Knight Capital Group Inc. Q2 2008 Conference Call Transcript

Jul.16.08 | About: KCG Holdings, (KCG)

Knight Capital Group Inc. (NITE) Q2 2008 Earnings Call July 16, 2008 10:00 AM ET


Margaret E. Wyrwas - Senior Managing Director, Investor Relations

Thomas M. Joyce - Chairman and Chief Executive Officer

Steve Bisgay - Senior Managing Director and Chief Financial Officer

James P. Smyth - Executive Vice President


Roger Freeman - Lehman Brothers

Richard Repetto - Sandler O'Neill

Niamh Alexander - Keefe Bruyette & Woods

Christopher Allen - Banc of America

Ken Worthington - JP Morgan

Michael Vinciquerra - BMO Capital Markets

Daniel Harris - Goldman Sachs


Welcome to the Knight Capital Group second quarter earnings conference call. Today’s conference is being recorded. Our presenters today will be Chairman and Chief Executive Officer, Thomas Joyce and Chief Financial Officer, Steven Bisgay.

As a reminder we will be conducting a question-and-answer session following the presentation and now to kick-off our program I’d like to turn the call over to Marg Wyrwas, Senior Managing Director of Communications, Marketing and Investor Relations.

Marg Wrywas

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 email and fax list please contact a member of the CMIR team.

I am pleased to welcome you to Knight’s second quarter 2008 conference call and webcast. With me in the room today are Tom Joyce, Chairman and CEO; and Steve Bisgay, Senior Managing Director and CFO, who will make formal remarks. Jim Smyth, Executive Vice President and Greg Voetsch, Executive Vice President are also in the room today.

Before we begin, I’ll 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 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 U.S. Securities and Exchange Commission including without limitation those detailed under the heading “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 the SEC from time-to-time.

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 the SEC from time-to-time and now I would like to turn the call over to Knight’s Chairman and CEO, Tom Joyce.

Tom Joyce

The second quarter 2008 revealed that it’s clear the credit crisis is not over. Daily headlines are highlighted in the overall stresses in this system. So the 2P’s are fear and uncertainty combined to make the markets extremely challenging. Within that context we are very proud to say that Global Markets posted yet another strong quarter despite declining volatility and broad market volumes that were somewhat tapered. The VIX averaged 20.7 in the second quarter versus 26.1 in the first quarter. In May the VIX stayed below 20 for the first time since the outset of the credit crisis last summer.

Our volumes tracked ahead of expectations in April and May before trading off somewhat in June as the May, June indexes were in a steep decline. The financial result in Global Markets reflects the success of our virtual exchange model and growth strategies, not to mention the tremendous operational efficiencies from our superior trading technology and scale; the type we bid today about stepping up efforts to explore our model and approach to trading overseas.

In asset management, Deephaven’s started to get back on-track during one of the worst performance period ever recorded for the hedge fund industry. According to hedge fund research, hedge funds in the group are down 0.75% year-to-date, which represents the worst first half performance since the HFR began tracking returns in 1990. During the same six-month period Dow Jones Industrial average declined to 14.4%, the SMP 500 was down 12.8% and the NASDAQ composite index fell 13.5%. At the end of the second quarter the U.S. equity markets were nearing official classification at the bear market. In short, it’s tough out there. That makes our success all the more remarkable.

Turning to our financial results, Knight’s total earnings in the second quarter 2008 were $0.32 per share, which was 33% higher than the $0.24 per share in the second quarter of 2007. Global Markets contributed $0.42 on pre-tax earnings of $64.4 million, about doubled the second quarter of 2007.

Asset management lost $0.05 on pre-tax loss of $7.9 million and the corporate segment gave back $0.05 on a pre-tax loss of $7.2 million. The firms pre-tax earnings for the second quarter 2008 were $49.4 million compared to $39.9 million in the second quarter of 2007.

Consolidate pre-tax margins for the second quarter 2008, were 23%, again exceeding our previously stated goal of 20% across market cycles, compared to consolidate pre-tax margins of 20% for the second quarter of ’07. The total revenues for the second quarter 2008 were $219 million, compared to $201 million for the second quarter 2007.

Now, turning to Global Markets; revenues for the second quarter of 2008 were $201.3 million, which is a 22% increase from the second quarter of 2007. The average daily equity trades for the second quarter of 2008 increased 60%, again for similar time period in ’07. Average daily dollar value traded rose 67% again against the second quarter of ’07. The average daily shares traded decreased 9% from Q2 of ’07 and that’s a reflection of the continued weakness of the Bulletin Board and Pink Sheet sector.

Looking at the first half of 2008, the average daily equity trades were up 60% from the first half of ’07. The average daily dollar value traded was up 74% and average daily shares traded decreased 13%. The dramatic gains, daily equity trades, and dollar value traded are driven by new client growth plus our electronic market access and trade execution services, which allow us to work with more clients of diverse sizes, strategies and styles as well as handle considerably more trade volume.

Some highlights: Broker-dealer electronic trading consistently leads the industry with superior execution quality and has a consistent revenue generator. Knight Direct is growing volumes and commissions when compared to the second quarter of ’07 and recently added trading capabilities and foreign exchange in European ordinaries.

KnightLink continues to bring new clients and order flow into Knight. Hotspot FX turned in a very nice quarter and Knight BondPoint began a sustained sales initiative earlier this year, which has resulted in several high profile new clients. Our sales traders, block traders and cash traders continue to provide actionable market intelligence and trading insights for clients in a downward market. Specifically, our ability to source liquidity and minimize market impact in spite of the conditions demonstrates the specific skills that we could bring to bear on behalf of our clients.

Pre-tax income from London while solid was held back a bit by costs incurred for our expansion in Europe. The second quarter pre-tax margins are up 32% across Global Markets, a function of the growth of electronic market access and trade execution services as a percentage of revenues that continue the refinement of current trading models and introduction of new ones and internal efficiencies realized through our superior trading technology in tremendous scale.

Again pre-tax margins we believe are a far more relevant and accurate indicator of how we are functioning than revenue capture and while I discouraged people from putting too much emphasis on revenue capture, I realized many of you still look at it and in the past our revenue capture is tended to plateau within certain ranges overtime, but again I want to caution everyone because by the very nature of the models we use to handle the majority of outflow, the revenue capture range will move in somewhat unpredictably.

For example, we’ve recently introduced a couple of models that we believe will allow us to interact with a lot more flow. These models appear to be nicely profitable, so we will continue our deployment of them, but they will likely drive overall revenue capture lower. Remember, this is a good thing. We are positioning Knight to drive greater revenues with attractive margins, even though the revenue capture per dollar volume trade is dropping. In fact with some models they could drop below one basis point.

So while revenue capture is an interesting metric, it does not reflect where our business is going, rather it depicts where our business has been. As long as our trading models are dynamic creations, which we intent to be the constant state here, we will be hesitant to encourage analysts to spend too much time on revenue capture; our focus is on pre-tax margins. We will maintain our focus on achieve pre-tax margins of at least 20% across market cycles.

During the second quarter of 2008, we made further progress in executing the growth strategy and expanding fee-based revenues in three areas. First, we formed a joint venture called Knight Portfolio Access, which is an open architecture platform to provide products and services to retail brokerage firms and registered investment advisors offering separately managed accounts, SMA’s, which is to say we are bringing in a top-flight asset management product to their clients.

SMA is one of the fastest going segments for sponsored firms. According to industry analysts assets held in SMA’s grew to $869 billion in 2007 and are projected to reach $2.8 trillion in 2012. Knight Portfolio Assets is designed to help firms expand their offerings, attract assets and generate additional fee-based recurring revenues and since the announcement we have signed up several institutional quality investment managers and have begun discussions with the major SMA sponsors starting with IRA’s including wirehouses, regional broker-dealers, independent planner firms and banks.

Second, we announced the acquisition of Libertas Holdings; an institutional fixed income broker-dealer specialized in a high-yield and high grade corporate bonds, distressed debt, asset-backed and mortgage-backed securities, and convertible bonds and syndicated loans. After the deal closed the $75 million paid comprised of $50 million in cash and $1.45 million of unregistered shares and I’d like to add a potential $75 million earn out included in the deal, is staggered and tied to a series of performance benchmarks.

Libertas gives us fixed income capabilities to offer our more than 1,700 institutional clients. Given the tendency of many institutional clients to employ strategy that combined equities of certain fixed income securities like high-yield and distress debt, the potential is significant to particularly given the type of market we are in now.

Libertas also has approximately 600 institutional relationships of it’s own with the close of the acquisition on July 11, we’ll turn our attention to cross-selling equities and fixed income to the respective client basis. Gary Katcher, founder and CEO of Libertas, has joined Knight as Senior Managing Director and Head of Global Institutional Fixed Income.

The third item, I would like to point out is Knight Transition Management and the expansion of services we provide to help plan sponsors and investor managers, preserved value and mitigate risk and transitions traded by an asset allocation shift or change in fund manager or some other events. Of the estimated $3 trillion in assets that are transitioned annually approximately 45% are handled by third parties such as Custodian Bank consultant and execution brokers.

As a specialized discipline, Transition Management is also highly complementary to other global market offerings. Knight currently has more than 400 planned sponsor clients through Donaldson and company, which provides commission management programs. In addition our program trading does often play the critical role in transitions during the conversation from legacy to target portfolios.

Knight’s success to-date is based on our hypermarket model for accessing the global capital markets in multiple asset classes and expertise in trading across fragmented markets. Our focus is to provide buy and sell side clients with consistent high quality trade executions. Our financial results demonstrate an ability to grow revenues, pre-tax earnings and margins in a hyper competitive U.S. market and we believe there are substantial opportunities overseas, particularly in Europe right now, when listed with respect to last fall triggering numerous market structure changes.

The expected benefits are many, including the establishment of a single regulatory framework across member states, increased competition among market centers and greater transparency in the trade execution process. However, firms will also have to manage the challenges such as increasingly fragmented liquidity, trading technology gaps and modernizing clearing and settlement.

As the landscape there shifts, we believe this presents an opening. We are adding to our organization. For example just this morning, we announced the hiring of Bradley Duke formerly Jefferies to lead our Institutional Electronic Sales effort in Europe. To be certain there will be costs associated with expanding our presence there. Right now, we have a profitable voice trading business in London.

We’ll need to make further investments to intersect, build out our quantitative and electronic trading capabilities in the form of trading technology, larger office space and addition talent in order to compete. Plus we’re starting to lay the groundwork for expansion into Asia. In the second half of 2008, we’ll work towards establishing a voice team in Hong Kong, expected to open sometime in early 2009, which will also require investments.

Turning now to Asset Management, Deephaven’s fund performance improved measurably during the second quarter of 2008. Thanks to increased liquidity in anticipation of certain technical dislocations in the market from the first quarter of 2008. Deephaven’s blended fund performance for the second quarter was a positive 2.8% excluding the performance of the Event Fund, which is in the process of being rundown, blended fund performance was 4.5%.

In contract the HFRI relative value, multi-strategy index was down 0.92% in the second quarter. Looking at some of the economic data from the second quarter, fear of negative near-term developments was a major factor behind June’s perceptive declines. Deephaven believes this was evident by a jump in one month’s implied volatility, which did not extend its elongated implied volatility.

Speaking broadly, a continued focus on fundamentals which we began to see in the second quarter should benefit Deephaven strategies and holdings in the recent months ahead. A retreat into markets driven by technical factors however is a real concern given the events of the last few weeks in June.

Deephaven generated asset management fees of $14.4 million and recorded a pre-tax loss of $7.9 million, which was due largely to a lower level of incentive fees as well as compensation expenses. In comparison Deephaven generated asset management fees of $29.1 million and pre-tax earnings of $6.3 million in the second quarter of 2007. As of July 1, assets under management were approximately $3.3 billion. In comparison AUM as of July 1, 2007 was $4.2 billion. The decrease is primarily due to the closing of the Event Fund as well as the negative performance of certain other single-strategy funds.

While Deephaven improved during the second quarter, fund performance year-to-date still lags expectations. Given the industry wide performance issues I mentioned earlier investors are now far more discerning with allocations. Deephaven will have to continue the positive fund performance to regain momentum and built AUM.

So, at this point I would like to turn the call over to Steve Bisgay, for a more detailed financial review of the first quarter. I will return with some closing remarks and then of course we’ll be available for questions. Steve?

Steve Bisgay

Before I review the business segment results I would like to briefly recap our overall quarterly performance. Our earnings were $29.4 million or $0.32 per diluted share. Pre-tax earnings including minority interest expense of $1.1 million were $49.4 million during the quarter.

The main components of our second quarter pre-tax results are $64.4 million of earnings from Global Markets, which represents $0.42 per diluted share offset by a loss of $7.9 million from asset management which represents a loss of $0.05 per diluted share and a loss of $7.2 million from our corporate segment which also represents a loss of $0.05 per diluted share.

Let’s review the results of our business segments, starting with Global Markets. Global Markets revenues were $201.3 million during the second quarter, down 9% from the first quarter and up 22% from the second quarter of 2007, excluding Direct Edge, which was deconsolidated at the end of the third quarter of 2007. Global Markets revenues were up 33% compared to last year’s second quarter.

Global Markets had pre-tax earnings of $64.4 million during the second quarter, down from the earnings of $78.9 million we achieved in the first quarter. When we exclude Direct Edge, Global Markets pre-tax earnings were up 91% from $33.8 million in last year’s second quarter.

Knight’s U.S. equity dollar volume traded in the second quarter was up 8% from the volumes in the first quarter and was up 70% from last year’s second quarter. On an average daily basis, dollar volumes were up 3% from the first quarter and up 67% from last year’s second quarter.

A significant driver of this increase was new clients and strategies. These new clients and strategies contributed to the continuing 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 more than doubled since the second quarter of 2007.

We continue however to see a decline in the speculative retail activity, as evidenced by the decline of the Bulletin Board volumes and the overall market. In the current environment Bulletin Board activity continues to have less impact on the results for our Global Markets business.

Pre-tax margins for Global Markets was 32% during the second quarter, marking our third consecutive quarter in which Global Market’s pre-tax margins exceeded 30%. This trend is primarily the result of the growth and success of our electronic trade and execution products. In addition our strong pre-tax margins reflect expansion of that platform and the benefits of operating leverage and scale.

We planned to continue to develop our hybrid market model through innovation and investment at the new geographies. We are investing within Global Markets to further cultivate our electronic and voice trade execution products and leverage our infrastructure. An example of this is our International expansion and development of voice and trade access products into new and existing markets, including Europe and Asia.

In addition, we continue to invest in developments on initiatives, such as Knight Portfolio Access and Knight Capital Partners to better serve our clients, expand our product offering and leverage our platform.

During the second quarter, the combination of our international expansion and developments on initiatives on a net basis result in a charge representing approximately $0.01 per diluted share. As these investments progress in the second half of the year, we expect that they will have a greater impact on the quarterly results for the reminder of 2008.

Now let’s review the results from our Asset Management segment. In the second quarter Deephaven rebounded from one of its most challenging quarters to post a positive blended return of 2.8% across all assets under management. When excluding the Event Fund, which is in the process of being rundown, the blended fund return was positive 4.5%.

As a point of reference, Deephaven had a negative blended return of 8% during the first quarter and a positive blended return of 2% during the second quarter of last year. Deephaven recorded net asset management fees of $14.4 million during the second quarter down from asset management fees of $15.2 million in the first quarter and down from $29.1 million in last year’s second 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 $9.2 million during the second quarter down from $9.8 million in the first quarter and down from $10.1 million in last year’s second quarter. Average assets under management during the second quarter of 2008 was $3.4 billion, down from $3.6 billion in the first quarter and down from the average of $4 billion in last year’s second quarter.

The decrease in assets under management was principally affected by the distribution of the Event Fund assets relating to the closure of the fund as announced as part of an 8-K filing on January 31, 2008. As disclosed in that filling, we are not collecting any management fees from the assets under management in the event fund as we wind down these investments. As of July 1, 2008, Deephaven’s total assets under management were approximately $3.3 billion.

Incentive fees, which vary based on the funds returns were $5.2 million in the second quarter down slightly from $5.4 million in the fourth quarter and down from $19 million in last year’s second quarter. Please note that we do not earn incentive fees for certain funds in the second quarter of 2008, despite the positive blended returns for the period as a majority of Deephaven’s funds still have negative returns on a year-to-date basis. Until these funds achieve positive year-to-date returns no incentive fees will be recorded.

In the second quarter of 2008, asset management had a pre-tax loss of $7.9 million, which included minority interest expense of $1.1 million. These compares to a loss of $4.1 million in the first quarter, which included minority interest expense of $1.5 million and pre-tax earnings of $6.3 million in the second quarter of 2007.

Effective February 1, 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 agreement, which included minimum annual distributions for the first fiscal year after exercise.

The second quarter’s minority interest expense of $1.1 million represents the second quarter’s accrual of the one-year minimum distributions with Deephaven mangers reported presumes the Deephaven Holdings LLC agreement. As previously disclosed the exercise of the option only effected the financial reporting of the profit sharing paid through the Deephaven managers.

The amount accrued presumed to the LLC agreement post exercise of the option 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 Knights share of the pre-tax earnings within the business is calculated. This only effects the presentation on our income statement and not the economics of our arrangement with the Deephaven managers.

As an additional remainder we’ve reported 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 segments; which include the returns from our strategic investments and our corporate overhead expenses. Towards the second quarter our corporate segment had a pre-tax loss of $7.2 million compared to a loss of $19 million in the first quarter and pre-tax earnings of $868,000 in last years second quarter.

The P&L impact of our corporate investment in the Deephaven’s funds was a pre-tax earnings of $2 million compared to a pre-tax loss of $7 million in the first quarter and a pre-tax gain of $6.3 million in the second quarter of 2007. The average balance of our corporate investment in the Deephaven’s funds was $77 million during the second quarter, down from $78 million in the first quarter and down from $200 million in the second quarter of 2007. As you may recall we’ve redeemed $120 million of our Deephaven Investment in the fourth quarter of 2007.

A blended return on our corporate investments in the Deephaven funds was 2.7% compared to a negative blend of return of approximately 8.3% during the first quarter and again a 3.2% during last years second quarter. Due to the mix of the Deephaven funds in which Knight has invested, a 2.7% gain on our corporate investment in the Deephaven funds in the second quarter was lower than the positive 4.5% overall blended return of all the assets under management of Deephaven excluding the Event Fund.

Remember that a significant percentage of Knight’s corporate investments 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 23% in the second quarter were down slightly from first quarter’s consolidated pre-tax margins of 25%, primarily due to the performance of our asset management segment. Compensation excluding minority interest expense was 38% of revenue, both in first and second quarters down slightly from 39% in last year’s second quarter.

When factoring in minority interest expense the compensation margin was 39% for both the first and second quarters. Knight’s total headcounts was 946 at the end of the second quarter, versus 851 at June 30, 2007. The increase was due to the addition of employees related to the acquisition of EdgeTrade in the first quarter as well as growth related to our expansion and new product initiatives.

Given that asset management and corporate revenues have no corresponding transactional related expenses, we look at these expenses on an individual basis as a percentage of total net trading revenues plus commissions. Execution and clearance represented approximately 12% of second quarter net trading revenues and commission which is consistent with the first quarter and down from 14% in last year’s second quarter and they exclude the effects of Direct Edge. These costs fluctuate as the percentage of revenue due to changes in volume, product mix and operational efficiencies and scale.

Soft dollar expenses represented 8% of net trading revenues and commissions in the second quarter of 2008 as compared to 9% in the first quarter and 10% in last year’s second quarter, when you exclude the effects of Direct Edge. For both the first and second quarters, payment for order flow represented 4% of net trading revenues and commissions as compared to 5% in last year’s second quarter when you exclude the effects of Direct Edge. These costs fluctuate as a percentage of revenue due to changes in volume and profitability.

All other expenses were $37.4 million in the second quarter, up from $30.2 million in the first quarter and up from $25.9 million in last year’s second quarter. These costs in the second quarter are higher than the quarterly average of $30 million over the past four quarters due to the increased cost related to our general growth and our international and hybrid market expansion efforts.

Now let’s discuss our balance sheet. Knight’s financial condition remained solid. As of June 30, we had $332 million of cash on-hand on our balance sheet. Additionally, we have approximately $77 million invested in the Deephaven funds. We repurchased 401,000 shares for $7.1 million during the second quarter. Since the inception of the repurchase program, we have repurchased 61 million shares for $656 million. We had shareholders equity of $964.9 million as of June 30, 2008. Using our average diluted shares outstanding for the second quarter our book value is approximately $10.42 per diluted share.

Finally, late in the second quarter, we drew down the remaining $70 million of our credit facility, which will be used for various corporate purposes. Thank you for participating on our conference call today.

Now, I would like to turn the call back over to T.J.

Tom Joyce

In the second quarter of 2008 we continued to post strong financial results in a market environment that remained tough, due to the continuing effects of the credit crisis. After mid-year we are appreciably ahead of where we were in 2007 and as you recall the first half of 2007 was clear sailing in the market we were appreciably ahead of where we were in 2007 on an earnings per share basis.

In Global Markets we grew revenues, pre-tax earnings and the margins year-over-year for the second quarter, while continuing to expand and diversify trade volumes across large mid and small cap stocks. We are executing on the growth strategy by expanding products and services, growing the client base, capturing an ever greater share of client trade volume across asset classes and cross-selling related products and services.

The acquisition of Libertas, renamed Knight Libertas following last week’s close, is an important development in expanding our institutional client offering and building liquidity as fixed income. We’ve transformed our offerings and fundamentally changed the underlying dynamics. Superior front and back-end trading technology allows us to process trades more efficiently and profitably.

Constantly, enhancing current trading models while developing new ones positions us to better serve our clients. Growing the client base and increasing internal efficiencies will continue to serve us well even if they are somehow predictive. Broad stock market declines decelerate a bit, I should say broad stock market volumes decelerate a bit and/or the markets continue their downward trajectory.

In the second half of 2008, we’re planning to make meaningful investments in Europe as of course mid-term market construction structure changes create conditions we believe favor our virtual exchange, our approach to trading and our client centric philosophy. Additionally, we’ll be investing in our Hong Kong presence, working towards establishing voice trading to open an early 2009.

In Asset Management, during the second quarter of 2008, Deephaven started to get back on track during one of the worst performance period ever recorded for the hedge fund industry. Blended fund performance exceeded the relevant HSRI benchmark indexes. While the results are encouraging Deephaven has to sustain its performance in what is a defining period in the history of the hedge fund industry.

To recap, the second quarter of 2008, Global Markets turned in another excellent quarter and has been consistently profitable for the past 12 quarters. In addition, Global Markets have achieved three consecutive quarters of pre-tax margins greater than 30%. We’ve demonstrated an ability to grow revenues, pre-tax earnings and margins in the hypercompetitive U.S. equities markets. We will continually work to improve upon our offering and we are now making investments to grow in Europe and Asia.

When considering all we’ve accomplished and the immediate opportunities ahead, I am extremely excited about our long-term prospects. Thank you for your time today and we will now open up the line for questions. Erin?

Question and Answer Session


(Operator Instructions) Your first question comes from Roger Freeman - Lehman Brothers.

Roger Freeman - Lehman Brothers

If I look at net trading revenues and then commissions and fees, so commission and fees were up sequentially 1Q and 2Q with pretty weak market volumes. Can you comment just in aggregate what’s really driving that? You’d touched on a number of those things on this call and is it general from market share increase with some of the challenge that other brokers are facing.

Has that been part of it or is it just better cross selling and you can update us on so where your cross selling penetration is now versus last quarter and on the trading revenue side that actually was down more than the overall market; maybe you could just talk a little bit to that. It seems like you have actually been picking up more of the broker-dealer flows. I would have expected that to be a little bit higher, maybe just a sequential comparison.

Tom Joyce

Well, obliviously we think the model is working. We have a model that is light on leverage that focuses on attracting as much order flow as possible and we have built quantitative trading models which handle the flow in an incredibly efficient manner. In point of fact we have developed and constantly developing new models which add to our scope. So we’ve been able to take in new flows from yet before sources that we have not been able to access. So, in point of fact the model is working. It’s as simple as that. We have had expanding market share in the institutional business. The broker-dealer business again is building new models to access more volumes. We continue to build on its success. It’s really pretty straight forward.

Roger Freeman - Lehman Brothers

In the trading revenue or the net trading revenues, those were down more than market volumes were despite increased penetration on the broker-dealer flow, so you can certainly talk to the captured, that comes down but you think of the revenues themselves will still being keeping track with volumes right?

Tom Joyce

Well the revenue capture has definitely changed. The portfolio revenue capture has definitely changed because we introduce new models all the time. So the profile will look differently in point of fact our scope is expanding, so when you’re in position, you ask for further success. So, we look forward to building out new models and adding to this as we move forward because we think the team is well-positioned to increase our market share in several areas.

Roger Freeman - Lehman Brothers

If you look at pre-tax margins in Global Markets, which has been more your focus rights in revenue capture, that came down a bit and I know there is some cost relative to the build outs, but you have those last quarter or two. If you think about that incremental flow coming on and margins actually being down a little bit sequentially is there any reconciliation around that or is there some new volumes? Is it still at this point dilutive to overall pre-tax margin in Global Markets or is it added as yet?

Steve Bisgay

It’s clearly added.

Tom Joyce

It’s clearly added. I think Roger the impact on margins what you’re seeing from a 35%, 36% down, to the investment that we’re looking at now in expanding our product base and our geographies went into effect more so this quarter than we saw in prior quarters and with that in fact I would expect that our expenses, our other operating expenses unlike as they’re higher this quarter I would expect that we are going to see that investment. You’re seeing the benefits or the impact in this quarter and I would expect you will see some of that as well in Q3 and Q4 as well.

Steve Bisgay

Well they should accelerate going into the second half. As the build out will expand, we’ll be hiring new talent and it will be a great story. First of all we are certainly not going to apologize for the 32% margins in this environment. I think almost every single competitor on the planet that we’re bang heads against everyday would be drawling over our Global Markets pre-tax margins and we are certainly not going to give anybody any sense that we’re going to dial back our expansion plans, because that’s how you grow. We have said many times, we are going to have much better results overtime.

We are not going to be in a linear fashion because we are going to grow for the future and our growth pattern will be bulk at times and it’s getting to be a little bulky looking into the second half of the year or at the start of the second quarter. So we are very proud of the margins and we’re proud of the expansion plan that we have and think that it’s just -- if all goes well for continuing to produce results moving right through the balance of ’08 and certainly into ’09.

Roger Freeman - Lehman Brothers

Yes, I’ll definitely get that on the total gross margins, just then, just lastly can you just talk to that increase in expenses this quarter because you said a penny of expenses this quarter. I think last quarter you had a penny and a half worth of expenses for some of the growth initiatives. So can you help us with that step-up and also just talk a little bit more about Europe if you can? There is a lot of change going on over there. There is three new MTS launching in September through November. How do you see yourselves positioned as an electronic execution provider there?

Tom Joyce

Sure, the expense side frankly we think the added expenses for our expansion over the second half of the year could impact, why we don’t ever give out guidance quite frankly the impact would be $0.05 or $0.10 per shareholders for the second half of the year. In terms of our position in Europe, we believe products like KnightLink will be incredibly popular over there. It’s expensive to execute across the European Continent. Different exchanges have different fees structures obviously, but it’s expensive to operate.

At some cases you get charged here to provide liquidity, they charge you assets liquidity, they charge you to cancel trade, they charge you to show up and we KnightLink because of its model, and how it interacts with flow and in fact that we charge our clients nothing, will be a very attractive model and we frankly have gotten some good feedback. Early days, we’ve gotten some good feedback from our clients in term of utilizing the offering.

Additionally, the retail space is one is that the automated models were developed here. We think we can help in terms of the best execution mandate that [inaudible] has in the retail space. So, KnightLink is the major focus going over there and KnightLink has been offering that we think will be well received because it’s a newish, a new offering in Europe. Servicing retail flow is certainly not new, but we think with our automated skills we can certainly add to the best execution story over there, which we believe like it does here will attract flow. The magnetic attraction of the best execution steps we believe would be transferable to the European client base.


Your next question comes from Rich Repetto - Sandler O'Neill.

Richard Repetto - Sandler O'Neill

You’ve talked about these new strategies and the new programs your writing and we saw the success with what we used to call ALP. Are they just an extension of ALP or are they something that’s just dramatically different, the new strategies we are talking about?

Tom Joyce

I’d said it’s both actually. Some are with ALP clients and some are with newly different source of liquidity. They were talking about several new models, so they don’t have a single profile. So it’s definitely new avenues of liquidity we’re pursuing as well as new ALP clients.

Richard Repetto - Sandler O'Neill

And then when you went through the growth or maturity of the ALP of KnightLink program, but at least you have broker-dealers. You saw a dramatic increase or a material increase in the, and I know we are not suppose to focus on revenue capture, but the point is overtime with these new programs, do you expect to see the same type of improvement on what you actually make on the flow?

Tom Joyce

No, some of these models. Well it depends on the model really. Some of these models are inherently going to produce very low revenue capture and by definition it will. Having said that at the margin they’re all very profitable, because it’s added and it’s leveraging the plant that’s already in place. With ALP clients that profile continues, when they are new they are less profitable, when they mature we get to know them better and you know the types of their flows better.

So the ALP story hasn’t changes as with the new models often haven’t completed the profile, and so you end-up with a blend that you’re affecting revenue capture on a blended basis. Several models of very high revenue capture, some of the new models with very low revenue capture. So that’s why the target moves so much, it’s hard to give out a static range. It’s too dynamic to get too focused on it and it will continue to be that way.

Richard Repetto - Sandler O'Neill

Giving us a little view on what the retail segment, it’s been surprisingly resilient channel checks. At least in July it show up and trading up in a very weak tape. I’m just trying to see whether the Europe flow validates it, this sequential increase in July and the resilience that we think there is?

Tom Joyce

It’s resilient but it’s not on model top by any strategy. There are certainly different segments. Our client trading obviously there is some of the more rapid fire and some of the professional traders are certainly as accurate as ever. A mom and pop we think has dialed back a little bit if you want to use that overworked phrase, but in general, yes, the volume flows are fairly consistently. I wouldn’t challenge your channel check. I think it’s what we’re seeing too.


Your next question comes from Niamh Alexander - KBW.

Niamh Alexander - Keefe Bruyette & Woods

Just on the international I’d like to go back to it if I may. You mentioned $0.05 to $0.10 T.J., is that for the full second half of the year. I assume it’s not per quarter, but more importantly the qualitative stuff as well. Help me understand is it entirely voice based business right now? Is there any electronic trading on the ground or is it a full rollout you have to do, rebuilding what you built in the U.S. and transporting it there?

Tom Joyce

You’re right Niamh, it is over the course of the second half, not on the quarter-by-quarter basis. That range on expense increases again over the second half. The business over there is currently very much oriented towards the voice business, as well as the traditional sales trader institutional relationship business. So, we have to port what we have here over there. Once again we are going to leverage what we already have, so it is going to be a much lower cost, let’s say building out or replicate of what we have here, because most of the stuff that we use here we can in a point of fact, redeploy over there.

There is certainly expenses associated with it not at least of which obviously we have a very well regarded and highly successful voice team over there. We don’t have a lot of quantitative types, so we got to go higher, again add to the talent base over there, but the number of additional folks will be lower that you might otherwise expect, because we can leverage what we have here, so the electronics business doesn’t really exist, it’s going to be build out, but it will be a more of a migrating what we kind of having in the U.S. over to there and the additional cost while not in significant, will not even remotely approach what would be if it was a total new built.

Niamh Alexander - Keefe Bruyette & Woods

Is there anyway you can help us get a sense of the revenue now or what you think the revenue opportunity is and the business is primarily institutional in Europe right now. Would it be starting from the scratch into the whole selling side of the business as well?

Tom Joyce

It would be a little bit of starting from scratching. Thankfully, because of the presence in general, we have relationships, but we certainly haven’t harvested the whole selling relationships as much as we would have liked to; we intend to going forward. So, some of the relationships we’ll be starting afresh, some of the relationships of course as you all know, all firms have a global footprints so relationships here will also be able to migrate. If we have a relationship with XYZ bounce backing from here, well that firm also have a longing presence and because we have a good relationship and a good track record here, it’s much easier to open up the dialogue with them over there.

So, while we are going to be starting a new business locally, we have a fairly high probability of while we know we are going to be able to migrate our skill set in U.S. over there and we have a fairly high probability of migrating our relationships in the U.S. over to there as well. So, while all new ventures are challenging until you can prove you’ve done it, we think because of the success here in the relationships we have that the probability of succeeding in Europe we believe is a lot higher than it would be again in a straight new build.

Niamh Alexander - Keefe Bruyette & Woods

Probably at this point in time now do you feel like you have gotten to a better place in the core institutional business in the U.S. that you brought on enough of the various different liquidity providers? You have the funding from the core operations?

Tom Joyce

The core operation in the U.S. thankfully is quite healthy and we continue to build on it, but we don’t think we are tapped out at any stretch. We certainly have had success in signing up some fairly large clients for KnightLink and you could say the obvious easy clients were spoken to in our emotion with those people, but that leaves a ton of other clients certainly and as we build new models there are new areas we can get into and talk to our clients about.

So, while the success in the U.S has been nice certainly we expect a lot more of it, but yes it does also provide us a little spring work before going into Europe year. The biggest thing about going to Europe is frankly mixed with focus in best execution and the encouragement of competing trade destinations. That’s a very big deal. Our model will look a lot better post message that it would have looked pre message, so I think our timing on all this is right and the fact that we have established relationships here that we can tap over there should order well.

Niamh Alexander - Keefe Bruyette & Woods

Deephaven, Steve if maybe you could just help me understand something. The quarter-on-quarter, the revenue is down, but the expenses were up an extra $4 million sequentially and is there like a minimum payout to the management team at Deephaven. Was there a catch up payment in the second quarter or is there something that we might need to consider for the full year for example, if we assume that the markets are challenging and there is no incentive fees accrued?

Steven Bisgay

The minority interest expense number was about 1.5 last quarter it’s down to a 1.1 and that represent the minimum payout requirement under the contracts of the Deephaven managers for one year. That number varies a little bit based upon how the guarantees are satisfied and some performance plays into that. Revenues are down about $1 million quarter-to-quarter, but the assets are come down slightly from $3.6 billion down to $3.4 billion and even more so if you factor out the effect of the European events or say the events on itself which we don’t get any benefits from there as well.

So, that’s a piece and with the incentive fees also the funds we’re only going to have revenues on the funds that are positive on a year-to-date basis. Overall expenses however are up about $3 million. The story is behind, competition is up as well as some other expenses but nothing materially, and nothing individually that’s significant.

Niamh Alexander - Keefe Bruyette & Woods

And just lastly on Deephaven. Is the event got fully worn down now or should we expect some residual in that?

Steve Bisgay

It is not fully worn down. The expectation is to wind it down by the end of this year and its being done under the plan. So it’s being done overly over the course of the year.

Niamh Alexander - Keefe Bruyette & Woods

So far, how much is left?

Tom Joyce

Because of the investors on the phone, it probably doesn’t make any sense for us to articulate what is originally left because that’s again the relationship between the repayment and their individual investors.


Your next question comes from Chris Allen - Bank of America Security.

Christopher Allen - Banc of America

I’m not understanding why compensation would be up in the Deephaven segment on a sequential basis when revenues and incentive fees are down; can you elaborate on that somewhat?

Steve Bisgay

Mostly guarantees.

Christopher Allen - Banc of America

From new hires or?

Steve Bisgay

No, we were just accrued over the course of the year.

Christopher Allen - Banc of America

Following up on Europe, you have obviously laid out on the expense side what was the going like over the second-half of the year, how should we think about it on the revenue side in terms of realizing a return on those investments from a timeframe perspective?

Tom Joyce

No revenue this year, starting to see revenues in ’09 for sure and thinking that, I believe it was about 2010 could be reasonably robust. Again we don’t breakout the revenues as the smaller parts of the organization, so I’m not going to tell you what our budget looks like, but we’re fairly confident ’09 and 2010 will produce some attractive results with attractive margins obviously, the lower revenue base since it’s a bit of a start-up.

Christopher Allen - Banc of America

If we touch a little bit on share repurchases obviously, have you closed the Libertas deal? If 340 million remaining are so under the reauthorization, under the authorization, can you give us some color in terms of how much capital flexibility you have in terms of implementing share repurchases and what the appetite is correctly?

Tom Joyce

We have a lot of flexibility in the appetite is we’re going to buy a fair amount of it particularly if it trades in a geological fashion today.


Your next question comes from Ken Worthington – JP Morgan.

Ken Worthington – JP Morgan

Steve, just on the balance sheet a couple of line items moved around. I was hoping for a little bit of an explanation. Security zone popped up quite a bit and then receivables from the broker-dealers fell a favorite more than usual. I don’t if they’re linked or not linked, but can you explain the changes there?

Steve Bisgay

I don’t think there was anything that was that unusual certainly from receivables prospective and the payables for the broker-dealer for some open trade activity. There is also some fair activity that occurs in Europe that does have the effective of grouping up our balance sheet, but I think the normal, the expectation that we see is that I would expect that the run rate and average dollar basis would be more in-line with between the 4.50 -- the 4.25 to 5.25 level. This just popped a little bit before the end of June, but I think it’s now back to where it should be around, around about 5, 5.25.

Ken Worthington – JP Morgan

T.J. I want to talk on Europe, a lot of expectations on method. Can you just maybe talk about how the trading environment in Europe has already evolved since method? Like I know it’s probably evolving quite quickly, but to what extent has trading behavior changed on both the buy-side and sell-side and so how much has actually already happened and how much is yet to come in the future?

Tom Joyce

I think what’s already happened is that you are seeing flows starting to fragment. There aren’t a lot of destinations yet, there’s some announced. There are certainly several out there like [Chaiex] already exists. So you’ve seen the beginnings of fragmentation. You’ve not seen quite yet the introduction of a bunch a new and different dark pools. I’m sure that all in the works, but right now the first story out of the gate is the one we expected and that is the commencing of the fragmenting of order flows over there.


Your next question comes from Mike Vinciquerra - BMO Capital Markets.

Michael Vinciquerra - BMO Capital Markets

I don’t want to look to stringently at one month, but when I look at just the statistics that you reported for June today, your NASDAQ market share was down actually a couple of hundred basis points if I have the numbers correctly. Was there anything strange about the trading during June that busted that again? I don’t want to put too much emphasis on one month, but it caught my eye.

Tom Joyce

Not really Mike, our channels such as our own client our market share has been fairly consistent. We certainly are doing more enlisted flows so I’m sure if the comparisons look a little unusual listed versus NASDAQ, but we continue to believe there would the obvious exception of the place E-Trade, which obviously we recapitalize last autumn with Citadel and we have a Most Favorite Nation agreement with Citadel and E-Trade now without an example like that, not withstanding we believe our market share has hung in there nicely if not gone up in NASDAQ frankly.

So, I am not sure what the detail is you are looking at, but we are pretty confident that our market share in NASDAQ is up if anything. Certainly our market share enlisted is up a fair amount, so I am not sure whether the balance looks unusual, but we feel pretty good about our market shares right now.

Michael Vinciquerra - BMO Capital Markets

On the retail side, with the growth in options trading and you having sold your market maker a couple of year’s ago, is that an area of opportunity or is that an area of maybe potential weakness in your offerings to the retail side because options have grown as a percentage of overall activity?

Tom Joyce

Right, I think our clients completely bifurcate their decisions on writing order flow between options and equity, so I don’t think it hurts us that we don’t have that offering. Having said that as you pointed out it looks like an opportunity, now that options are by-and-large going to decimals etc, that some of the market structure changes that we were anticipating have happened, we are certainly looking at that as an opportunity. I think people have asked me in the past about acquisitions. It would be highly unlikely if we ever did an acquisition in that space, but building the team from the ground up is something that has a certain appeal sure.

Michael Vinciquerra - BMO Capital Markets

When I look at your revenue capture the things that are excluded from revenue capture and they are starting to add up, I just want to run through them and make sure I got them right. BondPoint, Hotspot, Rich and Donaldson, London, DMA and now Libertas, is that correct?

Tom Joyce

That’s correct.

Michael Vinciquerra - BMO Capital Markets

And so, we are going to be looking at that revenue capture represents less than, it’s going to be well less than 70% of your total trading revenue and my thinking about that is correct as well?

Tom Joyce

I’m sorry not necessarily. When we say trading revenue those businesses that you referred to were principally AMC models, so they would be more on the commissions. In terms of getting more specific on our income statement that will be part of the commissions and fee line items rather than on the net trading revenue line item.

Michael Vinciquerra - BMO Capital Markets

Sure that’s not captured in the revenue capture number though that you reported there?

Steve Bisgay

That’s correct; those are outside of that was being core equity revenues in the calculation for revenue capture.

Tom Joyce

And this is an additional note, back to Roger’s question about trading revenue. As you can see in the release, our trading revenue was up $30 million second quarter of ‘08 versus second quarter of ’07, but it was down sequential quarters. Again the trading revenues are obviously while we say frequently we are much more volume volatility sensitive and market directionally sensitive.

We are still sensitive to all the dynamics in market, so like better trading environment in the first quarter clearly existed and clearly as reflected within our Data Trading revenue number in the first quarter, but don’t expect linear returns as much as we’d like to make it an easy pass business, it’s not, but as you see over periods of time the growth is notable and we believe it will continue, continue to be notable on the trading revenue side. Actually, I think speaking of questions I think I have only have time for one more.


Your last question comes form Daniel Harris - Goldman Sachs.

Daniel Harris - Goldman Sachs

I was wondering if you could just comment a little bit, the payment for order flow continues to decline pretty meaningfully, is that something that we should expect to continue going forward?

Tom Joyce

I wouldn’t say so. It continues to decline, some of it is as a percentage basis it will probably continue to decline, but in terms of an absolute number I don’t think it will change a whole lot. In point of fact it could go up if we do more business concerning counterparties that like payment for order flow, but as a percentage of overall revenues, as a percentage of trading revenue certainly we’d like to the percentage drop or we think the absolute number won’t change a whole lot; if anything depending upon the counterparty relationship we have it may tick up a little overtime.

Daniel Harris - Goldman Sachs

About the other revenues in Global Markets, they ticked down about 11% this quarter. It was only one business that was a little weaker or should that be something that we will look to go back up to what we saw in the first quarter as we look. I know you don’t give guidance but was there anything specific in this quarter?

Tom Joyce

Not really, the second quarter was certainly a general profile than the first quarter, so again it’s that issue about the linear mix of our business and that it is and it can get a little bulky at times, so there wasn’t anything note worthy to point out.

Tom Joyce

Well again, thank you all for part taking in today’s conference call. I really appreciate your question and answers and again we are very proud of the quarter we had and look forward to delivering many more good-to-great ones in the way forward. Thanks everybody. Have a great day.

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