Bear Stearns' Bearish Outlook on Knight[Fool on the Hill] February 4, 2000

An Investment Opinion

Bear Stearns' Bearish Outlook on Knight

By Bill Mann (TMF Otter)
February 4, 2000

It seems at times that one would more likely see one of the big Wall Street firms put on a burlesque show than release an unfavorable piece of analysis on a stock. From an individual investor's perspective, you would think that since impartial analysis is supposed to be their job, these guys would be looking out for their clients' best interests. And yet, over and over we see evidence to the contrary. To wit:

- Three analysts maintained "buy" ratings on Iridium even as it carried $5 billion in debt, lost 95% of its share value and went into bankruptcy;
- Of the 38 analysts covering Lucent Technologies (NYSE: LU), not one notified their clients that its inventories and receivables were skyrocketing prior to the 35% drop in share price last month;
- Rite Aid (NYSE: RAD), amidst yet another reorganization, a cash crunch, and accusations by the State of Florida, of, among other things, racketeering, was rated by 1 out of 12 covering analysts as a "moderate sell", all others had it at "hold" or better.

So excuse my cynicism when I ask what on earth Knight-Trimark Group (Nasdaq: NITE) had to do to deserve an "unattractive" rating in the latest Bear Stearns (NYSE: BSC) analyst report?

I take that back. DON'T excuse the cynicism. Wall Street sell-side analysts, in the aggregate, have earned it. They are Wise, and they are not looking out for you. They have a thinly veiled veneer of objectivity surrounded by rife conflicts of interest -- the least of which are proper service and accountability to their customers. And although it is difficult to prove on an individual case basis that the Chinese Wall between the investment bank and brokerage portions of these companies have been pierced, one must only look at the totality of their work product to see some disturbing trends.

In general, there are five analyst ratings, strong buy, buy, hold, sell, strong sell. They call 'em different things, but that's it in a nutshell. Among the top Wall Street firms, less than 1% of all analyst recommendations are either sell or strong sell.

In this environment a Bear Stearns' analyst, Amy Butte, has a strong enough opinion on Knight-Trimark to warrant bucking the trend in the industry and cover it with a rating of "unattractive." In Wall Street parlance this is the equivalent to saying that Knight-Trimark is doomed. Knight-Trimark is the largest Market Maker for the Nasdaq and Over-the-Counter (OTC) stock markets, meaning that it acts as the broker's broker in matching buyers and sellers.

Moreover, when there is no buyer for a stock that is being offered for sale, the market makers purchase it themselves to keep the markets liquid. For each trade, the market makers charge a spread, the difference between the purchase and sale price, with the general rule being that the more liquid the security, the smaller the spread. As Knight-Trimark (Knight Securities makes markets in Nasdaq and OTC, Trimark in Amex and NYSE companies) largely deals in smaller securities, sometimes its spreads are quite significant, to take into account the increased risks inherent in these securities.

Knight-Trimark handled more than 21% of all trades made on Nasdaq and OTC companies in January 2000, in excess of 10 billion shares. This compares with an 18.8% of Nasdaq and OTC trades and 6.5 billion shares just two months before. For listed securities, Knight-Trimark holds approximately 8% of the total U.S. market, the third largest market maker for listed securities after Merrill Lynch (NYSE: MER) and Citigroup (NYSE: C) component Salomon Smith Barney. Bear Stearns competes in the realm as well, with a market share of listed securities of about 3% and 1.5% for Nasdaq/OTC.

Knight-Trimark has the kind of financials that bring a tear to the eyes of the number-cruncher crowd: 100% annual revenue growth between 1998-99, zero long term debt, Net margins of 20%, $365 million in cash and equivalents, retained earnings of $139 million, return on equity of 53%, price-to-earnings ratio of 23. Add to this the fact that the market Knight-Trimark is addressing, securities and equities trading, is continuing its three-year trend of exponential growth with no real sign of abating.
Bear Stearns uses a few points as the basis for its unattractive rating. First, that Knight-Trimark will be unable to maintain its growth in market share. This would be a big problem in a slow- or no-growth industry, but it rings a little false to give a company its last rites if it loses some market share in a rapidly growing market. The major threats? Electronic Communications Networks (ECN), Instinet, and growth from full-service competitors.

The report also pointed out that two companies, Ameritrade (Nasdaq: AMTD) and E*Trade (Nasdaq: EGRP) hold a combined 8.4% of Knight-Trimark's stock and, given those companies' cash burn rate they may need to liquidate their holdings to meet working capital needs.

The second item is inarguable, except to ask the obvious question: Where are the Bear Stearns analyst reports informing investors of the impending capital crunches at Ameritrade and E*Trade? The other issue is that this is not a new threat, so in all likelihood the price of Knight-Trimark has long had this priced in.

In regard to the first one, it seems a bit curious that Bear Stearns would, in effect, count itself as a factor in two of the three items. Bear Stearns has invested in excess of $100 million in ClearNet and other ECNs, and it is clearly one of the "full service brokerage competitors" to Knight-Trimark. Again, neither of these threats are new. Knight-Trimark is the new kid on the block, the one that has forced the good-ole boy brokerages to change how they run their shops.

The innovator in this neighborhood is Knight -- to the point that Knight-Trimark has also invested some capital in ECNs (like ClearNet) mindful of the role they will play in stock trades. But ECNs have not yet shown significant improvement in their ability to match buyers and sellers, and they do nothing to replace the Market Makers' role of keeping the market liquid. . Finally, ECNs are limited to filling limit orders, while 40%+ of all orders are stop/limit and market orders, and are filled by market makers

All told, this analysis may turn out to be correct. It's just curious that an analyst from a company whose lunch has been eaten by Knight-Trimark would come out and use a rating that even some of the biggest basket-case companies somehow avoid, citing information and threats that are not new nor all that persuasive.

Were Wall Street to have a more even-handed approach to its treatment of companies, with a fair spread of ratings between buy and sell, this report would not cause me to react. But the fact is, Wall Street operates in a conflicted, agenda-laced environment, and to take such an abnormal move as to actually rate a company negatively, Bear Stearns should have to feel the scrutiny of the environment it has helped to create.

Fool on.

Bill Mann, TMFOtter on the boards

Related Link:
Knight-Trimark home page