Employee compensation and benefits expense, which is largely
profitability based, fluctuates, for the most part, based on changes in net
trading revenue, our profitability and our number of employees. Payments for
order flow fluctuate based on U.S. equity share and options volume, the mix of
market orders and limit orders, the mix of orders received from broker-dealers
who accept payments for order flow and changes in our payment for order flow
policy. Execution and clearance fees fluctuate primarily based on changes in
equity trade and share volume, option contract volume, the mix of trades of OTC
securities compared to listed securities, clearance fees charged by clearing
brokers and fees to access electronic communications networks, commonly
referred to as ECNs. Our international expansion efforts have increased our
operating expenses.
Employee compensation and benefits expense primarily consists of salaries
and wages paid to administrative and customer service personnel and
profitability based compensation, which includes compensation and benefits paid
to market-making and sales personnel based on their individual performance, and
incentive compensation paid to all other employees based on our overall
profitability. Approximately 67% of our employees are directly involved in
market-making, sales or customer service activities. Compensation for employees
engaged in market-making and sales activities, the largest component of
employee compensation and benefits, is determined primarily based on a
percentage of gross trading profits net of expenses including payments for
order flow, execution and clearance costs and overhead allocations. Employee
compensation and benefits will, therefore, be affected by changes in payments
for order flow, execution and clearance costs and the overhead costs we
allocate to employees engaged in market-making and sales activities.
Payments for order flow represent customary payments to broker-dealers, in
the normal course of business, for directing their order flow in equity
securities and options to us. We only pay broker-dealers for orders that
provide us with a profit opportunity. For example, in our U.S. equities
market-making activities, we make payments on market orders and marketable
limit orders, but do not pay on non-marketable limit orders. Payments for order
flow also change as we modify our payment formulas and as our percentage of
customers whose policy is not to accept payments for order flow varies.
Execution and clearance fees primarily represent clearance fees paid to
clearing brokers for OTC and listed securities and options contracts,
transaction fees paid to Nasdaq, payments made to third parties for exchange
seat leases, execution fees paid to third parties, primarily for executing
trades in listed securities on the NYSE and AMEX and for executing orders
through ECNs and execution and clearance fees for our international businesses.
Due to our significant equity share and trade volume, we have been able to
negotiate favorable rates and volume discounts from clearing brokers and
providers of execution services.
Communications and data processing expense primarily consists of costs for
obtaining market data and telecommunications services.
Depreciation and amortization expense results from the depreciation of fixed
assets purchased by us and the amortization of goodwill, which includes
contingent consideration resulting from the acquisitions of the listed
securities market-making businesses of KCM and Tradetech Securities, L.P.,
(''Tradetech''). Depreciation and amortization expense also includes the
amortization of goodwill related to our purchases of various options-related
businesses.
14
Professional fees primarily consist of fees paid to computer programming and
systems consultants, as well as legal fees and other professional fees.
Occupancy and equipment rentals expense primarily consists of rental
payments on office and equipment leases.
Business development expense primarily consists of travel and entertainment
expenses and promotion and advertising costs.
Other expenses primarily consist of administrative expenses such as
employment costs, general office expenses and other operating costs.
Income Tax
Income tax expense (benefit) in the Consolidated Statements of Operations
represents actual income taxes incurred through September 30, 2001 and 2000,
respectively. Prior to merging with KTG on January 12, 2000 (the "Merger"), KFP
was a limited liability company which was treated as a partnership for tax
purposes and its U.S. federal and state income taxes were borne by KFP's
individual partners. As such, KFP's historical financial statements only
include a provision for non-U.S. income taxes. Subsequent to the Merger, KFP's
income is subject to federal income taxes and state income taxes. Pro forma
income tax expense reflects income taxes as if the Company was subject to
federal and state income taxes on KFP's income prior to the Merger.
Results of Operations
Three Months Ended September 30, 2001 and 2000
Revenues
Net trading revenue from equity security market-making decreased 53.6% to
$65.7 million for the three months ended September 30, 2001, from $141.7
million for the comparable period in 2000. U.S. equity trading revenue
represents the majority of our equity security market-making. This decrease in
equity trading revenue was primarily due to decreased average revenue capture
per U.S. equity share. Average revenue capture per U.S. equity share was
impacted by a reduction in spreads due to decimalization and the introduction
of a one-penny Minimum Price Variant in the second quarter of 2001. Average
revenue per U.S. equity share decreased to $.0022 for the three months ended
September 30, 2001, from $.0065 for the comparable period in 2000. The decrease
in equity net trading revenues was offset, slightly, by a 43.3% increase in
total U.S. equity share volume to 31.4 billion equity shares traded for the
three months ended September 30, 2001, from 21.9 billion U.S. equity shares
traded for the comparable period in 2000. The increase in U.S. equity share
volume is largely due to higher share volume in very low-priced Bulletin Board
and Pink Sheet stocks. Net trading revenue from options market-making increased
59.6% to $37.3 million for the three months ended September 30, 2001 from $23.4
million for the comparable period in 2000. This increase was primarily due to a
69.1% increase in U.S. option contract volume, which was impacted by KFP's
continuing purchases of additional exchange posts during the last year which
increased our options market-making coverage. Total U.S. option contracts
executed increased to 8.7 million contracts for the three months ended
September 30, 2001 from 5.1 million for the comparable period in 2000. The
increase was offset slightly by a decrease in average revenue per U.S. option
contract to $4.25 per contract for the three months ended September 30, 2001
from $4.28 per contract for the comparable period in 2000.
Asset management fees increased 5.0% to $10.5 million for the three months
ended September 30, 2001, from $10.0 million for the comparable period in 2000.
The increase in fees was primarily due to an increase in the amount of funds
under management in the Deephaven Market Neutral Master Fund, which contains the
15
majority of funds under management, from $630.0 million at September 30, 2000
to $1.2 billion at September 30, 2001. The increase was offset, in part, by a
decrease in fund return from 6.55% for the third quarter of 2000 to 2.56% for
the third quarter of 2001.
Commissions and fees increased 64.2% to $9.6 million for the three months
ended September 30, 2001, from $5.9 million for the comparable period in 2000.
This increase is primarily due to payments received by our professional option
execution services business, KEP, for directing order executions, as well as an
increase in commissions from institutional customers for listed trade
executions.
Interest income, net of interest expense increased 16.7% to $6.6 million for
the three months ended September 30, 2001, from $5.7 million for the comparable
period in 2000. This increase was primarily due to larger cash balances held at
banks and our clearing brokers.
Investment income and other income decreased slightly to $1.1 million for
the three months ended September 30, 2001, from $1.2 million for the comparable
period in 2000. This decrease was primarily due to a decrease in income from
our investments.
Expenses
Employee compensation and benefits expense decreased 6.4% to $53.6 million
for the three months ended September 30, 2001, from $57.3 million for the
comparable period in 2000. As a percentage of total revenue, employee
compensation and benefits expense increased to 41.0% for the three months ended
September 30, 2001, from 30.5% for the comparable period in 2000. The decrease
on a dollar basis was primarily due to decreased gross trading profits and
lower margins, offset, in part, by our growth in the number of employees. The
increase on a percentage basis is primarily due to the decrease in average net
revenue per U.S. equity share and our increase in the number of employees. Due
to decreased net trading revenue and profitability, profitability based
compensation decreased 28.0% to $25.4 million for the three months ended
September 30, 2001, from $35.3 million for the comparable period in 2000, and
represented 47.5% and 61.7% of total employee compensation and benefits expense
for the three months ended September 30, 2001 and 2000, respectively. Our
number of employees increased to 1,377 employees as of September 30, 2001, from
1,209 employees as of September 30, 2000. This increase in employees was
primarily in our options market-making and asset management businesses.
Execution and clearance fees increased 8.9% to $26.6 million for the three
months ended September 30, 2001, from $24.5 million for the comparable period
in 2000. As a percentage of total revenues, execution and clearance fees
increased to 20.3% for the three months ended September 30, 2001, from 13.0%
for the comparable period in 2000. Execution and clearance fees increased
primarily due to a 69.1% increase in U.S. options contracts to 8.7 million
contracts for the three months ended September 30, 2001 from 5.1 million
contracts for the comparable period in 2000. Execution and clearance fees also
increased as a result of our international expansion efforts in Europe and
Japan. The increase was offset, in part, due to the 22.3% decrease in U.S.
equity trades executed to 24.4 million equity trades for the three months ended
September 30, 2001 from 31.4 million equity trades for the comparable period in
2000. The increase in execution and clearance charges as a percentage of total
revenue was primarily due to the decrease in average revenue per U.S. equity
trade and per U.S. option contract and an increase in U.S. options volume.
Payments for order flow decreased 61.3% to $14.4 million for the three
months ended September 30, 2001, from $37.3 million for the comparable period
in 2000. As a percentage of total revenue, payments for order flow decreased to
11.0% for the three months ended September 30, 2001 from 19.8% for the
comparable period in 2000. The decrease in payments for order flow on a dollar
basis and as a percentage of total revenue was primarily due to changes in our
payment for order flow policy initiated in the second quarter of 2001 resulting
from decimalization, partially offset by the 43.3% increase in U.S. equity
shares traded and the introduction of payment for order flow in the options
marketplace in the third quarter of 2000.
16
Communications and data processing expense increased 64.3% to $13.2 million
for the three months ended September 30, 2001, from $8.1 million for the
comparable period in 2000. This increase was generally attributable to an
increase in our number of employees, investment in technology, growth in our
options business and our international expansion in Europe and Japan.
Depreciation and amortization expense increased 44.0% to $10.6 million for
the three months ended September 30, 2001, from $7.4 million for the comparable
period in 2000. This increase was primarily due to the purchase of
approximately $71.2 million of additional fixed assets and leasehold
improvements between September 30, 2000 and September 30, 2001 and the
amortization of goodwill related to our acquisitions of the listed securities
market-making businesses of KCM and Tradetech and various options specialist
businesses.
Occupancy and equipment rentals expense decreased 23.3% to $4.1 million for
the three months ended September 30, 2001, from $5.4 million for the comparable
period in 2000. This decrease was primarily attributable to the decrease in
computer equipment lease expense.
Professional fees decreased 37.0% to $3.7 million for the three months ended
September 30, 2001, from $5.8 million for the comparable period in 2000. This
decrease was primarily due to decreased consulting expenses related to our
investments in technology, our European and Japanese expansion efforts and
legal and other professional fees.
Business development expense was $2.4 million for each of the three months
ended September 30, 2001 and 2000, respectively. The primary reason was that
travel and entertainments costs remained at about the same levels.
Other expenses increased 9.3% to $5.7 million for the three months ended
September 30, 2001, from $5.2 million for the comparable 2000 period. This was
primarily the result of increased administrative expenses and other operating
costs in connection with our overall business growth.
During the three months ended September 30, 2001, pre-tax non-operating
charges of $6.6 million were incurred. The charges consist of write-downs of
assets and other expenses in connection with our excess real-estate capacity.
Our effective tax rates for the three months ended September 30, 2001 and
2000, respectively, differ from the federal statutory rate of 35% due to state
income taxes, non-deductible foreign losses as well as non-deductible expenses,
including the amortization of goodwill resulting from the acquisition of KCM
and a portion of business development expenses.
Nine Months Ended September 30, 2001 and 2000
Revenues
Net trading revenue from equity security market-making decreased 62.0% to
$319.5 million for the nine months ended September 30, 2001, from $840.3
million for the comparable period in 2000. U.S. equity trading revenue
represents the majority of our equity market-making revenue. This decrease in
equity trading revenue was primarily due to decreased average revenue capture
per U.S. equity share. Average revenue capture per U.S. equity share decreased
to $.0035 per share for the nine months ended September 30, 2001 from $.0097
per share during the same period in 2000. This decrease was offset, in part,
due to an increase in U.S. equity share volume. Total U.S. equity share volume
increased 5.4% to 91.9 billion equity shares traded for the nine months ended
September 30, 2001, from 87.3 billion equity shares traded for the comparable
period in 2000. The increase in U.S. equity share volume is largely due to
higher share volume in very low-priced Bulletin Board and Pink Sheet stocks.
Net trading revenue from options market-making increased 12.7% to $106.0
million for the nine months ended September 30, 2001 from $94.1 million for the
comparable period in 2000. The increase is due to higher
17
U.S. option contract volume, offset by lower average revenue capture per U.S.
option contract. Total U.S. option contract volume was impacted by KFP's
continuing purchases of additional exchange posts during the last year which
increased our options market making coverage. Total U.S. option contract volume
increased 110.3% to 27.6 million contracts for the nine months ended September
30, 2001 compared to 13.1 million contracts for the comparable period in 2000.
The increase was partially offset by the decrease in average revenue capture
per U.S. option contract, which decreased to $3.74 per U.S. option contract for
the nine months ended September 30, 2001 from $6.78 per U.S. option contract
for the comparable period in 2000.
Asset management fees increased 2.6% to $31.8 million for the nine months
ended September 30, 2001, from $31.0 million for the comparable period in 2000.
The increase in fees was primarily due to an increase in the amount of funds
under management in the Deephaven Market Neutral Master Fund, which contained
the majority of funds under management, from $630.0 million at September 30,
2000 to $1.2 billion at September 30, 2001. The increase was offset by the
decrease in fund return from 26.55% for the first nine months of 2000 to 10.80%
for the first nine months of 2001.
Commissions and fees increased 93.5% to $36.6 million for the nine months
ended September 30, 2001, from $18.9 million for the comparable period in 2000.
This increase is primarily due to payments received by our professional option
execution services business, KEP, for directing order executions, as well as
higher equity share volumes from institutional customers in listed securities.
Interest income, net of interest expense, increased 55.3% to $20.6 million
for the nine months ended September 30, 2001, from $13.3 million for the
comparable period in 2000. This increase was primarily due to changes in our
market making positions from net long to net short.
Investment income and other income decreased 1.8% to $7.8 million for the
nine months ended September 30, 2001, from $8.0 million for the comparable
period in 2000. This slight decrease was primarily due to a decrease in income
from our investments.
Expenses
Employee compensation and benefits expense decreased 42.7% to $192.0 million
for the nine months ended September 30, 2001, from $335.1 million for the
comparable pro forma period in 2000. As a percentage of total revenue, employee
compensation and benefits expense increased to 36.7% for the nine months ended
September 30, 2001, from 33.3% for the comparable pro forma period in 2000. The
decrease on a dollar basis was primarily due to decreased gross trading profits
and lower margins, offset, in part, by the growth in the number of employees.
The increase on a percentage basis was primarily due to the decrease in average
net revenue per U.S. equity share and U.S. option contract and a growth in our
number of employees. Due to decreased net trading revenue and profitability,
profitability based compensation decreased 64.1% to $98.0 million for the nine
months ended September 30, 2001, from $273.4 million for the comparable pro
forma period in 2000, and represented 51.1% and 81.6% of total employee
compensation and benefits expense for the nine months ended September 30, 2001
and 2000, respectively. Our number of employees increased to 1,377 employees as
of September 30, 2001, from 1,209 employees as of September 30, 2000. This
increase in employees was primarily in our options market-making and asset
management businesses.
Execution and clearance fees increased 3.8% to $86.8 million for the nine
months ended September 30, 2001, from $83.6 million for the comparable period
in 2000. As a percentage of total revenue, execution and clearance fees
increased to 16.6% for the nine months ended September 30, 2001, from 8.3% for
the comparable period in 2000. The increase on a dollar basis was primarily
due to a 110.3% increase in U.S. options contracts executed from 13.1 million
U.S. options contracts executed for the nine months ended September 30, 2000 to
27.6 million for the nine months ended September 30, 2001. Execution and
clearance fees also increased as a result of our international expansion
efforts in Europe and Japan. The increase was offset, in part, by a 20.6%
decrease in U.S. equity trades executed to 86.4 million equity trades for the
nine months ended September 30,
18
2001, from 108.8 million equity trades in the comparable period in 2000. The
increase in our execution and clearance fees as a percentage of total revenue
was primarily due to a decrease in average revenue per U.S. equity trade and
per U.S. option contract and an increase in options volume.
Payments for order flow decreased 52.3% to $64.3 million for the nine months
ended September 30, 2001, from $134.9 million for the comparable period in
2000. As a percentage of total revenue, payments for order flow decreased to
12.3% for the nine months ended September 30, 2001 from 13.4% for the
comparable period in 2000. The decrease in payments for order flow on a dollar
basis and as a percentage of total revenue was primarily due to changes in our
payment for order flow policy, resulting from decimalization, initiated in the
second quarter 2001. The decrease was partially offset by the 5.4% increase in
U.S. equity shares traded, a decrease in our average revenue per U.S. equity
share and the introduction of payment for order flow in the options marketplace
in the third quarter of 2000.
Communications and data processing expense increased 77.1% to $39.5 million
for the nine months ended September 30, 2001, from $22.3 million for the
comparable period in 2000. This increase was generally attributable to an
increase in our number of employees, investment in technology, growth in our
options business and our international expansion in Europe and Japan.
Depreciation and amortization expense increased 82.6% to $31.2 million for
the nine months ended September 30, 2001, from $17.1 million for the comparable
period in 2000. This increase was primarily due to the purchase of
approximately $71.2 million of additional fixed assets and leasehold
improvements between September 30, 2000 and September 30, 2001 and the
amortization of goodwill related to our acquisitions of the listed securities
market-making businesses of KCM and Tradetech and various options specialist
businesses.
Occupancy and equipment rentals expense increased 7.3% to $13.7 million for
the nine months ended September 30, 2001, from $12.8 million for the comparable
period in 2000. This increase was primarily attributable to additional office
space occupied. We occupied 286,608 square feet of office space at September
30, 2001, up from 271,924 square feet of office space at September 30, 2000.
Professional fees decreased 22.0% to $12.9 million for the nine months ended
September 30, 2001, down from $16.5 million for the comparable period in 2000.
This decrease was primarily due to decreased consulting expenses related to our
investments in technology, our European and Japanese expansion efforts and
legal and other professional fees.
Business development expense decreased 6.6% to $9.9 million for the nine
months ended September 30, 2001, from $10.6 million for the comparable period
in 2000. This decrease was primarily the result of decreased advertising costs
and travel and entertainment costs in the first nine months of 2001 compared to
the first nine months of 2000.
Other expenses increased 31.4% to $15.9 million for the nine months ended
September 30, 2001, from $12.1 million for the comparable period in 2000. This
was primarily the result of increased administrative expenses and other
operating costs in connection with the growth in our options business as well
as European and Asian expansion.
During the nine months ended September 30, 2001, pre-tax non-operating
charges of $18.2 million were incurred. The charges consist of a $10 million
non-recurring charge relating to an impaired investment in a non-public
e-commerce company, $6.6 million related to a write-down of assets related to
excess real-estate capacity and $1.6 million related to a write-down of certain
exchange seats.
Our effective and pro forma effective tax rates for the nine months ended
September 30, 2001 and 2000 differ from the federal statutory rate of 35% due
to state income taxes, non-deductible foreign losses as well as nondeductible
expenses, including the amortization of goodwill resulting from the acquisition
of KCM and a portion of business development expenses.
19
Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments, including
certain derivative instruments imbedded in other contracts, and for hedging
activities. In June 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133--an amendment of FASB Statement No. 133. In June
2000, the FASB issued SFAS No. 138 Accounting for Certain Derivative
Instruments and Certain Hedging Activities, which is an amendment to SFAS No.
133 and is effective concurrently with SFAS No. 137. We adopted the provisions
of SFAS No. 133, 137 and 138 as of January 1, 2001. The adoption of these
statements did not have a material impact on our financial statements.
In September 2000, the FASB issued SFAS No. 140, Accounting for the
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities--a replacement of FASB Statement No. 125. This statement resets
accounting standards for differentiating between securitizations and other
transfers of financial assets that are sales from transfers that are secured
borrowings. We adopted certain provisions of SFAS No. 140 as of December 31,
2000, which did not have a material impact on our financial statements. We
adopted the remaining provisions of SFAS No. 140 effective April 1, 2001, which
did not have a material impact on our financial statements.
In June 2001, the FASB issued SFAS No. 141, Business Combinations. This
statement requires that companies account for all business combinations
initiated after June 30, 2001 using the purchase method of accounting. Business
combinations completed before June 30, 2001 originally accounted for under the
pooling of interest method will continue to be accounted for under that method.
This statement also addresses the initial recognition and measurement of
goodwill and other intangible assets acquired in a business combination. We
adopted the provisions of SFAS No. 141 as of July 1, 2001. The adoption of this
statement did not have a material impact on our financial statements.
In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
Assets. This statement establishes new standards for accounting for goodwill
and intangible assets acquired outside of, and subsequent to a business
combination. Under the new standards, goodwill and certain intangible assets
with an indefinite useful life will no longer be amortized, but will be tested
for impairment at least annually. Other intangible assets will continue to be
amortized over their useful lives. We anticipate adopting the provisions of
SFAS No. 142 on January 1, 2002. We are currently evaluating the impact the
statement will have on our financial position, results of operations and cash
flows.
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, 2001, we had $3.1 billion in assets, 90.6% 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 $4.9 million and $28.0
million during the three months ended September 30, 2001 and 2000,
respectively. Depreciation and amortization expense, which related to fixed
assets and goodwill, was $10.6 million and $7.4 million during the three months
ended September 30, 2001 and
20
2000, respectively. Capital expenditures were $15.4 million and $12.6 million
for the three months ended September 30, 2001 and 2000, respectively, primarily
related to the purchase of data processing and communications equipment, as
well as leasehold improvements. In acquiring fixed assets, particularly
technology equipment, we make a decision about whether to lease such equipment
or purchase it outright based on a number of factors including its estimated
useful life, obsolescence and cost. Additionally, we made cash payments of
$463,000 for the three months ended September 30, 2000 in connection with our
acquisitions of the listed securities market-making businesses of KCM in 1995
and Tradetech in 1997. These arrangements ended during 2000. We anticipate that
we will meet our 2001 capital expenditure needs out of operating cash flows.
As registered broker-dealers and market makers, KS, KCM, KFP and KEP are
subject to regulatory requirements intended to ensure the general financial
soundness and liquidity of broker-dealers and requiring the maintenance of
minimum levels of net capital, as defined in SEC Rule 15c3-1. These regulations
also prohibit a broker-dealer from repaying subordinated borrowings, paying
cash dividends, making loans to its parent, affiliates or employees, or
otherwise entering into transactions which would result in a reduction of its
total net capital to less than 120.0% of its required minimum capital.
Moreover, broker-dealers, including KS, KCM, KFP and KEP, are required to
notify the SEC prior to repaying subordinated borrowings, paying dividends and
making loans to their parents, affiliates or employees, or otherwise entering
into transactions, which, if executed, would result in a reduction of 30.0% or
more of their excess net capital (net capital less minimum requirement). The
SEC has the ability to prohibit or restrict such transactions if the result is
detrimental to the financial integrity of the broker-dealer. At September 30,
2001, KS had net capital of $255.0 million, which was $252.2 million in excess
of its required net capital of $2.8 million, KCM had net capital of $50.7
million which was $49.7 million in excess of its required net capital of $1.0
million, KFP had net capital of $50.3 million which was $50.0 million in excess
of its required net capital of $250,000 and KEP had net capital of $2.4 million
which was $2.3 million in excess of its required net captial of $100,000.
Additionally, KSIL, KSJ and KFP are subject to capital adequacy requirements of
the Securities and Futures Authority Limited in the United Kingdom, the
Financial Supervisory Agency in Japan and the Australian Stock Exchange in
Australia, respectively. As of September 30, 2001, we were in compliance with
the capital adequacy requirements of all of our foreign subsidiaries.
We currently anticipate that available cash resources and credit facilities
will be sufficient to meet our anticipated working capital and capital
expenditure requirements for at least the next 12 months.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Our market-making and trading activities expose our capital to significant
risks. These risks include, but are not limited to, absolute and relative price
movements, price volatility and changes in liquidity, over which we have
virtually no control.
We employ automated proprietary trading and risk management systems which
provide real-time, on-line risk management and inventory control. We monitor
our risks by a constant review of trading positions and their appropriate risk
measures. We have established a system whereby transactions are monitored by
senior management on a real-time basis as are individual and aggregate dollar
and inventory position totals, appropriate risk measures and real-time profits
and losses. The management of trading positions is enhanced by review of
mark-to-market valuations and position summaries on a daily basis.
In the normal course of our equities market-making business, we maintain
inventories of exchange-listed and OTC securities. The fair value of these
securities at September 30, 2001 was $127.4 million in long positions and
$109.8 million in short positions. Additionally, we have $89.0 million in long
positions and $7.7 million in short positions in an account managed by
Deephaven. The potential change in fair value, using a hypothetical 10.0%
decline in prices, is estimated to be a $9.9 million loss as of September 30,
2001 due to the offset of gains in short positions with losses in long
positions.
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In the normal course of options market making, we maintain inventories of
options, futures and equities. Our main exposure is from equity price and
volatility risk. We manage these exposures by constantly monitoring and
diversifying our exposures and position sizes and establishing offsetting
hedges. Our market-making staff and trading room managers continuously manage
our positions and our risk exposures. Our systems incorporate trades and update
our risk profile using options pricing models on a real-time basis.
Our proprietary options risk management system allows us to stress test our
portfolio on a real-time basis. On a daily basis, 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 September 30, 2001, 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%............. $1.5 million 0.1 million ($0.1 million)
None............. 1.1 million -- 0.5 million
-10%............. 0.5 million 0.1 million 1.3 million
This stress analysis covers positions in options and futures, underlying
securities and related hedges. The 10% changes in stock prices and volatility
in the charts above make the assumption of a universal 10% movement in all of
our underlying positions. The analysis also includes a number of estimates that
we believe to be reasonable, but cannot assure that they produce an accurate
measure of future risk.
For working capital purposes, we invest in money market funds, commercial
paper, government securities or maintain interest bearing balances in our
trading accounts with clearing brokers, which are classified as cash
equivalents and receivable from brokers and dealers, respectively, in the
Consolidated Statements of Financial Condition. These other amounts do not have
maturity dates or present a material market risk, as the balances are
short-term in nature and subject to daily repricing.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We and certain of our officers and employees have been subject to legal
proceedings in the past and may be subject to legal proceedings in the future.
We are not currently a party to any legal proceedings, the adverse outcome of
which, individually or in the aggregate, we can predict with any reasonable
certainty, could have a material adverse effect on our business, financial
condition or operating results. We and certain of our past and present officers
and employees are currently the subject of legal proceedings, such as those
stated in our 8-K filings of November 30, 2000 and August 29, 2001,
respectively. We are unable to predict the outcome of any such proceeding and
assess or quantify the potential damages, if any.
From time to time, we have been threatened with, or named as a defendant in,
lawsuits, securities arbitrations before the NASD, and administrative claims.
Compliance and trading problems that are reported to the NASDR or the NASD by
dissatisfied customers of our broker-dealer clients may be investigated by the
NASDR or the SEC and may rise to the level of arbitration or disciplinary
action.
The securities industry is subject to extensive regulation under federal,
state and applicable international laws. As a result, we are required to comply
with many complex laws and rules and our ability to so comply is dependent in
large part upon the establishment and maintenance of a qualified compliance
system. From time to time, NASDR and the SEC make allegations of our
noncompliance which we defend vigorously.
22
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
On July 18, 2001, the Company announced that Peter S. Hajas was promoted to
President and Chief Operating Officer of the Company, as recommended by
Chairman and CEO Kenneth D. Pasternak and ratified by the Company's Board of
Directors at its quarterly meeting.
In light of changing market conditions and consistent with others in the
financial industry, the Company continued to evaluate its cost structure and
all projects that facilitate equity trading during the third quarter and in
October. As a result, the Company has made further reductions in its domestic
equities workforce and in its European workforce.
Item 6. Exhibits and Reports on Form 8-K
None.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereto until duly authorized.
KNIGHT TRADING GROUP, INC.
/S/ ROBERT I. TURNER
--------------------------------------
By: Robert I. Turner
Title: Director, Executive Vice President, Chief
Financial Officer and Treasurer
(principal financial and
accounting officer)
Date: November 13, 2001
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