Knight Capital Group Q4 2009 Earnings Call Transcript

 |  About: KCG Holdings, Inc. (KCG)
by: SA Transcripts


Good day and welcome to the Knight Capital Group fourth quarter earnings call. Today’s call is being recorded. Our presenters today will be Chairman and Chief Executive Officer Thomas Joyce, and Chief Financial Officer Steve Bisgay. As a reminder, we will be conducting a question and answer session following the presentation. And now to kick off our program, I would like to turn the call over to Marge Wyrwas, Senior Managing Director of Communications Marketing and Investor Relations. Please go ahead.

Margaret E. Wyrwas

Thank you, Mark. Good morning, ladies and gentlemen. I am Marge Wyrwas. At this point, you should have received copies of this morning’s press release. If you did not receive a copy, or if you would like to have your name added to our company’s e-mail and fax list, please contact a member of the CMIR team. I am pleased to welcome you to Knight’s fourth quarter 2009 conference call and webcast. With me in the room today are Tom Joyce, Chairman and CEO, and Steve Bisgay, Senior Managing Director and CFO.

Before we begin, I will briefly direct your attention to the cautionary terms regarding forward-looking statements in today’s discussion, certain statements contained herein, and the documents incorporated by reference. They constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Please take a moment to read the Safe Harbor statement contained in today’s press release, which is incorporated herein by reference.

In addition, participants should carefully review the risks and uncertainties disclosed in the company’s reports with the United States Securities and Exchange Commission, including without limitation, those detailed under the heading certain factors affecting results of operation and risk factors, as well as the company’s consolidated financial statements and the notes there to contained in the company’s annual report on Form 10-k for the year ended December 31, 2008, and in other reports of documents the company files with or furnishes to the SEC from time to time.

Before I turn the call over to Tom Joyce, please note that Knight has separated the Global Markets segment into two business segments, Equities and Fixed Income Currency and Commodities, or FICC. The change is a reflection of the evolution of the firm and is in keeping with the promise made at analyst day in November 2009, which provided a greater degree of transparency at the business level.

In addition, Knight’s fourth quarter 2009 earning’s press release contains volume statistics for Knight’s Direct, our suite of electronic products and services, and Hotspot FX, our institutional foreign exchange ECM. These disclosures will be part of the monthly volume statistics beginning with January 2010 volume step press release which will be issued on February 12, 2010.

As a reminder, volume statistics are published before the market is open on the tenth business day of each month. And now, I will introduce tonight’s Chairman and CEO, Tom Joyce. TJ?

Thomas M. Joyce

Thank you, Marge. Good morning, everyone. In the fourth quarter of 2009, Knight recorded solid results — strong revenues on higher trade volumes despite weaker market conditions relative to the intense trading activity and historic volatility witnessed in the fourth quarter of 2008. In the equities market, the Dow Jones industrial average, the S&P 500, and Nasdaq Composite Index, recorded gains of 7%, 5%, and 7% respectively during the fourth quarter. Volumes and volatility, however, were muted. The VIX Volatility Index averaged 23 with little variation, compared to 59 in the fourth quarter 2008, and broad stock market volumes fell 14% compared to the fourth quarter of ‘08.

In the debt market, average daily dollar volume of investment grade and high yields entry 34% and 15% respectively compared to the fourth quarter of ‘08. However, volumes did trail off in the final couple of weeks of December.

During the fourth quarter, we witnessed a continuation of the factors that impacted revenue capture and pre-tax margins during the third quarter —specifically, the profile of our order flow and the continued investments in new initiatives.

Now a brief recap of earnings per share; in the fourth quarter of '09, Knight recorded earnings from continuing operations of $0.45 per diluted share, and a loss from discontinued operations of $0.01 per diluted share. The results included a non-recurring tax benefit of $0.12 a share. Steve Bisgay will provide greater detail in financial results, including revenues, pre-tax income, and pre-tax margins in his review of the quarter.

We continue to focus on delivering 20% pre-tax margins across business cycles, and while we dipped below in the second half on ‘09, we did achieve 20% pre-tax margins for the full year of 2009. Our goal remains intact, and we will continue to focus on it as I believe it is certainly achievable.

Now, looking at the new standalone equities business segment, during the fourth quarter we reported revenues of $232 million and pre-tax income of $56.7 million. Pre-tax margins of 24% reflect the weaker market conditions and investments in new initiatives.

Despite lower broad market volumes and reduced volatility in comparison to the fourth quarter of ’08, Knight’s total dollar value traded rose 10%. In shares traded it increased 220% from the fourth quarter of ’08. We recorded average daily dollar value traded of $24.8 billion, an average daily trade volume of $3.6 million, and average daily share volume of $12.4 billion. I believe the results demonstrate the benefits of diversification and our resiliency across market cycles.

During the fourth quarter, Knight continued to gain market share despite declining trading activity as institutional clients focused on protecting gains achieved earlier in the year. The global institutional sales and trading team performed well in an environment in which the overall commission wallet decreased over 20% in the U.S. and about 40% in Europe.

In light of lower client activity during the quarter, our U.S. institutional sales and trade offerings increased revenue slightly and continued to add new accounts at a pace greater than last year. Market conditions improved abroad during the quarter, and our European sales and trading team capitalized on this trend producing solid results.

We recognize the significance of expanding our footprint in the Asian region by continuing to invest in our sales and trading capabilities. The team made progress during the year and continues to grow our client base in market access and the region.

During the fourth quarter, Knight Direct reported record average daily equity trade volume of 84.6 million shares. That is a 70% increase from the fourth quarter of ’08. We attribute this growth to several factors including the cross selling initiative by the global sales and trading team, opening of new accounts by the Knight Direct sales team, and by continuing to create innovative products and services. For the third consecutive year, Edge Trade Algorithmic Suite, which is imbedded in Knight Direct was ranked number one among brokerages in Nasdaq trading cost against VWAP in the annual Elkins/McSherry Global Transaction Cost Analysis Study.

We continued to develop content in order to add value beyond the trading just by seeking opportunities to help clients in the investment decision making process. The Knight strategic research group was created to provide clients with a nontraditional perspective on global market issues and has been very positively received by our clients. The corporate access team continues to coordinate sector specialized conferences that create a forum for executives and industry experts to share views, thought leadership, and market intelligence.

During the fourth quarter, the team hosted an investment conference on Metals and Mining, as well as co-hosted a panel on shipping. During the fourth quarter, results from Knight’s broker-dealer client activity also demonstrated resiliency. While revenues for the electronic trading group decreased due to market conditions, continued high levels of activity and low priced stocks and investments in price improvement full year 2009 revenues increased 9% over 2008.

Knight’s electronic market-making is the overall industry leader in terms of market share at executing client order flow from broker-dealers. We consistently rank at or near the top in all categories of order execution quality, covering speed, price improvement, effectively quoted spread, and at or better percentage.

During the fourth quarter, we saw a slight disconnect between market performance and retail trading activity. Specifically, as the indexes continued to post gain, individual investors pulled back a bit. The shift suggests individual investors may have grown somewhat wary of the rally that began back in mid-March of ’09.

Knight Link is a driver of success and continues to be a popular choice for clients seeking rapid executions at high fulfillment rates with little or no market impact. Our clients include many of the bulge bracket firms in banks on Wall Street. During the fourth quarter, Knight Link grew average daily share volume 5% year over year. For the full year, average daily share volume increased 52% compared to 2008.

In November, we formally launched Knight Link in Europe after testing with a handful of clients. Knight is a direct member of more than 20 European exchanges in multilateral trading facilities. The team has begun actively selling to European firms. Altogether, more than 90% of order flow from broker-dealer clients is executed electronically here.

For the fourth quarter, net trading revenues declined 7.5% compared to the fourth quarter 2008. For the full year, net trading revenue was up almost 9% compared to ’08, which is in line with broad market volumes.

And for a brief update on the options market-making initiative, as we have discussed, we are working to add options capabilities in addition to the execution services and equities in fixed income. During the fourth quarter, Knight acquired trading rights on the ISE’s auction exchange, covering every options class listed on the exchange. We expect to begin market-making activities on a limited basis in the first half of this year.

In terms of self clearing, as you know we have formed a Knight Clearing Services broker-dealer and made approximately 30 new hires to eventually become self reliant in terms of clearing. I am pleased to report that in December we self cleared an average of 50,000 trades a day. We plan to gradually transition an ever increasing percentage of trades to Knight Clearing Services throughout this year. The cost savings once we are fully self clearing are estimated to be about $20 million per year.

Now looking at the U.S. Equities Market for the full year of 2009 — the Dow rose 19%, the S&P went up 23%, the Nasdaq jumped 44%, broad stock market volumes rose about 10 % compared to ’08. At Knight, the average daily dollar value traded increased 20%, average daily trade volume rose 53%, and average daily share volume was up 150% compared to 2008. As a point of comparison, dollar value traded at the New York Stock Exchange and Nasdaq declined 43% and 32% respectively year over year.

For the full year of 2009, AutEx ranked Knight number one in share traded of listed Nasdaq and bulletin boards amongst securities firms. I believe the results are further evident that Knight’s client offering in an approach to trading clearly resonate with buy and sell site firms. The growth of trade volumes, in particular during the fourth quarter when broad equity market volumes fell sharply, demonstrates a preference for Knight’s deep liquidity coverage of more than 19,000 U.S. equities and high quality trade executions.

On a final note, with the separation of equities into a standalone segment, we realigned the senior management structure. Greg Voetsch has been named Head of Equities with responsibilities for institutional and broker-dealer clients. Jim Smyth has moved into a senior advisory role focusing on relationships with strategic clients and will represent Knight within industry groups and on various boards, including Direct Edge and the STA. In addition, Jamil Nazarali, Head of the Electronic Trading Group, will report directly to me. The moves were effective at the beginning of January 2010.

Now turning to the new FICC segment; fixed income, currency and commodities. During the fourth quarter of 2009, we reported revenues of $70.2 million and pre-tax income of $7.2 million. The pre-tax margins of 10% in the fourth quarter reflect investments and new initiatives, such as capital markets, obviously year end compensation expenses, and seasonally sluggish trading activity in the last two weeks of December. For the full year, pre-tax margins were 18%. The revenues were predominately driven by the Knight Libertas institutional fixed income.

In the past 18 months, in response to industry volatility, we have opportunistically pursued several initiatives to enhance our market presence. Specifically, we added talent across research sales and trading, we expanded product and geographic coverage, we grew the client base rapidly, and we built up trade volumes. Head count more than doubled from 86 people at the end of ’08 to 175 at the end of ’09.

During the fourth quarter, we hired a co-head of U.S. Sales, a global head of ABS Strategy, and a director in fixed income research strategy, among others. For the full year of ’09, we roughly doubled our number of research and desk analysts.

Over the course of the year we added capabilities in depth to the team across products resulting in more balanced revenue contributions.

In ’08 revenues were chiefly derived from US corporates in ABS/MBS. In 2009 we drew major contributions from US and European corporates, ABS/MBS, emerging markets and converts. At present we are building our capital markets in origination businesses partnering with firms with strong issuer relationships that need Knight strong distribution platforms.

Given the capabilities of Knight Libertas, the number of clients increased from approximately 825 of the end of 2008 to over 2,300 at the end of last year. Good market conditions for fixed incomes certainly a factor in the growth to date. During the fourth quarter Knight Libertas averaged daily notional value traded lows over 220% compared to the fourth quarter of ’08.

Libertas accomplished a great deal in the 18 months since the acquisition. Backed by Knight’s resources, Knight Libertas has continued to build scale, augment research, sales and trading capabilities, develop a global presence, expand product coverage, and enhance its infrastructure.

A priority for 2010 is to focus on margins while managing further growth. Knight (inaudible) are electronic fixed income trading solution for brokerage dealers continues to achieve exceptional growth by providing centralized liquidity and automating formerly manual processes.

The sales team added 90 new clients in 2009 including several major broker dealers and private wealth managers, which brought the total number of clients to approximately 455 at the end of the year.

Knight Bond Points revenues for the full year 2009 were more than 40% higher compared to 2008, while pre-tax income doubled. The financial results were due in part to superior technology and productivity that allowed Knight Bond Point to handle orders faster, better and cheaper.

Likewise, Hotspot FX has best quarter in year since the acquisition in April of 2006. A refocusing of the sales team earlier in the year resulted in client growth and greater diversification. During the fourth quarter average daily dollar traded was $30 billion an 86% increase compared to the fourth quarter of ’08. For the full year of ’09 average daily dollar value traded was $22.8 billion. And that’s a 23% increase over ’08.

Needless to say, an improvement in the financial results followed. Hotspots revenues for the full year of ’09 was 7% higher compared to 2008. While pre-tax income rose significantly.

The reasons behind the success are many. As I mentioned we have a refocused sales team under a new head of sales. We’re picking spots to cross sell. Nice institutional clients and fixed income and equities. Perhaps most important, the foreign currency ECN model generates high fulfillment rates while our technology makes it fast and efficient.

Now I’ll turn the call over to Steve for a more detailed financial review of the quarter and then I’ll return with some closing remarks. And after that we’ll have some questions. Steve?

Steven Bisgay

Thank you, T.J. Good morning. On a consolidated basis, Knight’s fourth quarter earnings were $41.8 million or $0.44 per diluted share. These consolidated results include, earnings of $30.9 million from continuing operations or $0.33 per diluted share, a loss of $655,000 or a loss of $0.01 per diluted share from discontinued operations, and $11.6 million or $0.12 per diluted share in non-recurring tax benefits.

These tax benefits primarily relate to the recognition of state net operating losses as a result of a legal entity restructuring. As well as the recognition of the purchased net operating losses from certain acquisitions based on recent profitability.

Turning first to continuing operations, we’ve recorded pre-tax earnings of $49.8 million. As a point of reference, under our previously reported segment classification, we would have reported $62.6 million of pre-tax earnings from global markets and a pre-tax loss of $12.8 million from corporate.

Under our new segment reported format, results from continuing operations consist of, $56.7 million of pre-tax earnings from equities, $7.2 million of pre-tax earnings from fixed income, currencies and commodities, or FICC, and a pre-tax loss of $14.2 million from our corporate segment.

Our equity segment which consists of a market making and institutional sales and trading activities generated revenues of $232 million during the fourth quarter, up 7% from the third quarter and down 12% from the fourth quarter of 1008.

Equities achieved pre-tax earnings of $56.7 million during the fourth quarter, up from the third quarter’s pre-tax earnings of $44.3 million, but down from $121.6 million earned during the fourth quarter of 2008, a period of extreme market volatility.

Equities performance was driven by a combination of factors including, market conditions, market share gains, the profile of our order flow and competitive forces.

While overall market volume from retail and institutional investors decreased we were able to increase our market share in certain areas this quarter, including quantitative market making, including Knight Link and Knight Direct.

Meanwhile, the profile of our market making order flow was similar to that of the third quarter. With a high concentration of low price stocks, our order flow was also impacted by a decrease in broad based and single stock volatility, as well as continued competition from the larger firms and other alternative liquidity providers.

In addition to these market conditions, we’ve provided a high level of price improvement in the fourth quarter, which enhanced our execution quality.

Given all these factors, we were still able to maintain a consistent level of revenue captured during the fourth quarter due to the solid performance of our trading strategies.

Against the backdrop of the market environment, our equity based electronic products and services accounted for revenues or approximately $134 million, or 58% of our fourth quarter equities revenues, up from $120 million or 55% of third quarter equities revenue.

The increase in revenues in the fourth quarter was driven by the improved performance of our quantitative trading models, as well as by volume growth in Knight Direct.

Equities voice products and services primarily consist of broker dealer cash equity trading and global institutional sales and trading. In the aggregate, these voice businesses contributed $94 million in revenues, or 41% of the total equities revenues in the fourth quarter, down slightly from $97 million for 45% of total equities revenue in the third quarter.

For the entirety equity segment, pre-tax margins were 24% during the fourth quarter. Up from 20% in the third quarter but down compared to 29% margins achieved in the first half of 2009. The margin improvement from the third quarter reflects our improved trading performance and market share gains.

Turning now to our fixed segments, which includes the results of Knight Libertas, HotSpot FX and Knight Bond Point, we reported a decrease in both revenues and pre-tax margins compared to third quarter. Much of this decrease is due to the general slowdown in the institutional fixed income market in the fourth quarter, partially offset by increased volumes and profitability at HotSpot FX.

HotSpot’s volumes in the fourth quarter almost doubled compared to the same time period in 2008. On a full year basis, HotSpot’s volume increased almost 25% in 2009.

Overall, fixed revenues were $70.2 million in the fourth quarter, down from $78.3 million in the third quarter but up from $35.2 million in the fourth quarter of 2008.

The year over year increase is primarily attributable to the growth we’ve achieved at Knight Libertas on its acquisition in July of 2008.

Pre-taxed margins for the fixed segment were 10% during the fourth quarter, down from 20% in the third quarter and 16% in last year’s fourth quarter.

During 2009, we’ve invested in the growth of Knight Libertas by adding people and improving infrastructure. These investments impacted the FICC margins in the second half of the year. But it’s helped us achieve both revenue and market share growth.

Now, let’s briefly discuss our corporate segments, which includes the returns from our strategic investments, corporate overhead expenses, and other expenses that are not attributable to the equities or FICC segments.

For the fourth quarter, our corporate segment had a pre-tax loss of $14.2 million, compared to a loss of $10.2 million in the third quarter and a gain of $19.5 million in the fourth quarter 2008. A quarter in which we recorded at $51.6 million gain related to the sale of a portion of our investment in Direct Edge.

The decline from the third quarter to the fourth quarter is attributable to the decrease in revenues from our remaining corporate investments in Deephaven funds. The P&L impact of our corporate investment in the Deephaven funds was a pre-tax loss of $1.7 million, compared to a pre-tax gain of $1.1 million in the third quarter and a pre-tax loss of $14.8 million in the fourth quarter of 2008.

On December 31st our corporate balance in the Deephaven funds was $7.1 million. In connection with the start transaction we have elected to reduce our remaining fund balances to cash. Now let's discuss our pretax margin and expense trends from continuing operations as a whole. Pre-tax margin from continuing operations was 17% in the fourth quarter which is consistent with the third quarter, but down from the full year 2008 pre-tax margin of 31% when you exclude the gain from the partial sale of Direct Edge.

In addition to the factors already discussed, our pre-tax margins have also been affected by ongoing investments in our infrastructure and businesses across products and geographies. In the fourth quarter we invested approximately $8.5 million on a pre-tax basis or approximately $0.05 per diluted share in our international expansion efforts, the development of new products such as options market marking, and our infrastructure such as our move to self clearing.

Turning now to certain expense line items, in the fourth quarter compensation expense represented 47% of revenues compared to 46% of revenues in the third quarter, and up from 37% for all of 2008 excluding the Direct Edge gain. Increase in compensation margin from 2008 to the fourth quarter of 2009 is primarily attributable to our overall growth and the shift in our business mix.

Our head count within continuing operations grew from 910 employees at December 31st 2008 to 1,126 at the end of 2009. Approximately half of this increase comes from the growth of our institutional fixed-income business while the balance relates to general infrastructure, new products, and geographic expansion.

The compensation margin also increased from last year due to the business mix shift experienced during 2009 with our fixed segment which traditionally has a higher compensation ratio contributing a greater share of total revenue.

Execution and clearance represented approximately 16% of fourth quarter net trading revenues and commissions, a slight improvement over the 17% third quarter level, but up from the 12% level for all of 2008. These costs fluctuate as a percentage of revenue due to changes in volume, product mix, execution quality, regulatory fees, and operational efficiencies and scale. Please also note that Section 31 fees which significantly increased in the second quarter 2009 have been reduced in the middle of January.

Payment for order flow represented less than 5% of net trading revenues and commission for the fourth quarter, compared to 6% in the third quarter of this year and consistent with 2008. These costs fluctuate as a percentage of revenue due to changes in volume and profitability. All other expenses were $47 million in the fourth quarter, up from $43 million in the third quarter and up from an average of $41 million over the prior four quarters. This increase reflects the general growth of our infrastructure as well as an increase in interest expense related to our new stock loan activity.

Next I'd like to briefly discuss our discontinued operations. As previously disclosed, on March 31st 2009, Deephaven closed the sale of substantially all of its assets to Stark & Roth. As Stark replaced Deephaven as investment advisor of the Deephaven funds, Deephaven exited the asset management business. Therefore effective Q1 2009, the asset management segment has been reported as a discontinued operation.

During the fourth quarter, discontinued operations reported a pre-tax loss of $1.5 million. Though we may incur additional wind down costs during 2010, we believe that substantially all of the costs are behind us.

We'll now discuss our balance sheet. Our financial condition remains strong and liquid. As of December 31st we had $3 billion in assets, 75% of which consisted in cash or assets readily convertible into cash, principle securities owned, and receivables from brokers and dealers. Despite the increase in our gross book size to $1.6 billion at December 31st, which was driven by overall growth, we maintained an average bar of $1.7 million during the quarter which compares to $2.4 million in the third quarter and $2.6 million in the second quarter.

We had $427 million in cash and over $200 million in excess capital. We employed limited leverage as evidenced by our 0.12 debt to equity ratio due to the $140 million credit facility that we drew down over two years ago. We had shareholders equity of $1.2 billion as of December 31st 2009. Using our average diluted shares outstanding for the fourth quarter of 94.3 million, our book value is approximately $12.87 per diluted share.

Finally, we had an unlevered return on intangible equity, excluding discontinued operations of 19% for the year. Thank you, and now I'd like to turn the call back over to TJ.'

Thomas M. Joyce

Thanks, Steve. During the fourth quarter 2009, Knight recorded solid results on strong revenues and higher trade volumes despite declining trading activity in equities and fixed income as the year drew to a close.

Given the contrast in market conditions compared to the fourth quarter of 2008, our product and service teams performed remarkably well. The results demonstrate the benefits of a diversification and Knight's resiliency across market cycles. It's worth briefly recapping progress made over the course of the year. We extended market share gains in US equities and now rank a clear number one in secondary trading across listed Nasdaq and bulletin boards. Presented with a market opening and an institutional fixed income, Knight Libertas aggressively built scale and now has multiple products in global reach. Knight's institutional equities electronic products and services benefited from a refocused sales effort and grew trade volumes.

We added electronic equities trading and institutional fixed-income sales and trading to our capabilities in Europe. We added institutional equity sales and trading to our capabilities in the Asia-Pac region, and we are building a foundation in capital market services to leverage our equities and fixed-income distribution platforms. In the process Knight is gradually evolving from a leading US equities trade execution boutique into what is now a global capital markets firm.

Wall Street has changed drastically in the last two years and I wouldn't be surprised if it looks completely different two years from now, but through it all from the upheaval of 2008 to the aftermath of 2009, we have seized opportunities, taken on the competition that prior to a couple of years probably wouldn't have even considered us competition, and showed extraordinary resiliency during some tough quarters. We are stronger as a firm than we were at the start of the financial crisis. We've self-financed new initiatives with internal cash flows to position this firm for future growth and we are on track to reach the financial goals we've laid out in previous investor presentations.

I want to thank you for your time this morning and we'll now open up the line for questions. Mark?

Question-and-Answer Session


(Operator's Instructions) Our first question will come from Roger Freeman, Barclays Capital.

Roger Freeman - Barclays Capital

Well thanks for the new segment reporting, definitely very helpful. I think it would also be helpful if we had all four quarters of last year, but thanks for the third quarter numbers too on the call. I guess, so trying to triangulate some of this, in equities, just looking at, I guess, the year-over-year comparisons, which I’d done before the calls. I kind of see this $30 million decline in revenue as $30 million increase in expenses. I guess, if you kind of look at the composition in the increase in expenses between sort of direct costs, maybe the Section 31 fees and paying that forward and for etcetera, versus what’s related to build out, particularly clearing. Can you maybe talk to what’s there?

Thomas M. Joyce

Revenue is down obviously because market conditions changed. Evicted 23 is dramatically different then at Exit 59 as we’ve often said to kind of anybody who’d listen volume and volatility definitely matter to us. And obviously volume and volatility were definitely different in ’09, fourth quarter ’09 then they were in fourth quarter of ’08. So that’s kind of I guess not a surprise.

On the expense side, as we’ve mentioned in previous calls, we definitely saw an increase in our execution clearing costs. We saw that first trading in low price stocks that lasted for several months. We definitely saw it as a competitive situation grow a bit. So payment for water flow and price improvement were much sharper in the second half of the year than the first half of the year. And of course there were obviously, with the larger firms, becoming some of the more competitive again. There was definitely some pressure on comp and comp issues increased.

So I think those are the big three expenses in the equity businesses. The same three I believe we mentioned in prior calls. The dynamic really didn’t change a whole lot during the quarter. Steve, do you want to talk about the break up between self clearing and the equity business?

Steven Bisgay

Sure. I think one of the big impacts also shorter of a quarter for looking year over year is also the impact of investments as well. These investments for Q4 2009 were worse, and for all 2009 for that matter were more significant for the year was about $36 million in total. That compared to last year, 2008 $15 million in investments. And in Q4 we had investments of about $8.5 million and roughly 75% of that came through the equity segment. That compares to Q4 of 2008 where we had about two thirds of those calls.

Thomas M. Joyce

Right. And to recap, self clearing is a big one. Building (inaudible 0:36:10) European equity electronic trading team. Those are just kind of three very large ones. Obviously the building up products and fixed income as well. As I mentioned Capital Markets came, bank long trading, a few things like that. So, as Steve said the bulk of the charges were again, the equity business and the number was kind of significant. Having said that, we expect to be harvesting our investment. And things like options market making and self clearing more as we progress in 2010.

Roger Freeman - Barclays Capital

Okay. That’s all for now. I guess, just as you think of it and maybe sort of sequentially it seems like – well, I mean, AmeriTrade talked about payment forward also haven’t come down. I guess the question there is a bit simply a function of does the change in mix in terms of lower volumes on the low price, high volume stock.

Thomas M. Joyce

Yeah. We did – our ratios didn’t change much during – I mean, our formula to compensate people for payment forward wasn’t changed this year in the quarter. So it really a question of makeshift in the kind of flow we’re seeing.

Roger Freeman - Barclays Capital

And then on a competitive front in terms of just the competitiveness of market making, the tightness of close, etcetera, from some of your competitors. Anything change or is that kind of flat sequentially?

Thomas M. Joyce

It was pretty flat sequentially. I think the big changes was kind of during the second quarter, beginning of third quarter. (Inaudible 0:37:43) it you would more intense levels and kind of stayed that way throughout the balance of this year.

Roger Freeman - Barclays Capital

So here’s where kind of where I’m trying to go with it, is if you kind think about the things that sort of impact, obviously revenues and capture rate, as much as you don’t like to talk about that, but the headwind, the high volume low price stock price, that’s abating. The comparative press seems to be sort of a push. The Section 31 fees are going down. It seems like there’s really nothing short of renewed intense competition that really could sort push you, that capture rate lower right now, right?

Thomas M. Joyce

There’s always the mid shift and the volumes. I mean –

Roger Freeman - Barclays Capital

And volatility comes down all ready.

Thomas M. Joyce

Volatility down. It’s going to go into the change. It’s done it before. So it’s hard to predict what the operating volume is going to look like. But we don’t see a dramatic change in the operating environment going forward. And we think, of course, the second half of the year the investments we’ve made and think which options market making – shift in market making. We’ll start to pay off obviously a big thing last year was our Asia Pacific expansion. We put obviously in a growth phase last year which made is incur losses, probably a little bigger than we expected. They’re starting to turn around. We’ll get completely turned around this year. Probably not (inaudible 0:39:12) definitely be a stronger performance financially in ’09 as been ’08.

I don’t know if a competitive environment is going to change a whole lot. You’re guess is as good as mind what happens in volumes. But I do believe that as the year progresses some of the headwinds we had may well turn into a tail wind.

Roger Freeman - Barclays Capital

Okay. Thanks. Just last, I’ve taken, I know, a lot of time. (Inaudible 0:39:35) you said revenues are basically down 10% sequentially it looks like. What would you say is sort of market share gains were in negative? Seems like for the dealers we estimate maybe that the credit rating is actually down closer to 15%-20% sequentially. So looks like – would you agree with that, that sort of the balances is a market share gain?

Steve Bisgay

I know for sure we picked our market share during the quarter. Although, even though notwithstanding the last two weeks of the year were quite quiet. I don’t have any great metrics in market shares in the fixed (inaudible). To be completely honest with you I know our volumes, our businesses have been growing up and obviously part of it is market share gains and part of it is more expanding the new products. Instead of being kind of a two trick pony in ’08, credit and (inaudible). We had more things going on now. Which is kind of one of the neat things about fixed income. There’s so many different verticals you get to pursue and to (inaudible).

Roger Freeman - Barclays Capital

Okay. Very good stuff, thanks.


And next we hear from Rich Repetto with Sandler O’Neill.

Rich Repetto - Sandler O’Neill

My first question’s on the fixed income and I guess Libertas. But given the numbers that Steve gave out so we can back it, revenues and margins sequentially. So it look liked expensive. You say that 10% margin in 4Q, 20% margin in 3Q. Looks like expenses were flat, even though revenues came down 10%. And I guess the question is, who cares about the past but looking forward, what are the incremental margin, what’s the scalability on the fixed income side? Where can margins go, is it really a flat fixed – I wouldn’t think it but –

Thomas M. Joyce

I think you all know that in the commission orientation that we have or the commission like orientation we have in our voice businesses that there are certain payouts one has and fixed income business has kind of a high payout. So like any of those businesses it scale those revenue, the revenue scale, we definitely saw a slow down at the end of the year. We’ve definitely seen business perk up, thankfully, this month. So I think as you look forward, at any given phase where we have, we’re growing and hiring people versus, if you will, harvesting a stable or consistent headcount situation. I think that the range of success in the fixed income business is probably somewhere between 16%-17% pre fixed margins or the lower side to 23%-25% on a higher side. So there’s definitely scale, it doesn’t scale, like an electronic business would scale. But it definitely scales and it will scale as revenue momentum returns.

Rich Repetto - Sandler O’Neill

Okay. That’s helpful, Tom. And then tax range this past quarter was down a little bit, 37 and change. And I think just trying to get the – given the international mixes, what’s the run expected reasonable number for 2010?

Steve Bisgay

The tax rate was mostly adversely effected by the amount accruing tax benefits. When you pull those out and your normalize the tax expense for this quarter, we came in more in line with say 40%. And also for the year 2009 we would come in about 40% as well. I would suggest that that 40% (inaudible) where I think we would be next year as well.

Rich Repetto - Sandler O’Neill

Okay. We’ll recheck our calculation. We’ll come up with something a little bit lighter. And then lastly, Tom, back to an old issue, but what regulation – anything that is more recently developed, anything’s changed on your outlook in regards to what are the risks to Knight in regards to what the SEC is proposing whether it be IOIs, dark pools or – but anyway, what’s your up to date assessments of the risk relative to proposed regulations?

Thomas M. Joyce

Sure. Nothing’s really changed because then we chatted about this stuff. If you will when you look at the fact – I guess if anything has changed it will be kind of cumulatively in that with the release of SEC doing that concept release it appears they’re starting to look at things much more holistically which is a great step forward. They seem to have had gone from a issue by issue approach to a more broad view of how the equity markets work. And how more broadly should things be assessed as opposed to kind of the minutia of individual issues. So I think it’s a big step forward that a concept release was put out there.

As to the individual issues that they had mentioned in the past and we talked about, we keep hearing a short sale rule is going to be released imminently. Haven’t heard obviously any details around it. So we’re watching that. I think there’s a general consensus there’s going to be some kind of a circuit breaker but you never know till you see what you get.

As I said in the past, any rules in around dark pools don’t seem to have a big direct effect to us. The single biggest issue for us is there IOI indications of interest and how they’re clarified. And obviously clarity is important under certain circumstances. We’ll have to change our operating environment. Under other circumstances we wouldn’t have to change much at all. So I’d say the biggest delta around what happened to the market making business here is where they come out in indications of interests.

In terms of response of excess or if you will naked access, naked sponsor of access, we think that is a very wise thing to do to regulate that area. It’s probably one of the few areas in the equity markets where you could in fact in gender sustenance risk, testing a problem there’s already a problem where you attesting a problem in milliseconds is that much bigger a problem. So putting qualifications in and around that and containing that in a much better fashion we think is great for the markets. Much safer stronger environment to operate in. And I guess the other side of that would be if there are fewer folks accessing the markets because naked access is banned, well I guess theoretically it could arguably help us because there will be few competitors in the market.

So there’s a push and a pull in all this stuff. Some stuff could help us. Some stuff could hurt us. It’s impossible to get to access where we are because we don’t have crystal ball either. But my biggest complement in this stage of the process that I could make is could pat the SEC on the back because issuing this concept release was a wonderful step forward. It’s the first real concept release since Market 2000 came out. And that was obviously quite a while ago. So we think this is the right step at the right time.

Rich Repetto - Sandler O’Neill

I’m assuming you don’t offer any naked access?

Thomas M. Joyce

No, sorry we don’t. You’re right, we don’t.

Rich Repetto - Sandler O’Neill

Okay. This is helpful. Thanks, Tom.


And next we hear from Mike Vinciquerra, BMO Capital Markets.

Mike Vinciquerra – BMO Capital Markets

Thanks very much. Two topics I wanted to touch on. First, Tom, could you give us an update on what’s going on with your efforts to burr up a market making operations out of Europe? Is that actually active today or if not when does that start to ramp?

Thomas M. Joyce

Yes, it is active. We hope it’s ramping as it is active. We actually had coming up party if you will last month announcing the launch in (inaudible 0:47:41) Europe. We’re a retail service provider and we’re a launching out marketing Knight Linkout to various clients. So obviously the universe of retail firms in Europe is somewhat smaller than it is in the US. Considering smaller. So it will be a smaller product anyway. But it is out, it is making money. Although only in a small fashion right now. And in a good position to grow. So it’s been launched.

Mike Vinciquerra – BMO Capital Markets

Does the structure of the European market make it more challenging to try to repeat what you’ve had so much success with here in the US?

Thomas M. Joyce

Well, I think when they did the (ph 0:48:23) directive in the Indigo 7, it started to make Europe look more like the US. So on a broader scale regulatory, if you will, the opportunity should be similar. Of course, Europe is still somewhat balking eyes in their different operating procedures. And even if the rules have been harmonized you definitely have different behaviors in different countries by the players. So I think just the fact that it is – united countries of Europe as opposed to the United States of America, there are different hurtles to handle. Having said that, the missive directive definitely made the environment much more appealing which is why we expanded post that. So, yeah it isn’t quite as large an opportunity. Obviously it’s not a large an opportunity as the US is. But it’s still a pretty attractive opportunity.

Mike Vinciquerra – BMO Capital Markets

Okay. And then shifting over just to hot spot, your grow year over year basis in the fourth quarter (inaudible 0:49:21) trader was pretty phenomenal. But I think you said, Tom, that your revenues were only up 7% on a year over year basis. Did I hear that correctly? And if so what’s the disconnect between those two numbers?

Thomas M. Joyce

We had some commission compression year over year. So that accounts for the change in revenue. The volumes did go up a lot. A lot of the volumes of course came from the trades, like high frequency traders and things like that. And obviously they operate at kind of low commission schedule. Due really on a volume that put through. So we did see some commission pressure, but thankfully it was more than offset by the volume increase. And in fact the impact on pre-tax was kind of dramatic. Pre-taxes went up a lot faster than revenues when up on a percentage basis. So it was clearly the best quarter and the best year we ever had in Hot Spot. We’re going to double check that 7% number just to confirm.

Mike Vinciquerra – BMO Capital Markets

Great, thank you. Then just squeak one in for Steve. And I apologize that I missed something on the interest expense line. Kind of tripling sequentially. Did something happen in the quarter that to bump that up?

Steven Bisgay

That represents the new stock loan activities. It’s part of our self clearing initiative we’re also going to have stock lending. And we’re doing that in fact now. We’re doing that on a national basis. You have as reported on the face of our balance sheet, approximately $400 million of borrows and also $400 million of loans. So it’s important to note that we’re charging interest as well as paying interest as well. So it’s a net business. But it does have the impact of grossing up a balance sheet to extent. And also our income standing as well.

Mike Vinciquerra – BMO Capital Markets

Perfect. Thanks, Steve. Thanks guys.


Our next question will come from Niamh Alexander, KBW.

Niamh Alexander- KBW

The diversification looks great. The fixed income, the disclosure, thank you very much. It’s only a quarter of your business now. But when I look at the environment and equities and both fixed income corporate (inaudible 0:51:25) have come in so much drastically and then volatility is coming down, equity volume is down, flows are negative. What levers can you pull to help grow your earnings this year when the market environment isn’t kind as favorable?

Thomas M. Joyce

Well, we’re going to continue to grow. We fully intend to. And I think so far it’s in point of fact happened. We’re going to continue to work expanding market share trying to get a bigger slice of the pie. Additionally, we intend to grow in new products and new geographies. For example, we have some pretty definite plans about expanding our presence in the mortgage business. Obviously a lot of the play is in the mortgage have fallen by the way side for very public reasons. We think there’s an opportunity there. We have some views on how we can grow that. We expect to grow the bank loan business. Did a lot of work last year preparing, if you will to launch the bank loan business. So we’re talking to people there as well to bring them in.

So we expect to have more products, especially in the fixed income side. We certainly expect to gain market share in both fixed income and equities. If you look at the equity side, it’s kind of similar story. Instead of, if you will, mortgages and bank loans, we want to grow our ETF and listed options business. So we definitely believe the combination of continued focused on enhancing our relationships with our clients and getting more of their wallet. As well as bringing new products to the market. New products under the Knight heading to the market, will resonate with our clients. So we know the environment is – I don’t know if we’re going to see Q4 of ’08 again anytime soon. We know the competition is out there, but we believe the teams are great in terms of their ability to take market share. And we believe strategically we’re going to add products that will deliver a lot of growth over the next few years.

Niamh Alexander- KBW

That’s really helpful. Thank you, T.J. And I guess with respect to adding the new products. Are you going to continue to add new talent? And in that context also, you’ve been investing what was it about $5-$10 million a quarter. How should we think about that pace of investment?

Thomas M. Joyce

$10 million a quarter, well there will always be investments. So I guess at some point or another we’re going to be planning executing for the president, planning for the future. So we definitely will have invested. I would argue that we might be kind of at the upper end of the range of the investment range. If we just look at two examples. Options market making, the team is probably 75% two figured already and ready to execute. And it will be building over the course of the next year. So as we grow out that business we only have to add a handful of people. So the investments have been made and we should start.

I know I use this word too many times but we should start harvesting those investments soon. And self clearing initiative we have a full team here. And they’re doing a wonderful job getting us ready. And when we’re ready to the double – we’re paying both sides of the coin. We’re paying Merrill and we’re paying our internal staff. So as soon as that comes to fruition we’re going to see a large savings there. And the bill that expense will – it won’t be a build out any more. It’ll be an operating entity, saving the firm moneys.

I know there will always been investments. But I believe it’s fair to say that at $10 million a quarter it’s kind of at the upper end of the range. And it should come down over the course of 2010.

Niamh Alexander- KBW

That’s really helpful. Thanks, T.J. And I guess just lastly switching over to your repurchases. You increased your repurchases slightly during the quarter. And you’ve got $200 million of excess capital. How should we think about repurchase there or any kind of reinvigorating that or is it primarily just related to employee related (inaudible)?

Thomas M. Joyce

I would say we kind of think that having the shares upstanding count being in the low 90s is where we want to keep stay. So I don’t really want it to drift about 95 million shares, nor do I expect it to get down to 85 million shares. I’d like it to be close to the 90 that it is. So we’ll have a modest, if you will, share by back right now.

And we’re modest because we are self financing at this point all these growth initiatives. For example, if the (inaudible) making business gets the kind of head of steam we think is going for us at the year from now that it’ll be using, $50 million in capital. You can put a spin more number on the European market making team as it builds out. So it’s no inconceivable in a very brief period of time we could be utilizing a lot of our excess capital. So we want to make sure we have it. We want to be growing pre-tax as opposed to shrinking – if you will schematically we want to grow pre-taxes, not simply shrink the shares outstanding. We will likely trim the shares outstanding as we pursue growth and pre-tax.

Niamh Alexander- KBW

Okay. That’s helpful. Thanks, T.J.

Margaret E. Wyrwas

Steve, do you want to follow up on that question from Mike Vinciquerra.

Steven Bisgay

Thank you, Marge, just as a quick clarification. The (inaudible year over year did in fact increase by 7%. But the 2008 numbers had the retail business included for that particular year. That business as we know has been sold in 2009. And so it’s a comparative that’s really not apples to apples. There’s another business that was imbedded within. We pulled it out. Well, that would be relatively significant data from an institutional perspective.

Thomas M. Joyce

And from what it’s worth, the retail business didn’t have very much in the way of pre-tax income. So that’s why the pre-tax income jumped a lot more, than of the revenues on a percentage basis. We’re actually quite happy with Hot Spot the way it’s been developing and the amount of attention it’s getting from our client base. So it’s growing a lot more rapidly than some of its competitors and we kind of like it’s positioning right now.

I think we’re going to go on to the next person in the queue, Mark.


And the next question will come from Patrick O'Shaughnessy, Raymond James.

Patrick O'Shaughnessy, Raymond James

Just had one quick question, which is the clearance statement, the $20 million of savings per year, for going self clearing, $5 million per quarter. What amount of that would you say that you’re achieving at this point? Are you achieving anything or is that really just – it’s going to take a few more quarters before you start realizing some of that $5 million per quarter?

Thomas J. Joyce

I guess we’re achieving kind of nothing on it now. Ultimately you will see the full effect in the third quarter 2011 because the contract with Merrill Lynch runs out in June or July of 2011. So at that point we’re definitely going to be going self clearing. As I said we’re going to migrate more order flow into our self clearing unit as getting close to 2010. Among other reasons you have to make sure you have confidence that you can handle all out of flows. Best way to have the confidence is to test it out before you do a big bank kind of switch. So we’ll be moving it forward. We may see some incremental savings over the course of this year. But I continue to focus on 2011 as the year we start to see meaningful savings in the self clearing initiatives.

So in point of fact, throughout this year – assuming first half of this year and probably all this year you can still consider us in the investment mode in self clearing.

Patrick O'Shaughnessy, Raymond James

Thank you.


And our next question will come from Ken Worthington, JP Morgan.

Ken Worthington – JP Morgan

Hi, good morning. Just a follow up on regulation. In the concept release and other chatter we’re hearing, there seems to be a lot of proposals that either directly or indirectly go after internalization. How big an impact would changes in international for broker dealers have on your business?

Steve Bisgay

It would have large impact. I mean, as a market maker that’s what we do. So, it would be meaningful. It’s hard to really try to guess because who knows it’s going to come out. Obviously we think it’s full hardy to even remotely challenge internalization. When there was no competition in the market and when the exchanges had 85% of market share, the resale execution quality was dismal. I could have used another word, but it was dismal. Once you introduce competition in the market, the resale investor benefits immediate. There’s never been a better time to be a resale investor. Resale investors have never had the opportunity to buy stock this quickly and as cheaply as they do now. That is directly related to competition.

So we feel that any kind of implied notions that internalization should be changed is completely wrong footed. Because if you do change the investor entity you’re going to hurt are the retail investors, which would be kind of counterproductive to what the SEC wants.

So if they do tamper with it, it could have quite a big effect on our business. It makes no sense to me to tamper with it. But I guess we’ll have to see what the concept release produces.

Ken Worthington – JP Morgan

Thank you very much.


Rob Rutschow with CLSA is next.

Rob Rutschow- CLSA

I think most of my questions have been asked. But you talked a couple of quarters ago about launching new algorithms and high frequency trading strategies. I’m wondering if you can talk about the efficacy of those and how new launches are going in terms of profitability and how that compares to previous launches of new products.

Thomas M. Joyce

We don’t have a set schedule for launching new initiatives. When they come out of the laboratory, if you will, we put them in play. So over the course of the last year we had a couple come out that seemed to do very nicely. We were very pleased with a couple of the new ones came out the last two months of last year. So hopefully we’ll have them for the full effect this year. We’re still working on models that would allow us to trade, if you will, futures on financial products, futures on commodities, whether it’s gold or oil or financial futures. Those are still if you will in the laboratories.

So the things that we did roll out were only a couple in the second half of the last year and they both performed well. And so we’re looking forward to the full year effect this year and obviously during the course of this year rolling some more out. So it’s kind of a dynamic process. It isn’t one you can predict because we don’t roll it out of the laboratory, if you will, until the confidence level is pretty high. So that’s going to be an ongoing focus for us. And I’d say we’re in the early stages right now.

Rob Rutschow- CLSA

Okay. And not to delve into the minutia (ph) too much. But we’ve heard some chatter about you getting some underwriting business on the fixed income side. Can you talk about the pipeline there, what you’re looking at and does the partnering with underwriters to provide distribution represent any sort of change to the strategy?

Thomas M. Joyce

I don’t think the partnering with folks who have investment banking core business and obviously of course (inaudible) with the distribution core business if there’s any change in the strategy is just sort of us reaching out to find more ways to leverage our core platforms, core distribution pipeline. So it’s not really a change in the strategy. It’s an enhancement, if you will, I guess, I’m perhaps word-smithing here. But it’s not a change because we’ve always known we have an incredible presence in trading. For example, we are the number one trader in over 1,100 issuer names. Whether those 1,100 issuers need to access the capital markets is another question. But we clearly know how those companies trade better than anybody else. So we think it’s an untapped vein in the mind, if you will.

So partnering up with somebody who has complementary capabilities we think could turn out to be quite interesting. We’ve only had a couple opportunities to join market with firms at this point. So it’s very early stages. In terms of mandates, we have two or three right now, which of course is also in the early stages with a, we think a robust pipeline of prospects. We have a couple three ATMs on the equity side and we have a couple – we have one or two high yield mandates on a fixed income side. So, early days but we’re starting to see a nice payout for all the efforts in the second half of ’09 from that team.

Rob Rutschow- CLSA

Okay. Great, thank you.

Thomas M. Joyce

Mark, I think this is the last question.


Thank you very much. And just, our final question will come from Daniel Harris with Goldman Sachs.

Daniel Harris - Goldman Sachs

Steve, all else equal, if you think about the change in Section 31 fees in this quarter versus say the fourth quarter, how does that impact the margin in the equities business?

Steven Bisgay

The Section 31 fees didn’t have an impact. There was no change from Q4 to Q3 –

Daniel Harris - Goldman Sachs

I mean, Q1 to Q4.

Steven Bisgay

Dan, thinking back to Q1 of last year when we did a pro form analysis, you mentioned that on revenues where they were the impact would be an incremental $6 million. So it was about a 2% increase based upon that five-fold increase. Now the rates are going to be cut in half. So, largely we’re talking about something in the neighborhood of the 1% margin impact.

Daniel Harris - Goldman Sachs

Okay. And is the non-compensation rate that you guys generated in the quarter, is that indicative of how we should be thinking about going into 2010, the run rate given all the investments you guys are making across the different businesses?

Thomas M. Joyce

The non-compensation expense? Well, as I mentioned earlier, the investments will probably at the high end of the range. It’ll probably drift lower over the course of 2010. There’s not a lot in the non-compensation expense base that I see changing. We obviously we’re kind of stable in CapEx. The stuff’s been around payment for (inaudible) and things like that. Probably won’t change a whole lot. I don’t see it changing a whole lot. So the big variable, I guess, will be investments that you mentioned. And that number will likely drift lower over the course of the year as the execution in those areas starts to improve.

Obviously another good example are the team in Asia Pac (ph) as they start to really assert themselves, the loss will switch to a gain. So I don’t see a big change in the non-compensation ratio, expense ratio. We obviously are focused on making sure we get the compensation ratio more in line with where we think it should be. And we are, of course, going to see less spend on the investment side. Still spend, but less spend as the year progresses.

Daniel Harris - Goldman Sachs

Okay. That’s helpful. And then just lastly then. On the employee count, you guys were up high single digits this year. But it seems like a lot as you mentioned of those people lottery (ph) that double counted the clearing, or your building out options are sort of in-house already. So should we be thinking in fact a much lower number in 2010?

Thomas M. Joyce

I think the growth rate will lower. We’ll still add people. I bet there are 60 resumes on the desk of various people up in Knight Libertas. Folks who are interested in talking to us about coming over. Are we going to hire all 60? No. Jamaal and the ETG group, he’s constantly looking for new programmers as we expand to new asset classes. Greg’s developing a nice team over in the EETF and the (inaudible) team. So we’ll definitely be hiring. Although I assume that the pace of hiring will slow. But we’ll definitely be hiring.

Daniel Harris - Goldman Sachs

Okay. Great. Thanks, guys.

Thomas M. Joyce

Thanks, Dan. And I know rumor has it that there’s some big firm about to go out at 11:00. I don’t know who those guys are. But I know you have to run. So I really want to thank you for your time. I know it’s an incredibly busy time with earnings reports coming out this time of the year. So I really appreciate everybody’s attention. And look forward to tuning in with you again in three months or so to talk about our first quarter results. So thanks everybody. Have a great day.


And that does conclude our conference call. Thank you for your participation.

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