Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Executives

Margaret Wyrwas – Sr. Managing Director & IR

Thomas Joyce - Chairman & CEO

Steve Bisgay – Senior Managing Director & CFO

James Smyth – Executive Vice President

Analysts

Ken Worthington - JP Morgan

Richard Repetto - Sandler O'Neill

Niamh Alexander - Keefe Bruyette & Woods

Dan Harris - Goldman Sachs

Joseph Edelstein - BMO Capital Markets

Roger Freeman - Lehman Brothers

Christopher Allen - Banc of America

Knight Capital Group Inc. (NITE) Q1 2008 Earnings Call April 16, 2008 9:00 AM ET

Operator

Good day and welcome to the Knight Capital Group conference call. (Operator Instructions) Our presenters today will be Chairman and Chief Executive Officer, Thomas Joyce and Chief Financial Officer, Steve Bisgay. And now I would like to turn the call over to Margaret Wyrwas, Senior Managing Director of Communications Marketing and Investor Relations; please go ahead ma’am.

Margaret Wrywas

Good morning ladies and gentlemen. I’m Marg Wyrwas. At this point you should have received copies of this morning’s press release. If you didn’t receive a copy or if you would like to have your name added to our company’s email and fax list please contact a member of the CMIR team. I’d also like to let you know that our 2007 Annual Report is now available online at www.knight.com in the Investor Center.

I’m pleased to welcome you to Knight’s first quarter 2008 conference call and webcast. With me in the room today are Thomas Joyce, Chairman and CEO and Steve Bisgay, Senior Managing Director and CFO who will make formal remarks. Joining them is James Smyth, Executive Vice President. Unfortunately Greg Voetsch, Executive Vice President is travelling today and not available to participate.

Before we begin I’ll briefly direct your attention to the precautionary terms regarding forward-looking statements in today’s discussion. Certain statements contained herein and the documents incorporated by reference may 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 US Securities and Exchange Commission including without limitation those detailed under the headings of certain factors effecting results of operations and risk factors in the company’s Annual Report on Form 10-K for the year ended December 31, 2007 and in other reports or documents the company files with or furnishes to from time to time the SEC. This information should also be read in conjunction with the company’s consolidated financial statements and the notes thereto contained in the company’s Annual Report on Form 10-K for the year ended December 31, 2007 and in other reports or documents the company files with or furnishes to from time to time the SEC.

Finally I’d like to invite you to participate in the webcast of our 2008 Annual Meeting for Shareholders on Wednesday, May 14, 2008 at 1:00 pm Eastern time. And now I’d like to turn the call over to Knight’s Chairman and CEO, Thomas Joyce.

Thomas Joyce

Thanks Marg, good morning everybody. Well the first quarter of 2008 witnessed some remarkable events in the capital markets, from the rogue trader at SocGen to the fire sale of Bear Stearns and the opening of the Fed discount window to investment banks. As a result volatility remained high while the major market indexes slid. A renewed focus on liquidity and heightened volatility typically bode well for our business it did so in Q1. Global Markets had another terrific quarter from a revenue standpoint as we continue to demonstrate the strategic value to our clients in the trading process.

We have deep liquidity in our virtual exchange across multiple asset classes. Our hybrid market model provides clients with access to electronic and voice trade executions and we always take a truly client-centered approach. During the first quarter of 2008 the CBOE volatility index, the VIX, remained at sustained high levels averaging 26.1 in comparison to VIX average 21.6 and 22 in the third and fourth quarters of 2007 respectively.

Volumes fluctuated somewhat during the first quarter of 2008; January started strong with high levels of trading activity. Volumes and volatility waned a bit in February. March saw intermittent surges in volume uncorrelated to volatility which we attributed to deleveraging. By contrast in asset management Deephaven experienced one of the more difficult quarters in its 14-year history. The battered credit markets continued to present liquidity issues and the threat of a US recession combined with growth deceleration in the Global Markets depressed stock valuations.

Just look at the major market indexes. In the first quarter of 2008 the Dow Jones Industrial average declined 7.6%, the SMP 500 was down 9.9% and the NASDAQ composite fell 14%. Now let’s turn to our financial results.

Knight’s total earnings in the first quarter of 2008 were $0.35 per diluted share. In comparison Knight’s total earnings in the first quarter of 2007 were $0.31 per diluted share. Global Markets contributed $0.51 on pre-tax earnings of $79 million. Asset management lost $0.03 on a pre-tax loss of $4.1 million. And the corporate segment gave back $0.13 on a pre-tax loss of $19 million which included negative returns on corporate investments and the Deephaven funds.

Pre-tax earnings for the first quarter of 2008 were about $56 million compared to $54.7 million for the first quarter of 2007. Consolidated pre-tax margins for the first quarter of 2008 were 25% which easily exceeded our goal of 20% across market cycles. Our total revenues for Q1 were $225 million compared to about $242 million for the first quarter of 2007. And to briefly update Knight’s share repurchase program, during Q1 we bought back 1.4 million for about $23 million and since the inception of the billion dollar program we have invested $649 million to repurchase 60.6 million shares.

Turning to Global Markets revenues for the first quarter of 2008 were approximately $219 million which is a 27% increase from the first quarter of 2007. I’d like to point out now that Global Markets has been consistently profitable over each of the last 11 quarters. Our results including revenues, pre-tax margins and pre-tax earnings are similar to those of the fourth quarter of 2007 and considering that stock market volumes were slightly lower in the first quarter of 2008 this is a pretty remarkable achievement.

We have seen indications of gains in market share and increased operational leverage. We continually enhance, refine and develop new trading models. I believe we’ve created a base of sustainable results in our Global Market segment across market cycles. During the first quarter of 2008 average daily equity trades were $1.76 million which was an increase of 60% from the first quarter of last year. Also during the quarter average daily dollar value traded was $16.8 billion which was an increase of 82% from the first quarter of last year.

Looking more closely at our first quarter results the 65% year-over-year increase in net trading revenues was driven by the increase in the number of clients as well as further growth in listed volumes in a record quarter from our London-based team. Recent increases in listed volume were helped by the success of KnightLink, an offering we introduced just a little over a year ago. Revenues from London are derived primarily from our cash and sales traders and part of our voice team.

In the first quarter of 2008 London generated 100% year-over-year increase in pre-tax income. In the coming year we aim to build on the success of London by cross selling electronic products and services such as Knight Direct EMS, our broker neutral trading platform to European firms. On April 23rd, next week, I’ll deliver the key note address at Trade Tech Paris, on the rise of self-directed trading in the European union on how to manage the greater liquidity fragmentation expected in the post MiFID environment.

Over the past five years revenues from electronic market access and trade execution services as a percentage of Global Market’s revenues grew from 9.7% to now over 47%. Over that period we’ve demonstrated consistent improvement in Global Market’s pre-tax margins. We intend to keep our focus on continuing these trends as we enhance our electronic products and services. As a whole, the expanded client base, the addition of new products and services and diversification of shares traded, more than offset lower volumes in OTC Bulletin Boards and Pink Sheets.

Also during the first quarter of 2008 we closed the Edge Trade acquisition. Prior to the deal closing we began offering Edge Trade algorithms on Knight Direct. Shortly after the closing the Edge Trade staff relocated to Knight’s headquarters in Jersey City where they are now located just off the trading floor. I am pleased to report that due in part to the swift integration Edge Trade posted a record quarter in terms of volumes.

And finally, during the first quarter of 2008 we re-launched ValuBond our electronic fixed income trading solution as Knight Bond Point which has also experienced impressive growth. Knight Bond Point operates and effective fixed income marketplace. It automates trading thereby increasing operational efficiencies for our client firms facilitating trading and lowering related transaction costs. The rebranding more closely aligns Knight Bond Point with Knight and we have begun a sustained sales initiative targeting Knight’s broker dealer clients which has already resulted in several significant new clients for Knight Bond Point.

As mentioned we’re demonstrating strategic value to our clients in the trade process. We have deep liquidity in our virtual exchange across multiple asset classes. Our hybrid market model provides clients with access to electronic and voice trades executions and we always take a truly client-centered approach. We are adding new products and services that make it easy for firms of diverse sizes, investment strategies and styles to trade and trade effectively with us across multiple asset classes. As a direct result we’ve grown our client base to more than 2,450 firms; both buy and sell side. In fact that includes about 750 sell side firms and about 1,700 buy side firms.

And as we add products and services and increase activity in Europe, we expect that number will only grow. Pre-tax margins of 36% in Global Markets during the first quarter of 2008 also demonstrate we’re systemically increasing operational leverage to expand margins. As we adjust to the relatively recent expansion of parts of our client base our ability to efficiently serve individual clients should improve over time. And as I mentioned at the outset I believe we’ve created a base of sustainable results across market cycles.

Turning now to asset management, Deephaven performed respectively given the difficult environment. Continuing liquidity issues due to the weakness in the credit markets combined with the threat of a US recession and growth deceleration in the Global Markets acted to depress valuations. Deephaven generated asset management fees of $15.2 million and recorded a pre-tax loss of $4.1 million. In comparison Deephaven generated asset management fees of over $60 million and pre-tax income of almost $19 million in the first quarter of 2007.

Deephaven’s blended performance for the first quarter was a negative 8%. Needless to say performance was certainly less than we’d expected across investment strategies and funds but looking at some of the data coming out on the first quarter in terms of negative hedge fund performance and redemptions suggest that other firms grappled with similar issues.

As announced on January 31st, after review of the firm’s investment processes and results, market conditions and investor behavior, Deephaven management decided to close its event fund. The decision was based on a number of factors including substantive macro economic changes in the US that reduced the types of event-driven opportunities that are critical to achieving the results investors in the event funds expect over the short and intermediate term. These same issues have impacted event-driven funds across the hedge fund industry.

As of April 1st, 2008 assets under management were about $3.5 billion. Assets under management on April 1st, 2007 were $3.9 billion. The decrease in assets under management is largely due to the closing of the event fund. Speaking broadly we expect volatility and de-leveraging will continue in the second quarter of 2008.

Finally during the first quarter of 2008 Deephaven senior managers exercised an option to acquire a 49% ownership stake in the firm; in Deephaven specifically. We believe it will more closely align the interest of Deephaven’s senior management with Knight. We also believe investors will welcome the stability in the management team.

Now I’d like to turn the call over to Steve Bisgay for a more detailed financial review of the first quarter. I’ll then return with some closing remarks and after that we’ll open it up for questions.

Steve Bisgay

Thank you TJ, good morning. Before I review the business segment results I’d like to briefly recap our overall quarterly performance. Our earnings were $32.5 million or $0.35 per diluted share. Pre-tax earnings including minority interest expense were $55.8 million during the quarter. The main components of our first quarter results are: $78.9 million of earnings from Global Markets, which represents $0.51 per diluted share offset by a loss of $4.1 million from asset management which represents a loss of $0.03 per share and a loss of $19 million from our corporate segment which represents a loss of $0.13 per diluted share.

Let’s the review the results of our business segments starting with Global Markets. Global Market’s revenues were $218.8 million during the first quarter, down less than 1% from the fourth quarter and up 27% from the first quarter of 2007. Excluding Direct Edge which was deconsolidated at the end of the third quarter of 2007, Global Markets’ revenues were up 36% compared to last year’s first quarter. Global Markets had pre-tax earnings of $78.9 million during the first quarter which is on par with the earnings of $79.4 million we achieved in the fourth quarter. When we exclude Direct Edge, Global Markets pre-tax earnings were up from $37.3 million in last year’s first quarter.

Knight’s US equity dollar volume traded in the first quarter was down only 6% from the record volumes we saw in the fourth quarter but was up 82% from last year’s first quarter. When looking at our volumes on an average daily basis, dollar volumes were down 3% from the fourth quarter but were up 82% from last year’s first quarter. In addition to being aided by market volatility with the VIX reaching a five-year high in March, a significant driver of this increase was growth in the number of and volumes from new clients.

Contributing to the growth in our dollar volumes compared to the prior year is the shift in our product mix with listed and other high dollar value stocks representing a larger percentage of our total volumes and revenues. As a point of reference, listed dollar volumes have increased in excess of 100% over the first quarter of 2007. We also continue to see a retrenchment in speculative retail activity as evidenced by the decline of the Bulletin Board volumes in the overall market.

In the current environment Bulletin Board activity continues to have less impact on the results of the Global Markets business with revenues from Bulletin Board stocks down slightly for the quarter. As we’ve said previously we are not focused on revenue capture metrics but rather on revenue growth and pre-tax margins within Global Markets. Pre-tax margins for Global Markets were 36% during both the first quarter of 2008 and the fourth quarter of 2007. This represents an increase compared to pre-tax margins of 21% in last year’s first quarter. This increase is primarily the result of the success and growth of our electronic trade execution products and the sale of Direct Edge in the third quarter as Direct Edge was a very low margin business.

Excluding Direct Edge our 36% pre-tax margins for Global Markets were still higher than pre-tax margins of 23% in last year’s first quarter. As in 2007 we continue to invest in building new businesses within Global Markets to further develop our electronic and voice trade execution products and leverage our infrastructure. A timely example of this is our recently announced launch of Knight Portfolio Access which expands our product offering to our sell side clients. In addition we continue to explore new organic and inorganic initiatives to better serve our clients and leverage our platform. These developmental initiatives similar to our investment in Knight Capital Partners, represent approximately $0.01 to $0.01.5 per diluted share of operating losses during the quarter which is consistent with prior quarters.

Now let’s review first quarter results from our asset management segment. Deephaven navigated through one its most difficult and challenging quarters finishing with a blended negative return of 8% across all assets under management. This compares to the blended positive returns of 1.4% during the fourth quarter and 4.9% during the first quarter of last year. Deephaven recorded asset management fees of $15.2 million during the first quarter, down from net asset management fees of $28.2 million in the fourth quarter and down from $60.7 million in last year’s first quarter.

Asset management fees have two components; management fees which are determined based on a percentage of assets under management and incentive fees which are determined as a percentage of the funds’ returns. Management fees were $9.8 million during the first quarter, down from $11.8 million in the fourth quarter and down from $11.3 million in last year’s first quarter. Average assets during the first quarter of 2008 were $3.6 billion, down from $4.2 billion in the fourth quarter and down from the average of $4.1 billion in last year’s first quarter.

The decrease in assets under management was affected by the closure of the event funds announced as part of an 8-K filing on January 31st, 2008. As disclosed we are not collecting any management fees from the assets under management in the event fund as we wind down these investments. As of April 1st, 2008 Deephaven’s total assets under management were approximately $3.5 billion.

Incentive fees which vary based on the funds’ returns were $5.4 million in the first quarter, down from net incentive fees of $16.4 million in the fourth quarter and down from incentive fees of $49.4 million in last year’s first quarter. Please note that we were able to earn incentive fees in the first quarter despite the negative blended return for the period as certain of Deephaven’s single strategy funds had positive returns for the quarter.

In the first quarter of 2008 asset management had a pre-tax loss of $4.1 million which included a minority interest expense of $1.5 million, compared to a loss of $426,000 in the fourth quarter and down from a pre-tax earnings of $18.9 million in the first quarter of 2007. As discussed in our regulatory filings on February 1st, 2008, the Deephaven managers exercised an option to acquire a 49% interest in Deephaven in exchange for the termination of their employment agreements. Following the exercise of the option, pre-tax earnings are allocated between Knight and the Deephaven managers in a similar manner as under their previous employment agreements which included minimum annual distributions for the first fiscal year after exercise.

The first quarter’s minority interest expense of $1.5 million represents the first quarter’s accrual of the one year minimum distribution to the Deephaven managers recorded pursuant to the Deephaven Holdings LLC agreement which Knight filed with its Form 8-K on February 8th, 2008. As previously disclosed the exercise of the option only affected the financial reporting of the profit sharing page of the Deephaven managers. The amount accrued post-exercise of the option pursuant to the LLC agreement is reported as minority interest expense instead of employee compensation and benefits as it is considered distributions to equity owners.

Again, there is no change in how Knight’s share of the pre-tax earnings related to the business is calculated. This only affects the presentation on our income statement and not the economics of our arrangement with the Deephaven managers.

As an additional reminder, we report the net returns from our Deephaven corporate investment with our other strategic investments within our corporate segment and not in the results of our asset management business segment.

Now let’s discuss our corporate segment which includes the returns from our strategic investments and our corporate overhead expenses. For the first quarter our corporate segment had a pre-tax loss of $19 million, compared to breakeven results in the fourth quarter and a pre-tax loss of $339,000 in last year’s first quarter. The P&L impact of our corporate investment in the Deephaven funds was a pre-tax loss of $7 million, compared to a pre-tax gain of $4.9 million in the fourth quarter and a pre-tax gain of $8 million in the first quarter of 2007.

The average balance of our corporate investment in the Deephaven funds was $78 million during the first quarter, down from $194 million in the fourth quarter and down from $193 million in the first quarter of 2007. As you may recall we redeemed $120 million of our corporate investment in the fourth quarter. Our blended return on our corporate investments in the Deephaven funds was negative 8.3%, compared to a positive blended return of approximately 2.4% during the fourth quarter and a gain of 4.2% during last year’s first quarter.

Due to the mix of the Deephaven funds in which Knight has invested the 8.3% loss on our corporate investment in Deephaven funds in the first quarter was slightly greater than the negative 8% overall blended return of all of the assets under management at Deephaven. Remember that the majority of Knight’s corporate investment is in Deephaven’s global multi strategy fund which represents approximately 60% of Deephaven’s overall assets under management.

Now let’s discuss our overall expense trends on a consolidated basis. Consolidated pre-tax margins of 25% are down from fourth quarter consolidated pre-tax margins of 31% primarily due to the performance of our asset management and corporate segments. Compensation, ignoring minority interest expense was 38% of revenues in the first quarter, up from 36% of revenues in the fourth quarter and down from 42% in last year’s first quarter.

In the first quarter of 2008 when factoring in minority interest expense the compensation margin is 39%. Knight’s total headcount was 928 at the end of the first quarter versus 868 at December 31st, 2007. The increase is due to the addition of employees related to the acquisition of Edge Trade as well as general growth.

Given that asset management and corporate revenues have no corresponding transaction related expenses, we look at these expenses on an individual basis as a percentage of net trading revenues plus commissions. Execution and clearance represented 11% of first quarter net trading revenues and commissions as compared to 11% in the fourth quarter and 13% in last year’s first quarter when you exclude the affects of Direct Edge.

These costs fluctuate as a percentage of revenue due to changes in volume, product mix and operational efficiencies and scale. Soft dollar expense represented 9% of net trading revenues and commissions in the first quarter of 2008 as compared to 8% in the fourth quarter and 9% in last year’s first quarter when you exclude the affects of Direct Edge. For the first quarter payment for order flow represented 4% of net trading revenues and commissions as compared to 5% in the fourth quarter and 5% in last year’s first quarter when you exclude the affects of Direct Edge. These costs fluctuate as a percentage of revenue due to changes in volume and profitability.

All other expenses were $30.3 million in the first quarter, down from $32.7 million in the fourth quarter and about the same as the $30.2 million in last year’s first quarter. These costs in the first quarter are on par with the quarterly average of $30.6 million over the past four quarters.

Now let’s discuss our balance sheet. Knight’s financial condition is solid. As of March 31st, we had $222 million of cash on our balance sheet. Additionally we have approximately $74 million invested in the Deephaven funds. We repurchased 1.4 million shares for $22.8 million during the first quarter. Since the inception of the repurchase program we have repurchased 60.6 million shares for $649 million. We had shareholders equity of $934.2 million as of March 31st, 2008.

Using our average diluted shares outstanding for the quarter, our book value is approximately $10.11 per diluted share.

Thank you for participating on our conference call today; now I’d like to turn the call back over to TJ.

Thomas Joyce

Thanks Steve. In the first quarter 2008 we extended the revenue momentum generated in the previous year despite the difficult events testing the liquidity of the global capital markets. In Global Markets we significantly grew year-over-year revenues in a quarter marked by high volatility and at times, inconsistent volumes. The primary drivers included new clients in our electronic market access and trade execution services.

At the same time we increased operational results and expanded pre-tax margins without a leveraged balance sheet. We aren’t burdened by the five to one or six to one debt equity ratios like so many other investment firms. Our results are due to our relentless client focus, not indiscriminately leveraging up our balance sheet. Our business model has certainly proven its value and strength especially when compared with a recent performance of many of our competitors.

In that spirit during the first quarter of 2008, we continued to add to our portfolio of products and services devoted to our clients. We closed the acquisition of Edge Trade which promptly set a new record for their volume in the quarter. Also after much behind the scenes work, we re-launched Knight Bond Point and began a sustained sales initiative targeting our broker dealer clients. We will continue to enhance and refine our trading models and look for new opportunities to add products and services.

In fact on April 14th, two days ago, we announced the establishment of Knight Portfolio Access, a joint venture with Clearbrook Financial. Clearbrook is a small specialized financial services firm catering to investment professionals that serve high net worth investors. Knight Portfolio Access is an open architecture platform which will provide asset management products and services to retail brokerage firms and registered investment advisors offering separately managed accounts.

Heading up the JV, will be industry veteran John Galvin, formerly of UBS, Lincoln Financial and before that Merrill. For Knight the JV represents an opportunity to extend our products and services to our broker dealer clients and increased fee based revenues at the same time. And as of April 10th, Knight Portfolio Access will be a consolidated subsidiary of Knight for financial reporting purposes.

In asset management during the first quarter of 2008 Deephaven performed respectably given the environment and negative direction of certain asset classed strategies. Again, the industry reports out this week on the first quarter hedge fund performance indicate we’re obviously not alone in this regard. While we believe volatility will continue and deleveraging may further depress some stock valuations Deephaven will continue moving forward. Among the immediate priorities, continual institutionalizing the business, speed expansion into Europe and prepare for the launch of a new fund.

And as Steve just indicated, as of March 31st, 2008 Knight had $934 million in shareholders equity which is a book value of $10.11 per share and that’s up from a book value of $9.28 per share at the end of last year’s first quarter.

Looking ahead we’re excited about the progress we are making in enhancing our offerings and our expansion internationally for both Global Markets and asset management. We believe the future is very bright for Knight’s business model.

I want to thank you for your time. At this point I’d like to open up the lines for some questions.

Question-and-Answer Session

Operator

Your first question comes from Ken Worthington - JP Morgan

Ken Worthington - JP Morgan

I just wanted to ask a question about the competitive landscape with regard to two things. One in the servicing of the alternative liquidity providers, to what extent are we seeing or are you seeing more competition there or a change in the way that your competitors are reacting in that or for that customer segment? And then secondly the competitive landscape from the larger bulge bracket brokers, to what extent is the capital constraint that they’re seeing in other businesses kind of flowing over into places where they compete with you and if there are any changes is it helping you out or are you seeing greater competition given the successes that you’ve had?

Thomas Joyce

Ken in terms of the competitive landscape for our KnightLink product which we service what we call alternative liquidity providers, just another name for clients, our KnightLink product has grown pretty nicely obviously over the last year and change. We continue to expect further growth from it both in terms of more clients and hopefully a year from now we’ll be able to talk about the strong performance it’s starting to exhibit in Europe. We hope to launch that later this fall – KnightLink in Europe. We definitely see competition in that space. There are a handful of able competitors but we have been blessed with a lot of very good relationships so we’ve been able to open a lot of doors when we get there. Often times we get there first which is a wonderful thing, but unfortunately like some of the other parts of our business there are competitors and they’re quite able. So the key to us is to expand it as rapidly as possible. Target the clients that we haven’t gotten to yet – target the prospects we haven’t turned into clients yet, and we like our chances there.

In terms of the bulge bracket type firms they have a lot of problems on their hands as we all know. Having said that, they don’t have a lot of problems on their hands in the equity business. They seem to be doing reasonably well in the equity business so the competitive landscape there hasn’t really changed that much. Admittedly in some cases, the eye may be off the ball a little bit but we’ve only seen that in temporary instances so we haven’t really seen any kind of an I’d say door-opening for easy business. There’s no new low-hanging fruit because of the challenges they’ve encountered – most of those challenges have largely left their equity businesses alone.

Ken Worthington - JP Morgan

Thank you. And maybe two technical questions, one, the New York Stock Exchange and NASDAQ have both tweaked prices. Any either direct impact on your transaction costs or thoughts about change of behavior of your customers based on the pricing change that New York and NASDAQ or are they just too small to really make a difference.

Thomas Joyce

I’ll take the second one; we haven’t seen any behavioral change in our customers. Steve you can comment on –

Steve Bisgay

As far as transactional expenses we have not seen [inaudible] or ascernable difference at this point.

Ken Worthington - JP Morgan

Okay and then I think you stated that the Deephaven returns was 8% blended for the quarter, does that include or exclude the impact of the event fund for January?

Steve Bisgay

That is a fully blended return of all the assets under management so yes it includes the results of the event fund.

Ken Worthington - JP Morgan

Okay, what would it have been excluding the event fund?

Thomas Joyce

Well unfortunately if we give you that you can back into certain results directly. It would have been somewhat lower but I don’t know if we want to give the exact details, but it would have been lower because the events funds’ performance was worse than that.

Ken Worthington - JP Morgan

Okay, that’s what we wanted to know, thank you very much.

Operator

Your next question comes from Richard Repetto - Sandler O'Neill

Richard Repetto - Sandler O'Neill

First question is, on London it appears that’s working extremely well. I was just trying to see whether we could get a little bit more detail. I know you talked about cash sales, 100% increase in pre-tax but any more definitive or quantitative on the contribution from Europe?

Thomas Joyce

I hear you and I understand why you’d want to take a little more granular look at it Rich, but unfortunately we’re not in a position to break it out at this point. Arguably, when it gets to be a bigger part of our performance next year, we hope at this time we can speak about it in more detail. But at this point we’re going to keep the specific results within the business.

Richard Repetto - Sandler O'Neill

Okay. Next question, awesome quarter in the margins that the Global Markets were at the 36% level, flat again, the one thing that did jump out a little bit was on the corporate side. If you strip out the impact of Deephaven which we know can be up or down, your investment in Deephaven but it’s still – it looked like the loss at corporate was $12 million versus $5 million in the prior quarter and that run rate of $4 to $5, $6 million so is there something different going on there now?

Thomas Joyce

There’s not a whole lot different but Steve can give you some more detail.

Steve Bisgay

Rich, I don’t think so. Certainly the largest driver of the results of the segment was of course the fee paying results, no question about that. But from an operating expenses perspective quarter-over-quarter they were slightly up over Q4. Operating expenses were about $9.8 million in Q1 versus about $8 million in Q4 and nothing specifically larger impactful. There’s a little bit more in Q1 – we do have some payroll taxes and benefit related costs which are knock-ons from the Q4 bonus cycle which is expected in the first quarter but nothing to speak of.

Thomas Joyce

Yes, we haven’t seen – maybe more generally, Richard we haven’t seen – there are no new trends of our operating expenses at this point.

Richard Repetto - Sandler O'Neill

Okay, I’m just pulling out what you report as a loss and then subtracting the investment in Deephaven from that corporate loss and but we can discuss that offline. You’ve put up two now just robust quarters, and we get some competing factors – you mentioned deleverage and I guess that’s a market sort of affect not a Knight affect. But I’m just trying to see the sustainability of the realization rate. The bar to me has been reset in regards to given all the flow you have, do you look at it the same way that the bar is reset given all the volume at ALP and now it being at the same realization rate and how do you look at the rest of the year versus that versus the deleveraging affect that you mentioned for March?

Thomas Joyce

We definitely are expecting more from ourselves as we’ve experienced the growth and enjoyed the growth we’ve had and we definitely internally are expecting more from ourselves. We of course are still somewhat, well not somewhat; we are still very beholden to volume and volatility. So to answer your question I think specifically we feel very confident in the sustainability of our model assuming volume and volatility profile in the market doesn’t change a whole lot. You give us a bunch of volumes and you give us reasonable volatility we have a lot of confidence that we’ll do well. You know the volumes drop off, the volatility gets muted whatever, the profile, the results will certainly change. But we think, clearly the last six months there was a lot of volume and a lot of volatility and we did pretty well. So you give us that operating environment we definitely have a high bar set for ourselves in that regard.

Richard Repetto - Sandler O'Neill

What do you think that the realization rate would stay in the 1 4 to 1 6 or 1 7 range if volume dropped off 15% to 20% and volatility went say in the at least around the 20 level rather than 25 to 30 on the VIX?

Thomas Joyce

You know I hate making predictions about realization rate but I wouldn’t argue with you too strenuously on that. It would probably drift towards the lower end if the market environment was the one you just described, but I wouldn’t argue with you too strenuously with that bracket, that range you just described.

Richard Repetto - Sandler O'Neill

Great, congratulations on a great quarter.

Operator

Your next question comes from Niamh Alexander - Keefe Bruyette & Woods

Niamh Alexander - Keefe Bruyette & Woods

Good quarter and congratulations. If I could just move back to Deephaven for a second, can you give me a sense of how much of the Deephaven event fund has been winding down? I’m just trying to build a model for going forward.

Thomas Joyce

A reasonable amount has been wound down; we don’t give out specifics because we are sensitive to all the investors certainly. A reasonable amount has been wound down and we have every expectation that over the next several months it will be completely wound down. It’s a little over – it’s probably close to 30% to be a little more granular than I probably would like to be.

Niamh Alexander - Keefe Bruyette & Woods

Okay, just close to 30% wound down by now or left?

Thomas Joyce

Wound down by now with the balance to be done hopefully over the next several months.

Niamh Alexander - Keefe Bruyette & Woods

Okay, that helps. Thanks TJ I appreciate it. If I could just go back to Steve on the Deephaven and the minimum distribution, that’s about 1.4 so just so if you could drill it down for me going forward, if for example Deephaven were to continue to generate an operating loss for the remainder of the year, Knight would still need to pay that minimum contribution to the Deephaven management is that correct?

Steve Bisgay

There are minimum distribution guarantees pursuant to the LLC agreement. Certainly the calculation itself though is complicated and it also speaks to the performance of the funds as well as the business. But yes if we continue to have a downward trend with regard to the performance of the business we would still have the continued minimum distribution on the quarterly basis. It could vary from that number that you saw but you would – but it would be certainly performance related would have the biggest impact on all of that.

Niamh Alexander - Keefe Bruyette & Woods

Okay that’s helpful, thank you. And the other thing is Edge Trade. Can you give me a sense of maybe how much Edge Trade contributed towards the revenues during this quarter and then similarly on Hotspot. I know other businesses have suffered in retail FX. Maybe if you can’t quantify, you could just give me a sense if it has kind of fallen off like other retail FX businesses?

Thomas Joyce

As in much the same way I didn’t answer Rich’s specific question about London we are hesitant to answer specific questions about individual business units. Edge Trade did well. We’re not going to break out the financials. Hotspot is experiencing industry-like trends. I wish I could be more specific but again we don’t want to get too granular in divisional activity.

Niamh Alexander - Keefe Bruyette & Woods

Okay. If I could just move back to the trading part of the core Global Markets which is wholesaling, retail; a lot of that is retail driven. How should we think about this market environment and retail customer? I’d be inclined to think that they are pulling back a little bit. You’d certainly indicated earlier they’re retrenching and maybe more of the speculative activity is it fair to make that assumption?

Thomas Joyce

Again, I wouldn’t argue with you if you pointed that retail has quieted down of late. It’s hard to make any projections around that of course but that’s one of the reasons we’re so focused on building up the KnightLink business. It gives us the chance to diversify away at least somewhat from strict reliance in our broker dealer business on retail flows. So we continue to focus on broadening our client base but in terms of projecting out, of course I’m not going to. But I wouldn’t argue with you that the most very, very recent trends in retail activity have been towards the slower end of recent ranges.

Niamh Alexander - Keefe Bruyette & Woods

Okay that’s helpful. Thanks.

Operator

Your next question comes from Dan Harris - Goldman Sachs

Dan Harris - Goldman Sachs

I was wondering if you could help me, talk me through the execution and clearing fees this quarter. I understand Steve from what you were saying about backing out Direct Edge in the past that it certainly has a somewhat different impact on the numbers would otherwise show, but it certainly seems like its continuing to decline as a percentage of revenues. I was wondering if revenues continue to increase and where can that percentage go, could it continue to move lower than what I’m looking at – like a 10.8% this quarter?

Steve Bisgay

Dan the reason of course that I stripped out the impact of the corporate returns as well as asset management is just that – the denominator can really swing as we see year-over-year, quarter-over-quarter pretty dramatically. But if you look at it solely on – from a Global Markets perspective and more specifically focusing on commissions and net trading revenues as I did in my prepared remarks there quarter-over-quarter we’re talking about a pretty consistent 11%. It was technically as you pointed out 10.8%, it was 11.3%. We did see year-over-year dramatic operational efficiencies given the growth of the business, the platform and the like and with that we saw execution and clearance margin of almost 13.5& nearly 14%.

Thomas Joyce

I’d just like to add two things to that if I could Dan. One is our clearing rate has dropped because we’re relatively relentless negotiators with our clearing agent and we did see a slight drop in our clearing rates which is obviously good news. Secondly we have absolutely focused some of our trading styles to reduce the taking of liquidity on ECNs to the extent that we can and try to add to the posting of liquidity on ECNs. So we are trying to be very disciplined in how we trade with ECNs; i.e. to reduce what we pay out and increase what we get back and I think you saw some of that starting to pay off in Q1.

Dan Harris - Goldman Sachs

It certainly did and I would even argue that a 50-basis point sequentially is a – has a significant impact on your overall margins. So that is very helpful information. And TJ, I was hoping I could follow-up with you, you mentioned deleveraging a couple of times throughout the course of your commentary and certainly the impact on credit and the structured products are pretty apparent and easy to understand. Can you sort of help me frame what you’re seeing on the equity side as it relates to the deleveraging, maybe it’s from different funds or from the sell side balance sheet? And as I understand it there’s still at this point anyway, given some of the [long-shorts] have pulled some money off the table, there’s just a ton of capital and leverage available when the markets potentially stabilize and how would you characterize that going forward?

Thomas Joyce

We’ve mentioned deleveraging a couple of times because as you all know we run 95%, at times even more than that, 95% of the order flow that we handle is handled by algorithms. These algorithms are built to produce a yield from this order flow and there’s a variety of different styles and models within the algorithms that we deploy and some of these algorithms are much – are very sensitive to what some of the large quant funds are doing in the market to be frank. Because some of the algorithms have things like momentum models built into it, some of the algorithms have things like regression to mean built into it. Some of these investment strategies are similar of course to what some of the larger quant funds deploy as well. So if there’s too much money chasing those particular strategies it impacts our ability to produce yields from the flow, as you might imagine. So when there’s a deleveraging with some of the monies leaving the space we think that has contributed to our better performance over the last six months. Remember this started last August and while August itself was a bit of a debacle we saw things get better in September. And nothing goes in a straight line in this business of course, but as deleveraging takes place in the industry i.e. there’s somewhat less competition for some of these investment strategies we think that is net positive to the way our algorithms will behave when handling our clients’ flows.

Dan Harris - Goldman Sachs

That’s interesting so for you on the equity cycle – certainly your volumes remain high but that’s actually a positive. Okay. And then I’ll just touch on the Deephaven investment a little bit. How do you think about that investment at this point? You’ve obviously lowered it and I’m sure that you’re going to say that you’re happy with where it is but is there a reason why you do keep that $73 million investment at Deephaven rather than investing it in something that may be a little less risky in an environment like this or do you have a contractual obligation to keep any of those funds there?

Thomas Joyce

Dan, I’m happy with the investment the way it is. We support Deephaven. It’s in a variety of funds and in the past we have been able to seed some of their funds. We support them. Now we of course have fiduciary responsibility for other things we focus on and we thought it would be a much better way – there were much better ways to deploy our cash and so we took out a whole bunch of money in Q4. But we continue to support Deephaven. We watch that very closely. We don’t have any other driving urgent needs for some of those funds at this point so we continue to invest with them as long as that is, you know, literally excess cash. And we probably will continue to invest in them because we have a high degree of confidence in their abilities notwithstanding the toughness of Q1. To specifically answer the last part of your question there are no contractual agreements between the parent and Deephaven the subsidiary in terms of a minimum amount of funds to keep there.

Dan Harris - Goldman Sachs

Okay TJ thanks. Great quarter.

Operator

Your next question comes from Joseph Edelstein - BMO Capital Markets

Joseph Edelstein - BMO Capital Markets

Just want to follow-up and I know you’ve already not gone into too much detail on some of the smaller businesses, but I just want to come back to London. Can you tell us a little bit about the behavior of client trading in Europe? What types of products are they trading or kind of from another side, is it more US clients that are trading European listings?

Thomas Joyce

Again without getting into any of the financials we see about a 70-30 blend of our European business in European clients trading European ordinaries and European clients going into the US. So it’s a much, much more heavily weighted local business than it is sort of across the pond kind of business which we think is very healthy. Obviously if we’re going to make our presence in Europe grow we need to transact and transact well in the local ordinaries. So that blend we think is good news. Secondly the presence we have in London is very similar to the large sales trader presence we have in the US. It’s the voice part of our hybrid model. There are a little over 15 or so sales traders in there calling on accounts, providing liquidity and market insights and giving them the clients’ service that they like and then they reward us with our efforts with orders that we then deploy in our liquidity pool. So it’s very much a traditional voice business with very much a focus on the local European markets.

Joseph Edelstein - BMO Capital Markets

Do you have much presence with the retail brokers there as you do here in the States?

Thomas Joyce

No, we do think one of the opportunities over there is in fact that and we think we need to have our trading software adapted to trade with ordinaries, with European ordinaries, no doubt starting with the LSC, the UK stocks because they’re a deep liquid pool and we believe our algorithms will fit quite nicely within that model. But at this point most of the flows coming out of Europe for us are institutionally oriented. We expect that to continue for a while and we also think the retail opportunity over there is real and will grow now that MiFID has been enacted.

Joseph Edelstein - BMO Capital Markets

Thanks.

Operator

Your next question comes from Roger Freeman - Lehman Brothers

Roger Freeman - Lehman Brothers

Just wanted to follow-up on a few things that have been asked already, I guess around the trading environment, can you – if you were to rank the month during the quarter it sounds like from your prepared comments the best month would have been January followed by February and then March the weakest. Is that a fair assessment?

Steve Bisgay

January definitely, February March tied for second.

Roger Freeman - Lehman Brothers

Okay I guess with March sort of having been a peak in the de-levering I was wondering if maybe that one was a step function below i.e. would we have maybe seen a basis point capture rate point one higher or so?

Thomas Joyce

You know its such a nuance view at that point. If you really wanted to pair it down, it was and we already reported it was January and then February with March right behind it. So they were very similar months in many respects.

Roger Freeman - Lehman Brothers

And I guess just sort of tied to that I’m curious just more from a macro perspective because I know you obviously focused on that business on a pre-tax basis, if we then back into the what we think are institutional trading bin, it looks like it was down sequentially versus market volumes obviously being up overall. I’m curious if you view the results that way and if that say anything to your hedge fund client base as you tend to service the sort of smaller mid-sized hedge funds in that business, about what their trading activity was like obviously due to de-levering?

Thomas Joyce

Unfortunately our client blend is weighted towards hedge funds but not dramatically so. We have a large, large base of shall we say traditional clients. And the actual revenues that we enjoyed in the institutional business, while we’re not going to break them out overly specifically, but the revenues were up 6%. So we actually saw – we saw growth in our institutional business in Q1.

Roger Freeman - Lehman Brothers

Okay great and what was the percentage of volume that came through KnightLink; I think it was 16% last quarter?

Steve Bisgay

That was actually up a little bit from there Roger, its 19% for this quarter.

Roger Freeman - Lehman Brothers

Okay and again you’ve got all the large clients on that that customers have been targeting right, that’s just sort of incremental pick up from existing customers?

Thomas Joyce

I don’t know if we have all of them but we have a bunch of them and we need a bunch more.

Roger Freeman - Lehman Brothers

Any update on manning as it applies to the Bulletin Board; we haven’t seen any updates on that. I know it had been delayed. Did it get implemented during the quarter?

Thomas Joyce

No, but there’s two things there. One is and no I don’t have an update on it but two is the Bulletin Board business unfortunately has gotten slower and slower. Clearly the retail investor has pulled in his and/or her speculative horns as it were because the Bulletin Board and Pink Sheets base is just quiet. We have a pretty attractive market share in the space so we pretty much see what’s going on there as soon as anybody and the volumes in the space are down. So of course the smaller the business is the less any impact of a regulatory change would be frankly. So that’s sort of a two-edged sword. We’re not happy the volumes are down and that’s a macro event, that’s not relative to us but at least if there’s any regulatory impact off of the lower base if will have less impact.

Roger Freeman - Lehman Brothers

Okay and then one question on Deephaven, I think you talked to the North American event fund, how much that’s been wound down. How successful have you been in migrating some of that AUM over to the European fund?

Thomas Joyce

I don’t think I can speak specifically about which client did what and how much of that went from here to there. I can tell you though that the European event fund is doing quite nicely and it has done a very particularly nice job in attracting assets under management. In fact, I think they’re close to their target in terms of AUMs so the European event fund has been a bright spot.

Roger Freeman - Lehman Brothers

Okay and then again back on the environment sort of thinking about the here and now. We’ve seen a market slowdown in volumes across sort of equities, options, futures, fixed income ever since the Fed opened up the discount window to the large cap brokers, is there any reason to believe that sort of that trend we’re seeing would not be affecting you at the same degree as the broader industry?

Thomas Joyce

Well I think I will revert back to the two Vs. The volume and volatility are big, big components of our results to the extent that either of those two metrics change, you can leap to your own conclusions.

Roger Freeman - Lehman Brothers

Thanks a lot.

Operator

Your final question comes from Christopher Allen - Banc of America

Christopher Allen – Banc of America

Just two quick questions, one when I strip out the US core equity revenues which I estimate about $154 million, the other revenues kind of in as a trading piece about $59 million which is up about $15 million sequentially. What drove the sequential growth in that other bucket? Was it London, was it Hotspot?

Steve Bisgay

Well again I guess as TJ mentioned Chris, I don’t know that we give specific clarity around the businesses themselves. There certainly was a broad uptick overall in terms of revenue quarter-over-quarter slightly. But it’s not specific with regard to any individual –

Thomas Joyce

Yes, I don’t know if we could point to any one area that leaps off the page. Continued growth in KnighLink was probably – if I had to point to one thing I’d probably point to that.

Christopher Allen – Banc of America

And then just one quick question on the tax rate chunk; pretty meaningful on a sequential basis, the 40.7%. Is that a real tax rate to use going forward? Was there any impact from Deephaven in there?

Steve Bisgay

No there’s definitely not an impact from Deephaven in there. Our tax rate is certainly a provision and assumption that we make throughout the course of the year. We do as you would imagine, we do – we calibrate things over time. I would think that the rate will hover around the 39% to 40% level and will continue to be there at that level going forward.

Christopher Allen – Banc of America

Great, thanks.

Thomas Joyce

At this point I want to thank all of you for dialing in and listening to our quarterly conference call. I appreciate the attention and appreciate the support and I hope you all have a wonderful day. Thank you.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Knight Capital Group Inc. F1Q08 (Qtr End 03/31/08) Earnings Call Transcript
This Transcript
All Transcripts