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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 JUNE 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 August 13, 2001 the number of shares outstanding of the registrant's
Class A common stock was 124,029,187 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 JUNE 30, 2001
TABLE OF CONTENTS
Page
----
PART I FINANCIAL INFORMATION:
Item 1. Financial Statements........................................... 3
Consolidated Statements of Income.............................. 3
Consolidated Statements of Financial Condition................. 4
Consolidated Statements of Cash Flows.......................... 5
Notes to Consolidated Financial Statements..................... 6
Management's Discussion and Analysis of Financial Condition and
Item 2. Results of Operations.......................................... 12
Item 3. Quantitative and Qualitative Disclosures About Market Risk..... 20
PART II OTHER INFORMATION:
Item 1. Legal Proceedings.............................................. 21
Item 2. Changes in Securities and Use of Proceeds...................... 21
Item 3. Defaults Upon Senior Securities................................ 21
Item 4. Submission of Matters to a Vote of Security Holders............ 21
Item 5. Other Information.............................................. 22
Item 6. Exhibits and Reports on Form 8-K............................... 22
Signatures.............................................................. 23
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Income
(Unaudited)
For the three For the six
months ended June 30, months ended June 30,
------------------------- -------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
Revenues
Net trading revenue.... $135,030,160 $282,515,465 $322,484,606 $769,293,569
Commissions and fees... 12,419,249 5,997,936 26,931,449 13,025,564
Asset management fees.. 8,595,133 11,241,256 21,315,169 21,014,845
Interest and dividends,
net of interest
expense............... 8,708,576 4,111,692 14,017,890 7,619,109
Investment income and
other................. 1,053,446 3,261,602 6,704,576 6,773,901
------------ ------------ ------------ ------------
Total revenues....... 165,806,564 307,127,951 391,453,690 817,726,988
------------ ------------ ------------ ------------
Expenses
Employee compensation
and benefits.......... 57,104,741 102,286,239 136,808,600 277,485,029
Execution and clearance
fees.................. 30,095,990 28,917,311 60,145,045 59,139,599
Payments for order
flow.................. 20,200,309 38,319,274 49,918,735 97,636,834
Communications and data
processing............ 13,396,452 7,104,826 26,227,840 14,230,819
Depreciation and
amortization.......... 10,368,150 5,501,436 20,590,730 9,716,399
Professional fees...... 3,520,265 6,106,709 9,174,276 10,638,771
Occupancy and equipment
rentals............... 4,586,170 4,314,147 9,597,028 7,407,333
Business development... 4,104,472 2,884,409 7,474,230 8,123,102
Other.................. 4,269,219 2,302,611 10,203,757 6,908,372
Loss on writedown of
assets and investments
and severance costs... 13,096,513 -- 13,096,513 --
------------ ------------ ------------ ------------
Total expenses....... 160,742,281 197,736,962 343,236,754 491,286,258
------------ ------------ ------------ ------------
Income before income
taxes and minority
interest................ 5,064,283 109,390,989 48,216,936 326,440,730
Income tax expense....... 3,556,491 41,906,095 21,538,620 122,360,456
------------ ------------ ------------ ------------
Income before minority
interest................ 1,507,792 67,484,894 26,678,316 204,080,274
Minority interest in
consolidated
subsidiaries............ 2,295,222 -- 4,042,160 --
------------ ------------ ------------ ------------
Net income............... $ 3,803,014 $ 67,484,894 $ 30,720,476 $204,080,274
============ ============ ============ ============
Basic earnings per
share................... $ 0.03 $ 0.55 $ 0.25 $ 1.67
============ ============ ============ ============
Diluted earnings per
share................... $ 0.03 $ 0.53 $ 0.24 $ 1.61
============ ============ ============ ============
Pro forma adjustments
Income before income
taxes................. $326,440,730
Adjustment for pro
forma employee
compensation and
benefits.............. (267,109)
------------
Pro forma income before
income taxes.......... 326,173,621
Pro forma income tax
expense............... 123,003,743
------------
Pro forma net income... $203,169,878
Pro forma basic
earnings per share.... $ 1.66
============
Pro forma diluted
earnings per share.... $ 1.60
============
Shares used in basic
earnings per share
calculations (see Note
8)...................... 123,683,862 122,234,246 123,603,466 122,192,533
============ ============ ============ ============
Shares used in diluted
earnings per share
calculations (see Note
8)...................... 125,884,824 126,795,238 126,046,085 127,007,447
============ ============ ============ ============
The accompanying notes are an integral part of these consolidated financial
statements
3
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Financial Condition
(Unaudited)
June 30, December 31,
2001 2000
-------------- --------------
Assets
Cash and cash equivalents.................... $ 347,384,808 $ 364,057,534
Securities owned, held at clearing broker, at
market value................................. 1,643,644,013 1,799,966,679
Receivable from brokers and dealers.......... 810,134,190 114,047,275
Fixed assets and leasehold improvements at
cost, less accumulated depreciation and
amortization................................ 90,261,326 79,014,393
Goodwill, less accumulated amortization...... 41,820,295 45,239,177
Investments.................................. 74,452,276 64,917,975
Income taxes receivable...................... 6,472,465 --
Other assets................................. 58,795,028 54,166,139
-------------- --------------
Total assets............................... $3,072,964,401 $2,521,409,172
============== ==============
Liabilities and Stockholders' Equity
Liabilities
Securities sold, not yet purchased, at market
value........................................ $1,867,452,000 $1,427,214,323
Payable to brokers and dealers............... 278,976,772 184,269,478
Accrued compensation expense................. 46,474,033 62,444,645
Accrued execution and clearance fees......... 5,965,621 6,092,754
Accrued payments for order flow.............. 4,374,269 11,635,069
Accounts payable, accrued expenses and other
liabilities.................................. 18,831,743 30,576,814
Income taxes payable......................... -- 4,813,771
-------------- --------------
Total liabilities.......................... 2,222,074,438 1,727,046,854
-------------- --------------
Minority interest in consolidated
subsidiaries................................... 27,047,171 20,175,872
-------------- --------------
Stockholders' equity
Class A Common Stock......................... 1,237,740 1,232,908
Additional paid-in capital................... 332,386,841 309,611,248
Retained earnings............................ 496,657,258 465,947,294
Unamortized stock-based compensation......... (831,090) --
Accumulated other comprehensive income
(loss)--foreign currency translation
adjustments, net of tax..................... (5,607,957) (2,605,004)
-------------- --------------
Total stockholders' equity................. 823,842,792 774,186,446
-------------- --------------
Total liabilities and stockholders'
equity..................................... $3,072,964,401 $2,521,409,172
============== ==============
The accompanying notes are an integral part of these consolidated financial
statements.
4
KNIGHT TRADING GROUP, INC.
Consolidated Statements of Cash Flows
(Unaudited)
For the six months ended June 30,
----------------------------------
2001 2000
---------------- ----------------
Cash flows from operating activities
Net income................................ $ 30,720,476 $ 204,080,274
Adjustments to reconcile net income to net
cash (used in) provided by operating ac-
tivities
Income tax credit from stock options ex-
ercised................................ 1,976,947 1,957,177
Depreciation and amortization........... 20,622,688 9,716,399
Minority interest in earnings of consol-
idated subsidiaries.................... (4,042,160) --
Writedown of assets and investments..... 11,571,513 --
(Increase) decrease in operating assets
Securities owned........................ 156,322,666 (517,978,312)
Receivable from clearing brokers........ (696,086,915) (102,349,002)
Income taxes receivable................. (6,472,465) --
Other assets............................ (6,200,402) (16,292,648)
Increase (decrease) in operating liabili-
ties
Securities sold, not yet purchased...... 440,237,677 633,557,908
Securities sold under agreements to re-
purchase............................... -- (10,409,736)
Payable to clearing broker.............. 94,707,294 (31,705,430)
Accrued compensation expense............ (15,970,612) 7,514,737
Accounts payable, accrued expenses and
other liabilities...................... (14,758,536) (35,236,575)
Accrued execution and clearance fees.... (127,133) 816,192
Accrued payments for order flow......... (7,260,800) (3,956,915)
Income taxes payable.................... (4,813,771) 3,520,970
---------------- ----------------
Net cash provided by operating activi-
ties................................. 426,467 143,235,039
---------------- ----------------
Cash flows from investing activities
Purchases of fixed assets and leasehold
improvements............................. (27,668,782) (30,320,845)
Investments and acquisitions.............. (20,284,300) (29,786,872)
Payment of contingent consideration....... -- (4,631,141)
---------------- ----------------
Net cash used in investing activi-
ties................................. (47,953,082) (64,738,858)
---------------- ----------------
Cash flows from financing activities
Stock options exercised................... 2,852,773 1,153,687
Minority interest in consolidated subsidi-
aries.................................... 28,001,116 --
---------------- ----------------
Net cash provided by financing activi-
ties................................. 30,853,889 1,153,687
---------------- ----------------
(Decrease)/Increase in cash and cash
equivalents.............................. (16,672,726) 79,649,868
Cash and cash equivalents at beginning of
period................................... 364,057,534 304,053,554
---------------- ----------------
Cash and cash equivalents at end of peri-
od....................................... $ 347,384,808 $ 383,703,422
================ ================
Supplemental disclosure of cash flow in-
formation:
Cash paid for interest.................. $ 12,143,676 $ 14,679,188
================ ================
Cash paid for income taxes.............. $ 32,824,856 $ 119,828,612
================ ================
The accompanying notes are an integral part of these consolidated financial
statements.
5
KNIGHT TRADING GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 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.
and in Europe. The Company also maintains an asset management business for
institutional investors and high net worth individuals through its Deephaven
Capital Management ("Deephaven") subsidiary. The Company also operates a
professional execution services business through Knight Execution Partners
("KEP"). KS, KCM, KFP and KEP are registered as broker-dealers with the
Securities and Exchange Commission ("SEC" or the "Commission"). Additionally,
KS and KCM are members of the National Association of Securities Dealers, Inc.
("NASD").
In the first quarter of 2001, the Company began its Knight Roundtable Europe
venture. 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.
6
Investments
Investments on the Consolidated Statements of Financial Condition are
comprised of ownership interests of less than 20% in publicly and non-publicly
traded companies which are accounted for under the equity method or the cost
basis of accounting. 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 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 June 30, 2001 and 2000 was
$4,106,691 and $7,991,811, respectively. Interest expense for the six months
ended June 30, 2001 and 2000 was $11,883,917 and $14,863,967, 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 clearing brokers, are recorded at the amount of cash
collateral advanced or received. Securities borrowed transactions require the
Company to deposit cash or similar collateral with the lender. With respect to
securities loaned, the Company receives collateral in the form of cash in an
amount generally in excess of the market value of securities loaned. Interest
income and interest expense are recorded on an accrual basis. The Company
monitors the market value of securities borrowed and loaned on a daily basis.
Substantially all of the Company's securities borrowed and securities loaned
transactions are conducted with banks and other securities firms.
Foreign currencies
The functional 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.
7
Depreciation, amortization and occupancy
Fixed assets are being depreciated on a straight-line basis over their
estimated useful lives of three to seven years. Leasehold improvements are
being amortized on a straight-line basis over the life of the related office
lease. The Company records rent expense on a straight-line basis over the life
of the lease. The Company capitalizes certain costs associated with the
acquisition or development of internal-use software in accordance with
Statement of Position No. 98-1 and amortizes the software over its estimated
useful life of three years.
Income taxes
Income tax expense in the Consolidated Statements of Income represents
actual income taxes incurred through June 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.
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
8
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:
June 30, December 31,
2001 2000
-------------- --------------
Securities owned:
Equities....................................... $ 727,852,762 $ 661,327,729
Options........................................ 850,138,946 1,126,483,498
Convertible bonds.............................. 52,466,488 --
U.S. government obligations.................... 13,185,817 12,155,452
-------------- --------------
$1,643,644,013 $1,799,966,679
============== ==============
Securities sold, not yet purchased:
Equities....................................... $ 850,791,116 $ 170,167,713
Convertible bonds.............................. 2,017,258 --
Options........................................ 1,014,643,626 1,257,046,610
-------------- --------------
$1,867,452,000 $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:
June 30, December 31,
2001 2000
------------ ------------
Receivable:
Clearing brokers................................... $748,603,379 $ 86,156,298
Securities failed to deliver....................... 23,396,105 19,815,796
Securities borrowed................................ 38,134,706 8,075,181
------------ ------------
$810,134,190 $114,047,275
============ ============
Payable:
Clearing brokers................................... $266,911,808 $175,552,245
Securities failed to receive....................... 8,391,565 8,574,981
Securities loaned.................................. 3,673,399 142,252
------------ ------------
$278,976,772 $184,269,478
============ ============
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 $34.1 million at June 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) and other public and
non-public companies. In June 2001, the Company took a $10 million charge
related to an investment in a non-public e-commerce company and wrote down the
value of certain exchange seats by $1.6 million.
9
6. Significant Customers
The Company considers significant customers to be customers who provide the
Company with 10% or more of its equity order flow, as measured in equity share
volume, during the period. One customer provided 10.4% of the Company's equity
order flow during the second quarter of 2001. Order flow payments to this firm
amounted to $1.6 million during the same period.
7. Comprehensive Income
Comprehensive income includes net income and changes in equity except those
resulting from investments by, or distributions to, stockholders. Comprehensive
income is as follows:
Three months ended Six months ended June
June 30, 30,
---------------------- -------------------------
2001 2000 2001 2000
---------- ----------- ----------- ------------
Net income/pro forma net
income.................... $3,803,014 $67,484,894 $30,720,476 $203,169,878
Foreign currency
translation adjustment,
net of tax................ 370,178 (567,480) (3,002,953) (630,854)
---------- ----------- ----------- ------------
Total comprehensive income,
net of tax................ $4,173,192 $66,917,414 $27,717,523 $202,539,024
========== =========== =========== ============
8. Earnings per Share
Basic earnings per common share ("EPS") has been calculated by dividing net
income by the weighted average shares of Class A Common Stock outstanding
during each respective period. Diluted EPS reflects the potential reduction in
EPS using the treasury stock method to reflect the impact of common share
equivalents if stock awards such as stock options and restricted stock were
exercised or converted into common stock.
The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations for the three and six month
periods ended June 30, 2001 and 2000:
For the three months ended June 30,
------------------------------------------------
2001 2000
----------------------- ------------------------
Numerator / Denominator
Numerator / Denominator pro forma / pro forma
net income / shares net income shares
----------- ----------- ------------ -----------
Income and shares used in ba-
sic calculations............ $ 3,803,014 123,683,862 $ 67,484,894 122,234,246
Effect of dilutive stock
awards...................... -- 2,200,962 -- 4,560,992
----------- ----------- ------------ -----------
Income and shares used in di-
luted calculations.......... $ 3,803,014 125,884,824 $ 67,484,894 126,795,238
=========== =========== ============ ===========
Pro forma basic earnings
per share................. $ 0.03 $ 0.55
=========== ===========
Pro forma diluted earnings
per share................. $ 0.03 $ 0.53
=========== ===========
For the six months ended June 30,
------------------------------------------------
2001 2000
----------------------- ------------------------
Numerator / Denominator
Numerator / Denominator pro forma / pro forma
net income / shares net income shares
----------- ----------- ------------ -----------
Income and shares used in ba-
sic calculations............ $30,720,476 123,603,466 $203,169,878 122,192,533
Effect of dilutive stock
awards...................... -- 2,442,619 -- 4,814,914
----------- ----------- ------------ -----------
Income and shares used in di-
luted calculations.......... $30,720,476 126,046,085 $203,169,878 127,007,447
=========== =========== ============ ===========
Pro forma basic earnings
per share................. $ 0.25 $ 1.66
=========== ===========
Pro forma diluted earnings
per share................. $ 0.24 $ 1.60
=========== ===========
10
9. Net Capital Requirements
As registered broker-dealers, KS, KCM, KFP and KEP are subject to the SEC's
Uniform Net Capital Rule (the "Rule") which requires the maintenance of minimum
net capital. KS, KCM and KEP have elected to use the basic method, permitted by
the Rule, which requires that they each maintain net capital equal to the
greater of $1.0 million ($100,000 for KEP) or 6 2/3% of aggregate indebtedness,
as defined. KFP has elected to use the alternative method, permitted by the
Rule, which requires that it maintains net capital equal to the greater of
$250,000 or 2% of aggregate debit items, as defined.
At June 30, 2001, KS had net capital of $274,900,343 which was $272,869,288
in excess of its required net capital of $2,031,055, KCM had net capital of
$46,945,698 which was $45,945,698 in excess of its required net capital of
$1,000,000, KFP had net capital of $43,552,727 which was $43,302,727 in excess
of its required net capital of $250,000 and KEP had net capital of $7,873,192
which was $7,773,192 in excess of its required net capital of $100,000.
Additionally, KSIL and KSJ are subject to regulatory requirements in the
countries in which they operate, including the requirements of the Securities
and Futures Authority Limited in the United Kingdom and the Financial
Supervisory Agency in Japan. As of June 30, 2001, the Company was in compliance
with these capital adequacy requirements.
10. Business Segments
The Company has two reportable business segments: securities market-making
and asset management. Securities market-making primarily represents market-
making in equity securities listed on Nasdaq, on the OTCBB of the NASD, in the
over-the-counter market for NYSE- and AMEX-listed securities and in options on
individual equities, equity indices, fixed income instruments and certain
commodities. The asset management segment consists of investment management and
sponsorship for a series of private investment funds.
The Company's net revenues, income before income taxes and minority interest
and assets by segment are summarized below:
Securities Asset
Market Making* Management Total
-------------- ----------- --------------
For the three months ended June 30,
2001:
Revenues.......................... $ 156,222,356 $ 9,584,208 $ 165,806,564
Income before income taxes and
minority interest................ (858,747) 5,923,030 5,064,283
Total Assets...................... 3,016,837,561 56,126,840 3,072,964,401
For the three months ended June 30,
2000:
Revenues.......................... 294,269,256 12,858,695 307,127,951
Income before income taxes........ 99,487,714 9,903,275 109,390,989
Total Assets...................... 2,274,982,407 36,595,687 2,311,578,094
For the six months ended June 30,
2001:
Revenues.......................... 367,237,150 24,216,540 391,453,690
Income before income taxes and
minority interest................ 33,408,375 14,808,561 48,216,936
Total Assets...................... 3,016,837,561 56,126,840 3,072,964,401
For the six months ended June 30,
2000:
Revenues.......................... 793,548,745 24,178,243 817,726,988
Pro forma income before income
taxes............................ 307,362,920 18,810,701 326,173,621
Total Assets...................... 2,274,982,407 36,595,687 2,311,578,094
--------
* Includes $13.1 million in pre-tax non-operating charges, which consist of a
$10 million non-recurring charge relating to an impaired investment in a non-
public e-commerce company, $1.6 million related to a write-down of certain
exchange seats and $1.5 million related to severance costs incurred during
the second quarter.
11
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion of our results of operations should be read in
conjunction with our consolidated financial statements and notes thereto
included in our Annual Report on Form 10-K for the year ended December 31,
2000. This discussion contains forward-looking statements that involve risks
and uncertainties. Our actual results may differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including, but not limited to, those set forth elsewhere in this document.
We have experienced and expect to continue to experience, significant
fluctuations in quarterly operating results due to a variety of factors,
including the value of our securities positions and our ability to manage the
risks attendant thereto, the volume of our market-making activities, volatility
in the securities markets, our ability to manage personnel and expenses, the
amount of revenue derived from limit orders as a percentage of net trading
revenues, changes in payments for order flow or clearing costs, the addition or
loss of sales and trading professionals, regulatory changes, the amount and
timing of capital expenditures, the incurrence of costs associated with
acquisitions and general 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 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 return to the rates of revenue
growth that we have experienced in the past, that we will be able to improve
our operating results or that we will be able to sustain our profitability 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. and Europe. 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 28.7 billion and 16.7 billion, or 84% and
78% of our total equity share volume, for the three months ended June 30, 2001,
and 2000, respectively. KCM's share volume totaled 5.4 billion and 4.8 billion,
or 16% and 22% of our total equity share volume for the three months ended June
30, 2001 and 2000, respectively. KFP's U.S. option contract volume totaled 10.5
million and 4.5 million for the three months ended June 30, 2001 and 2000,
respectively. Deephaven's total assets under management totaled $1.0 billion
and $477.1 million at June 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 equity trade and
share volumes and option contract volumes, our revenue capture per share and
option contract, our ability to derive trading gains by taking proprietary
positions, changes in our execution standards, volatility in the marketplace,
our mix of broker-dealer and institutional customers and by regulatory changes
and evolving industry customs and practices.
12
OTC securities transactions with institutional customers are executed as
principal, and all related profits and losses are included within net trading
revenue. Listed securities transactions with institutional customers are
executed on an agency basis, for which we earn commissions on a per share
basis. We also receive fees for providing certain information to market data
providers and for directing trades to certain destinations for execution.
Commissions and fees are primarily affected by changes in our trade and share
volumes in listed securities.
Asset management fees represent fees earned for sponsoring and managing the
investments of private investment funds. Asset management fees are primarily
affected by the rates of return earned on the funds we manage and changes in
the amounts of assets under management.
We earn interest income from our cash held at banks and cash held in trading
accounts at clearing brokers, net of transaction-related interest charged by
clearing brokers for facilitating the settlement and financing of securities
transactions. Net interest is primarily affected by the changes in cash
balances held at banks and clearing brokers and our level of securities
positions.
Expenses
Our operating expenses largely consist of employee compensation and
benefits, payments for order flow and execution and clearance fees. A
substantial portion of these expenses vary in proportion to our trading revenue
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 equity share and options volume, the mix of
market orders and limit orders and the mix of orders received from broker-
dealers who accept payments for order flow. Execution and clearance fees
fluctuate primarily based on changes in equity trade and share volume, option
contract volume, the mix of trades of OTC securities compared to listed
securities, clearance fees charged by clearing brokers and electronic
communications networks, commonly referred to as ECNs. Our international
expansion efforts have increased our operating expenses.
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, we make payments on market
orders, but do not pay on limit orders. Payments for order flow also change as
we modify our payment formulas and as our percentage of customers whose policy
is not to accept payments for order flow varies.
Execution and clearance fees primarily represent clearance fees paid to
clearing brokers for OTC and listed securities and options contracts,
transaction fees paid to Nasdaq, payments made to third parties for exchange
seat leases and execution fees paid to third parties, primarily for executing
trades in listed securities on the NYSE and AMEX and for executing orders
through ECNs. Due to our significant equity share and trade volume, we have
been able to negotiate favorable rates and volume discounts from clearing
brokers and providers of execution services.
Communications and data processing expense primarily consists of costs for
obtaining stock market data and telecommunications services.
13
Depreciation and amortization expense results from the depreciation of fixed
assets purchased by us and the amortization of goodwill, which includes
contingent consideration resulting from the acquisitions of the listed
securities market-making businesses of KCM and Tradetech Securities, L.P.,
("Tradetech"). Depreciation and amortization expense also includes the
amortization of goodwill related to our purchases of various options-related
businesses.
Professional fees primarily consist of fees paid to computer programming and
systems consultants, as well as legal fees and other professional fees.
Occupancy and equipment rentals expense primarily consists of rental
payments on office and equipment leases.
Business development expense primarily consists of travel and entertainment
expenses and promotion and advertising costs.
Other expenses primarily consist of administrative expenses and other
operating costs.
Income Tax
Income tax expense in the Consolidated Statements of Income represents
actual income taxes incurred through June 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 June 30, 2001 and 2000
Revenues
Net trading revenue from equity security market-making decreased 55.9% to
$108.1 million for the three months ended June 30, 2001, from $244.9 million
for the comparable period in 2000. This decrease was primarily due to decreased
average revenue capture per equity share, which was impacted by a reduction in
spreads due to decimalization and the introduction of a one-penny Minimum Price
Variant. Average revenue per equity share decreased to $.0031 for the three
months ended June 30, 2001, from $.0114 for the comparable period in 2000. The
decrease in net trading revenues was offset, slightly, by a 58.3% increase in
total equity share volume to 34.1 billion equity shares traded for the three
months ended June 30, 2001, from 21.5 billion equity shares traded for the
comparable period in 2000. The increase in 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 decreased 28.3% to $27.0 million
for the three months ended June 30, 2001 from $37.6 million for the comparable
period in 2000. This decrease was primarily due to decreased average revenue
capture per option contract. Average revenue per U.S. option contract decreased
to $2.40 per contract for the three months ended June 30, 2001 from $7.38 per
contract for the comparable period in 2000. The decrease was offset, in part,
by a 134.4% increase in U.S. option contract volume to 10.5 million contracts
for the three months ended June 30, 2001 from 4.5 million contracts for the
comparable period in 2000.
Commissions and fees increased 107.1% to $12.4 million for the three months
ended June 30, 2001, from $6.0 million for the comparable period in 2000. This
increase is primarily due to payments received by our professional execution
services business, KEP, for directing order executions, as well as higher
equity share volumes from institutional customers in listed securities.
Asset management fees decreased 23.5% to $8.6 million for the three months
ended June 30, 2001, from $11.2 million for the comparable period in 2000. The
decrease in fees was primarily due to a decrease in fund return from 8.91% for
the second quarter of 2000 to 2.92% for the second quarter of 2001. The
decrease was offset, in part, by an increase in the amount of funds under
management in the Deephaven Market Neutral Master Fund, which contained the
majority of our funds under management, from $477.1 million at June 30, 2000 to
$1.0 billion at June 30, 2001.
14
Interest income, net of interest expense increased 111.8% to $8.7 million
for the three months ended June 30, 2001, from $4.1 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 67.7% to $1.1 million for the
three months ended June 30, 2001, from $3.3 million for the comparable period
in 2000. This decrease was primarily due to a decrease in income from our
investments, primarily our investments in the private hedge funds that we
sponsor and manage.
Expenses
Employee compensation and benefits expense decreased 44.2% to $57.1 million
for the three months ended June 30, 2001, from $102.3 million for the
comparable period in 2000. As a percentage of total revenues, employee
compensation and benefits expense increased to 34.4% for the three months ended
June 30, 2001, from 33.3% 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 equity share and our increase in the number of employees. Due to
decreased net trading revenue and profitability, profitability based
compensation decreased 70.6% to $24.2 million for the three months ended June
30, 2001, from $82.5 million for the comparable period in 2000, and represented
42.5% and 80.6% of total employee compensation and benefits expense for the
three months ended June 30, 2001 and 2000, respectively. Our number of
employees increased to 1,397 employees as of June 30, 2001, from 1,074
employees as of June 30, 2000.
Payments for order flow decreased 47.3% to $20.2 million for the three
months ended June 30, 2001, from $38.3 million for the comparable period in
2000. As a percentage of total revenues, payments for order flow decreased to
12.2% for the three months ended June 30, 2001 from 12.5% for the comparable
period in 2000. The decrease in payments for order flow on a dollar basis and
as a percentage of total revenues 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 58.3% increase in equity shares traded
and the introduction of payment for order flow in the options marketplace in
the third quarter of 2000.
Execution and clearance fees increased 4.1% to $30.1 million for the three
months ended June 30, 2001, from $28.9 million for the comparable period in
2000. As a percentage of total revenues, execution and clearance fees increased
to 18.2% for the three months ended June 30, 2001, from 9.4% for the comparable
period in 2000. Execution and clearance fees increased primarily due to a
134.4% increase in U.S. options contracts to 10.5 million contracts for the
three months ended June 30, 2001 from 4.5 million contracts for the comparable
period in 2000. The increase was offset, in part, due to the 4.5% decrease in
equity trades executed to 31.8 million equity trades for the three months ended
June 30, 2001 from 33.3 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 equity trade
and per U.S. option contract and an increase in options volume.
Communications and data processing expense increased 88.6% to $13.4 million
for the three months ended June 30, 2001, from $7.1 million for the comparable
period in 2000. This increase was generally attributable to an increase in our
number of employees, investment in technology and our international expansion
in Europe and Japan.
Depreciation and amortization expense increased 88.5% to $10.4 million for
the three months ended June 30, 2001, from $5.5 million for the comparable
period in 2000. This increase was primarily due to the purchase of
approximately $68.4 million of additional fixed assets and leasehold
improvements between June 30, 2000 and June 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.
15
Professional fees decreased 42.4% to $3.5 million for the three months ended
June 30, 2001, from $6.1 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.
Occupancy and equipment rentals expense increased 6.3% to $4.6 million for
the three months ended June 30, 2001, from $4.3 million for the comparable
period in 2000. This increase was primarily attributable to additional office
space. We occupied 280,253 square feet of office space at June 30, 2001, up
from 161,909 square feet of office space at June 30, 2000.
Business development expense increased 42.3% to $4.1 million for the three
months ended June 30, 2001, from $2.9 million for the comparable period in
2000. This increase was primarily the result of additional travel and
entertainment costs.
Other expenses increased 85.4% to $4.3 million for the three months ended
June 30, 2001, from $2.3 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 June 30, 2001, pre-tax non-operating charges
of $13.1 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, $1.6 million related to a write-down of certain exchange seats and
$1.5 million related to severance costs incurred during the second quarter.
Our effective tax rates for the three months ended June 30, 2001 and 2000,
respectively, differ from the federal statutory rate of 35% due to state income
taxes, as well as non-deductible expenses, including the amortization of
goodwill resulting from the acquisition of KCM and a portion of business
development expenses. Our effective tax rate increased to 70% for the three
months ended June 30, 2001 from 38% for the three months ended June 30, 2000
primarily due to non-deductible foreign losses and state and local income
taxes.
Six Months Ended June 30, 2001 and 2000
Revenues
Net trading revenue from equity security market-making decreased 63.7% to
$253.9 million for the six months ended June 30, 2001, from $698.6 million for
the comparable period in 2000. This decrease was primarily due to lower equity
share volume and decreased average revenue capture per share. Total equity
share volume decreased 7.4% to 60.5 billion equity shares traded for the six
months ended June 30, 2001, from 65.3 billion equity shares traded for the
comparable period in 2000, while average revenue capture per equity share
decreased to $.0042 per share from $.0107 per share during the same period in
2000. Net trading revenue from options market-making decreased 3.0% to $68.5
million for the six months ended June 30, 2001 from $70.7 million for the
comparable period in 2000. The decrease is due to lower average revenue capture
per option contract, offset by higher U.S. option contract volume. Average
revenue capture per option contract decreased to $3.51 per U.S. option contract
for the six months ended June 30, 2001 from $8.39 per U.S. option contract for
the comparable period in 2000. The decrease was offset, in part, by a 136.7%
increase in U.S. option contract volume to 18.9 million contracts for the six
months ended June 30, 2001 from 8.0 million contracts for the comparable period
in 2000.
Commissions and fees increased 106.8% to $26.9 million for the six months
ended June 30, 2001, from $13.0 million for the comparable period in 2000. This
increase is primarily due to payments received by our professional execution
services business, KEP, for directing order executions, as well as higher
equity share volumes from institutional customers in listed securities and
higher fees for providing certain information to market data providers.
16
Asset management fees increased 1.4% to $21.3 million for the six months
ended June 30, 2001, from $21.0 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 our funds under management, from $477.1 million at June 30, 2000 to
$1.0 billion at June 30, 2001. The increase was offset by the decrease in fund
return from 18.76% for the first half of 2000 to 8.03% for the first half of
2001.
Interest income, net of interest expense, increased 84.0% to $14.0 million
for the six months ended June 30, 2001, from $7.6 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 1.0% to $6.7 million for the
six months ended June 30, 2001, from $6.8 million for the comparable period in
2000. This decrease was primarily due to a decrease in income from our
investments, primarily our investments in the private hedge funds that we
sponsor and manage.
Expenses
Employee compensation and benefits expense decreased 50.7% to $136.8 million
for the six months ended June 30, 2001, from $277.5 million for the comparable
pro forma period in 2000. As a percentage of total revenue, employee
compensation and benefits expense increased to 34.9% for the six months ended
June 30, 2001, from 34.0% for the comparable pro forma period in 2000. The
decrease on a dollar basis was primarily due to decreased gross trading profits
and lower margins, offset, in part, by a growth in the number of employees. The
increase on a percentage basis was primarily due to the decrease in average net
revenue per equity share and a growth in our number of employees. Due to
decreased net trading revenue and profitability, profitability based
compensation decreased 69.5% to $72.6 million for the six months ended June 30,
2001, from $238.1 million for the comparable pro forma period in 2000, and
represented 53.1% and 85.7% of total employee compensation and benefits expense
for the six months ended June 30, 2001 and 2000, respectively. Our number of
employees increased to 1,397 employees as of June 30, 2001, from 1,074
employees as of June 30, 2000.
Payments for order flow decreased 48.9% to $49.9 million for the six months
ended June 30, 2001, from $97.6 million for the comparable period in 2000. As a
percentage of total revenue, payments for order flow increased to 12.8% for the
six months ended June 30, 2001 from 11.9% for the comparable period in 2000.
The decrease in payments for order flow on a dollar basis was primarily due to
changes in our payment for order flow policy initiated in the second quarter of
2001 resulting from decimalization and a 7.4% decrease in equity shares traded.
The increase in payments for order flow as a percentage of total revenue was
primarily due to a decrease in our average revenue per equity share and the
introduction of payment for order flow in the options marketplace in the third
quarter of 2000.
Execution and clearance fees increased 1.7% to $60.1 million for the six
months ended June 30, 2001, from $59.1 million for the comparable period in
2000. As a percentage of revenue, execution and clearance fees increased to
15.4% for the six months ended June 30, 2001, from 7.2% for the comparable
period in 2000. The increase on a dollar basis was primarily due to a 136.7%
increase in U.S. options contracts executed from 8.0 million U.S. options
contracts executed for the six months ended June 30, 2000 to 18.9 million for
the six months ended June 30, 2001. The increase was offset, in part, by a
19.9% decrease in equity trades executed to 62.0 million equity trades for the
six months ended June 30, 2001, from 77.4 million equity trades in the
comparable period in 2000. The increase in our execution and clearance fees as
a percentage of net trading revenue was primarily due to a decrease in average
revenue per equity trade and per U.S. option contract and an increase in
options volume.
Communications and data processing expense increased 84.3% to $26.2 million
for the six months ended June 30, 2001, from $14.2 million for the comparable
period in 2000. This increase was generally attributable to an increase in our
number of employees, investment in technology and our international expansion
in Europe and Japan.
17
Depreciation and amortization expense increased 111.9% to $20.6 million for
the six months ended June 30, 2001, from $9.7 million for the comparable period
in 2000. This increase was primarily due to the purchase of approximately $68.4
million of additional fixed assets and leasehold improvements between June 30,
2000 and June 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.
Professional fees decreased 13.8% to $9.2 million for the six months ended
June 30, 2001, down from $10.6 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.
Occupancy and equipment rentals expense increased 29.6% to $9.6 million for
the six months ended June 30, 2001, from $7.4 million for the comparable period
in 2000. This increase was primarily attributable to additional office space
occupied and increased computer equipment lease expense. We occupied 280,253
square feet of office space at June 30, 2001, up from 161,909 square feet of
office space at June 30, 2000.
Business development expense decreased 8.0% to $7.5 million for the six
months ended June 30, 2001, from $8.1 million for the comparable period in
2000. This decrease was primarily the result of decreased advertising costs in
the first half of 2001 compared to the first half of 2000.
Other expenses increased 47.7% to $10.2 million for the six months ended
June 30, 2001, from $6.9 million for the comparable period in 2000. This was
primarily the result of increased administrative expenses and other operating
costs in connection with our overall business expansion.
During the six months ended June 30, 2001, pre-tax non-operating charges of
$13.1 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,
$1.6 million related to a write-down of certain exchange seats and $1.5 million
related to severance costs incurred during the second quarter.
Our effective and pro forma effective tax rates for the six months ended
June 30, 2001 and 2000 differ from the federal statutory rate of 35% due to
state income taxes, as well as non-deductible expenses, including the
amortization of goodwill resulting from the acquisition of KCM and a portion of
business development expenses. Our effective tax rate increased to 45% for the
six months ended June 30, 2001 from a pro forma effective tax rate of 37% for
the six months ended June 30, 2000 primarily due to non-deductible foreign
losses and state and local income taxes.
Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments, including
certain derivative instruments imbedded in other contracts, and for hedging
activities. In June 1999, the FASB issued SFAS No. 137, Accounting for
Derivative Instruments and Hedging Activities--Deferral of the Effective Date
of FASB Statement No. 133--an amendment of FASB Statement No. 133. In June
2000, the FASB issued SFAS No. 138 Accounting for Certain Derivative
Instruments and Certain Hedging Activities, which is an amendment to SFAS No.
133 and is effective concurrently with SFAS No. 137. We adopted the provisions
of SFAS No. 133, 137 and 138 as of January 1, 2001. The adoption of these
statements did not have a material impact on our financial statements.
In September 2000, the FASB issued SFAS No. 140 Accounting for 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
18
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.
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 June 30, 2001, we had $3.1 billion in assets, 91.2% 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 $14.2 million and $73.0
million during the three months ended June 30, 2001 and 2000, respectively.
Depreciation and amortization expense, which related to fixed assets and
goodwill, was $10.4 million and $5.5 million during the three months ended June
30, 2001 and 2000, respectively. Capital expenditures were $11.7 million and
$16.6 million for the three months ended June 30, 2001 and 2000, respectively,
primarily related to the purchase of data processing and communications
equipment, as well as leasehold improvements and additional office facilities
to support our growth. In acquiring fixed assets, particularly technology
equipment, we make a decision about whether to lease such equipment or purchase
it outright based on a number of factors including its estimated useful life,
obsolescence and cost. Additionally, we made cash payments of $867,000 for the
three months ended June 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 June 30, 2001,
KS had net capital of $274.9 million, which was $272.9 million in excess of its
required net capital of $2.0 million, KCM had net capital of $46.9 million
which was $45.9 million in excess of its required net capital of $1.0 million,
KFP had net capital of $43.6 million which was $43.3 million in excess of its
required net capital of $250,000 and KEP had net capital of $7.9 million which
was $7.8 million in excess of its required net capital of $100,000.
Additionally, KSIL and KSJ are subject to capital adequacy requirements of the
Securities and Futures Authority Limited in the United Kingdom and the
Financial Supervisory Agency in Japan, respectively. As of June 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.
19
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 June 30, 2001 was $290.5 million in long positions and $282.0
million in short positions. The potential change in fair value, using a
hypothetical 10.0% decline in prices, is estimated to be a $900,000 loss as of
June 30, 2001 due to the offset of gains in short positions with losses in long
positions.
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 June 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%................................. $4.2 million (0.8 million) $ 8.2 million
None................................. 3.8 million -- 9.8 million
-10%................................. 2.9 million 0.6 million 10.9 million
This stress analysis covers positions in options and futures, underlying
securities and related hedges. The 10% changes in stock prices and volatility
in the charts above make the assumption of a universal 10% movement in all of
our underlying positions. The analysis also includes a number of estimates that
we believe to be reasonable, but cannot assure that they produce an accurate
measure of future risk.
For working capital purposes, we invest in money market funds, commercial
paper, government securities or maintain interest bearing balances in our
trading accounts with clearing brokers, which are classified as cash
equivalents and receivable from clearing brokers, respectively, in the
Consolidated Statements of Financial Condition. These other amounts do not have
maturity dates or present a material market risk, as the balances are short-
term in nature and subject to daily repricing.
20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
We and certain of our officers and employees have been subject to legal
proceedings in the past and may be subject to legal proceedings in the future.
We are not currently a party to any legal proceedings, the adverse outcome of
which, individually or in the aggregate, we can predict with any reasonable
certainty, could have a material adverse effect on our business, financial
condition or operating results. We and certain of our past and present officers
and employees are currently the subject of legal proceedings, such as those
stated in our 8-K filing of November 30, 2000, that are in their preliminary
stages. As such, we are unable to predict the outcome of any such proceeding
and assess or quantify the potential damages, if any.
In our Form 8-K filing of November 30, 2000, we noted that we were named as
a defendant in a putative class action entitled Prager v. Knight Trading Group,
Inc. et al. In general, the complaint alleged that the Company improperly
traded securities for its own account in advance of trading securities for
broker/dealer clients. Upon our motion, and pursuant to an Order of the United
States District Court, District of New Jersey, dated July 17, 2001, the action
was dismissed with prejudice. In accordance with the Federal Rules of Appellate
Procedure, the plaintiff has thirty days to appeal the Order.
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
The Company held its Annual Meeting of Shareholders on May 16, 2001 for the
purposes of: (i) electing its Board of Directors; (ii) approving the Knight
Trading Group, Inc. Executive Incentive Plan; (iii) amending the Company's 1998
Long-Term Incentive Plan to increase the number of shares of the Company's
Class A Common Stock authorized for issuance thereunder from 24,291,000 to
27,291,000; (iv) approving an additional amendment to the Company's 1998 Long-
Term Incentive Plan to increase the maximum amount of restricted stock and
restricted stock units which may be issued thereunder from 1,000,000 shares
each to 3,000,000 shares each; and (v) ratifying the appointment of its
independent auditors. The Board of Directors consists of a total of thirteen
people who are elected by the holders of the Company's Class A Common Stock.
The thirteen people were nominated by the Board of Directors to serve as
directors for a term of one year.
The following sets forth the results of the election of directors:
DIRECTORS
Name of Nominee For % Withheld %
--------------- ----------- ----- ---------- -----
Charles V. Doherty......................... 119,624,895 98.87% 1,367,210 1.13%
Robert Greifeld............................ 118,693,845 98.10% 2,298,260 1.90%
Gary G. Griffith........................... 119,600,764 98.85% 1,391,341 1.15%
Peter S. Hajas............................. 119,235,713 98.55% 1,756,392 1.45%
John G. Hewitt............................. 108,716,402 89.85% 12,275,703 10.15%
Robert M. Lazarowitz....................... 119,230,983 98.54% 1,761,122 1.46%
Bruce R. McMaken........................... 119,234,436 98.55% 1,757,669 1.45%
Kenneth D. Pasternak....................... 113,488,737 93.80% 7,503,368 6.20%
Walter F. Raquet........................... 119,215,033 98.53% 1,777,072 1.47%
Rodger O. Riney............................ 118,775,819 98.17% 2,216,286 1.83%
V. Eric Roach.............................. 103,173,560 85.27% 17,818,545 14.73%
Anthony M. Sanfilippo...................... 113,446,603 93.76% 7,545,502 6.24%
Robert I. Turner........................... 119,170,112 98.49% 1,821,993 1.51%
21
No proxies were solicited from the holders of the Class B Common Stock since
no such shares are outstanding. There was no solicitation in opposition to the
nominees proposed to be elected by the holders of the Class A Common Stock in
the Proxy Statement.
The establishment of the Knight Trading Group, Inc. Executive Incentive Plan
was approved by the Stockholders with 65,673,842 votes FOR (54.15%), 7,765,143
votes AGAINST (6.40%), 283,440 votes ABSTAINED (0.24%), and 47,553,120 BROKER
NON-VOTES (39.21%). Under applicable law, only abstentions are counted as votes
against this proposal.
The amendment to the Company's 1998 Long-Term Incentive Plan to increase the
number of shares of the Company's Class A Common Stock authorized for issuance
thereunder was approved by the Stockholders with 91,361,223 votes FOR (70.75%),
21,477,661 votes AGAINST (16.63%), 8,153,221 votes ABSTAINED (6.31%), and
8,153,221 BROKER NON-VOTES (6.31%). Under applicable law, only abstentions are
counted as votes against this proposal.
The Stockholders approved the additional amendment to the Company's 1998
Long-Term Incentive Plan to increase the maximum amount of restricted stock and
restricted stock units which may be issued thereunder with 94,972,132 votes FOR
(73.54%), 17,890,591 votes AGAINST (13.86%), 8,129,382 votes ABSTAINED (6.30%),
and 8,129,382 BROKER NON-VOTES (6.30%). Under applicable law, only abstentions
are counted as votes against this proposal.
The ratification of the appointment of PricewaterhouseCoopers LLP as
independent auditors for the Company for the fiscal year ending December 31,
2001 was approved by the Stockholders with 120,042,580 votes FOR (99.06%),
750,706 votes AGAINST (.62%), 198,818 (0.16%) votes ABSTAINED, and 198,819
BROKER NON-VOTES (0.16%). Under applicable law, only abstentions are counted as
votes against this proposal.
Further information regarding these matters is contained in the Company's
Proxy Statement dated April 11, 2001.
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. Previously, the Company announced on June
21, 2001 that Anthony M. Sanfilippo was named Head of Global Equities and that
John G. Hewitt, President of Knight Securities, L.P. and co-Head of Global
Equities, and David Shpilberg, Executive Vice President, Chief Operating
Officer and Chief Technology Officer of the Company, had left the Company.
On June 21, 2001, the Company also announced that in light of changing
market conditions and consistent with others in the financial industry, the
Company was evaluating its cost structure and all projects that facilitate
equity trading. As a result, the Company was considering a reduction in the
number of its domestic equities employees. On or about June 26, 2001, a
reduction of approximately 5% in the number of our domestic equities employees
was completed. On August 7, 2001, the Company announced that it expects to
reduce its European workforce within a target range of 10 percent to 20
percent, as part of overall corporate cost-cutting measures.
Item 6. Exhibits and Reports on Form 8-K
None.
22
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: August 13, 2001
23