Thursday, April 15, 1999

Knight/Trimark Group
(Nasdaq: NITE)
Phone: 201-222-9400
Website: http://www.knight-sec.com
Price (4/14/99): $100 1/16


The Internet. Return of the bull market. The Internet. Raging bull market. The Internet.

While that might explain lots of recent Doubles, it applies especially well to Knight/Trimark, Nasdaq's top market maker. The company has benefited from surging trading, especially hyperactive online trading in Nasdaq stocks, especially trading in Internet stocks.

That's a lot of especiallys, but we're talking about a stock that's more than tripled just since late February when the firm sold 2.4 million more shares to the public at $35 a share. It had gone public last July at just $14 1/2. And the darn thing is a twenty-six bagger since enduring the "nite-mare" low of $4 1/2 in October!

This Knight/Trimark has earned such shining armor by serving as a kind of proxy for the current bull market. Yet, it's also been working hard to expand its significant market share and enhance its technology. Investors don't mind being scalped for a few pennies per share when a market maker makes such good sense and even more dollars.


Knight/Trimark is a leading market maker in both Nasdaq securities and the over-the-counter (OTC) or Third Market for New York Stock Exchange and American Stock Exchange securities. It serves mainly national and regional full-service broker-dealers, online brokers, and institutional investors, executing trades by offering to buy or sell securities for its own account

Its Knight Securities unit is the largest Nasdaq market maker, accounting for perhaps 20% of Nasdaq trading, according to a recent report from BancBoston Robertson Stephens. Knight executes trades in 6,700 stocks, including issues on the OTC Bulletin Board. Its Trimark Securities subsidiary trades NYSE and AMEX issues. The firm handled about 300,000 trades a day in the March quarter, a little less than half its capacity.

Insiders own 30% of the company while a group of independent broker-dealers hold a 32% stake. This group includes Ameritrade (Nasdaq: AMTD) with 4 million shares and E*Trade (Nasdaq: EGRP) with 1.8 million. This entire roster of broker-dealer owners accounted for 41% of Knight/Trimark's share volume last year.

In January, the SEC indicated it would not charge Knight/Trimark's CEO Kenneth Paternak with securities violations. He had been investigated as part of a long-running probe into the Nasdaq market for his role as a trading room supervisor while at a division of Spear, Leeds & Kellogg.


Income Statement*

12-month sales: $355.7 million
12-month income: $50.8 million
12-month EPS: $0.96
Profit margins: 14.3%
Capitalization: $5,548.4 million
*(Pro forma; assumes shares outstanding as if IPO had occurred at the beginning of FY98.)

Balance Sheet*

Cash: $117.4 million
Total Assets: $358.9 million
Total Liabilities $158.7 million
Long-Term Debt: none
*(Prior to the recent follow-on offering, which raised $80.3 million net.)

Price-to-earnings: 104.2
Price-to-sales: 15.6


In the past few years, the SEC and NASD cracked down on abuses by market makers and instituted new order handling and price display rules. As a result, the "spread" between the "bid" (what a buyer will pay) and the "ask" (the price a seller will accept) has narrowed, making it tougher for market makers to turn a profit.

As in other highly competitive markets, this evolving market for stocks gave the advantage to high-volume firms that could thrive despite smaller profits per transaction. Since Knight was owned largely by a group of trading firms, it had a leg up on independent market makers in terms of attracting increased trading volume.

Its December deal to acquire the Third Market trading operations of D.E. Shaw Securities simply reflected "the ongoing consolidation of liquidity to a smaller universe of liquidity providers," Pasternak said in a press release at the time. Indicative of this consolidation, Knight claimed 15.6% of Nasdaq/OTC trading in December, according to the AutEx Group. That was up from 8.1% in the year-ago period.

Companies often underperform the market after conducting follow-on stock offerings, especially in cases where insiders and major investors are big sellers (collectively, they jettisoned 6.6 million shares in the February offering). That's because sellers usually wait until the price is right. Yet, such selling hasn't bothered too many stocks caught in Internet mania.


Q4 revenue soared 78% to $119 million and adjusted EPS shot up 83% to $0.33. Return on equity hit an annualized 37%. For the full year, revenues traded up 57% to $356 million, pushing adjusted EPS up 78%.

The company's major expense (employee compensation) rose faster than revenues in Q4, causing operating margins to fall slightly, though pre-tax profits for the year rose pretty much in line with EPS. Still, its model offers considerable leverage since incremental improvements in trading volume should produce outsized profits given the relatively fixed costs of the basic technology infrastructure.

Moreover, Knight/Trimark benefits from the increased trading without spending heavily on advertising and marketing, as the retail brokers must. Of course, that doesn't mean the firm isn't investing for growth.

This year, the company will hire 25 more sales professionals to handle institutional clients, doubling its sales force in that niche, which accounted for 18% of Q4 revenues. Revenues from institutional trading skyrocketed 76% from the third quarter.

Knight/Trimark also plans to spend $20 million in FY99 on its technology infrastructure. With electronic communications networks (ECNs) like Instinet and Island competing with Wall Street's traditional market makers for order flow, Knight/Trimark must provide good executions and cutting-edge technology.

Investors seem to realize this. Knight/Trimark lifted off into triple digits after the April 8 announcement of e.Knight. This proprietary web product will allow the firm's broker-dealer and institutional customers electronic access to its trading systems, thus enabling them to initiate and monitor securities transactions from their desktops -- just like individual investors!

Earnings estimates have been boosted, thanks to the raging bull and the follow-on offering, which gave the underwriters a good excuse to pump up their old numbers. The current consensus calls for EPS of $1.69 for FY99 and $2.14 for FY2000. Is the stock a bargain at 59 times this year's earnings and 47 times next year's? Based on a 28.5% long-term growth estimate, no.

But Knight/Trimark is getting a larger slice of a growing pie. Owing to the desire for price competition, it's not in any broker-dealer's interest for one market maker to completely dominate OTC trading. So there's a theoretical cap on how big Knight/Trimark's market share can get. For now, though, the company looks poised to grow faster than a fast-growing market.

Whether the market has already priced in this good news is an open question. Those searching for an answer will want to check out the firm's Q1 earnings, due Wednesday, April 21.

-- Louis Corrigan

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